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1、Tax Incentive and Innovation in ChinaDing XuedongMinistry of FinanceBeijing, ChinaJun LiSchool of Entrepreneurship and BusinessUniversity of EssexIntroductionChina has sustained rapid economic growth for over 2 decades after initiating reform and opening to the outside world. Chinas GDP reached RMB
2、21.18 trillion in 2006, ranked fourth place in the world after the United States, Japan and Germany. Under its “market for technology” policy, China has become the second largest recipient of FDI just after the US over the past decades. It is noted that Chinas opening to foreign investment was not m
3、otivated by a shortfall of domestic savings; rather, through the concept of a “markdet for technology”, FDI, foreign trade and technology transfer were expected to contribute to the modenisation of the national economy (OECDa, 2007). While foreign direct investments have led to knowledge spillovers,
4、 they did not appear to generate much needed technology transfers. This has prompted China to transform its mode of economic growth from the existing low value-added, export-driven growth to innovation-driven growth. Incentivizing innovation can take two basic forms: a) financial incentives direct g
5、overnment funding for private sector innovation activities through grants, loans, subsidies, etc; and b) fiscal incentives tax relief measures which encourage firms to carry out innovation activities by reducing their cost (Eourpean Commission, 2003). As one of the main instruments of innovation pol
6、icy, tax incentives are justified by knowledge spillovers and innovation risk. In contrast with subsidies, it can also improve the domestic environment for R&D expenditure without any sectoral or technological targeting, thereby reducing administrative costs. OECDs latest study (2007b) has shown, so
7、me 20 OECD countries use tax instruments to encourage firms to increase their R&D expenditure, and such instruments are also being developed in non-membre countries, including China. Fiscal incentives allow companies to reduce their tax bills as a reward for carrying out innovative activities, enbli
8、ng them to reduce the total costs of such investments (Atkinson, 2007). China initiated the “Medium- to Long-term Strategic Plan for the Development of Science and Technology” in 2006 that sets out the key objective and priorities in science and technology. The overarching goal is to make China an “
9、innovation-oriented” society by the year 2020. The fulfillment of this ambitious task requires, among other things, a significant improvement of incentive structures. Currently, our understanding of tax incentives in China remains very limited as a result of underdeveloped research into the relation
10、ship between fiscal incetives and innovation in the Chinese context. For example, what are the main characteristics of tax incentives in China? how do fiscal incentives in China evolve? what is the relative effectiveness of R&D tax incentives? And how do tax incentives fit in the overall policy mix
11、for supporting R&D and innovation? This paper makes no intention to answer all these questions. As a tentative effort in part of an ongoing research project, it rather has two limited objectives in that a) to describe the evolution and main features of tax incentives in China, and b) to explore some
12、 of the policy issues concerning the effectiveness of fiscal policies.Chinas Innovation PerformanceChinas science and technology (S&T) policy reform and development have been driven and underlined by a wider economic reform agenda. The evolution of post-reform S&T policy can be divided into four pha
13、ses, i.e. the experimentation phase (1978-1985), structural reform (1985-1995), deepening of the S&T reform (1995-2005), and the development of a firm-centred innovation system (2005 onwards)(OECDa, 2007). Up to now, assessment of innovation performance in China is still far and few. Nevertheless, e
14、vidence from a few studies seems to suggest a considerable improvement of innovation performance in China after continued reforms of S&T policy over the four phases (Naughton and Segal, 2003; OECDa, 2007; Zhong and Yang, 2007; Zhou and Leydesdorff, 2006): China has become a major S&T player in the w
15、orld in terms of inputs to innovation. The R&D/GDP ratio has more than doubled in a decade and reached 1.34% in 2005 compared to only 0.6% in 1995; The business sector has become the dominant R&D actor, now performing over two-thirds of total R&D, up from less than 40% at the beginning of 1990; Chin
16、a has relied heavily on technology imported from abroad, and the development of its scientific and technological capability has until recently lagged behind its economic growth. This trend was reversed towards the end of the last decade and since then significant progress has been made towards devel
17、oping the countrys innovative capabilities.Yet, serious problems remain with the development of independent innovation capability. First, although the impressive investment in resource for science technology has contributed significantly to the rapid socio-economic progress registered in China in th
18、e last decade, it has not yet translated into a proportionate increase in innovation performance. Particularly, the innovation outcomes of the domestic business sector are much lower than what one would expect given its share in total R&D and human resources in science and technology (HRST) (OECDa,
19、2007). This has raised the question of efficiency and effectiveness of fiscal policy design and implementation.Second, the rapid increase in business sector R&D has resulted, to a significant extent, from the conversion of some public research institutes into business entities. The vast majority of
20、Chinese enterprises still have both limited capabilities and a low propensity to innovate. The question will be whether there are defective incentive structures in tax incentives or whether fiscal policy alone can sufficiently incentivize firms to innovate.Third, manufacturing firms have dramaticall
21、y increased their funding of R&D by outside research institutes. This reflects the perception among firm managers that buying or contracting for research from outside research institutes is more cost-effective than attempting to develop new product or process technology in-house (Liu and White, 2001
22、).Finally, programmes to support innovation, such as Spark and Torch, account for the lions share of public funding, arguably indicating an imbalance in public support.These problems indicate the sources of ineffiencies steming from structural imbalance within the innovation system and defective inc
23、entive structures for actors. In the development of a firm-centred innovation system, demand-side factors will play a growing role in determining the scale, allocation and impact of S&T investment.Tax Policies and InnovationAs an important instrument of state macro-control, taxation plays a crucial
24、role in allocating resource and promoting technological innovation. Statistics indicate the presence of over 600 items of preferential tax treatment in 20 taxes levied by China since the compound tax system was set up in the 1980s. Now there are 118 preferential policies for technological innovation
25、, including 48 turnover tax policies, 58 income tax policies, and 12 property tax policies. The number of preferential policies for technological innovation is the second largest after the number of preferential policies for social welfare. At the same time, the amount of tax exemption and reduction
26、 allowable for science and technology is almost in the highest range. Chinas tax incentives for technological innovation encompass all forms of internationally adopted tax credit, pretax deductions and accelerated depreciations. Therefore, China has set up a fairly comprehensive taxation regime orie
27、ntated to support the development of innovation system. Corresponding with science and technology development strategies, China has undergone a series of transformations and adjustment in R&D tax incentives over the years. Firstly, there has been a shift from the dual-track income tax system in favo
28、ur of foreign funded enterprises to the unified income tax system for domestic and foreign funded enterprises to pay the same income tax rate; secondly, there was a transformation from the production-based VAT system to the consumption-based VAT system; thirdly, there was adjustment and fine-tuning
29、of preferential policies in respect of R&D expenditure pretax deduction, accelerated depreciation, and etc. Corporate Income Tax UnificationSince initiating reform and opening to the outside world, China had long adopted the “dual-track” income tax model under which two separate income tax systems e
30、xisted side by side for domestic and foreign funded enterprises respectively. With regard to foreign funded enterprises, in order to meet the needs of attracting foreign investment, technologies and talent, and the needs of encouraging international economic and technological cooperation, China enac
31、ted and implemented a series of laws and regulations, e.g. the Income Tax Law on Sino-Foreign Joint Ventures in 1980; the Income Tax Law on Foreign Enterprises in 1981; and integration of two separate income tax laws for wholly foreign funded enterprises and foreign enterprises into the Income Tax L
32、aw on Foreign-Funded Enterprises and Foreign Enterprises in 1991. In respect of domestic enterprises, the State Council enacted the Income Tax Regulations on State-Owned Enterprises (Draft) in 1984; the Provisional Income Tax Regulations of Collectively Owned Enterprises in 1985; the Provisional Inc
33、ome Tax Regulations on Private Enterprises in 1988. The State Council also consolidated the two separate sets of income tax regulations for domestic enterprises such as state-owned, collectively owned and private enterprises into the Provisional Regulations on Corporate Income Tax in 1993, which too
34、k effect in 1994. By that time, the “dual-track” income tax model was completed with two separate income tax regimes in parallel for domestic and foreign funded enterprises. This model resulted in differences in pretax deduction, preferential policies, and applicable tax rates for domestic and forei
35、gn funded enterprises. As regards pretax deduction, domestic enterprises were imposed a ceiling on the amount of pretax deductions for payroll expenses, charitable donations, advertisement fees, staff training expenses, employee benefits and employee union fees, whereas foreign funded enterprises we
36、re allowed to deduct such costs before tax without any restriction. In respect of preferential taxation treatment, to boost the policy initiatives of attracting foreign investment, the state adopted a series of preferential taxation policies, mainly including “two-year income tax exemption and tax r
37、eduction by 50% for another three-year” incentives for foreign funded production enterprises, “five-year income tax exemption and tax reduction by 50% for another five-year” incentives for foreign funded enterprises investing in port/harbor and energy, and the reduced tax rate of 15% or 24% for fore
38、ign funded production enterprises located in special economic zones and economic and technology development zones. Evidently, Chinese government offered a broad range of generous incentives to foreign funded enterprises with preferential policies aiming to attract foreign direct investment, encourag
39、e export, and utilize advanced technology etc. In comparison, domestic enterprises were entitled to a narrow band of preferential taxation treatment. With regard to effective tax rates, domestic enterprises were subject to a statutory baseline income tax rate of 33% and a reduced tax rate of 18% or
40、27% in the case taxable income falling in the range of RMB 30,000100,0000. Foreign funded enterprise were subject to a proportional income tax rate of 30% plus a local income tax rate of 3% (total tax rate: 33%). While the income tax rates of domestic funded and foreign funded enterprises appeared t
41、o be the same, the effective enterprise income tax rates (burdens) were below nominal tax rates after adjusting for allowances offered by preferential policies under different tax laws and regulations. For example, 3% local income tax included in foreign funded enterprise income tax was exempted in
42、most areas of China. As mentioned earlier, domestic and foreign funded enterprises were subject to different preferential taxation treatments, which caused an actual tax burden of foreign funded enterprises below that of domestic enterprises. According to the findings of a nationwide survey on corpo
43、rate income tax, the actual average tax burden was approximately 25% for domestic enterprises and approximately 15% for foreign funded enterprises, i.e. 10% additional tax burden for domestic funded enterprises. From a historical perspective, the “dual-track” income tax model played a positive role
44、in promoting Chinas technological progress and innovation, attracting a huge amount of foreign investment, and importing advanced technologies and management methods, while promoting Chinas openness and science and technology progresses. Given Chinas greater emphasis on indigenous innovation, howeve
45、r, the discrepancies between the two separate taxation regimes for domestic and foreign enterprises were in contradiction with Chinas science and technology development strategies. Nor they delivered a unified fair and normative taxation policy environment for all forms of enterprises and created a
46、tax policy environment for independent innovation. Therefore, it was inevitable for China to unify the income tax regimes for domestic and foreign funded enterprises. The Corporate Income Tax Law of China was enacted at the 5th Meeting of the 10th National Peoples Congress in 2007 and became effecti
47、ve on 1st January 2008. Under this law, domestic and foreign funded companies will be subject to a unified income tax system. The unified income tax rate for domestic and foreign funded enterprises is 25% (or 20% for small firms with low profit margin). Under the unified pretax deduction methods and
48、 criteria, enterprises are allowed to deduct before tax all reasonable expenses incurred in earning revenues; unified preferential taxation policies are shifted from regional based incentives to industry based ones in line with industrial policies to encourage resources and energy conservation, envi
49、ronmental protection and high-tech development. The new tax law has a number of preferential policies to encourage technological innovation, including:1) A preferential income tax rate of 15% for high-tech enterprises applicable to all such enterprises nationwide rather than exclusively to those located in State High and New Technology Industry Development Zones;2) Tax credit for R&D expenditures in developing new technologies, new products and new proc
