When fair taxation is discussed, many people simply talk about replacing preferential income tax policies extended to foreign companies.

A more imminent problem is that the country's favourable VAT collection policies for foreign businesses has put domestic companies at a disadvantage in trying to compete.

Under current VAT collection policies, domestic businesses have to bear a heavier tax burden than their foreign competitors.

China's VAT system is characterized by tax on equipment purchases being a fixed investment.

Such a system was adopted in 1994 to make collection smoother and get a stable revenue growth started, and more importantly, to keep a check on the investment boom and rising inflation under way at that time.

The policy was wise under those macro-economic conditions, but problems have also stemmed from it.

The policy forced businesses to increase their investment in their operations because of the high prices of equipment. Having to make such large investments in equipment not only impeded companies' technical upgrading and equipment renewal, but also restrained private investment.

The policy also led to some distorted taxation.

Because tax credit is extended to buying equipment in most countries with a VAT system, China's additional tax on it even after customs duty made the country less appealing to foreign investors. In a move to offset this negative effect, the government patched up the problem with import-related tax exemptions for foreign-funded companies who bought, and offered a 50 percent tax reduction for domestic firms' imports brought in for technical upgrading.

But these practices not only resulted in discriminative taxation on equipment imports between domestic firms and foreign-funded companies, it also wore away the domestic equipment suppliers' competitive edge by taxing their products more heavily than imported ones.

Thanks to growing demands from domestic investors and equipment suppliers, the country stopped foreign investment's tax breaks on imported equipment in 1996.

After the Asian financial crisis in 1997, China's shrinking export business and sluggish domestic demand made it necessary to attract more foreign investment to sustain economic growth.

The country resumed tax exemptions on imported equipment and expanded the deal to investors at home and from abroad.

Although the new policy could help lower the import costs of technology and equipment, it plunged domestic equipment manufacturers in hot water.

In spite of the government's efforts to protect domestic industries with two categories of non-tax-exemption imports, investors easily got round the restrictions and tax breaks for the import of whole sets of equipment encouraged domestic businesses to buy foreign products, instead of domestic products, which had extra taxes imposed on imported parts.

To encourage foreign-funded companies to buy domestic equipment, a preferential tax policy was drawn up last year, allowing a 40 percent reduction of income tax for their purchase.

These preferential policies enjoyed by foreign-funded companies are against the WTO's rules, and are likely to prompt other members to retaliate against China after its entry into the trade body.

In summary, the root of all the problems is that China's current VAT system does not conform well to international practice.

What is urgently needed is a shift from a VAT system which lays the tax emphasis on production to one that emphasizes taxing consumption.

China's economic conditions have changed a lot in recent years. Insufficient demand, especially weak investment demand, has become a key obstacle to the country's economic development.

To help businesses' investments, equipment renewal and restructuring are key to creating jobs and propelling economic growth.

The production-oriented VAT system, aiming at checking fixed investments, no longer meets the demands of the current economic conditions, and long-term growth goes against the country's efforts to stimulate domestic demand.

Tax on equipment will inevitably increase production costs and a consumption-based VAT system will help to reduce tax.

Businesses will then not have to worry about the extra VAT burden, whether they buy domestic equipment or imported equipment. After the transition period following China's entry into the WTO, tax on imports will also be substantially reduced. In these circumstances, the current tax exemption for imported equipment and the tax credit for buying domestic equipment could also be abolished.

By reducing investment costs, China can foster a fairer competition environment for domestic businesses.

In the next five years China will witness a crucial transition period, integrating its economy with the world economy. An immediate readjustment of its taxation system to that of international practices is imperative and of vital importance.

(China Daily 10/26/2000)