China eyes shift in VAT regime to boost investment

Under the current ‘production-based’ VAT regime, firms may not deduct from their VAT bills the tax incurred when they buy machinery and other capital assets. If China switches to ‘consumption-based’ VAT, which is how it is levied in most other countries that have the tax, companies would be able to do so.

‘I think it's quite right for the government to launch the VAT shift nationwide now, especially as the risk of the economy overheating has faded,’ said Jia Kang, a senior researcher at the Institute of Fiscal Science, a Ministry of Finance think tank.

The ministry said this month it was actively working on a plan to roll out such a reform across China after pilot programmes in a handful of provinces.

The government has long debated reforming the basis for VAT, which accounts for about half of all its tax revenue, but Jia said economic conditions meant the time could now be ripe.

‘Officials and researchers from the top down in fiscal circles all believe the new VAT system should be put in place as soon as possible,’ he said. ‘It could encourage companies to invest more, which would give the economy a fairly good boost.’

The expected tax tweak is just one of a slew of measures that analysts say the government is considering to prevent an excessive slowdown in growth, which dropped to 10.1 percent in the second quarter from 11.9 percent in all of 2007.

China has already loosened banks' lending quotas, let banks go much easier in lending to small firms and increased export tax rebates for textile manufacturers.

JPMorgan Chase said on Tuesday that Beijing was looking at a stimulus package worth 200-400 billion yuan ($29-58 billion).

In an Aug. 14 report, Medley Global Advisors said top policy makers had agreed to 150 billion yuan in tax cuts and extra spending of 220 billion yuan. The total package, worth nearly 1.4 percent of GDP, was aimed at keeping the economy growing at around 10 percent in the second half of 2008, the report said.

A spokesman for Medley Global Advisors said the company does not comment on proprietary reports for its clients.

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China started experimenting with consumption-based VAT in its northeastern rustbelt in 2004, a decade after it first introduced the tax.

It expanded the trial this month to some cities in Sichuan, Gansu and Shaanxi, which were struck by an earthquake on May 12 that killed 70,000 people and devastated swathes of the economy.

Xing Ziqiang, a senior analyst at CICC Securities in Beijing, said allowing companies nationwide to deduct VAT paid on capital assets would save them only about 100 billion yuan in tax.

That is small change for the government, which ran a consolidated budget surplus of 1.19 trillion yuan ($173 billion) in the first half of the year as tax revenues surged 33.5 percent, according to the Ministry of Finance.

Even if policy makers' focus on post-quake reconstruction causes a delay, many researchers said VAT reform is only a matter of time.

‘The economy is slowing this year, while fiscal revenue has been rising rapidly. I think it's necessary to shift the VAT system at some point to give the economy an extra hand,’ said Zhang Yongjun, a researcher at the State Information Centre, a think tank for the government's top economic planning agency.

At the aggregate level, China hardly needs more investment. Gross capital formation accounted for a whopping 42.1 percent of GDP in 2007. But, at the margin, tax incentives would encourage companies to buy state-of-the art equipment that would raise productivity, Zhang said.

But Xing at CICC doubted the overall impact would be huge as economic fundamentals, not tax rates, dictate firms' capital spending plans.

‘If companies still have a gloomy outlook for the economy, they won't invest much even if taxes are lower,’ he said.