VAT And China’s Other Taxing Problems

CHINA STARTED TO replace its Business Tax with a value-added tax (VAT) in 2012 when a pilot scheme was launched in Shanghai. VAT has since been steadily expanded, both geographically and sectorally.

Earlier this month, following an executive meeting of the State Council, chaired by Prime Minister Li Keqiang, plans were announced for streamlining the administration of VAT and acknowledging that it has become a universal national tax.

The service sector first saw the tax in May last year when it was applied to property, financial and consumer services sectors. At the same time, VAT was extended fully nationwide.

Authorities say that between then and June, the switch to VAT has saved businesses 85 billion yuan ($12.8 billion) in taxes, providing an important boost to the ‘rebalancing’ of the economy towards consumption. Total tax savings since the pilot scheme started is put at 1.6 trillion yuan.

In July, the four VAT brackets (17%, 13%, 11% and 6%) were reduced to three with the elimination of the 13% bracket. Agricultural products, tap water, publications and several other ‘13%’ goods were moved down to the 11% bracket, though that still leaves more VAT tiers than the international average.

The new plans foresee digitization of the tax system, simplifying procedures for tax filing and switching from physical to electronic versions of the invoices-cum-receipts (fapiao) that serve as legal proof of purchase for goods and services. Fapiao are a key component of enforced compliance with China’s tax law as they compel companies to pay tax in advance on future sales.

The VAT fapiao is also used for tax deduction purposes within VAT, so digitising the whole process should streamline the accounting.

The tax is still referred to as “the VAT reform pilot program” though that status as a pilot looks like ending de jure as well as de facto; the State Council executive meeting also indicated that more detailed national VAT legislation would be forthcoming.

There is more work to be done on standardising it as a national tax. There are still inconsistencies between sectors in the rates applied to the same goods and services. Also, some tax payers are not able to make full VAT deductions. A further issue to address is compliance costs for taxpayers with multiple business locations.

One major issue that a national VAT does not address is how the tax take is shared at the provincial level. (Germany and Japan, for example, use allocation rules based on population and aggregate consumption, respectively.)

However, China has a bigger problem of fiscal redistribution to tackle. The country has the largest share of local government spending in the world, largely because public services and the social safety net (health, education, welfare, etc.) are centrally mandated but delivered and paid for at the local level. Many federal countries decentralise their social insurance system, but China is a rarity in having both its public pension system and unemployment insurance managed at the local level.

Yet, since the fiscal reforms of 1994, provinces and municipalities have negligible revenue raising powers of their own. Further, although 60% of taxes are collected by local government, those taxes are handed over to central government with some to be returned via revenue-sharing and other transfer schemes through rules that are still not completely transparent.

Transfers from the central government were supposed fully to finance local-government deficits since provinces and municipalities were barred from issuing debt.  In practice, however, local governments were given increasingly large unfunded mandates. Because of the prohibition on issuing debt, they resorted to selling land and using off-budget special-purpose vehicles to borrow and spend on infrastructure, starting the infamous local-government debt bomb ticking.

Local governments debt had reached the equivalent of around 40% of GDP by 2015.

A fiscal reform plan was announced in 2016 to address the misalignment, but it will take a comprehensive imposition of taxes such a market-value-based property tax, local surcharges to personal income tax and maybe even an additional provincial-level VAT — though that is difficult technically to administer; few if any countries have pulled it off.

It will also mean converting the pilot scheme for issuing and trading municipal debt started in 2014 when back door borrowing through special-purpose vehicles was banned, into a national muni-bond market. That, in turn, will require broader financial-system reforms.

Those are proceeding at a cautious, measured pace. Short-term stability and state-centric control is the current leadership’s instinctive approach. That may change after the forthcoming Party congress, but, more likely, it will not. In that context, streamlining VAT to puts greater taxation capacity in Beijing’s hands makes political as well as economic sense.

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US Imposes More North Korea Sanctions On Chinese Firms

THE UNITED STATES has given another turn to the financial-sanctions screw it is driving into North Korea. The US Treasury has added six Chinese and Russian individuals and ten organisations with financial ties to Pyongyang’s weapons program to its list of entities banned from conducting business with U.S.-linked companies and individuals.

Most notable among the latest additions is Mingzheng International Trading Ltd, which Washington considers a front company for North Korea’s state-run Foreign Trade Bank, which itself has been subject to American sanctions since 2013. In June, the US Department of Justice filed suit against Mingzheng for laundering money on behalf of blacklisted North Korean entities, seeking to seize $1.9 million of the firm’s funds.

These latest sanctions appear to target coal importers and agencies supplying North Korean labour to foreign countries in its continuing attempt to sever Pyongyang’s supply lines of hard currency needed to fund its nuclear and missile programmes. In the same vein, the US had sanctioned Bank of Dandong, bank, along with Dalian Global Unity Shipping and two Chinese citizens, Sun Wei and Li Hong Ri, in June.

The United States charged that “at least 17%” of the $786m in customer transactions conducted through Bank of Dandong’s  US correspondent accounts from May 2012 to May 2015 involved “companies that have transacted with, or on behalf of, US and UN-sanctioned North Korean entities”.

The bank which is mainly owned by municipal agencies, is small in the order of banks; its assets were only $10.7 billion as of the end of 2016. A bond issuance prospectus last year revealed that the bank a 1% stake in Dandong Xinliu Group, a state-owned company engaged in trade with North Korea.

Unlike the UN sanctions recently announced, which required lengthy negotiations with Beijing, this latest round appears to have been imposed unilaterally by the United States, as evidenced by China’s reaction which was to say the Washington should “immediately correct its mistake”.

For his part, Kim Jong-un has ordered a step-up in the production of warheads and solid-fuel rocket engines for long-range ballistic missiles, taking some of the wind out of the sails of United States officials who have started to suggest that the possibility of a resumption of talks on a negotiated settlement might be appearing on the horizon.

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China’s Press On Academic Freedom

Cambridge University Press, a leading academic publisher whose China Quarterly is one of the leading English-language social science journals devoted to China has reversed its decision to comply with the demands of China’s censors to block sensitive content.

The university press had initially removed some 300 China Quarterly articles on politically sensitive topics from its website in China on the instruction of the media regulator on penalty of not being allowed to publish at all in China.  The press changed its mind following protests, including a petition published by academics from around the world, condemning restrictions on academic freedom of thought.

It was a dilemma that many foreign businesses have faced: the choice between being shut out of the Chinese market for refusing to comply with authorities’ controls of markets or suffer reputational risk outside China by knuckling under. In information markets, the reputational risk of complying with controls on freedom of expression is potentially a higher cost for an academic institution that it would be for a commercial technology or media company. Online content providers,

Chinese and foreign, have been a particular focus of the censors’ attention this year, as online content, previously more laxly regulated than offline media, has been brought under the same control regime as traditional print and broadcast media.

Tech groups and media companies have bowed to government demands to close down hundreds of mobile video platforms and promised to work more closely with state media. Under the new cyber security law that came into force on June 1, only those online content creators who have been issued with a media licence are permitted to upload videos featuring news or political commentary.

This has reinforced Chinese firms’ pre-emptive self-censorship, and more foreign firms to accept specific demands.

Beijing has to tread a careful line with foreign academic publishers. While censoring politically sensitive material is one thing — and social scientists in Chinese universities, once an important source of policy advice to government, have come under greater freedom of expression constraints since President Xi Jinping took over in 2012 — it is another cutting off the country’s scientists and technologists from the latest foreign academic research in those fields.

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China’s ‘Achilles’ Heel’ Of Debt

THE IMF’S LATEST Article 4 consultations report on China’s economy retraces some well-trodden ground. While edging up its projections for China’s growth projections, the Fund again underlines the growing risk from debt in the medium term.

Arguably this is the greatest macroeconomic risk that China faces and which the Fund says needs to be addressed now if sustainable growth is to be sustained. It summarises that risk in a supplementary note to the main report thus:

International experience would suggest that China’s credit growth is on a dangerous trajectory with increasing risks of disruptive adjustment and/or a marked growth slowdown.

Managing the debt issue is inseparable from rebalancing the economy, away from infrastructure investment and export-led growth to domestic consumption.

Progress in rebalancing, the Fund acknowledges, is being made, particularly in reducing industrial overcapacity. Borrowing by local governments is being made more transparent, and regulators have started to address financial sector risks.

The Fund, though, calls, as it has repeatedly done in the past, for the pace of reforms to accelerate, taking advantage of the relatively robust growth the economy is now enjoying.

Its check list of five action points will be familiar:

  • boost consumption by increasing social spending by the government and making the tax system more progressive;
  • increase the role of market forces by reducing implicit subsidies to state owned enterprises and opening up more to the private and foreign sectors;
  • deleverage the private sector by continuing the recent regulatory tightening in the financial sector and greater recognition of bad assets in the financial sector;
  • ensure macroeconomic sustainability by focusing more on the quality of growth and less on quantitative targets; and
  • improve policy frameworks so that the economy can be better managed.

The fund particularly recommends accelerating the reform of state owned enterprises by moving social functions away from them and opening their protected sectors to more private and foreign competition.

There will be a cost to that which will strain the financial system. Bankruptcies will rise with the elimination of blanket state guarantees and lenders that have made uncreditworthy loans will get into trouble. The political concern is that strain on the financial system turns into social stress.

IMF China reforms scorecard August 2017

As this Bystander has noted before, policymakers have been steadily if cautiously managing down the GDP growth rate for several years, mostly by reducing too high investment and too rapid credit growth. They have been less active in opening up replacement sources of growth, notably by opening up to the private sector.

The fund also lays great importance on the need to liberate private savings for consumption by increasing public spending on health, pensions and education, three areas in which its spending is well below the OECD average, and by increasing social transfers to the poor, who are disproportionately greater savers than the poor in other countries,

Again as this Bystander and many others have noted before, the longer China delays tackling the structural underpinning of its debt load, the longer resolving them will take and the greater the risk of not doing so becomes.

This is an opportune moment from an economic point of view to do so. Growth in the first half of the year was more robust than expected with both the global economy and financial conditions being benign. Domestically, the effects of cutting industrial capacity are starting to work through, bolstering profits and areas of the private sector where state-owned enterprises are largely absent, such as e-commerce are showing exemplary dynamism.

Also, balance-of-payments and exchange-rate management have been adept while some old-school fiscal stimulus six to nine months ago has also kicked in.

Markus Rodlauer, deputy director of the IMF’s Asia and Pacific Department, put it this way:

The situation at this point right now…should be used as an opportunity…to bear down and to buckle down and continue with this financial sector adjustment, which is really the Achilles’ heel now of the economy.

Once the 19th Party Congress due to be held in October or November is out of the way, and assuming it has not changed politics appreciably, that may happen more visibly.

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China Systematically Cracks Down On The Internet

IT IS EASY to assume that the Cyberspace Administration of China (CAC)’s investigations into three of the country’s leading social media platforms are just a tightening of censorship typically to be expected ahead of the forthcoming Party congress.

Tencent Holdings’ messaging app WeChat, Sina’s Twitter-like service Weibo, and Baidu’s communication forum Tieba face complaints that they have allowed their users to spread terror-related material, rumours and obscenities, breaches of the law that “endangered national security, public security and social order”.

But there is a more systematic effort to control information in play.

The new cybersecurity law that took effect on June 1 and of which the social media platforms have fallen foul as it makes online platforms responsible for the content they carry, is the third piece of recent legislation codifying China’s doctrine of cyber-sovereignty.  The National Security Law and the Anti-Terrorism Law, both passed in 2015, are the other two.

Collectively they form the basis of Beijing’s intended state control of the internet, which, in turn, is part of the greater crackdown on incipient dissent.

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China Walks The Line On North Korea

THE LIKELY PRICE of China’s support for the tough new sanctions on trade and investment that the United Nations has voted to impose on North Korea is that they do not include oil. That will mitigate the risk of economic collapse in North Korea that Beijing so fears will trigger a tidal wave of refugees into its north-east provinces and the breakdown of internal order in the northern half of the peninsular that could leave US or US-allied troops hard against its border.

Beijing is having to play a difficult game in keeping the Trump administration in Washington from reverting to unilateral military action to stop Pyongyang’s nuclear programme, with all the uncertain consequences that might bring. Our man at the UN sends word that Russia, presumably with China’s support, tried but failed to get the United States to avow military action.

At the same time, Beijing’s erstwhile ally in Pyongyang continues to see the benefits of being a nuclear-armed regime as far outweighing any economic pain it has to endure to get there. Regime survival rather than national well-being is its underlying priority.

In the end, as this Bystander has previously suggested, the rest of the world may have to accept a nuclear-armed North Korea and bring it into the arrangements the nuclear powers use to ensure such weapons are not deployed but remain deterrents.

However, Pyongyang still has a way to go in its nuclear arsenal before it can feels secure with deterrence. It may have an intercontinental ballistic missile that it can lob on the United States, but not yet the capability for that missile to deliver a targeted nuclear strike.

The United States is determined that Pyongyang’s nuclear programme be rolled back, so it does not reach that point. That does not seem something that Pyongyang will accept, as its still inflammatory rhetoric implies. Threats of engulfing the US in “an unimaginable sea of fire” will do little to mollify US President Donald Trump.

China has called on Pyongyang to halt its tests (in exchange for the suspension of large-scale U.S.-South Korean military drills), in a bid to lower the temperature and get the six-party talks going again. Much of the being-the-scenes activity at the ASEAN meeting now underway in Manila and where all the actors including North Korea will be present, will be to that end.

Footnote: The latest UN sanctions ban North Korean exports of coal, iron, iron ore, lead, lead ore and seafood. In November, the Security Council capped the North’s coal exports at $400 million annually. China, the largest buyer, suspended imports in February.

Reuters news agency quotes a U.N. diplomat as saying that the expected value of North Korea’s exports of iron and iron ore in 2017 was $251 million, with $113 million coming from lead and lead ore, and $295 million from seafood.

The latest available full year figures from trade data, for 2015, show North Korea’s exports of minerals and metals at $1.4 billion, accounting for 49.9% of exports. Seafood exports totalled $115 million.

The new sanctions also prohibit countries from hiring additional North Korean labourers working abroad, bans new joint ventures with North Korea and any new investment in current joint ventures.

In 2015, a UN human rights investigator estimated that Pyongyang had sent more than 50,000 people to work abroad, mainly in Russia and China, earning between $1.2 billion and $2.3 billion a year for the government.

Enforcement of the sanctions falls heavily on China, which buys 83% of North Korea’s exports.

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China’s Djibouti Base Raises The Flag

Satellite image taken in early 2017 showing location of Doraleh Multi-Purpose Port and construction of adjacent Chinese naval base. Picture credit: Google Maps.

THE PLA-NAVY formally opened its base in Djibouti this week, China’s first military base overseas — though Beijing prefers to call it support facilities. Symbolically, it raised the flag in Djibouti on the same day as the PLA’s 90th anniversary.

The base is next to the Doraleh Multi-purpose Port to the west of Djibouti City on the southern side of the Gulf of Tadjoura which opens out into the Gulf of Aden. The $420 million port was only formally opened in May and is still half-finished. The biggest Chinese port construction project in the region, it was built by China State Construction and Engineering Corp. (CSCEC). China Merchants Holdings International is a stakeholder in the port’s operations.

A base comprising an encampment adjacent to a Chinese-built commercial port is a model seen in the making in Gwadar in Pakistan and likely to be repeated in Sri Lanka, and perhaps elsewhere.

Bases operated by the US Navy and the Japanese Maritime Self-Defense Force are only a few kilometers to the southeast. The United States runs some of its most secret drone operations in the Middle East from its Camp Lemonnier base next to Djibouti’s international airport.

Map of Djibouti City showing location of Doraleh Mult-purpose Port adjacent to China's naval base and the US military's Camp Lemonnier.

China’s base has been under construction since early last year, at a reported cost of $590 million. It covers a little more than one-third of a square kilometer and can accommodate several thousand military personnel. Satellite imagery of a later date than Google’s seen above suggests hangar facilities for helicopters and a short runway have been built before berths.

However, there are no deepwater channels running to the base, so the neighboring port, which does have deepwater berths, one of which is reserved for the PLA-N, is going to have to be living up to its name.

China has taken a ten-year lease on the land for its naval base and is a major funder of the Djibouti government, footing the bill for at least $14 billion-worth of infrastructure from railways to ports, airports and water conduits.

The rent China is paying for its naval base is not publicly disclosed (our man with his nose in the sand reckons that it is $20 million a year), but the US pays $63 million a year under its 20-year lease on its base.

The debate over the extent to which the base represents power projection will only continue, though that power projection will likely be steady but incremental as Beijing practices at being a world power.

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