widened. Second, the employment share of the state sector fell steadily, including through massive layoffs, beginning in the mid-1990s. Third, since the mid-1990s, urban unemployment has been both open and substantial. At the same time, poverty, once regarded as an almost exclusively rural phenomenon, emerged as a salient feature of the urban landscape.
Chinese leaders have recently become highly concerned with the widening economic inequalities. To address the problem, they will need to adopt some of the following policy measures:
• Reform intergovernmental finances to counteract regional inequality by means of transfers and central government expenditures in favor of poorer localities. To a degree, this is already being done, through regional development initiatives, such as the initiative for the 12 western provinces. However, the extent of redistribu- tion from richer to poorer localities in China is low by international standards, with most of the revenue collected from richer regions returning to those regions.
• Increase subsidization of the cost of essential services for low-income households.
The costs of education and health care have risen sharply over the reform period, forcing low-income households to cut back on both. Recognizing the problem, the government has exempted poor localities from school fees and introduced sub- stantial subsidies for participating in the rural cooperative health insurance scheme.
• Introduce income maintenance schemes to prevent deprivation. The urban population already benefits from a two-tiered social safety net, consisting of unemployment insurance and MLSA. In contrast, the social safety net in rural areas is grossly inadequate. An MLSA scheme for the rural population, similar to the one for the urban population, should be a major element in the fight against poverty.
4. Promoting job creation and a training program for rural inhabitants to facilitate their transfer from farming to jobs in services or industry, and raising the urban- ization rate from just over 40 percent to 47 percent by the end of the plan.
5. Broadening the scope of regional development priorities from the western region to include the central region and the northeast.
6. Reforming the framework of intergovernmental finances, including by reas- signing expenditure responsibilities of government tiers and ensuring that each tier has sufficient disposable revenue to meet its obligations.
7. Raising the efficiency of resource use, and arrest further deterioration of the environment, eventually reversing environmental degradation. Concrete targets include a 10 percent cut in the emissions of major pollutants and a 20 percent reduction in energy consumption per unit of GDP by the end of the plan.
The first five reforms require a substantial increase in budgetary expenditure.
Raising education expenditure to 4 percent of GDP will require allocating an additional 1.5 percent of GDP to education. Improving and widening access to health care will require a very large increase in expenditures, given that government expenditure currently stands at just 1.5 percent of GDP and health care usually requires a higher fraction of GDP than education. Thus, achieving the expenditure targets on education and health would require additional gov- ernment expenditure of 5.3 percent of GDP. Assuming that meeting the third, fourth, and fifth reforms would cost an additional 2 percent of GDP, imple- menting all of these reforms would require additional government expenditure of about 7–9 percent.
Increasing Tax Revenue
What are the feasible options for raising additional tax revenue of this magnitude?
Sound principles of tax design are to broaden the tax base; shift toward taxes with growth potential; seek the smallest possible distortions; promote greater fairness (the expenditure side of the budget is often more effective than the revenue side with respect to this objective); and simplify and hold down the costs of adminis- tration and compliance. The principal candidates for additional tax revenue are personal taxes, which account for 6.8 percent of total tax revenue (1.2 of GDP);
VAT, which yields 34.7 percent of the total tax revenue (5.9 percent of GDP);
and consumption or excise taxes, which provides 5.3 percent of tax revenue (0.9 percent of GDP).
The yield from personal tax has risen sharply since the tax reform of 1995, but it is still very small compared with that in developed economies. With 47 percent of the labor force in farming and more than half of the population classified as rural, the percentage of the adult population that is captured by the personal tax net is limited in China. Given the rapid rate of urbanization, however, there would seem to be ample scope for raising the share of the personal tax, which should be a rapidly growing source of revenue.
Two other reforms of personal taxation are also needed. The first is using a comprehensive measure of income (including, in particular, in-kind benefits) and treating different types of income equally. The current practice of taxing different types of income differently goes against the grain of established principles of tax- ation. The second is using the same definition of income for personal tax and for payroll tax for social insurance. Currently, these definitions differ.
The introduction of VAT and the speed with which it has become by far the largest tax source is a major success story. However, there is scope for raising the yield from VAT. The main rate of 18 percent is comparable to that in many European economies, but the range of goods and services covered by VAT is narrower.
Extrapolating from international experience, raising the ratio of VAT yield to GDP from the current figure of 5.9 percent to 9–10 percent would seem to be feasible.
In addition to extending the VAT net, there are strong arguments for switch- ing from a production-based to a consumption-based tax. This switch-over is planned, and a pilot experiment is under way in the three northeastern provinces.
(For a more detailed discussion of VAT and other tax issues, see chapter 6.) At 0.9 percent, the yield from consumption taxes beyond VAT is remarkably small compared with those in developed economies. Excise taxes on fuel, tobacco, and alcohol are revenue sources in developed economies and have much to com- mend themselves because of the externalities they cause. A tax on oil aimed at encouraging greater efficiency should be coupled with an appropriate oil pricing policy. Although 57 percent of current oil consumption is met from domestic production, there are strong arguments for pricing oil as if all of it were imported and setting the domestic price with reference to the cost of imported oil. There may be an argument for smoothing short-term fluctuations in oil prices but not for insulating the domestic price from the international price.
In terms of carbon emissions and global warming, coal is more polluting than oil or gas. This should be embodied in the price through taxation or other means.
For all energy sources, greater efficiency is very important for energy security, cost saving, and the environment, within China and globally.
China is the largest consumer of tobacco, accounting for 32 percent of the world’s total. Sixty percent of men over 15 smoke. Yet China’s tobacco tax rate is only half the world’s average. The case for a substantial increase is very powerful.
There is ample scope for using land as a tax base. This source of revenue has been neglected in many countries and is difficult to resurrect once neglected.
Starting from a situation of collective or state ownership of land, China potentially faces less resistance to the use of this tax base than other countries. Land is already used as a tax handle, and land lease is a major revenue source in municipalities.
What is needed is a national framework for land taxes and the leasing of publicly owned land, particularly in urban areas, where migration and rapid economic growth are creating very large capital gains.
Raising tax revenue to cover the planned expenditures on education, health, and job training appears to be feasible. The potential for growth from enlarging the tax base on personal income tax, VAT, excise taxes, and taxes on urban land
is strong. Moreover, with appropriate design, these taxes can be less distorting and more equitable than other taxes (Ahmad 2006).
Improving Intergovernmental Fiscal Relations
The growth of off-budget revenue sources and the heavy reliance of lower government tiers on such revenue are symptoms of problems of intergovernmental fiscal relations. Resolution of these problems is essential for reducing inequality, especially between rural and urban areas.
Three (complementary) options could be adopted to deal with these problems:
• Reform the system of transfers from higher to lower government in order to ensure that each government tier has sufficient revenue to finance basic services of appropriate quality.
• Reallocate responsibilities for financing basic services from lower to higher government tiers.
• Within the limits implied by tax coordination across various tiers of government, extend the powers of lower government to levy taxes. Currently, lower government tiers have very limited powers of taxation, which forces them to resort to off-budget charges and levies. The land tax would seem to be a good candidate as a major revenue source for lower tiers in urban government.
Protecting the Environment and Natural Resources
There is broad scope for using taxes and charges to prevent further deterioration of the environment and to begin to reverse the damage. Environmental problems facing China include pollution and depletion of natural resources. In urban and urbanized rural counties, ambient concentrations of hazardous particles and gases are many times higher than the safe limits. Contamination of surface water and groundwater is widespread, and the northern half of the country is critically short of water. Land degradation from the discharge of solid wastes and hazardous matter is common.
In one form or another, a large and growing percentage of the population suffers the adverse impact of environmental pollution, especially of water. Damage to health and economic activity caused by pollutants has become a source of popular discontent, which occasionally takes a violent form.
China is also a profligate user of natural resources. Its consumption of primary energy sources (in particular coal and oil), cement, and steel accounts for a much higher percentage of world supplies than its percentage share of world GDP. Its energy consumption per unit of GDP is 7 times that of Japan, 6 times that of the United States, and 2.8 times that of India. This discrepancy is caused largely by the inefficient use of material and fuel. China cannot maintain its current pattern of consumption of resources for long without triggering further increases in prices and hitting up against the constraint of world supply.
China has all the components of an effective system of pollution control. There is a comprehensive corpus of environmental laws and regulations, and adminis- trative organizations in charge of protecting the environment are in place at each tier of government. Principal among these is the State Environment Protection Agency and its counterparts at the subcentral levels. The implementation of laws and regulations and the prevention and abatement of pollution have been less impressive. One significant positive development is the strengthening of the requirement to conduct an environmental impact assessment for investment projects, which has been in place since 1975 but poorly implemented.
Achievement of the 11th Plan depends crucially on encouraging the adoption of resource-saving technologies. Measures include raising environmental taxes, imposing taxes on energy, and pricing energy appropriately. The 11th Plan marks a crucial step in dealing with the problem of water shortage by proposing to charge for all extraction of water from natural sources.