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China’s New Weapon Against Tax Cheats

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China Power

China’s New Weapon Against Tax Cheats

Authorities are trying an innovative approach to combating tax evasion, with some success.

How is China fighting tax evasion in the underground economy?

With lottery tickets.

Tax evasion has long been endemic to China. Some estimates have put the total “underground economy” in China at one-sixth of GDP. Under-reporting is even more pronounced in the service industry, where the proportion of unreported economic activity may be as high as 20 to 30 percent, according to Junmin Wan, professor of economics at Fukuoka University in Japan.

The government started to address the problem by issuing mandatory receipt machines – known here as fapiao – which would record each transaction and could not be manipulated.  Government officials could periodically check the machines to get a true picture of sales activity. The problem: businesses would simply refuse to use the machine. This is an issue of information asymmetry; short of stationing government monitors at each business, it was simply impossible to get accurate sales figures.

So China introduced a novel tactic: lottery tickets. The government officially made each fapiao receipt a lottery ticket as well, in an attempt to compel customers to demand the receipt from businesses. The tickets are free for the customer and can in some cases win the holder up to 5,000 yuan.

The lottery receipt experiment represents a shift in government policy for a country that has often relied on punitive measures; for example, until 2011, you could be executed for tax evasion. It also reflects the growing use of behavioral economics to guide public policy, most recently advocated by University of Chicago economics professor Richard Thaler and Harvard Law professor Cass Sunstein.

“The fapiao system is a big innovation,” said Wan, who has researched the system and its impact in China. “The consumer has the information advantage. The consumer has no cost and does not take any cost for the government to capture the full [transaction] information. So the government can pay money to buy the information from the consumer, not from the business owner.”

So far, the lottery receipts seem to be working. Using data from the program’s early years, Wan found that overall tax revenue and revenue in areas with the program was significantly higher than in areas without it. A report by the China Taxation Bureau from 2002, for instance, when the program was still in an experimental stage, showed that the total prize money was 30 million yuan ($4.88 million), compared to an estimated increase in tax revenue of 900 million yuan.

It may be surprising that a country renowned for its strong police state could feature such widespread duping of the government. The problem stems largely from China’s heavy use of cash for transactions. According to some estimates, 95 percent of transactions in China use cash, as opposed to checks, debit or credit cards. In 2010, there were roughly 7 billion non-cash transactions in China, compared to 20 billion in Brazil and well over 100 billion in the United States. Last year, a New York Times report cited two men who purchased a $130,000 BMW 5 Series Gran Turismo entirely in cash. The money was lugged around in a sack and a backpack.

With non-cash transactions, there’s a verifiable record, often created and kept by third parties, such as banks or credit card companies. But with cash, there’s no paper trail. Businesses can simply lie about their business.

The system, as Wan emphasizes, is not perfect. For one, the government must maintain a balance between the winnings it offers customers and the tax revenue it receives. “If the winnings value is too high, the government cannot make enough revenue,” Wan said. “But if it is too low, the consumer has no incentive to report the information. So it’s a different ratio for each country and the ratio is determined by the consumer’s preference.”

There are periodic announcements touting the prize money and encouraging customers to ask for the fapiao, though there’s some evidence the government may exaggerate the total value of possible winnings. In 2002, before the draws took place, the Beijing Local Tax Bureau announced more than 13 million yuan in total winnings; only 1.67 million yuan were actually paid out.

Further, crafty business owners have developed their own measures to combat the fapiao system, offering free drinks and desserts or overall discounts to customers that do not request the fapiao receipt.

Wan has suggested that the policy could be instituted in some Southern European countries where tax evasion has been described as a “national pastime.” According to the most recent estimates, the “underground economy” accounted for 22.3 percent of GDP in Italy, 19.3 percent in Spain, and in Greece, more than 25 percent. Some observers have emphasized tax fraud’s role in hobbling efforts to lighten those countries’ sovereign debt loads.

Though the policy has proven successful, in the end, persistent entrepreneurs will likely develop innovative means to avoid the taxman.

“I think the important point is even though the fapiao system is in use, monitoring by the government is necessary,” Wan said. “The monitoring is simply reduced by the fapiao system. The fapiao system can improve the tax evasion problem but it cannot totally remove it.

David Logan is a Shenyang, China-based writer.