This is a welcome measure, as it helps protect the incomes of the lower-income segments of the population. Consideration might be given to adjusting it in line with inflation in order to prevent its erosion in real terms over time.
Finally, reform of the personal income tax could have important intergovern- mental implications, not so much because it is a shared tax (as its yield currently remains limited) but because limited tax policy powers on personal income tax could be devolved to the provinces.18In particular, provinces could be allowed to provide a supplemental basic monthly allowance tied to certain objectives and transparent provincial economic indicators; they could also impose provincial personal income taxes that piggyback on the national rate structure. The central government could prescribe limits on either measure. As provinces would be expected to bear the revenue consequences of their own discretionary policy actions, these changes should carry no implications for the way in which the revenue from personal income is divided between the central government and provincial governments.
Other Taxes
There is scope for introducing new taxes and rationalizing existing ones. As China’s economy grows, environmental considerations should be built into the design of its tax system. China’s current level of excise taxes on vehicles and petroleum products, which are low by international standards, should be reassessed.19Real estate taxes should also be rationalized, on the basis of a unified conceptual and valuation frame- work; along with the possible piggybacking on the personal income tax mentioned above, these taxes could prove valuable tax handles for local governments (Ahmad 2006). More generally, the appropriate design of local taxes, including bounded local control over rates, should be high on the reform agenda.
These reforms would help make the tax system more transparent and efficient.
They would also contribute to ensuring an appropriate level of resources for the government to fulfill its development and redistribution objectives. In this con- nection, it has also been increasingly advocated that SOEs, which currently do not pay dividends to the government, start doing so.20In addition to reducing the pro- cyclicality of investment financed by retained earnings, dividends paid to the budget could help fund a stronger social safety net, particularly for rural households.
Such a measure could reduce the incentive for households to save, thereby boost- ing consumption—objectives that are in line with the government’s new growth strategy. More generally, it would contribute to offsetting possible revenue losses associated with some of the reform options identified above.
Some Issues Affecting Expenditure Policy Reform
macroeconomic perspective on expenditure policy reforms and puts forward some general considerations to help frame the debate on these issues. It does not cover specific sectoral issues.
Insufficient provision of social services is among the factors driving households’
sizable precautionary savings in China. The limited coverage of the pension system, as well as the high cost of health and education, has led households to build up savings to “insure” against expenses related to these services (Prasad and Rajan 2006). Strengthening the provision of social services would address both equity and macroeconomic concerns.
In terms of expenditure mandates, China is one of the most decentralized countries in the world. Subnational spending in China represented more than 70 percent of total government spending during the 1990s, a much higher per- centage than the 32 percent in OECD countries, 26 percent in transition economies, and 14 percent in developing countries (Wong 2005). China stands out for relying almost entirely on local governments to provide health care and education, areas in which local governments account for 90 percent of govern- ment expenditure (table 4.5).
Health Care and Education
China’s subnational expenditure mandates in the social sectors are the legacy of the industrial restructuring process, in which responsibilities for education, health care, and pensions were shifted from SOEs to local governments. However, local authorities were not provided with adequate resources to fulfill their new respon- sibilities. The most glaring result of these actions is that the provision of public services is uneven and suffers from significant shortfalls in rural and inland areas.
Partly because of local governments’ financing constraints, China’s government sector today spends much less on health and education than comparator countries (table 4.6).21 Public spending on education remains below the government’s objective of 4 percent of GDP, which according to the 10th Five-Year Plan (2001–05), was to be achieved by the end of 2005. Moreover, a comparatively large share of such spending is channeled to tertiary education (OECD 2006).
Public spending on health has declined over the past decade, mainly as a result of the 1996 reform aimed at establishing a market-based system. The drop has not only resulted in a sharp increase in out-of-pocket spending, it has also led to a decline in health insurance coverage.22Privately provided services have proved expensive.
As a result, the share of out-of-pocket spending reached almost 60 percent of total spending on health care by the end of 2003, up from 20 percent in 1978 (see chapter 12 of this volume). At the same time, total spending on health care increased from 3 percent of GDP in 1978 to about 5.5 percent in 2003 (Ministry of Health 2006).
In rural areas, efforts have been made to provide health insurance through the rural cooperative system. This system, created in 2002, largely replaced an older scheme funded by farmers’ contributions, which had become unsustainable.
Under the new system, rural cooperatives are supported by government transfers as well as private voluntary contributions. By the end of 2005, nearly 24 percent of counties were covered, including 236 million farmers (179 million of which participated in the scheme). About Y11.5 billion had been raised and nearly Y9 billion of benefits paid out. The central government and local governments doubled their per capita contributions beginning in 2006, to Y20 each, while the contri- bution paid by farmers has remained unchanged at Y10 per capita.23However, these contributions—of about $5 per capita per year—have not proved sufficient to cover services so far.
Public spending on education, although growing, remains inadequate. Limited public funding has led to a shift of financing responsibilities to families. It is
Table 4.5 Shares of Central and Local Government Spending, by Expenditure Category, 2004
Spending assignment Central Local government governments (percentage of (percentage
central and of central and Percentage local government local government Percentage of total
Expenditure category spending) spending) of GDP spending
Education 6.1 93.9 2.3 12.7
Health 2.6 97.4 0.5 3.0
Agriculture 8.5 91.5 1.0 5.9
Social relief 1.4 98.6 0.3 2.0
Social security 12.6 87.4 1.0 5.4
Pensions 9.4 90.6 0.6 3.6
Tax administration 9.5 90.5 0.7 3.9
Administration 17.4 82.6 1.5 8.6
Technical transformation
and science 22.3 77.7 0.8 4.3
Interest payments 100.0 0.0 0.5 2.6
National defense 98.7 1.3 1.4 7.7
Capital spending 39.5 60.5 2.1 12.0
Urban maintenance
and construction 0.0 100.0 0.7 3.7
Other 14.4 85.6 1.3 7.2
Subtotal 25.7 74.3 14.7 82.6
Total expenditure 27.8 72.2 17.8 100.0
Source:Authors’ calculations, based on data from National Bureau of Statistics 2005.
Note:Figures are based on classifications by the Chinese authorities. No economic classification is available.
Expenditure
reported that 20–25 percent of operational expenses are shouldered by schools directly, based on contributions from families; these contributions reportedly increased from 0.5 percent of GDP in 1993 to 1.75 percent of GDP in 2001.
While central transfers to western regions and poor areas have been significantly increased since the late 1990s, inadequate funding remains a major obstacle to achieving universal compulsory education.
The Chinese government has recently launched new programs to ensure free compulsory education and strengthen the provision of health insurance in rural areas.
These programs are being implemented by a number of local governments and are slated to be scaled up nationwide over the next few years. Preliminary results are encouraging. However, there is a need to adopt a comprehensive strategy that goes beyond the programs’ limited sectoral scope toward broad-based reforms that would replace the current piecemeal approach to social programs. The government’s own estimates indicate that these programs are quite affordable. For example, providing free compulsory education in rural areas nationwide has been estimated to cost some Y220 billion over the 2006–10 period, equivalent to 1 percent of 2006 GDP.
In addition to limited funding, capacity constraints may hinder implementation of these programs. Some local governments are experiencing a lack of qualified staff to manage and carry them out. While financial support from the central govern- ment is necessary for program success, it is nonetheless not sufficient, unless accom- panied by measures to ensure that funds are properly spent, including strengthening budget execution and reporting and introducing performance indicators.
Table 4.6 Spending on Education and Health in Selected Economies, 2004
(percentage of GDP)
Economy Education Health
OECD
Australia 4.8 6.4
Japan 3.7 6.4
Korea, Rep. of 4.6 2.8
New Zealand 6.9 6.3
Non–OECD
Brazil 4.1 3.4
China 2.3 0.5
Hong Kong (China) 4.7 n.a.
India 3.3 1.2
Indonesia 0.9 1.1
Philippines 3.2 1.4
Russian Federation 3.7 3.3
Singapore n.a. 1.6
Thailand 4.2 2.0
Source:UNESCO Institute for Statistics 2006; WHO 2006.
n.a. Not applicable.
The Pension System
China’s current state pension system, which reflects reforms started in the mid-1990s, is based on three pillars: a mandatory defined benefit base pension, a largely mandatory funded individual account, and a funded voluntary supplementary pension. The first two components make up the so-called basic pension system, which is intended to cover all urban workers and is managed by government agen- cies rather than individual enterprises.
In contrast to international practice, the provision of social security (in particular pensions and unemployment insurance) is assigned to lower levels of government in China. Both efficiency and risk-pooling considerations would call for these programs to be undertaken by the central government. Pension pooling in China (as well as the establishment of unemployment insurance funds) takes place at relatively low levels of government, such as cities and counties.24These arrange- ments do not ensure appropriate coverage, and they have put significant strain on local governments’ finances. In addition, the highly decentralized and fragmented nature of the pension system impedes labor mobility, allows discretionary policies to proliferate, hinders resource sharing, and creates perverse incentives for false reporting to maximize subsidies from higher government levels.
The underfunded transition from the old to the new pension system has given rise to a number of problems. Contributions rates are high, because liabilities under the old system are paid by contributions under the new system. As a result, some employers have found these rates unaffordable, leading to low compliance. In addition, the individual accounts have been notional, as funds accumulated in these accounts have been used largely to fund liabilities under the old system.
Finally, the insufficient level of pooling has resulted in uneven contribution and benefit levels across the country.
In an attempt to address these shortcomings, a pilot pension reform was imple- mented in the northeast provinces in late 2000. The pilot introduced a number of changes. First, the base pension fund and individual accounts were separated, chang- ing the individual accounts from “notional” to actually funded accounts. Employers’
contributions are channeled into the base pension, while employees’ contributions fund only the individual accounts, which are portable. Base pension and individual accounts are managed separately, with individual accounts managed at the provincial level and their investment restricted to Treasury bonds. Second, incentives have been introduced to induce workers to postpone retirement by increasing benefits gradu- ally for each extra year of paid contributions, up to a cap. Third, the coverage of the pension system has been widened to include rural contractual workers, the self- employed, and employees of private firms (civil servants remain under the old sys- tem). The measures relating to the individual accounts were extended to an additional eight provinces in 2006, and new formulas for the base pension were implemented.
Despite these recent reforms, pension coverage remains limited. At the end of 2004, the pension system covered about 123 million urban workers, or 46 percent of the urban workforce. In contrast, only about 54 million rural workers, or 11 percent of the total rural workforce, participated in the pension schemes set up for rural areas.
For the country as a whole, about 750 million, or 23 percent of the working population, had pension coverage (Deutsche Bank Research 2006).
The sustainability of the pension system over time is far from ensured, largely because of China’s rising dependency ratio, which is projected to increase from 34 percent in 2005 to more than 50 percent by 2015 and 100 percent by 2035;
increasing early retirement (workers are often induced to retire early to create job opportunities for new job entrants); the fragmentation of the risk-pooling system;
and the poor financial returns on the accumulated pension funds (Sin 2005). In addition, under the current system, individual accounts would be depleted about 10 years after retirement, as fixed annuities are equivalent to 120th of the accu- mulated funds. The World Bank estimates the government’s implicit pension debt at about 140 percent of 2001 GDP, with a financing gap of about 95 percent of 2001 GDP (Dorfman and Sin 2001; Sin 2005).25While China’s implicit debt may be lower than in many OECD countries, this largely reflects the fact that China’s pension system covers only about 20 percent of the workforce while pension systems in OECD countries cover about 90 percent.
A number of parametric changes could significantly reduce the financing gap.
These include gradually increasing the retirement age to 65, paying out individual accounts using annuities calculated based on life expectancy at retirement, and indexing base and individual account pensions to consumer prices instead of wages. Any remaining financing gap could be filled by sources other than payroll contributions, such as privatization proceeds.
The lack of effective pooling at the provincial level means that even if the basic pension funds are in overall balance (or even in surplus) at the provincial level, each province would have to finance the pension funds in deficit at lower levels (municipal or county). Currently, some of the burden on provinces is met by transfers from the central government. At a minimum, provincial-level pooling should be implemented. Ultimately, national pooling would offer additional benefits, because the provincial funds in surplus could be used to cross-subsidize the funds in deficit, thereby reducing the fiscal burden on the deficit provinces and eventually on the national government.26China’s rapidly aging population means that some provinces will move sharply into deficit in the next few decades.
For this reason, over the longer term, national-level pooling is desirable.