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Macroreview: Why Taxes Matter for Economic Growth

08-13 17:34 Caijing

A government policy that favors turnover taxes over other tax methods benefits fiscal coffers but dampens GDP growth.

By Shen Minggao

(Caijing.com.cn) To combat the recession, the Chinese government has decided to slash projected 2009 tax revenues by at least 500 billion yuan.

So far, the government has adjusted export tax rebate rates seven times and lowered taxes on real estate transactions, personal incomes and low-emission cars. It's also cut the securities transaction stamp tax, while raising taxes for tobacco products.     

Tax adjustment is a delicate process. How has China shaped its tax administration? And is there room for improvement?

A lot can be learned by carefully analyzing the nation's taxation process since 1999. One lesson is that the best way to achieve fast economic growth is to decrease personal income and value-added taxes.

China's rapid economic growth has been accompanied by a steady rise in fiscal revenues, including tax and fee receipts. Tax revenues rose to 4.56 trillion yuan in 2007 from 1.07 trillion yuan in 1999. The inflation-adjusted average growth rate for tax revenues was 16.2 percent during that period, much higher than the average gross domestic product (GDP) growth rate of 9.8 percent.

The ratio of tax revenues to GDP rose to 18.3 percent in 2007 from 11.9 percent in 1999, with the average annual increase at 0.8 percentage points. In 2001 and '07, the increases were respectively 1.3 and 1.8 percentage points.

The United Nations in 2000 upwardly adjusted what it called an optimal ratio of tax revenues to GDP for a developing economy to 22 percent from 18 percent. Meanwhile, according to economic theory and empirical analysis, the optimal ratio in developed countries is about 30 percent.

China's ratio seems low according to the UN standard. But Chinese fiscal revenues are greater than its tax revenues, as various income sources such as land fees are not counted as tax revenues. If all taxes and fees were considered, China's ratio would be 27.2 percent in 2007 -- much higher than the UN optimum for a developing economy. Comparable ratios are 13 percent India, 20.5 percent in Mexico, 29 percent in Russia, and 35.3 percent in Brazil.

Compared with Organisation of Economic Co-operation and Development (OECD) countries, a greater percentage of Chinese government revenues come from turnover taxes on goods and services, including value-added tax, than income taxes. Personal income tax rates are lower and corporate income tax rates higher in China compared with those in OECD nations.

Taxes related to products and services in OECD countries accounted for 32 percent of total tax revenues in 2005. But in China, the amount in this tax category comprised more than 70 percent of government revenues. In this way, China's tax system is similar to Brazil's.

Corporate income taxes accounted for about 10 percent of total tax revenues in OECD countries but nearly 20 percent in China. Personal income taxes, salary taxes and social security insurance fees contributed 50 percent of government revenues in OECD countries, but only 10 percent in China.

Income taxes are levied directly on laborers and capital, dampening private sector enthusiasm to expand production. These taxes also can narrow the gap between rich and poor, outstripping any negative effects tied to higher costs for individuals, enterprises and governments.

Sales, value-added and business taxes have fewer negative effects on production than income taxes. Sales and value-added tax rates are often higher when levied on expensive goods. Furthermore, it is harder to hide affected business transactions from tax authorities, so collection costs for turnover taxes are lower than they are for personal income taxes.

Value-added taxes, including those levied on imported goods, accounted for 58 percent of China's 2008 fiscal revenues, while corporate income taxes accounted for 34 percent and land fees 8 percent. Put another way, the combination of personal income taxes, corporate income taxes, value-added taxes and business taxes accounted for more than 60 percent of total tax revenues in 2008.

Property taxes, land fees and inheritance taxes are widely viewed as the least detrimental to economic growth but most effective for redistributing wealth.
A look at the relationship between tax revenues and economic growth in China reveals that the 1999-2007 rise in fiscal revenues caused a decline in economic growth. Every increase of 1 percent in fiscal revenue shaved 0.045 percent from China's GDP growth rate.

As we find in many countries around the world, the negative impact of private sector taxation in China has outpaced the benefits financed through government revenues spent on services such as public order and social programs.

Hiking a corporate income tax rate is not as hard on an economy as increasing a personal income tax rate. If the ratio of corporate income taxes to total revenues increases 1 percent, GDP will increase 0.61 percent. But if the ratio of personal income taxes to total revenues goes up 1 percent, GDP will fall 0.63 percent.

An increase in the business tax rate accompanied by a decrease in the value-added tax rate would be a move conducive to economic growth. If total revenues remain unchanged and the business tax rate rises 1 percentage point, while the value-added tax is reduced the same amount, GDP will grow 0.75 percent. But the opposite will drive down GDP by 0.63 percent.

Clearly, tax policy has a direct affect on economic growth. China's policymakers should weigh this fact carefully.

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