On March 18 US trade representative Robert B. Zoellick announced the United States had filed a case at the World Trade Organization (WTO) regarding China's tax rebate policy for manufacturers of integrated circuit.

The US is accusing China of granting discriminatory tax rebates to domestic producers. Such a practice, according to the US, is "inconsistent with the national treatment obligation China assumed when it became a WTO member country in 2001 and distort international investment in the integrated circuit sector."

The case, the first against China since 2001, has sparked a 60-day consultation between China and the United States, which is still under way. It is an international concern whether and how the two countries will reach a deal.

As a matter of fact, China's tax rebate policy is only designed to protect fledgling domestic industries - which is permitted under WTO rules. And it serves the national interest in the long run to improve China's industrial structure.

According to traditional theories on international trade, commodity sees several phases in its life cycle: research and development, growth in production, commercial maturation and decline in demand. In these phases, production of these commodities evolves from technology-intensive to capital-intensive and labor-intensive at last.

If a country is rich in labor, energy and raw materials, it can take over the production of the commodity and occupy a large share of market after the commodity becomes popular. But the commodity is most profitable when it is fresh in the market and the country that invented and initiated the production gets most profits.

The policy derived from such theories concludes that a country should try to stimulate its technology, boost research and development of high-tech products and encourage innovation. This way, its position in international trade could be improved and it could profit more from global trade.

Though China has a competitive edge in labor, it is facing increasing pressure in the supply of farmland and energy, especially technology. If it keeps sticking to labor-intensive production with low technological levels, it can only see limited margins in trade, hence remaining at a disadvantaged position in terms of international commercial ties.

As a result, it was inevitable the Chinese Government would grant favorable treatment to the high-tech sectors, including manufacturers of semiconductors.

On June 24, 2000, the Chinese Government issued a regulation to boost the growth of software and semiconductor chips. According to this regulation, firms producing and designing integrated circuit are subject to a 17 percent value-added tax (VAT), but they can get a partial refund of the VAT when their actual tax burdens surpass 6 and 3 percent respectively.

On September 29, 2001, another State Council regulation revised the tax refund percentage, giving the same VAT refund to integrated circuit manufacturers and the designers if their tax burdens go beyond 3 percent.

Two terms must be distinguished here: "tax rate" and "tax burden."

The VAT in China is applied at each link - at a rate of 17 percent - of the exchange of goods in the production process.

Chip making is a process composed of several links - with each serving as the supplier of the next - before the product finally comes out. At each link, the 17 percent VAT on the increased value is levied. Part of the taxation on the producer at each link is deducted because that portion has been paid and is included in the supply the producer buys from the previous link.

Because the deduction is made at each link, the final taxpayer appears to pay a much lower rate of tax, which is called tax burden. In fact, the chip maker has paid a full VAT - the rate of which is 17 percent in China -throughout the stage-by-stage process.

Due to taxation differences, however, US chip makers do not pay tax before the final consumption stage. In other words, US chips arrive at Chinese customs free of any taxation.

By levying a 17 percent VAT on them, the Chinese Government puts overseas and domestic firms on a level playing field, although domestic makers are much weaker and vulnerable to market competition.

China's tax rebate policy for chip makers in the domestic market formerly stipulated the portion above the 6 percent line of the firms' "tax burden" - not "tax rate" - would be rebated.

Experts estimate that Chinese firms' real tax burden is not more than 6 percent, and in some cases as low as 3 or 4 percent. It means domestic firms cannot enjoy significant benefit from the policy.

This tax rebate policy does not violate international trade protocol. Article III of Part II of the General Agreement on Tariff and Trade (GATT) outlines national treatment on internal taxation and regulation.

It states the national treatment in the provisions "shall not prevent payment of subsidies exclusively to domestic producers, including payments to domestic producers derived from the proceeds of internal taxes or charges applied consistently with the provisions of this Article and subsidies effected through governmental purchases of domestic products."

Comparing this with China's two regulations, it is clear China's favorable treatment to domestic integrated circuit technology manufacturers and designers is reasonable. The US accusation is groundless.

A detailed analysis of the US accusation points to several key reasons for it.

The United States is trying to maintain its leading role in the integrated circuit sector. As globalization expands, the roles of different countries in the international production chain are likewise altered. Many developed countries still try to keep their leading roles in the international production chain to reserve their profits.

The United States has long imposed harsh restrictions on high-tech exports to China to retain its competitive advantage.

China's tax rebate policy helps boost the domestic semiconductor sector. The US manufacturers are concerned that more semiconductor manufacturers will invest in China and the US sector will be threatened. They hope the WTO case will affect foreign investment in China in this sector and slow down the transfer of international semiconductor business to China.

In April 2002, the General Accounting Office of the United States released an 83-page report titled "Export Controls: Rapid Advances in China's Semiconductor Industry Underscores Need for Fundamental US Policy Review."

The report stated that since 1986 China has narrowed the gap between its semiconductor manufacturing technologies and that of the US. China's progress in this technology improves its manufacturing facilities for more advanced consumer goods. Since the US export restrictions have not slowed the advance of China's semiconductor industry, it is necessary to review the restrictions and achieve a balance between commercial profits and national security of the United States.

Basing on these considerations, it is only natural for the United States to contain the further development of Chinese semiconductor industry.

When China used policy to boost the growth of this sector, it became a sensitive issue to the United States and triggered the WTO filing.

In addition to development strategy, economic interests motivate the Americans' over-reaction to China's tax rebate policy.

The information technology industry in China ranks third in the world behind the US and Japan. National sales reached 1.88 trillion yuan (US$226.5 billion) in 2003.

China is now also a major producer of electronic commodities that employ semiconductor technology. The total market value of semiconductor products manufactured in China is estimated to be US$22 billion in 2006.

At the same time, semiconductor products are the second biggest US export to China. The total US export of integrated circuits to China was US$2 billion last year.

But China has set a target that the domestically produced semiconductor commodities should reach 50 percent of all demand of the domestic market, which puts significant pressure on US semiconductor manufacturers.

Basically, the US file to the WTO answers the demand of its domestic industry. But it could have negative influences upon bilateral trade ties if not dealt with properly.

The United States is now using a new way to contain China's economic growth: pressure through the WTO framework. How to face the challenges becomes an important question.

Nevertheless, China will not change its decisions to develop the fledgling semiconductor industry simply because of US pressure. After all, that is a key direction of China's industrial restructure.

(China Daily April 20, 2004)