Written By: Wei Cui

Posted On: January 30, 2020

In an earlier blog, I commented on a recent American Economic Journal article that studied China’s VAT reform in 2009. That study (Liu and Mao 2019) showed that China’s decision to remove a 17% tax on fixed asset purchases stimulated Chinese firms’ investment and productivity. A natural question to raise about the study is: What is the general significance of a finding about the success of China’s tax policy 10 years ago?

Consider the following critique. In the absence of extraordinary circumstances, it really does not make sense for any government to impose a very large tax on firm’s investments in equipment, etc. That China did it renders it an international outlier. Even if other countries wanted to stimulate firm investment and productivity growth, they would not have the policy option China had in 2009—because, most likely, they would never have had such an irrational tax in place to be eliminated.

To underscore this critique, one could note that a recent paper by Professor Juan Carlos Suarez Serrato from Duke University confirmed that the Chinese reform was “one of the largest tax incentives for investment in recent history”—across the world. (By the way, Professor Suarez may present his paper at the Tax Law and Policy Workshop at Allard Law in February.) According to Professor Suarez’s analysis, the 2009 tax cut in China offered a far larger investment stimulus, for any given firm to which it applied, than even the 2017 adoption of the Tax Cut and Jobs Act (TCJA) in the United States. (The TCJA had been perceived to be a veritable earthquake for corporate tax systems around the world.) To find an equivalent stimulus, Professor Suarez and co-authors considered a 17% investment tax credit: so generous a tax credit has not been made available to most U.S. businesses for decades.

I noted the apparent uniqueness of China’s 2009 VAT reform in a 2012 book chapter comparing China’s and European countries’ responses to the global financial crisis: “VAT reform constituted the most important tax policy action China took during the [GFC]. If China had had a more typical tax structure, this specific policy instrument…would not have been available. Conversely, because of the idiosyncrasies of China’s current tax structure, some of the policy measures commonly deployed in other countries also cannot be used.”

Indeed, there is another dimension to the uniqueness of the Chinese experience. Also in 2012, I was invited to talk about the need for tax reform on Radio China in Beijing, and I tried to explain how further VAT reform would enhance the efficiency of the economy. A fellow guest on the show, Professor Lin Shuanglin from PKU, asked me: “How fast do you want China to grow?” I didn’t have an answer, as the question clearly points to a puzzle: How could China have experienced such a high level of economic growth before 2009, under some very distortionary taxes? Which other country can grow for 30 years at breakneck speed, and then say, “OK, we’ve really been handicapping ourselves with high taxes, so let’s cut taxes a bit so that we can keep on growing”?

To be clear, from a pure research perspective, it is possible to give some answers to the question about the “external validity” of the Liu and Mao study. For example, in most U.S. states, and in Canadian provinces like British Columbia, sales taxes still apply to many business purchases and thus distort firms’ investment decisions. That is the most important argument for abolishing the Provincial Sales Tax and adopt the Harmonized Sales Tax, which functions like the VAT. Any such reform may have the same kind of stimulus effect as China’s VAT reform in 2009, even though the magnitude of the stimulus would be smaller. From another perspective, China continued to carry out further VAT reform between 2012 and 2016, converting the “business tax” to the VAT. That reform still reverberates through the Chinese economy. The policy outcomes of the 2009 reform certainly could help us to understand this later round of reform. If the concern about “external validity” arises only because Chinese taxation seems rather different from taxation systems in other countries, this concern should apply to much public economic research, e.g. many studies done on the U.S. tax system.

Nonetheless, for me, there is indeed something special about China’s 2009 VAT reform that does not revolve around its lacking counterparts in other countries. Instead, reading Liu and Mao 2019, I had the feeling of reading about a bygone era.

In 2009, the Chinese government’s tax policy slogan was “structural tax reduction”. This phrase connoted two ideas. First, in the government view (and the view of international public finance experts), the overall level of taxation in China at that time was not high. There was indeed room for further raising revenue, in order to fund more public goods and services. Second, at the same time, inefficient features of the existing tax system can be reformed, and often this can be implemented through cutting or eliminating outdated taxes.

This technocratic view of tax policy is generally shared by tax policymakers in Western democracies. In Canada, the United States, and many other countries, the phrase “tax reform” embodied the same orientation—improving tax systems but all the while sustaining welfare states that looked after the well-being of all citizens. In 2009, in other words, China was moving in the direction of the Western world.

In the past decade, however, the Chinese government has gradually surrendered the assumption of the legitimacy of taxation. More and more, taxes are portrayed from two perspectives. One is that taxes are a burden on workers and firms, and the burden needs to be reduced. The other is that the government should gain legitimacy by cutting taxes. In early 2019, the State Council introduced the idea of “inclusive” tax cuts, embracing the idea that the more people get tax cuts, the better.

This is an extraordinary transformation. It should also look very surprising. While China is surely a lot richer today than a decade ago, the amount of public goods and services delivered by the government is still nothing compared to most advanced economies. The general level of taxation also has not risen. How is it that the Chinese people have lost interest in public goods, and are only interested in keeping more cash in their own pockets?

This question, of course, is beyond the scope of standard tax policy research. To my knowledge, it has also been completely ignored by Western China observers. While the frenzy of tax cuts in China generates much opportunity for empirical economic research, the underlying political forces seem to me to deserve much greater attention than they have received so far.

Follow