Although the deficit ratio was modest, the government was under severe fiscal stress.
All government tiers were relying on two extrabudgetary channels for expenditure and revenue: directed lending through the state banking system to particular institutions or for particular purposes and extrabudgetary or off-budget revenue.
Directed lending by state-owned commercial banks, which was off budget, made it possible for the government to short-circuit government borrowing on its own account to finance loss-making enterprises. This mechanism can be thought of as disguised public borrowing to finance implicit deficits. The process was highlighted by several rounds of capital injection into state-owned commercial banks.
Off-budget revenue sources have always existed, but they grew in importance over the reform period. In the 1950s, these sources consisted largely of the sup- plementary levy on agricultural produce and informal revenue demands from local enterprises used to finance local government expenditure.
Over the reform period, off-budget sources have proliferated, in response to the fiscal stress arising out of the combination of a falling ratio of budgetary revenue to GDP and rising demand for expenditure. The fiscal decentralization over the period facilitated their proliferation by giving subnational governments the discretion to charge fees and introduce levies. In addition, the development of a market economy created ample opportunities for profitable activities.
Extrabudgetary revenue sources have included user charges for public utilities;
fees in return for service; surcharges on taxes; earmarked levies for specific purposes or funds, such as education; and revenue from commercial or business undertakings by government agencies or enterprises set up for this purpose. In recent years, proceeds from the sale of land leases and land-use rights have grown rapidly, emerging as the largest off-budget revenue sources in many localities.
The driving force prompting lower tiers of government to explore off-budget revenue sources was the gap between their expenditure responsibilities and their on-budget revenue. By the early 1990s, fees (or off-budget revenue more generally) had become a regular and significant revenue source for all government tiers, particularly lower tiers. For many rural local governments, these sources financed half or more of their expenditures, including spending on basic services.
Two aspects of an off-budgetary revenue source are relevant for its evalua- tion: its governance aspect and its characteristics as a tax. A key adverse feature of off-budgetary sources is that they may escape the assessment and scrutiny that are appropriate for budgetary items. One of the basic requirements of a well- functioning market economy is transparent and accountable government processes and actions that can provide the clarity on which private decision making depends. This clarity can be undermined by off-budgetary processes, which are more likely to be discretionary, arbitrary, and unpredictable than budgetary processes—and therefore more prone to corruption. A crucial fea- ture of good fiscal processes is that they provide clear and open information on where money comes from and how it is spent. Building these processes is a central part of building a functioning, efficient, and fair market economy.
Nonbudgetary revenue sources cover a wide range. Some rank well on the basic economic criteria for a tax: incentives, efficiency, and distribution. Others do less well. Nonbudgetary revenue sources also vary in their administrative costs and costs of compliance, although, given their local and straightforward nature, some of these costs may be lower than the costs of formal taxation.
Depending on the design of land-lease and land-use rights, their sale can fare well in terms of efficiency and equity. Difficulties, however, can lie in the details and implementation of such measures. In rural areas, these revenue sources can be particularly sensitive to the distribution in the size of holding and on the specifics of property rights.
Charges for services and earmarked levies often apply to services, such as basic education, that many would argue are fundamental rights and should therefore be free. Poorer households or those in backward areas have fewer alternatives than richer households and thus are particularly badly hit, raising equity issues.
By their very nature, off-budget levies and charges fall on the residents of a particular jurisdiction; reliance on this type of instrument thus limits distribution of the cost of public services across jurisdictions. Lower government tiers—for which off-budget revenue sources are of crucial importance—vary widely in per capita income. In general, the lower the government tier, the greater the varia- tion in their taxable capacities, whether on or off budget. As a result, reliance on off-budget revenue to finance essential public services leads to wide variations in the standards of provision, which in many localities falls well short of what might be considered a basic minimum.
Dependence on off-budget revenue sources also affects the expenditure pattern, biasing government activities in favor of those that yield revenue, such as setting up enterprises, and away from those that do not, such as providing basic services.
The result is that poor people from poor localities have great difficulty acquiring the human capital needed to escape poverty. This system can thus exacerbate social exclusion and erect a severe obstacle to building a harmonious society.
Like off-budget revenue, directed bank lending can lead to corruption. It undermines the crucial information base that is necessary for a functioning market economy. It also hinders development of the banking system. Directed lending absolves banks from assessing the risk of loans and making provision for the risk of default, because, by directing lending and bailing out banks, the government effectively assumes the risk and the responsibility for the decision. Historically, the operations, procedures, and organizational structures of state-owned commercial banks were adapted to the disbursement of directed credit. They did not assess the creditworthiness of borrowers, and they were not particularly concerned about ensuring that loans were serviced. As a result, Chinese banks have had portfolios of nonperforming loans that far exceed the initial subsidy in the directed lending. They have hindered the response to the microeconomic and macroeconomic problems of improving the low overall efficiency of capital in China. The presence of directed lending has prevented the Chinese economy from using capital more efficiently.
There have been two major changes in the classification of off-budget revenues and expenditures, both of which resulted in a sharp decline in their shares of rev- enues and expenditures (table 2.2). One was implemented in 1992, when the revenues and expenditures of state enterprises were excluded from the off-budget account. The second took place in 1997, when all intergovernmental transfers were taken off the off-budget account.
Since 1997, off-budget revenues and expenditures have been small relative to their on-budget counterparts in the central government account but substantial relative to those of subnational governments. In the case of subnational governments, relative to their on-budget budgets, both off-budget revenues and expenditures have fallen steadily since 1997, in large part as a result of the policy of replacing off-budget fees with on-budget taxes. The share of total revenues represented by off-budget revenues (42.5 percent) has also been substantially higher than the share of off-budget to total expenditures (22.2 percent). The explanation is that off-budget revenue is not used exclusively to finance off-budget expenditure; a substantial percentage goes to finance on-budget expenditure items, including basic public services. The implication is that any significant reduction in off-budget revenue has to be accompanied by a com- pensating rise in on-budget revenue in order to maintain these services.
The anomalies created by resorting to off-budget revenue sources for financing can be addressed in three broadly complementary ways:
• 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.
Table 2.2 Off-Budget Revenues and Expenditures as a Percentage of Total Budget Revenues and Expenditures, 1989–2003
Off-budget/budget revenue Off-budget/budget expenditure
Central Subnational Central Subnational
Year government government government government
1989 130.4 86.1 109.8 78.9
1990 108.1 84.1 103.3 80.3
1991 147.2 84.2 115.8 79.7
1992 174.3 85.8 136.1 80.0
1993 25.7 35.0 15.2 33.5
1994 9.7 68.3 12.8 36.8
1995 9.8 70.0 17.6 41.0
1996 25.9 78.6 48.1 48.4
1997 3.4 60.6 5.7 37.9
1998 3.4 58.6 4.5 36.2
1999 3.9 56.4 4.0 32.9
2000 3.5 55.9 3.8 32.0
2001 4.0 50.7 4.5 27.3
2002 4.2 47.4 3.8 23.4
2003 3.2 42.5 4.4 22.2
Source:http://www.stats.gov.cn.
Note:State enterprise budgets were removed from the list of off-budget items in 1993. Other intergovernmental transfers were removed from the list in 1997.
• Reallocate the responsibilities for financing basic services from lower to higher government tiers.
• Within the limits implied by tax coordination across government tiers, extend the powers of lower government to levy (on-budget) taxes.
China has adopted the first two options (as well as the third to a very limited degree). It transfers revenue from higher tiers of government, especially the central government, to lower tiers. Recently, the central government has moved the level of financing of basic education in rural areas from townships to the next tier up, counties. China has 2,861 counties, the average population of which is about 330,000—15 times that of townships. Moving financing from townships to counties implies a pooling of resources and should reduce differences in resources available for financing basic education. It may also reduce the degree of local accountability of teachers and administrators, although there are a number of ways of making schools more responsible to local communities (see, for example, World Bank 2004). As for the third option, by international standards, lower tiers of government in China have very restricted powers of levying taxes, which forces them to resort to off-budgetary sources of revenue.