the middle kingdom runs dry: tax evasion in china

The Middle Kingdom Runs Dry: Tax Evasion in ChinaAuthor(s): William GambleSource: Foreign Affairs, Vol. 79, No. 6 (Nov. - Dec., 2000), pp. 16-20Published by: Council on Foreign RelationsStable URL: http://www.jstor.org/stable/20049964 .

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The Middle Kingdom Runs Dry

Tax Evasion in China

William Gamble

China watchers regularly warn that a raft

of well-known problems besets the Middle

Kingdom. These usual suspects include a

ballooning population, environmental

degradation, growing ethnic tensions, and uncomfortable relations with Chinas

neighbors. But the country has an even

more immediate problem that has until

now received far too little attention: Beijing can barely collect its taxes. At a time when

China s economic growth rate is slowing and its thirst for public funds is growing, this chronic inability to collect taxes

has all but crippled the government. And so far, all efforts to address the

problem have failed.

Throughout the 1990s, successive

crackdowns on tax evaders were launched

to little avail. Government income as a

share of gross domestic product (gdp)

continued to decline throughout the

decade, sinking to 12 percent in 1998 from 32 percent in 1978?a rate lower

than those of the world s most laissez

faire economic regimes. At the same

time, individual income as a proportion

of gdp increased from 49 to 61 percent.

Understanding Chinas desperate thirst for cash is not difficult. It owes in large part to the enormous losses regularly suffered by the noncompetitive state

owned enterprises (soes) that employ most

of the workers in urban China. These

hemorrhaging businesses must be bailed

out by loans from state banks that then

become insolvent themselves, requiring re

capitalization and extending the economic

crisis down the line. Workers laid offby those soes not kept on life support by the banks also require government support.

At the same time, Beijing is spending huge amounts on economic stimulus packages to prop up its gdp. The government also

keeps expanding defense budgets to com

pensate the armed forces for the recent loss

of their commercial businesses, which

Beijing stripped from them in an attempt to reduce the military s power.

Yet while expenses are increasing, Chinas government income has dwindled.

Beijing has tried to reverse this dangerous trend by improving the efficiency of its tax

system; the latest efforts to alleviate the

funding drought have included public

William Gamble is a lawyer and a principal in Emerging Market Strate

gies, a forecast and risk management firm specializing in the global marketplace.

[16]



The Middle Kingdom Runs Dry executions of tax evaders, upgraded

computer systems for the tax bureaucracy, intensified scrutiny of bank transactions,

and closure of many loopholes. These

measures may increase revenues somewhat, but because of the inefficiencies inherent

in a centrally planned economy, they will not stop the decline of government revenues relative to gdp.

Part of the problem lies with the modern

structure of China's government. In the

early stages of Chinas communist develop ment, economic, political, and legal power was concentrated in the government's

hands, and this seemed to work?at least

at first. But the overwhelming power of the

central government devolved over time to

local officials and, especially, to managers of large enterprises. These managers also

assumed the duties of landlord, mayor, fire

chief, and even school principal. These same local managers and govern

ment officials now collude for their own

personal interests, those of their enterprise or

industry, and those of their locality?but not those of Beijing. The result is that

Beijing gets an ever-decreasing share

of the tax pie, forcing it to rely on other

sources for revenue, such as the few state

owned firms that do earn profits?namely,

monopolies in industries such as telecom

munications. Years of tinkering have left a

tax system full of incentive schemes and

loopholes that benefit powerful vested

interests but offer no new means to collect

taxes from local authorities who protect tax

evading firms. Devolution of power from the center has, on the one hand, stimulated regional economic growth and

reform. But as local governments have

attained de facto control, they have seri

ously weakened Beijing s ability to achieve and sustain macroeconomic stability.

Moreover, the system now depends on the very corruption that makes tax

collection so difficult. Chinas inefficient

centrally planned goods-distribution system

requires collusion between managers of

state enterprises and lower officials to

resolve surpluses and shortages. This has

led to the formation of large networks

of informal contracts, swaps, reciprocal

relationships, and black markets, all of

which enrich the participating individuals but add little to government coffers.

Despite their negative side effects, however,

many of these arrangements are essential

for correcting the shortcomings in the state

economic system and for maintaining the

output of Chinas state enterprises. China s managers and government

officials, unchecked by legal restrictions,

political restraints, or market discipline, have thus become indispensable to the

economy. But they enjoy both the incen

tives and the means to corral large amounts

of public resources and have not hesitated

to take advantage of such opportunities. Local officials, for their parts, offer tax

concessions to managers while finding

ways to avoid sharing taxes with the

central government. This may help local

economies, but it only worsens the tax

drought in Beijing.

ENERGETIC AVOIDANCE

A glance at the sorry specifics of Chinas

tax system helps explain just why govern ment revenues are so low. The problems are

staggering. To begin with, 70 to 80 percent of Chinese citizens have had no dealings

with tax officials in their entire lives. For

more than 30 years, in fact?from 1948 to

1987?China had no income tax at all.

Today, although most urban wage earners have taxes automatically deducted

FOREIGN AFFAIRS- November / December 2000 [ 1J ]



William Gamble

from their monthly pay packets, a survey

of taxpayers in six cities showed that more

than 60 percent of them do not even

know what the tax threshold is (that is, the amount of income they have to earn

before they are required to pay taxes). And

if they did understand the system, few Chinese would be happy with it. Expenses are not deductible, and tax rates are not

adjusted to account for inflation and the

loss of subsidized social services formerly

provided to employees by local soes. The

withholding process is unpopular, and

various means?including payment by cash and bartering?are widely used to

avoid it. In fact, around 10 million of

Chinas 27 million self-employed business

people have not even registered to pay taxes in the first place. Mounting antago nism against the withholding system has

erupted in attacks on tax collectors and

tax bureaus and in hostile newspaper stories and editorials. Beijing is finding that merely passing

a law does not ensure

compliance, especially if the people do not see their interests served.

Oversight is also a problem. Tax

officials have enormous incentives to

accept bribes to help individuals or enter

prises avoid paying taxes. These officials

are part of the same government that is

trying to stop corruption. But there is no

independent agency on the local level to

supervise their work or act as a check on

venal activities. Quite the reverse: local

governments have incentives to ensure

that their main sources of revenue?local

enterprises?remain competitive by

avoiding any extra costs, including taxes.

Since evasion has been institutionalized,

complying with the tax code has become

more expensive than avoiding it. A citizen

who chooses to defy a tax officials extortion

and to simply pay according to the official tax code runs the risk of attracting ground less criticism and being fined, and has

little recourse for appeal.

SEDUCTIVE SIMPLICITY

In the United States, taxes are organized and codified through a

top-down process,

starting with statutes, then regulations and rulings, and then administrative and

court hearings. Applying American tax

law is an almost continuous process, one

concerned with accurately and fairly ascer

taining specific facts and then correctly

interpreting and applying the law to them.

The process is enmeshed with myriad other laws that define, refine, and elucidate

the system. Together, these laws provide a

uniform and fairly transparent process for

both taxpayers and tax collectors.

In contrast, China s new tax statutes

and regulations are both skimpy and

inflexible. They favor accountancy preci sion over legal finesse and mathematical

symbols over words. Their legal simplicity makes no distinctions between the sub

tleties of individual economic situations

and fails to account for the myriad trans

actions of a sophisticated market economy. There is no adequate system to fairly determine the facts; local officials simply use their (often arbitrary) discretion. A

one-size-fits-all system, Chinas tax code

virtually guarantees that its application will be exceptionally unfair, unpopular, and unworkable.

In China the government, local or

central, holds the power to tax whatever it

wants to whenever it wants to. In defining the categories subject to individual taxation,

the Chinese system includes a catchall

"other income" category, the meaning of

which remains open to interpretation by

[l8] FOREIGN AFFAIRS - Volume79No. 6



The Middle Kingdom Runs Dry the finance departments of the State

Council (Chinas cabinet). Exemptions are likewise approved by this same body.

Furthermore, the system includes only a standard deduction and provides

no

adjustments for individual situations.

Without specific deductions, both sides of a business transaction are often subjected to tax. Unsurprisingly,

a system with this

level of uncertainty lacks credibility. And the conditions are ripe for corruption.

Without consistency or an honest method

of fact-finding, it becomes safer and more

reliable to bribe local tax officials than to submit to the system.

Income tax in China provides less

than two percent of government tax rev

enue, as opposed to the one-third share it

contributes in major developed economies.

To make up the shortfall, Beijing relies instead on a regressive value-added tax

(vat) to produce more than half of its income. The vat is generally deemed

more efficient than an income tax because

it taxes consumption and encourages

saving. Furthermore, vats are easier to

collect, since they are paid by businesses, which are obviously fewer in number

than consumers, have a lot more money, and usually keep better records.

Yet despite its advantages, even the

vat is difficult to administer in China. A thriving market in fake invoices has

sprung up to circumvent the system. These documents are forged and resold

to companies who fill them out with

inflated figures that overstate the value

of inputs and thereby avoid the tax. This

practice continues today despite the exe

cution of people found to have used such

phony vat invoices to embezzle state

funds. Chinese businesses also manage to avoid paying vat by persuading tax

authorities that their products are worth

less than the raw materials used to make

them?often the case in inefficient state

owned enterprises.

UNINTENDED CONSEQUENCES

Placing their faith in technological solu

tions, Chinese officials are upgrading their computer systems and providing businesses with adding machines to record

revenues that can then be checked by the

tax authorities' computers. The problem with this process, however, lies in getting

people to actually use the new machines.

Making transactions even harder to

monitor is the fact that Chinas remains a

cash-based economy At least eight of

each ten transactions at major department stores in large cities are made in cash. In

the countryside, the proportion probably rises to nearly 100 percent. And the in

centive to use cash will only grow with

the introduction of more technology, as

people realize that their transactions are

being tracked. Meanwhile, giving people access to better technology may only result in more

sophisticated tax evasion.

As in the case of techonological im

provements, the structure of some of

the newer Chinese taxes may also have

unexpected detrimental effects. A tax

on interest earned on bank deposits is

prompting people to take their money out of banks. But Chinas four major banks are

technically insolvent, and the

last thing they need is a diminution of

their asset base. A similar problem exists

with a proposed social security tax on

employees and employers to go into indi

vidually owned accounts. Any money set

aside in such accounts would be wasted, for where would funds be invested?

Chinese government debt? Accounts in

FOREIGN AFFAIRS- November / December 2000 [ 19 ]



William Gamble

insolvent banks? Shares of money-losing soes? Speculative real estate? None of

these present very attractive alternatives.

The failure of banks to allocate funds

to more robust sectors of the economy?

which, unlike the soes, show potential for growth and trade in hard currency? also limits tax revenue. One of the more

energetic parts of the Chinese economy since the mid-1980s, for example, has

been the growing township enterprises that provided the state with 20 percent of its revenues in 1997. Unfortunately, the growth of these famous enterprises,

which are theoretically owned by various

townships and villages, has been steadily

slowing since 1993. Starved by the state

banks, their rate of growth has dropped from 65 percent in 1993 to 15.4 percent in

1997. As they continue to lose steam, so

will their ability to pay taxes.

The same problem exists with high

tech, high-growth manufacturers. For

example, Huawei, a telecommunications

equipment manufacturer, has seen its sales

double annually for the last four years. Yet

despite its success, the company has had

trouble getting a loan. At the same time,

notwithstanding efforts by Beijing to get banks to tighten up lending, loans to the

inefficient state sector grew by 16 percent in 1998. Tax-consuming sectors of the

economy therefore continue to receive

more than ample money, while tax

producing sectors are starved.

THE NEW MATH

With a budget deficit of only 1.8 percent of gdp and a total domestic debt of only 10 percent of gdp, Chinas inability to

collect taxes may not appear to be an

urgent problem. These figures take on a

new urgency, however, when considered

in light of the government s general failure

to raise money. Sixty percent of central

government revenues last year came from

the issuance of debt. Ofthat debt, 70.9

percent went to servicing and financing

redemption of other debts. China cannot

continue to service its debt for long by simply issuing more. It needs the cash that

would come with increased tax collections.

Some observers see relief coming from

the trade revenues and foreign investment

that will be generated by China s entrance

into the World Trade Organization (wto). But euphoria is tempered by foreign

misgivings over whether China can faith

fully implement the required concessions

and handle an influx of foreign competitors. Without the uniformity of law, the likeli

hood that the regulations of a supranational

body will be enforced throughout the coun

try is small, especially if they threaten the

SOES, the Communist Partys main power base. Private businesses remain insecure

and are unlikely ever to enjoy the inviolable

status accorded by China s constitution to

state-owned companies. In a truly law-based society, rules

deter narrow interest groups from stealing national resources from society as a whole.

Without the protection that such rules

provide, however, powerful individuals

and groups remain free to follow their

parasitic path and enrich themselves

while impoverishing the country. Such

is the case in China today. As long as

narrow but powerful interests continue

to obstruct the rule of law, the central

government will never be able to collect

taxes efficiently. And if taxes cannot be

collected, China s one-party government will fall deeper into debt. The economic

drought will spread, threatening stability within China, and potentially beyond.?

[2o] FOREIGN AFFAIRS Volume y 9 No. 6



the middle kingdom runs dry: tax evasion in china

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