Taxing times for China's tax reformers(3)

Challenges ahead

"The planned expansion of the VAT pilot reform to 10 provinces, autonomous regions and municipalities suggested that the authorities are expecting the VAT reform to be completed by 2015," said Kenneth Leung, a partner of Tax & Business Advisory Services at Ernst & Young.

"However, some of the regions may not be ready for the reform, thus a rush out may lead to chaos," Leung said.

Meanwhile, the expansion still has to deal with issues such as some sectors complaining of a heavier tax burden even when authorities face declining tax revenues.

A survey of 65 logistic companies by the China Federation of Logistics & Purchasing has shown results that are not so promising.

For transportation companies, the average tax burden was twice as much as before under the pilot reform because the tax rate was raised to 11 percent from the previous 3 percent and there weren't many items eligible for deduction.

One out every 12 companies came from the transportation sector, while companies in cultural and creative industries accounted for nearly a quarter of the total. One fifth were technology innovators and service providers.

Two-thirds of the logistics companies involved in the VAT reform have seen their tax rising by an average of 50,000 yuan, according to the federation.

"Authorities need to work more on these problems found in the Shanghai pilot. A rushed expansion of the pilot will cause shocks," the federation stated.

Meanwhile, what is beneficial for Shanghai businesses might cause a crisis for companies in surrounding areas.

"The pilot preferential policies in one region will pose a 'depression effect' drawing in capital from surrounding areas, which is de facto discrimination against outsider companies," said Sun Gang, a researcher with the fiscal science research center affiliated to the Ministry of Finance.

Besides geographical expansion, China may select certain industries to roll out VAT reform nationwide in 2013, Leung said. Such industries include transportation, building installation and post and telecommunications, he said.

Transportation is likely to take the lead as the first sector in the reform to see the application of VAT nationally, according to Wolfers of KPMG China.

Although the scope of the reform is expected to extend across the country, tax reform in certain sectors such as finance and property seems unlikely in the short term, according to Alan Wu, China indirect tax leader with PricewaterhouseCoopers.

The reform may not spread to the central and western areas of China either at present because the number of businesses in service sectors is not big enough to make a big difference.

The biggest difficulty for the tax reform, experts say, is that it touches on the country's fiscal system.

Under China's current tax regime, VAT is collected by the State taxation authorities, with 75 percent going to the State coffers and the rest to local governments. Revenues from business tax belong to local governments and account for more than one-third of local government incomes.

In Shanghai, the national and local taxation authorities are one and the same, which means that the pilot program would not face many institutional problems.

However, the expansion of the reform will inevitably force the repositioning of the local taxation departments in the governments of the involved cities and provinces.

In the tax reform in Beijing, local tax authorities get to retain all the new VAT revenues, but Wolfers said authorities still need to work out a plan for the long term if the reform is implemented in more provinces and sectors.

Beijing municipality's fiscal revenue, for example, grew 5.3 percent year-on-year in the first half, which is far below the 10 percent annual target set for this year.

Slower growth in fiscal revenue is sparking concerns that the cash-starved authorities may impose tougher enforcement during tax collection, resulting in a rise in the burden for taxpayers.

Bai Jingming, deputy director of the fiscal science research center with the Ministry of Finance, said that with the expansion of the tax reform, the country will see a reduction of its tax revenue for the time being and, in the long run, it will promote the development of related industries, which will lay a solid foundation for the country's taxation system.