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Don't expect too much from end to interest tax

By Sun Lijian (China Daily)
Updated: 2007-07-06 11:39

The author Sun Lijian is a professor of finance at the School of Economics, Fudan University

Last week the Standing Committee of the National People's Congress authorized the State Council to suspend or cut the 20 percent tax on interest earned on personal savings accounts under certain economic and social situations.

For quite a while, the public, academics and others concerned have been discussing the future of the tax on interest.

Some held that the interest tax should be ended because the real interest rate has been pulled below zero after the current inflation rate is deducted from the current interest rate.

Others are saying that the interest tax could be ended as part of the central bank's efforts to check the swelling inflation.

There is also concern over a stock market slump.

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The variety of concerns over the interest tax are not baseless. However, those concerned may be expecting too much from suspending the tax.

Launched in 1999, the interest tax came as a countermeasure to sluggish consumer demand and looming economic contraction. The interpretation was that the authorities were trying to stimulate consumption, using the tax to discourage bank deposits.

This is not the whole picture. The interest tax played a more important role as a reliable source of income for the government, which at that time was making every endeavor to carry out a pro-active fiscal policy.

For a few years after the Asian financial crisis in 1997, the heavy spending by the government, in line with the pro-active fiscal policy, became the powerhouse for China's high-speed economic growth. A stable income, from the interest tax, was a valued asset for policymakers under that circumstance.

One decade later, the Chinese economy is totally different. The pro-active fiscal policy has been phased out and the government is nurturing themarket economywith a prudent fiscal policy. The economic boom lasting for over two decades has helped China accumulate huge social wealth and the government has seen double-digit growth in its total tax income in recent years.

As Jin Renqing, the minister of finance, said, the central government would not suffer financially if the interest tax were cut or suspended. Furthermore, it would help advance the country's tax reform.

Therefore, the authorities should adjust the interest tax rate or eliminate the tax because of the transformation in the mode of economic development. This move is a strategic one for economic soundness in the long or medium term.

In recent years, the Chinese economy has seen increasing liquidity brought about by the surplus in commodity trade as well as the increase in direct foreign investment. The central government tightened its monetary policy to cushion the economy from the threat of excessive liquidity. However, no impressive progress has been achieved.

Some advocate the removal of the interest tax to check liquidity. However, they are confusing the goals of the monetary policy and the taxation policy.

With the taxation policy, the government tries to provide public facilities and services, ensure a fair distribution of social wealth and maintain social fairness. The monetary policy, an instrument of the central bank, maintains the currency value and reduces economic ups and downs.

If the two policies were not applied independently of each other, it would damage the policy goals.

In the current situation, the excessive liquidity in the Chinese economy is produced by the surplus from international payments as well as banks' desire to make loans driven by high deposits.

Since the interest rate is low, there is little chance that money will flow to banks from the securities market. This will remain true even after the interest tax is totally abolished.

More importantly, the central bank has been reforming decision-making in monetary policy to make it more transparent and credible. Such reform will improve the effectiveness of the monetary policies in the long run.

If the taxation policy is used to reach a monetary policy goal at this time, it would damage the authority of the central bank as well as the power of the monetary policy in the future.

Judging from the above analysis, the interest tax should not have a negative influence on stock market investment revenue. However, it seems many investors have formed an incorrect idea of the influence on the market that reducing or ending interest tax will have. Their perceptions, rather than the tax itself, would have a substantial impact on market sentiment, hence on the price of capital.

Rather than spending a lot of time and effort on studying the possible impact of reducing or removing the interest tax, the authorities should make better use of the abundant liquidity to further reform the capital market.

When the capital market is mature, it could act as a supplement to the banking sector in financing the industry. The Chinese economy would be stronger to withstand all kinds of shocks.