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Will China's VAT reforms add value?

China's tax reforms, namely the full-scale implementation of Value-Added Tax and the introduction of a new cross-border E-Commerce Tax, have sent consumers and businesses into a flurry. Touted as the crown jewel of China's fiscal reform, officials hope that the overhaul of China's tax frameworks will help restructure and revive the stagnating economy.

What is the VAT reform and why is it important?

The VAT reform will replace all existing business and sales tax in all sectors with a new Value-Added Tax. On 1 May 2016, outstanding industries such as transport, postal services, telecommunications, construction, real estate, finance and consumer sectors will be incorporated under this new tax structure. Although analysts disagree over the overall impact on the Chinese economy, the effects of the VAT reform are manifold.

Introduced as part of economic restructuring and reforms meant to encourage innovation and growth in technology, e-commerce and services, the VAT part of China's 13th 5 Year Plan aimed at reducing bureaucracy and facilitating China’s shift away from a manufacturing-intensive to a service-oriented economy. As the world’s second largest economy, this move seeks to further integrate China into the international economy where China will join the ranks of 140 other economies with a VAT system.

Tax cut or hike?

Its difficult to compare tax rates between the old and new system because the tax base for business taxes is different from the tax base under a VAT system. For example, businesses under the old system were unable to claim credits for capital expenditure but will now be able to do so. Under the old framework, companies were required to pay both Business Tax and VAT. Business Tax is levied on the company's gross turnover, with no deductible provisions. As both taxes are mutually non-deductible, companies often ran the risk of double taxation.

Chinese officials estimate that the full-scale implementation of VAT will reduce tax revenue by an estimated 500 - 900 billion RMB. Officials hope these tax cuts will spur industrial restructuring, optimization, innovation and entrepreneurship. Tax breaks have also been granted on research and development to encourage companies to upgrade. Service oriented business will benefit while manufacturing-intensive firms such as real estate and construction companies will be subject to higher tax rates.

Not all that glitters is gold

While official news outlets were quick to point out benefits of lower tax rates under the new system, tax advisers and industry insiders such as Ernst and Young (EY) recommend caution. EY, in a report released before implementation, warned that that complex VAT rules and liability of activities could potentially impact costs and pricing strategy of businesses, not necessarily leading to cost reductions. Companies would also need time to restructure to take full-advantage of the new system and immediate economic benefits, if any, will not be visible.

Another potential ‘loser’ of this reform are provincial and local governments. Traditionally, a large proportion of local government revenue comprises of business ta. Under the new tax regime, VAT will be collected by the central government who will then disburse 'only' 25% of VAT receipts to local government. Despite the State Taxation Administration rolling out interim measures to help local governments tide across this transition, it is unclear if these measures are sufficient to make up the shortfall in revenue and what new sources of revenue local governments can tap on.

Considering that many of the target growth sectors only comprises a small part of national income while 'traditional' drivers of growth such as manufacturing and construction will be adversely affected, it remains to be seen if this new fiscal stimulus package in the form of VAT can deliver its promises of economic restructuring.




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