Beijing Bungles Corporate Tax Reform

China has one of the most archaic corporate tax systems in the world, from which the new value-added tax structure was supposed to provide much-needed relief.

China’s tax complexity and inconsistent enforcement has become an efficiency drain on China’s own economy and a roadblock to foreign companies wishing to set up business in China.

The country’s ongoing conversion from business tax to value-added tax (VAT)—which aimed to jumpstart corporate investments—has hit a snag. And after years of empty promises, top policymakers in Beijing finally gave indications that broad VAT tax reform to lower the overall corporate tax burden is on the way. Expectations for reform rose after tax policy statements leaked late last December following the Central Economic Work Conference, a policy-setting congregation of top central government and Communist Party officials.

Chinese media outlets cited these documents, which delineate plans to reduce VAT rates for several industries and contain designs and schematics aimed at reducing overall corporate taxes.

But it may be too little, too late. China’s corporate tax reform now faces a perfect storm of reduced business growth forecast and a slew of political and economic headwinds.

Streamlining VAT

Streamlining China’s VAT system has implications for domestic businesses and foreign businesses looking for a foothold in China.

While VAT is a foreign concept in the United States, it’s a popular direct tax system in most European and Asian countries. Under the VAT, a seller reduces the tax paid for its purchases from the tax it charges its customers. In effect, tax is levied only on the “value-added” component at each stage of production.

In practice, VAT differs greatly from the existing business tax, introduced in 2008 and levied on a company’s total sales without considering cost of inputs. Business tax creates double taxation issues, whereas VAT is imposed only on new value created by a company.

In 2012, China began phasing out corporate business tax and replacing it with VAT, with the goal of full implementation across all industries by 2015. The goal was to lower the overall tax burden of businesses and reduce the price of goods and services downstream for consumers.

China has VAT rates ranging from zero to 17 percent depending on the industry. Manufacturing was the first sector to implement VAT, and others followed. But as of early 2016, four national industries—financial services, construction, real estate, and consumer services—still have not been given the green light to begin implementation.

Mainland media suggested a full VAT would be unveiled for the real estate, construction, and consumer services sectors in the first quarter of 2016, but according to Caixin, a Chinese business publication, VAT for the financial services industry would be delayed due to complexities in calculation and enforcement.

For companies in the service industry, VAT would allow “input VAT credits” on operating costs not directly tied to raw materials, such as the purchase of machines, fuel, and other goods and services.

Revenue Reduction for the Party

In 2012, when China initially proposed the VAT program, it was estimated that the shift to VAT from business taxes would reduce nationwide tax collections by more than 900 billion yuan ($137 billion). Back then, the economy grew at a fast clip and both foreign and domestic investments flowed into the country. Because of the bigger tax base from a growing economy, the conversion to VAT was not expected to have a net revenue impact for the state.

But the plan was barely on track for a year before it went south.

Tax revenues came in smaller than planned each year since 2013 due to slower economic growth (and probably corruption). As a result, Beijing intentionally missed the 2015 deadline for full business tax to VAT conversion. The country lost 485 billion yuan ($74 billion) in tax revenue in the first half of 2015 while certain industries converted from business tax to VAT, according to the State Administration of Taxation.

In hindsight, China completely botched the VAT rollout. It should have pushed the new tax structure to the services and construction sectors first, which would have lowered their tax burden and stimulated investment. The service industries are exactly what Beijing wants to promote for future growth, while less efficient manufacturing and industrial sectors can adopt later.

A further complexity is that conversion to VAT pits local governments against the central government. Business taxes were a major revenue source for local governments. VAT funds, on the other hand, are shared between local and central governments.

Pain at small to medium-sized businesses—which generate more tax revenues at the local and provincial levels—has hurt tax collection for local and regional officials. And how to divide the VAT tax pool has become an increasingly contentious issue between local and central government authorities, one which could take months to resolve.

Today, the double whammy of lower tax revenues due to lower economic output and a smaller VAT tax base has caught Beijing flat-footed.

While the ever-important services sector awaits its VAT rollout, Beijing’s much-vaunted corporate tax reform so far has brought more questions than answers.