CAMBRIDGE, England — The Chinese government has announced that death sentences have been imposed on seven people for tax fraud, in this case fraudulent claims for value-added-tax refunds on export sales. More death sentences, followed quickly by executions, are expected during what Premier Zhu Rongji has described as an “urgent economic struggle” against export-rebate fraud, which he said is an “outstanding social and economic problem.” In some ways, the deaths of these cheaters can be seen as a consequence of the way Zhu and other members of the Chinese government chose to respond to the Asian financial crisis.
For reasons best known to itself, the Chinese government chose not to devalue the yuan when other East Asian and Southeast Asian countries were devaluing their currencies. This made Chinese exporters and domestic producers competing with imports less competitive. However, Zhu is too much of an economist not to realize that the Chinese economy could not be isolated from the effects of the crisis in this way. One of the ways he convinced his colleagues in the government to cope with the impact of the crisis, given the determination not to devalue, was to protect exporters and importers from the effects of the other devaluations as best he could. He did this partly by directly subsidizing some sectors that had lost their competitiveness. There is also a suspicion that old-style import controls and export quotas were dusted off and foisted onto state-owned enterprises.
But the most important policy introduced to mitigate the combined impact of the Asian devaluations against the Chinese currency was to increase the rate at which Chinese traders could claim back refunds of VAT paid on the production of exports. China’s ever-inventive criminal classes responded quickly.
The VAT export-tax refund scam works by claiming refunds on exports that were never made. The phantom exports can take several forms. They can be physically represented by empty containers being shipped abroad — and taking them to Hong Kong is enough, or even simply shipping them filled with sand that is then dumped in Hong Kong and the empty container returned. Often there is not even any physical pretense of exporting, just the submission of phony export documents, in which there is reputedly a vigorous market — even blank invoices have a value.
Actually, the cheaters did not have to think up these scams: All they needed was a bit of a memory. We have been here before. Cheating became a popular pastime for the criminal classes soon after the Chinese government introduced VAT and the associated export rebates in the early 1990s. Then the response was to reduce the rate of rebate, in some cases to zero, in order to reduce the incentive for fraud. The immediate consequence, because the reduction was only to be phased in over some six months, was a massive explosion of “exports” before the rebates were withdrawn or substantially reduced. With all their skills, and probably stocks of invoices, still intact, the cheaters must have thought that miracles do happen when Zhu decided not to devalue the nominal exchange rate but to devalue the real effective exchange rate faced by exporters by reintroducing the higher-rate refunds.
As the confidence of the export-rebate cheaters increased, so did China’s “exports.” Although exports increased by only around 30 percent last year, VAT rebates on exports almost doubled, to 75 billion yuan. In Guangdong Province they tripled. One has to ask how much of the widely lauded export performance was illusory. Well, commentators on the Chinese economy have recently been claiming that capital flight from China is running at around $20 billion a year. It is likely that a significant part of this is not capital flight at all, but a trade surplus that exists only because nonexistent exports used to claim VAT rebates have been counted as real exports. Yes, yet another problem in trying to make sense of China’s official statistics.
Part of the problem appears to result from the methods the Chinese use to run the VAT system. In a standard system, VAT is not paid on exports at all; there can be no refund. A producer of goods or services in a VAT system is refunded all VAT paid on inputs and then adds VAT at whatever is the appropriate rate on its domestic sales; the rate on exports is zero. A company that does not sell on the domestic market at all would not pay any VAT on its inputs or its output.
In the Chinese system, the exporter has to produce documents to show that exports have taken place before the refund of the VAT is made, against receipts that purport to show that tax has been paid. This discriminatory system is probably illegal according to World Trade Organization rules, since it is operating as an export subsidy. It also creates the incentive for lucrative fraud.
This year, however, the topic is not as pressing as it was last year. Party leaders are distracted by changes in the leadership due next year. For the time being, expect more selective clampdowns on corruption rather than a root-and-branch attack, with the cases reflecting shifts in the balance of power as much as anything else. As my old teacher, Karl Popper, used to say, corruption is tolerated in authoritarian regimes because of the power it gives the leaders over the corrupt.
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