US to China: See you in court (maybe)
When I saw that the US was initiating a WTO case challenging China's various tax favors and export rebate, I knew who to turn to for analysis.
Emmanuel — a regular participant in the comments section - has long encouraged me to take a closer look at China's export rebates in particular.
Rather than do that, I decided to give the floor over to him for a day. Emmanuel's guest post follows.
Emmanuel:
The dispute over China’s large and growing trade imbalance with the United States centers on the perceived undervaluation of the yuan. Yet, other components of Chinese trade policy aside from its foreign exchange regime have largely eluded attention–until now. US Trade Representative Susan Schwab has just requested dispute settlement consultations with China in the World Trade Organization over Chinese measures that appear to contravene WTO rules. These consultations are just the first step in what may end up in judicial proceedings, though only about forty percent of such disputes reach the point of being resolved through rulings. If the US and China are unable to resolve this dispute after a period of bilateral consultations lasting sixty days, then the US can ask the WTO to form a panel to settle this dispute. (Continues)
Emmanuel:
Targeted are income tax reductions and refunds, value-added tax (VAT) exemptions, tariff exemptions, discounted lending rates, and exemptions from mandatory worker benefit contributions said to be made available to Chinese and foreign-invested enterprises (FIEs) satisfying certain export performance requirements. Also cited are income tax and VAT refunds given to companies that purchase Chinese-made equipment and accessories. See 4.2.1 (b) and (c) here for sample benefits to FIEs–many of which have ties to China’s neighbors. USTR charges that these are in violation of WTO stipulations on Subsidies and Countervailing Measures for they “require recipients to meet certain export targets, or to use domestic goods instead of imported goods.” Until the actual complaint is posted on the WTO site, there is still uncertainty over the specific products and measures in question (hat tip: International Economic Law blog).
The USTR charges that while it has repeatedly mentioned its concerns to them, Chinese officials have not taken steps to remove these measures. The timing of this episode attracts interest: Why is it only now that the US is acting despite knowing about these measures before? The Financial Times suggests that the administration is responding to pressure from the Democratic congressional majority over the bilateral trade imbalance, and that Bush is keen on winning congressional support for extending his fast-track authority in trade negotiations once it expires at midyear. This authority might be crucial if an international agreement is made during the restarted WTO Doha development round. I would add that election season 2008 is near, hence these efforts to garner political support–especially in the rust belt. If this matter is favorably resolved before reaching the adjudication stage, Republicans should gain clout with those in the manufacturing sector. Even if the case does reach the adjudication stage, it should still give Republicans political capital for they can point to “doing something” about China as proceedings will be ongoing right in the middle of the campaign season. It is a heads-up move politically.
Some of these export-promotion measures are considerable, like export-tax rebates. In 1994, China introduced a national value-added tax system that had a main rate of 17%, with a rate of 13% applied to basic goods. Exporters were able to claim rebates of 17% and 13% respectively, effectively negating the VAT. While these rebates were reduced twice to 10% and 6% by 1996, the onset of the Asian financial crisis meant that China had to find a way of maintaining its export competitiveness. Though it did not devalue the yuan for doing so would have likely caused doubts over the soundness of China’s finances at a time when other Asian economies were in crisis, China did increase the rates of these rebates to compensate. According to official statistics, the average rebate rate reached 14.75% by 1999 and 15.6% by 2002. More recently, China has lowered rebates on export goods from high-pollution industries like steel and textiles. While the rates on these rebates have bounced around, the amount spent has increased in recent years together with China’s export growth. Below is a chart depicting what China has spent on these export-tax rebates in dollar terms using year-end conversion rates:
In 2005, these export-tax rebates totaled $41.78B. Official statistics put the H1 2006 figure at about $27B. From 2001 to 2005, these rebates were somewhere between 4.5% and 5.6% of the value of Chinese exports. It is important to point out that export-tax rebates are not as clearly in violation of WTO rules as some of the other measures previously noted. If demonstrated, two things should help them be deemed legal. First, these rebates should not exceed the amount paid to domestic tax authorities. If the VAT rate paid is 10% for example, then the rebate given should not be greater than 10%. Second, foreign firms exporting from China should also be able to claim these rebates.
Can this episode spark a trade row? China has replied that this case is “a pity.” Yet, in response, China appears amenable to concessions on steel and perhaps other products. These rebates are not cheap, either, and have accounted for between 14% and 38% of the central government’s total expenditures in past years. The government has already accumulated substantial arrears in its export-tax rebate payments. The continued use of these rebates and other measures seem to conflict as well with China’s avowed intention of transitioning to a more consumer-driven economy as government spending is directed towards promoting exports instead of creating social safety nets thought necessary in encouraging a consumer culture. As of now, the long-awaited Sino-American showdown at the Trade O.K. Corral is not yet in the cards, but we might be getting there sooner than we think.
Emmanuel,
As you pointed out on the other blog, VAT rebate is not illegal per se. Similar to a state in U.S. not charging sales tax for export from that particular state. The other name for VAT is sales tax (except VAT is collected incrementally), and use tax.
How is your estimate of VAT rebate derived? I suppose that only applies to the value added by the final exporter — ie an upstream part maker is not rebated for its value add — so you can’t simply multiply the export value by the VAT rate, in which case the estimated number seems rather big.
But I agree that it makes no sense for China to subsidize export.
Chinese IT companies (chip makers, e.g.) seem to export their parts first to escape the VAT even if the parts are destined for domestic consumption. It works because of the zero tariff on IT products. So not all VAT rebates are necessarily export subsidies. Many companies must be using it for tax avoidance.
I came across this while reading company reports. One company reports that all parts are exported (so it does not pay VAT) even though I know their main market is inside China.
A simple final sales tax seems to make a lot more sense and avoid all the complexity and administrative headaches associated with VAT. Domestic equipment makers are at a distinctive disadvantage if they have to pay VAT but importers don’t have to and import tariff is lower than VAT rate. That “import substitution subsidy” isn’t really a subsidy. There is more than what meets the eye.
Can we be sure about the link between export rebates paid out by the government and actual exports? And therefore that a change in export rebate policy would impact exports?
http://www.atimes.com/atimes/China_Business/IA30Cb02.html
“…a considerable part of China’s trade surplus is not real, but in fact comes from “fake” exports by enterprises that fraudulently obtain export rebates from the government…
…A popular practice is to export certain goods to get tax rebates and then smuggle or import the goods back to sell in the domestic market…
…This “mis-invoicing” was commonplace among Chinese importers over the last decade, but back then it was a way of getting money out of China…Now it is the other way around…
…the actual trade surplus in 2005 was probably only $35 billion after the deduction of false export claims and concealed non-trade capital inflow, which could total $67 billion…”
If there is any truth to this, it might throw some light on why some numbers just do not add up. Any sanctions or tariffs the US imposes will be ineffective anyway, as goods made in China will be labelled “made in Indonesia” and shipped with papers stating they originate from Indonesia, without actually having entered an Indonesian port.
I believe there is little chance that a panel will be formed in this case. In addition, I see this as a profoundly defensive rather than offensive move by the USTR.
1) The Administration is clearly trying to take momentum away from the Democratic Congress on trade issues in general (e.g. see recent Bush and Bernanke offensive). Specifically, this case can be viewed as a quasi-substitute to prevent anti-China legislation such that would change existing US trade laws to allow CVD complaints against non-market economies. The Bush administration is clearly looking to buy time rather than punish China. Protectionism, particularly in the US, is usually an administrative rather than a legislative phenomenon. The biggest threat is not the enactment of Smoot-Hawley (or Schumer Graham), but opening the administrative floodgates to US industry complaints.
2)The USTR has limited options to bring good cases. After contemplating several high profile cases (including IPR), the USTR has found that American firms are profoundly unwilling to help bring cases against the Chinese that might result in retribution from the Chinese government. This moves to the point that anti-dumping and other trade laws have not sufficiently evolved with changes in the global economy. From a diplomatic perspective, this fits the US strategy of treating China as a “stakeholder.”
3) Will this case spark a trade row? Probably not. This case is actually a positive for the Chinese in that provides political cover to undertake reforms that the government WANTS to do but is unable to do strong interest group opposition. Keep in mind, some of the USTR case/evidence is essentially taken from a document that China itself submitted to the WTO last year regarding remaining subsidies in their domestic system. In the end, it seems that both sides win.
The Bush administration is credited with “doing something” while actually not really doing much of anything. It also stems off harmful legislation for a period of time (even better if a panel forms which takes even more time). The Chinese get more time and cover to perform reforms. The real question is how long will this placate Democrats, my guess is not long when they finally wake up.
HZ,
I saw your comments after posting mine. Your statement about the company that exports 100% despite being mainly a domestic player would be consistent with the Asia Times paper.
Also: Who pays? The government. Who benefits? All factories, whether they actually export or not. Who owns the factories? Probably people who are well connected to the government. So why on earth would they decide to stop the flow of export rebates funds into their own pockets???
one question being if it may all be adding up to a spectacular abuse and misallocation of resources:
“water shortages could be the bottleneck to China’s economic and social development.” http://news.bbc.co.uk/2/hi/business/6336079.stm
Export tax rebates are hardly the direct taxpayer subsidies that the US government pays inefficient sugar cane farmers in Alabama and Louisiana. Moreover, export tax rebates are NOT illegal under WTO trade regulations. The European Union provides export tax rebates for the luxury German automobiles exported and high-value added Airbus transport aircraft, but the Chinese get hammered for providing export tax rebates in the labor-intensive textile industry that has long ago migrated to developing nations. The bottom line: The USTR has absolutely no case whatsoever in this politically motivated lawsuit.
HZ: The annual amount of export-tax rebates recorded can be found on the website of the Chinese tax authorities. Look at the last line (after 17.) for 2005 and H1 2006. On this website you can find data that goes back to 1994–when China adopted the VAT system. Note that while China has granted export-tax rebates since 1981, the amount spent on these rebates has gone up markedly since the VAT system was adopted.
Read this too if you are interested in how export-tax rebates are calculated.
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Indonesia: I too have seen that Asia Times article by an author claiming some export-tax rebate claims are bogus.
It’s possibly another reason to discontinue this support. Like many developing countries, China doesn’t yet have the best governance mechanisms in place.
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Anonymous: While we are waiting for the complaint to be filed on the WTO website, we cannot be entirely sure whether American firms operating in China will be hit by “collateral damage.” My sense is it’s more of the Pacific Rim-partnered FIEs whose exports are in competition with those made in the USA that will be targeted. After all, the National Association of Manufacturers (NAM) heartily approves of this action.
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Guest: Part of the reason why China is reducing rebates on steel, textiles, etc. is to curb resource-intensive and polluting products. Presumably, the aim is to move China in the direction of cleaner, higher technology exports.
UPDATE: The World Trade Law site has just posted the US consultations request. It lists where to find the measures that are allegedly in violation of WTO rules.
It is important to note that there are several other export promotion measures in question other than export-tax rebates such as tax refunds for those who buy Chinese-made equipment. And, China will have a difficult time disproving that it has not given them as the evidence is scattered all over the Internet that China does give them.
“Presumably”
but if the structure is already in place and has to run at full capacity to keep feeding the machine, a bit difficult to suddenly retrofit mid-stream?
One consequence of this action is that by going through WTO, it deflects calls for doing something outside of the WTO system. My guess is there is going to be some negotiated settlement similar to what happened with textiles since there aren’t any reasons I can see why the PRC would dig in their heels.
I don’t think that it is going to change the overall balance of payments situation. Something important to point out is that no one in Congress really cares about the balance of payments or the value of the RMB, they care about jobs in their districts. I think that what you will end up is some Chinese agreement to some protectionist measures for politically critical industries in the United States, but these won’t do anything to change the overall balance of payments which is driven by the need for the US to raise cash.
probably a dumb question, but if it needs cash, can’t the US raise it by making a few calls to any number of tax havens?
my impression is that subsidy disputes go beyond jobs and balance of payment issues.
Excellent post Emmanuel.
I sorta go with what Dave (Ok, and Joseph) says, but prolly on a lot less information.
Yes, my information is that the co-venturing (trans nationals) are key players in this trade business and have vested interests in that pegged currency. So while the US trade officials may have public announcements in response to politicians who are receiving calls from job-endangered constituents, I want to hear from, say, GM or Ford who have a different and closer, I think, connection to most of those representatives.
Joseph Wang: True, congressmen of all stripes care about getting re-elected first and foremost. Survival is the basic instinct of any elected official.
In contrast, I would be wary of using the term “protectionist” here. Going by the WTO rule book, some of China’s measures are difficult, nay, almost impossible to defend. Expect China to back off on some of the more flagrant measures, though you never know. Some “professional wrestling”-style trade negotiation antics would definitely enliven things.
Yes, even if this case is resolved in favor of the US, I really doubt whether it will make a significant improvement in the BOP situation. There’s a deeper structural issue about the current state of US manufacturing behind this case that isn’t being addressed. It should be good for some votes, though.
Emmanuel,
Thanks for the references. The rules do look very complicated. It is still not clear to me whether imports are subject to VAT — if not, for zero or low tariff items (such IT products) domestic producers are at a disadvantage tax wise.
Calmo and HZ: You might be referring to two earlier cases that the United States brought against China in the WTO. Unlike the current one which concerns subsidies for Chinese exports, the first two concerned market access for American products in China.
The first case involved semiconductor exports. American semiconductor manufacturers complained that their products were subject to 17% VAT in China whereas a partial VAT refund was given to semiconductors made by Chinese firms. (VAT is applied in China to imports as well.) China relented by removing refunds on locally-made ICs and this case didn’t reach the adjudication stage.
The second, still ongoing case involves US, EU, and Canadian auto parts manufacturers complaining about their parts being made more costly for Chinese manufacturers to use than locally-made parts. A panel has been formed to investigate this complaint though proceedings are still ongoing.
Emmanuel,
Thanks. You have been very informative. I did a bit digging and it seemed to me that imported equipment can qualify for exemption from import duty and VAT. In that case the charge on “import substitution subsidy” through VAT refund could not really stand. Here is the website that gave the info from KPMG http://www.altassets.com/casefor/countries/2002/nz2847.php
Customs duty and import VAT exemption on tangible goods
Equipment and its components, as well as the technologies associated with the equipment (hereafter collectively referred to as tangible goods), imported for the purpose of producing the goods listed in the State High-technology Product List should be exempt from customs duty and import VAT. However, if the imported tangible goods fall within the List of Goods Disqualified for Tax Exemption for Domestic Invested Projects, the abovementioned exemption will not apply (Ministry of Finance and SAT Circular [1999] No 273).
Tangible goods imported by certified software companies should be exempt from customs duty and import VAT. The importation should not be accounted for as total investment, for the purpose of determining the total exemption amount. However, if the products fall within the List of Goods Disqualified for Tax Exemption for Foreign Invested Projects or the List of Goods Disqualified for Tax Exemption for Domestic Invested Projects, under the State Council Circular [1997] No 37, the exemption will not apply (Ministry of Finance, SAT, and State Administration of Customs Circular [2000] No 25).
Similar tax exemption policies are applicable to electronic integrated circuit projects (Ministry of Finance, SAT, and State Administration of Customs Circular [2000] No 25). In addition, qualified electronic integrated circuit companies (ie with total investments exceeding Rmb8bn or producing circuits less than 0.25µm wide) will be exempt from customs duty and import VAT on the raw materials imported for their own production.
HZ: No problem. Note that what we’re talking about now is veering off into another topic largely unrelated to the original post: sending US exports to China, not sending Chinese exports to the US. Sending US exports to China is the subject of the first two cases brought by the US against China in the WTO, not the current one.
Be cautious in ascribing current Chinese policy to this circular for it is dated. A passage from it exactly describes the objections over semiconductors mentioned in the first case:
Reduced VAT rate for integrated circuit manufacturers
According to the Ministry of Finance, SAT, and State Administration of Customs Circular [2000] No 25, a general taxpayer engaged in the production of integrated circuits will be subject to an effective VAT rate of 6 per cent. If the VAT effective tax rate is more than 6 per cent, the taxpayer is entitled to receive a refund for the excess amount. Companies engaged in the export of, or who contract other companies to export, electronic integrated circuits do not qualify for the abovementioned VAT policy.
China overturned this measure when the US brought the case on behalf of US IC manufacturers to the WTO.
Guanxi strikes again.
As for the Olivia Chung article posted by Indonesia, it would be irony indeed if foreign investors, using shady means to speculate on yuan appreciation, got burned.
I tend to think the surplus is more or less real, though. Chinese products so saturate our stores that it’s difficult to believe that they aren’t making money on it, even if they are being exported by foreign corporations. Presumably the money stays in China.
Charles of MercuryRising
http://www.phoenixwoman.wordpress.com
Emmanuel,
We seem to have cross talked a bit. WTO is mainly concerned with non-discrimination. What I was trying to say is that VAT rebate itself is not necessarily discriminatory. On the export side rebate seems to be standard practice. On the rebate for domestic equipment, it is also not discriminatory if imports of the same equipment are exempt from VAT. So devil is in the details and hopefully USTR has done her homework well.
I was also trying to understand why companies first export ICs even if they are destined for domestic consumption. The exemption of VAT for both imports and exports seem to explain that.
There seems to be noise being made in China that VAT is too high (accounting for half of government revenue). Maybe China should simplify the structure and rachet down the rate, while US could raise the tax on consumption. That could help the balance?
It is my understanding that WTO passed a special rule to allow the VAT game to go into play.
And, yes, it is a big deal.
Everyone: Again, let me be clear on this point. Export-tax rebates are not automatically WTO-illegal. To be deemed illegal, (1) the refunded rate must be higher than the VAT rate applied by tax authorities. If the VAT rate applied is 10% but the refunded rate is 13%, for example, then China is subsidizing its exports. Or (2) the other possibility is that China grants export-tax rebates to Chinese exporters but not to foreign firms exporting from China. Action (1) would violate stipulations on the use of subsidies, while action (2) would violate the principle of national treatment that all firms operating in China should avail of similar benefits regardless of where they originated from.
What is often underappreciated is the extent to which China uses export-tax rebates and the rest in devising its trade policy. The value of the renminbi is just part of the equation. Especially for commodity exports whose margins are wafer-thin, these measures can make or break a firm’s profitability. For instance, there are signs that textile exporters in China are feeling the heat from dwindling rebates. Tinkering with the FX rate is a blunt instrument that affects practically all exports, while manipulating the export-tax rebate on a sector-by-sector basis is a more nuanced instrument.
Like Movie Guy said, it’s a big deal, and I’m surprised that most of the other economics bloggers haven’t picked up on this filing when they feature nearly endless stories on the value of the renminbi. Even the Economist magazine doesn’t have a story on it in this week’s issue. Ultimately, I second what Andy Mukherjee of Bloomberg wrote in the link I posted:
That doesn’t mean China’s export-led strategy is sustainable. The Chinese authorities are aware of the urgent need to contain the ballooning trade surplus and deliver on their promise of rebalancing the economy.
Increasing domestic consumption, lowering income inequality and arresting the damage to the environment are more pressing priorities for China than selling yet more widgets to the world.
Emmanuel,
I completely agree with your new post.
The textile example, though, is a little funny. It is more a political gesture to other developing economies than either of the pressing priorities you quoted, i.e. “increasing domestic consumption, lowering income inequality and arresting the damage to the environment”.
Here is a link that has a lot of insight to what China may be up to:
http://www.financialsense.com/editorials/navarro/2007/0204.html
I am not sure where I came across this link, maybe on this forum somewhere?
In the article, it states that China’s undervalued currency is only about 11% of the advantage that China has in trade.
The article did leave me feeling somewhat disturbed. But, new ideas, and new awareness helps me to prepare for the future.
Picking up from what Emmanuel and HZ noted above, I want to make sure people do not remain confused: among countries with a VAT system, full rebates for all exporters are the norm. They are consistent with full VAT rates on imports. China gives partial rebates on exports. It is not obvious to call this a subsidy. If the US takes China to the WTO for partial VAT rebates for exporters, it can take dozens of countries to the WTO for full VAT rebates for exporters.
China has been encouraging and subsidizing manufacturing in several ways. However, the VAT rebates for exporters are an odd choice to focus on.