Tax reforms could give SMEs fair shot at success

Focus on picking winners keeps pressure on small business community

When the 2008 global financial crisis flattened overseas demand for Chinese exports, many saw the resulting dent in China's trade portfolio as a sign that the world's second-largest economy needed to expand domestic consumption. Indeed, the past several years have seen policymakers and planners focus on supporting emerging industries and young entrepreneurial companies amid broader efforts to transform not only China's economic model, but its position in the global value chain.

Unfortunately, a financial policy framework based around administrative meddling continues to slow the wheels of change. If planners really want to support the next generation of emerging entrepreneurs, they should consider tax code changes that make it easier for all of the country's small businesses to develop.

Tuesday saw China's Ministry of Finance acquire stakes in 49 venture capital (VC) funds for a combined 2 billion yuan ($324 million), according to an announcement from the ministry. Specifically, these funds will focus on start-ups as well as small and medium-sized enterprises (SMEs) in emerging industries like biotechnology, new energy and environmental conservation.

This is just one in a series of recent moves aimed at funding innovation, creating jobs and carrying out industrial upgrades. While many companies have surely benefited from government funding support, the impact of such largesse on the business community as a whole is still up for debate. To alleviate financial pressure all around, relevant authorities should look into tax code reforms.

Government efforts to support emerging industries through VC money date back to at least 2009, when authorities acquired stakes in several small-scale companies that were doing well at that time. Since then, officials have also taken positions in nearly 200 existing VC funds with roughly 42.7 billion yuan, according to data from the Ministry of Finance.

As in all VC arrangements though, there is never enough money for all potential targets. Businesses at the end of the funding chain will naturally find it difficult to secure funding, no matter how badly they need it. To maximize efficiency and ensure that the most promising, innovative businesses get the money they deserve, VC funds need to operate in accordance with market-oriented principles.

In the case of China, where management companies operate VC funds in collaboration with local governments, fund managers should demonstrate expertise in the emerging industries they are targeting. The market - rather than officials - should also have the final say in deciding which enterprises have the most potential to survive and grow.

Nevertheless, attention to such considerations cannot change the fact that the largest source of financial strain among SMEs is China's tax code. Therefore, instead of using VC money to pick winners among emerging enterprises, the best strategy to foster the small business community may be offering tax breaks to companies in the early stages of development.

According to a survey of companies trading on China's share transfer system for SMEs - also known as the New Third Board - released by China Everbright Bank in March, the tax bills of the companies it examined averaged 138.89 percent of their pretax profits in 2012. In comparison, companies trading on the A-share market averaged a rate of 120.45 percent, suggesting that many of the country's largest businesses face lighter tax burdens compared with their emerging peers.

The report also noted that from 2010 to 2012, the tax-to-profit ratio of companies listed on the ChiNext board rose by 20 percentage points. Asking for unreasonably large tax contributions from emerging enterprises is not only unfair, it could drive many of China's future business elites out of business.

According to recent information from the State Administration of Taxation, the switch to a value-added tax in the service sector saved businesses an estimated 85.1 billion yuan in tax payments during the first half of 2014. The same privileged tax policy should be extended to other areas of the economy, particularly start-ups and high-technology enterprises. Ideally, such steps should coincide with other trial reforms that reduce income taxes and offer tax credits to businesses.

Many of China's SME owners and entrepreneurs are no doubt glad to see the government supporting the VC market. Ultimately though, such funds should represent just one aspect of official efforts to foster a strong, vibrant SME community. To break the bottlenecks that have long held back the development of smaller businesses, planners must roll out preferential tax policies as well.