Adding Value

May 1, 2016, was a turning point for four Chinese industries — construction, real estate, finance, and consumer services — as they bid farewell to the business tax system, marking the start of comprehensive reform of the country’s taxation system and the end of the 66-year-old business tax.

Contrasting business tax, which was simply levied on gross revenue, the value-added tax (VAT) applies only to new value created by a business after commodity production, circulation, or labor service, aiming to minimize repeated taxation and accelerate commerce by alleviating the tax burden on enterprises.

The idea of levying corporate tax upon added value emerged soon after World War I, when Carl von Siemens in Germany proposed a “reformatory corporate income tax” as a substitute for the multistage business tax. In 1954, the French government renamed its production tax “value added tax,” marking the formal implementation of the tax system, which proved successful in assuring steady growth of fiscal revenue, promoting commodity production and circulation, and enhancing international competition. Soon, it was extensively levied in countries around the world. Now, over 120 countries use it as one of their primary sources of revenue.

Today, China uses a multifaceted taxation system combining turnover taxes, income taxes, and resource taxes with a tax distribution system featuring level-to-level administration from the Central Government down to local governments. In 1994, the country introduced the VAT to its manufacturing industry, but not for the service sector.

That has caused a huge problem: VAT could not be equally applied in the manu- facturing industry and the service sector. A reform project aiming to transform business tax to VAT was launched on January 1, 2012, in Shanghai, a pace car for the country and the first to replace the business tax with VAT in sectors of transportation and modern services. Ten pilot provinces followed. In 2014, the VAT was expanded to cover railway transportation, postal services, and telecommunications. On May 1, 2016, the last four segments, construction, real estate, finance, and consumer services, were added.

Apparently, the reform has produced fruitful results in just a short period of time. Incomplete statistics show that from the pilot year of 2012 to the end of 2015, the new policy saved businesses a total of 500 billion yuan in taxes. In 2016, the figure will approach 600 billion yuan. Data shows that the claim that the shift from business tax to VAT “guarantees all industries tax breaks rather than hikes” is not just a slogan. The reform has practically reduced tax burdens and simplified tax payment.

Still, during its comprehensive launch, every stakeholder had big expectations, but a problem emerged.

“The Central Government and local governments are facing a challenge in how to decentralize the power of taxation, which is a top issue for future reform,” notes Jiang Zhen, associate research fellow at the Research Center for Tax Revenue of the Institute of Finance and Trade Economics under the Chinese Academy of Social Sciences.

“For the current VAT, the split between the Central Government and local governments is 75 percent to 25 percent,” continues Jiang. “In the past, business tax belonged to the revenue of local governments. The replacement of business tax with VAT means that the two share VAT. The former system produced more local revenues. A big issue now is preventing local governments from exhausting their tax revenues.”

This issue has always plagued reform of the business tax into a VAT. During the early stage of pilot reform, proceeds from the newlyimplemented VAT in the pilot areas were eventually returned to the local governments rather than divided, to stabilize local fiscal revenue and mobilize the local government’s enthusiasm for reform.

As for lost local revenues due to VAT reform, Lou Jiwei, Minister of Finance, explained at a press conference during this year’s NPC and CPPCC sessions that after the reform, both the Central Government and local governments would suffer from some losses, which means that the government as a whole will lower taxes on enterprises.

Clearly, returning all revenues to local governments will only work for the early stage of pilot reform and won’t be sustainable for the long run. What will be the ultimate solution? As early as 2013, the Central Government placed the optimal proportions for VAT revenues high on their agenda, identifying the need to straighten out distribution between the central and local governments. Recently, some media outlets have been rallying around a figure of 50/50.

The plan is yet to be finalized, but one thing is certain: The introduction of the VAT will surely energize China’s reform of finance and tax systems as well as comprehensive reform of broader economic institutions.

The persisting question is how best to divide revenues between the central and local governments in a scientific, sustainable way.