Of China's Trade Discrepancies and Chinese Tax Havens

A research paper by the US Small Business Administration was recently posted at the US-China Economic and Security Review Commission, China's Global Trade Balance Discrepancy: Hong Kong Entrepot Effects and Round-Tripping Chinese. The SBA's goal for the research was to discover why there was a $319.4 billion discrepancy between the $554.2 billion China trade surplus with 41 major trading partners as reported by those trading partners, and the $234.8 billion surplus with the same trading partners as reported by China.

The authors identify 7 traditional factors that have been used to account for this discrepancy which has been measured since at least 1999. Those 7 factors are:

1. Indirect Trade Through Hong Kong
2. Hong Kong Price Markup
3. Imports/Exports Measurement Discrepancies
4. Exclusion of Servicing Trade
5. Exclusion of Intangible Trade
6. Underestimate of False Invoicing and Transshipment
7. Process & Improvement Trade

Through an extensive study (based on a 2004 study by Geng Xiao of the Brookings Institution), the authors conclude that the major factor, accounting for ~50% of the discrepancy, is actually the round-tripping of currency for tax haven purposes. The de facto tax haven destination for this currency is Hong Kong.

Here's how the authors say it works: "Chinese enterprises undervalue exports or artificially overvalue imports, in order to move Chinese capital across the Mainland border." This capital then returns to the Mainland as foreign investment and receives a lower tax rate. Hong Kong is chosen as the de facto tax haven for the following reasons:

1. A 17.5% corporate income tax rate compared to China's 25%;
2. Hong Kong only taxes Hong Kong source income;
3. "[A]n extremely tax-friendly territorial principle that is flexibly applied to
   rather loose and relaxed residency and income-sourcing criteria" (essentially the same as the prior factor, but, hey, it's their list);
4. No tax on capital gains, dividends, or retained earnings; and
   
5. The ability to carry losses forward indefinitely.

The authors are thus arguing that about 50% of the discrepancy in reporting is due to Chinese enterprises lying about their trade statistics to pay a more favorable tax rate. One of the main culprits? SOEs, according to the report. Considering this is from the SBA by way of the USCC based on research from Brookings, I think the point is supposed to be that wealthy Chinese people are getting wealthier by lying and cheating on their taxes, kind of like Wall Street corporate fat cats, but not Americans.

Of course, if I was going to make an accusation like that, I'd need some sort of basis for attacking their results. I'm not saying that there ain't a bunch of tax evasion going on, but the numbers seem substantially inflated. Fortunately for me, they make a few of assumptions that make their results questionable:

1. Rather than offer actual evidence of round-tripping, they assume that since both the de jure tax haven of the British Virgin Islands and the de facto tax haven of Hong Kong, plus a handful of other tax havens, provide over 50% of FDI into China, that in and of itself is direct evidence of round-tripping. That's a fine assumption if the Chinese were the only ones to actually use tax havens. They're not.
2. The data is based on a "conservative" estimate of a Chinese round-tripping FDI of 50%, and a returned round-tripping FDI ratio of 25%. The 25% comports with Xiao's findings, but the 50% is the high estimate of Xiao's research.
3. This data itself is based on the assumption, from Xiao's research, that the net errors and omissions on the PRC's balance sheet is "a proxy for capital flight," and the assumption "that all capital that flies out of the Mainland is through an overstatement of Chinese imports."

Guestimations are fun, but using a string of guestimations based on guestimations to advance policy seems irresponsible. There is simply no hard evidence that $150 billion of the FDI into China last year was round trip capital for the purpose of tax evasion. It would be hard to figure this number out in any country, but there are too many assumptions working in this study for the final numbers to hold too much water.