China to Remove Dividend Tax for Long-Term Shareholders

China has recently announced that Chinese investors holding shares of stock for more than one year will be exempted from a 5-percent dividend tax. The immediate objective of the tax policy change appears to be to promote long-term share-holding and suppress short-term speculation in the stock market, but it is another important step in making the Chinese tax system one of the most growth friendly in the world.

Dividend income in China is subject to graduated tax rates based on the length of time the shares have been held. The new tax policy has eliminated the dividend tax on long-term investors, while dividend tax rates for short term stock holdings stay the same. Investor who hold shares for one month or less incur the full dividend tax rate of 20 percent; and those holding shares for between one month and a year are taxed at 10 percent. Before the latest change, persons holding shares longer than a year paid a 5 percent tax on dividends. That rate now drops to zero. China has been reducing tax rates on dividends since 2005.

Tax rate paid by Chinese taxpayers on dividends on stocks:

In most countries, corporate income is taxed twice, first by a tax on corporate income, and again by taxes on dividends and capital gains (which may be viewed as a second tax on retained corporate earnings that are reinvested to increase the value of the company). A reduced tax rate on dividends is a means of reducing the extra layer of tax on corporate income. The Chinese system goes further, in that it also exempts capital gains on stocks from the individual income tax. These steps encourage saving and investment in the Chinese economy, and have contributed to China’s rapid economic gains of recent years.

The Chinese tax code is far more consumption-based than income-based, and its income tax avoids much of the double- or triple- taxation of corporate income and personal saving that is found in other income taxes around the world.

There are two methods for treating saving and consumption evenly in a tax system. In one, saving is initially tax-deferred, and taxed later, along with its earnings, when they are withdrawn for consumption. This is the method found in a regular IRA or pension in the United States. In the other approach to neutral treatment, saving is taxed up front, and the earnings of the saving are exempt from further tax. The Chinese system generally follows the latter method.

The Chinese central government is financed primarily by a value added tax (VAT) in which investment spending is excluded from the tax base (full expensing). It is a form of consumption tax. Any income used for saving is tax deferred with respect to the VAT until it is spent.

There is a corporate income tax with a top rate of 25 percent, in line with the average in the developed world.

The provinces are permitted to use an income tax, with the parameters set by the central government. In the Chinese income tax, wages are taxed at progressive marginal tax rates up to 50%.

Income from saving, however, receives special treatment to avoid double taxation:

• Interest on bank accounts is tax exempt.
• Capital gains on Chinese shares are tax exempt.
• Dividends are taxed at a reduced tax rate.
• There is no estate tax in China.

China’s tax system falls short of a completely neutral tax system in only two respects:

• Its income tax employs depreciation instead of immediate expensing of investment outlays.
• Its wage tax has progressive marginal rates.

In other respects, however, it now has the same saving-consumption neutral tax base as the Flat Tax, the Personal Expenditure Tax, the Bradford X Tax, or the cash flow tax, in which saving and consumption are treated equally. In effect, all saving is given the sort of returns-exempt treatment found in the U.S. Roth IRA, without limits on contributions or withdrawals. The avoidance of the income tax biases against saving and capital formation in the Chinese tax system has enabled the country to get the most benefit from its shift to a market economy and personal ownership of businesses.