By+JOHN+ROSS

TAX reform is one of the most widely discussed issues in China. In this respect， it is far from being unique！ In the U.S.， disputes over health care payments and taxation of better-off citizens underlined last years government shutdown. The question of who will pay the tax increases that are inevitable in China as it begins to build more comprehensive health care and social security systems will be key not only to its economic development， but also to its future social stability.

In all countries， including China， economic strategy must determine the direction of effective tax reform. Attempts to analyze tax reform without situating this within overall economic dynamics necessarily result in discussions and policies that are ambiguous and ineffectual， and risks that create social instability.

The links between tax reform， economic development and social stability are precise. Clearly， taxes are not a goal in themselves but merely the means to fi nance government expenditure. China must， therefore， face the fundamental reality that as it makes the transition from a “developing economy” to its current goal of a “moderately prosperous”society， and eventually to a “high income” economy， the proportion of government spending in GDP will increase. As government spending must eventually be fi nanced via taxes， this means taxation in China will also have to increase. Who pays these taxes will， therefore， greatly affect social stability. So for tax reform to be effective， discussions of short- and medium-term measures must be integrated into this longer-term perspective.

The issue may indeed be stated bluntly： If the struggle against corruption is today at the forefront of discussions on Chinas social stability， in the medium term， the type of tax system created will be equally decisive.

To take the most fundamental starting point， the chart below shows why increases in taxation are inevitable in China as it becomes a more developed economy. It shows how much lower Chinas government expenditure is as a proportion of GDP than in an advanced country – the comparison is of China with the leading industrial economies. Not only is the 25 percent of GDP accounted for by state spending in China much smaller than the 45 percent in Germany， and 41 percent in Japan， but it is also far lower than the 39 percent in the U.S. – an advanced economy normally taken as a model of small government. As government expenditure， except in the purely short term， must be fi nanced by taxation， the increase in government expenditure that will take place as China makes the transition to a more advanced economy necessarily requires corresponding increases in taxation.

Attempts to avoid this reality result either in self-con- tradictory proposals – such as the suggestion that China needs both lower taxation and increased social safety-net spending to stimulate household consumption – or reliance on measures that are temporary and economically destabilizing – such as the present excessive reliance of local government on land sales.

Many authors on Chinas economy have pointed to immediate urgent priorities in social spending， but these have immediate tax implications. For example， for Chinas 260 million migrant workers， coverage of employers paying pension insurance is only 14 percent， industrial injury insurance 24 percent， and unemployment insurance eight percent. Given that coverage of such taxes would essentially be 100 percent in an advanced economy， the expansion of employers tax coverage in China， which is to come in， is clear – personal taxation is dealt with below.

More fundamentally， to see the overall trajectory of government spending in an advanced economy， the chart below shows U.S. civilian government expenditure. This rose from 12.3 percent of GDP in 1947 to 30.4 percent of GDP in the second quarter of 2013. This rise in the proportion of government spending in the U.S. economy was driven by precisely the same forces that will operate in Chinas urbanization and economic development – the cost of urban infrastructure construction and establishment of a social safety net.

To illustrate the comparison between Chinese and U.S. government spending， the chart below shows the development of total government expenditure in China and the U.S. in the 21st century – this data includes military as well as civilian spending. As can be seen， the share of Chinas government expenditure in the economy already rose significantly， from 17.1 percent of GDP to 24.9 percent， but the U.S. share also rose， from 32.6 percent of GDP to 38.8 percent. Therefore， the gap between the U.S. and China only shrank from 15.5 percent of GDP to 13.9 percent. Chinas proportion of government spending in GDP remains far below the level of an advanced economy.

Given these trends， the relation between social stability and taxation is evident. If Chinas government expenditure is not raised towards the level of an advanced economy it is impossible to create an adequate health care and social safety net. In that case social instability would be inevitable – a sense of insecurity is already a complaint and a restraint on consumer spending. But if tax increases faster than GDP， the necessary consequence of a rise in the percentage of state spending in GDP， then the question of who is to pay these tax increases will inevitably become a key factor in social stability and perceptions of social justice.

Attempts to avoid this fundamental issue by expedients such as local government land sales are not only inherently temporary in character but have undesirable side effects such as attempts to infl ate land values and， therefore， housing costs.

Turning to how taxation is to be reformed to meet such increases in government expenditure， the first principle， as is widely pointed out， is that there must be a shift from indirect to direct taxation； attempts to fi nance increases in government spending primarily via increases in indirect taxation would both increase the relative tax burden on the least well-off sections of the population and be infl ationary. China indeed shows the characteristic features of a developing economy in being far more dependent on indirect taxes than an advanced economy. To take an extreme example， only three percent of Indias population pay income tax compared to 49 percent in the U.S.

Income tax is the dominant form of direct taxation both in China and other countries， and in the U.S. it is integrated with capital gains tax – although in other countries they are separate. However， China currently lacks two direct taxes that would be taken for granted in a developed economy – a universally applied property tax and an inheritance tax.

On direct taxation China has a key decision on principle to take. One of the reasons the U.S. tax system is so effi cient in its collection， in the sense of being hard to avoid， is that it rests on two key principles. First a U.S. citizen must pay U.S. taxes on their income no matter in which country they are living， and second that if they attempt to evade this by renouncing U.S. citizenship they have to pay an “exit from citizenship tax” （expatriation tax）. Given the effi ciency of collection in the U.S. tax system China would be well advised to follow these U.S. principles.

In contrast to the complexities of personal taxation， the principles of company taxation are simple. Statistics show the majority of economic growth is produced by investment. Company taxation should be designed to create a low rate of taxes on investment with a high rate of taxation on anything that subtracts from investment such as dividend payments.

Naturally， the framework outlined above， which constitutes the minimum to make a transition towards the tax system of an advanced economy， is far more than could be implemented at either the recent Third Plenum of the 18th CPC Central Committee or even at a series of Plenums in the near future. It represents a comprehensive series of tax reforms to be implemented over a prolonged period. Nevertheless， it indicates the direction of travel China will have to go down as it moves towards becoming an advanced economy.