Download Evolving Tax Structures: India vs. China

Taxes and Development:
India vs. China
Roger Gordon
UCSD
Taxes and Economic Growth:
India vs. China
• What is the role of tax structure in economic
growth in India?
• Evolution of tax structures remarkably similar to
that in China
• Surprising given very different political systems
• Objective of presentation
– Lay out similar development of tax structures during
the reforms in the two countries
– Suggest a story to explain the observed interplay
between taxes and economic reforms
Pre-reform Economies Very
Similar
• Initial per capita GDP:
– China
– India
$175 in 1979
$215 in 1991
• Dominant role for SOE’s in both countries,
with a particular focus on heavy industry
• Allocation decisions subject to direct
government controls
• Minimal international trade or FDI
• Tax system had little allocative role
Initial Reforms
• Relax government licensing restrictions
and other direct controls
• Relax controls over allocation of credit
• Cut tariff rates and nontariff barriers
• Relax controls over exchange rate and
FDI
• Outcome after 14 years of reform:
– China: GDP pc grew from $175 to $536
– India: GDP pc grew from $215 to $548
National taxes at beginning of
reforms
CHINA
INDIA
Corporate Tax
55% rate
50% to 55% rate
Excise Taxes
High and variable
rates
High and variable
rates
High Tax Rates on a Narrow Base
• Revenue only from SOE’s in China
• Mainly from large industrial firms in India
– Excise taxes confined to manufacturing
– Yet manufacturing only 16% of GDP (1991)
– 67% of corporate tax from manufacturing
– 40% of revenue from SOE’s
Policies Used to Protect
Narrow Tax Base
• Protect heavy industry with tariffs. In India,
average effective rate was 75% in 1990 (though
reforms cut it to 15% at present)
• Provide cheap credit to highly-taxed firms
• Restrict hiring and firing of workers in SOE’s
• Direct controls on entry and investment in other
sectors – “license, permit, quota Raj”
• Highly taxed industries plausibly larger, rather
than smaller on net, due to tax distortions
Reforms Relax Controls
• When relax controls, resources (and accounting
profits) shift to low-taxed sectors
• Major drop in the role of SOE’s, from 68% of
paid-in capital in 1992 to 28% in 2002
• Drop in size of heavy industry, e.g. capital good
production falls from 25% to 7% of GDP
• Expansion in size of (lightly taxed) service sector
• Given large tax distortions, reallocation not
necessarily an efficiency gain
Resulting Fall in Tax Revenue
• In China,
– corporate tax revenue fell from 7.8% of GDP in 1985
to 1.5% in 1993
– Total nontariff revenue fell from 20.5% to 11.5%
• In India,
– excise tax revenue fell from roughly 8.4% of GDP in
1991 to 7.7% by 2004
– But corporate revenue increased from 0.9% to 2.3%
– nontariff revenue up from 12.0% to 13.4% of GDP
• Likely reason for difference is improved tax
enforcement in India
Further Economic Reform
Requires Tax Reform
• With relaxed controls, narrow tax base
creates major distortions
• Either limit relaxation of controls to
preserve some tax revenue and to limit
misallocations, or undertake major tax
reform
• China did try a retrenchment in 1988-91,
but political and economic costs too high
Both Countries Undertook a Major
Tax Reform
• After 15 years of reform, both countries
largely replaced excise taxes with a VAT
– 17% rate in China
– 16% rate in India
• Both countries broadened the tax base for
indirect taxes
– China imposed national taxes on non-SOE’s
– India expanding excise tax base to include
services and wholesale sector
• Both countries cut the corporate tax rate to 33%
• Growing importance of personal income tax in
both countries, capturing some income from
informal sector
• But while easy to cut rate on heavy industry,
hard to increase effective tax rate elsewhere
• Revenue in China fell further, from 12.3% in
1993 to 10.1% in 1996
• With improvements in enforcement, though,
revenue later grew to 17.7% in 2004
Tax Structure Now More
Compatible with a Market Economy
• Firms now face closer to neutral tax incentives in
allocation decisions
• With revenue largely unaffected by allocation,
government finally has a fiscal incentive to fully
support pro-market policies
• In China, reforms followed by rapid and
consistent economic growth
• In India, a concern that national revenue still
comes largely from manufacturing, plus some
from service sector
Taxation by State and Local
Governments
• If only firms mobile, incentives neutral if collect
same taxes per resident, regardless of which
firms enter
• Effective tax rates varied dramatically by type of
firm
– In China, tax on profits and sales of local firms
– In India, excise taxes at variable rates on local firms
– Agriculture and service sector very lightly taxed
Tax Competition
• Incentive to protect heavily taxed firms
from competition from other locations
• In China, local governments encouraged
entry in heavily taxed industries by
providing valuable inputs and cheap credit
• In India, tax competition undermines
revenue collection
Implications of Low Tax Revenue
• Poor quality of public utilities immediately
threatens further growth
• Poor quality education and health care
undermines longer run growth
– Average education is only two years
– Only 35% of age group enrolled in secondary
school
– One third of children have low birth weight
What to Do?
• Hope tax revenue improves
– China’s revenue has indeed improved gradually,
growing from a low of 10.1% of GDP to 17.7% now
– But the economic costs of waiting can be very high
• Borrow against future tax revenue. But current
deficits already 10.3% of GDP
• Increased use of user fees, perhaps with private
provision?
– Key response in China, particularly for roads,
education, health, telecom
– Problem that poor may do without. Use available
budget to subsidize purchase by the poor?
Is problem low revenue or poor
incentives to provide services?
• Funding for state governments not THAT low
– State revenue plus transfers in India in 2002 was
9.7% of GDP
– S&L current expenditures in U.S. were 12.9% of GDP
– But current figure for China is 13% of GDP, yet
problems remain severe there
• Incentives to provide services seem poor
– Voice: Key difference from China. But provides weak
oversight
– Exit: But mobility across States low due to language
and cultural differences
How can Incentives be Improved?
• Note that incentives high if have user fees
• Shift funding (and expenditure responsibility) to
panchayats, where mobility pressures are
greater
• Tie intergovernmental transfers to population (or
# of school kids), providing an incentive to
compete to attract residents
• Break down barriers to mobility
– Ease restrictions on rental markets
– Ease taxes and restrictions on land sales
Why is Deficit so High in India?
• Some debt appropriate if tax revenue will
increase in future
• National deficit: Response to rapid turnover of
party in power? China vs. India or U.S.
• State and local deficits: Soft budget constraint?
– Parallel problems in China
– No cases of fiscal bankruptcies
– Intergovernmental grants cover any shortfalls,
creating incentives to have high debt or poor
infrastructure
What is to be Done?
• Shift to fiscal transfers based more on
formulas, e.g. population
• Restrict use of debt by S&L governments
to capital projects, perhaps with
repayment limited to resulting revenues, a
third reason to have user fees
• Set up clearer legal rules to handle
defaults on debts of state and local
governments
Broader Story about
Reform Process
• Pre-reform, controls essential to protect narrow tax base
• Reforms relax controls, improving incentives for firms,
but undermining tax revenue
• Pressures force move towards a more neutral tax
structure
• Incentives on firms and government improve, but
revenue likely falls further in short-term
• Can reform policies survive the resulting fiscal
pressures?
– Risk that poor infrastructure undermines growth
– Risk of default on debt
– Risk of a populist government undoing reforms