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Reported trade figure discrepancy, regulatory arbitrage, and round-tripping: Evidence from the China–Hong Kong trade data

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Abstract

This study uses reported trade figures from China and Hong Kong to examine the relationships among market impediments, trade figure irregularities, and tax-induced regulatory arbitrage. The empirical findings, consistent with our tax-induced regulatory arbitrage models and the round-tripping phenomenon in China (that is, moving funds across the Mainland Chinese border through trade, typically to Hong Kong or an offshore tax haven, before re-entering China as foreign direct investment), provide support for several conclusions. First, the spurious flows of funds to and from China, via the underreporting of exports and the overreporting of imports, closely follow the preferential tax incentives accorded to foreign investors. Second, the underreporting of exports is negatively related to export tax rebates. Third, the overreporting of imports is negatively related to import tariffs. Finally, both of these two appear to be most prevalent in state-owned enterprises.

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Notes

  1. Bermuda, British Virgin Islands, Cayman Islands, Hong Kong, Mauritius, and Samoa accounted for 58% of China's FDI inflows in 2006 (China Statistical Yearbook, 2007).

  2. Likewise, Rugman (1985) argues that vertical integration, transfer pricing, and quality control are examples of market imperfections, which lead to internalization or multinational hierarchical activity.

  3. Some studies list other reasons for round-tripping, such as leaving money overseas to reduce the currency risk due to inconvertibility of the Chinese currency, and protecting the property rights (ownership) of export earnings (Fung, Leung, & Zhu, 2004; Xiao, 2004). We discuss other motivations in the Theoretical Models and Hypotheses section.

  4. While the extant literature has documented significant trade misinvoicing for China trade, there is a dearth of analysis of the factors driving this phenomenon. For recent studies, see Kar and Cartwright-Smith (2008) and the Christian Aid Report (Christian Aid, 2009). Kar and Cartwright-Smith find high volumes of illicit flows from China, and call for an in-depth analysis of factors driving such outflows from China.

  5. Dunning (1977, 1979) proposes an eclectic paradigm of international production, known as the OLI framework in the international business literature, combining ownership – (O), location – (L), and internalization – (I) specific advantages of an MNE to explain why FDI occurs. The OLI framework suggests that FDI occurs if the MNE has a comparative advantage in these one of these three sets of factors. For example, among other things, China’s preferential tax treatment of foreign investors represents an attractive location- or country-specific advantage for MNEs. For this paper, however, the OLI framework, which was originally intended for MNEs investing in a foreign country, is not strictly applicable, because round-tripping FDI originates from Chinese firms. We refer to this framework here only for referencing the concepts encapsulated in these sets of “advantages”, which are commonly referred to in the FDI literature.

  6. The economy of scale in Krugman's (1979) new trade theory is an ownership or firm-specific advantage.

  7. Market impediments can also include non-economic factors. Filatotchev, Strange, Piesse, and Lien (2007) find that cultural factors, historic ties, and equity stakes play an important role in affecting the decision to undertake FDI in emerging markets.

  8. The creation of the eurodollar market was the result of market impediments caused by government policy, that is, the Interest Equalization Tax imposed in 1963 by the US government on foreign investors. Similarly, Fung et al. (2004) suggest that the non-deliverable forward market for the Chinese currency is the result of inconvertibility of the Chinese currency.

  9. Aliber (1978) shows how arbitrageurs exploit differential rates in the interest rate and foreign exchange markets in a covered interest arbitrage.

  10. Transfer pricing entails shifting the corporate profits from a high- to a low-tax jurisdiction through the manipulation of prices of goods and services charged for intra-firm transactions. In a typical transfer-pricing scheme, affiliates of an MNE charge each other a lower than the fair market price for intra-firm transactions. This type of “misinvoicing within the same invoice” as a matter of agreement between buyer and seller as a form of transfer pricing will not produce any discrepancy in the reported export and import values, as pointed out by Kar and Cartwright-Smith (2008). Thus transfer pricing cannot be used to explain the discrepancies in reported trade figures in this study, which is the main focus of the current study.

  11. Recent studies, such as Kar and Cartwright-Smith (2008) and the Christian Aid Report (Christian Aid, 2009), using different methodologies, attempt to quantify trade mispricing in China as an estimate of illicit financial outflows. Since the focus of the current study is solely on trade misinvoicing, whereas previous studies on trade mispricing include all types of illicit financial flows, estimates from the current study are not strictly comparable with those from previous studies.

  12. For tax rebate policy changes in China, see Cui (2003).

  13. It is noted that the relaxation of this assumption will not affect the outcome of the theoretical model, because the amount of export earnings understatement, x, in Eq. (1) can simply be adjusted by a fraction that indicates the percentage of underreported earnings returning to China.

  14. Should there be any search fees for the agent, they can easily be incorporated into the model in Eq. (1). The fee is a fixed cost that does not vary with the dependent variable in Eq. (1), so leaving it out of the model will not significantly affect the result.

  15. In this paper, the terms “understatement” and “underreporting” (“overstatement” and “overreporting”) have the same meaning. However, in contexts where confusion could arise, we carefully choose the term that clarifies its meaning.

  16. The penalty, P, can be defined as a variable with a probability of being caught times the penalty rather than a fixed dollar amount. Because the probability of being caught does not change with the dependent variable in the model, and will not affect the model solution, we use a fixed penalty amount in the interest of simplicity. We thank an anonymous reviewer for suggesting this clarification.

  17. If the marginal cost of penalty is high enough, the denominator on the right-hand side of the equation is sure to be negative.

  18. Relaxation of the assumption that not all of the understated amount returns to China as FDI does not affect our results. If a partial amount of the understatement returns to China, the two results (Results 1 and 2) will still hold as before, with a slightly different scaling factor. (See also footnote 11.)

  19. The WITS website is http://wits.worldbank.org. In addition to the United Nations Statistical Division's Commodity Trade (COMTRADE) database (http://data.un.org/wiki/ComTrade.ashx), WITS can get access to: the UNCTAD Trade Analysis Information System, which contains information on imports and various tariffs and non-tariff measures for 119 countries; the World Trade Organization (WTO) Integrated Database, which contains imports by commodity and by partner country, and MFN applied tariffs for over 80 countries; and the Consolidated Tariff Schedule database, which contains WTO bound tariffs, initial negotiating rights, and other indicators.

  20. In estimating the global volume of trade mispricing, Kar and Cartwright-Smith (2008) exclude the Hong Kong data from the database, IMF Direction of Trade Statistics (DOTS), because trade partner countries of China often mislabeled the exports originating in Hong Kong as coming from China and vice versa. This “mislabeling” problem arising from the Hong Kong re-export trade has severe implications for estimating the trade mispricing between China and its trading partners (not Hong Kong). However, this potential problem does not affect the current study, since our focus is on the trade mispricing (more specifically, misinvoicing) between China and Hong Kong, and not between China and other trade partners. There is no reason to believe that such “mislabeling” of Hong Kong's exports by China's trade partners will systematically bias our results in one way or another. Moreover, the COMTRADE database provides detail entrepôt trade by product and by trading partner country, allowing us to exclude Hong Kong's re-export trade from our sample. Other trade databases such as the IMF DOTS, which record aggregated data at national or regional group level, would not allow separation of the re-exports from direct exports/imports.

  21. Kar and Cartwright-Smith (2008) estimate a total of trade mispricing at $253.26 billion in 2004 for all China's trading partners excluding Hong Kong. Our estimate of $21.22 billion (the sum of export understatement of $14.3 billion and import overstatement of $6.92 billion) is about 8.4% of China's trade mispricing as estimated by Kar and Cartwright-Smith. Our estimate seems to be in line with theirs, given that Hong Kong's trade accounted for 9.8% of China's total trade amount in 2004 (based on statistics from China Statistical Yearbook, 2005). The Christian Aid Report (Christian Aid, 2009) estimates trade mispricing at $27.03 billion in 2005, arising from the bilateral trade between China and the United States and European countries. Given that the US and EU trade accounts for about 32.9% of China's total trade amount in 2004, this estimate seems to be conservative as compared with the $253.26 billion estimate for all China's trading partners given by Kar and Cartwright-Smith (2008) and the $21.22 billion estimate for China and Hong Kong in our study. This comparison should be made with a caveat that the estimate from the current study is solely for trade misinvoicing, whereas estimates from the two previous studies are for trade mispricing. Thus the estimate from the current study may serve as an estimate for the lower bound of the trade mispricing problem in China.

  22. The monotonic property may be distorted for gap values between −$1 and $1 when the natural logarithm is taken for the absolute value, but in our sample we have no observation whose gap value falls within this range.

  23. The main purpose of the export tax rebate policy is to avoid double taxation on export goods and to enhance the country's competitiveness in foreign markets. Under both the General Agreement on Tariffs and Trade and the WTO , export tax rebates are not considered a subsidy as long as the tax rebate does not exceed the amount of tax paid to domestic tax authorities (Cui, 2003).

  24. Data were obtained from http://www.mac.doc.gov/China/Docs/searchableothertariffs.pdf.

  25. China’s preferential policies and tax incentives for foreign direct investment are presented in the Appendix.

  26. Although Hong Kong and Macau are part of China, for statistical reporting and tax purposes they have always been considered “foreign” by the Chinese authorities. We therefore use “foreign-funded enterprises” to refer to “real” foreign-funded enterprises and those enterprises funded by Hong Kong, Macau, and Taiwan, allowing readers to reconcile the figures with China's official statistics, at the expense of a slight misnomer.

  27. This rate is taken from “Briefing of VAT under China's tax system”, accessed at www.itdweb.org.

  28. We thank an anonymous reviewer for suggesting these control variables for robustness.

  29. We also ran all the tests using an alternative definition for “foreign”, defined as the percentage of foreign capital over total capital in an industry. Results are qualitatively the same.

  30. Note that the effective rate for the tobacco industry is 9%, resulting in a negative tax break at −1%.

  31. Regressions with clustering at the four-digit product level yield similar results, not reported here to conserve space.

  32. Since a higher percentage of state capital implies a lower percentage of foreign capital, the significant positive coefficient on the state variable suggests that a greater percentage of state-owned enterprises in an industry is associated with a more severe mis-statement problem, or a greater percentage of foreign enterprises is associated with a less severe mis-statement problem.

  33. If our theory is correct, we should observe similar over- or underreporting patterns in China's trade flows with other countries, particularly countries with high FDI in China. Thus, as a robustness check, we tested our hypotheses using another sample: China–Thailand trade flows in 2000, the same year as in the China–Hong Kong trade flows analyzed above. Results in the China–Thailand sample are similar to those in the China–Hong Kong sample, and are consistent with the round-tripping argument. Results are available from authors upon request.

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Acknowledgements

We are grateful to Louis T. W. Cheng, Joseph Lau, Wai-Kin Leung, Kui-Wai Li, Dileep Mehta, three anonymous reviewers, Lee Radebaugh (Editor), and Lorraine Eden (Editor-in-Chief) for valuable comments and suggestions, and Stephen M. Miller for assistance in data collection. We also thank the Editor-in-Chief for suggestions on the final title of the paper.

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Accepted by Edward Mansfield, Guest Editor, 25 April 2010. This paper has been with the authors for three revisions.

APPENDIX

APPENDIX

Preferential Policies and Tax Incentives for Foreign Direct Investment (FDI) (as at the end of 2007)

FDI incentives in China include significant reductions in national and local income taxes, land fees, import and export duties, and priority treatment in obtaining basic infrastructure services. There are also special preferences for projects involving high-tech and export-oriented investments. Priority sectors include transportation, communications, energy, metallurgy, construction materials, machinery, chemicals, pharmaceuticals, medical equipment, environmental protection, and electronics. Tax incentives are among the most prominent investment promotion policies.

(1) Income tax

  1. a)

    General rate of income tax

    • (a.a) The income tax rate on enterprises with foreign investment is 33%.

    • (a.b) The income tax rate on enterprises with foreign investment located in special economic zones, new- and high-tech industrial zones, or economic and technological development zones is 15%. Tax reduction and exemption

    1. 1

      Production enterprises with foreign investments made for 10 years are exempt from income tax for the first 2 years, and enjoy a 50% reduction for the next 3 years.

    2. 2

      Enterprises with foreign investment engaged in agriculture, forestry, and animal husbandry, and enterprises with foreign investment established in remote and underdeveloped areas, may, upon approval, be allowed a 15–30% reduction in the income tax for another 10 years after the tax exemption and reduction period described above.

    3. 3

      The income tax on enterprises with foreign investment located in mid-west China that are engaged in projects encouraged by the government is 15% for another 3 years following the expiration of the 5-year period of tax exemption and reduction.

    4. 4

      Enterprises with foreign investment that adopt advanced technology are exempt from income tax for the first 2 years and allowed a 50% reduction for the next 6 years.

    5. 5

      In addition to the 2-year tax exemption and 3-year tax reduction treatment, foreign-invested enterprises producing for export enjoy a reduced income tax of 50% as long as their annual export accounts for 70% or more of their sales volume.

    6. 6

      Foreign investors in an enterprise with foreign investment that reinvests its share of profit obtained from the enterprise in a project with an operation period of at least 5 years benefit from, upon approval, a 40% refund of the income tax already paid on the reinvested amount.

(2) Circulation-stage tax (value-added tax, VAT)

  1. a)

    Technology transfer and technological development by foreign enterprises and enterprises with foreign investment are exempted from VAT.

  2. b)

    For foreign-invested enterprises engaged in projects in the encouraged or restricted-B categories, the VAT on China-made equipment purchased by the enterprises within their total amount of investment is fully refunded for qualified equipment.

(3) Tax policy for the software industry and the integrated circuit industry

  1. a)

    VAT rates: 3% and 6%.

  2. b)

    In addition to a 15% reduced rate of income tax, after approval of the application, there is an exemption from tax for the first 5 years and a reduced corporate tax rate of 7.5% for the following 5 years.

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Fung, HG., Yau, J. & Zhang, G. Reported trade figure discrepancy, regulatory arbitrage, and round-tripping: Evidence from the China–Hong Kong trade data. J Int Bus Stud 42, 152–176 (2011). https://doi.org/10.1057/jibs.2010.35

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