Academic journal article Multinational Business Review

A Taxation Dilemma of Foreign Direct Investment in an Evolving Market Economy

Academic journal article Multinational Business Review

A Taxation Dilemma of Foreign Direct Investment in an Evolving Market Economy

Article excerpt

Applying a social psychology model, the paper examines the determinants of tax evasion and avoidance in emerging markets, specifically in China. The paper asks two questions. What are the factors which give rise to firms' tax evasion and avoidance behaviors under post-planning economies like China? What lessons can China learn from its own experience and what can other countries, who are under going similar process, learn from China? Analyzing cases and survey results, the paper argues that instead of granting fiscal incentives preferential to foreign direct investment, efforts should be turned to eliminate distortions, discretions, and confusions. It suggests that allowing equal competition for inward foreign direct investment will create a more transparent, consistent, and stable environment for attracting foreign investments. Its findings and analytical framework will have important implications for government policies and for firms doing business in these countries.

INTRODUCTION

In contrast with the recent economic recessions in major industrial countries, China has experienced a double digit growth rate in the past several years. Economic reforms have transformed China into an important world trading nation and made it a preferred location for foreign investment. In 1993 alone, $110 billion in foreign capital was newly committed, an increase of 90 percent over the previous year (Price Waterhouse, 1994). At the end of 1993, there were 167,500 foreign investment entities in China. The export growth was 8 percent for the same year. Foreign firms now account for more than 20 percent of Chinese export. Despite the fast economic growth, China's tax revenue has fallen relative to national income since 1985 (refer to Exhibit 1). According to sources from both outside (Sender, 1993) and inside China (People's Daily, 1994), there are massive tax evasion and avoidance activities by all business entities -- state owned firms, collective owned firms, private owned firms, and foreign related firms.1 .

Three problems have contributed to the phenomenon. One is the proliferation of variety foreign investment incentives which differ across provincial governments, regions, and economic sectors. Second is expatriation of local currency denominated profits because of the convertibility of the Chinese currency. It triggers the transfer pricing activities to bring fund out of China despite preferential investment incentives. Third is a weak tax mentality prevailed in a postplanning economy in general. Above three problems have seriously challenged this changing society: massive revenue loss exacerbates government budget deficits; violent resistance to tax collection intensifies social tensions; and overestimates of inward direct investment (FDI) to China create wrong signal for policy makers2.

By applying a social psychology model to the tax evasion and avoidance of firms, the paper examines the determinants of tax evasion and avoidance in emerging markets in general and China in specific. The paper asks two types of questions. On the micro level, what are the unique factors which give rise to MNC's tax evasion behaviors operating in emerging markets or post-planning economies like China? On the macro level, what lessons can China learn from its own experience and what can other countries undergoing a similar process learn from China?

Due to lack of data and access, little research has been conducted in this area to provide insights for foreign firms doing business in China and for government policy makers managing a rapid transformation from a planning oriented economy to market oriented one. Yet specific and general lessons can be learned for doing business in a post-planning economy. Focusing on the issues of tax evasion, avoidance, and fund remittance of the foreign invested firms in China, this research will analyze and identify several strategies and practices which firms employ to minimize their tax payments and maximize their freedom to shift funds out of blocked currency under China's unique environment. …

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