between these reforms and the system of intergovernmental transfers. The last section summarizes the recommendations for reform.
Attempts by the central government to use specific-purpose transfers to address basic spending responsibilities also blur local responsibilities for such spending.
There are also considerable monitoring and implementation difficulties, given the constraints on information flows on subnational operations. Although the budget law prohibits direct borrowing and guarantees by local governments, ambiguity permits agencies or enterprises of local governments to borrow, often on behalf of local governments. Some of the gray elements of the “market-preserving federal- ism” of the early period, which facilitated the initiation of the growth process, now create uncertainties and risks. Greater clarity over the ground rules is needed to continue to provide incentives for sustainable growth in conjunction with creat- ing the basis for a Xiaokangsociety.
It is useful to examine some of the methodological issues that might be con- sidered in establishing a road map for tax reforms at the central and subnational levels in China. This discussion draws on the literature of optimal taxation and desirable directions of reform, as well as more recent developments in inter- governmental finance. Interactions between central tax reforms and the revenue shares accruing to local governments are stressed. Although personal income taxes are one of the fastest-growing sources of revenue, given the increasing incomes of the Chinese population, collections are still relatively small. The focus is therefore on the VAT. Some options are presented for reforming local
Figure 6.1 Central, Local, and Total Government Revenues, 1980–2005
0 5 10 15 20 25 30
1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004
Percentage of GDP
20 25 30 35 40 45 50 55 60
Percentage of total revenue
Total revenue
Central government revenue
Local government revenue
Source:Ministry of Finance various years; chapter 4 of this volume.
Note:Total and local government revenues are measured as percentages of GDP, along the left-hand axis. Central government revenue is measured as a percentage of total revenue, along the right- hand axis. For comparability with older data, the official definition of revenueis used.
taxation to strengthen local accountability and enhance competition in the short to medium term.
Principles Underlying Tax Reforms
It is useful to examine welfare-improving reforms in tax systems in terms of rev- enue implications as well as distributional effects, production efficiency, and administrative constraints (Ahmad and Stern 1991). While theory and empirical work suggest that a degree of differentiation in the tax element in the price of goods is likely to be welfare improving, a single-rate VAT is strongly preferred to a complex, multiple-rate VAT, which is difficult to administer (Ebrill and others 2001). However, the insights from Ahmad and Stern continue to apply, and it is useful to examine jointly the complete set of indirect tax instruments, particularly VAT and excise taxes. A judicious combination of a single-rate, consumption- based VAT and excises can move in the right direction.
Much of the contribution of the personal income tax to the desired distribu- tional considerations comes from the initial exemption limit. A relatively small number of bands is needed for distributional purposes. A similar principle can be applied to the taxation of agricultural land and urban property. The exemption limit not only serves the distributional objective, it also simplifies the work of the tax administration, although vigilance is required (by cross-checking information from various sources, for example) to guard against tax evasion or misrepresenta- tion of property values.
It has long been recognized that the corporate income tax (also known as the enterprise income tax [EIT]) does not need to be set at different rates or differen- tiated by types of ownership (foreign or domestic) or by lower levels of govern- ment. The Chinese approach to achieving uniformity of the EIT has been expedient and gradual, driven by the very practical desire not to create major perturbations in the resources accruing to different levels of government.
Many of the principles underlying tax reforms were enunciated as the driving force behind the 1994 tax reforms (Xu and Lin 1995). Implementation has been gradual, however, and complicated by detailed intergovernmental considerations superimposed on each tax. The resulting tax system is overly complex, lacks trans- parency, and does not meet its full potential of providing incentives to local government. A significant reform agenda thus remains.
Subnational Taxation
Two different approaches underpin the issue of tax assignments to different levels of government (see Ambrosanio and Bordignon 2006 for a comprehen- sive review). The normative approach follows the tradition of Musgrave (1961) and Oates (1972); the public choice approach builds on Brennan and Buchanan (1980).
The normative approach relates tax assignments to the optimal spending functions of each level of government. As redistribution and macroeconomic stabilization are typically central responsibilities, the theory suggests that pro- gressive income taxes and the corporate income tax should also be assigned to the center. Benefit taxation is generally recommended in relation to the allo- cation function to be shared by the central and local governments. This approach also recommends that local governments should tax immobile bases or assets to prevent tax competition; tax bases that are evenly distributed, to avoid exacer- bating horizontal inequalities; and use taxes that have a stable yield to facilitate expenditure planning. It has been criticized for assuming that governments are benevolent and maximize social welfare and for ignoring political power and bargaining.
The positive approach models political power and incentives. It recommends broad tax bases to minimize tax evasion, with higher rates imposed on less-elastic bases. This approach stresses the benefits of tax competition among local govern- ments as one of the constraints on government size and rapaciousness, thus sug- gesting that subnational taxes be levied on mobile tax bases. It has been criticized on the grounds that local tax competition can lead to allocative distortions and beggar-thy-neighbor policies.
More-recent political economy models stress the importance of taxation as a source of finance for local governments, in order to generate “yardstick competi- tion” (see Besley and Coate 2003; Lockwood 2006). Such taxation helps focus the attention of citizens on the efficiency of resource use within their jurisdictions.
Although China is a unitary state, its size and complexity suggest that the experi- ences of large federal countries may be relevant (tables 6.1 and 6.2).
Table 6.1 Sources of Tax Revenues of Local Governments in Selected Federal Countries, 2001
(percentage of total revenue)
Income Taxes on
tax and General specific Taxes on
tax on Payroll Property consumption goods and use and Other
Country profits tax tax tax services so forth taxes
Australia 0 0 100.0 0 0 0 0
Austria 37.7 19.1 10.0 22.7 3.8 1.7 5.0
Belgium 85.8 0 0 1.4 7.9 4.6 0.3
Canada 0 0 91.6 0.2 0 1.6 6.5
Germany 77.1 0 16.6 5.2 0.5 0.4 0.2
Mexico 0 0.1 88.5 0 1.9 0.9 8.6
Switzerland 83.1 0 16.6 0 0.2 0.1 0
United States 6.2 0 71.5 12.4 5.1 4.8 0
Source:Ambrosanio and Bordignon 2006.
There is consensus that own-taxes are needed at the subnational level. This need is highlighted in a dynamic context, in order to enforce a hard budget constraint at the subnational level. Central governments can create soft budget constraints by providing transfers to meet local budget deficits or bailing out local governments.2A hard budget constraint that affects local government behavior is not credible without the presence of own-tax revenues, which force local governments to meet additional spending out of own resources. A corollary is that even with own-source revenues, local governments may not have an incentive to use them if the center designs gap-filling transfers or engages in debt bailouts.
There are degrees of local taxation. At one extreme is revenue sharing as prac- ticed in China, in which local governments have no control over rates or bases.
The revenues shared on a derivation base could be approximated by transfers whose magnitude is determined by formula. If the revenues are transferred on a redistributive basis, for example, using equalization criteria, revenue sharing is
Table 6.2 Sources of Tax Revenues of Local Governments in Selected Unitary Countries, 2001
(percentage of total revenue)
Income tax Income tax Taxes Taxes
and tax on and tax General on specific on use profits on profits Property consumption goods and and so Other Country (individuals) (corporate) tax taxes services forth taxesa
Denmark 91.1 2.2 6.6 0 0 0 0
Finland 78.6 16.9 4.3 0 0 0 0.2
France 0 0 49.1 0 7.6 3.4 39.8
Greece 0 0 56.2 2.8 23.1 17.9 0
Hungary 0.8 0 22.2 71.1 1.0 4.5 0.4
Iceland 80.4 0 12.4 7.2 0 0 0
Ireland 0 0 0 100.0 0 0 0
Italy 8.8 0 18.0 0 8.7 10.6 53.9
Japan 47.5 27.4 31.1 7.0 8.1 5.4 1.0
Luxembourg 0 92.6 5.8 0 1.0 0.2 0.3
Netherlands 0 0 57.5 0 0 42.5 0
Norway 90.6 0 7.5 0 0 1.8 0
Portugal 22.4 7.9 44.3 17.3 12.3 3.3 0.3
Spain 25.3 21.9 37.4 11.7 9.9 13.7 1.9
Sweden 100.0 0 0 0 0 0 0
United 0 0 99.9 0 0 0 0.1
Kingdom
Source:Ambrosanio and Bordignon 2006.
a. Other taxes include taxes on net wealth (Norway); estate taxes (Finland and Portugal); and some residual taxes, mainly on business (France and Italy).
indistinguishable from equalization transfers. Shared revenue seldom qualifies as own-revenues in the sense described above, in that local governments cannot raise additional revenues, if needed, using this source, although revenue sharing is important in closing vertical imbalances.
At the other extreme, local governments may have full control over rates and bases. This is the case for property taxation in most countries, although the rates may be subject to upper and lower bounds to prevent a “race to the bottom.”
There is a considerable debate as to whether the share of the VAT should be considered as a subnational own-tax in the sense described above. Much of the discussion relates to ease of administration. In countries where the constitution permits them to do so, governments have chosen to centrally administer the VAT.
In Australia VAT revenue is redistributed by the Commonwealth Grants Commission through the equalization system; although it is treated as a state tax, it is thus de facto a central tax that finances an equalization transfer.
An alternative, discussed below, is one in which local surcharges are levied on central government bases, as in the United States. This provides a degree of control over revenues to the local government while minimizing administrative burdens and complexity. The critical issue is that local governments should have control over some tax rates at the margin. This does not have to be very extensive, as shown in the OECD examples in table 6.3.