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2 Problems in Chinese Intragovemmental Fiscal Relations, Tax-Sharing System, and Future Reform

Ehtisham Ahmad, Vito Tanzi, and Qiang Gao
Published Date:
September 1995
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Gao Qiang*

This paper outlines the main problems in Chinese intragovernmental fiscal relations and the main difficulties to be faced in future reform.1 It also presents a discussion of the tax-sharing arrangements envisaged. These issues cover the division of fiscal revenues between different levels of government, the responsibility for fiscal expenditures, and other fiscal relations.

Current Intragovernmental Fiscal Relations

China’s present fiscal system was set up in 1988. It includes six kinds of contracting methods: The first is “contracting of progressive increases in revenue.” This method is based on the 1987 local government final accounting of revenues and local government obligations, the rate of increase in revenue and withholdings, and the percentage to be paid to the central government determined on the basis of the increase in revenues during the previous several years. Revenues within the progressive rate of increase are divided between the central government and local governments at a prescribed retention and payment percentage. Revenues in excess of the progressive rate of increase are retained entirely by local governments. When revenues do not meet the progressive increase rate, the shortfall in payment to the central government is made up out of local governments’ own financial resources. Ten areas practice this method.

The second is “dividing up the total amount.” This method is based on approved base figures for fiscal receipts and expenditures for the previous two years. Local government total fiscal revenues as a percentage of total expenditures are used to determine the ratio between local government retention and payment to the central government. Three areas practice this method. The third method is to “divide up the total amount, and any increase.” This means that in addition to dividing up the total amount, the amount of revenue increase over the previous year is also shared proportionately. Three areas practice this method.

The fourth is “contracting of a progressive increase in the amount to be paid to the higher authority.” This method uses the base figures for revenue payments to the central government in 1987; the amount to be paid increases progressively at a certain rate each year. Two areas practice this method. The fifth method is “payment of a fixed amount to the higher authority.” This method is based on previously approved revenue and expenditures base figures, and a fixed amount of the portion of revenues in excess of expenditures is paid to the central government. Three areas practice this method.

The sixth method is the “fixed amount subsidy.” This method uses a base figure for previously approved revenues and expenditures, and the central government provides a fixed amount subsidy to cover expenditures in excess of revenues. Sixteen areas practice this method. Because the central government has no uniform regulations to cover fiscal contracting among governments below the provincial level, all jurisdictions suit general methods to specific circumstances, and the practices vary greatly.

Unlike the previous fiscal system’s “unified state control over revenues and expenditures,” the fiscal contracting system has greatly stimulated local governments’ interest in increasing revenues and reducing expenditures. It has also provided favorable fiscal conditions for the development of the local economy. Nevertheless, the fiscal contracting system is still an unstandardized, incomplete method that does not meet the needs for building a socialist market economy. Its inherent shortcomings are becoming increasingly apparent as time goes by.

Weakened Central Government Macroeconomic Regulation and Control

The most important characteristic of the contracting system is that it sets unequivocally the revenues that local governments are to pay to the central government. Except for a stipulated percentage to be paid to the central government, local governments retain all increments to fiscal revenues. Consequently, central government revenues are inelastic. Since the implementation of the fiscal contracting system in 1988, local governments’ annual revenue increases paid to the central government have been less than 10 percent. More than 90 percent of increased revenue has been retained by local governments. In addition, because tax revenues are collected mostly by local tax agencies, and because local governments have substantial authority to grant tax reductions or exemptions, a decline in the share of central government revenues is difficult to avoid. Consequently, in 1992 central government “own” revenues (exclusive of liabilities) amounted to only 28.7 percent of national fiscal revenues. This has weakened the central government’s macroeconomic regulation and control capability and has been detrimental to financing central government expenditures, such as key national construction projects.

Contracting Losses But Not Profits

The fiscal contracting system provides that local governments may retain all increased local governments’ fiscal revenues, except for the amount to be paid to the central government in accordance with regulations. However, in the implementation of the contracting system, for various reasons (such as the floods in parts of east China two years ago), fiscal revenues in some areas do not reach the contracted progressive increase level. In such cases, the central government is obliged to reduce or exempt the amount due from such areas. In addition, the expenditures assigned to local governments, under expenditure contracting, may also require the central government to provide special subsidies or transfers. This increases the central government’s fiscal difficulties.

Detrimental to Adjustment of the Industrial Structure and Implementation of Industrial Policy

The fiscal contracting system divides both enterprise income taxes and the turnover tax between the central government and the local government jurisdiction in charge of collection. This closely links industrial and commercial enterprise taxation to local fiscal revenues. Thus, in order to broaden their own sources of revenue, jurisdictions frequently vie with each other to develop projects that show quick results and that produce high revenues and large profits in order to gain the greatest fiscal returns for their own area. They also protect the sale of products from these local projects; for example, state policy restricts development of tobacco and alcoholic beverage industries. However, since the tax rate on these products is high and returns are great, each jurisdiction seeks to expand their output. Not only does this cause duplication of construction and skewing of the industrial structure, but it hinders formation of a unified domestic market and wastes resources.

Large Amount of Discretion in the Contracting System

The fiscal contracting system was worked out through negotiations between the central government and the provinces, autonomous regions, and municipalities under direct central government administration. Because of the “horse-trading” done concerning a fairly large number of matters, policies are not uniform, the system is not standard, and strict legal restraints are lacking. This is not in keeping with requirements for building a socialist market economic system or for expressing the rule of law, openness, systematization, and fairness.

Thanks to many years’ study and reference to prevailing international practices, the distribution of fiscal responsibilities between the central government and local governments will be solved through a tax-sharing arrangement. Thus, during the second half of 1992, the central government selected nine localities, namely, Liaoning Province, Zhejiang Province, Shenyang, Dalian, Tianjin, Qingdao, Wuhan, Chongqing, and the Xinjiang Uygur autonomous region, as pilots for reform. The tax-sharing system that is being experimented with contains both certain elements of a general tax-sharing system and also retains certain methods of the fiscal contracting system. Its basic configuration calls for the division of existing fiscal revenues into three categories: permanent central government revenues, permanent local government revenues, and revenues to be shared between the central government and local governments.

Revenues to be shared between the central government and local governments include the product tax, the value-added tax, the business tax, the uniform industrial and commercial tax, and the resources tax. Two ratios are used for the division of the shared revenues, namely a “50–50” division between the central government and local governments in general, and an “80–20” division between the central government and minority nationality areas. In the pilot areas, the portion of local government permanent fiscal revenue plus jointly shared revenue, that is, revenue greater than the base figure for local government expenditures, is contracted for payment to the central government at an annual increment of 5 percent. If the portion of permanent local fiscal revenues plus shared revenues is less than the base figure for local fiscal expenditures, the central government provides a fixed sum subsidy. Appropriate care is accorded to minority nationality areas.

The situation in the pilot areas shows some inadequacies in this plan, mostly that the amount of shared revenues is too large, that the main kinds of taxes to be shared by the central government and local governments have not been clarified, and that central government macroeconomic regulation and control capabilities have not improved markedly.

To promote the building of a socialist market economic system, the State Council has decided to enhance the reform of the revenuesharing and transfer systems. Beginning in 1994, with the nationwide dismantling of the existing fiscal contracting system, the tax-sharing system is to be implemented across China. This reform requires that tax system reform, state-owned enterprise profit distribution system reform, financial system reform, and investment system reform proceed in tandem. This reform has a bearing on readjustment of the economic interests of all. It requires solving several major difficulties and crucial problems: one, how to divide equitably the main forms of taxation between the central government and local governments; two, how to set up separate central government and local government tax agencies; three, how to define clearly the division of fiscal and other powers among governments; and four, how to be fair in setting local fiscal revenue and expenditure base figures, as well as in central government transfers to local governments.

Policy Orientation of China’s Tax-Sharing System

The Fourteenth Party Congress spelled out reform goals for the establishment of a socialist market economy system, and a widespread consensus has also been gradually reached among governments at all levels about the establishment of a fiscal system in which tax sharing is the main feature. At the end of August 1993, the State Council Standing Committee convened and approved in principle a tax-sharing system and fiscal reform plan; it also called for further amplification and improvement of the plan. The following covers basic principles and ideas for the fiscal system reform in the near future.

Basic Principles

A reform of the tax-sharing system affects adjustment of the interests of all and has a bearing on the overall macroeconomic situation. Proceeding from Chinese realities, and with reference to international practice, the following basic principles have been emphasized by the government.

The implementation of tax system reform is to be simultaneously accompanied by the distribution of tax revenues among governments. The establishment of a scientific, equitable, and stable taxation system provides the foundation for pursuing the tax-sharing system. The State Council has already approved, in principle, reform plans for China’s tax system for the near future, the basic ingredients of which are across-the-board promotion of value-added tax (VAT), uniformity in the domestically owned enterprise income tax, amplification of the individual income tax, the merging of various small taxes, and the introduction of new kinds of taxes as economic development requires. A simultaneous reform of the tax-sharing system and a complete reform of the taxation system pose great difficulties and risks, but until the taxation system is sound, a scientific reform of the tax-sharing and transfer system will be difficult. After a tax-sharing system is instituted, separate central government and local government agencies for tax collection and administration will be set up to ensure the separate revenues of the central government and local government; each jurisdiction will collect its own taxes. At the same time, tax legislation and administrative authority will also be spelled out.

Rationally adjust the distribution of financial capacity among regions. In the division of tax revenues among governments, consideration must be given to both the need to enhance central government macroeconomic regulation and control capabilities, and local governments’ need for financial resources to develop economic and cultural, educational, and scientific research endeavors. This would stimulate the interest of both the central and local governments.

On the basis of the foregoing principle, all taxes are divided into central government taxes, local government taxes, and taxes shared by the central and local governments. Assigned to the central government are all taxes closely related to the maintenance of national rights and interests and helpful to the exercise of macroeconomic regulation and control. Taxes that produce a large amount of revenue, and that can steadily increase tax revenues, are to be shared between the central and local governments, with most of such revenues going to the central government. Local tax assignment is suited to local government collection and administration. This division both helps establish and perfect a system for the central government’s macroeconomic regulation and control, and also takes into account the Chinese realities of a vast area, a large population, and the very numerous economic and social functions that local governments perform. It also ensures that local governments can play a full role and regularly discharge functions in providing regional social services.

Establishment of a standard system for central government transfers to local governments, together with a special disbursements system. Economic development varies greatly between one area and another in China (see Chapter 3). Following the division of taxes, a substantial portion of the central government’s increased revenues will be returned to local governments through grants and transfers. The principle used in such transfers is that they must help economically developed areas continue a fairly high speed of development and must gradually increase the financial resources of economically undeveloped areas.

Adherence to the principle of unified policies in combination with control by different levels of government. Dividing tax revenues requires not only consideration of the distribution of revenues between the central and local governments, but also consideration of the regulatory role of taxation on economic and social development and social distributions. After tax sharing, the main function of the central government will be diligent maintenance of a unified nationwide market that protects fair competition among enterprises. The formulation of all principal forms of taxation, the kinds of items to be taxed, and tax rates, should be the responsibility of the central government, along with the responsibility for maintaining nationwide uniformity. At the same time, local governments can be given a certain amount of flexibility in the administration of small taxes that provide revenues for local governments.

Highlighting important points and paying close attention to principal contradictions. A reform of fiscal functions among governments affects a broad spectrum and sparks conflicts of various kinds. It cannot be accomplished in a single step, nor can all problems be solved simultaneously. Priorities must be set. The main forms of taxation used for macroeconomic regulation and control must be differentiated, and various technical problems, or problems resulting from conditions not being appropriate, may be gradually solved during implementation.

Content of New System

The concrete content of the new tax-sharing system is as follows.

Assignment of mandates and expenditure responsibilities between the central government and local governments. According to the present distribution of mandates between the central and local governments, the central government is responsible for expenditures relating to national security and foreign affairs, administrative expenses for the central government departments, the necessary expenditures in adjusting the national economic structure, coordinating regional development and executing macroeconomic control, as well as the development expenses for the sectors that come under the direct control of the central government. The specific categories of expenditure are national defense expenses; armed police administrative expenses; expenses for foreign affairs and financial aid to other countries; administrative expenses for central government departments; capital construction investment under the control of the central government; expenses for technical innovation and new product pilot production of enterprises that belong to the central government; geological prospecting expenses; expenses for supporting agriculture; expenses for debt service on domestic and foreign debt incurred by the central government; expenses for police, procuration, and courts at central levels; and administrative expenses for culture, education, and health care.

The local governments are responsible for their administrative expenses and the relevant necessary expenditures of the development of the local economy and sectors, which include local administrative expenditure; expenditure for public security; procuration organization and court; part of the armed security force expenditures; administration expenditure for civil militia; capital investment of local government; technical renovation and new product experiment expenses of local enterprises; expenditures for assisting agriculture; urban maintenance and construction expenditures, some administration expenses for local culture, education, and health care; and price subsidies and other expenses.

Revenue assignment of central and local governments. Central government revenues include customs duty, consumption tax, and VAT collected by customs, consumption tax, income tax of central enterprises, income tax of local banks, foreign ventures in banks and nonbanking financial institutions, revenue submission from railway transportation departments, head offices of all banks and all insurance companies (including business tax, income tax and profits, and tax on urban maintenance and construction), as well as profit from the enterprises of the central government. All tax rebates on exported goods are to be borne by the central government.

Local government revenues include the business tax (not including the business tax from railway transportation department and all head offices of all banks and insurance companies), income tax of local enterprises (except the income tax of the above-mentioned local banks, foreign investment banks and nonbanking financial institutions), profits from local enterprises, personal income tax, urban and town land use tax, investment orientation adjustment tax for fixed assets, urban maintenance and construction tax (except the payment from the railway transportation department, and all head offices of all banks and insurance companies), house property tax, vehicle and vessel use tax, stamp tax, slaughter tax, agricultural (animal husbandry) tax, deed tax, fertile land use tax, inheritance and gift taxes, land value increment tax, and payment for the use of national land, and so on.

The revenue shared by central and local governments will include the VAT, natural resource tax, and transfer tax. As for the sharing of the VAT, 75 percent will be allocated to the central government and 25 percent to local governments. After the reform of the industrial-commercial tax, the VAT will become the most important indirect tax, and will apply to all stages, from industrial production to commercial wholesale and retail trade.

The rationale for including the resource tax in revenue sharing is that the state is the owner of all resources and the central government retains the right to share part of the revenue. However, the actual situation is that most of the mineral resources are located mainly in midwest regions and in poor areas (see Chapter 3). Thus, distribution is to be according to the types of resource: most of the resource tax will go to the local governments. However, the resource tax on offshore oil will be allocated entirely to the central government.

The transfer tax will be shared equally by central and local governments. The reason for sharing the tax in this manner is that, although the stock exchanges are located in large cities, the tax revenue comes from all over the country. Therefore, it is inappropriate to allow the local government, where the exchanges are located, to retain all the revenues. Consequently, the tax is to be shared by central and local governments.

Fix the amount of tax repayment from the central government to the local governments. In order to maintain the present activity levels of local governments, and achieve the objective of the reform gradually, a part of the taxes collected by the central government is to be returned to local governments on the base of 1993 local revenues. Thus, according to the actual revenue of local governments in 1993, given the new tax reform and revenue assignments, the net sum to be turned over by the local governments to the central government would be determined by the consumption tax plus 75 percent of VAT revenues minus established transfers from the central to local governments. Thus, if the net amount to be turned over is equal to the 1993 transfer, this amount will be retained by the local government—thereby ensuring 1993 levels of aggregate local resources. After 1994, the transfer will increase annually given the 1993 base. The increment would be determined by a 1:0.3 coefficient, based on the average rate of increase of national VAT and consumption tax revenues; that is, an increase of 1 percent of the above-mentioned two taxes would lead to a 0.3 percent increase in the central government transfer to the local governments.

Treatment of the central and local government transfers. In order to implement the tax-sharing system reform smoothly, after its introduction in 1994, the distribution pattern of the old system will be reformed gradually. Thus, the central government subsidy (or transfer) will remain in practice, and the turnover system for local governments will be retained as well. Those areas with a “payment of a fixed amount to the higher authority,” and “progressive increase in the payment to the higher authority” will still practice these methods. Those areas with “dividing up the total amount” and experimenting with the new tax-sharing system will practice the method of “progressive increase in the payment to the higher authority.”

In general, after the introduction of the tax-sharing system reform, the initial central government revenue is expected to increase to 57 percent of the total national revenue. However, the amounts equivalent to the increment will be transferred to the local governments given the base-year formulation described above. Therefore, the central government’s own revenues will initially remain unchanged, and the center will not benefit directly from the newly introduced tax system reform. But from a long-run perspective, the central government will have approximately little more than half of the increment of the VAT. This practice embodies the principle that the central government will eventually control most revenues, achieved on an incremental basis.

There are also some weaknesses in this reform scheme. First, the base figure is determined in the hope that local financial capability will be secured. There is no large adjustment between regions; therefore, the existing disparity between regions in financial capacity cannot be eliminated. Second, more studies are needed in order to establish a more scientific and reasonable transfer system in China.

Generally speaking, the basic objective of the intergovernmental reform in China is to adjust the fiscal system, to adapt to the need of building a socialist market economy, and to get closer to the established international practices. This is an important and time-consuming task and will require major efforts on the part of the central and provincial governments.


Ministry of Finance, China


Given that China is a unitary state, the term “intragovemmental” is used by the authorities in preference to the term “intergovernmental” fiscal relations. Ed.

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