A taxing time for the Chinese enterprise: Teresa Poole reports from a remote corner where Peking's attempts to balance its books threaten a factory with bankruptcy

HE ZHAORUI, boss of the Lijiang Fur and Hide Factory, laughed. 'Yes, we will be 100 per cent loss-making this year,' he agreed. But surely last year the plant had been comfortably in profit? 'Last year was last year. This year is this year,' he sighed.

This year, as the Chinese government tries to grapple with what the World Bank has described as a 'half-reformed' economic system, some of its policies are hitting the wrong targets - including Mr He's factory.

New tax rules introduced at the beginning of January to ease the central government's financial crisis are pushing thousands of state enterprises back into the red, just as the government has been exhorting the state sector to stand on its own feet. A new cycle of near- bankruptcy followed by state bail- outs appears imminent.

Far from the booming coastal areas and special economic zones, the Lijiang Fur and Hide Factory, producing shoes and leather goods, is a typical medium-sized Chinese factory.

Lijiang prefecture is in the north-west of Yunnan, a province bordering Burma, Vietnam and Laos. It is a poor mountainous area, where more than half the population is from China's under- privileged minority nationalities; Lijiang town is home for most of the Naxi nationality.

Mr He's factory is categorised by the Chinese as an urban collective enterprise, but, as in many cases in China, ownership is a difficult concept to pin down.

The factory was set up in 1954 by 51 traditional fur and leather workshops and then expanded by the local government. Mr He described the factory as 'owned jointly', but could not say by whom.

When there are profits, they are shared between the state (in the form of tax payments), the enterprise and the workforce of more than 400, he said.

Under the old central planning ways, the local government provided the raw materials, issued production quotas and sold the finished goods. Now, all this is decided by the factory managers. Since 1990, the factory has been expected to be self-reliant.

It seems a well-run enterprise, although the equipment is basic and the shoes are made almost entirely by hand. Some 40 per cent of its shoes end up overseas, while the leather jackets are sold all around China.

Money-belts and boots for nomadic Tibetans are two of its smaller ranges. Dog-fur rugs are another minor product, although not for export to squeamish Western markets. The average worker's salary of 3,800 yuan ( pounds 316) a year is low, but similar to that of a government cadre.

Unravelling the company's financial situation is an accountant's nightmare. In 1993 the factory seems to have had sales of 10.6m yuan and paid about700,000 yuan in tax, leaving profits of 500,000 yuan.

Self-sufficiency 'with Chinese characteristics' means that, according to Mr He, 'the government has some policies and will return a certain amount of tax to us, and this becomes profits'. So last year, the factory was also reimbursed about 300,000 yuan of its tax payments.

That was last year. This year the overall tax rate for the Lijiang Fur and Hide Factory will jump from 4 per cent of sales to 17 per cent. It is all part of the central government's desperate need to straighten out the tax system (which in most cases simply means collecting the taxes owed to it).

The other aim is to improve what the Finance Minister, Liu Zhongli, has described as the country's 'acute' contradiction between the supply and demand of funds. This year the central government budget deficit is due to more than double to 67bn yuan.

The new tax regime involves value-added tax, land appreciation tax, business tax and consumption tax. New rules that will also force the provinces to repatriate a larger share of their revenues to the centre are all designed to let the central coffers share in the wealth being created in the booming coastal and big city areas. It is far less suited, however, to a province like Yunnan and other hinterland areas.

It also hits directly at the Chinese government's other big problem, the state enterprises. In the first quarter of 1994, half of China's state-owned companies made losses, up from 34 per cent in the same period in 1993. (The collective sector is not included in this category, although in practice collectives, such as Mr He's, are state- owned, not private.)

Ye Zhen, at China's State Statistical Bureau, said that the new tax system had resulted in many previously profitable enterprises now showing losses. Total losses in the first quarter were 17bn yuan, up nearly 80 per cent from the equivalent period in the previous year.

So what will Mr He do? 'This is the law, so we have to pay the taxes.' This year his factory would make losses of 700,000 yuan, he sighed.

Will there be any tax rebate? 'This year we have no idea if they will give us money back. We will see at the end of the year.' His job this year would be 'much harder than previous years', he grinned.

Will the factory go bankrupt? 'Hard to say,' Mr He said. 'The government will have some protection policies towards such minority nationality industries and remote areas.

'The new tax system is really for coastal areas. If there is this new problem, it is not just this factory but many factories in such areas . . . Almost all the factories which use agricultural products as their main materials now face the same problem.'

In practice, the government is too alarmed by the social consequences of rising unemployment to allow such factories to go bankrupt, especially in relatively under-developed areas such as Lijiang. So yet more man-hours will be spent arranging rebates and new subsidies to rescue factories such as Mr He's from the new tax regime, even while they are being told that they must be subject to market forces.

Would it not make more sense to pay tax as a percentage of profits? Mr He, an economist, was unconvinced, although his reasoning was difficult to follow.

'It's more sensible to decide tax according to sales not profits because if it is done by profits there will be some effect on the cost of the products. It is Chinese practice to pay tax as a proportion of sales.'

According to the State Statistical Bureau last month, the plight of state companies, especially in mining, coal production, machinery and metallurgy, has worsened. Many are closed or working only half-time and unable to pay wages. Even Peking's Capital Steel works had to get bank loans to pay February's wages.

Lijiang prefecture has 182 enterprises; all but three are state- owned or collectively owned, employing nearly 20,000 workers. Last year, 21 were loss-making. This year, with the new tax rules, many more will be.

The prefecture itself, with a population of just over a million, already has problems balancing the books. And, as Zhou Wenzhong, the vice-director of the prefecture's Economic Commission said, that meant that last year the prefecture's revenues covered less than half its expenditure and the gap had to be plugged by subsidies from the Yunnan provincial government.

(Photograph omitted)