Information about Asia and the Pacific Asia y el Pacífico

10 Unifying the Enterprise Income Tax and Reforming Profit Distribution Between Government and State-Owned Enterprises

Ehtisham Ahmad, Vito Tanzi, and Qiang Gao
Published Date:
September 1995
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Information about Asia and the Pacific Asia y el Pacífico
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Shi Yaobin*

China will establish a socialist market economic system, as has been clearly stated during the Fourteenth Congress of the Communist Party of China. This is a fundamental change, requiring comprehensive and substantial reform of the overall economic system. As an important component of the overall distribution system, the system of profit distribution between the government and state-owned enterprises (SOEs) needs a thorough reassessment.

Historical Background

Since the founding of the People’s Republic of China in 1949, the system of profit distribution between the government and the state-owned enterprises has experienced various changes. Despite the variety, however, two stages can be identified: pre-1978 (i.e., before the Third Plenary Session of the Eleventh Congress of the Communist Party of China) and 1978 to the present.

Reforms Before 1978

Before 1978, the distribution relationship between the government and the state-owned enterprises was basically a unified system of revenue and expenditure. The enterprises were subject to 100 percent profits tax—that is, realized profit was handed to the government—but were free from income tax. This system was determined by the then highly centralized planning system. Of course, owing to circumstances and different stages of economic development and political environments, the unified system of the revenue and expenditure took various forms.

During the economic recovery period (1950–52), all profit realized by the state-owned enterprises was handed over to the government, and the enterprises had no own financial resources at all. During the first five-year plan period (1952–57), the Enterprise Incentive Fund and the Extraplan Profit-Sharing System were introduced. Resources retained by the industrial enterprises accounted for 3.6 percent of their total realized profit. During the period of the “Great Leap Forward” (1958–59), in order to further mobilize the incentives of the local governments, the enterprises, and administrative agencies, the profit retention system was introduced, and some of the profits were partly retained by the enterprises. With this system in place, the autonomous financial resources of the enterprises and administrative agencies were further expanded. Profits retained by the industrial state-owned enterprises amounted to 10.2 percent of total realized profits. During the three-year period 1960–62, the profit retention system was abolished and the Enterprise Incentive Fund was renewed. During the Cultural Revolution (1966–76), the Employees’ Welfare Fund System replaced the Enterprise Incentive Fund, the actual result being that almost all the realized profit was appropriated by the government.

In sum, under the highly centralized planned economic system before 1978, the own financial resources of state-owned enterprises were very limited. Even these limited autonomous financial resources could not be actually utilized by the enterprises, because of the policy stance, which seriously depressed the initiative of the enterprises and employees, and which in turn hampered production.

Reforms After 1978

The reforms after 1978 can be roughly divided into three stages: (1) from 1978 to 1982, experimenting with the enterprise fund system, and reintroducing the profit retention system; (2) from 1983 to 1986, the transformation from profit delivery to tax payment by the state-owned enterprises; and (3) from 1987 to the present, various forms of the contract management responsibility system were promoted widely and comprehensively, and experimentation with the separation of tax from profit was tried.

From 1978 to 1982

In 1978, the Government began to experiment with the enterprise fund system. With this system in effect, provided the enterprise fulfilled all the eight annual planning indicators stipulated by the government (i.e., output, variety, quality, cost, profit and labor productivity, and so on), it could allocate, out of profits, to the enterprise fund an amount equivalent to 5 percent of the total payroll. Failure to fulfill one indicator would mean a certain decrease in retained profits. The enterprise fund could be used for the employees’ welfare and bonuses. In 1979, to further expand the financial capacity of the enterprises, the State Council promulgated “Stipulations on the SOE’s Profit Retention’ followed by specific stipulations concerned issued jointly by the Ministry of Finance, the (then) Economic Commission, and the People’s Bank of China. According to these stipulations, a pilot enterprise could retain a certain share of the realized profit, according to the ratio approved by the government, which would be used to establish the production development fund, the employees’ welfare fund, and the employees’ incentive fund. In 1981, based on the lessons gained from the pilot enterprises, another document was issued jointly by the Ministry of Finance and the Economic Commission entitled “Stipulations on the Method of the Profit Retention and Profit-Loss Contract by the Industrial and Transport SOEs,” which introduced many kinds of profit-retention and profit-loss contract methods.

As for profit retention, the major forms were “base-number profit retention plus incremental profit retention,” and “contracting subsidy for loss and sharing or retaining the loss deduction.” During this period, profit retention by the industrial state-owned enterprises reached, on average, 22.3 percent of the total realized profits.

From 1983 to 1986

To generate experience and smoothly promote the profit-cum-tax reform, the reform was first tried in more than 600 state-owned enterprises in 1980. Several years of experimenting gained quite a large body of experience, and the outstanding effects achieved led to consensus on the reform. In this context, the State Council decided in January 1983 and October 1984 to carry out, in two steps, the overall profit-cum-tax reforms of the state-owned enterprises.

The major objective of the first step was to replace the profit delivery by income tax at the rate of 55 percent. Profits, after deducting income tax, would be further distributed in many forms between the government and the enterprise: one part would be left to the enterprise in accordance with the ratio approved by the government; the remainder would be subject to a number of taxes, such as the regulation tax, and contract provisions—such as the progressive increase contract, and fixed number contract. A progressive profit tax, with eight rates, was levied on the small enterprises. For a few enterprises with exceptionally large profits, the government would usually charge an additional contract fee. In enterprises with relatively small profits or losses, however, a profit-loss contract was specified.

The main objective of the second step of the profit-cum-tax reform was to levy an enterprise income tax and a regulation tax on the enterprises, and all posttax profits would be retained by the enterprises. The enterprise income tax was levied on large and mid-sized enterprises at a rate of 55 percent. The regulation tax would be levied on these enterprises if their posttax profit was greater than their previously retained profit. The regulation tax rate was determined case by case, and while it was a tax in name, it was a de facto profit adjustment. Enterprises were permitted to repay the fixed investment loans with the pretax profits, and to allocate a portion of the posttax profit to the employees’ welfare fund and the employees’ incentive fund. During this period, the profit retention by the industrial state-owned enterprises was 22.4 percent of the realized profit.

The profit-cum-tax reform differed from the practice of delivering profits by the enterprises to the government, and for the first time introduced the income tax into the distribution relationship between the government and the enterprises. In this sense, this reform had epoch-making significance and lasting influence. The reform had the following effects: (1) there was reduced bargaining about the base number and ratio of profits for distribution; (2) the distribution structure between the government and the state-owned enterprises became more rational; (3) there was a large increase in retained profits by the enterprises—in 1986, the profits retained by the industrial state-owned enterprises amounted to Y 26.5 billion, being Y 14.6 billion more than those in 1982, an increase of 123 percent, the share of the profits retained to total enterprise profits increased from 20 percent in 1982 to 41 percent in 1986; and (4) there was an enhanced enterprise capacity for restructuring, accumulation, and development.

The reform strengthened the enterprises’ capacity for technological transformation and accumulation in two aspects. First, by allowing the enterprises to repay investment loans with the pretax profits, there was an incentive for enterprises to invest. On the other hand, banks, being assured repayment out of pretax profits, had incentives to lend to the enterprises. From 1983 to 1986, the fixed investment loans to the industrial enterprises jumped to Y 123.1 billion from Y 54.3 billion, increasing by 127 percent, with an annual average growth rate of 31 percent.

From 1987 to the Present

In December 1986, State Council “Stipulations on Deepening the Enterprise Reform and Enhancing the Enterprise Vitality,” promoted the contract management responsibility system to all the state-owned enterprises. The major goal of the responsibility system was to establish a contract for the entire realized profits of the enterprises. It was important to “fix the base amount (of the contract),” to ensure a share for the government, allowing enterprises to retain a larger share of excess profits, but shifting responsibility for losses to enterprises. Forms of contracts included, inter alia, the indexed contract, an increasing share contract, a nominally fixed contract, a contracted subsidy to enterprises, contracts linked to technological renovation, payroll, asset management, and so on.

The contract system was conducted for two rounds (for most of the enterprises). The first ran from 1987 to 1990. Compared with the two-step profit cum tax, the contract system created a more favorable environment for enterprises, allowing them greater profits—generating enterprise enthusiasm for the system. By 1990, the enterprises practicing the contract system accounted for 84 percent of all the state-owned enterprises. During the first round of the contract system, from 1987 to 1990, the retention by the industrial enterprises accounted for 43 percent of the total realized profits. In order to ensure policy continuity, the second round of the contract system was based on marginal adjustments. This round of contracts, however, proceeded far less smoothly than the first. Enterprises showed a general lack of initiative and confidence. This was, in part, due to the external economic environment, and the need to restrict credit to control inflationary trends. Enterprises continued to have an incentive to borrow. In 1991, despite administrative intervention, enterprises practicing the contract system accounted for 77 percent of all the state-owned enterprises, only 7 percent less than the previous year.

Two basic conclusions can be drawn from the historical changes and transformations of the distribution relationship between the government and enterprises in China. First, since 1949, the general trend of the profit distribution system of the state-owned enterprise has been characterized by a gradual expansion of the enterprises’ autonomous financial resources and capacity, with the government’s share of profits gradually decreasing, and the share of enterprise retention increasing. Before 1978, the share of enterprise retention in realized profits was 4.5 percent on average. During the period 1979–81, the profit retention by the industrial enterprises in successive years was 22 percent, 33 percent, and 43 percent, respectively.

Second, the distribution relationship between the government and the state-owned enterprises shifted from simply emphasizing tax reduction and profit concession to establishing a scientific and rational distribution system. While tax and profit exemptions played an important role in mobilizing the initiatives of the enterprises in various historical periods, and therefore promoting the production development of the enterprises, these practices failed to address, in a fundamental way, the incentive issues relating to the enterprises. Although the autonomous financial resources of an enterprise do have an impact on investment potential (especially when the autonomous financial resource base is small), the reformed operating mechanisms and the creation of a fair and rational competitive external environment, such as taxation, pricing, and market discipline, are crucial for enterprise incentives. Therefore, the reforms should be aimed at generating proper incentives for enterprises for efficient economic development.

Current Problems in the Profit Distribution System

The contract-based system has achieved much in rural reforms, which promoted rapid development of the rural economy. But the contract-based system implemented in state-owned enterprises differs from the rural contract system on two accounts. First, the enterprises contract an assignment of the income tax to the government; second, the enterprise contract system is based on enterprises that have large-scale production. These two basic points lead to different results. At the preliminary stage of implementing the contract system in current enterprises, it had positive effect on incentives for increased enterprise production. However, along with further reform and evolution of economic activity, problems have gradually emerged. While the contract-based enterprise system led to assured revenues during periods of low growth, enterprises faced losses when contracts exceeded profits. In periods of rising profits, however, the government’s share of profits has declined.

Varying Tax Rates

Different enterprise income tax rates, applied according to the different ownership classification of enterprises, have resulted in unfair market competition. The income tax rate for large and medium-sized enterprises was 55 percent, with an additional adjustment tax. In the eight-slab, progressive tax rate above contracts, the highest rate was 55 percent, and the lowest 10 percent. Private firms face a 35 percent tax rate, which was 30 percent for foreign-funded firms, together with an additional 3 percent local tax. In coastal areas, the rate was 24 percent, plus a 3 percent local tax. In special economic zones and economic and technology development areas, the rate was 15 percent, plus a 3 percent local tax. Moreover, tax-accounting standards vary according to ownership, and this was also unfavorable for fair competition. While there were about ten items considered as pretax expenditures, the main item that enterprises could deduct was loan repayments for fixed asset investments. Township and collectively owned firms could deduct 60 percent of profits for the abovementioned purpose, but other types of firms were not permitted the same benefit. Cost expenditure standards varied greatly; for example, foreign-funded firms, Sino-foreign joint ventures, and Sino-foreign cooperative firms could withdraw bad debt provisions as a bonus, but domestic enterprises and collectively owned firms were not allowed to do so. There were no unified standards for business fees.

Disparity in Tax Collection and Tax Burdens

The state-owned enterprises’ nominal tax rate was 55 percent. However, in the implementation of the profit contract system, which mixes profits and taxes, the government negotiated different contracts with each firm, and the profit and tax rates differed from one firm to another. Effectively, with this system, the income tax ceased to exist, although a nominal tax rate remained. In the early 1990s, the average real tax rate for enterprises was about 30 percent; the tax rate for about 20 percent of enterprises was 5 percent; in some large and m’edium-sized enterprises, the rate even reached as high as 50–70 percent. According to the regional distribution, in some provinces, the tax rate was about 10–20 percent, whereas in other provinces, the rate reached 40–50 percent. There were also additional cases of policy-based tax exemptions for other types of firms.

Constraints on Enterprise Restructuring

Reforms over the past ten years of the contract system increased retention funds for enterprises. However, this was at the expense of revenues at a period of budgetary stringency and extensive infrastructure needs. A response by the state was to withdraw directly 1 percent of enterprises’ net revenues for technology and new product development, after contracts and income tax payments.

The relationships between the state and enterprises often changed, and as a result, enterprises had an incentive to generate nominal losses to minimize contracted payments to the state. This had an unfavorable influence on the further development potential of enterprises. There was little provision for maintenance expenditure for equipment, or resources for replacement of machinery or investment. For some firms, payment of contracted amounts could not be supported by actual profits incurred, thus resulting in cumulative losses, and a draw-down of state-owned assets.

Inappropriate Investments

The system weakened the sense of responsibility of enterprise managers, which generated an uncontrolled expansion of fixed assets investment. In 1992, borrowing for fixed assets investment, in domestic enterprises, was more than Y 450 billion, in 1995, the existing loans for firms’ fixed assets investment are expected to reach Y 1,100 billion (using the average growth rate of investment between 1986–91). Such a heavy burden not only influences the development of firms but also places a negative constraint on the sustainable growth of the economy. If allowed to continue unchecked, the resulting debt will form a heavy burden for the national budget. It is thus essential to curtail the adverse incentives generated by the system of treating loan repayments as part of pretax profits.

Enterprise Behavior

The economic structure was not conducive for enterprise response to the market, such as price signals. Since the reforms have been implemented, China has undertaken major price reforms, with liberalized prices for many products, and price signals should play a significant role in economic restructuring. However, the enterprise profit contract responsibility system remains a major obstacle to a more market-oriented system.

In general, the contract profit distribution system has generated more problems than benefits for enterprises. The problems restrict efficient functioning of the market mechanism.

Results of Experiments Since 1988

Further reforms of the profit distribution system of state-owned enterprises are to be based on “Two Standards” (that is, the “Accounting Standards” and the “General Regulations on Enterprises Finance and Accounts”). In effect, enterprises would pay to the government income taxes and dividends, and the loan repayment mechanism described above would be reformed. First, enterprises will pay the state income tax, from their realized profits, according to the legal tax rates. Second, the pretax loan repayment will be abolished. The state could provide some direct support to firms, after considering their current situation, prospects, and industrial policy goals. The Construction Fund, for key energy and transportation projects and for depreciation of enterprises’ fixed assets, and the Budgetary Adjustment Fund would be abolished.

Pilot reforms in enterprises, known as “separation of tax from profit,” have achieved certain successes. Since 1988, in Chongqing and Xiamen, 4,000 enterprises have experimented with the new system. Although there is room for further improvement of experimental methods, the experiments have shown several things.

First, a rational tax burden has been achieved, together with the principle of sharing both interest and risk between the government and enterprises, along with a reasonable stability of enterprises’ profit distribution. Between 1990 and 92, in experimental enterprises, on average, 32.2 percent of profits was paid in taxes to the government, profits retained accounted for 38.8 percent, and loan repayments amounted to 29.0 percent of total profit. This pattern remained stable during the period. But, in other enterprises in the two cities, the profit distribution structure varied greatly. For example, between 1987 and 92, the top effective income tax transfer by state-owned enterprises to the state varied from 39 percent (in 1987) to 27 percent (in 1988 and 1992). The stability of the tax payments by the experimenting firms was noticeable.

Second, the reform has put the stabilization role of income tax into full play. Under the contract system, with a “fixed profit and tax base assignment,” during the high growth period (1988–92), the state revenue ratio declined, while enterprise retention rate increased. During the economic recession (in 1990), state revenues increased while the enterprise profit retention rate declined. This pattern countered the stabilization needs, by enhancing profits during a boom, and contracting profits during the recession; it thus exacerbated cyclical swings. The scenario is different in the experimental firms: during the economic downturn in 1990, the proportion of profits paid in income taxes was 33.6 percent, with a 40.2 percent profit retention ratio of total profit. The profit retention rate was 7 percent higher than in the firms that had not implemented the new system and was thus favorable for economic recovery. During the expansionary period, the retention rate in experimental enterprises was 2 percent lower than in those not implementing the new system. Thus the new system would help to curtail economic overheating in expansionary periods, as well as to cushion economic downturns—forming an automatic stabilizer for macroeconomic policy purposes.

Third, the borrowing pattern of experimenting enterprises has been consistent with the growth of production. In 1992, borrowing by pilot enterprises grew by 14 percent, which is higher than the growth rate of firms that had not implemented the new system, but lower than the growth rate of sales (59.0 percent). The new rules concerning loan repayment have curbed the unbridled expansion of fixed investments and encouraged an emphasis on investment efficiency.

Fourth, the speed of loan repayment has been accelerated. In 1992, the loan repayment rate of “experimenting firms” was higher than that in firms not implementing the new system.

And finally, the technology renovation capacity and the potential development of the firms have been increased in the pilot firms. The experimental enterprises face lower effective tax rates, with the abolition of the “Two Funds” policies, increasing their financial autonomy, loan repayment speed, and efficiency.

Unifying the Enterprise Income Tax Rate

The enterprise income tax (EIT) rate was unified to 33 percent in 1994. However, considering the low economic efficiency and low level of profits in some enterprises, two additional levels of tax rates were set as transitional measures—a rate of 18 percent applied to firms with an annual taxable profit below Y 30,000 and 27 percent for firms with taxable profits between Y 30,000 and Y 100,000. The regulation tax was abandoned.

The 33 percent standard EIT rate was set by taking into consideration the following factors. First, the new EIT rate is lower than the ratio of enterprises’ current (paid-in) profit rate. The current paid-in profits include payments for enterprises’ income tax payments and the profit delivery. From 1990 to 1992, the paid-in profit rate (including payments for “Two Funds” from retained earnings) for profitable enterprises was 45.6 percent, 43.3 percent, and 35.6 percent in each year respectively, with a period average of 41.5 percent.

Second, the new EIT rate is close to the international average. According to statistics for 91 countries, the average EIT rate is 33.8 percent, 33.0 percent for developed countries, and 34.7 percent for developing countries.

Third, the unified EIT rate of 33 percent is the same as the current tax rate for joint ventures, and is around the level of the average tax rate for collectively owned enterprises and privately owned businesses. At present, the 33 percent tax rate is applied to Sino-foreign ventures, according to the “Income Tax Law for Foreign Investment Joint Ventures and Foreign Enterprises within the P.R.C.”: an eight-level progressive tax rate is used for collectively owned enterprises, with an average rate of about 30 percent; and 35 percent for privately owned businesses. In this context, the unified tax rate will not add an additional burden to the nonprivate sector.

Fourth, the new EIT rate will assure relatively stable state revenues. The fiscal function of the government and the ongoing difficult financial situation have made it clear that state revenue should not be adversely affected by the reform, and therefore, the EIT rate should not be set too low.

Fifth, the setting of a two-level concessionary tax rate is a transitional and temporary measure for those enterprises with annual taxable profits below Y 100,000, in parallel with the prevailing 33 percent unified rate. The rationale for temporarily setting concessionary tax rates is that, first, some enterprises may have difficulty in surviving the reforms; second, because of the current low level of paid-in profit of these enterprises, the concessionary tax rate will not have much effect on fiscal revenue.

Reforming the EIT Base

The new rule for borrowing for enterprises’ investments is that interest and amortization payments shall be repaid from enterprises’ retained earnings, rather than being deducted from before-tax profits.1 This regulation changes the practice of loan repayment and is based on two reasons. First, the purpose of enterprise borrowing for investment is to obtain future gains, and in this connection, the repayment of borrowing should come from enterprises’ retained earnings. The previous practice of treating loan payments as a before-tax item is financed, in fact, by reduced fiscal revenues—thus enterprises borrow money and enjoy investment gains, whereas the state shoulders the burden of repayment. This separation of responsibility for rights and profits is not justified. Second, the policy of repayment before tax leads to overborrowing for fixed asset investment, which could adversely affect the sustainable growth path of the economy.

The state will take various measures to collect gains from investment in state assets. The main practices include dividend sharing for shareholding enterprises, profit sharing for joint ventures, and profit allocation, after tax, for purely state-funded enterprises. Taking into account the difficulties facing the enterprises, as well as the industrial policies, and the need for enterprise technology transformation, temporary measures are applied, such as allowing those purely state-funded enterprises, registered before 1993, to keep after-tax profits, and tax holidays (or reduced rates) for some enterprises with low profitability.

Actually, the state can take various measures to collect investment gains from state-owned assets. Investment in state-owned assets mainly benefits state-funded enterprises and the joint entities, which comprise state and other forms of assets holdings. In the category of direct state investment, investment benefits can be collected directly, according to the decisions made by the enterprises’ Board of Directors. If enterprises make the investment, they will obtain the investment benefits, first from joint entities, and then shared with the state. In general, for joint entities, the ways to collect investment benefits are simple, as asset ownership is clear. “The General Applicable Financial Principle” cites explicitly that the distribution order of profits after tax is as follows: (1) losses from confiscated assets, fines for delaying payments, and penalties for violating regulations of tax law; (2) previous losses; (3) provident funds; (4) mutual benefit funds; and (5) profit distribution among investors. In this way, provident funds can ensure enterprises’ interests; mutual benefit funds guarantee the interests of enterprise management and employees; and profit distribution as dividends to investors will ensure the interest of the state as the owner. Of course, the amount of investment benefits that can be collected by the state will depend on factors as to whether the production of enterprises is in line with state industrial policies, the potential of the enterprises, and so on.

Abolishing the “Two Funds”

The rationale for abolishing the “Two Funds”—the Construction Funds for energy and transportation and the Budget Adjustment Fund—is to abandon a nonstandard practice, increase enterprises’ financial capacity, and accelerate the reform pace of enterprises’ profit distribution system. The Two Funds were set up under specific historical circumstances, when the state underwent extreme financial difficulties and a severe shortage of construction funds for key energy and transportation projects. The practice helped to accumulate a greater amount of funds to support state key projects and to contribute to the budget balance. Collecting the Two Funds, however, is not a standard practice in itself, which makes the enterprises’ profit distribution system even more abnormal. Thus the Two Funds will be abandoned, as a reform measure, to standardize the enterprises’ profit distribution system. The increased financial capacity will be used to repay past borrowings.

Past Borrowings

Most of the old enterprise loans are required to be paid back in full. Should enterprises have real difficulty in repaying the loans, repayment periods can be extended, subject to examination by banks. The approved bad debt could be reversed with banks’ bad-debt provisions, according to relevant regulations. At the same time, the bad-debt provision ratio should be raised. Most enterprises have improved their repayment capacity through the reform. Therefore, although the enterprises’ profit distribution system changes the current enterprises’ repayment practices, it significantly strengthens enterprises’ repayment capacity, rather than having an adverse effect on the firms.

Preferential EIT for Joint Ventures and Special Economic Zones

These preferential arrangements will remain unchanged for the duration of the stipulated agreements.


Ministry of Finance, China.


According to regulations, increasing depreciation and interest on loans for fixed asset investment, as well as bonuses and expenditures on research and development, should also be treated as posttax items of expenditures.

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