How China Navigated the Dilemma of Trade Liberalization and Government Revenues

How China Navigated the Dilemma of TradeLiberalization and Government Revenues

Yung-Hsing Guo

ABSTRACT

Many economists believe that in the long run, the aggregate performanceof open economies is better than that of closed ones, and that open policiescontribute significantly to economic development. At the same time, manypolitical scientists and policy makers fear that, in the short run, one of the stepstowards openness — trade liberalization — may harm government revenues.However, in the 1990s, China successfully navigated the dilemma of tradeliberalization and government revenues. In this period, China decreased tar-iff and non-tariff barriers for WTO accession, but has achieved dramaticallyincreased tariff revenues since 1999. This study explores how China im-plemented trade liberalization and simultaneously increased tariff revenuesin the 1990s. It demonstrates that a series of institutional arrangements, in-cluding a reform of Criminal Law, rigorous anti-smuggling activities and ade facto tax imposed on the export sector, successfully curbed smugglingactivities through the processing trade, and made foreign-invested manufac-turing enterprises the major contributors to the stability of customs revenue.China’s case shows that a prosperous, export-oriented and foreign-investedmanufacturing sector could potentially provide a developing country with asource of customs revenue.

INTRODUCTION

Amongst economists, many would argue that, in the long term, the aggregateperformance of open economies is better than that of closed ones, and thatopen policies contribute significantly to economic development (Greenawayet al., 2002; Krueger, 1998). However, one of the steps towards opennessis trade liberalization, and many political scientists and policy makers fearthat, in the shorter term, this can harm government revenues (Rodrik, 1992;Tanzi and Zee, 2000). It has been suggested that, in theory, strengthening

The author is grateful to Terrence Yu for his help in translating complicated Chinese terms andphrases into English. He is indebted to Jack Hou and the journal’s referees for comments andsuggestions on earlier drafts. He also thanks the National Science Council of Taiwan for financialsupport.

Development and Change 44(4): 991–1012. DOI: 10.1111/dech.12048C© 2013 International Institute of Social Studies.Published by John Wiley & Sons Ltd, 9600 Garsington Road, Oxford OX4 2DQ, UK and350 Main St., Malden, MA 02148, USA

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value-added tax may be a prescription for recovering revenue (Haque andMukherjee, 2005; Keen and Ligthart, 2002; Mujumder, 2004; Naito, 2006).In practice, however, this proposal has proved to be impractical because thelarge informal sector in most developing countries is difficult to tax (Emranand Stiglitz, 2005).

In fact, economics provides no satisfactory solution to the dilemma oftrade liberalization and government revenues in developing countries. Al-ternative sources of revenue are not necessarily easy to mobilize; lowertariff revenues may force governments to cut public investment in infras-tructure, as well as public spending on education, health, public works, etc.The decrease in public spending could hinder growth and cutting welfarespending may hurt the poor. Therefore, the spending adjustments in thewake of trade liberalization may damage future growth and the poorer seg-ments in the economy (Thirlwall and Pacheco-Lopez, 2008; Winters et al.,2004).1

Yet, in the 1990s, China successfully navigated the dilemma of trade lib-eralization and government revenues. In this period, under the requirementsof the WTO accession agreement, tariff reform in China proceeded at a rapidpace. The reductions in tariffs between 1992 and 2001 lowered average tar-iffs by two-thirds (Ianchovichina and Martin, 2004). In the 1990s, scholarswere concerned that these tariff reductions would lead to decreased gov-ernment revenues and that the consequent tax adjustments might widen thepoverty gap (Wang and Zhai, 1998). However, something remarkable hap-pened in 1999. Without a dramatic increase in imports, the tariff revenuesof China’s Customs (General Administration of Customs of the People’sRepublic of China) doubled in that year and, as shown in Figure 1, hasincreased significantly almost every year since.

Moreover, in 1999 China was suffering a severe financial deficit causedby the 1997 Asian Financial Crisis; most of the main taxes stagnated oryielded less than the government had forecast. However, the level of two taxrevenues were almost double the amounts expected in the budgets, providingthe Chinese government with critical budget support. Both of these — theconsumption tax and value added tax (VAT) on imports2 and tariffs — werecollected by the Department of Customs and Excise (Ministry of Financeof the PRC, 2000). The sudden increase in customs-related revenues hasbeen overlooked in previous literature and has become an unsolved puzzlein China’s economic development.

1. Moore and Zanardi (2011) argue that even though reliance on trade tax revenues acrossthe developing world has decreased since 1990–2005, there is little systematic evidence toshow that it has led to a shift in the composition of spending across central governmentspending categories, especially in areas such as health, education and social protection.

2. Since the consumption tax applies to only a few consumer goods (Chen et al., 2006), thebulk of the revenue on imports are collected from VAT.

Trade Liberalization and Government Revenues in China 993

Figure 1. China’s Tariff Revenues and Total Value of Imports 1986–2008

0100002000030000400005000060000700008000090000

0200400600800

100012001400160018002000

1986

1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

Tariff Revenues (100m Yuan) Total Value of Imports (100m Yuan)

Source: National Bureau of Statistics of China (1996, 2009).

The official explanation for this sudden and significant increase in tar-iff revenues is that ‘the intense Customs administration and anti-smugglingactivities contributed the increase’ (Ministry of Finance of the PRC, 2000:53). This raises two questions that need to be explored further. Why (andhow) could intense customs administration and anti-smuggling activities in-crease revenues so dramatically? While improving the efficiency of customsadministration could be expected to increase tariff revenues, such a large-scale increase in such a short period is unusual in other developing countries(Wulf and Sokol, 2005). And, following from this, is there another reasonthat underlies the official explanation?

I have studied China’s export sector for a decade. From numerous inter-views with managers of foreign-invested enterprises and local bureaucratsin China, I have found that a series of institutional arrangements in the1990s made a dramatic increase of tariff revenues possible in the shortrun. In this article, I will demonstrate that the 1997 Criminal Law reforms,which imposed severe punishment for smuggling crimes, as well as de-termined and unwavering anti-smuggling activities and customs adminis-tration reforms in the late 1990s, successfully curbed smuggling throughthe duty-exempt channel of processing trade and increased imports throughthe duty-paid channel of ordinary trade. This transformation significantlyraised China’s tariff revenues while the total value of imports changed onlymoderately. Furthermore, these institutional arrangements also significantlyincreased the negotiating power of the customs authority over enterprises inthe export-oriented processing trade sector. As a result, a de facto export taxon processing trade firms was imposed and foreign-invested manufacturingenterprises have become the major contributors to the stability of customsduties. In the following sections, I will examine the manner in which theseinstitutional arrangements influenced China’s trade tax, before discussingthe implications of this research.

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THE GENERAL EXPERIENCE OF DEVELOPING COUNTRIES

Many developing and emerging market economies continue to rely heavilyon trade taxes as a source of government revenue. Typically, revenue fromtrade tax constitutes between one-quarter and one-third of total tax revenuesin low- and middle-income countries (IMF, 2005). In the early stages oftrade liberalization, the first steps — often involving reducing non-tariff bar-riers, eliminating distorting exemptions, cutting prohibitively high tariffs,and raising low tariff rates in moving towards a more uniform tariff struc-ture — may lead to an increase in imports and trade tax revenues (Ebrillet al., 1999). Eventually, trade liberalization must reduce trade tax revenues(simply because free trade ultimately means no trade taxes); this is the po-sition in which many countries now find themselves (IMF, 2005; Kowalski,2005; Longoni, 2009). As a result, for those relying heavily on trade taxrevenue, ‘An important policy issue is how countries should react to falls inrevenue as tariffs are cut’ (African Trade Policy Centre, 2004).

Theoretically, the standard prescription for recovering revenue is tostrengthen domestic indirect taxes, or value-added tax (VAT). Keen andLigthart (2002) show that, for a small economy, a cut in import dutiescombined with a point-for-point increase in domestic consumption taxesincreases both welfare and public revenue. This benchmark research has in-spired researchers such as Haque and Mukherjee (2005), Mujumder (2004)and Naito (2006) to explore further. However, Emran and Stiglitz (2005)point out that presenting VAT as an alternative is impractical in the contextof (developing) economies with a large informal sector, as this preventstaxation of some items of final consumption.3

In terms of empirical studies, scholars have recently focused attentionon a broader issue: the impact of trade liberalization on total tax revenues.Scholars believe that the full implications of trade reform may cause a‘second-round’ increase in overall revenue. For example, the efficiency gainsfrom trade liberalization mean an increase in aggregate real income, part ofwhich could be captured as government revenue through income tax. Theempirical results, however, suggest that trade liberalization in developingcountries hardly benefits either trade tax or overall tax revenues (Khattryand Rao, 2002), especially in low-income countries (Baunsgaard and Keen,2010).4

3. However, Ebeke and Ehrhart (2011) demonstrate that the departure from trade taxes towardsindirect domestic taxes, a reform that is currently occurring in developing countries, isbeneficial to limiting tax revenue instability.

4. Wagle (2011), using the estimation strategy of Baunsgaard and Keen (2010) with differentspecifications and years, suggested that tax recovery in low–income countries may be higherthan Baunsgaard and Keen (2010) indicated. Meanwhile, Keen and Mansour (2010) focusedon sub-Saharan Africa and their conclusions are rather less pessimistic than Baunsgaard andKeen (2010). They demonstrated that countries that lost trade tax revenue may be able torecover the loss from domestic sources.


Table 1. China’s Tariff Rates, Total Value of Imports, Tariff Collection andCentral Government Revenue in 1990s (100m Yuan %)

Gov. revenueAverage statutory Final (T) astariff rates (%) Tariff percentage Central

Imports revenue of budget National gov. T/I T/G T/CGYear Simple Weighted (I) (T) account (%) (G) (CG) % % %

1985 43.3 . . .1988 43.7 . . .1991 44.1 . . . 3,398.7 187.3 104.0 3,149.5 938.3 5.5 5.9 20.01992 42.9 40.6 4,443.3 212.8 106.4 3,483.4 979.5 4.8 6.1 21.71993 39.9 38.4 5,986.2 256.5 111.5 4,349.0 957.5 4.3 5.9 26.81994 36.3 35.5 9,960.1 272.7 82.6 5,218.1 2,906.5 2.7 5.2 9.41995 35.2 26.8 11,048.1 291.8 94.1 6,242.2 3,256.6 2.6 4.7 9.01996 23.6 22.6 11,557.4 301.8 143.7 7,408.0 3,661.1 2.6 4.1 8.21997 17.6 18.2 11,806.5 319.5 94.0 8,651.1 4,226.9 2.7 3.7 7.61998 17.5 18.7 11,626.1 313.0 104.3 9,876.0 4,892.0 2.7 3.2 6.41999 17.2 14.2 13,736.4 562.2 184.3 11,444.1 5,849.2 4.1 4.9 9.62000 17.0 14.1 18,638.8 750.5 131.4 13,395.2 6,989.2 4.0 5.6 10.72001 16.6 12.0 20,159.2 840.5 136.2 16,386.0 8,582.7 4.2 5.1 9.82002 ∗ 12 ∗ 5.56 24,430.3 704.3 95.2 18,903.6 10,388.6 2.9 3.7 6.8

Sources: Tariff rate 1985–2001: Ianchovichina and Martin (2004) and Prasad (2004). Tariff rate 2002:Ministry of Finance of the PRC (2003: 126). Other data: National Bureau of Statistics of China (2010);Ministry of Finance of the PRC (1992–2003).Note: *There is an inconsistency about tariff rates between the official data (the Ministry of Finance’sFinance Yearbook of China) and Ianchovichina and Martin (2004). For example, the tariff rates for 2001in the Finance Yearbook of China 2003 are 15.3 (simple) and 9.5 (weighted), which are obviously lowerthan the data in Ianchovichina and Martin (2004).

TRADE LIBERALIZATION AND CUSTOMS REVENUES IN CHINA

In the 1980s and 1990s China was classified as a low-income country (IMF,2005). If it were to follow the experience of trade liberalization of otherdeveloping countries, its trade tax and total tax revenues should have sufferedfrom trade liberalization. However, China’s experience illustrates a differentscenario. In order to become a member of the WTO, China’s trade policyreforms made substantial progress in reducing non-tariff and tariff barriersduring the 1990s. For example, the number of tariff lines subject to quotas andlicences fell from 1,247 in 1992 to 261 in 1999 (Lardy, 2002). Meanwhile,as shown in Table 1, the unweighted average tariff rate dropped from 44.1in 1991 to 16.6 in 2001.

Consistent with the general experience of developing countries, in theearly stages of China’s trade policy reform, the decrease of tariff and non-tariff trade barriers contributed to an increase in total value of imports andtariff revenue. In the early 1990s, China made major foreign trade policyreforms5 and experienced a swift increase in imports and exports (Bachet al., 1996). As the tariff rate increased slightly, China’s imports and tariff

5. For example, foreign exchange system reforms were introduced in early 1994, when thedual exchange rate system was unified.

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revenue increased significantly. The unweighted average tariff rate decreasedsignificantly from 44.1 in 1991 to 39.9 in 1993. The total value of importsnearly doubled and the tariff revenues increased by 37 per cent in the sameperiod.

Similar to the experience of other low-income developing countries, thecontribution of trade tax to China’s national revenue also shrank after asustained decrease in the tariff rate. From 1993 to 1998, the weighted tariffrate decreased by 51 per cent and the ratio of tariff revenue to nationalrevenue fell from 5.9 per cent to 3.2 per cent. In fact, China’s importskept increasing, except for 1998 when they shrank as a result of the AsianFinancial Crisis, and its revenue from tariffs still grew 22 per cent from 1993to 1998. Compared to the significant 139 per cent growth in GDP in the sameperiod, the stagnation of tariff revenue was obvious. Moreover, there was amore serious concern about trade tax as a stable source of national revenue.From 1994, with the exception of 1996, the collected tariff revenues hadbeen lower than the budget account. Putting aside the exception of 1996(which will be discussed in a later section), it was very clear that after theearly stage of trade liberalization, the Chinese government was unable tocollect the amount of trade tax planned.

The stagnation of tariff revenue, and the inevitable further decrease of thetariff rate, created concern among scholars about the stability of governmentrevenue. Wang and Zhai (1998) simulated three tariff-reducing scenarios andall three showed that further trade liberalization would reduce governmenttariff revenues significantly. However, this concern about the further lossof tariff revenue did not materialize. In 1999, after years of stagnation,China’s customs revenue dramatically increased against a background of amoderate increase in imports. Since 1999, China has sustained high growthin customs revenue; its abundant tariff revenues have allowed it to avoid theside effects of trade liberalization so many other developing countries havehad to contend with, such as an enforced tax adjustment. What happened in1999? Was there a structural change in China’s import sector or in the tradetax collection system?

INCREASING CUSTOMS REVENUE: THE PUZZLE OF 1999

What mechanism could be responsible for nearly doubling China’s customsrevenue in 1999? Although there was no dramatic increase in the total valueof imports calculated in renminbi (RMB) in 1999, three possible structuralchanges in the import sector could have significantly increased customsrevenue: (1) a sharp appreciation of the RMB; (2) a large increase in thetariff rate; (3) a striking change in import composition. As will be shownbelow, these three structural changes did not occur at the end of the 1990s,with the result that the large-scale increase in customs revenue remains apuzzle.


The first possibility concerns the RMB: had the RMB appreciated sharplyin 1999, even if the total value of imports calculated in RMB increased onlymoderately, the real amount of imports could have increased dramatically,with a resulting jump in customs revenue. But such a scenario did not playout in China in 1999. China’s de facto exchange rate regime was pegged tothe US dollar from 1995 to July 2005, and the exchange rate of the RMBagainst the US$ did not change over this period (Coudert and Couharde,2007). A large increase in the tariff rate in that year could also have haddramatic consequences. In fact, following the trend of decreasing tariffrates in accordance with the requirements for accessing the WTO, China’sgovernment slightly lowered the import rate of 1,014 items at the beginningof 1999. In that year, the import rate was not raised for a single item, andthe unweighted average tariff rate fell to 17.2 from the previous year’s 17.5,as Table 1 shows.

The final possibility is a striking change in the composition of imports.In this scenario, even with the total value of imports, the exchange rateand tariff rate all remaining stable, a large-scale decrease in imports with alow tariff rate and a simultaneous increase in imports with a high tariff ratemay contribute to a significant increase in customs revenue. However, theevidence shows that no such striking change in the composition of importsoccurred in 1999. If we measure China’s import composition in 1998 and1999 against the SITC 2-digit level of Pearson’s product-moment correlationcoefficient, there was a very high positive correlation (r = 0.982, p < 0.01)between the two years’ data. So it is reasonable to conclude that there wasno striking change in import composition in 1999.

Since there was no structural shift in the import sector in 1999, the officialaccount that ‘the strict customs administration and anti-smuggling activitiescontributed to the increase’ becomes an important clue to the uniqueness ofthe Chinese case. In the following sections, I will demonstrate that severalinstitutional arrangements, including reforms of customs administration andstrict anti-smuggling activities, contributed to a structural change in the tradetax collection system and enabled the Chinese customs department to collectsufficient tax.

China’s Anti-smuggling Activities and Customs Administration Reforms in theLate 1990s

Even though China had steadily lowered its tariff levels in the 1990s, theunweighted average tariff rate was still over 17 per cent, and together witha basic rate of 17 per cent VAT on imports of general goods, this wassufficient to make smuggling lucrative. The former Premier Zhu Rongjiargued that smuggling activities had reached unprecedented levels by 1998when commodities worth as much as 100 billion Yuan were smuggled intoChina each year. Smuggling of goods gravely threatened the stability of the

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Chinese economy. For example, in 1998, competition from cheap smuggledproducts forced domestic oil companies to close 3,000 oil wells. Moreover,smuggling not only resulted in a loss of customs taxes but also corrupted theadministration, since smugglers generally use a portion of their proceeds tobribe law enforcement officers and regulators, particularly the officials ofChina’s Customs.

D.L. Yang (2004) comprehensively describes the top-down anti-smuggling activities and customs administration reforms in the late 1990s.In mid-July 1998, the Chinese Communist Party (CCP) Central Committeeand the State Council convened a national meeting on combating smugglingwhich led to the launch of a national anti-smuggling campaign. Massiveinvestigations of customs officials were undertaken and many officials wereimprisoned, or even executed, following the investigation. In Zhanjiangprovince, for example, six customs officials, including the head of Zhan-jiang customs and the director of the customs investigation department,were sentenced to death in May 1999 for taking bribes and assisting smug-glers. By 2002, more than 400 corruption cases involving 800-plus customsofficers had been uncovered in the Bureau of Customs.

Besides the efforts to improve the transparency of customs administration,a decision was also taken during the national meeting to establish an anti-smuggling police force under direct leadership of the central government.In the past, personnel in local anti-smuggling offices were appointed bylocal governments and beholden to local government officials. Since manyofficials in local government saw smuggling as a quick way to boost localeconomic growth or even their private bank accounts, it was often impossiblefor the local anti-smuggling offices to police smugglers effectively. To freeanti-smuggling forces from local influence, the new anti-smuggling police,called the Smuggling Investigation Bureau, was placed under the directcommand of the Bureau of Customs. This armed force was set up at thebeginning of 1999 and given broad authority to search, detain and arrestsuspected smugglers (Guo, 2011; D.L. Yang, 2004).

The Chinese government’s efforts to curb smuggling went beyond customsadministration reforms. In the summer of 1998, the CCP Central Committeeand the State Council ordered the military, armed police and public securityand judicial departments to sever their ties with commercial business. Thiswas because some business operations of these government agencies wereheavily implicated in smuggling. The successful divestiture of governmentagencies’ business operations in 1998 and beyond not only helped reducesmuggling and corruption, it was also a vital step in China’s efforts toestablish an arm’s-length regulatory framework for business (D.L. Yang,2004).

The effects of the anti-smuggling activities and customs administrationreforms in the late 1990s contributed much to the tariff revenue. However,as suggested above, the moderate increase of the total value of importscould not fully explain the doubling of tariff revenue in 1999. If, however,


Figure 2. China’s Total Value of Imports by Customs Regime, 1991–2002(US$ 100 million)

Source: National Bureau of Statistics of China (2009).

a distinction is made between a processing trade channel and general tradechannel in the total value of imports, the dramatic increase of trade tax couldbe explained. In other words, if smuggling through the duty-exempt channelof the processing trade were curbed, imports through the duty-paid channelwould increase — and so would the tariff revenue, even with the total valueof imports remaining constant.

A Main Smuggling Channel: The Processing Trade

Figure 2 shows the total value of China’s imports by customs regime from1991 to 2002. Most tariff revenues were collected from ordinary trade;other kinds of trade, including the processing trade, generally enjoyed tariffreductions or exemption. Most imports through the processing trade were in-termediate materials for re-export after processing and assembling in China.Imports through ordinary trade were intermediate materials or consumergoods for China’s domestic consumption. As shown in Figure 2, from 1993to 1998 the total value of imports through ordinary trade remained at thesame level, around US$ 40 billion a year. It is hard to believe that in themiddle of the 1990s, China’s domestic demand for foreign intermediate ma-terials and consumer goods did not increase. In fact, from 1993 to 1998,Chinese GDP at least doubled, and domestic demand for imports shouldhave done the same. The stagnation of imports through ordinary trade in themiddle of the 1990s shows that the domestic market’s increasing demandsfor imports was satisfied by smuggling. It comes as little surprise, then,that the Ministry of Foreign Trade and Economic Cooperation at that timeestimated that about half of the 10 million mobile telephones sold in Chinain 1998 were smuggled goods (D.L. Yang, 2004).6

6. At that time, portable electronic products like mobile telephones or digital cameras couldbe smuggled into China through the processing trade. For example, processing trade firms

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Table 2. Smuggling through Processing Trade Detected by China Customs*1997 and 1999

The ratio to all smuggling Total value The ratio to all smugglingYear Cases cases detected (100m Yuan) amounts detected

1997 401 36% 33.3 54%1999 447 39.5% 28.7 53%

*Only severe smuggling cases (over 300,000 Yuan) were counted.Source: Shao et al. (2001: 82).

In the 1990s, the processing trade, which is based on the temporary ad-mission of imports, expanded rapidly and amounted to about half of allinternational trade (Guo, 2012); it also became a main channel for smug-gling. As Fisman and Wei (2004) have argued, smuggling, by its very nature,is difficult to observe. However, the statistics of detected smuggling offera good impression of the characteristics of smuggling activities. Table 2shows smuggling through the processing trade detected by China Customsin 1997 and 1999. In both years, over half of the total value of smuggledgoods detected by customs was smuggled through the processing trade. Sincethe processing trade was a main channel of smuggling, the anti-smugglingcampaign of the late 1990s also had to block smuggling through thischannel.

The Reforms of Processing Trade Regulations in the 1990s

In order to attract foreign investment and earn foreign currency, China’sgovernment recognized the processing trade system, a customs-free man-ufacturing sector, from the end of the 1970s. Furthermore, to promote thedevelopment of the processing trade, the Chinese government did not restrictthe circulation of duty-exempt intermediate materials or the factories usingthose materials inside the severely monitored industrial parks, such as theexport processing zones (EPZs) in other developing countries. As early asthe mid-1980s, China Customs became aware that intermediate materialscould be smuggled into the highly protected domestic market through theprocessing trade. However, due to the priority given to earning foreign cur-rency at that time, the government did not impose any strict regulations onthe processing trade. It was not until the mid-1990s, when China Customscould not collect as much tariff revenue as it had expected (Guo, 2011), thatthese measures were taken.

Before the mid-1990s, the management of duty-exempt intermediate ma-terials by processing trade enterprises was monitored only by the customsauthorities. However, customs administration did not have much information

might secretly sell export-oriented and duty-exempt products (or products with duty-exemptparts) into the domestic market without informing the Bureau of Customs (J.F. Yang, 2004).


about the commercial activities of enterprises. This asymmetric informationstructure caused severe problems of moral hazard, referred to as SanWuQiYe (‘Three No’ Firms). This refers to enterprises that have no factories,no production equipment and no employees but apply for processing tradelicences to sell duty-exempt goods on the domestic market. To solve theasymmetric information flow between the customs authorities and firms, theChinese government set up a new regulatory system in 1996, on a nationalscale. The new system requires firms to apply for a processing trade sealof approval from the Chamber of Commerce of the local government be-fore applying to the customs authorities. The Chamber of Commerce issuesthe certificate only if a firm has submitted the required documents and hasproven its ability to process the imported materials and re-export the finishedproducts (Guo, 2011). The outcome of the reform is significant. As Table 1shows, when the tariff rate continued to decrease, the Chinese governmentwas unable to collect the amount of trade tax planned in its budget accountsof 1994 and 1995. However, the reform of 1996 successfully curbed smug-gling through the processing trade and China Customs collected 1.4 timesthe tariff revenues it expected that year (Ministry of Finance of the PRC,1997: 119).

To further curb smuggling activities, the Chinese government amended itsCriminal Law in 1997. When China’s Criminal Law was legislated in 1979,there were only two articles relating to smuggling crimes. Punishment forviolations was moderate with the strictest judgement being a fixed term ofimprisonment of no more than ten years (Cohen, 1982).7 In 1997, China’sCriminal Law was amended substantially with the total number of articlesincreasing from 192 to 452, most of them relating to economic crimes. Theamendment8 gives an exhaustive description of the offences that constitutesmuggling and the penalties that apply. Moreover, a special article, Article154, was drawn up that deals with smuggling through the processing trade.The details of Article 154 are presented in Table 3 and show the severityof the sanctions. Smuggling goods or articles and evading payable duties ofmore than ¥ 500,000 is punishable by life imprisonment or even death.

7. Article 116: Whoever violates the customs laws and regulations engaging in smuggling, if thecircumstances are serious, in addition to having the smuggled articles confiscated and a finepossibly imposed in accordance with the customs laws and regulations, [may face] criminaldetention, and may also [face a] sentence of confiscation of property. Article 118: Whoevermakes a regular occupation of smuggling or speculation, or whoever smuggles or speculatesin huge amounts, or who is a ringleader of a group that smuggles or speculates, shall besentenced to no less than 3 years and not more than 10 years of fixed-term imprisonment,and may be sentenced additionally to confiscation of property (Cohen, 1982: 158).

8. Since 1997, China’s Criminal Law has been subject to eight amendments. The severepunishments for smuggling have remained unchanged. However, in the eighth amendment,in the spring of 2011, the most severe punishment for smuggling of general goods wascommuted from death to life imprisonment.

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Table 3. Smuggling Crimes Related to the Processing Trade Listed in theCriminal Law of the People’s Republic of China

Seriousness of Punishment (determined by theOffences the offence seriousness of the offence)

1. Smuggling of general goods(Article 153).

Smuggling goods orarticles and evading ordodging payable dutiesto the amount of morethan 500,000 Yuan

The offender shall be sentenced tofixed-term imprisonment of notless than 10 years or lifeimprisonment and shall also befined not less than once but notmore than five times the amount ofpayable duties evaded or dodgedor be sentenced to confiscation ofproperty; if the circumstances areespecially serious, the offendershall be sentenced to lifeimprisonment or death and also toconfiscation of property.

2. Without approval by the Customsand without having paid theoverdue customs duties, sellingfor profit without authorization,within the territory of China,authorized imported bonded goodssuch as materials supplied byforeign clients for processing,parts supplied by them forassembly or raw or processedmaterials, parts, finished productsor equipment for compensationtrade (Article 154).

Smuggling goods orarticles and evading ordodging payable dutiesto the amount of morethan 150,000 Yuan butless than 500,000 Yuan

The offender shall be sentenced tofixed-term imprisonment of notless than 3 years but not more than10 years and shall also be finednot less than once but not morethan five times the amount ofpayable duties evaded or dodged;if the circumstances are especiallyserious, the offender shall besentenced to fixed-termimprisonment of not less than 10years or life imprisonment andshall also be fined not less thanone time but not more than fivetimes the amount of payable dutiesevaded or dodged or be sentencedto confiscation of property.

3. Without approval by the Customsand without having paid theoverdue customs duties, sellingfor profits without authorization,within the territory of China,imported goods and articlesspecially designated for thereduction of or exemption fromduties (Article 154).

Smuggling goods orarticles and evading ordodging payable dutiesto the amount of morethan 50,000 Yuan butless than 150,000 Yuan

The offender shall be sentenced tofixed-term imprisonment of notmore than 3 years or criminaldetention and shall also be finednot less than once but not morethan five times the amount ofpayable duties evaded or dodged.

Where a unit commits the crime mentioned in the preceding paragraph, it shall be fined, and the personswho are directly in charge and the other persons who are directly responsible for the crime shall besentenced to fixed-term imprisonment of not more than 3 years or criminal detention; if thecircumstances are serious, they shall be sentenced to fixed-term imprisonment of not less than threeyears but not more than 10 years; if the circumstances are especially serious, they shall be sentenced tofixed-term imprisonment of no less than 10 years.

Source: Criminal Law of the People’s Republic of China (1997); see http://www.china.org.cn/english/government/207320.htm.


In 1999, as central government was setting up its own police force tocombat smuggling, extensive anti-smuggling activities aimed at processingtrade firms were undertaken. The Bureau of Customs conducted large-scaleon-the-spot inspections of firms, and the force arrested at least a dozenrepresentatives of foreign affiliates on suspicion of smuggling (Zhu, 1999).These large-scale arrests deeply frightened foreign affiliates prompting theTaiwanese government and influential Taiwanese industry associations tosend representatives to China to lobby for a special court for Taiwanesebusinessmen. The lobbying failed as it was a violation of the Criminal LawProcedure (Guo, 2006).

China Customs also reformed the regulations for the processing trade.The 1999 amendment was aimed mainly at regulating the management ofprocessing trade enterprises and cracking down on smuggling. One of themost important changes was a classification system which was created forcommodities of the processing trade. These commodities were divided intobanned, restricted and permitted categories. The banned commodities weregoods that were not allowed to be imported into China or that were impossi-ble to supervise as duty-exempt goods. Restricted commodities were thoseitems of which the domestic price was much higher than the internationalprice. In other words, the restricted commodities were goods that yieldedsignificant profits through smuggling, such as materials for the textile andplastics industries. A second significant change was the classification sys-tem that was established for processing trade enterprises. In this system,enterprises are classified in four categories (A–D) in accordance with theircredibility and the extent of their law-abiding activities in customs. Level Aenterprises are firms with the best records related to customs affairs, whilstcategory D encompasses those with the worst records (Guo, 2011; Lian,2007).

The adjustment included the following stipulations. First, banned com-modities were not permitted to be imported through the processing trade.Second, level D enterprises were forbidden to engage in the processing trade.Third, regardless of types of commodities level C enterprises imported, theywere required to make advance payments of tariff tax and VAT on importsto the Bank of China through their customs duty deposit accounts; the sameapplied to level B enterprises that imported restricted commodities. Thefunds would be returned, with interest, after the products had been exportedand the procedure of the processing trade was completed without fraud orerror.

Due to the large-scale lobbying activities of foreign-invested enterprises,the measures introduced through the adjustment were relaxed. For example,in 2000, permission was granted to replace payments to customs duty depositaccounts with a letter of guarantee (L/G) from the Bank of China (Guo, 2006).Although some of the initial measures of the 1999 reform were eased, thereform succeeded in putting in place a more effective monitoring systemand building a dynamic system of management adjustments. China Customs

1004 Yung-Hsing Guo

could effectively trace high-risk goods by listing them in the catalogue ofbanned and restricted commodities. Moreover, after the adjustment, mostprocessing trade enterprises were classified as level B. The few level C andlevel D enterprises that had bad records, and thus a higher potential for fraud,were successfully sifted and monitored (Guo, 2011).

De Facto Tax on the Export Sector

In a series of field trips in the coastal provinces of China since 2003, Ihave heard many representatives of foreign-invested firms complain aboutthe extra burden from the campaign called ZiCha-BuShui (‘pay tax evadedafter self-investigation’) or ZiCha-ZiBao (‘self-report tax evasion after self-investigation’). The campaign of ZiCha-BuShui usually entailed customsofficers requesting processing trade enterprises to check whether the man-agement of bonded goods had breached the rules. If the enterprises wereguilty of transgressions, they had to pay the penalties. Most enterprisesbreached the rules to some extent, with the result that the customs author-ities collected plenty of revenue through the ZiCha-BuShui campaign. Therevenue from ZiCha-ZiBao could be considered as a kind of export tax onprocessing trade enterprises. In the spring of 2006, Li Sau Hung, an influ-ential entrepreneur in Hong Kong and a member of the National Committeeof the Chinese People’s Political Consultative Conference, wrote an articletitled ‘Stop the ZiCha-ZiBao on Processing Trade Enterprises’ for HongKong’s newspaper WenWeiPo. Li complained that ‘lots of enterprises areafraid of the “troubles” (from customs officers) and have no choice but toreport the “proper” amount of “tax evasion” during the ZiCha-ZiBao. Thecampaign did not reflect the real situation of enterprises’ operations, but onlyadded an extra burden to enterprises and enlarged Customs’ tax revenue’(Li, 2006).

Why would enterprises violate the rules of the processing trade knowingthat penalties are unavoidable? The most common violation of processing en-terprises concerns a discrepancy between the bookkeeping figures of bondedgoods recorded in the Processing Trade Registration Handbook and the ac-tual amount of goods stored in warehouses. Inconsistencies often occur due tothe rigidity of the regulations of the processing trade. Before enterprises en-gage in the processing trade, companies have to report to Customs the amountof bonded goods used in future production. Usually, the application requiresa company to predict the bonded goods that will be needed in the next three tosix months. Most firms can only make a rough estimation and must employother means to acquire enough bonded goods for actual production, for exam-ple, by borrowing from other processing trade enterprises. As a result, theremay be a difference between the amounts of bonded goods reported in theProcessing Trade Registration Handbook and the actual amount stored in thewarehouse (Cai, 2004; Yuan, 2007). In the classification management system


mentioned above, one of the requirements for receiving level A classificationis that the inconsistency between bonded goods recorded in the Handbookand the real amount of goods stored in the warehouse is under 5 per cent. Thisillustrates that even enterprises with the best customs records cannot avoidinconsistencies.

Marked inconsistencies would raise the suspicion of smuggling and theanti-smuggling policy of customs would effect an on-the-spot inspection ofthe enterprise. Slight inconsistencies would be tolerated only if the enter-prises paid the proper fines to customs officers (Yuan, 2007; Zhang, 2003).Since inconsistencies exist in most processing trade enterprises, the customsauthorities could collect substantial fines during every ZiCha-BuShui cam-paign. In 2009, China Customs introduced a third party accounting systemduring the ZiCha-BuShui campaign (Yuan, 2010). Prior to 2009, there was noobjective procedure to establish the actual amount owed due to ‘tax evasion’:the practice of ZiCha-BuShui came down to a negotiation between the enter-prises and customs officers about the amount payable. For example, duringthe campaign of 2005, many enterprises complained to the mass media thattheir self-investigation reports were rejected by local customs because thereported amount of ‘tax evasion’ was lower than officers’ expectations (Ap-ple Daily, 2005). In practice, the reforms of processing trade regulations andcustoms administration in the 1990s increased customs officers’ bargainingpower. After the reforms, enterprises had to face the threat of the on-the-spotinspection and the extremely strict laws of anti-smuggling (such as the deathpenalty). Enterprises would rather pay the financial penalties than annoy thecustoms authorities (Guo, 2006; Wang, 1999).

Although there are no statistics publicly available for the amount of rev-enue China Customs collected during every ZiCha-BuShui campaign,9 fromthe information in some official documents it can be deduced that ZiCha-BuShui represents an extremely important means of tax collection for thecustoms authorities. A press release from the Shenzhen Customs District in200610 illustrated how China Customs operated ZiCha-BuShui to overcomethe shortage of tariff tax in 2005:

On 4 April 2005, the atmosphere at Customs’ national general revenue meeting was bad, andthe senior officers from all Customs districts felt nervous and under pressure. This is becausethe national Customs revenue of the first quarter was less than 2.3 billion Yuan compared

9. Because no breakdown is given of customs revenue (into tax, overdue tax or fines), Icannot provide data on the amount of ‘tax evasion’ money collected by the ZiCha-BuShuicampaigns. Access to detailed data would be vital for future research on China’s tariffrevenue.

10. Entitled ‘527.8 Billion Yuan – The Law’s Power for Customs Revenue’, Shenzhen Cus-toms District, 1 October 2006. The press release is available on the website of the Shen-zhen Customs District: http://www.customs.gov.cn:82/gate/big5/shenzhen.customs.gov.cn/publish/portal109/tab31107/info17161.htm

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to the same period of last year . . . Facing the difficult situation, the General Administrationof Customs decided to implement a series of supervision-enhancement campaigns, such asfighting smuggling and ZiCha-BuShui . . . Due to the hard work of Customs officers, thewhole year’s Customs revenue exceeded last year’s total amount, and exceeded 527.8 billionYuan by the end of the year.

China Customs started the campaign of ZiCha-ZiBao to detect tax evasionin processing trade enterprises in the 1980s when its capacity for supervi-sion on bonded goods was relatively weak (Guo, 2011). Since the 1990s,ZiCha-ZiBao has become an important instrument in collecting sufficienttax for customs districts in coastal provinces where the processing tradeis prosperous. In China, every customs district has a quota for tax rev-enue and since the careers of customs officers are greatly influenced bytheir performance, officers try their best to fulfil the quota, including usingcontroversial methods (Guo, 2006). In practice, if a customs district withplenty of processing trade enterprises discovered that tariff revenues werebelow expectations in the first half of the year, the local customs authori-ties would administer ZiCha-ZiBao in the second half of the year to ensurethat the district could fulfil its quota by the year-end (Apple Daily, 2005).Historically, the strict administration of ZiCha-ZiBao usually took place inthe years when China’s customs revenue stagnated, such as 1998 (Wang,1999), 2002 (Guo, 2006) and 2005 (Commercial Times, 2005). It is reason-able to infer that the prosperous processing trade, an export-oriented andforeign-invested manufacturing sector (Lemoine and Unal-Kesenci, 2004),has provided China Customs with a potential tax base to offset decreases inthe tariff revenue, such as a dramatic decrease of the tariff rate or an economicrecession.

China officially became a member of the WTO on 11 December 2001and sharply lowered its tariff rate on 1 January 2002, in accordance withstipulated requirements for accession. The weighted tariff rate fell to 5.56from 9.5 in 2001 (Ministry of Finance of the PRC, 2003). In July 2002, a strictZiCha-ZiBao campaign was launched in Guangdong province, the largestbase of the processing trade and biggest exporter of most commodities ofall provinces. Foreign-invested processing trade enterprises, especially thelarge-scale ones, were asked by local customs authorities to check whetherany tax evasion had occurred in the first half of 2002. If the firms couldsubmit the correct amount of overdue tax, the local customs would notcarry out a customs inspection on the firm. Due to the hard work of customsofficers and the cooperation of enterprises, China Customs collected a recordmonthly revenue in September 2002 of ¥ 2.63 billion, a 24 per cent increasecompared to the previous September (Guo, 2006). Even with the successfulZiCha-ZiBao campaign, China lost nearly half of its weighted tariff rate in2002 — a hefty price for WTO membership — but it bore only a slight lossin tariff revenue when there was no significant increase of imports in thatyear.


DISCUSSION AND CONCLUSION

Although many economists believe that open policies contribute signifi-cantly to economic development, present economics provides no satisfactorysolution to the dilemma of trade liberalization and government revenues indeveloping countries. However, the Chinese government successfully im-plemented trade liberalization and increased tariff revenue at the same timein the 1990s. This raises the question whether China’s experience can bereproduced in other developing and transition countries. In this regard, ithas to be noted that without its rapid economic growth and unique reformpolicies, China’s dramatic increase of tariff revenue would have been hardto achieve. On the other hand, the Chinese experience does provide someinspiring lessons for other developing countries and for the literature relatedto the dilemma of trade liberalization and tariff revenues.

China’s case shows that effective anti-smuggling activities could greatlyincrease a developing country’s tariff revenues, or could even fully offsettrade tax losses as a result of trade liberalization. In other words, China’sexperience demonstrates that recovering evaded customs duties offers po-tential and significant revenues for developing countries. What happenedin China before the tariff-related reforms in the 1990s is consistent withthe depressed reality in many developing countries. The achieved tariff col-lection rates — calculated as assessed collected taxes — are pretty low inunderdeveloped countries compared to what should have originated fromimports given statutory protection. Jean and Mitaritonna (2010) show thatachieved tariff collection rates are frequently less than 70 per cent in Africa,and in some cases they do not reach 50 per cent; the worst reported case isthe Democratic Republic of Congo, with 80 per cent of customs taxes notbeing collected.

To improve achieved tariff collection rates, researchers have tended tofocus on enhancing efficiency and transparency. As Brenton et al. (2007: 5)have noted: ‘there are the standard recommendations with regard to improv-ing the efficiency of tax collection’. In the digitized era, Jean and Mitaritonna(2010) have added that the automated treatment of customs data could poten-tially be a powerful lever to combat evasion. In addition, curbing corruptioninside the bureaucratic apparatus is also vital. However, empirical data andother estimates typically attribute customs revenue losses not only to corruptpractices but more broadly to inefficiency (Ferreira et al., 2007).

China’s experience also demonstrates that if developing country gov-ernments intend to raise achieved tariff collection rates significantly, thesuggestions offered on the basis of previous research may not be sufficient.Although the Chinese example shows that reforming customs institutions iscritical — hundreds of corrupt customs officials were dismissed in the late1990s — the Chinese government’s measures went far beyond improvingefficiency and transparency of customs institutions. Firstly, instead of tryingto improve the efficiency of the existing anti-smuggling offices, which were

1008 Yung-Hsing Guo

controlled by local governments where smuggling activities could be seento boost the local economy, the central government disbanded the originalanti-smuggling organizations and established new forces under its own lead-ership. Furthermore, anti-smuggling activities were no longer treated as onlycustoms-governed affairs; the activities became part of a national campaign,led directly by the government. This completely top-down execution modelhas shielded China’s anti-smuggling activities from the influence of interestgroups.

Secondly, rather than simply detecting smugglers, China’s activities tocombat tax evasion comprised a broad range of policies which not onlyexceeded the conventional jurisdiction of customs administration, but wasalso embedded in the Chinese social, economic and political context. Sincethe processing trade had become a main channel for smuggling in the 1990s,China’s government amended the Criminal Law and added a special andsevere article in 1997 to address tax evasion through the processing trade. Thegovernment also substantially reformed processing trade regulations aroundthe same time. These reforms have helped to block illegal imports throughthe processing trade and contributed to the increase of imports throughordinary trade and, consequently, tariff revenues. China’s case shows thatsuccessful anti-smuggling and anti-tax evasion policies should consist ofa reform package which is aligned with the conditions of the country inquestion.

Another inspiring aspect of the Chinese experience is that the de facto ex-port tax on processing trade firms provided China with an important resourceto stabilize tariff revenues. Economists have seldom considered export taxas a resource to offset tariff losses caused by trade liberalization. This isbecause export tax is usually collected from domestic primary products indeveloping countries, and a new tax on this sector would damage domesticfirms and the welfare of workers and farmers (Hasan et al., 2001; Warr,2001). However, processing trade enterprises in China are export-orientedand foreign-invested manufacturing firms and could thus be considered anenclave (Lemoine and Unal-Kesenci, 2004). This means that, although theyhired Chinese labour, these firms had few connections to China’s domesticeconomy; most of the materials for production were imported from abroadand most final products were exported. Collecting export tax from thesefirms therefore seems to do less damage to the domestic economy.

At present, export-oriented and foreign-invested manufacturing firms areclustered not only in China but also in several other developing countries.According to the ILO database on export processing zones (Boyenge, 2007),the ratio of zone exports as a percentage of total exports is very high in manydeveloping countries: in Algeria it is 85 per cent; Morocco, 61 per cent;Gabon, 80 per cent; Ghana, 70 per cent; Kenya, 86.9 per cent; Lesotho,80 per cent; Mali, 80 per cent; Mozambique, 85 per cent; Nigeria, 75 percent; Zimbabwe, 80 per cent; Madagascar, 80 per cent; Philippines, 60 percent; Bangladesh, 75.6 per cent; Malaysia, 83 per cent. Within the EPZs of


low-income countries, foreign-invested firms generally dominate production(Stein, 2008). In the light of tariff reductions or exemptions granted whenestablishing EPZs, governments can only hope that the potential tax revenuelosses are outweighed by gains accrued in terms of employment creationand provision of foreign exchange earnings (United Nations, 2005).

The Chinese government has now demonstrated a different scenario andhas successfully collected export tax from foreign-invested firms of exportprocessing to stabilize its tariff revenues. This begs the question, wouldother developing countries be able to collect proper export taxes from theseforeign-invested manufacturing firms in EPZs? The answer is not readilyavailable, not only because every country has its own unique conditions, butalso because no existing literature has ever considered collecting export taxfrom the EPZ sector. However, China’s case implies that this sector couldbe a potential resource for customs revenue: it may inspire other developingcountries with large-scale EPZs to consider adopting the appropriate policiesto collect export tax from the EPZ sector.

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Yung-Hsing Guo is Associate Professor of the Graduate Institute of Main-land China Studies and Dr Sun Yat-sen’s Thoughts, Chinese Culture Uni-versity, Taipei, 11114, Taiwan (e-mail: [email protected]).

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How China Navigated the Dilemma of Trade Liberalization and Government Revenues