thus becomes a procyclical mechanism that exacerbates economic fluctuations instead of moderating them (Agarwala 1992). When government expenditure increases in line with GDP, the deficit is likely to expand.
The fiscal contracting system also increased regional disparities, because it favored better-off provinces with more bargaining power and allowed provinces to move some revenues to extrabudgetary funds without sharing them with the center.
Provinces with enormous economic potential, such as Guangdong, accumulated a substantial and growing revenue base by retaining most of the incremental revenues within the province. This shift in financial flows from the early 1980s—when the central government received more from provinces with surpluses than it paid out in transfers and grants (Ahmad 1997)—handcuffed the central government in stabi- lizing the economy and bridging horizontal imbalances.
The transition from a vertical hierarchy to horizontal administration began with Deng’s decentralization of state enterprise ownership to provincial and county governments and local communes during the 1970s (Sachs, Woo, and Yang 2000). Since 1983 the central government has been less involved in super- vising provincial-level appointments, making appointments only “one level down.” Directors of fiscal agencies and tax bureaus are now appointed by provincial governments and their party committees (Huang 1996).
In combination with fiscal decentralization, provincial governments now have the wherewithal and authority to circumvent central plans and policies in favor of regional priorities. Although provincial fiscal agencies and tax bureaus are subject to the hierarchical (professional) instructions of the Ministry of Finance, they are under the leadership of their respective provincial governments.
The new mechanism has problems of its own. As one observer notes, “The shortcoming of the two-level downward system was excessive centralization and unwieldiness; the problem with the one-level system was that it encouraged nepo- tism and localism because it concentrated too many appointment decisions locally”
(Manion 1985).
The Tax-Sharing Reform
In 1992 the 14th National Congress of the Communist Party of China clearly defined the objective of reform as the establishment of a socialist market economy system. Based on the experiences of China and other countries, the government launched the “tax-sharing” reform in 1994. The reform—the most intensive and far-reaching institutional innovation in Chinese intergovernmental fiscal relations since 1949—created a framework of fiscal relations between central and local governments, using the policy tools of taxes and transfers that encourage the devel- opment of a market economy.
In order to implement this tax-assignment system and ensure the effective collection of the central government’s revenues, the central and provincial tax administrations were separated, with the establishment of the State Administration of Taxation (SAT), which is responsible for collecting central and shared taxes.
The central and provincial governments are responsible for collecting their own taxes. SAT collects the shared taxes and shares the receipts with the central and provincial governments.
This new tax-assignment system met with unprecedented resistance from provin- cial authorities, who obtained significant concessions from the central government (Wang 1997). In practice, after the provinces share taxes with the center under the new rule effective since 1994, they would have had to hand over remittances to or receive subsidies from the center according to the old revenue-sharing contracts. To overcome resistance, the central government therefore issued a guarantee to the provinces, ensuring them that they would receive the revenues they received under the pre-1994 system.
The 1994 reforms of the tax-sharing system strengthened the central gov- ernment’s ability to achieve macroeconomic stabilization, regional equaliza- tion, and the efficient provision of public goods. The objectives of the reform package were to simplify and rationalize the tax structure by reducing tax types and tax rates, unify the tax burden on taxpayers, and reduce exemptions; raise the revenue to GDP ratio; raise the central to total revenue ratio; and put central- local revenue sharing on a more transparent, objective basis by shifting the negotiated sharing of general revenues to an automatic rules-based system of tax assignment.
A unified taxation system was established so that local governments could no longer introduce tax reductions or exemptions without approval by the central government. These measures contributed to the rapid growth in overall govern- ment revenues (figure 8.2). Between 1994 and 2005, national fiscal revenues increased from Y521.8 billion to Y3,161.8 billion, an average annual increase of 17.8 percent. Total government revenue as a percentage of GDP increased from 12.3 percent in 1993 to 17.3 percent in 2005. Central government revenue as a percentage of total government revenue grew from 22.0 percent in 1994 to 52.3 percent in 2005 (figure 8.2), dramatically reducing the central government’s
Figure 8.2 Total Government Revenue as a Percentage of GDP and Central Government Revenue as a Percentage of Total Government Revenue, 1993–2005
0 20 40 60
Percent
1993 1994 1995 1996 1997 1998 1999 Year
2001
2000 2002 2003 2004 2005
Total government revenue Central government revenue
Source:Ministry of Finance 2006.
reliance on local governments to turn over tax revenues. As a result, the macro- adjustment and macro-control capacity of the central government increased.
As government revenues increased, governments at all levels were able to sub- stantially increase their resources for public services, including education, science and technology, agriculture, social security, and infrastructure. These increases helped ensure smooth progress of the key reforms of the economic system.
The reform also enabled the central government to narrow regional fiscal disparities. Since 1994 central government expenditure as a percentage of total government expenditures had been kept at about 30 percent, dropping slightly in recent years (figure 8.3). Additional resources have been allocated to poorer regions and to achieve more-balanced growth and increase fairness and harmony in intergovernmental fiscal relations. In 2005 the ratio of fiscal revenues in the eastern, central, and western parts of China stood at 60:23:17, while the ratio of their expenditures stood at 46:29:25, indicating the redistributive role played by the central government. Since 2000 the importance of spending by local govern- ments has risen (figure 8.3).
Reform of the Sharing of Income Tax Revenues
The income tax–sharing reform, launched in 2002, is designed to enhance the development of a market economy, increase taxation of a growing revenue base, and permit additional resources to be allocated to achieve more-balanced regional development. While maintaining the central government’s exclusive right to corporate income tax revenues in a limited number of sectors, including railway
Figure 8.3 Percentage of Government Expenditure Made by Central and Local Governments, 1994–2005
29 31
24
70 71 73 73 71 69 68 73 71 73 74 76
29 27
29 27 27 27 26
30 0 20 40 60
Percent
80 100
1994 1995 1996 1997 1998 1999 2000 2001 Year
2002 2003 2004 2005 32
Local governments Central government Source:Ministry of Finance 2006.
and postal services, the reform led to an increase in the central government’s share of all other income tax revenues from 29 percent to 60 percent over two years.
The reform also established a mechanism to ensure steady growth of general- purpose transfers, to improve the effectiveness of equalization efforts by the central government. As a result of the reform, nearly 80 percent of the income-tax rev- enues collected by the central government comes from eastern China (figure 8.4).
The additional revenues are used for general-purpose transfers to localities, espe- cially in central and western China. General transfers from the central government to local governments increased from Y2.1 billion in 1995 to Y112 billion in 2005, with 95 percent of them transferred to the central and western areas. The revenues available for equalization transfers are greater than they were following the 1994 reforms, creating a major redistributive effect.