One of the most intriguing things about living in China is seeing how the rule of law is gradually expanding throughout the nation (or perhaps it would be better to say, throughout the state). This seems to be something that those living outside China, such as US senators, do not understand. Accustomed as those gentlemen are to living in a nation where the rule of law is a long-accustomed societal and governmental tradition and the writ of the state runs without question, stretching so far back that folk memory does not remember periods of real disorder, it is always worth keeping in mind that China only really emerged from a state of near anarchy in 1976 – less than forty years ago. “Anarchy” here does not mean the cheap tabloid usage of fleeting disorder, but the deeper sense of the destruction of social norms and practices, and the customs of law. Civil law is of course mostly based on precedent: when all history is torn up to write a new page, what happens is the destruction of centuries of social habits which accumulate into the very basis of that society. These traditions take a long time to form and consolidate into standard practice.
Thus, the customs and practices which we take for granted in the west are here in China being only gradually solidified. The newcomer to China might be surprised that an economic powerhouse, the world’s second largest economy, might be one where piracy, counterfeiting and document fraud are endemic and seem to be implicitly condoned, and, similarly, one where large sections of the state apparatus can fairly easily be bypassed. Taxes, rents, payrolls, bills, all the necessary documentation of the state, can be evaded and outmaneuvered, much to the occasional disbelief of the naive newcomer.
This state of affairs is always worth remembering. China is the world’s second largest economy, true, but its per capita GDP ranks 90th out of 183, behind Namibia and Belarus (according to the IMF’s 2011 estimates). It is still very much a developing country, in all senses of the word. This of course, has tremendous implications for how one does business here. Let’s say, for example, you are a foreign company with a good relationship with a Chinese supplier. You use this company, and this one only, to supply you with an essential item. At some point, though, the owner of the Chinese company wants to sell the company and retire. Elementary business practice tells you that you should buy the company to ensure continued supply. However, as Dan Harris of China Blog points out (in his analysis of this kind of case), in China it isn’t that simple. He explains why he opposed this kind of deal:
I said that there is a good chance the Chinese manufacturer is paying half of its employees completely under the table and reporting to the government only half of what it was paying the other half. I then talked of how there is also a good chance the Chinese manufacturer is underpaying its taxes and of how its rent also may be paid under the table. I then said that this sort of thing may be all well and good for Chinese companies, but that if the US manufacturer were to buy this Chinese manufacturer, it would need to do so as a WFOE and it would then immediately be on a "whole 'nother level" with respect to China's various tax authorities.
I then told the US manufacturer that if it were to buy the Chinese manufacturing business, it would need to bring every single employee onto the payroll and that would likely mean the payroll expenses would be close to doubled. I then gave my estimated numbers. All of the wages now being paid under the table would need to be paid above the table and that would mean that the US manufacturer would, in turn, need to pay all sorts of employer taxes, pensions, and insurance. I told the US manufacturer to figure that these items would be about 40% of all wages. So if you have an employee who is now getting $1000 a month under the table and you then report to the government that you are paying that employee $1000, you should figure on needing to pay about $400 on that to the government.
Let's also take rent. The Chinese manufacturer is probably paying the landlord under the table and the landlord is not reporting it. Heck, there is a very good chance the landlord is not even legally able to lease out the property, but for the sake of the numbers, let's assume that the landlord is actually authorized to lease it. If you are going to buy the Chinese manufacturer's company you are going to have to do so as a WFOE and to get a WFOE approved at all, you are going to need to have a legitimate lease. That means that before you buy this Chinese manufacturer, you are going to need to go to the landlord and tell it that you need to get your landlord-tenant relationship "on the grid" and that the landlord is going to need to register the lease with the appropriate authorities.
The landlord will likely call you an idiot (trust me on this) and initially balk. You will then need to explain that you absolutely must get on the grid and that you are prepared to cover the landlord's increased costs to do so. Figure on this raising your rent by around 25%. Again though, this assumes that your being able to stay at this facility is even possible.
Okay, so now that I have explained how the above will eat into your numbers, let's talk about income taxes. You are going to have to pay income taxes on the money you make, even though the Chinese manufacturer maybe never did. Figure 25% of your profits will go to income taxes.
Similar issues occur with piracy and all the things US politicians imagine can be stopped instantly. It is remarkable to be in a country where the economy is developing incredibly quickly and where the reach of the state and the rule of law are consolidating incrementally. We foreigners, unaccustomed to this, tend to project our assumptions onto how we approach business in China. It is no wonder Chinese business people often think us naive.
One of the most intriguing things about living in China is seeing how the rule of law is gradually expanding throughout the nation (or perhaps it would be better to say, throughout the state). This seems to be something that those living outside China, such as US senators, do not understand. Accustomed as those gentlemen are to living in a nation where the rule of law is a long-accustomed societal and governmental tradition and the writ of the state runs without question, stretching so far back that folk memory does not remember periods of real disorder, it is always worth keeping in mind that China only really emerged from a state of near anarchy in 1976 – less than forty years ago. “Anarchy” here does not mean the cheap tabloid usage of fleeting disorder, but the deeper sense of the destruction of social norms and practices, and the customs of law. Civil law is of course mostly based on precedent: when all history is torn up to write a new page, what happens is the destruction of centuries of social habits which accumulate into the very basis of that society. These traditions take a long time to form and consolidate into standard practice. 
I said that there is a good chance the Chinese manufacturer is paying half of its employees completely under the table and reporting to the government only half of what it was paying the other half. I then talked of how there is also a good chance the Chinese manufacturer is underpaying its taxes and of how its rent also may be paid under the table. I then said that this sort of thing may be all well and good for Chinese companies, but that if the US manufacturer were to buy this Chinese manufacturer, it would need to do so as a WFOE and it would then immediately be on a "whole 'nother level" with respect to China's various tax authorities.
