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Book Excerpt: why personal income tax matters little in China
Wei Cui, Professor at the University of British Columbia, on how the economic elite in China hatched up a deal with the government to their own benefits
Professor Wei Cui joined the law faculty at the University of British Columbia in 2013. Before becoming a full-time academic, Wei practiced tax law for over 10 years in New York and Beijing. During 2009-2010, he was Senior Tax Counsel at the China Investment Corporation, China's largest sovereign fund. He has also served as a consultant to China’s National People’s Congress, the Ministry of Finance, and the State Administration of Taxation, as well as to the United Nations.
© Wei Cui 2022. All Rights Reserved.
Professor Cui’s new book, The Administrative Foundations of the Chinese Fiscal State, offers a novel, systematic, in-depth, yet concise analysis of the foundational institutions in Chinese taxation — how it quickly jettisoned the Western approach of self-assessment, audits, and the rule of law, and why it emphasizes monitoring of taxpayers and ex ante interventions, at the expense of deterrence and truthful reporting norms.
By taking on a critical perspective on Chinese law and taxation, this book reveals the lessons China’s successful revenue-raising effort holds for developing countries, and the reasons why mainstream economic theories must be revised to recognize fundamentally different types of state capacity, and the challenging questions the Chinese paradigm raises for the future of taxation.
'One of the foremost international tax scholars in the world, Cui Wei presents a fascinating yet largely unknown recent development in international fiscal policy: the extraordinary decision by China to implement its income tax system without relying on principles - the rule of law, and self-assessment by taxpayers - that are foundational elements of sound tax administration in most developed countries. Cui's highly readable, carefully researched, and balanced account is must-reading for those interested in understanding China's likely future place on the world stage.' George K. Yin, Distinguished Professor of Law and Taxation Emeritus, University of Virginia
'This book provides a fresh and informative account about how the Chinese tax system really works. Even those not specifically interested in China or taxation can learn much from this examination of the development of China's policy in this area. Wei Cui's book offers not only a novel approach to studying tax administration but also many useful lessons for anyone concerned with implementing public policy in any country. In policy analysis, the devil is usually found in the details: this is a rare study that not only delves into the relevant details but also carefully places them within the relevant context and shows how context shapes both policy and outcomes,' Richard M. Bird, Professor Emeritus of Economic Analysis and Policy, Rotman School of Management, University of Toronto
'Cui presents an engrossing story of the operation of the Chinese tax and fiscal systems. The rich empirical data, the refreshing perspective from which the subject matter is examined, and its novel arguments make a valuable contribution to the field. Readers familiar with taxation or Chinese legal systems will appreciate the author's mastery of his materials as well as his ability to identify key features from an array of discrete and complex information sources and to interpret those features in familiar terminologies to readers outside China.' Yan Xu, The China Quarterly
'In his [remarkable] book…Cui composes a detailed picture of an organized modern tax system that does not depend on rule of law. Yet the Chinese fiscal system is neither a dissolute mess nor a top-down exercise of discretionary power…This is more than a story about tax farming or crony Communism … Cui's observations are valuable and thought-provoking for the study of any jurisdiction's tax system.' Susan C. Morse, Florida Tax Review
'Cui's monograph is a must-read: it is carefully crafted, beautifully written, and absolutely fascinating.' Kim Brooks, Canadian Tax Journal
Moreover, on top of the generous exemptions and wide rate brackets, the 2018 PIT legislation introduced “additional special deductions” for high-income households, such as the mortgage interest expense and children’s education deductions. This means that rich Chinese families can send children to study abroad and claim a PIT deduction for a portion of the expense.
The personal income tax (PIT) plays a minor role in China’s tax system: its revenue pales not only against revenues from taxes on goods and services and the corporate income tax, but even in comparison with social insurance contributions—which can be seen as simply another set of taxes on wage income. By contrast, among OECD countries, the PIT generated 23.5% of tax revenue in 2016 on average. Yet, at the same time, the PIT plays an outsized role in the imagination of China’s affluent urban class: the rich in China talk about the PIT as though they live in a country where the PIT matters. Unfortunately, these two facts are not unrelated: the opposition to the PIT by China’s rich has been breathtakingly successful in undermining the tax during the last decade.
The PIT is typically a minor source of government revenue in developing countries. There are two standard explanations for this. First, since its initial adoption in industrialized countries in the early 20th century, the PIT has tended to generate most of its revenue from the taxation of wages, i.e., from employers’ withholding of the tax from paychecks written to employees. In many developing countries, the formal employment sector is small, and therefore the wages of formally employed workers yield a relatively small tax base. Moreover, perhaps because of their lack of capacity in making social transfers to the poor, poorer countries tend also to set their PIT exemptions high relative to the income distribution, so that a greater portion of the population is exempt from the PIT. Second, notwithstanding the possibility of a “flat tax,” it is often believed that the PIT must possess certain features—e.g. progressive tax rates, certain types of deductions, etc.—that make the tax administratively complex. Thus, low administrative capacities in developing countries further handicap revenue-raising through the PIT.
These standard explanations, however, are largely irrelevant for developments in China’s PIT in the last 25 years. China’s PIT revenue rapidly rose between 1994 and 2005 as percentages of total tax revenue, from 2% to over 7%. In a study completed in 2006, Thomas Piketty and Nancy Qian predicted that the PIT would become a “mass tax” in China, which would have major implications for the evolution of the country’s income inequality. Yet this prediction turned out to be wrong: China’s PIT languished after 2006, at around 6% of total tax revenue and 1% of GDP. The trend since 2006 clearly bears no relationship to the rising income of the Chinese people or the maturity of Chinese tax administration. Instead, China’s PIT began to follow a trajectory that Piketty and Qian had found for the PIT in India: it seems doomed to remain an “elite tax.”
Tax lawyers and accountants can attest to the fact that at least before 2018, the Chinese PIT was not unduly complex. While wage and business incomes are taxed at progressive rates, capital income is taxed at lower flat rates, implementing the type of “dual income tax” standardly recommended by international organizations. Even for business and self-employment income, simplified rules are extensively adopted. The administrability of the tax is further strengthened by extensive reliance on third-party withholding rather than individual self-declarations. Certain aspects of tax enforcement have also steadily improved in recent years. For example, a 20% PIT on capital gains realized by owners of private companies on the sale of their company shares represent a rapidly increasing source of PIT revenue due to better monitoring of such transactions.
The primary factor that explains the stagnant revenue contribution of the Chinese PIT since 2006 is the changing amount of monthly wage income that is exempt from the tax. In taxing wage income, the Chinese PIT imposes a progressive rate structure on monthly wage income above an exemption threshold. Between 1994 and 2006, this threshold was set at CNY 800. As urban wage income grew, more and more employees began to be subject to PIT withholding. Even so, the average PIT rate on wage income faced by urban households only increased from 1.1% to 3.1% from 1997 to 2005. In comparison, the general VAT rate was 17% throughout this period and most consumer services were subject to the Business Tax at 5%. Taxes on consumer expenditures thus bore much, much more heavily on the purchasing power of Chinese taxpayers than the PIT.
Nonetheless, the National People’s Congress (NPC) raised the PIT exemption threshold for wages to CNY 1,600 in 2006, and just 1 year later, to CNY 2,000. The result was that the lowest six deciles of wage earners in urban China paid nearly no PIT in 2008. Zhan et al 2019 showed that in 2007, the median individual wage income in an urban household lay below the CNY 19,200 amount that corresponded to the CNY 1,600 monthly exemption applicable that year. Xu et al 2013 calculates that in 2008, the lowest 6 deciles of urban earners of income contributed 5.4% of total PIT revenue—as compared with 4.4% in 1997 and 11.5% in 2005. Their calculation includes PIT revenue on all sources of income (e.g., sole proprietor business income, interests, etc.) and not just wages, and suggests that all of the PIT revenue gains from increasing urban wages before 2008 were wiped out by the lifting of the exemption threshold that year to CNY 2,000.
Notably, because the urban population was only 45% of China’s total population in 2007 but by far the richer, urban households already represented the richer half of Chinese people. Any further increase of the monthly exemption threshold would only benefit the richest 18% of Chinese individuals.
But that was exactly what the government chose to do. In 2011, Premier Wen Jiabao requested the NPC to raise the monthly exemption amount to CNY 3,500: within just 5 years, the exemption level increased by 337%. The Ministry of Finance estimated at the time that this reduced the number of PIT taxpayers from 28% of urban wage earners to 12%. (Using the urban household survey, Zhan et al 2019 confirmed that even in 2013, the median wage income was clearly below CNY 42,000—the annual amount exempted under the 2011 PIT change.) Moreover, the 2011 PIT change broadened rate brackets, such that even in 2013, less than 3% of urban wage earners faced marginal tax rates higher than 20%, and a vanishing portion faced marginal rates higher than 25%.
The 2011 legislative change to the PIT was devastating to PIT administration in China. Many cities lost almost all of their PIT revenue from wages. One city where I recently conducted research ranked in the top third decile of Chinese cities in per capita GDP terms in 2017 (its GDP per capita level was 117% of China’s national average). In that year, 86.1% out of all returns filed by wage withholding agents (i.e., employers) reported zero PIT remittable. In terms of individual wage earners reported on these withholding returns, only 36.4% had a positive PIT liability. This was after urban average wages increased 80% from 2011 to 2017! Because the PIT generates so little revenue, most local tax agencies cannot afford to invest in auditing individual taxpayers and compiling databases about them. Therefore, even the government itself has little information about individuals’ income.
In 2018, the Chinese government took this information-destroying tax policy further, and raised the monthly exemption again to CNY 5,000, corresponding to an annual amount of CNY 60,000. Only two provincial jurisdictions, Beijing and Shanghai, had average individual income above that level in that year. The 2018 PIT legislation also moved further up the rate brackets, so that one needed to earn CNY 204,000 a year (USD 32,380) to face even a 20% marginal tax rate. Moreover, on top of the generous exemptions and wide rate brackets, the 2018 PIT legislation introduced “additional special deductions” for high-income households, such as the mortgage interest expense and children’s education deductions. This means that rich Chinese families can send children to study abroad and claim a PIT deduction for a portion of the expense. Researchers have calculated that these special deductions may further remove 5% of the urban wage-earning population from the PIT tax base.
In summary, since 2008, China has steadily cut the PIT for the highest 10% or 5% of wage earners in the country. Contrary to observations from cross-country studies and studies of countries with long histories of PIT, China’s exemption from the PIT moved up—as opposed to down--the income distribution as China got richer in the last two decades. This has led to a dramatic reduction in the redistributive effect of the Chinese PIT.
The government’s repeated undercutting of the PIT since 2006 went against the preferences of bureaucrats in the Ministry of Finance and the State Administration of Taxation. How the rich in China has been so successful in persuading the decisionmakers in China’s State Council to enact the tax cuts is a puzzle. (Most scholars of public finance in China either offered faint praise for the tax cuts or remained silent, perhaps to avoid public derision for asserting that the PIT should remain higher.) One might speculate that two factors are likely relevant.
First, the regions that benefit most from the tax cuts are the rich cities hosting the highest wage earners—Shenzhen, Shanghai, Beijing, etc. These cities have engaged in tax competition for many years by handing (borderline-illegal) PIT tax breaks to bankers and entrepreneurs. They have also continuously sponsored a media mis-information campaign claiming that the low PIT rates in Hong Kong and Singapore are the international norm, and that China needs to cut its top marginal tax rates to be “internationally competitive.” One might thus conjecture that the State Council has been particularly influenced by these regions in making tax policy. Second, the Chinese government has tolerated public attacks on the PIT, as though complaints about taxation represent one subject where public dissent is permitted. The PIT thus appears to be a preferred way for China’s political leadership to cut deals with the country’s economic elite.
Professor Cui’s introduction to The Administrative Foundations of the Chinese Fiscal State has been published on Pekinology, in which he underlines the political paradigm behind “state-sponsored social ordering” in China. Click the link below to read the full article:
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