Post Submitted By: Patrick McQuire

Very few people would be surprised to hear that a very large percentage of American companies are moving into China. That’s the name of the game these days. You have to be in China if you want to do business in today’s world. One billion customers and one billion laborers—who can resist? You can find many stories in the media about Wal-Mart driving its suppliers into China for the lower manufacturing costs. But one aspect of the Chinese market that is largely overlooked is another significant business decision—tax exposure.

China built its economy up over the last couple decades with a lot of investment from foreign companies, including most of the companies we hear about, talk about, and buy from everyday—Microsoft, Coca-Cola, McDonalds, etc. But they haven’t just used their population to attract these companies. They’ve provided tax incentives to foreign companies, even charging lower tax rates for foreign companies than they do for domestic ones. (How about that for a supposedly “communist” country?)

With the Chinese economy continuing to post sustained, high growth (higher than 7% per year for more than 25 years, according to this The Wall Street Journal article (”Why China Grows So Fast”), Beijing is coming to the decision that they might not need to entice so many foreign companies to invest in their economy. This second Wall Street Journal article (”China Close to Ending Global Firms’ Tax Break”) points out that this shows China is so attractive to foreign companies that the incentives aren’t as necessary anymore (supply and demand, of course, says charge more when demand is high—again, is China really a “communist” country?)

The other interesting thing I found is that China seems to be coming to the decision that their economy has too much foreign ownership. Such irony–you’d hear the same thing from most TV commentators if you asked them about the state of the American economy today! In the session with Professor Ramezani, we talked about the impact Foreign Direct Investment has on an economy. Many Americans, of course, are concerned by the trade deficit America has with China, and the concerns over foreign investment. China obviously runs a trade surplus, but just like the USA, they are also worried that their economy is becoming too foreign (evidence of this may be the expulsion of Starbucks from Tiananmen Square) and that domestic businesses are being held back by the prevalence of foreign companies.

Now FDI certainly helped China over the last few years. China’s economy is humming along, but maybe now they don’t need or want so much help. A concept that really fascinated me in one of my international economics courses while studying in Ireland (a country also a major beneficiary of FDI) is Convergence—developed countries invest in less developed countries because the room for growth (and the Return on Investment) is so much higher. As the country becomes more developed, the marginal return shrinks, the growth rate slows, and the ROI comes closer in line with rates in the investing country. The levels of development “converge”, eventually meeting up at a moderate growth rate. China’s economy still has a very high growth rate, of course. It is clear that there is still a very high ROI rate possible with Chinese investment if Beijing feels it can raise tax rates without a negative impact on investment. But it seems that China now feels its economy is healthy enough that its domestic business can carry the economy further.

Here are some things to think about:

• If China is now trying to put more emphasis on domestic economy, does this mean that convergence has done its job and we’re going to see slower growth in China?
• Will we start to see less foreign involvement in China? Is China going to become less attractive to foreign companies if the tax incentive is removed? Will this make the USA more attractive once again for American companies? Or is the Chinese labor force enough comparative advantage? Will China soon become more marketplace than manufacturing base?
• Will this help or hurt the Chinese economy?
• Will this help domestic Chinese companies compete with the foreign companies? And will we in turn see more Chinese companies investing in the US?
• Where is China on the convergence curve? How far has it come and how much longer will it be before the country’s economy has “converged?” Is the change in tax policy a sign that China has made significant progress on the convergence curve? Could the change in policy toward foreign businesses slow China’s convergence?
• Is this a real threat or an empty threat? I read another article about Las Vegas Sands the parent company of the Venetian Resort in Las Vegas (and Macau, a Chinese Special Administrative Region), which also holds land on Hengqin Island in China. For years, the company has avoided property taxes on the land because the Chinese has not enforced its Land Appreciation Tax. However, the Chinese government recently announced that they intend to being enforcing that tax, which could result in millions of dollars in tax liability for the LVS if China does not create a special exemption for Hengqin Island. Does this example show that China is now getting tough on taxes or does it show a history of goodwill on tax enforcement?
• Is China making the right decision for its economy?

[Professor Carr Addendum:  See also the related and informative China Law Blog posts on taxes in China -- click here and here.]