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China VAT reform stirs global risks

  • May 9, 2016 | Richard Asquith

China VAT reform stirs global risks

On 1 May 2016, China completed a four-year program to overhaul its antiquated VAT regime and replace its existing Business Tax on services. But the $77 billion tax cut is creating wider economic undercurrents nationally and globally.

The new VAT system will give a major boost to the country’s economic ambition to pivot away from investment and exports to a consumer-led economy. This is vital to helping prop-up the country’s flagging growth rates and avoid social unrest from unemployment.

However, the reforms are creating tensions between local and central governments after the division of tax proceeds was redrawn. This has forced local governments into unconventional fund raising measures, adding to China’s huge debt binge which is now endangering global growth.

Chinese VAT reform

Previously, China’s 17% VAT (for goods) and 5.5% Business Tax (for services) regimes led to complex compliance burdens and frequent double taxation on businesses. This encouraged a large proportion of companies to focus on VAT-exempt exports.

As global demand for Chinese goods has slowed in the past five years, and China’s GDP growth spluttered, the punitive indirect tax regime has come under scrutiny.

In 2012, a pilot in Shanghai fired the starting pistol on an overhaul, replacing the existing VAT and Business Taxes with a VAT based on the OECD’s model. This includes VAT being charged/offset at each stage of the production chain until the final consumer.

The pilot was a rapid success, and was accelerated across the country, sector-by-sector. The last industries – financial, consumer and real estate services – were included in the latest reform wave on 1 May 2016.

$77bn boost for manufactures and economy

The changes in the tax regime will cost the Chinese government an estimated $77 billion per annum. This will effectively be an economic stimulus for the country. This will be very welcome, especially amongst smaller enterprises.

Brewing political and economic problems

However, the VAT reforms have been causing strains between the central and local governments. The latter relied on the old Business Tax for up to 40% of their revenues. The proceeds from the reformed VAT are now split between central and local government, 75% and 25% respectively. Many of the richer states, such as Guangdong, stand to lose heavily.  However, this spilt should potentially by 50:50 according to pronouncement number 26 (2016) of the State Council.

These losses for states of indirect tax proceeds add to similar tax reforms over the past 20 years, all favoring the centre which has looked to finance its consolidation of control over the states. This has forced local governments to sell large tracks of land to support their expenditure. This in turn has partially fuelled a huge property price bubble – exasperated by the government opening up the credit taps to sustain waning growth.

Many states have also taken out off-balance sheet lending to fund the losses in indirect taxes. This has contributed to China’s debt doubling in the past ten years to 260% of GDP, a level that generally leads to a major economic crash.

Reforms with unwelcome consequences

China’s VAT reforms will certainly help the country prepare for life after 20 years of an export-led, high growth bonanza. But they have contributed to a brewing storm of internal political tensions and an bloated debt problem. There have been many predictions of a major meltdown in China as a result of these concerns. Whether or not this happens, the next ten years of China’s history will look a lot different to the last.

VP Global Indirect Tax
Richard Asquith
VP Global Indirect Tax Richard Asquith
Richard Asquith is VP Global Indirect Tax at Avalara, helping businesses understand their compliance obligations as they grow globally. He is part of the European leadership team which won International Tax Review's 2020 Tax Technology Firm of the Year. Richard trained as an accountant with KPMG in the UK, and went on to work in Hungary, Russia and France with EY.