The pathways to reform presented here are guided primarily by economic ration- ale, principles of good grant design, and lessons from experience. They describe one possible package of policy reform options for dealing with the principal issues facing China today.
Sharing Tax Bases or Decentralizing Taxes to Handle the Fiscal Gap
China could discontinue tax-by-tax sharing for personal income tax and enter- prise income tax and allow provincial and local governments to impose supple- mentary variable flat rate charges. In addition, subnational governments could be given the flexibility to set their own tax rates within a defined range. It is also important to make the enterprise income tax a source-based tax and set rules that attribute income to various locations based on taxes such as VAT, employment taxes, and sales tax. Doing so would allow western provinces to claw back addi- tional enterprise income tax revenues and discourage wasteful interjurisdictional tax competition. These measures have the potential to reduce the fiscal gap while enhancing accountability to local residents.
Establishing a Legal Framework and Designating a Coordinating Ministry
Industrial countries and a growing number of developing countries require grant programs to be established through enabling umbrella legislation (fiscal arrangements acts) and implementing regulations. They also designate a coordinating body, usually the Ministry of Finance. China could consider instituting a legislative framework for major grant programs and designating the State Council or the Ministry of Finance to play a coordinating role. In addition, a fiscal arrangements committee compris- ing representatives of the central government and subnational governments, chaired by the central government’s minister of finance, could be appointed to act as the primary initiating and deliberative body on central transfers.
Establishing a Framework for Fiscal Transparency, Responsibility, and Accountability
In the foreseeable future, the central government will remain the dominant source of financing subnational services in China, especially in the western regions and in the provision of rural services throughout the country. Over time, China has afforded ever-expanding autonomy to local governments. To forestall future fiscal
risks, it is important to establish a national framework for fiscal transparency, responsibility, and accountability that is binding on all levels of government. This framework should specify principles and rules for fiscal prudence and fiscal disci- pline, credit market access, and fiscal insolvency for local governments, and it should ensure transparency and access to information by all. Recent experiences of Brazil and South Africa with such legislation may be instructive for China.
Rationalizing and Simplifying the Fiscal Equalization Program
China’s fiscal equalization program could be rationalized and simplified by intro- ducing an explicit standard of equalization, such as a national average standard for fiscal capacity or a fraction of this standard that subnational governments must meet.
This standard should determine both the pool and the allocation. The RTS could be simplified by having fiscal capacity calculated from only eight sources: VAT, personal income tax, enterprise income tax, business tax, urban maintenance and construction tax, housing property tax, vehicle taxes, and all other taxes combined.
User charges should be excluded from these calculations. The RES should be dis- continued for fiscal need calculations; instead, per capita (per service population) output-based transfers for national merit goods should be used, as discussed below.
Instituting National Minimum Standards Grants
China could institute national minimum standards grants by introducing output- based fiscal transfers to achieve national minimum standards in merit goods, such as education, health, and infrastructure. The central government must play a larger role in financing rural services, in view of rural areas’ inability to raise adequate own-source revenues.
Merit-based transfers could be based on the relevant service population. For example, a performance-oriented education grant could use the school-age popu- lation as the basis of allocations (Shah 2002, 2007b). Unconditional equal per pupil distributions could be made to both public and private schools, as long as the local government raises achievement scores and provides universal access to primary and secondary education regardless of parents’ income. Schools that do not comply with the standards imposed by the central government could face public censure and reduction of their grant funds. Incentives for cost efficiency could be included by allowing local governments to retain savings.
Tailoring Provincial-Local Transfers to the Size and Urban/Rural Nature of the Local Area
Local areas vary in population, size, area served, and type of services offered. In view of this, it would be advisable to classify local governments by population size, municipality type, and urban/rural character and to apply separate formulas to each class and type of municipality. It is also important to give special consideration to financing rural services.
Customizing Infrastructure Assistance to Local Governments
To deal with infrastructure deficiencies, a blend of capital grant finance and responsible access to borrowing may be needed in different provinces. The cen- tral government could consider providing local governments with assistance on project design and evaluation and credit market access.
Notes
The authors are grateful to Professor Baoyun Qiao of Shanghai University for comments and inputs.
1. China’s five separately planned cities—Dalian, Ningbo, Qingdao, Shenzhen, and Xiamen—are treated as provincial governments fiscally.
2. In the “Province Managing County” model, the provincial government directly man- ages the counties. There are no fiscal relations between the prefecture governments and the county governments.
3. The equalization transfer was called a transitory period grantuntil 2001; since 2002 it has been called a general-purpose grant.
4. The income tax from the following enterprises is excluded from the sharing policy:
rail transportation, the state post office, the Industrial and Commercial Bank of China, the Agricultural Bank of China, the Bank of China, the Construction Bank of China, the State Development Bank, the China Bank of Agricultural Development, the Import and Export Bank of China, offshore oil and national gas enterprises, the China Petroleum and Natural Gas Co. Ltd., and the China Petroleum Chemical Co. Ltd.
5. The fiscal contracting system included six types of central-provincial revenue-sharing methods, each applied to some provinces. For instance, the method “fixed contracted remittance” means the province remitted to the central government a fixed amount every year.
6. The weighted Gini index, which weights each difference in per capita revenue by its population size, is calculated by the equation
where is the national mean; piand pj are the populations of provinces iand j, respec- tively; pis the national population; and nis the number of provinces. Granges from 0 for perfect equality to for perfect inequality.
References
Budget Committee, National People’s Congress. 2002. Discussion of Fiscal Transfers by Experts at Home and Abroad.[In Chinese: Zhongwai Zhuanjia Lun Caizheng Zhuanyi Zhifu] Beijing:
China Financial and Economic Publishing House.
Ministry of Finance. 2006. “Intergovernmental Grant Flow in China.” Beijing.
(1−p ) p
i
R G
R R R p p
i j p
i j
j n
i n
= 1
2 2
⎛
⎝⎜
⎞
⎠⎟
∑ ∑
− ,National Audit Office. 2003.Audit Report on Central Budget and Other Fiscal Revenue and Expenditure.Beijing.
National Bureau of Statistics. 2005. China Statistical Yearbook. Beijing: China Statistics Press.
Qiao, Baoyun, and Anwar Shah. 2006. “Local Government Organization and Finance in China.” In Local Governance in Developing Countries,ed. Anwar Shah. Washington, DC:
World Bank.
Shah, Anwar. 1994. The Reform of Intergovernmental Fiscal Relations in Developing and Emerging Market Economies.Washington, DC: World Bank.
———. 1996. “A Fiscal Need Approach to Equalization.” Canadian Public Policy22 (2):
99–115.
———. 1998. “Balance, Accountability, and Responsiveness: Lessons about Decentralization.” Policy Research Working Paper 2021, World Bank, Washington, DC.
———. 2002. “Fiscal Decentralization in Developing and Transition Economies.” In Federalism in a Changing World: Learning from Each Other, ed. Raoul Blindenbacher and Arnold Koller. Montreal and Kingston: McGill–Queen’s University Press.
———. 2004. “Fiscal Decentralization in Developing and Transition Economies. Progress, Problems and the Promise.” Policy Research Working Paper 3282, World Bank, Washington, DC.
———. 2007a. “Institutional Arrangements for Intergovernmental Fiscal Transfers and a Framework for Evaluation.” In Intergovernmental Fiscal Transfers: Principles and Practice, ed.
Robin Boadway and Anwar Shah, 293–318. Washington, DC: World Bank.
———. 2007b. “A Practitioner’s Guide to Intergovernmental Fiscal Transfers.” In Intergovernmental Fiscal Transfers: Principles and Practice, ed. Robin Boadway and Anwar Shah, 1–54. Washington, DC: World Bank.
Tsui, Kai-yuen. 2005. “Local Tax System, Intergovernmental Transfers and China’s Local Fiscal Disparities.” Journal of Comparative Economics33: 173–96.
Zhang, Zhihua, and Jorge Martinez-Vazquez. 2003. “The System of Equalization Transfers in China.” Working Paper 03-12, Andrew Young School of Policy Studies, Georgia State University, Atlanta.
The Reform of Intergovernmental Fiscal Relations in China:
Lessons Learned
JIWEI LOU
A
significant feature of China’s economic reform, which began in 1978, is the devolution of the central government’s control over the economy to subnational governments. The fiscal system has been decentralized across five levels of governments—national, provincial, municipal, county, and township—categorized broadly as center, provincial, and local governments (all subprovincial governments).Changes in public finances were heralded by shifts in revenue bases: the system of 100 percent taxation of (largely) state-owned enterprises (SOEs) was gradually replaced by a modern system of corporate taxation in line with international norms, leading to a precipitous decline in both total government revenues and the central government’s share of revenues (Ahmad, Keping, and Richardson 2002). Throughout the 1980s, the inability of the central government to cut spending as revenue declined created persistent budget deficits, which contributed to mounting infla- tionary pressures. Reforms also led to the shedding of several social functions, which expanded expenditure responsibilities for SOEs (Wong 1991). The central government also responded to fiscal pressure by attempting to devolve expenditure responsibilities to lower levels of government, which also faced considerable fiscal pressures. The result was complex bargaining among different levels of government over sharing schemes (sharing rates and period). The resulting fiscal pressures created by the contract system of the 1980s led to undesirable responses by subna- tional governments, which diverted resources from budgetary to extrabudgetary channels; duplicated industries to capture revenues that formerly flowed to the national treasury; granted generous tax concessions to local SOEs under their juris- dictions; and expanded local bank lending to these SOEs.
This chapter outlines some major economic and administrative mechanisms that affect intergovernmental fiscal relations. The next section briefly describes the evolution of China’s intergovernmental fiscal relations in the reform period. The second section discusses the improvement of the transfer payment system. The third section identifies the major policy lessons learned.