New Tax Law in China: Implications

On March 16, China enacted a sweeping new tax law , bringing foreign-invested enterprises (FIE’s) more in line with domestic firms.

As some readers may know, I have complained about various kinds of arbitrage that China offers: tax, labor, and environmental. Prior to the law, domestic firms were at distinct disadvantage vis-à-vis foreign firms. Domestic firms were taxed at 25-30%, whereas foreign firms were taxed at 15%. In some cased, foreign firms enjoyed no taxation. Tax, together with environmental and labor arbitrage, enticed many western firms to relocate to China, putting pressure on western countries to lower tax rates and wages and environmental regulations.

Below are some highlights of the new law:

• One standard rate of 25% for both indigenous and foreign firms
• Foreign firms presently taxed at the lower rate are protected for five years, during which time their tax rates will slowly be adjusted to the new 25% rate.
• “State-encourage high and new technology enterprises established within special zones …may continue to transitional tax treatment.”
• “…enterprises that have yet to enjoy preferential treatment due to their failure to make any profits, the preferential treatment period shall commence from the year this Law becomes effective”
• New law effective January 1, 2008.

Commenting on the new law, the OECD observed:

• China will incur a revenue loss of 93 billion. Foreign firms will generate 41 billion more; domestic firms, 134 billion less.
• Round-tripping will decrease. Round-tripping occurs when Chinese capital goes abroad, sets up a bogus foreign firm, then sets up a “foreign firm” inside China. For a more exact and nuanced description, see here.
• Special Economic Zones will continue to enjoy preferential treatment, for they do not discriminate between foreign and domestic firms.
• Tax avoidance, including transfer pricing, will be discouraged.

Before commenting on the implications, let me point out that according to the OECD foreign firms paid 795 billion in all types of taxes, “representing 21.1% of total national tax revenue.” That, my friends, is a healthy sum. China uses that money, of course, to buy T-bills so that we can continue the consumption of goods our firms make in China–a delicious circle. In short, our debt (loss of taxes) and our wage loss (together with the multiplier effect) are part of the profits our companies are now enjoying. The stock market booms. There is a direct link between that “stock market boom” and our debt, both public and private. China is only part of the story. In many developing nations the story is the same.

Some implications:

• Because foreign firms account for almost 60% of China’s exports, expect some additional inflationary pressures in 2008, increasing thereafter during the transitional period as grandfathering expires. And what will the Fed do then?
• Expect also an increased rush to China on the part of firms wishing to be grandfathered.
• Expect no changes in SEZ’s. (Remember where the iPod comes from.)
• Expect China to continue to use taxes as a lure to new technology. Its climb up this ladder will continue. I would expect more and more research centers to leave the U.S. Taxes and proximity to manufacturing will lure them. China is intent on becoming a complete market—not merely an assembly plant. I have no quarrel with its motives; they are natural enough. I continue to have a beef with its labor and environmental standards, and I do have a beef with our mnc’s and our government that sees this entire process as a good one. Do we have a trade policy?
• I should add that Chinese attempts to change international standards vis-à-vis technology will continue to meet sturdy resistance, at least for a while. If and when this resistance melts, we will know we are in trouble.

How does the U.S. meet this challenge? Vouchers for education and health care? Reduce corporate taxes? Reduce labor standards in our own SEZ’s?

There is one OECD quotation in the above piece that hits the target: “for they [SEZ’s] do not discriminate between foreign and domestic firms.” That clause describes the heart of WTO. Now, consider, the iPod is made in a SEZ at .60/hour under sweatshop conditions. (See my April 15 post, “China’s Cheap labor: It’s part of the solution to our 65 trillion dollar debt” for a more complete description.) The WTO pays little heed to sweatshop brutalities precisely because those brutalities do not discriminate between foreign and domestic firms. The same logic holds true for environmental regulations.

What’s a person to do? Complain to your local WTO.

And please, no one tell me to visit the IFO. It’s useless. The WTO has all the cards.