Taxes and Development: India vs. China

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Taxes and DevelopmentIndia vs. China

• Roger Gordon
• UCSD

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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 SOEs 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
CHINA INDIA
Corporate Tax 55 rate 50 to 55 rate
Excise Taxes High and variable rates High and variable rates
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High Tax Rates on a Narrow Base

• Revenue only from SOEs 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 SOEs

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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 SOEs
• 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 SOEs, 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

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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

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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

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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-SOEs
• India expanding excise tax base to include
  services and wholesale sector

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• 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

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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

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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

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What to Do?

• Hope tax revenue improves
• Chinas 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?

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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
• SL 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

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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

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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

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What is to be Done?

• Shift to fiscal transfers based more on formulas,
  e.g. population
• Restrict use of debt by SL 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

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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