China has achieved impressive successes over the past three decades, but the road ahead is still paved with important challenges. Promoting a harmonious society and scientific advances are high on the reform agenda; they need to be bolstered by a coordinated reform strategy, in which fiscal policy has an important role to play.
The reforms suggested in this chapter can be summarized as follows:
• In the tax policy area, VAT should be shifted from a production base to a con- sumption base, and it should be extended to services, to align it with international practice; the refund system and its administration should be rationalized; the enterprise income tax regime for domestic and foreign-invested enterprises should be unified and tax incentives streamlined; the personal income tax structure should be simplified; the appropriate design of local taxes, including bounded local control over rates, should be examined; and SOEs should start paying dividends to the government.
• In the expenditure policy area, best international practice and efficiency con- siderations call for a more centralized pooling of social security. In addition, parametric changes to the pension system should be introduced, to make it sustainable in view of aging pressures, and health care and education programs should be cast in a medium-term expenditure framework to ensure their sustainability and effectiveness.
• In the public financial management area, Treasury and budget reforms should be deepened; the coverage of fiscal operations should be broadened to include extrabudgetary accounts and quasi-fiscal activities; and a registry of local gov- ernments’ indirect borrowing should be set up as a prerequisite for relaxing, under well-specified requirements, the ban on their direct borrowing.
The interconnections among different fiscal reforms will need to be carefully assessed. In particular, the intergovernmental fiscal relations dimension of the various reforms should be examined. For example, strengthening the provision of health care and education services will put strain on local governments’ finances, unless the transfer system is made more equitable and transparent, the tax autonomy of local governments is increased, or both.
China has traditionally used a piecemeal approach to reforms, by taking incre- mental steps or by first experimenting with reforms through geographically circumscribed pilots. However, as China’s economy evolves and becomes more integrated in the globalized world, a step-by-step approach to reforms may be counterproductive, because limited reforms may induce distortions and create incentives for mobile factors to take advantage of them through arbitrage oppor- tunities (Prasad and Rajan 2006). Hence, the time is ripe for a comprehensive reform effort. The system of intergovernmental relations, which has remained broadly unchanged since 1994, is a prime candidate for a wide-ranging reform.
Inaction is not a risk-free option. Maintaining the status quo may exacerbate imbalances, impose potentially large welfare costs, and require policy distortions that may create instability down the road.
While fiscal reforms are important, other reforms, particularly in the banking sector and the exchange rate regime, also have roles to play (Blanchard and Giavazzi 2005; Prasad and Rajan 2006). It would be misleading to suggest that fiscal policy alone can dominate the reform agenda and secure its success.
Reforms must be launched at a propitious time if they are to be successful.
China’s sustained macroeconomic achievements and its progress on the reform path undertaken so far suggest that now is such a time. Reforms are best under- taken from a position of strength. Strong growth, low inflation, and low levels of explicit government deficit and debt provide China with the room to design and move ahead with its implementation of needed reforms.
Notes
The analysis and policy recommendations presented in this chapter draw extensively on previous work by a number of colleagues in the IMF’s Fiscal Affairs Department. In par- ticular, the authors gratefully acknowledge contributions from Ehtisham Ahmad, Holger van Eden, and Howell Zee.
1. Data are based on information available as of May 2006. For this reason, data used in this chapter may differ somewhat from data used in other chapters in this book.
2. Proactiveand prudentare the terms used by the Chinese authorities to characterize their fiscal policy formulation and implementation.
3. China’s external debt is less than 0.5 percent of GDP. This figure compares very favor- ably to the average for emerging countries (about 36 percent of GDP) (Prasad 2004).
These data need to be interpreted with caution, however, as the coverage and definition of debt statistics vary widely across countries. In China government debt includes the securitized liabilities of the general government. Data on the debt of state-owned enter- prises are not available.
4. Based on authorities’ data, the stock of nonperforming loans is estimated at about 25 percent of GDP at the end of 2005 (including the stock of nonperforming loans originally transferred to asset management companies, equivalent to some 8 percent of 2005 GDP).
5. A restructuring of revenue raising and spending responsibilities across levels of govern- ment should also be accompanied by a review of the system of intergovernmental trans- fers and of revenue-sharing formulas, to ensure adequate vertical and horizontal balances among and within different levels of government, a topic not covered in this chapter.
6. In 1994 the government was faced with steadily declining tax ratios (total revenue had declined to less than 12 percent of GDP in 1994, from more than 29 percent of GDP in 1980) and shrinking shares of central revenue in total revenues. To stem these trends, a major reform was implemented in 1994. This reform introduced a new tax-sharing system, shifting revenue collection and distribution away from a negotiated basis to a mix of tax assignments and tax sharing; enacted a new VAT; and made the State Administration of Taxation responsible for collecting central and shared taxes, while leaving the collection of local taxes in the hands of local government agencies.
7. India and the United States do not have a central VAT (both are federal states).
8. The incremental method used for VAT deductions has allowed investment pressures associated with the shift from a production-based to a consumption-based VAT to be
contained. Under this method, VAT credits are allowed only for the “incremental base” from 2003, that is, up to the change in the VAT debit position relative to 2003.
9. Refund rates have changed frequently. They were last significantly modified on January 1, 2004, when rates were reduced to 17, 13, 11, 8, and 5 percent. The refund system did not change for sectors then promoted by the government, such as electronics and automobiles. For ordinary consumer goods, tax refunds were cut significantly. The most-affected sectors were those exporting “natural resource” goods (pulp, oil, and lumber), for which VAT refunds were cancelled altogether.
10. Currently, only traders wholly engaged in exports (with no production destined for the domestic market) may claim VAT refunds each month for credits accumulated the previous month. Exporters engaged in both domestic and export sales are subject to a double regime. Exporters for whom exports represent more than 50 percent of total sales may claim refunds of VAT credits remaining after these have been carried forward for three months; exporters for whom exports represent less than 50 percent of total sales are not permitted refunds and must offset credits against domestic VAT liabilities.
11. Arrears topped 2 percent of GDP at the end of 2003. They have now been fully set- tled. Meanwhile, budgetary allocations for VAT refunds have been significantly increased.
12. It is difficult to predict such losses. Based on input-output table data, in 2001 IMF staff estimated that revenue losses could amount to about 40 percent of VAT collections in 2000, or about 2 percent of GDP.
13. An average progressive rate structure has undesirable properties. For example, a domestic enterprise with taxable profits of Y30,000 would incur a tax liability of Y5,400 (Y30,000 ⫻0.18); if its taxable profits rise by Y1,000, its tax liability would jump to Y8,370 (31,000 ⫻0.27). Hence, the additional taxable profits of Y1,000 would result in an increase in the tax liability of Y2,970, equivalent to taxing those additional prof- its at a rate of 297 percent. Such high implicit marginal tax rates at the borders of the rate brackets are not only grossly unfair, they can also seriously distort the behavior of enterprises that have profit levels close to such borders.
14. There would be little economic justification for having a progressive rate structure, whether average or marginal, under the enterprise income tax if the taxpayer in the prospective unified enterprise income tax law would be based, as expected, on the con- cept of the legal person rather than the concept of “independent accounting unit,” as currently applied to domestic enterprises. With such a shift in the definition of the tax- payer, small unincorporated enterprises would simply be taxed under the progressive rates of the personal income tax.
15. Since the early 1980s, the Chinese authorities have used tax incentives, provided pri- marily to foreign-invested enterprises in specially designated development zones, to attract foreign direct investment. The structure of enterprise income tax incentives is extensive and complex, and it is subject to frequent ad hoc changes. Moreover, some incentives are applied on top of other incentives, approval of incentives involves dif- ferent government agencies and sometimes different levels of government, and the incentives differ for foreign-invested and domestic enterprises.
16. About 75 percent of OECD countries currently practice some form of tax expenditure reporting; a small but increasing number of developing countries also do so.
17. These sources of revenue together account for about 70 percent of local governments’
total revenue.
18. Currently, tax policy powers reside exclusively in the hands of the central government with respect to all but a few minor taxes in China. Until 2001, revenue from the personal income tax accrued to provincial governments. Since 2002, personal income tax revenue above the 2001 level has been shared between the central and provincial governments in fixed proportions (50/50 in 2002 and 60/40 as of 2003).
19. The rates of consumption taxes were modified as of April 1, 2006; new excises are now applied to some oil products, including naphtha, solvent naphtha, lubricating oil, fuel oil, and aircraft turbine fuel.
20. SOEs do pay dividends to other (nongovernment) shareholders. Profits of central SOEs rose 30 percent in 2005 to Y628 billion (3.4 percent of GDP, representing about 80 per- cent of all SOE profits). Central SOEs include many of China’s best-known corporations, such as oil and steel companies. Including the 1,000 less profitable SOEs controlled by provincial governments, total SOE profits amounted to 4.3 percent of GDP in 2005.
21. Data on spending should be interpreted with caution; the current budget classification, which is being upgraded, does not provide an accurate description of expenditure by economic and functional types. Hence, it is difficult to explain the size of and trends in expenditure programs.
22. According to a survey of the Ministry of Health, less than 50 percent of the urban population and less than 20 percent of the rural population were covered by health insurance in 2003 (OECD 2006).
23. This scheme, called 20-20-10, apparently applies to more needy western regions; in richer eastern regions, contributions are different from those reported here.
24. A pilot in the three northeast provinces has so far not succeeded in shifting pooling to the provincial level.
25. Implicit pension debt is a measure of the present value of accrued benefits under the pension system if the system were terminated at a particular date (including benefits to be paid to current pensioners and pension rights that current workers have earned up to the termination date). The financing gap measures the sum of the net present value of the balance (revenue less expenditures) over the projection period (75 years).
26. This presupposes national legislation on social security applying the same standards nationwide.
27. Initiated by the Ministry of Finance in 2001, the TSA reform has been introduced in all 160 departments of the central government and all 36 provinces, autonomous regions, and municipalities (the second of five levels of government); it is being pursued in some 500 prefectures and larger cities (the third and part of the fourth level of government).
28. The fiscal year starts in January. The National People’s Congress traditionally convenes in March; within 30 days, detailed budget authority is provided to ministries, which are required to advise their subsidiary units within 15 days. The budget is not “activated”
at the central level before mid-May. Provincial budgets cannot be approved until the
central government budget is approved; the budgets of prefectures cannot be approved until provincial budgets are approved, and so on for counties and townships. Hence, local budgets are approved much later than mid-May; in some townships, budgets are approved in the last two months of the fiscal year.
References
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Dorfman, Mark, and Yvonne Sin. 2001. “China: Social Security Reform: Strategic Options.” World Bank, Washington, DC.
Hussain, Athar, and Nicholas Stern. 2006. “Public Finances, the Role of the State and Economic Transformation in China: 1978–2020.” Paper presented at the “Roundtable on Public Finance for a Harmonious Society,” Beijing, June 27–28.
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Part II
Fiscal Reform and Revenue
Assignments
Expenditure Assignments in China: Challenges and Policy Options
JORGE MARTINEZ
-
VAZQUEZ,
BAOYUN QIAO,
SHUILIN WANG
,
ANDHENG-
FU ZOUT
he decentralization of public services provision, a key component of fiscal federalism, is widely viewed as the means of improving the efficiency of the public sector by using the potential information advantage of local government to better match the needs and preferences of local residents (Hayek 1945; Oates 1972). In addition, the decentralization of public services can be seen as a necessary component of “market-preserving federalism,” whereby the role of subnational governments is aligned with the goals of local economic development and local welfare (Qian and Weingast 1997). For these efficiency gains to be real- ized, subnational governments need to be responsive to their constituencies. The existence of accountability mechanisms, such as the election of local officials, is widely acknowledged as a necessary condition for effective fiscal decentralization (see, for example, Seabright 1996).China’s most successful experiences of fiscal reform may result from expenditure decentralization. With some important exceptions, especially in expenditure assignments (addressed below), China’s current system of decentralized finance is generally consistent with the conventional wisdom regarding the desirable features of fiscal decentralization. The basic economic argument for fiscal decentralization is greater economic efficiency in the allocation of resources in the public sector. This suggests that policies governing the provision of public services that are sensitive to regional and local conditions are likely to be more effective in encouraging growth than centrally determined policies that ignore these geographical differences (see Oates 1993; Martinez-Vazquez and McNab 2003).
Although quantitative studies of the impact of fiscal decentralization on economic growth in China yield conflicting results (because of differences in the measurement of fiscal decentralization), most of this research finds that decentralization has con- tributed to overall economic growth.1However, not all aspects of decentralization policy are positive or desirable, as international experience shows. Poorly designed decentralized systems, for example, that lack hard budget constraints for subnational governments can lead to waste and macroeconomic instability.2Basic institutional failure in issues such as accountability or the presence of bureaucratic corruption
5
can lead to the capture of government by local elites, with perverse outcomes.3 Subnational governments may also lack adequate technical and administrative capacity to realize the potential gains from decentralization (Bahl and Linn 1992).
On the expenditure side of the budget, China is one of the most decentralized countries of the world. This high level of decentralization offers many advantages, but it also presents some clear disadvantages. Aspects of the current system that require policy attention include the mismatch between expenditure responsibilities and revenue sources at the lowest levels of governments (counties and townships), where many important social services are concentrated; the murkiness created by the lack of formal assignment of expenditure responsibilities, especially those government units below the province level; several inappropriately assigned responsibilities at the lowest level, such as pensions and unemployment insurance;
and the lack of horizontal accountability mechanisms in the system, which can have important undesirable consequences, particularly the underprovision of basic public services.4
The chapter is organized as follows. The first section examines current expen- diture assignments in China. The second section discusses the main issues affecting expenditure assignments at different levels of government. The last section explores policy options for their reform.