Tariff Reduction, Tax Replacement, and Implications for Income Distribution in China

JOURNAL OF COMPARATIVE ECONOMICS ARTICLE NO.

26, 358–387 (1998)

JE981521

Tariff Reduction, Tax Replacement, and Implications for Income Distribution in China1 Zhi Wang* Purdue University and United States Department of Agriculture, Economic Research Services, Room 5141, 1800 M Street, NW, Washington, DC 20036-5831

and Fan Zhai Development Research Center, the State Council, Beijing 100017, People’s Republic of China Received February 18, 1997; revised December 4, 1997 Wang, Zhi, and Zhai, Fan—Tariff Reduction, Tax Replacement, and Implications for Income Distribution in China This paper considers the distributional effects of trade liberalization and government tax replacement policies during foreign trade reform. The analysis uses a 22-sector, 12-representative-household computable general equilibrium (CGE) model for China. The simulation results show that trade liberalization can enhance both economic efficiency and income equality in China. However, the extent of the efficiency gains from trade liberalization depends on which tax instrument the government chooses to balance its budget. Imposing a progressive household income tax reduces the Gini coefficient while retaining most of the efficiency gains. Hence, this is likely to be one of the appropriate tax policies for China’s government to choose to replace lost tariff revenue during trade liberalization. J. Comp. Econom., June 1998, 26(2), pp. 358–387. Purdue University and United States Department of Agriculture, Economic Research Services, Room 5141, 1800 M Street, NW, Washington DC 20036-5831; and Development Research Center, the State Council, Beijing 10017, People’s Republic of China. q 1998 Academic Press

Journal of Economic Literature Classification Numbers: D58, F10, H20.

1. INTRODUCTION Since the beginning of economic reform and its opening to the outside world, China’s economy has been growing at a rate of more than 9% annually * Corresponding author. 1 Views expressed in this paper are those of the authors and do not represent the institutions with which they are affiliated. The authors thank John Bonin and two anonymous reviewers for very valuable suggestions. The authors also express their gratitude to Dr. Terry Sicular, Dr. Frederick Crook, Mr. Huijiong Wang, and Mrs. Shantong Li for their comments on an earlier version of the paper. However, the authors are responsible for any remaining errors. 0147-5967/98 $25.00 Copyright q 1998 by Academic Press All rights of reproduction in any form reserved.

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and its external trade has expanded by nearly 15% a year. This phenomenal growth has been accompanied by rapid changes in the structure of the economy. China’s trade behavior is increasingly consistent with its comparative advantages. However, China still has a long way to go in replacing direct administrative intervention with indirect market-based instruments for managing its foreign trade. Despite the fact that the degree of government control over imports has declined, a fair percentage of imports are still subjected to some form of administration controls. Moreover, China’s nominal tariffs still remain higher than those in most developing countries. With the successful conclusion of the Uruguay Round, the levels of import protection will likely be reduced around the world. This worldwide trade liberalization leaves China with little choice but to accelerate its foreign trade reform. If it does not reduce the levels of protection during the implementation of Uruguay Round, China will be worse off because of the trade diversion effect (Wang, 1997). Continuing unilateral trade reform to lower its protection levels, along with those of most developing countries in the post-Uruguay Round environment is necessary to avoid trade diversion resulting from liberalization by other countries. On April 1, 1996, China lowered its average nominal tariff by about 35%. According to China’s General Administration of Customs, this new liberalization effort included substantial cuts on 4,994 tariff lines and lowered China’s simple average tariff from 35.9 to 23.2%. However, such an average tariff rate is still too high to justify China’s WTO membership. After eight rounds of multilateral talks on global trade, the average tariff in developed countries dropped from 40% in 1948 to about 5%. An average tariff of about 13% is currently maintained by most developing countries and transition economies (Whalley, 1995). With the implementation of the Uruguay Round, the tariff rate of WTO contracting parties will fall even further. Negotiations between China and the WTO members are still ongoing, China is planning a new round of tariff cuts to reduce its average tariff to around 15% or lower by the year 2000. As shown by Table 1, tariff revenue is an important source of central government finance in China as it accounts for between 13 to 15% of total central government revenue in recent years. A significant trade liberalization program faces the conflicting objectives of increasing economic efficiency and preserving government revenues; it presents the government with the tasks of both finding a way to replace the lost revenues and dealing with the associated structural adjustment problems. The redistribution issue becomes more important if we consider the sharply widening personal income gap that has accompanied China’s rapid economic growth.2 2 About five million households, approximately 2% of all households in China, have annual incomes more than 50,000 yuan (about $6000 U.S. dollars). One million of these households have personal assets of more than one million yuan (about $120,000 U.S. dollars). However, most Chinese working families still have very low incomes as 12.5 million urban residents, about 5% of the urban population, fall under the poverty line having less than 1200 yuan (about $150 dollars) income per capita a year.

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Taxation has long been an important policy instrument to reduce income inequality. To implement a dramatic trade reform in a domestic economic environment with increasing personal income disparities, the government has to choose tax policies that will avoid further increases in income inequality and balance the government budget with minimal social costs. This paper investigates and quantifies the welfare and distributional effects of trade liberalization under alternative tax replacement assumptions. The analysis uses a 22-sector, 12-representative-household computable general equilibrium (CGE) model for China. We provide some empirical evidence for policy makers to evaluate the effects of adopting different trade reform and tax replacement options from the perspectives of efficiency and equality. We address the following four questions. First, what is the welfare impact of recent and planned tariff cuts on different types of households? Second, what are the effects of these trade liberalization programs on government tariff revenues? Third, what are the implications of different tariff-cutting scenarios under alternative government tax replacement policies for the distribution of income? Finally, does government tax replacement matter in terms of its efficiency and equality consequences for trade liberalization policies? The conflict between economic efficiency and equality of the distribution of income has long been recognized in economics. CGE models provide an unified quantitative framework to analyze the various trade-offs. In the CGE framework, the income flows between factors and agents are completely and explicitly specified. The linkage between returns from various production factors and income flows to major groups of households permits the analysis of both functional and size distribution among economic agents (Adelman and Robinson, 1988). This capability provides a valuable means for economists and policy makers to capture the efficiency–equality trade-offs induced by different policy scenarios and thus to obtain a better understanding of the possible social consequences of the proposed policy changes. Section 2 of this paper outlines the basic structure of the CGE model for China and presents major assumptions. Section 3 describes the basic characteristics of the base year data and highlights the structure, sources, and distribution of household income in China. Section 4 describes the simulation scenarios and Section 5 uses simulation results to assess the efficiency and equality consequences of trade liberalization under five types of government tax replacement policies. Section 6 concludes by drawing policy implications. 2. THE BASIC STRUCTURE OF THE CGE MODEL FOR CHINA Specifications of the CGE model follow closely the prototype CGE model for trade and environment programs developed by the OECD Development Moreover, 60 million people in inland rural areas still live in poverty. The incomes of the top 20% urban households are 13 times the incomes of the lowest 20% of the rural households, which is very high, even by international standard (Huang, 1996).

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11,962.5 14,928.3 16,909.2 18,530.7 21,617.8 26,635.4 34,515.1

1987 1988 1989 1990 1991 1992 1993

ceal 9,966.9

5,985.7

4,443.3

3,398.7

2,574.3

2,199.9

2,055.1

1,614.2

1,498.3

Imports

5,218.1

5,088.2

4,153.1

3,610.9

3,312.6

2,947.9

2,628.0

2,368.9

2,260.3

Total gov. revenue

2,906.5

1,696.7

1,649.2

1,399.7

1,367.9

1,105.5

1,045.5

905.8

916.7

Central gov. revenue

330.0

256.5

212.8

187.3

159.0

181.5

155.0

142.4

151.6

Tariff revenue

6.3

5.0

5.1

5.2

4.8

6.2

5.9

6.0

6.7

Tariff/gov revenue %

11.4

15.1

12.9

13.4

11.6

16.4

14.8

15.7

16.5

Tariff/central gov. revenue

Note. The data source is China Statistical Yearbook (Zhongguo Tongji Nianjian), various issues, SSB, People’s Republic of China.

45,005.8

10,202.2

1986

1994

GDP

Year

Imports, Tariff Collection, and Central Government Revenue, 1986–1994 (Rmb 100 Million)

TABLE 1

3.3

4.3

4.8

5.5

6.2

8.3

7.5

8.8

10.1

Collected tariff rate %

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Center (Beghin et al., 1994). Our major modifications are the introduction of a value-added tax and export rebate mechanism to capture the major changes in China’s 1994 tax reform.3 Twenty-two production sectors and 12 representative households are specified.4 There are five primary factors of production in the model, namely agricultural land, capital, agricultural laborers, production workers, and professionals. Production and professional workers have basic education in common, but professionals usually have more advanced training. Agricultural laborers are those who have little or no education and work only in farm sectors. Primary factors are assumed to be mobile across sectors. 2.1. Production Suppose there is one competitive firm that produces only one product in each sector. Production is characterized by a multilevel nesting of constant elasticity of substitution (CES) functions. At the first level, firms are assumed to use a composite of primary factors plus energy inputs, i.e., value-added plus the energy bundle, and other intermediate inputs according to a CES cost function. Technology in all sectors is assumed to exhibit constant returns to scale, implying constant average and long-run marginal costs. At the second level, the division of other intermediate demand is assumed to follow a Leontief specification; therefore, there is no substitution among other intermediate inputs. At the same level, the value-added plus energy bundle is divided between labor and energy-capital bundles that are further split into energy and capital-land bundles. All composite bundles in each nest are assumed to substitute smoothly in a CES cost function. The degree of substitutability among them depends on their base year share in production and on the elasticity of substitution, which is assumed to be constant. The firm’s output is assumed to be sold on the domestic market or to be exported to the rest of the world by a constant elasticity of transformation (CET) function. 2.2. Demands Agents are assumed to consider products from domestic supply and imports as imperfect substitutes, i.e. the Armington assumption. The 12 representative households are assumed to maximize a Stone–Geary utility function over the 22 composite (Armington) goods, subject to their budget constraints, which leads to an extended linear expenditure system (ELES) of household demand functions. Household savings are treated as a demand for future consumption

3

Because of space limitation, only a description of the major characteristics of the model is presented. An algebraic sketch of the model can be found in Appendix A. 4 The sector specification and their SSB-Input/Output sector concordance is available upon request from the authors by interested readers.

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goods with zero subsistence quantity (Howe, 1975). An economy-wide consumer price index is specified as the price of savings. It represents the opportunity cost of giving up current consumption in exchange for future consumption (Wang and Kinsey, 1994). Other final demands, including government and enterprise spending and investment demand, are based on constant share functions that fix the structure of other final demands in real terms. The intermediate inputs for the firms, household consumption, and other final demands constitute the total demand for the same Armington composite of domestic products and imported goods from the rest of the world. A CES aggregation function is specified for each composite commodity. The total demand is divided between domestically produced and imported goods according to the assumption of cost minimization. 2.3. Income Distribution and Government Policy Instruments Production generates income, which is distributed to four major institutions, namely, enterprises (corporations), households, the government, and financial institutions (both domestic and foreign). Corporate earnings equal a share of gross operating surplus, i.e. the sum of capital remuneration across all sectors, minus government corporate income taxes. The tax rate is taken as a parameter in the model. However, it can be endogenized to meet government fiscal targets, in which case an adjustment parameter becomes endogenous. A part of net company income is allocated to households as distributed profits based on fixed shares, which are the assumed shares of capital ownership by households. Retained earnings, i.e. corporate savings for new investment and capital depreciation replacement, equal a residual of after-tax company income minus the distributed profits and other enterprise spending. Household income consists of labor earnings and the returns from land and capital that they own. Additionally, households receive transfers and subsidies from the government and remittances from the rest of the world. Therefore, total household income is the sum of labor income, returns from capital that they own, the distributed corporate profits, transfers and subsidies from the government, and remittances from abroad. Assume that rural households earn their labor income from both agricultural laborers and production workers, e.g. those employed in village and township enterprises, while urban households obtain their wages from both production and professional workers. The household income tax rate is set as a parameter, but an associated adjustment factor can be endogenous if the government budget is exogenous. In this case, household tax schedules shift in or out to achieve government budget balance. Otherwise, the household tax schedule is exogenous and the adjustment factor remains at its initial value of one. An adjustment factor on government transfers, similar to the adjustment factors on other taxes, provides another fiscal instrument to achieve a specified budget target. Household disposable income equals total household income less taxes.

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The government derives revenues from direct corporate and household income taxes, import tariffs, and various types of indirect taxes. Subsidies and export tax rebates enter as negative receipts. There are three types of indirect taxes in the model. The value-added tax, which is the most important part of indirect tax in China after 1994 tax reform, is treated as a tax levied on production factors; its revenues equal total sector value-added multiplied by a tax rate. The value-added tax is also levied on imports while firms obtain rebates when they export. The second indirect tax, a sales tax, includes household consumption taxes and other final demand taxes. The tax rate constitutes the difference between the aggregate Armington prices and prices of various demands. The other indirect tax, including various agricultural taxes and business taxes on construction, infrastructure, and services is treated as a production tax levied on sectoral outputs. 2.4. Equilibrium and Closure Equilibrium is defined as a set of prices and quantities for goods and factors such that (i) demand equals supply for all goods and factors; (ii) each industry earns zero profit; and (iii) gross investment equals aggregate savings, which is the sum of domestic savings plus foreign capital inflows. Closure in a CGE model involves both macroeconomic accounting balances and assumptions about adjustment behavior. There are three major macroeconomic balances in the model: (i) the government budget; (ii) aggregate savings and investment; and (iii) the balance of payments. In the benchmark equilibrium all three accounting balances hold. The behavioral aspect of closure in a CGE model involves choosing a mechanism by which macroeconomic balances are brought back into equilibrium when exogenous shocks disrupt the benchmark during an experiment. Thus, a macroeconomic scenario is imposed on the CGE model, and then the sectoral implications of the assumed macroeconomic behavior can be traced out (Devarajan, Lewis, and Robinson, 1990). Because the adjustment behavior is not based on optimizing behavior by rational agents, different assumptions about the adjustment process may lead to different results. Two government closure rules are implemented. Under the first rule, government savings are fixed at a base value and one of the taxes, or government transfers to households, is allowed to adjust uniformly to achieve the government fiscal target. Under the second closure rule, all tax levels and transfers are fixed, while real government savings are endogenous. This latter rule has significant consequences on the level of investment since investment is driven by savings in the model. The total value of investment expenditure equals the total resources allocated to the investment sector; it includes retained corporate earnings, total household savings, government savings, and foreign capital inflows.

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The last macroeconomic identity is the balance of payments. A smallcountry assumption is used; i.e., the local consumption of imports does not affect the border price of imports. The value of imports, at world prices, must equal the value of exports at border prices, i.e., inclusive of export taxes and subsidies, plus the sum of net transfers and factor payments and net capital inflows. An exchange rate is specified to convert world prices, e.g., in dollars, into domestic prices. Either this exchange rate, or total foreign capital inflow can be fixed while the other is allowed to adjust, providing alternative closure rules. An adjustable exchange rate implies that a change in the domestic price index is sufficient to sustain a constant current-account balance measured at world prices. Since the purpose of this paper is to estimate the efficiency and equality trade-offs induced by trade liberalization under different government tax replacement assumptions, we keep the domestic savings and investment gap constant in all the simulations conducted, except in the case without tax replacement. This is achieved by keeping the balance of payments, real government savings, and real government spending fixed. In this way, macroeconomic rigidity is imposed on the model. If government revenues change because of a reduction in tariffs, an increase in government tax earnings must be implemented. By a macroeconomic identity, this closure implies that a constant sum of domestic savings and taxes in real terms is needed to finance both real investment and the fixed real government expenditures. Thus, any changes in real gross domestic product (GDP) are induced by changes in real absorption, i.e., household consumption plus other final demand, making it easy to compare the efficiency impacts of different simulations. 2.5. Comparative Statics and Steady-State Dynamics Two types of gains are usually associated with trade liberalization: the gains from a more efficient utilization of resources, which leads to a onetime permanent increase in GDP and social welfare, and the gains from a medium-run growth bonus, which compounds the initial efficiency gains and leads to higher savings and investment. The first type of efficiency gains induces higher income and lower prices for capital goods, accelerates capital accumulation, and leads to a larger capital stock in the economy. This, in turn, yields more output, leading to further savings and investment. As Francois et al. (1995) have pointed out, the second type of gains, i.e., the midterm accumulation effect, is different from any long-run, permanent growth effect induced by human capital and technology improvement, since it ultimately declines to zero over time. To quantify these two gains, two alternative capital market closures, one static and one steady state, are used. Under static capital market closure, the aggregate productive capital stock is fixed and the economy-wide average rental rate adjusts to ensure that capital is fully utilized. This is the empirical

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analog of the comparative-static analysis common in theoretical work. Under steady-state capital market closure, the return of capital is held constant while the capital stock is determined endogenously. This closure assumes that China’s aggregate capital stock is at its steady-state level in the benchmark equilibrium and that liberalized trade will increase capital returns due to a more efficient allocation of resources. In a dynamic sense, this will lead to a higher rate of savings and investment. A larger capital stock decreases the marginal productivity of capital and, thus, reduces the return to capital back to its initial level. Although no information is produced about the transition path of the price of capital back to its steady-state equilibrium after an external shock, some light is shed on the approximate size of the accumulation effect of investment growth induced by trade liberalization in a classical Solow-type growth model at almost no additional implementation cost. The theoretical underpinnings of this approach are based on the concept of an invariant capital stock equilibrium proposed by Hansen and Koopmans (1972); it was introduced into the CGE analysis to estimate the accumulation effects of trade liberalization by Harrison et al. (1995).5 3. INCOME DISTRIBUTION AND GOVERNMENT REVENUE STRUCTURE IN CHINA Our CGE model for China is constructed according to a Social Accounting Matrix (SAM) developed by the Development Research Center (DRC) at the State Council of People’s Republic of China from China’s most recent input– output Table (SSB, 1996). The SAM provides a consistent framework to organize the relevant flow of value statistics for China’s economy to satisfy the requirements of a benchmark data set for CGE modeling, as outlined in Whalley (1985). Table 2 summarizes the sectoral structure of China’s economy in the base year. For each of the 22 sectors, the base year data for shares of output, employment, imports, exports, and trade dependence are reported. Columns 7 through 9 give information about the degree of domestic tax distortion and import protection. As may be seen in columns 1 through 4, the data are notably asymmetric among the shares of output, employment, and trade. For example, the crop sector accounts for more than 52% of China’s labor employment but only produces 7% of its output and about 3% of China’s total trade. While textile, apparel, and leather industries employ less than 3% of China’s labor force, they produce 8% of its total output and account for more than 30% of the country’s total exports. Export dependency is extremely high for the apparel and leather sectors, as about 60% of their products depend on foreign markets. Electronic and other light consumer goods are the other 5 The increased capital stock from simulations using such a capital market closure may be interpreted as additional capital stock accumulation over a medium term, induced by trade liberalization.

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7.3 5.9 3.2 5.9 5.5 1.5 0.7 3.3 3.2 7.1 3.7 4.6 2.1 6.1 1.7 2.2 1.8 1.6 7.6 3.9 8.4 12.8 100.0

Output 52.3 7.9 2.2 1.2 1.9 0.6 0.3 1.5 0.5 1.8 2.0 0.8 0.7 2.2 0.3 0.6 0.5 0.5 4.6 1.3 5.9 10.4 100.0

Labor force 2.8 1.1 4.4 2.6 9.3 0.3 1.6 4.8 2.2 16.2 1.0 8.7 1.3 23.8 4.0 3.8 8.5 0.4 0.0 0.0 0.0 3.1 100.0

Imports 3.6 1.6 4.7 6.4 14.4 11.7 5.1 8.8 1.2 7.9 2.4 2.0 2.9 8.2 0.3 3.3 5.5 0.3 0.0 3.8 1.3 4.5 100.0

Exports 2.5 1.3 9.1 3.4 12.9 3.0 28.2 11.4 4.6 15.0 2.0 12.0 4.7 23.2 17.3 11.9 29.9 1.7 0.0 0.1 0.0 1.7 7.0

Import/ domestic usea 3.5 1.9 8.0 8.3 21.3 59.7 60.0 21.6 2.6 9.7 6.2 4.3 11.7 11.0 1.5 13.0 23.1 1.9 0.0 7.4 1.2 2.6 7.9

Exports/ output 1.3 1.1 1.0 9.1 3.5 2.4 2.9 3.0 8.9 4.6 4.1 6.3 3.2 3.3 3.2 3.6 2.4 2.3 1.1 2.9 00.8 1.4 2.9

Net indirect tax rate

3.0 20.5 3.5 35.6 71.8 74.3 38.7 37.5 8.6 25.3 36.4 13.5 44.3 23.4 115.5 36.6 30.8 81.0 n.a. n.a. n.a. 1.0 31.6

Nominal tariff rate

0.5 2.8 0.9 11.1 4.4 1.1 0.5 3.6 3.2 4.1 6.7 3.2 6.1 3.5 28.9 4.5 4.0 3.9 n.a. n.a. n.a. 0.2 4.6

Collected tariff rate

Note. The data source is 1992 Social Accounting Matrix, Development Research Center at State Council, People’s Republic of China. a Imports/Domestic and Export/Output use domestic prices. The sectoral share of imports and exports use world prices. The net indirect tax rate is the tax rate less subsidies as a percentage of total output.

Crops Other agriculture Mining Processed food Textiles Apparel Leather Other nondurable goods Energy Chemicals Build materials Basic metals Metal products Machinery Road vehicles Electronic machinery Electronics Other industries Construction Infrastructure Commerce Service Total/average

Sharea

Major Structure and Main Economic Indicators for the Chinese Economy in 1992 (%)

TABLE 2

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— 46.71 11.53 28.22

— 28.89 27.21 38.48 3.55 1.19 0.68

1,070

2,734

Per capita income before tax (yuan/year) Income structureb (%) Earnings of ag. labor Wages of prod. workers Wages of professionals Returns from land & capital Price subsidy Gov. transfer Remittent from ROW

6.32 4.64 1,058

27.63 51.73 2,702

Low

Population (%) Disposable income (%) Per capita disposable income

Urban

TABLE 3

3.46 0.46 0.32

— 43.73 16.79 35.24

1,695

4.59 5.33 1,678

Mediumlow

3.54 0.38 0.50

— 36.85 21.23 37.50

2,262

6.86 10.65 2,241

Medium

3.75 0.27 0.70

— 30.39 26.25 38.64

3,350

4.65 10.67 3,312

Mediumhigh

3.63 0.17 0.97

— 16.09 37.07 42.07

5,738

5.21 20.44 5,657

High

0.00 1.38 0.04

54.44 31.40 — 12.74

974

72.37 48.27 962

Rural

0.00 11.83 0.02

79.00 5.63 — 3.52

453

12.69 3.92 446

Lowest

0.00 0.84 0.03

79.63 14.03 — 5.47

571

9.16 3.58 563

Low

0.00 0.68 0.03

72.12 21.06 — 6.12

686

9.39 4.41 677

Mediumlow

Sources, Structure, and Distribution of Household Income in China, 1992a

0.00 0.59 0.04

63.40 27.00 — 8.97

851

15.52 9.04 841

Medium

0.00 0.45 0.05

54.41 33.24 — 11.85

1,084

10.01 7.44 1,073

Mediumhigh

0.00 0.34 0.05

43.13 40.99 — 15.48

1,437

10.26 10.13 1,425

High

0.00 0.19 0.06

30.72 45.59 — 23.43

2,669

5.34 9.76 2,636

Highest

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98.89 0.00 0.00 1.01

85.08 13.91 0.00 0.96

76.94 22.10 0.00 1.12

61.71 37.17 0.71 0.69

51.48 47.12 0.06 1.09

79.60 19.25 0.00 1.54

98.46 0.00 0.00 1.35

92.98 5.67 0.00 1.27

88.41 10.32

0.00 1.15

82.89 15.96

0.00 1.04

78.10 20.86

0.00 0.86

74.22 24.91

0.30 0.95

66.78 31.98

Note. The data source is 1992 Social Accounting Matrix, Development Research Center at State Council, People’s Republic of China. a The grouping of urban and rural households is based on the urban household survey in 1991 and the rural household survey in 1992 from SSB. The urban households were grouped by the income available for living per-capita, while the rural households were grouped by peasants’ net income. We derived total households’ income from macroeconomic data. Total household income in our 1992 SAM equals household consumption from the input-output table, plus savings (deposits, cash increment, private investment) from China Statistical Yearbook, and taxes and fees. It is larger than the income figure per-capita in the household survey multiplied by the population. The macroeconomic data were used as control figures while the share data from household survey were used to construct the household sector in the SAM. To calculate the share, self-consumed farm production is included for rural households, but only cash incomes are used for urban households because most implicit subsidies to the urban household were not included in the SSB survey data. Rental value for housing was also excluded. ‘‘Income available for living’’ refers to the income of urban households that can be used for daily expenses, including regular or fixed income and one-off income, but excluding circulated income such as loans borrowed from relatives or friends, withdrawals from bank deposits, repayments of loans received, and gifts from relatives and friends. ‘‘Peasants’ net income’’ refers to peasant household’s total income during a year after the deduction of farm business expenses. It can be spent for investments for production and nonproduction construction and for daily life, while loan income borrowed from banks or friends and relatives is not included. It is an indicator of the peasants’ actual income level (China Statistical Year Book 1995, p. 314). b To derive this income distribution matrix, we constructed an initial matrix, based on the household survey data. The RAS method (Stone, 1961) is used to generate a balanced income distribution matrix from the initial matrix using macroeconomic data as control totals. The resulting matrix is presented here in percentage form. We derived all the distribution coefficients of factor incomes in our model from this matrix. c Fee is the extra-budget income of government such as various administration fees paid to local governments by households and enterprises.

Income tax Feec

Expenditure structure (%) Consumption Saving

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two export-oriented sectors in which almost a quarter of the output is sold on international markets. The sectors with the largest shares in imports are chemicals and machinery as they account for 16 and 24% of China’s total imports, respectively. The electronics and leather industries have both high export and import dependency, reflecting the fact that a large percentage of production in these sectors represents processing and assembling products from abroad, i.e., processed trade. Another notable feature of the base year data is the significant differences between China’s nominal tariff rate and the actual collected rate. It is well known that China’s tariff collection is significantly below its nominal tariff level because of a large volume of processed trade, extensive import duty exemptions and widespread smuggling activities (World Bank, 1994). However, the data in the final two columns of Table 2 indicate the dramatic variation of the nominal/actual tariff rate ratio among sectors as this statistic ranges from 70 in apparel and leather industries to around 2.6 in energy industries. In general, the more export-oriented sectors have the higher nominal/actual rate gaps because of the tariff exemptions applied to their imports of intermediate inputs and processed trade. Table 3 presents the sources and structures of household income with its distribution in China captured by the base year SAM. It provides a snapshot of the growing income inequality in China today. Urban households are less than 30% of China’s total population but they account for more than half of total household income. Per-capita annual income of a middle-income family in a rural area is still well below a low-income family living in urban areas. The urban to rural income gap reached 2.8:1 in 1992. The data in Table 3 show that earnings from agricultural labor are still the major source of income for China’s rural households, 55% although wages of production workers also constitute a significant portion of rural families’ income, 31%, reflecting the importance of the village and township enterprises in a rural household’s earnings. Returns from capital are the largest portion of urban households’ income, indicating the growing role of profits from property in an urban household’s income. The government price subsidies and other transfer policies favor urban residents; this is a major reason for urban/rural income inequality. On the expenditure side, high-income households have higher propensities to save, while low-income households are at a subsistence level with no savings. The household’s burden from income tax and fees was very low in 1992 at only about 1% of income. It is interesting to compare our data with the data used previously in other studies. Despite differences in the definition of household income, data sources, year of the data collected, and the derivation method, the resulting pattern of income inequality in China from our data is quite similar to that of other recent studies, e.g. Khan, Griffin, Riskin, and Zhao (1992). Both data sets show that income inequality between rural and urban households dominates inequality within each area, as reflected by substantially higher

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overall Gini coefficients.6 However, our data show that the Gini coefficient in urban China is slightly larger than the one in rural China, a result that is different from most of the previous works. Three factors may explain this difference. First, most previous studies were based on data sets collected in the 1980s when the economic reform in urban areas had just started, but our data was collected in 1992 when economic reform in urban areas had progressed, leading to deeper inequality among urban households. Second, most previous studies depended on disaggregated household survey data, but our data were based on aggregate quantile income data published by the State Statistical Bureau (SSB) of China and which averages out income disparities among different regions and individual households. Finally, since our data on urban households does not include implicit subsidies, it may overstate the income inequality in urban China. Direct and indirect taxes are the major sources of government revenue (more than 94%) in the base year SAM.7 Tariffs account for only 5% of total government revenues, i.e. the sum of central and local government revenues, thus, no significant impact on income distribution and on the government budget should be expected from our simulation results. However, the direction and relative magnitude of changes from model simulations shed light on the appropriate tax replacement policies during foreign trade reform. This SAMbased data analysis provides an overview of the characteristics of income distribution among different types of households and the redistribution role of the government in China. It has important implications for the distributional impact of trade liberalization and facilitates the understanding of simulation results reported later in this paper. 4. DESIGN OF ALTERNATIVE SCENARIOS Significant changes occurred in the taxation system because of China’s tax reform in 1994. To make our simulation more relevant for policy, we first 6

Based on the data of Khan et al., the Gini coefficients for rural, urban, and overall were 0.34, 0.23, and 0.38, respectively, while based on data from our SAM, they were 0.3, 0.32, and 0.42, respectively. 7 The indirect tax includes not only the product tax (Changping Shui), the value-added tax, (Zhengzhi Shui), and the business tax (Yingye Shui), but also agricultural and animal husbandry taxes (Nongmuye Shui), the fixed asset investment adjustments tax (Guding ZiChan Tongzhi Fangxiang Tiaojie Shui), the city construction tax (Chengshi Weihu Jianshe Shui), the urban land use tax (Cengzheng Tudi Shiyong Shui), the post tax (Yinhua Shui), the special tax on oil (Shaoyou Tebie Shui), the special consumption tax (Tebie Xiaofei Shui), the pollution and water resource tax (Wuran He Shuizhiyuan Shui), and the occupation of cultivated land tax (Gengdi Zhangyong Shui). The data on the fixed assets investment adjustment tax are from the China Statistical Yearbook 1994 (Zhongguo Tongji Nianjian). The data on agricultural and animal husbandry taxes are from the China Statistical Yearbook 1995 (Zhongguo Tongji Nianjian). Other data are from the Finance Yearbook of China 1994 (Zhongguo Caizheng Nianjian 1994). The data on household income taxes were provided by the Ministry of Finance, People’s Republic of China.

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update the model’s data base to make it consistent with the tax structure of China’s 1994 tax reform. This was accomplished by setting the value-added tax rate for all industrial and commercial sectors at 17%, and by imposing a 3% business tax on construction, infrastructure, and services. Sales taxes for processed food at a weighted average of 7.8% and for road vehicles at 2% were included, while the indirect taxes for agricultural sectors were maintained at their previous levels (Li, 1994). After updating the base year data, three tariff-reducing scenarios were examined under five types of government tax replacement policies and their results were compared with this newly obtained benchmark equilibrium. In the first scenario, tariffs were reduced from the 1994 level to the recently applied new tariff schedules. China’s new tariff data were aggregated from the Harmonized Commodity Description and Coding System (HS) tariff schedules published by China’s Custom Administration and weighted by the 1994 trade data. The actual collection rate was used. In the second scenario, a 50% cut of China’s current tariff level across all sectors was conducted. In the third scenario, a uniform tariff rate on all imports that raises the same tariff revenue as in the second scenario was used. The motivation for these experiments is to evaluate the implications for efficiency and equality by different tariff-reducing policies under five types of government tax replacement policies. In all these experiments, government revenue was fixed in real terms and tax rates were adjusted endogenously using the five tax replacement scenarios. Any reduction in tariff revenue was compensated by a domestic tax rate change that made the policy change revenue-neutral. For each of the three tariff-reducing scenarios, tariff revenue losses were financed from one of five taxes: a value-added tax on domestic products, a uniform sales tax on final demand, a corporate income tax, i.e. tax on capital, a progressive household income tax, and a lump-sum replacement tax that reduces government transfers to households. The three tariffreducing experiments were repeated using each of the above five taxes to replace lost government revenues from trade liberalization. An additional simulation with no government tax replacement was also conducted for each of the tariff reducing scenarios. In these cases, real government expenditure was adjusted to satisfy the reduced revenue due to trade liberalization. In all, 18 simulations were conducted. 5. MAJOR SIMULATION RESULTS8 Table 4 records the changes in the main efficiency and inequality indicators under the three tariff-reducing scenarios. Trade liberalization enhances both economic efficiency and income equality. Real absorption increases, while

8

All simulation results reported in this section use the steady-state capital market closure.

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Value-added tax Sales tax Corporate tax HH income tax Lump-sum transfer No replacement

0.272 0.479 0.517 0.520 0.565 0.622

Additional 50% cut 0.249 0.456 0.494 0.497 0.544 0.599

Uniform tariff

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0.34 0.47 0.47 0.49 0.52 0.62

Value-added tax Sales tax Corporate tax HH income tax Lump-sum transfer No replacement

0.24 0.47 0.47 0.48 0.54 0.71

Additional 50% cut 0.19 0.42 0.41 0.43 0.48 0.66

Uniform tariff

00.0034 00.0041 00.0038 00.0061 0.0066 00.0044

00.0024 00.0036 00.0026 00.0039 0.0038 00.0030

00.0038 00.0045 00.0042 00.0065 0.0063 00.0048

Uniform tariff

3.18 2.35 2.45 2.46 2.51 2.67

1996 tariff cut

5.65 4.31 4.41 4.41 4.50 4.77

Additional 50% cut

5.45 4.12 4.22 4.22 4.31 4.58

Uniform tariff

Percent changes in total exports

Additional 50% cut

Changes in Gini coefficient 1996 tariff cut

Note. The data source is authors’ calculation from simulation results.

1996 tariff cut

Financed by

Percent change in total output

1996 tariff cut

Financed by

Percent change in total absorption

063.69 064.13 064.08 064.04 063.96 063.92

Additional 50% cut

063.69 064.13 064.08 064.04 063.96 063.92

Uniform tariff

3.59 2.65 2.77 2.78 2.84 3.02

1996 tariff cut

6.39 4.87 4.98 4.99 5.09 5.39

Additional 50% cut

6.17 4.66 4.77 4.78 4.88 5.18

Uniform tariff

Percent change in total imports

031.08 031.78 031.54 031.49 031.40 031.95

1996 tariff cut

Percent changes in tariff revenues

Trade Liberalizations, Tax Policies, and Major Efficiency and Inequality Indicators (Change from Base)

TABLE 4

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the Gini coefficient declines, except for the case of government transfer reductions. All three tariff-reducing scenarios reduce government tariff revenues significantly; hence, the government must find other sources to replace lost revenue from trade liberalization. However, any government tax replacement has an efficiency cost. The largest increase in absorption and output occurs when the government does not replace lost revenues. When a tax replacement policy is imposed, the efficiency gain decreases, regardless of which type of tax is used. However, the magnitude of the reduced gains and the corresponding distributional effect indicated by changes of the Gini coefficient are quite different for the different tax replacement policies. The lump-sum tax replacement policy generates the largest efficiency gains because no additional distortion is imposed on the economy. However, it is also the only case in which the Gini coefficient increases, illustrating the conflict between efficiency and equality. The reason for the increased social inequality is that incomes of the poorest households, i.e. both urban low and rural lowest, depend heavily on government transfers in China. If the government reduces direct transfers to households to offset lost tariff revenues during trade liberalization, those poorest households are affected the most and they become even poorer relatively. Given the concern about increasing social inequality in China today, such a policy is obviously inappropriate. Among the other four types of tax replacement policies, the household income tax yields the greatest increase in real absorption with the largest reduction in the Gini coefficient for all three tariff-reducing scenarios. A corporate income tax achieves similar efficiency gains, but the reduction of inequality is much smaller. A value-added tax generates the lowest efficiency gains because it distorts production incentives. Three additional lessons can be drawn from the macro economic indicators reported in Table 4. First, by comparing the first and second scenarios, the increase in real absorption is generally smaller in the additional 50% tariffcut experiments, except for the cases of no replacement tax and the lumpsum transfer. These results indicate that additional tariff cuts may not bring additional efficiency gains for the economy if the government faces budget rigidity and must use other taxes to offset lost revenues. Second, by comparing the second and third tariff-cutting scenarios, the efficiency indicators under the uniform tariff label are generally worse than those under the 50% cut across current tariff structures, although the Gini coefficients are reduced slightly more in all types of tax replacement choices under uniform tariffs. This result provides empirical evidence for a well-known proposition in the trade economics literature (Dahl, Devarajan, and Wijnbergen, 1986) that replacing existing tariff structures with a uniform rate can lead to social efficiency losses in the presence of other tax distortions. Finally, trade expansion under almost all the tax replacement policies investigated is smaller than in the case of no replacement tax, except if a value-added tax is used to replace the lost tariff revenue. This result follows from the export value-added tax

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rebate mechanism (i.e., when the value-added tax rate increases, the export rebate rate increases at the same time), encouraging domestic firms to engage in trade. However, the greatest increase in exports comes with the lowest efficiency gains, indicating that export tax rebates may promote trade but may not always lead to the most efficient allocation of resources. Table 5 presents the equivalent variation (EV)9 of different types of households affected by trade liberalization under the six tax replacement assumptions. Estimates of the distribution of welfare gains from trade reform among the different types of Chinese households are helpful to understand better the distributional impact from trade liberalization. Although the aggregate welfare position of households improves in all the experiments (last row, Table 5), the distribution of welfare gains among households at different income levels is quite different under alternative government tax policies. For example, under the lump-sum replacement tax, the poorest households in both rural and urban areas lose, with the rural poorest losing the most at around 5% of their base year disposable income in the tariff cut in 1996 and 8.5% of their base year disposable income in the assumed future cuts. Under the progressive income tax, only the richest urban high-income households are subject to a welfare loss in the proposed future tariff cuts; they actually gain somewhat in the 1996 tariff cuts. This loss is quite small at lower than 0.5% of their base year disposable income. Considering the common international practice, the low tax burden of Chinese households and the increasing income gap between low- and high-income households, increasing the progressive income tax may be a reasonable choice. Under the other three tax replacement choices, all households gain from tariff cuts, regardless of their income levels, but the relative welfare gains are different for the various tax choices. For example, in rural areas, a uniform sales tax is more favorable for low and middle income families, while a lump sum government transfer reduction yields greater benefits for high income households. Because collection costs may be higher for the household income tax than for a uniform sales tax, using the sales tax to replace lost revenues may be another choice in China.

9 Equivalent variation is the Hicksian measure of the change in consumer surplus. It is a money metric measuring how much better or worse off the representative household is in the equilibrium after a policy change than it was in the initial equilibrium, using the base prices as reference. It represents the income change that would be equivalent to the household utility change resulting from the policy change. Mathematically, EV Å C[p0, U(p1, y1)] 0 C[p0, U(p0, y0)], where C(r) is the expenditure function, and U(r) is the indirect utility function. The first term in EV is the minimum income necessary to reach the utility level after the policy change, U(p1, y1), given price p0. The second term in EV is the minimum income level necessary to reach the initial utility level, U(p0, y0), given price p0. If EV is positive, the household is better off as a result of the policy change. Measured in base prices, an income greater than the household’s initial income is needed to reach the new utility level U(p1, y1). Because the consumer demand system in our model is ELES, household savings are also included in the vector y as an argument of the utility function.

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1.61 1.40 1.67 1.73 1.69 1.67 1.64 1.48 0.86 1.06 1.03 0.92 0.87 0.73 1.22

Rural Lowest Low Middle low Middle Middle high High Highest Urban Low Middle low Middle Middle high High Total

1.80

1.57 1.87 1.82 1.70 1.63 1.33

2.05 1.86 2.18 2.20 2.13 2.09 2.06 1.89

Sales tax

1.70

1.29 1.62 1.53 1.38 1.31 1.11

2.13 1.77 2.10 2.22 2.20 2.21 2.22 2.04

1.33

0.91 2.05 1.65 1.13 0.68 0.46

1.78 1.69 2.05 2.21 2.25 1.94 1.64 1.12

1.44

1.38 03.24 2.03 1.91 1.90 1.72

1.50 04.77 1.44 1.74 1.88 2.07 2.28 2.32

1.95

1.45 1.91 1.82 1.62 1.49 1.15

2.48 1.99 2.37 2.50 2.51 2.55 2.60 2.50

1.04

0.52 0.73 0.68 0.58 0.53 0.39

1.60 1.59 1.83 1.83 1.73 1.65 1.55 1.33

HH. LumpValueCorporate income sum No added tax tax transfer replacement tax

1.82

1.53 1.88 1.82 1.68 1.60 1.26

2.13 1.90 2.25 2.29 2.21 2.18 2.14 1.98

Sales tax

1.84

1.25 1.67 1.52 1.35 1.27 1.02

2.47 2.20 2.53 2.63 2.57 2.55 2.51 2.27

1.23

0.58 2.37 1.76 1.03 0.38 00.26

1.92 2.07 2.46 2.62 2.66 2.16 1.67 0.77

1.41

1.39 06.30 2.33 2.22 2.22 2.03

1.43 08.51 1.46 1.85 2.05 2.33 2.61 2.73

2.25

1.51 2.15 2.01 1.75 1.56 1.09

3.04 2.55 2.97 3.10 3.08 3.11 3.13 3.02

0.96

0.38 0.59 0.54 0.44 0.39 0.26

1.58 1.62 1.86 1.84 1.72 1.62 1.50 1.26

HH. LumpValueCorporate income sum No added tax tax transfer replacement tax

Additional 50% tariff cut

Note. The data source is authors’ calculation from simulation results.

Valueadded tax

Financed by

Tariff cut in 1996

1.74

1.39 1.73 1.67 1.53 1.45 1.13

2.11 1.94 2.29 2.30 2.21 2.15 2.09 1.91

Sales tax

1.76

1.11 1.53 1.38 1.21 1.13 0.89

2.45 2.24 2.56 2.65 2.57 2.53 2.46 2.21

1.15

0.45 2.24 1.62 0.89 0.24 00.39

1.90 2.11 2.49 2.63 2.65 2.13 1.62 0.69

1.33

1.26 06.45 2.20 2.09 2.09 1.90

1.40 08.49 1.49 1.86 2.04 2.30 2.56 2.66

2.17

1.38 2.01 1.87 1.61 1.42 0.96

3.02 2.60 3.01 3.11 3.08 3.08 3.08 2.96

HH. LumpCorporate income sum No tax tax transfer replacement

Uniform tariff

Trade Liberalizations, Tax Policies, and Household Welfare (EV) Changes (Percentage Change from Base-Year Disposable Income)

TABLE 5

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Despite these differences, common patterns arise in all the experiments. For all three tariff-cutting scenarios and under all six tax replacement choices, urban households in lower income groups gain relatively more than urban households in higher income groups with the lump-sum replacement tax as the only exception. Rural households gain relatively more than urban households, thus contributing to the reduction of the Gini coefficients in almost all simulations. An examination of changes of factor returns helps further understand these distribution patterns of the welfare gain from trade liberalization among households. Table 6 summarizes factor price changes in the three tariff-reducing scenarios under the six tax replacement assumptions. The changes in factor returns are difficult to interpret because of the complicated substitution effects in the model. However, several patterns emerge. Among the factors, the wages of production workers increase the most under all of the three tariff-cutting scenarios. This follows because trade liberalization allows China to realize its comparative advantage in producing labor-intensive commodities that use production workers intensively. Hence, the demand for these workers increases relatively more than for other factors, pushing up their relative wages. Because the share of income from production workers is larger for rural households than for urban households (31.4 over 28.9 percent as given in Table 3) and it is larger for urban low-income households than for urban high-income households, this relatively larger gain for production workers among all factors is the most important reason for rural households gaining relatively more than urban households and for urban low-income households gaining relatively more than urban high-income households, as observed in Table 5. Hence, this factor contributes significantly to the reduced income inequality from trade liberalization in China. This result is consistent with the fact that China’s village and township enterprises have employed 120 million rural laborers and produce more than one-third of the country’s exports; hence, they benefit greatly from trade liberalization. When additional tax distortions are present, professional workers gain more while land and agricultural laborers gain less, except in the case of a uniform sales tax. Returns to land and to agricultural labor increase more if a uniform tariff is applied than under the other two tariff-cutting scenarios. Consequently, the Gini coefficient decreased more for the case of a uniform tariff than it did in the other two tariff-cutting scenarios, because land and agricultural labor constitute the major income sources for rural low-income households. Across the different tax replacement choices, the government transfer reduction generates the smallest increase in returns to land and agricultural laborers, but it produces the largest increase in capital accumulation and wages of both production and professional workers. Because urban households rely heavily on income from these factors, this policy generates the only case of enlarged income disparity among all six tax replacement policies investigated here.

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Value-added tax Sales tax Corporate tax HH. income tax Lump-sum transfer No replacement

3.10 4.23 2.92 2.38 1.28 3.56

Additional 50% cut 3.39 4.54 3.22 2.67 1.55 3.86

Uniform tariff

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2.34 3.37 2.34 2.09 1.63 2.64

Value-added tax Sales tax Corporate tax HH. income tax Lump-sum transfer No replacement

2.78 3.62 2.76 2.37 1.62 3.24

Additional 50% cut 2.98 3.83 2.96 2.57 1.81 3.45

Uniform tariff

0.448 0.833 0.883 0.881 0.390 0.998

0.398 0.783 0.833 0.831 0.882 0.949

Uniform tariff

3.24 3.55 4.14 4.33 4.65 4.42

1996 tariff cut

2.87 3.89 4.36 4.67 5.18 4.82

Additional 50% cut

2.75 3.76 4.24 4.55 5.07 4.70

Uniform tariff

Wages of production workers

0.646 0.852 0.906 0.905 0.936 0.977

Additional 50% cut

Induced capital accumulation 1996 tariff cut

Note. The data source is authors’ calculation from simulation results.

1996 tariff cut

Financed by

Wages of agricultural labor

1996 tariff cut

Financed by

Land returns

3.34 3.67 4.34 4.40 4.64 3.12

1996 tariff cut

2.73 3.80 4.41 4.50 4.89 2.41

Additional 50% cut

2.61 3.68 4.29 4.38 4.77 2.28

Uniform tariff

Wages of professionals

Trade Liberalizations, Tax Policies, and Changes of Factor Prices (Percentage Change from Base)

TABLE 6

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6. MAJOR POLICY IMPLICATIONS AND LIMITATIONS This paper analyzes the distributional effects of trade liberalization and government tax replacement policy under foreign trade reforms. One major policy implication is that trade liberalization enhances both economic efficiency and equality given appropriate government policies. However, the magnitude of the efficiency gains depends on which tax instrument the government chooses to replace lost tariff revenues. A reduction of government transfers to households yields the largest efficiency improvements, but it may induce more income disparity when the poorest households rely heavily on government subsidies. Imposing a progressive household income tax seems to be an appropriate policy choice to replace the lost revenues from trade liberalization because it reduces the Gini coefficient but retains most of the efficiency gains. Although more evidence is needed to decide which tax replacement policy is best for China, our results show clearly that the choice of a government tax replacement policy matters in the trade-off between efficiency and equality. The social cost of trade liberalization can be reduced by the proper policy decision. Our results provide insights into the trade-offs between economic efficiency and distributional equality under trade liberalization and illustrate how CGE models can be valuable tools for evaluating trade and tax policies. However, several important limitations remain. First, the model used is a stylized simplification of China’s economy and does not specify explicitly the multi-ownership structure and the different behaviors of the different types of firms currently operating in China. Second, since the model uses the 1992 Chinese SAM as the benchmark data, it cannot capture completely all important aspects of China’s 1994 tax reform, even though we have tried to update the benchmark equilibrium based on the data currently available. Third, the model is calibrated according to the standard method widely used in CGE modeling; therefore, many key parameters are based on only one year of data or on a literature search rather than on econometric estimations. Finally, the simulation results may under- or overestimate the real effects of each tax replacement policy because the model does not take tax collection costs into account. Therefore, the results obtained must be interpreted with caution and may be best understood as indicative of the real effects. APPENDIX A: AN ALGEBRAIC SKETCH OF THE CGE MODEL FOR CHINA This appendix provides a sketch of the algebraic description of the essential features of the CGE model for China. Its objective is to explain the basic workings of the model without presenting detailed model specification. A complete set of equations and variables as well as a list of the key parameters of the model is available on request from the authors to any reader who is interested in the technical details.

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A.1. Building Blocks of the Mathematical Model Production and demand in the CGE model of China are characterized by multilevel nesting. Since the model is specified in its dual form rather than in the more familiar primal format, the algebraic expression is relatively simple and transparent in its structure. The building blocks of the model are pairs of composite goods (factor) prices and the corresponding component conditional demand functions. The composite goods price is also a unit cost function that is dual to an aggregator function (Diewert, 1982). It is assumed to be positive, twice differentiable, linear homogenous, and quasiconcave. In our model, it has form (CES) n

Q Å A 1 (∑ di 1 xi(s01)/s)s/(s01),

(A.1)

1

where Q is the composite outlay, A is the unit parameter, xi is the ith component in the aggregator function, di is the share parameter associated with xi , i Å 1, 2, . . . , n, and s is the elasticity of substitution. When Q Å 1, the unit cost function that is dual to it has the form n

C(P, 1) å c(P) Å

1 (∑ 1 dsi 1 pi10s)1/(10s), A 1

(A.2)

where C(P, Q) is the cost function, c(P) is the unit cost function, P is the ndimensional component price vector, and pi is the price for component i. By applying Shephard’s lemma to the cost function C(P, Q), the conditional demand function of component i in (A.1) can be derived as xi(P, Q) Å

SD S 1 A

10s

1 di 1

D

c(P) pi

s

1 Q;

(A.3)

i.e., it is a function of the share parameter and the ratio of the aggregate price (unit cost) to the corresponding component price, multiplied by total aggregate quantity (Wang, 1994). A.2. Set Definitions i, j √ I, indexes represent sectors. n is a subset of nonenergy commodities and e is a subset of energy commodities. l √ L, indexes represent the labor types. h √ H, indexes represent the household types. o √ O, indexes represent agents other than households, namely, g for government, c for enterprises, and z for investment. A.3. The Structure of Production There are four level nests based on cost minimization in the production tree of the model. In each nest, there are an aggregate price or unit cost

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function and its corresponding component demand functions similar to Eqs. (A.2) and (A.3). The only differences in specification between nests are the variable names and the parameter values. Top level. Sectoral output XPj is produced by two inputs (components) NDj , the nonenergy intermediate input, and KELj , the primary factor plus the energy bundle. The price for XPj , PXj is the unit cost function, while the demands for the two inputs NDj and KELj are specified as component demand functions. Second level. The other intermediate demand, NDj , is split into each nonenergy commodity, XAPnj , according to a Leontief technology. Its price, PNj , equals an IO coefficient-weighted-average price of each nonenergy commodity input. KELj is aggregated over total labor, ALj , and the capital, land, and energy input bundle, KEj . Its price, PKELj , is the unit cost function, while demands for ALj and KEj are specified as component demand functions. Third level. ALj is aggregated over three types of labors. The sectoral average wage, AWj , is the unit cost function. Each type of labor demand, Lij is specified as a component demand function. KEj is produced by the aggregate energy input Ej and the capital-land bundle KTj . Its price, PKEj , is the unit cost function and demands for Ej and KTj are specified as component demand functions. Bottom level. KTj is aggregated over Kj and Tj , i.e. capital and land. Its price, PKT is the unit cost. Demands for Kj and Tj are specified as component demand functions. The energy input, Ej , is aggregated over each type of energy. Its price, PEj , is specified as the unit cost function and the demands for each type of energy, XAPej , are specified as corresponding component demand functions. CET function. Sectoral output, XPj , is assumed to be sold on the domestic market (XDi) or to be exported to the world market (ESi) based on revenue maximization. Its price, PPi , is specified as a unit revenue function that has a format similar to Eq. (A.2), and the supplies of XDi and ESi are corresponding component supply functions whose formats are similar to Eq. (A.3). However, the elasticity of transformation, s, is negative here (Wang, 1994). The difference between PPi and PXi is the sectoral production tax rate. A.4. The Demand Structure Amington equations. Each of the 22 Amington composite goods, XAi , is an aggregation of domestically produced goods sold on the domestic market, XDi , and goods imported from rest of the world, XMi , according to cost minimization. Its price, PAi , is specified as the unit cost function, while demands for XDi and XMi are specified as component demand functions similar to Eqs. (A.2) and (A.3), respectively. Household demand. Each of the 12 households maximizes a Stone–Geary utility function subject to its budget constraint. Solving this utility maximiza-

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tion problem leads to an extended linear expenditure system (ELES) that defines the household demand for the 22 Armington commodities, XACih , and savings, SAVh . Specifically, XACih Å gih /

bih 1 SYh , PCih

∑ bih / i

SAVh Å1 SYh

SYh Å HYDh 0 ∑ PCjh 1 gjh

(A.4) (A.5)

j

SAVh Å

HYDh 0 (i PCih 1 XACih CPIh

(A.6)

CPIh Å

(i PCih 1 XACih . PC0ih 1 XACih

(A.7)

In the above, bih is the marginal budget share and gih denotes ‘‘subsistence’’ consumption, which is assumed to be zero for household savings. HYDh is household disposable income, SYh is supernumerary income, and CPIh , the consumer price index, is defined as the price of household savings. Other final demands. XAFDio Å aioTFDVio ,

(A.8)

where XAFDio , is the demand for commodity i by the government, enterprises, and investment, respectively. TFDVio is the corresponding expenditure and aio is the fixed-share parameter. A.5. Income Distribution and Government Policy Instruments Income generated from production is distributed to enterprises, households, the government, and financial institutions based on fixed coefficients from the distribution matrix given in Table 3. Define KY Å (RiKi , LY Å (PTiTi , YLl Å (WlLli , as total earnings of capital, land, and type l labor, respectively. Corporation earnings and savings. Suppose CY Å skcKY / LY and TAXc Å lctcCY define enterprise income and tax liability, respectively, where skc is the share of capital owned by enterprises, tc is corporate tax rate, and lc is corporate tax adjustment shifter. Then corporate saving can be calculated as SAVc Å (1 0 ∑ fch)(1 0 lctc)CY 0 ∑ PCicXAFDic , h

(A.9)

i

where fch is the share of corporate income distributed to a household type of h, PCic Å (1 / lstis)PAi , defines the sales price for composite goods, where tis is the sales tax rate for goods i, and ls is the sales tax adjustment shifter.

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Household income. Suppose TAXh Å lhthYHh defines household income tax and TRgh and TRfh define transfer payments from the government and the rest of the world, respectively. Then HYDh , the disposable income of a type h household, can be calculated as HYDh Å (1 0 lhth) ∑ VlhYLl / (1 0 skc)KY l

/ fch(1 0 lctc)CY / PlghtTRgh / ER TRfh ,

(A.10)

where Vlh is the labor income distribution coefficients, ER is the exchange rate, and P is the GDP deflator. Government revenues and spending. Suppose that sectoral value-added can be calculated as VAi Å RiKi / PTiTi / (lWlLli . Then the value-added tax VATX, the business tax PITX, the sales tax FDTX, the export rebate EXVA, and the tariff revenue YTRADE can be calculated as VATX Å ∑ lvatviVAi / ∑ lvatviPMiXMi i

(A.11)

i

PITX Å ∑ lptipPXiXPi

(A.12)

i

EXVA Å ∑ lvateiPEiESi

(A.13)

i

FDTX Å ∑ ∑ lstsiPAiXACih / ∑ ∑ lstsiPAiXAFDoi h

i

o

(A.14)

i

YTRADE Å ER ∑ lmtmiWPMiXMi ,

(A.15)

i

where ts and ls are related tax rates and adjustment shifters, respectively. Government revenue, GREV, is the sum of all types of taxes minus the export rebate, while government expenditure, GEXP, is defined as government spending on composite goods plus transfer to households: GEXP Å ∑ PCigXAFDig / P ∑ lghtTRh . i

(A.16)

h

A.6. Equilibrium and Closure Equilibrium in the composite goods market. XAj Å ∑ XAPij / ∑ XACjh / ∑ XAFDoj . j

h

(A.17)

o

Equilibrium in the factor market. Define TS, KS, and LSl as the fixed total supply of land, capital, and each type of labor, respectively. Factor market clearing condition can be specified as follows: LSl Å ∑ Lli; i

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TS Å ∑ Ti ;

KS Å ∑ Ki .

i

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(A.18)

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Equilibrium in the export market. Define EDi as the rest of world’s demand for China’s exports; the equilibrium also requires ESi Å EDi . Macro closure. Define SAVg as government savings or deficit, SAVf as the balance of payments, TFDVz as the value of total investment, WPMi and WPEi as the world import and exports prices, respectively. Then the following three macroeconomic identities hold: Government budget: SAVg Å GREV 0 GEXP;

(A.19)

Saving and investment: TFDVz Å SAVc / SAVg / ER SAVf / (hSAVh ;

(A.20)

Balance of payments or foreign savings: SAVf Å ∑ WPMiXMi / ∑ TRfh 0 ∑ i

h

i

WPEi 1 ESi. ER

APPENDIX B: LIST OF SYMBOLS All subscripts are in lowercase English letters. Q A xi di s aio bih gih skc fch Vh th lh tc lc tvi lva tip lp tei ts ls tmi

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Composite outlay Unit parameter ith components Share parameter Elasticity of substitution Share parameter of final demand Marginal budget share of households Subsistence consumption Share of capital owned by enterprises Share of corporate income distributed to household Labor income distribution coefficients Household income tax rate Household income tax adjustment shifter Corporate tax rate Corporate tax adjustment shifter Value-added tax rate Value-added tax adjustment shifter Business tax rate Business tax adjustment shifter Export tax rebate rate Sales tax rate Sales tax adjustment shifter Tariff rate

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(A.21)

TRADE REFORM & INCOME IN CHINA

lm ALi AWi CPih CY Ei EDi ER ESi EXVA FDTX GREV GEXP HYDh Ki KEi KELi KS KTi KY Ll,j LSi LY NDi P PAi PCic PEi PITX PKEi PKELi PKTi PNi PPi PTi PXi Ri SAVh SAVc SAVg SAVf SYh Ti TAXc

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Tariff tax adjustment shifter Aggregate labor sectoral average wage rate Consumption price index Enterprise income Aggregate energy input Demand for China’s export Exchange rate Exports supply Tax rebate for export Sales tax Total government revenues Total government expenditures Household disposable income Aggregate capital demand Capital-land-energy input bundle Primary factor plus energy bundle Capital supply Capital-land input bundle Total earnings of capital Demand for labor by sector and skill Labor supply Total earning of land Non-energy intermediate input bundle GDP deflator Price of Armington composite goods Sale price of composite good Aggregate price of energy bundle Business tax Price of capital-land-energy input bundle Price of capital-energy-labor bundle Price of capital land bundle Price of non-energy intermediate input bundle Producer price inclusive of taxes Rent of land Producer price exclusive of taxes Rent of capital Household saving Enterprise saving Government saving or deficit Balance of payments Income above subsistence level Aggregate land demand Corporate tax liability

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TAXh TFDVio TFDVz TRgh TRfh TS VAi VATX Wi WPEi WPMi XAi XACih XAFDio XAPi,j XDi XMi XPi YLi YTRADE

Household income tax Expenditures for other final demand Total investment Transfer payments from government Transfer payments from rest of the world Land supply Value-added at sector v Value-added tax Wage by skill Export price at the border Import price at the border Armington composite goods Household consumption Demand for commodity i by other final demand Intermediate consumption for nonenergy products Aggregate domestic sales of domestic production Imports Sector output Earning of labor by labor type Tariff revenue

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