China currently has a monopoly system implemented in the tobacco industry. This booming industry imposes a threat to human health but can hardly be uprooted. Obviously the existing economic system cannot cope with modern market development and vie with the global tobacco industry. How to generate a sound and vigorous tobacco industry is now the basic position of the industrial reform.

To some extent, reforms in process have made strides by introducing some open market systems. For example, the number of tobacco enterprises has declined to 31 from 180 in the last four years and tax revenues have doubled. Tobacco tax revenues account for nearly 8 percent of the nation's total.

According to a recent survey by Outlook Weekly, the industry is faced with multiple difficulties incurred by "misshapen" reforms that haven't affected the deeply rooted planned economic systems. An industry insider pointed out that a monopoly system doesn't equal a planned one. If we don't make necessary adjustments to the current reforms, the tobacco industry may move in a negative direction and create new obstacles toward development.

The dependency of local finance and taxation "misshapes" industrial reform

"If the tobacco (industry) sneezes, the government must have caught a cold; if it caught a cold, the government must also be suffering from fever," a relevant official of the Yuxi government of Yunnan Province said by way of explaining the dependency of local finances on the tobacco industry.

Yuxi is a tobacco-rich city with tobacco production accounting for more than 50 percent of the city's GDP and tax revenues surpassing 80 percent of the total financial revenue. But in the year 2000 financial revenues displayed negative growth after product fluctuation rippled through the Hongta Group, a huge tobacco conglomerate in the city.

The survey also revealed a similar finance and taxation structure prevails in most tobacco producing areas where different levels of government, from county to province, more or less depend on revenues generated from this industry. The tax levied on the tobacco industry is around 55 percent. Clearly, this high tax effectively prevents the industry from expanding blindly. But conversely it also fosters local governments' dependency on the tobacco industry because the consumption tax, the value added tax, along with additional taxes for urban construction and education are all main sources of local financial revenue.

"Tobacco factories are like the God of Wealth. No matter how big they are, tobacco factories bring the good life to the government wherever they are located," remarked a head of a county with no such factory under his jurisdiction. He spoke, brimming with envy.

"Tobacco factories' tax contributions cannot be changed easily in those places where they are located," said a financial official from a tobacco-rich province. He revealed that under the current system of tax distribution, the central finance department reimburses tax revenue based on the 1993 figures. For areas producing cigarettes, the previous tax base included "absolute contributions" from the tobacco industry, which means that the base will be much smaller if the tobacco tax ceased to exist. "In that situation, they would receive fewer returns from the central finance department. Their life would be 'miserable'," said the official.

This dependency has caused local governments to treat tobacco factories with kid gloves. A popular saying goes: "If the factory requests officials to attend a meeting at 8:00 AM, they will show up right on time."

However, such kindness and care are now considered burdens on the industry: the fact that governments attach so much importance to the industry has resulted in delays towards the goal of transforming the industry into a market-oriented one and it has also provoked weaker, rather than stronger competitive strength.

An example is given by the thriving "consolidation and restructuring" within the industry. In order to optimize product resources and strengthen brand consciousness, the number of enterprises has reduced from 180 to 31 through these mergers. But since restructuring may affect production quotas and vested interests, most are carried out following the compromise of "a tax base that does not affect local interests", making negotiations much more difficult.

According to Cheng Yongzhao, an economic researcher appointed by the State Tobacco Monopoly Administration, restructuring within the industry would undoubtedly encounter more obstacles due to financial dependency. Most completed restructurings were situated among enterprises within a province, after defeating various pressures from government authorities in counties and autonomous prefectures. If the tobacco industry is still a significant contributor in governmental tax bases, trans-provincial restructuring is virtually impossible. The number of cigarette factories in Yunnan has reduced from 9 to 3. But the plan of combining the 3 factories into a flagship corporation aborted due to special interests.

Some reform measures don't achieve the desired results due to the "special care" of local governments. The measure of "separating industrial and commercial enterprises" was aimed to disconnect these two kinds of enterprises from the basic system, to ensure that the revenue of commercial enterprises came from product sales, thus breaking any local blockage and forming a unified market. However, the survey indicated that local governments driven by tax revenue still enhanced their protection of local enterprises – they simply camouflaged it. According to 2006 statistics, of the 36 brand name cigarettes, half of them depend more on local markets – because that is where they derive over 50 percent of their revenues.

Some industry insiders have pointed out that sound development of the industry depends on removing tobacco from the local tax base, that is, to eliminate local governments' financial dependency.

Experts have put forward two solutions. One is to levy consumption tax during sales. For a long time, consumption tax has been levied during the production process, equating more production with higher tax revenues. This new measure would equate tax revenue with sales areas and break any blockage in production.

The other is to single out the tobacco consumption tax so as to disconnect local financial revenues with the tax revenues from tobacco.

Monopoly doesn't equals planning

"It seems that to be a manager of cigarette factory is quite cushy. All he needs to do is to organize production according to a set plan. There is no risk of losing money," satirized an insider. "A cigarette factory manager is just like a production director."

Mandatory planning of tobacco production, an important part of tobacco monopoly system, has upheld this system and ensured high tax revenues for a long time. But the rigid planning also impairs resource allocation and restricts brand development.

Set plans specify every chain of production – from material purchase, production arrangement to sales service. Moreover, all production details: trademarks, specifications and production dates should be strictly followed or factories will be severely punished.

The Outlook Weekly reporter was surprised to see an empty workshop in Honghe Cigarette Factory. "Though the market demand is far from saturated, we can do nothing without production planning," explained Manager Qiu Jiankang. As a veteran manager, Qiu was worried about the existing planning system: "Numerous facts have proven that administrative planning is unable to optimize resource allocation. Rigid planning is divorced from real life practice and restricts business growth in a market driven economy."

He pointed out that as tax collection systems improve, it would be just as imperative to remove planning management in order to guarantee successful market-oriented reform for the industry and, in fact, it is the only way for the industry's future development.

Without quota restraints, the tobacco industry would have ways to enable efficient enterprises to prosper and inefficient ones to be eliminated. Only in this way can outstanding enterprises rise in China to compete with the world tobacco giants, Qiu added.

Using tax to promote "the survival of the fittest"

"Frankly speaking, tobacco enterprises are very rich," an industry insider told the Outlook Weekly, "For an average-sized tobacco factory, if its sales reach 2 billion yuan, it will turn that into more than 1 billion yuan in taxes and gain a profit of 0.3-0.4 billion yuan. But for an open market based industry, this is inconceivable."    

"Actually, it's a tax problem," a tax official said. He believes that as an administrative monopoly industry with a large consumer market, the tobacco industry is clearly profitable. Currently China's overall tax burden levied against tobacco industry is about 55 percent. It seems quite high but profit rates remain at 20 percent, higher than that of other industries. "This shows that there is great potential for more tax revenues generated from the tobacco industry."

"If an enterprise has potential profitability, it should stimulate expansion and maintain its constant competitiveness. But if the profit level of the whole industry is far higher than the average profit level of the society, it is abnormal and this will prevent the survival of the fittest and the reform and development of this industry," said a tobacco industry insider.

In recent years, the tobacco industry nationwide launched a campaign of joint restructuring. But because the tobacco enterprises are generally very profitable and their profits affect many local interests, local governments and enterprises were not willing to have their businesses merged. The restructuring process did not go over well.

The Outlook Weekly also learnt that because of the overall high profit of the tobacco enterprises, they usually own excessively large amounts of funds. This in turn raises a higher demand for responsible businessmen. In 2006, the National Audit Office conducted a special audit of Yunnan tobacco and found that the book assets had reached 33.3 billion yuan, but more than 10 billion yuan had been lost. Seemingly responsible tobacco businessmen had become corrupt. They embezzled huge amounts of money and shared in "little hidden coffers". Some officials at the provincial level were also involved in these cases.

"Survival of the fittest is the law for business survival. If tobacco enterprises can easily gain high profits under no pressure at all, this would hamper them from optimizing resource allocations. They would refrain from expansion and strengthening and finally turn the industry into a mess," a researcher said.

Many insiders suggested that that the state raise tobacco enterprise tax levels. Increased taxes would force inefficient and unwelcome tobacco enterprises out of business.

"And the government could use these increased revenues to narrow the income gap nationwide through transfer payments instead of 'balancing' the development by way of protecting backwardness and restraining competitiveness," said a financial researcher.

(China.org.cn by Huang Shan and Zhang Ming'ai, October 12, 2007)