Taxes and Development: India vs. China

1. Taxes and Development:India vs. China Roger Gordon UCSD

2. 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

3. Pre-reform Economies Very Similar • Initial per capita GDP: • China $175 in 1979 • India $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

4. 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

5. National taxes at beginning of reforms

6. 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

7. Policies Used to ProtectNarrow 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

8. 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

9. 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

10. 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

11. 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

12. 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

13. 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

14. 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

15. 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

16. 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

17. 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?

18. 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

19. 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

20. 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

21. 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

22. 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