14th journées Louis-André Gérard-Varet

Font Size: 
Bad Bonuses: Incentive Incompatibility in China’s Income Tax Code
Jaimie W. Lien, Jie Zheng, Xiaohan Zhong

Last modified: 2015-05-06

Abstract


The Chinese personal income tax is one of the most influential tax codes in the world, affecting nearly 20 percent of the world’s population. We report on an incentive problem in China’s current tax policy, which has separately stated tax schedules for monthly salary and year-end bonuses. Conditional on a worker’s monthly salary bracket, there are certain annual bonus increases which not only can make workers strictly worse off, but differ from the official guidelines posted by the tax authority to avoid this ‘bad bonus’ problem. Given the prevalent use of annual bonuses among Chinese employers as a means of compensation, this presents an incentive gap in the tax code with substantial monetary loss to workers. In calculating the monetary loss at different income levels, we find that the penalty for following the tax authority’s plan serves as a regressive (implicit) tax, penalizing middle-class workers making slightly over 100,000 RMB ($16,000 USD) per year the most as a fraction of their total income. We propose a method which tax authorities can use to fix the current incentive problem, and show the conditions for an individual income tax to adhere to incentive compatibility.


Keywords


income tax, incentive problem, bonus income