the delivery of a particular service. Underprovision of services is more likely in the presence of extensive concurrent responsibilities.
While there are some broad divisions, such that only the central government and provincial governments tend to run higher education institutions and profes- sional and technical education is managed by the provinces and some cities, all levels of government run high schools and primary schools. In practice, expenditure responsibilities tend to be divided by “ownership” of assets: a school set up by the county is financed from county funds, while one set up by the township is financed from the township budget.
The lack of explicit assignments has also created considerable murkiness regarding which level is responsible for financing these expenditures or how these financing responsibilities are divided. This has facilitated the convenient offloading of respon- sibilities down the hierarchical structure of government. In education, for example, despite their inadequate resources, counties have been called on to finance basic education reform; some of these upper-level government measures can be perceived as unfunded government mandates.
Lack of Efficient Expenditure Assignments
Several current expenditure assignments are problematic. The most conspicuously inappropriate assignment is the responsibility assigned to city- or county-level governments for pensions, unemployment, and income support schemes. These assignments are replicated almost nowhere else in the world; in most countries, these programs are central government responsibilities.
Either provincial or national pooling would seem the correct approach to the assignment of these services, as these types of social security schemes require a level of risk pooling and redistribution that cannot be matched at the level of county governments.11 In terms of redistribution, poor communities with the highest needs are also least financially able to fund these expenditures. The inability of many local governments to finance the social safety net has led in recent years to widespread pension arrears and defaults that have forced the central government to intervene with subsidies.
basic public services, improve the accountability of public officials to residents, reduce government encroachment in the private sector, and help address vertical and horizontal fiscal disparities.
In the past two decades, China has made very considerable progress in separat- ing government from SOEs and redefining the functions and responsibilities of government in the economy. Significant problems from an expenditure assignment perspective still remain, however. In particular, a stable and transparent expenditure assignment at all levels of government emphasizing exclusive rather than concurrent responsibilities is desirable.12
Practice can substitute for explicit legal assignments, but young decentralized countries such as China can avoid these costly transactions through more explicit and clear assignments.13When concurrent responsibilities are needed or desirable, these assignments should be clarified by explicitly assigning the array of attributes that go with each concurrently assigned function, including actually producing a good or delivering a service; providing or administering the service; financing the service; and setting standards, regulations, and policies guiding the provision of government services. In addition to clarifying assignments, it is important to enhance coordinating institutions across levels of government to address different interpretations and conflicts arising from concurrent assignments.14
Reassign Selected Expenditure Responsibilities
The financing and provision of social security services (pensions, disability and survivor benefits, and unemployment) should be recentralized, at the provincial or central government levels. The recent policy measures assigning more responsibility for social security to the central government represent steps in the right direction.
Address Fiscal Disparities and Ensure That All Citizens Have Access to Basic Public Services
Addressing fiscal disparities will require significantly enhancing the role of equaliza- tion grants in the current intergovernmental system. This will require an increase in the pool of funds dedicated to equalization, the consolidation of many small transfers with equalization objectives, and adoption of a distribution formula that takes into account fiscal capacities and expenditure needs. At the subcentral level, clear guide- lines for the provinces and counties (if applicable) need to be legislated to introduce sufficient funding for equalization grants for the governments immediately below and distribution formulas that capture, to the extent the data allow, differences in fiscal opportunity and expenditure needs of their subordinate local governments.
A small set of conditional sectoral grants may also be considered in order to guarantee some minimum standards of service throughout China. In this regard, it may be worth considering the use of national minimum standards for basic public services and the use of conditional grants to ensure that all subnational governments
have the means to finance them. These standards could include items such as nine years of compulsory education, access to basic hygiene and medical treatment, basic unemployment compensation, survivor and dependent insurance, and essential communal facilities.
Some countries differentiate in the assignment of expenditure responsibilities to subnational governments between “delegated” and “own” responsibilities. In the case of delegated responsibilities, the central authorities have the right to reg- ulate and monitor the delivery of services at the subnational level but also the obligation to ensure financing and administrative capacity of subnational governments. While the use of national minimum standards for basic public services would help reduce regional disparities and enhance the country’s cohe- siveness, they would also reduce the autonomy of subnational governments. If the introduction of national minimum standards is the direction adopted, these measures should be preceded by revamped national sectoral policies in the affected sectors.
Improve Accountability and the Quality of Local Expenditure Management
The accountability of subnational government officials to local residents is weak;
the direct appointment of officials tends to make them accountable largely to gov- ernment authorities at higher levels. The system needs to introduce adequate accountability mechanisms to provide incentives to subnational governments to properly weigh spending on economic development and construction and other public services, especially social services. In addition to local elections, various approaches, such as reforming the system of residential status to improve mobility, could be explored to better empower communities.
Notes
1. See, for example, Zhang and Zou (1998); Jin, Qian, and Weingast (1999); Lin and Liu (2000); and Qiao, Martinez-Vazquez, and Xu (2005).
2. For similar warnings on the potential failures of decentralization policies, see Prud’homme (1995) and Tanzi (2000).
3. On local elite capture issues, see the discussion in Bardhan and Mookherjee (2000) and Bardhan (2002). On local versus central government corruption, see Tanzi (1995); Prud’homme (1995); Bardhan and Mookherjee (1998, 1999); Besley and Coate (1999); Brueckner (1999); and Treisman (1999a, 1999b, 1999c).
4. This is not a well-researched area in China’s fiscal federalism. For a case study of several local governments that highlights the importance of the lack of accountability at the local level, see Wang (2002).
5. Before the reforms of the mid-1980s, the government determined both the fiscal expenditures and the expenses of SOEs.
6. The contributions of both the central government and subnational governments increased to Y20 in 2006.
7. Press Conference of Premier Zhu Rongji in the Fourth Session of the Ninth National People’s Congress, People’s Daily, March 16, 2001.
8. Borrowing from the central government is significant. Subnational governments’ debt with the central government was estimated at $1.2 billion in 2005, representing 12 per- cent of total government debt that year.
9. This reform began in 2001, with the “Notice on Issues of Fiscal Treasury Management Reform,” issued by the State Council, and “Experimental Methods on Fiscal Treasury Management Reform,” issued by the Ministry of Finance and the central bank.
10. For other factors, see World Bank (2005).
11. See, for example, Ahmad (1995) and the references therein.
12. In many decentralized countries, including Australia, Brazil, Canada, the Russian Federation, and the United States, many responsibilities are assigned exclusively to local governments.
13. This is precisely what the Russian Federation attempted to do in the comprehensive Budget Code of 2002, although it fell short of achieving this aim.
14. Australia, Canada, and New Zealand use periodic formal meetings of elected officials and bureaucrats at different levels to discuss mutually important expenditure assign- ments and other fiscal issues.
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Taxation Reforms and the Sequencing of Intergovernmental Reforms in China:
Preconditions for a Xiaokang Society
EHTISHAM AHMAD
T
he Chinese authorities place great emphasis on the precepts of a Xiaokang society (a “well-rounded society with broad prosperity”), to ensure that the benefits of growth and development are shared with the disadvantaged members of society and with poorer regions with limited resources and capabilities.The concern with growth and distribution needs to be linked to the mechanisms to finance the needed spending, principally taxes but also shared revenues, transfers and borrowing. This chapter examines the context and interactions between tax reforms, revenue assignments and transfers, and access to capital markets with a view to establishing key principles and areas of work consistent with the medium- term perspective of the Xiaokang society, also enshrined in the government’s goals for 2020.
The intergovernmental reforms of the 1980s have been described as an example of “market-preserving” federalism (Montinola, Qian, and Weingast 1995; Qian and Weingast 1997). The growth response was spectacular, but local governments1 had incentives to minimize upward transfers to the center, and there was an expansion of off-budget revenues that were not shared. Together with the decline in total budget revenues because of the transition from a system based on profit transfers from state-owned enterprises, there was a precipitous drop in the revenues accruing to the central government (Ahmad, Li, and Richardson 2002;
chapter 3 in this volume). This led to severe constraints on the ability of the central government to pursue macroeconomic and redistributive policies. The initial positive aspect of the informal retention of revenues by local governments has become an impediment to deeper enhancements of market-based governance and the achievement of the objectives of the Xiaokang society.
6
The 1994 tax and revenue-sharing reforms laid the foundations of a modern tax system, with the establishment of the State Administration of Taxation, responsible for the collection of central and shared taxes. In addition, there have been continuing efforts by the authorities to make the budget system more transparent, with a rationalization of off-budget resources, and gradual requirement that all funds pass through treasury single accounts (TSAs), ensuring fuller disclosure of all financing.
This has fundamentally changed the nature of the intergovernmental system which had been based on upward-revenue-sharing arrangements.
While the reforms nominally took the central government’s share of increas- ing total revenues to around 55 percent (one of the main objectives of the exer- cise), the center’s effective room for redistribution remains severely constrained.
There is an unfinished tax reform agenda, aimed at creating production efficiency and a level playing field for the operation of market-led investments. The tax reforms also have to be assessed in terms of their distributional impact subject to administration constraints. The interactions between the tax reforms and transfer design are also critical. Similarly, completion of the agenda of enhanced subnational public financial management—including better-ordered, better-regulated, and transparent access to capital markets—is needed in order for the incentives for improved subnational governance to operate effectively. These are preconditions for the development of a harmonious society.
The creation of a level playing field involves the completion of the reform agenda for the value added tax (VAT) and income tax (both personal and corporate). Continuation of the VAT reforms (moving to a consumption base and expanding coverage of services) and reform of the income tax (addressing coverage as well as authority to set rates) will have an impact on subnational (termed local in China) revenue sources. In addition, there is an agenda for local taxation reforms. A critical deficiency of the current tax system, albeit consistent with China’s unitary constitution, is that local governments have little discretion over the setting of rates of subnational taxes. This precludes the establishment of hard budget constraints for lower levels of government or creation of incentives to manage their resources or spending efficiently. Thus, there is a weak basis for local government accountability. Despite the efforts to create provincial TSAs, remain- ing weaknesses in public expenditure management processes and incomplete information and the proliferation of informal effective local financing arrange- ments (through numerous fees and charges and indirect borrowing, for example) have now become a positive impediment to the creation of a harmonious society.
This chapter examines the sequencing of intergovernmental tax reforms in order to establish key principles and policy recommendations consistent with the medium-term perspective of the Xiaokang society, enshrined in the government’s goals for 2020. The next section assesses the 1994 reforms and makes the case for further consolidation and reform of the tax system as part of a consolidated effort to deepen fiscal reforms. The second section examines the main central and shared taxes (the VAT, the personal income tax, and the corporate income tax). The third section looks at subnational (local) taxation in China, examining the interlinkages
between these reforms and the system of intergovernmental transfers. The last section summarizes the recommendations for reform.