In this episode of China Money Podcast, prominent China economist at the Organization for Economic Co-operation and Development (OECD), Richard Herd, takes on China's tax systems and financial reform. Contrary to popular opinion, Mr. Herd disagrees with policy suggestions to cut taxes as fiscal stimulus. As he sees it, China's tax burden on companies and individuals is still light.

Mr. Herd talked with China Money Podcast on the sidelines of the EU-China Urbanization Partnership conference in Brussels. Listen to the podcast or read the excerpt below.

Q: In your research report, you pointed out the strong fiscal position of the Chinese government. The government has little net debt, and fiscal revenue has been growing at an average of 1.5 times of nominal GDP. Therefore, some Chinese economists are calling for tax cuts. Do you think that will be a good policy move?

A: Over the past 15 years, the growth in tax revenue has been quite rapid. But it was needed and was rooted in the tax reform of the mid 1990s. It lifted, in total with social security, government tax revenue to around 30 percent (of GDP). I think 30 percent, or perhaps 35 percent (of GDP), should be enough to cover most of the governmental expenditure needs. It will allow for a considerable increase in social benefits that’s so badly needed. Beyond that, there is a need to reform taxation so that tax revenue doesn’t grow too rapidly.

The disincentive effect is still quite limited because most people still don’t pay income tax. The main problem on incentives with the taxation system is in social security, where social security contribution (by employers) is around 40 percent of a person’s wage, that’s probably too high. Some of that too should be transferred to general taxation so that the incentives for employing labor are not cut too much.

As to whether taxes should be cut at this moment, I think that some of the main calls to cut taxes have come from those who think that the Chinese economy is going to a hard landing this year. I don’t think that seems at all likely at the moment. The need to reduce taxes is much less than a trillion Yuan. In fact, the government has announced income tax cuts and also stimulus programs to slightly raising the deficit to around 400-500 billion Yuan. That will go quite a long way to getting the economy going again.

Q: The domestic economists are arguing that the tax burden for individuals and companies are too heavy. Sounds like you have a different opinion?

A: I think that the tax rate for companies is 25 percent. That’s quite low by international standards. The tax rate for most individuals is, well, only a very small proportion of the Chinese population actually pays income taxes. You could perhaps say that in relation to other transition countries, China’s top tax rate is quite high because it’s at 45 percent. It’s much higher than in Hong Kong for example, which is 15 percent.

But on the other hand, China has a bigger social system than Hong Kong. The 45 percent tax rate doesn’t come until someone earns 36 times of the average wage, even then it’s just very few people who pay 45 percent. There is certainly a case for trying to move some of the social security contributions paid by the employer to a more general tax base.

Q: You said the government's increasing the deficit to around 500 billion Yuan is sufficient to stimulate the economy, but of course, you still think that the government should (further) loosen monetary policy, right?

A: Yes, indeed. The People’s Bank of China has reduced the reserve requirement ratio (RRR) twice now. That’s had an impact on interbank interest rates. Some more RRR rate cuts is likely in the next few months. Also, the growth of credit has picked up as well. That too should stimulate the economy.

Q: Lately, there have been many new policy initiatives in Beijing to reform the financial sector, including an experiment program on private lending in Wenzhou, setting up another offshore RMB center in London, significantly increasing QFII (Qualified Foreign Institutional Investors) quotas. There has been much debate about how best to open up China’s financial sector. What’s your recommendation?

A: At the moment, the Chinese government does have a window open for opportunity for opening up the capital account. The extent of the current account surplus has diminished enormously. Already overseas investments by Chinese companies are growing rapidly. The current account surplus in the first quarter of this year was 1.4 percent (of GDP). That means the output pressure on the exchange rate is much less now than it was five years ago when current account surplus was ten percent of GDP.

The way the government should move on financial reform would be first to take more steps on the QFII and RQFII (Renminbi Qualified Foreign Institutional Investors) areas. It is also important to allow people to invest outside of China, expanding that experiment in Wenzhou.

An equally important factor is at the same time of opening up the capital account, you need to liberate the setting of the interest rate. Otherwise, when you open up the capital account, that offers an opportunity for arbitrage between foreign markets and domestic markets. So I think the banking systems should be sheltered. You need to get rid of interest rate regulation and that should happen very early on.

Q: Is there a certain sequence that all these needed reforms should be following?

A: I think the essential thing is to start preparing the Chinese banking system so that it can live with much lower margins that it has been earning due to regulated interest rates. That would be among the first to try. The second is to open up the equity markets, then the bond market.

Q: If there is one or two pressing reforms that you could advise the Chinese government on, what would that be?

A: There are two areas. One is to improve the position of migrate workers in the cites. The way to do that is to detach social benefits for having a local Hukou. That makes it easier for the whole family of migrant workers to join and settle in the city. That’s a policy that China should follow and that is also a way to generate more consumption in the cities as well.

The other area is State Owned Enterprises (SOE). There are lots of areas to improve, but certainly one would be that SOEs should pay 30-40 percent of their profits to the Ministry of Finance and the Ministry of Finance should use that to either cut taxes or to increase social spending.

Our Guest Today:

Richard Herd is senior economist at the Organization for Economic Co-operation and Development (OECD), an influential Paris-based international organization that promotes better government policies. Mr. Herd is the head of OECD’s China and India research team and has been researching the Chinese economy for eight years. He graduated from the University of Cambridge.

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