By Ni Hongri

In the first half of this year, the State Council decided to reduce business tax rate for financial enterprises from 8 percent to 5 percent, with one percentage point decrease each year through a three-year period. It marks the beginning of reduction of tax burdens for financial enterprises in China. However, there is still a significant gap between the adjusted taxation policy and system and the general international practice. In light of China's imminent entry into the WTO and the general trend of opening up of the financial sector, it is highly necessary to re-examine and study the appropriate tax policy and system for financial enterprises based on the effectiveness of the above policy adjustment, the general international practice, China's particular conditions, the development of China's financial sector, the promotion of the competitiveness of Chinese financial enterprises and the prevention of financial risks.

I. Characteristics of the Financial Enterprise Taxation Policies and Systems in OECD Countries

Most of the OECD countries adopt direct tax as main tax for financial enterprises. Their taxation policies for income tax (direct tax) are basically similar to those for other sectors (with slight differences in particular stipulations), but their taxation system for indirect tax (namely, China’s circulation tax) follow the light rather than heavy taxation rules, which are different from other sectors. Normally, the practices of these countries may be considered as the general international practice.

In general, the OECD countries do not levy indirect tax (which approximately equals to China's business tax) on the total business income of financial enterprises. They divide financial services in detail into 27 large categories, including monetary settlement, deposit business, lending, financial guarantee, note and stock trading, futures, options and life insurance, and formulate different taxation systems for different financial services.

Most of the OECD countries (except the United States) implement the VAT and GST systems and adopt four taxation measures for different business of financial enterprises. They include (1) taxation; (2) tax exemption, which allows no recoupment for the VAT of the purchased goods; (3) zero tax rate, which allows recoupment for the entire VAT of the purchased goods while granting tax exemption; and (4) VAT exemption for financial services, namely, excluding financial services from the targets of VAT. Although different countries implement different taxation policies for financial services, there are still some common practices.

The common practice of most countries is the non-recouping tax exemption policy for most financial business, such as monetary settlement, savings and lending business. This means that no VAT is levied while no VAT of the purchased goods of the financial enterprises may be recouped. The main reason for the adoption of such a policy is the difficulty to define the tax base of VAT due to the particular nature of services provided by financial enterprise. With the non-recouping tax exemption policy, the non-recouping taxation for the income of the purchased goods is close to the "correct" taxation of the financial services and, therefore, may be regarded as taxation for financial enterprises. If the same invoice-based VAT recoupment is adopted for financial enterprises, it will not only be difficult to operate but may possibly lead to heavier taxes than for other commodities and services.

Another common practice is to tax the commission-charging business of financial services, such as the custody, consultancy and fund management business.

The United States represents a particular case. Currently, its indirect taxes mainly include consumption tax and retail tax. In general, financial services are exempted from taxation. However, based on relevant data, it levies consumption tax on insurance services provided by foreign insurance companies based on their premium incomes.

Compared with other countries, Japan taxes its financial service sector with significantly more taxes and a consumption tax is levied on the commission of banking business. However, there is no consumption tax for interest and insurance incomes.

South Korea levies VAT for commodities and labor services, but grants tax exemption to financial services like most other countries. A particular practice is a 0.5 percent education tax levied on the total incomes of the financial and insurance enterprises since 1982.

II. Characteristics of China's taxation policies and system for financial enterprises

Since the start of the reform and opening up, and along with the financial system reform, the relationship between the government and the state banks and the insurance companies has gradually changed. The previous relationship were characterized by the latter's turning in their profits and the former appropriating them with credit funds. In the new relationship, the financial institutions now pay taxes and the government makes investment to supplement the capital of the State-owned banks and insurance companies as their owners. A special taxation policy has been adopted for financial enterprises, especially for the State-owned financial institutions, to "differentiate" them from enterprises of other sectors. This special policy has some main characteristics. Firstly, the rate of business tax for the financial sector is higher than that for other sectors. The taxation system reform in 1994 implemented a 55 percent rate of income tax for the State-owned banks and insurance companies. It is 22 percentage points higher than the 33 percent rate of income tax for the non-state financial sectors and other sectors in China. In 1997, the rate of enterprise income tax for the State-owned financial institutions was adjusted to 33 percent, while the rate of business tax for all financial enterprises was raised from 5 percent to 8 percent. Since May 1, 2001, the rate of business tax for financial enterprises will be reduced to 5 percent through a period of three years. However, it will still be higher than the 3 percent rate of business tax for the transportation, telecommunication and construction and installation sectors in China, and will remain at a high level in the service industries. Secondly, the Chinese financial enterprises bear a greater tax burden than financial enterprises with foreign capital, as the latter enjoy preferential tax treatment in terms of enterprise income tax, and are exempted from the municipal maintenance and construction tax and education surcharge in terms of circulation tax.

China has adopted such a tax policy for its financial sector due to various reasons. Firstly, up to the present, the State-owned financial institutions still take up a dominant proportion in the financial sector and hold up 60 percent of the total financial assets. The property ownership relationship between the government and the State-owned financial institutions somehow leads the government to regard the State-owned financial institutions, especially the State-owned banks, as the "secondary public finance" or State coffers, instead of a venture industry in the market economy. Secondly, the tax revenue from the financial sector is a major source of finance revenue. In fact, major adjustments in the finance and taxation systems in the past have been based on short-term public finance interests, and the taxation system of the financial sector has always been designed to maintain the overall scale of tax income. Thirdly, compared with other sectors, the system reform in the State-owned financial enterprises lingers behind. This is also the major reason for the absence of important adjustment in the taxation policy for the financial sector. Fourthly, under China's current interest management system, the government may control and regulate the profits of financial enterprises with tax leverage when there is large difference between the interests of savings and loans. Among the above factors, the first two are the most important.

III. Heavy tax burden for China's financial enterprises under the current taxation system

Although VAT has been adopted in China, due to various reasons, the VAT system has not been applied to some service sectors, such as the financial, transportation and construction sectors, where business tax system applies. As financial enterprises are not allowed to recoup the VAT from their purchased goods when paying business tax, they actually bear the burden of both the VAT and the business tax.

Under China's taxation framework dominated by the circulation tax (internationally named as indirect tax), financial enterprises suffer a much heavier burden of circulation tax than income tax. At present, the amount of circulation tax paid by financial enterprises is over RMB 50 billion yuan, while the amount of income tax is only less than RMB 10 billion yuan. The former is five times of the latter. After paying the business tax and surcharge, financial enterprises are left with only a little profit. This is one of the external causes that lead to insufficient capital of financial enterprises.

Based on the practices of most OECD countries and the calculation method of the famous American expert on Chinese economy, Nicholas R. Lardy, analysis on the proportion of tax payment in the total amount of income of financial enterprises demonstrates that the current overall tax burden of China's financial enterprises (circulation tax plus income tax, excluding the VAT contained in the purchased goods of financial enterprises) stands at around 65 percent-75 percent. Take the exclusively state-owned commercial banks and insurance companies for example. In 1999, the four largest commercial banks with exclusive State-ownership, namely, the Industrial and Commercial Bank of China, the Agricultural Bank of China, the Bank of China and the Construction Bank of China, bore an average overall tax burden of 74.68 percent (see Table 1 for details). Meanwhile, the People's Insurance Company of China and the Life Insurance Company of China shouldered an average tax burden of 68.37 percent (see Table 2 for details).

Table 1 Overall Tax Burdens of the Four Largest Commercial Banks with Exclusive State Ownership -- the Industrial and Commercial Bank of China, the Agricultural Bank of China, the Bank of China and the Construction Bank of China

	Business tax and surcharge	Income tax	Total tax payment	Pre-tax profits	Tax burden (%)
	1	2	3	4	5=3/(4+1)
Industrial and Commercial Bank of China	127.68	--	127.68	41.26	75.58
Agricultural Bank of China	42.88	--	42.88	-3.55	109.03
Bank of China	54.99	14.32	69.31	43.41	70.44
Construction Bank of China	79.29	24.08	103.37	73.66	67.58
Total	304.84	38.40	343.24	154.78	74.60

Note:

1. Source of data: China Financial Year Book 2000, and calculations based on the income statements of the four largest banks.

2. Pre-tax profits are incomes before payment of the income tax.

Unit: RMB100 million

	Business tax and surcharge	Income tax	Total tax payment	Pre-tax profits	Tax burden (%)
	1	2	3	4	5=3/(4+1)
People’s Insurance Company of China	37.16	--	37.16	14.31	72.20
Life Insurance Company of China	3.94	0.21	4.15	5.01	46.27