The emphasis on transparency is critical to ensure that the available tax instru- ments are utilized effectively in establishing a proper competitive environment for subnational operations.
to the system were inadequate to make any significant equalization impact. In such a mechanism, any change in the capacity of a province to mobilize revenue would be picked up in the formula and the amount of transfers modified accordingly. A more targeted compensation system could hence be provided, adequately com- pensating the provinces facing revenue shortfalls as a result of tax reform.14
This redesigned transfer system would have the potential to achieve more effective redistribution, but it could probably not do so in isolation. Other meas- ures would be needed to convince richer provinces to give up their revenue returned and accept a more redistributive system. Such a comprehensive reform package would include a joint reassessment of expenditure responsibilities together with revamped revenue assignments, as well as more transparent access to capital markets and enhanced governance.
Currently, almost all tax rates and bases are set by the central government, even for taxes for which all revenues go to local governments. Tax reforms are needed to provide provinces and counties with some control over rates of assigned taxes at the margin. This is a key element of fiscal accountability. The choice of taxes should be such as not to lead to excessive economic distortions or tax competition.
There are strong arguments for standardizing the base for the personal income tax. However, bounded control over a number of percentage points for provinces (piggybacking) should provide them with much greater room for maneuver. Such reforms would also provide significant revenues to the more advanced coastal provinces, thereby reducing the political pressures for returning revenue. More extensive use of property taxes at the county-level, including enhanced valuation and recording mechanisms for leasehold properties, and basing annual taxes on the annual lease value equivalent should also be considered.
Poorly designed transfers can obviate any incentive to utilize own-source revenues. The absence of proper own-source revenue handles can shift the responsibility for poor service delivery to higher-level governments, creating the dynamic accountability problems described above.
These reforms form part of an extensive and interlocking package of measures that will take several years to implement fully. China cannot move on all these fronts simultaneously and rapidly. Although the pace of the reforms may be gradual, the scope should be comprehensive. The design of the overall reform package should be both internally consistent and consistent with the overall goals of the process.
Notes
This chapter draws on joint work with Raju Singh of the International Monetary Fund and Benjamin Lockwood of Warwick University. Helpful comments from Annalisa Fedelino are acknowledged.
1. In China, the term local governmentis taken to represent all levels of subnational adminis- tration, including provinces and municipalities, counties, and other lower levels.
2. “Fiscal dentistry” has been common in South Asia (Rao 2002).
3. The enterprise income tax on foreign companies was also subjected to the 33 percent tax rate, but investment incentives reduced the effective tax rate to 15 percent or less (for a description of the rate structures for domestic and foreign enterprises, see Ter- Minassian and Fedelino 2006).
4. The discussion in this and the following section draws on Ahmad, Lockwood, and Singh (2004).
5. Figure 6.2 shows a realistic case of 50 percent collection efficiency, but the picture is similar in the other polar case of 100 percent collection efficiency. Note also that three outlying provinces are responsible for the inverted-U- shape. If these provinces are excluded, the richer provinces would be seen to lose more than the poorer ones.
6. Generally, the new rate is equal to 0.25 times 134.17/(134.17 – X), where Xis the revenue gain/loss in billions of yuan.
7. In 2001 the financial and insurance sectors accounted for 28 percent of the business tax proceeds.
8. In terms of the Chinese classification of national income, the service sectors added to the VAT base are services to farming, forestry and fishery, geological prospecting and water conservancy, transport, storage, post and telecommunications services, real estate, and other services, as well as one-third of social services, health care, sports and social welfare, edu- cation, culture, arts, radio, film and television, scientific research, and polytechnic services.
9. Let Ri denote the business tax revenue in province i. Then ai= lsifor province i, where si is the share of insurance and finance in province i, and Solving these equations for land substituting back into
the first equation yields
10. Of course, when the VAT share of 25 percent is included, a province receives 25 percent plus the incremental tax share.
11. The extremely high figure for the United Kingdom reflects the facts that property tax is the only source of revenue for local government and a large part of the property tax on commercial property (the Uniform Business Rate) accrues to the central government.
12. The average price per square meter for the sale of land-use rights in China rose from Y223 in 1987 to Y1,279 in 1996 (Ding and Knaap 2001).
13. Separate operating and settlement arrangements are in place for off-budget funds.
14. Ahmad, Singh, and Fortuna (2004) discuss this option in greater detail.
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a s
s R
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i i i
=0.28 /
∑
.∑
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∑ ∑
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Part III
Intergovernmental Relations and
Fiscal Transfers
Fine-Tuning the Intergovernmental Transfer System to Create a Harmonious Society and a Level Playing Field for Regional Development
ANWAR SHAHANDCHUNLI SHEN
Get at the root of the problem while solving current issues.
—Chinese proverb
C
entral-provincial and provincial-local fiscal transfers are the dominant source of revenues of subnational governments in China. In 2003 they financed 67 percent of provincial, 57 percent of prefecture, and 66 per- cent of country and lower-level expenditures (Qiao and Shah 2006). Most service delivery responsibilities are assigned to subnational governments in China, but for reasons of efficiency in tax collection and administration, the central government collects revenues far in excess of its expenditure needs. In 2003 the central gov- ernment collected 70 percent of consolidated revenues but spent only 30 percent of consolidated expenditures. The fiscal surplus of the central government enables it to use its spending power to influence local priorities and provide financing to subnational jurisdictions for the achievement of national objectives.This chapter examines the incentives associated with the design of such transfers and their implications for the efficiency and equity of public service provision and accountable local governance. The next section presents an overview of the structure of central-provincial fiscal transfers. The second section describes provincial-local transfers. The third section examines the economic impact of these programs. The fourth section highlights conceptual and practical consider- ations in designing fiscal transfers. The fifth section reviews the existing structure of intergovernmental transfers. The last section presents plausible reform options for the existing system of fiscal transfers to further national objectives.