Reforming the Personal Income Tax System in the People's Republic of China

摘要 • The Amendment to the Personal Income Tax Law in 2018 was a fundamental reform to the personal income tax system in the People’s Republic of China. 2018年《中华人民共和国个人所得税法修正案》是中华人民共和国(中国)个人所得税(个税)制度的 一次根本性改革。 • International comparisons and case studies, however, show that some issues remain. These include (i) a narrow taxpayer base, (ii) broad special deductions, (iii) a heavy tax burden on labor income but a light one on capital income, (iv) a suboptimal tax rate structure, and (v) a low tax collection compliance rate. 然而,国际比较和案例研究表明,中国的个税制度仍存在一些问题,包括:(1)税基狭窄,(2)专项扣 除范围广泛,(3)劳动所得税负重而资本所得税负轻,(4)税率结构未达到最优,以及(5)税收遵从 率低。 • Lessons from successful tax reforms in Australia, Germany, Japan, Sweden, the United Kingdom, and the United States highlight the importance of a wide tax base, a limited scale and scope of special deductions, strong tax compliance, and increased transparency. 澳大利亚、德国、日本、瑞典、英国和美国成功推行税收改革的经验教训充分说明,拓宽税基、限制专 项扣除的规模和范围、强化税收遵从度以及提高透明度具有重要意义。 • Based on international experiences, this note provides policy recommendations in four areas: (i) broadening the tax base by freezing the current level of the basic deduction and including individual business income, pensions, and annuities into comprehensive income; (ii) streamlining and limiting special deductions; (iii) optimizing the tax rate structure by reducing the top marginal tax rate and increasing the minimum marginal rate; and (iv) strengthening tax compliance by stricter law enforcement. 基于国际经验,本政策简报提出以下四个方面的政策建议:(1)保持现行基本减除费用标准不变,并 将个体经营所得、养老金和年金所得纳入综合所得,以扩大税基;(2)精简专项扣除项目,并限制其 适用范围;(3)降低最高边际税率并提高最低边际税率,以优化税率结构;以及(4)加大执法力度, 以提高税收遵从度。

• International comparisons and case studies, however, show that some issues remain. These include (i) a narrow taxpayer base, (ii) broad special deductions, (iii) a heavy tax burden on labor income but a light one on capital income, (iv) a suboptimal tax rate structure, and (v) a low tax collection compliance rate.

澳大利亚、 德国、 日本、 瑞典、英国和美国成功推行税收改革的经验教训充分说明， 拓宽税基、 限制专 项扣除的规模和范围、 强化税收遵从度以及提高透明度具有重要意义。
• Based on international experiences, this note provides policy recommendations in four areas: (i) broadening the tax base by freezing the current level of the basic deduction and including individual business income, pensions, and annuities into comprehensive income; (ii) streamlining and limiting special deductions; (iii) optimizing the tax rate structure by reducing the top marginal tax rate and increasing the minimum marginal rate; and (iv) strengthening tax compliance by stricter law enforcement.
基于国际经验，本政策简报提出以下四个方面的政策建议： (1)保持现行基本减除费用标准不变， 并 将个体经营所得、 养老金和年金所得纳入综合所得， 以扩大税基； (2)精简专项扣除项目，并限制其 适用范围； (3)降低最高边际税率并提高最低边际税率， 以优化税率结构； 以及 (4)加大执法力度， 以提高税收遵从度。 观察与建议 I. BACKGROUND 1. The current tax system in the People's Republic of China (PRC) relies heavily on indirect taxes on goods and services, the growth of which has slowed significantly since 2016 following reforms of the value-added tax that sought to lower the tax burden on enterprises. The current tax structure in the PRC contrasts with international experience, which suggests that with increasing income levels, countries move away from indirect taxes toward direct taxes on income and property. In the PRC, personal income tax (PIT) contributed relatively little to tax revenue, amounting to 8.9% of the total tax revenue, or 1.5% of gross domestic product (GDP) in 2018, much less than the Organisation for Economic Co-operation and Development (OECD) average of 23.9% of tax revenue, or 8.3% of GDP in 2018. 1 The PIT reform in 2018 further reduced the share of PIT in tax revenue to 6.6%, or 1.0% of GDP in 2019. Improving PIT collection would make a direct contribution to strengthening the budget's revenue base.
2. The Amendment to the Personal Income Tax Law was approved on 31 August 2018 and came into effect on 1 October 2018. The amendment increased the basic deduction for PIT from CNY3,500 per month to CNY5,000, or, when annualized, from CNY42,000 per year to CNY60,000. It integrated income from wages and salaries, remuneration for personal services, and author's remuneration and royalties into "comprehensive income" by aggregating income from these categories each year. After deductions, this amount is then subject to a unified progressive tax rate. Changes also included the introduction of additional special deductions-to be deducted from annual comprehensive income-aiming at reducing tax burden by claiming special deductions for certain expenses such as children's education, further education, treatment for serious illnesses, and interest payments on housing loans and rental payments.
3. The revised Personal Income Tax Law is regarded as a milestone in reforming the PIT system. By introducing the concept of comprehensive income, the PRC moved to two coexisting taxation schemes, one comprehensive and the other schedular. The latter applies rates for each income category according to a specific tax rate table. Individual business income, interests, dividends, bonuses, income from the lease or conveyance of property, and other income are still taxed according to their respective tax rate table.
4. Although the amendment is an important step, international comparisons and case studies of PIT reforms show that some issues remain. Moreover, the outbreak of coronavirus disease  in early 2020 has put additional burden on the government budget. Not only will additional fiscal expenditure be needed to stabilize the economy but fiscal revenue is also going to decline as a result of the sharply slowing economy. This policy note focuses on recommendations to further reform the PIT, especially by broadening its taxpayer base, limiting the scope of special deductions, optimizing its rate structure, and strengthening tax compliance. Such efforts would help stabilize PIT revenue given the reduction in PIT collected following the amendment.

II. REMAINING ISSUES IN THE PERSONAl INCOME TAx SYSTEM
5. First, the high basic deduction results in a narrow PIT base. The PRC's basic deduction is high compared to other countries. With per capita income and per capita consumption expenditure in 2018 at CNY28,228 and CNY19,853, respectively, the annual basic deduction of CNY60,000 stood at 213% of the per capita income and was three times the per capita consumption expenditure. By comparison, basic deduction stood at 22.9% in Australia, 44.8% in the United Kingdom (UK), and 16.1% in the United States (US) of their respective per capita income; or 24.6% (Australia), 59.3% (UK), and 20.9% (US) of their respective per capita consumption expenditure. High basic deductions usually result in fewer taxpayers as more earners drop below the taxation threshold. According to an estimate of the PRC's Ministry of Finance, the share of taxpayers in urban employees declined from 44% to 15% after the amended Personal Income Tax Law took effect. 2 6. Second, two issues remain with the current special deductions. First, the basic and special deductions overlap: the basic deduction already considers basic consumption expenditures and has a dependency coefficient. Adding special deductions on top of that results in a high level of overall deductions. Second, the lack of income caps in applying special allowances narrows the PIT base and enables high-income groups to enjoy substantial tax benefits, which undermines the PIT's role in income redistribution.
7. Third, the tax burden on labor income is high, but the tax burden on capital income is relatively light. The PIT reform combined income from remuneration for personal services, author's remuneration and royalties, wages, and salaries into comprehensive income, and applies a unified progressive tax rate (from 3% to 45%) to it. However, the reform does not change the taxation of capital income at a 20% flat rate. Given that capital income usually increases with personal income, a lower tax rate on capital income weakens the role of PIT in income redistribution.
8. Fourth, the tax rate structure remains suboptimal. The latest PIT reform maintained the top marginal PIT rate at 45%, the same as in Australia, Germany, Japan, and the UK. Since the top marginal tax rate in the PRC now applies to comprehensive income-remuneration for personal 观察与建议 services included-the tax burden on professionals with higher labor income increased drastically and might discourage these professionals, if not lower their tax compliance rate. At the same time, the PRC's minimum PIT rate at 3% is lower than that in most advanced countries-e.g., 32% in Sweden, 20% in the UK, 19% in Australia, 14% in Germany, 10% in the US, and 5% in Japan. Considering that the PIT base in the PRC has become smaller alongside a higher basic deduction, there remains room to increase the minimum rate.
9. Fifth, the PIT collection compliance rate remains low. Reasons for the low compliance rate include (i) while a credit rating system for companies was established and tax authorities have issued more than 23 million company ratings, 3 PIT payments are not recorded in the social credit system; (ii) a unified and interconnected national taxpayer database has not yet been established, which limits information sharing and matching as well as targeted auditing; (iii) weak legal and institutional tax enforcement, including audit and investigation; (iv) insufficient reporting requirements and information sharing on financial transactions; (v) narrow coverage of the withholding tax; and (vi) insufficient tax compliance statistics.

III. lESSONS FROM INTERNATIONAl ExPERIENCES
10. Many advanced economies-notably Australia, Japan, Germany, Sweden, the UK, and the USundertook PIT reforms in recent years. The main elements of these reforms included the following: 11. Widen the tax base. Specific measures undertaken by the six mentioned countries to broaden the PIT base can be summarized as follows: • Include capital income in the definition of comprehensive income. Most OECD countries define interest income as a part of comprehensive income (e.g., Australia, the UK, and the US). Some of them have a withholding tax for interest income in place, i.e., they withhold a part of the interest income at the source at a fixed rate (e.g., Germany, Japan, and Sweden). In the US, taxpayers must declare their "ordinary dividend" in the comprehensive annual income tax returns.
• Tax income from pensions and annuities. All six countries tax pensions and annuities but in different ways. In the US, up to 85% of the pension from the first pillar is taxed as comprehensive income using a progressive tax rate. In Germany, a law adopted in 2004 specifies that the partial taxation of pensions from the first pillar will be gradually replaced 改革中国个人所得税制度 by full taxation by 2040. Japan has a separate progressive tax on retirement income, but pensions and annuities will be taxed as comprehensive income with special deductions.
12. Special deductions show several common characteristics. These deductions are intended to reduce tax burden for some types of taxpayers, e.g., those with many children, and frequently aim at income smoothing or redistribution. Basic and special reductions frequently do not overlap in the six countries mentioned. Special deductions are also often capped to avoid excessive amounts of deductions with rising total personal income. Finally, there are measures in place to verify deductions to avoid tax fraud.
13. Strengthen tax compliance through stricter law enforcement. All six mentioned countries have strong compliance measures in place to ensure high compliance rates. The US has an information system that matches income reported with related information from other sources to prevent underreporting or even nonreporting. When a taxpayer's action and fraudulent scheme rises to the level of criminal conduct in the US, the Internal Revenue Service stops auditing and refers the case to its Criminal Investigation Division, which conducts a criminal investigation, gathers evidence, and refers the case to the Department of Justice for prosecution. When taxpayers evade taxes in the UK, their cases are referred to the National Crime Agency for investigation and prosecution. Japan has the "Blue Return" system for taxpayers. Taxpayers who remain in good standing under the blue tax return system will be given certain tax-related privileges. In Germany, the regulations on electronic bookkeeping and online reporting have been strengthened in recent years.
14. Increase transparency by publishing tax compliance data. The majority of countries mentioned have a high degree of tax compliance transparency. With the exception of Germany, tax compliance statistics are published and readily available on their tax authorities' websites. This is not only useful for planning purposes but also to inform the public about the tax administration's accomplishments. Higher transparency can build trust in the tax system.

IV. POlICY RECOMMENDATIONS
15. Based on international experiences, further PIT reforms in the PRC should consider (i) broadening the tax base, (ii) streamlining and limiting special deductions, (iii) optimizing the tax rate structure, and (iv) reinforcing tax collection and administration.

观察与建议
Specific measures include the following: 16. First, broaden the PIT base. It is recommended to keep the current basic deduction unchanged. Given that the basic deduction for PIT was increased recently and is unlikely to be reduced anytime soon, widening the PIT base should mainly be achieved via the natural increase of taxpayers as more individuals become eligible taxpayers when their incomes increase to a level exceeding the minimum threshold. Another suggestion is to include individual business income, pensions, and annuities into comprehensive income, and apply uniform progressive tax rates-except on the portion of pensions or annuities stemming from contributions out of previously taxed income, which should be excluded to avoid double taxation.
17. Second, adjust the current special deductions. It is important to clarify the relationship between the basic deduction and the special deduction by clearly delineating their scope, and to streamline deductions that currently duplicate. It is recommended to reduce the special deductions gradually in line with rising total personal income. For instance, the special deductions for taxpayers with an annual taxable income in the CNY420,000-CNY960,000 bracket could be reduced by half, while earners in the highest PIT bracket-those with an annual taxable income above CNY960,000should not be eligible for special deductions.
18. Third, optimize the PIT rate structure by decreasing the top marginal rate and increasing the minimum marginal rate. Considering that the current top marginal tax rate is used for taxing major items of labor income, gradually reduce it from 45% to 35%, which could lift the motivation of highly qualified professionals and their tax compliance. The minimum marginal tax rate should be increased from 3% to at least 5%, as a higher basic deduction also raised the threshold for taxation of income.
19. Fourth, strengthen tax compliance by improving law enforcement. It is suggested to reinforce tax audits and include PIT payment records in the social credit system to encourage taxpayers to observe the law, and to publish general tax compliance statistics on the tax authorities' websites to establish a track record. To increase individual tax compliance, it would be helpful to establish a unified and interconnected national taxpayer database, and a two-way declaration system among withholding agents, taxpayers, and tax authorities.