Transition to Market

Chapter 13 China: Prolonged Reforms and the Weakening of Fiscal Control

Vito Tanzi
Published Date:
June 1993
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Mario I. Blejer

Starting in 1979, China has carried out wide-ranging economic reforms with the specific aim of accelerating the rate of output growth by increasing productivity and improving the allocation of resources. The nature and design of the reforms in China differ from those of the reforms taking place in many Eastern European countries. These differences should be kept in mind in analyzing the fiscal implications of the Chinese reforms.

First, the reforms were never explicitly designed, nor implicitly conceived, with the objective of fully or partially dismantling the socialist system. Therefore, the issue of privatization of state-owned enterprises, as well as the more general problem of ownership rights, has not played a central role in the Chinese reform scheme. Instead, some peculiar arrangements, such as the “contract-management responsibility system,” had to be introduced to provide incentives similar to those prevailing in a predominantly private system. Second, the Chinese reforms were largely “experimental,” in the sense that they were concentrated in specific areas of the economy, starting in agriculture, and did not cause wide systemic disruptions. On the contrary, they achieved the objective of rapidly accelerating the overall rate of growth and, in this manner, they tended to overheat rather than to depress the economy. This initial success, however, neither required nor resulted in an enhanced ability of the Government to conduct supporting fiscal and other macroeconomic policies. Third, more than in any other country (with the possible potential exception of the former U.S.S.R.) reforms in China were largely grounded on regional decentralization with the–unintended–consequence that much of the power of the Central Government to manage the system at the macroeconomic level (including the ability to raise revenue) has been lost to local and provincial governments. Fourth, unlike in the U.S.S.R. and in most of the Eastern European countries, the Chinese reforms were started and proceeded over a long period in an environment of (at least apparent) macroeconomic stability. Therefore, the conundrum of sequencing and combining adjustment with structural reforms was, in principle, absent. Macroeconomic imbalances, however, developed strongly in the second half of the 1980s, but it could be argued, as is done below, that much of the imbalances might be attributed to how the reforms were implemented rather than to the initial macroeconomic conditions.

Although these differences are indeed significant, China provides the longest continuous instance of a reforming socialist economy. Its experience, interesting in itself, can also provide important insights into the general patterns of macroeconomic performance during the transformation process. Moreover, the systemic changes that have taken place in China during the last decade have changed the functions and objectives of all major policy instruments, requiring their adaptation to the new demands. This evolution has been particularly marked in the case of fiscal policy, and the prolonged experience of China may contribute to the understanding of the evolving role of the budget in a reforming economy.

As a framework for discussing the fiscal implications of the Chinese reforms, this chapter first presents a summary of the evolution of the overall reform process, followed by an account of the main budgetary developments since the inception of the reforms. The next section analyzes the fiscal implications of the reforms, stressing the elements in the reform process that have affected the ability of the Government to collect revenue and to use fiscal instruments for effective macroeconomic management. Final remarks conclude the chapter.

Synopsis of Reforms

In 1979 a set of radical agricultural reforms were started across China.1 They ended the commune system, increased the size of allowed private plots, and legalized the informal markets for farm products in rural areas. These reforms increased the rate of growth of agricultural output from an average of about 2 percent a year during 1958-78 to about 8 percent a year in 1979-84.2 The rapid increase in productivity displaced labor from the agricultural sector, but large-scale migration to the cities was effectively prevented by the implementation of an additional reform: the elimination of the restrictions on nonagricultural activities in the rural areas. This led to the creation of a large number of individually or collectively owned enterprises–the so-called township and village enterprises–that by 1987 accounted for nearly one fourth of the gross value of industrial output and employed about 17 percent of the labor force.3

The second stage of the transformation began in 1984 by extending some of the agricultural reforms to the cities. At the core of the urban reforms was the enterprise reform, and its main feature was to allow enterprises to retain part of their profits. Before 1984 all profits of enterprises were fully remitted to the budget while, by 1986, almost all profits were subject to partial taxation with the net of taxes profits (and the depreciation allowances) being retained by the enterprises to finance their investments and for wage bonuses and incentive payments to management. In addition, the number of products allocated through the central plan was largely reduced, bringing the share of industrial output and retail sales subject to the plan to 30 percent by 1989, compared with close to 70 percent in 1979. Collectives and some private firms (mainly in services) were also permitted in the cities, and their share in retail sales rose from less than 10 percent in the late 1970s to more than 50 percent in 1987.

Partial price reforms also took place. Price liberalization began with the introduction of a two-tier price system, first implemented in rural areas and slowly expanded to include a number of industrial products. The system allows producers to sell their output, above a set quota, at free market prices. Many other commodities, however, remained subject to price guidelines, while the prices of a large portion of inputs and consumer goods were kept tightly controlled. Part of these controlled prices were administrated through budgetary intermediation, in the form of direct subsidies that cover the difference between procurement and retail prices.4

An important result of both the rural and the urban reforms was that a large fraction of the economy was diverted away from direct government control. Remarkably, the rates of aggregate growth reached unprecedented levels. During 1978-89 the average annual growth rate of per capita income was about 8 percent, with industrial output growing more than 16 percent a year on average in 1985-88.5

The reform measures were not, however, accompanied by strong financial policies, which resulted in large increases in aggregate demand that were compounded by the ability of enterprises to grant large raises in wages and bonuses and to borrow heavily in order to expand capacity. As will be discussed later, the particular way in which the reforms were implemented led to a deterioration in the budgetary accounts and, more important, to a loss in the ability of the Central Government to maintain macroeconomic discipline. In the second half of the 1980s, inflation increased rapidly and the external accounts deteriorated. By September 1988, inflationary expectations caused a rash of panic buying and bank runs that prompted the Government to adopt stabilization measures that were rather incompatible with the spirit of the reforms. Thus, credit was largely restricted and redirected to state-owned enterprises, stemming the development of the nonstate sector. Further, price controls were reimposed, and the decentralization of foreign trade was halted.

Following these measures, inflation fell to about 2 percent in 1990 but growth almost collapsed (output grew at less than 5 percent in 1989-90). Despite this partial retrenchment, however, reforms did not fully stop and there are indications of a current shift toward renewed liberalization. Export and consumer subsidies are being phased out, only one eighth of all farm produce is sold at procurement prices set by the Government, and the importance of the nonstate firms in industrial output continues to expand.6

Contrary to what is widely believed, the events of June 1989 were not the immediate cause of the apparent reversal of the Chinese reforms, but only strengthened a trend toward increased recentralization that had already started almost a year earlier. This observation is important because it demonstrates that the reforms ran into serious problems not for political reasons but rather for macroeconomic reasons. This strengthens, therefore, the need to consider in detail the interactions between microeconomic reforms and macroeconomic stability.

Budgetary Developments

The major developments since the inception of the reforms are described briefly below. The discussion refers to the consolidated state budget that covers both the Central Government and all levels of local government.

One of the most salient features of the evolution of government finances since the beginning of the reforms has been the continuous decline of the total revenue-GDP ratio, from more than 34 percent in 1978 to below 20 percent at the beginning of the 1990s (Table 1). The main reason for this trend has been the steady fall in revenue from the enterprise sector (direct taxation plus remittances) that plunged from 20 percent of GDP in 1978 to an estimated 4.5 percent in 1992. Although part of this fall has been the intended outcome of the decentralization process, the declining trend also reflects, as discussed in the next section, the unintended tax consequences of the institutional framework within which the reforms were carried out.

Table 1.China: Government Revenue(In percent of GNP)
Total revenue 134.430.027.024.820.619.116.4
Revenue from
Taxes on
Income and profits321.517.813.
Goods and services411.310.610.
Of which: VAT2.
International trade0.
Other taxes51.,0
Nontax revenue60.
Net budgetary contri-
bution of enterprises719.616.,6
Source: Ministry of Finance.

Total revenue, including nontax revenue.

Profit remittances and profit taxes, plus special levies on enterprises (tax on extrabudgetary construction), and tax on extrabudgetary receipts

Includes profit remittances

Includes product, value-added, and business taxes.

Other taxes include the wage bonus tax, estate taxes, and the tax on the income of foreign-related enterprises (joint ventures and foreign owned).

Excludes profit remittances.

Revenues from enterprises minus subsidies to loss-making enterprises (from Table 2).

Source: Ministry of Finance.

Total revenue, including nontax revenue.

Profit remittances and profit taxes, plus special levies on enterprises (tax on extrabudgetary construction), and tax on extrabudgetary receipts

Includes profit remittances

Includes product, value-added, and business taxes.

Other taxes include the wage bonus tax, estate taxes, and the tax on the income of foreign-related enterprises (joint ventures and foreign owned).

Excludes profit remittances.

Revenues from enterprises minus subsidies to loss-making enterprises (from Table 2).

Contrary to the performance of profit taxes, revenue from indirect taxes held rather well during the period. In 1984 four separate indirect taxes–the product tax, the value-added tax (VAT), the business tax, and the urban maintenance and construction tax–were introduced to replace the previous consolidated industrial and commercial tax.8 In China, however, indirect taxes are directly collected from enterprises and, unlike in market economies, they can rarely be shifted forward because of price controls. They became, therefore, akin to a profit tax as their incidence falls fully on the enterprise. Moreover, in addition to their revenue-generating potential, indirect taxes are largely used to compensate for perceived variations in enterprise profitability arising from the incomplete nature of price reforms. Indirect taxes contain, therefore, a discretional component that translates into a wide range of rates.

As in other centrally planned economies, individual income taxation and taxes on international trade do not account for a large share of Chinese revenues. However, efforts have been made to tax individual incomes that have increased substantially following the reforms.9 Consequently, receipts from personal income taxes, as well as receipts from foreign-related enterprises (foreign owned and joint ventures) have increased in importance after 1987.10

The reforms also had a profound impact on public expenditure, which, as a ratio of GDP, fell from 34 percent in 1978 to an estimated 19 percent in 1992 (Table 2). Most of the reduction took place in capital outlays, although the level of defense spending has also fallen sharply, as the Government demobilized about one million persons and converted a considerable number of military plants to civilian use. Capital expenditures declined rapidly (from 15 percent of GDP in 1978 to less than 5 percent by the beginning of the 1990s), as a result of reduced intermediation by the Government, larger profit retention by the enterprises, and because enterprises were required to use their own funds and bank loans to finance their investments.

Table 2.China: Government Expenditure(In percent of GDP)
Total expenditure34.133.228.526. 422.821.518.7
Current expenditure19.322.
To enterprises
Capital expenditure14.911.
Source: Ministry of Finance.

Data prior to 1981 may be less than a full accounting for subsidies because certain subsidies to enterprises were subtracted from taxes rather than shown as expenditure. Available information does not permit reclassification for those years.

Includes price subsidies on consumption goods (daily necessities) and subsidies to agricultural inputs

Source: Ministry of Finance.

Data prior to 1981 may be less than a full accounting for subsidies because certain subsidies to enterprises were subtracted from taxes rather than shown as expenditure. Available information does not permit reclassification for those years.

Includes price subsidies on consumption goods (daily necessities) and subsidies to agricultural inputs

Subsidies, after rising substantially in the early years of the reforms, remained broadly unchanged at approximately 6 percent of GDP in the 1980s, falling further in 1990-92. There are two types of budgetary subsidies in China: consumption subsidies and enterprise subsidies. Initially, consumption subsidies rose sharply as the Government compensated urban consumers for price increases arising from the agricultural reforms and the lifting of agricultural price controls. Subsequently, these subsidies declined (from 5.4 percent of GDP at the beginning of the 1980s to about 2 percent of GDP by 1990), following the policy of relying on increases in productivity and wages rather than on subsidies to maintain and enhance living standards. On the other hand, subsidies to cover enterprise losses have increased steadily from about 1 percent of GDP at the start of the process to 35 percent in 1988-89, being slightly reduced by 1990-91. Essentially, higher enterprise losses have arisen from the rigidity of administered prices in the face of increasing costs.11 The pressure on the fiscal accounts from the impact of the reforms on the budgetary contribution of enterprises is highlighted by the rapid drop in the net budgetary yield of enterprise activities, measured by the difference between revenues and subsidies to loss-making firms (Table 1, bottom line). The net contribution fell dramatically from more than 19 percent of GDP in 1978 to less than 3 percent by 1992.

Prior to the reforms, balanced budgets were emphasized and, in fact, the government budget recorded small surpluses almost every year for three decades. The evolution of the budget deficit over the 1980s, as a percentage of GDP, is presented in Table 3. After a few years of budget deficits averaging about 2 percent of GDP, there was a shift toward stabilization and tighter macroeconomic control. As a result, the deficit, while fluctuating from one year to another, fell to as low as 0.5 percent in 1985. However, from 1986 until 1989, the deficits rose again, reaching 2.4 percent of GDP in 1988, as revenue again tended to fall faster than expenditure. In the early years of the reforms, more than 80 percent of the deficits were financed by the central bank. In 1981, the Government began issuing bonds, which have financed an increasing proportion of the deficit and reflect the institutional changes brought about by the development of financial markets. Foreign borrowing has also become an important source of finance, averaging about 30 percent of the total yearly financing needs.12

Table 3.China: Consolidated Budget Deficits(In percent of GDP)
1992 (prel.)2.3
Source: Ministry of Finance.
Source: Ministry of Finance.

The fiscal deficits in China were not very large by international standards and could not, without further elucidation, constitute the main explanation for the rise in inflationary pressures. However, the measured deficit understates the correct magnitude of the macroeconomic impact of budgetary developments. Because government-financed investments declined fast, pressure grew on the publicly owned banking system to increase credit to enterprises so as to facilitate the financing of their investment.13 Loans to enterprises and individuals grew by more than 20 percent a year during 1985-88. This extension of excessive bank credit undermined monetary control after the mid-1980s and compounded the expansive effects of the rising budget deficit.14

Faced with inflationary and balance of payments pressures the authorities implemented, starting in the last quarter of 1988, a number of austerity measures. Spending guidelines were introduced to slash state investment outlays by 20 percent in 1989, and the budget deficit was actually reduced by almost 1 percent of GDP In addition, the central bank adopted highly contractionary monetary policies that resulted in a rapid deceleration of inflation and output growth. A further reduction in the deficit took place in 1990, based on additional cuts in public investment. Credit policy, however, was relaxed in late 1989 and 1990, mainly to bail out inefficient enterprises and avoid the deepening of the recessionary trends. Despite further cuts in expenditures, deficits grew again in 1991-92, largely due to continuous depressed revenues.

Fiscal Dimensions of Reforms

The reform process resulted in significant changes in the objectives and mechanisms of fiscal policy. Under strict central planning, fiscal policy aims to allocate resources administratively by regulating the rate of investment and by maintaining household incomes at a level consistent with the availability of consumer goods. Tax policy as such does not fulfill a major function, since there is no private sector participating in the production process and state enterprises are required to remit all their surpluses to the government. The primary instrument of fiscal policy is, therefore, the level and composition of government expenditure. Government funds are channeled back to the enterprises through the financing of investment and the provision of working capital and, in many cases, in the form of subsidies. The level of expenditures is largely determined by the guidelines implied by the quantitative plan and, if the need for aggregate demand adjustments arises, cutbacks in expenditure are the main instrument for reducing inflationary and balance of payments pressures.15 These were the characteristics of fiscal policy in China until the early 1980s. As market-oriented reforms started to be implemented, two important issues became relevant: first, the direct and indirect budgetary consequences of the reforms, or, more precisely, the type of built-in elements in the reform process that tend to create fiscal imbalances; and second, the ability of fiscal policy to perform an effective macroeconomic role under the prevailing circumstances. These issues are, of course, pertinent in the context of all reforming economies but they take a distinctive turn in the Chinese setting given the specificity of some of the measures adopted and the particular institutional and organizational arrangements within which the reforms became operational.

The central goal of the Chinese reforms, both rural and urban, was to improve productive efficiency. In order to reach this goal it was deemed necessary to increase the autonomy of economic agents, to reinforce their managerial capabilities, and to decentralize the economic decisionmaking process. The Government, however, did not intend to transfer the ownership of most of the means of production and, although private businesses and joint ventures were allowed in some sectors, public ownership of virtually all large enterprises was to be preserved. An institutional mechanism was therefore necessary to make government ownership compatible with the enhancement of productive incentives. The chosen mechanism had two components: a disengagement of enterprise finances from the fiscal budget and the adoption of the contract management responsibility system that was supposed to drive enterprises, in practice, toward a system in which they make their productive decisions “as if” they were privately owned.

The first component implies a reduction in the intermediation role of the budget: the profits of enterprises will be only partially taxed but they will become responsible for the financing of their investments as well as their working capital. This, of course, means that the observed decline in both government revenues and expenditure relative to national income was an integral component of the reforms. However, the second component, the contract responsibility system, led to continuous and unintended reductions in revenues, compounded by an erosion in enterprise profits arising from the incomplete nature of the reforms. The outcome was a fall in revenues much larger than expected and it exceeded the cut in expenditures, resulting in wider fiscal imbalances. Moreover, the system has involved widespread discretion, detracting from the predictability and effectiveness of fiscal policies. In addition, the manner in which the growing decentralization of fiscal authority to lower levels of government has been implemented has tended to reduce the revenue that is transferred to the Central Government, a development that has serious implications for macroeconomic management. These aspects of revenue developments, as well as some expenditure issues associated with the reforms, are discussed here in detail.16

Revenue Consequences of Contract Responsibility System

The contract responsibility system was introduced in the industrial sector in 1984 and currently covers more than 90 percent of large and medium-sized state-owned enterprises. It consists of a contractual arrangement between the management of an enterprise and the Central Government (or the local government) that owns it. The contract usually covers up to five years and provides for a minimum amount of profit to be realized or tax to be paid to the government each year.17 The contracted amount is typically the amount realized in the year preceding the signature of the contract or some fixed rate of increase over that amount. Profits in excess of the contracted amount are retained fully by the enterprise or are taxed at a lower rate. Firms that fail to reach their profit target are supposed to meet the contract from their reserves. However, when it is clear that the enterprise cannot meet the contract, the government is forced to reduce the contracted amounts since this would not be considered sufficient grounds for bankruptcy.

The contract system was supposed to expand the tax base by improving considerably the performance of the enterprises. However, the way the contracts set the tax obligations resulted, in practice, in an opposite effect. Since below-quota profits are subject to a flat tax while abovequota profits are taxed at a lower (or zero) rate, enterprises retain an increasingly larger share of their profits as output and profits expand, resulting in a continuously decreasing average tax rate and in an income elasticity of less than unity for the enterprise profit tax. The lack of buoyancy that is introduced by this system was aggravated by the absence of provisions for inflation, since in most of the multiyear contracts the tax is based on estimated profitability under an assumed standard inflation rate; if actual nominal income exceeds the estimates embodied in the contract (as was the case in 1988-89 when inflation was high), the effective tax rate declines further. This tends to reduce macroeconomic built-in stabilizers and to introduce a procyclical aggregate demand element into the tax system: after-tax profits of enterprises rise when growth and inflation are higher than the trend rates and fall when these rates are low.18

The contract responsibility system not only has tended to reduce the tax-GNP ratio (Table 1) but has largely impaired the flexibility of tax policy as a macroeconomic instrument. This is so because long-run contracts constrain the ability of the government to introduce new revenue measures in a timely manner and to change current policies in order to address unforeseen emergencies or to achieve stabilization targets.

Besides introducing serious microeconomic distortions, the high degree of discretion that arises from the contract system weakens the ability of the budget to perform an active and predictable macroeconomic function. The system has involved case-by-case negotiations of taxes between the government and the enterprises with the consequence that the government does not, in fact, assess and enforce taxes, but rather bargains for them. This leads to taxation rules that vary from one enterprise to another and which are very costly to change once the long-term contracts are signed. The discretion entailed in the bargaining process makes fiscal policy less effective in the macroeconomic sense, but it also detracts from the benefits of the reforms because it tends to validate the distortions in the system that could ultimately eliminate the incentives that the reforms intended to provide. This is so because the efficiency in the allocation of resources will not improve if decisions at the level of the firm continue to be made under a soft budget constraint. Discretion is bound to soften the budget constraint, thereby working against allocative efficiency.19

Erosion of Enterprise Profits

The negative impact of the contract system on government revenue was magnified by the shrinking of the tax base itself, caused by the decline in enterprise profits. Although there are no available data to estimate precisely the evolution of enterprise profits, there is strong evidence that these have indeed diminished over time.20 Within the contract system, the decline in the profit-GDP ratio causes the tax-GDP ratio to fall at a compounded exponential rate.21 The main cause behind the decline in enterprise profits is the incomplete nature of the reforms. Thus, an important factor lowering taxable profits in China has been the maintenance of price controls on final products, which has prevented many enterprises from shifting increased costs to prices. The higher costs have a number of causes: higher input prices (since prices of a number of raw materials were not tightly controlled), the depreciation of the exchange rate, and higher indirect taxes that cannot be shifted forward. In addition, the autonomy granted to enterprises regarding various aspects of wage policies, in the context of soft budget constraints arising from largely accommodating credit policies, led to a quite rapid increase in wages, benefit payments, and bonuses, which tended to reduce profits. Moreover, enterprises are allowed to treat both interest and loan repayments as deductible expenses in the calculation of taxable income, giving rise to an inverse relationship between the tax base and the level of indebtedness.22

Budgetary Repercussions of Regional Decentralization

Regional decentralization of fiscal powers was seen as an integral part of the economic transformation of China. The types of reforms adopted in this area, however, made tax revenues less buoyant and eroded the amount of revenue transferred to the Central Government. In China, local governments, mostly provincial and city governments, are in charge of collecting virtually all major taxes. The revenue is then shared upward with the next level of government. The sharing arrangements are not uniform, are subject to negotiation, and may vary from one case to another. Over the years, the revenue-sharing arrangements have undergone many changes, but, since the inception of the reforms in the late 1970s, the trend has been toward granting local governments more fiscal authority and allowing them to retain more revenue.

Regional decentralization reduced revenue collection, particularly following the introduction of the contract responsibility system for enterprises. Although in China tax policy is nominally set at the national level by the Central Government, local governments are responsible for negotiating contracts with the enterprises that they own. As this negotiation proceeds, local authorities have the power to set effective tax rates (as opposed to the statutory rates dictated from the center) through the establishment of quota profits and the rate of taxation of above-quota profits. Further, given the sharing rules between the center and the local governments, the latter have a clear stake in keeping as much financial resources as possible within their territory. In order to attain this objective, local governments are keen to grant generous tax treatment to their enterprises in the context of the negotiated contracts. In this way, resources remain within the local jurisdiction and local authorities can then tap these resources through “voluntary” contributions from enterprises to local projects–contributions that, of course, are not shared with the Central Government. Thus, while the effective tax burden on the enterprises is not reduced, explicit tax revenue, especially the budgetary revenue of the Central Government, is seriously eroded.

In order to address this problem and to provide incentives for local governments to collect and remit taxes, in 1988 the Central Government entered into contracts with each of the provinces. These contracts feature a quota arrangement, somewhat similar to the contract responsibility system for enterprises. The regional contracts replace the retention system previously in operation and specify the manner in which the resources raised in the provinces would be allocated between central and local governments. Typically, local governments contract to remit to the higher level of government a predetermined amount of revenue and retain all or part of the revenue above the quota.23

For two reasons, this type of revenue-sharing agreement weakens further the control of the center over fiscal policy and its ability to use it for macroeconomic purposes. First, the relatively low incremental revenue transfers that these contracts appear to set leave increased amounts of resources in the hands of local governments, which tend to generate higher local expenditures (that are difficult to control at the central level) and do not contribute to the improvement of the consolidated budget. Second, the fixed increment featured in the quota arrangements implies that the revenue transmitted to the Central Government is not affected by the underlying economic conditions, which affect only the revenue accruing to the local government. Since local governments usually do not consider themselves as responsible for country-wide demand management, the quota arrangement tends to compound the procyclical bias of the fiscal system generated by the enterprise contract system.24

Some recent information on the financial flows between the Central Government and local governments indicates that, indeed, a large proportion of the funds raised in the localities remain there, strengthening the constraints faced by the Central Government (Table 4) and restricting its ability to utilize fiscal instruments to attain global macroeconomic goals.

Table 4.China: Budgetary Operations of Central and Local Governments(In billions of yuan)
Central Government
Receipts of Central Government155.8185.0189.0183.6
Central government revenue collection110.5136.8140.0130.6
Profits remitted from localities45.
Outlays of Central Government166.7195.8207.2196.6
For central government expenditure110.5137.3151.8150.0
Central government financing of
local expenditures56.258.555.446.6
Local governments
Receipts of local governments240.5253.0276.6260.3
Local revenue collection184.2194.5221.1213.7
Transfers from Central Government56.358.555.546.3
Outlays of local governments238.7256.1278.6259.7
For local expenditure193.5207.9229.6206.7
Transfers to Central Government45.
Source: Ministry of Finance.
Source: Ministry of Finance.

Inflexibility of Public Expenditure

Although, as discussed above, the reduction in public expenditures as a proportion of GDP has been indeed significant, the question arises, in view of the trends in government revenues, whether the pace of spending cuts is consistent with the maintenance of macroeconomic balance. The decline in government expenditures has been constrained, in practice, by the interaction of the following: (1) the incomplete nature of reforms, particularly price reforms, that has required a sustained increase in budgetary subsidies to cover operating losses of enterprises; (2) the perceived need to raise consumer subsidies in order to avoid sharp increases in the prices of basic consumer goods that result from agricultural reforms; and (3) the limited success of the Government in transferring investment responsibilities to enterprises in an appropriate relation to the increase in their ability to retain profits.

In addition to these problems, further reforms now being considered or implemented also tend to put upward pressure on government expenditures or, at least, to limit their downward flexibility. In particular, a resumption of price reforms is likely to raise government spending since, in addition to the impact on the direct purchase of goods and services, and probably on wages, the demand for consumer subsidies will probably rise. On the other hand, freeing prices may allow many enterprises affected by price controls to become profitable and reduce the need for enterprise subsidies. Further pressure on expenditure will come also from the need to increase capital spending to relieve major bottlenecks in transportation, energy, and agriculture, or, at least, to limit their downward flexibility.

As a whole, therefore, much room for major contraction in the levels of expenditures cannot be realistically expected. Therefore, to prevent the emergence of serious fiscal imbalances it is crucial to address the revenue problems discussed above and, in particular, to streamline the tax system and the revenue-sharing arrangements so as to enhance the elasticity of revenue and strengthen the ability of the Government to use tax policy efficiently.

Concluding Remarks

The economic reforms taking place in centrally planned economies have brought risks and challenges that require a constant effort to monitor experience and find new strategies. Meeting these challenges necessitates the development of new policy instruments, or the modification of existing ones, to make them suitable to the changing circumstances that arise as a direct consequence of the reforms.

The central elements of economic reform in China have been granting greater decision-making powers to enterprises and enhancing the role played by market forces, while preserving the basic framework of socialist ownership. These changes require the development of instruments for indirect control over the behavior of increasingly autonomous economic agents. Among these instruments, fiscal policy plays a central role since it could be useful both for controlling aggregate demand and for affecting resource allocation. For these purposes, however, fiscal policy has to be transformed into an indirect lever of economic management rather than remaining a tool for the administrative allocation of resources.

In this paper, the evolution of fiscal policy over the course of the Chinese reforms has been examined with the objective of analyzing the main reasons for the major budgetary developments and assessing whether fiscal policy, under the conditions created by the reforms, can fulfill effectively its new macroeconomic role.

With respect to the first issue, the impact of reforms on the evolution of fiscal accounts, the Government is faced with a policy conflict. The goal of allowing enterprises to retain and freely dispose of a larger proportion of their profits means, at least in the short run, less revenue. However, the success of the reforms necessitates the maintenance of macroeconomic stability which entails a broad measure of fiscal balance. This, in turn, requires that the Government either divest itself further of spending responsibilities or redress the erosion of revenue elasticity that has arisen from the institutional framework associated with the reforms. While there is some scope for further reduction in spending, it is indeed quite limited and, therefore, ways must be found to enhance the elasticity of government revenue. This objective can only be attained, however, if the discretionary elements of tax policy are reduced.

The high degree of discretion, as well as the inflexibility entailed in current practices, particularly regarding the bargaining elements embodied in the contract systems, also limit the ability of the Government to exercise efficient fiscal control. The regional revenue-sharing arrangements, by leaving increased resources in the hands of local governments and by increasing their powers to set tax rates effectively, have eroded the command of the center over the mobilization of resources and have reduced its capacity to predict the outcome of policy measures.

Fiscal policies can and must play an important role in hardening the budget constraints during the transition from a centrally planned system. However, for this purpose a compromise should be found to solve the conflict between decentralization of decision making and maintenance of macroeconomic control and flexibility. Decentralization of decision making does not mean decentralization of macroeconomic instruments, which have to remain under firm government control. The need to adopt more transparent and flexible fiscal rules while developing the instruments for appropriate macroeconomic management seems to be an important lesson from the Chinese experience for other economies undertaking market-oriented reforms.


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Mario I. Blejer, a staff member of the Fiscal Affairs Department, is temporarily assigned to the World Bank as Senior Economic Adviser in the Europe and Central Asia Department.


The literature on the reforms in China is vast. For a survey, see Perkins (1988). On the macroeconomic dimensions of the reforms, see Blejer and others (1991) and Hussain and Stern (1991).


On the effects of agricultural reforms see, for example, McMillan, Whalley, and Zhu (1989) and Perkins and Yusuf (1984).


On the two-track price system see, for example, Wu and Zhao (1987).


Real GDP grew at an average of about 11 percent a year over the same period (1985-88), while the growth of industrial output exceeded 20 percent in both 1985 and 1988.


In 1978 state-owned enterprises accounted for about 80 percent of industrial output. In 1990 the figure was 54 percent and it is expected that it will not exceed 50 percent by the end of 1991. In 1990 the output of state-owned industries grew by 3 percent, while that of collectives was up by 20 percent and foreign joint ventures raised their industrial output by more than 50 percent (from a very low base). See “China’s Economy,” The Economist (1991).


The statutory profit tax rate that applies currently to most of large and medium-sized enterprises is 55 percent and, in addition, they may also be subject to an enterprise-specific income adjustment tax that is imposed to adjust for the differential endowment of assets inherited from the pre-reform period. Most of these enterprises, however, negotiate their tax liability in the context of the “contract responsibility systems” (see below). Small stateowned enterprises, as well as collective enterprises, are subject to a nonlinear tax schedule with a marginal tax rate equal to 55 percent. Since tax rates vary with the size and the type of ownership of the enterprises, this makes the revenues from enterprise taxes vulnerable to changes in the structure and ownership of enterprises.


For a full review of the Chinese tax system at the end of the 1980s, see World Bank (1990).


There are two types of individual income taxation: a long-standing individual income tax levied, in practice, on foreign residents, and the personal income adjustment tax, introduced in 1987, which is applied to Chinese citizens at rates varying from 20 percent to 60 percent.


The receipts from personal income taxes and from taxes on foreign-related enterprises are included in “other taxes” in Table 1. Wholly foreign-owned enterprises are subject to a progressive schedule ranging from 20 percent to 40 percent and a local surcharge of 10 percent. There is also a 10 percent tax on dividend remittances. Taxation on joint ventures is rather complicated, depending on the equity participation of the Chinese partner. The receipts from these taxes should, in fact, be added to the revenues from enterprises but no separate data were available.


See below for a discussion on the factors affecting enterprise profitability under partial reforms.


This pressure was sometimes intensified by the ability of local governments to obtain additional financial resources for the enterprises they own in order to induce them to invest in infrastructure projects in their localities.


For a discussion on the role of the budget in centrally planned economies and its evolution during the transition, see Tanzi (1991).


For a more detailed discussion of these issues see Blejer and Szapary (1990).


Usually, for large and medium-sized enterprises, the tax rate applied to the “agreed profits” is the statutory 55 percent rate.


The contracts also seem to result in “ratchet effects” because if enterprises expect that the target rate of profit in the next contract, and therefore the effective tax rate, would depend on their current performance, this would have a strong negative impact on the current enterprise behavior. Hussain and Stern (1991).


The Chinese authorities are currently experimenting with a different form of enterprise taxation, under which a flat, nonnegotiable tax rate of 35 percent of total profits is the norm. The enterprises then negotiate with the government (the “owner”) the distribution of posttax profits. This has limited coverage: no more than 20 cities are said to have implemented it so far with enterprises participating on a voluntary basis. Experiments of this type are expected to continue.


For a proof, see Blejer and Szapary (1990), Appendix I.


This policy was envisaged to be transitional and intended to put enterprises that have to rely on bank loans and those that continue to benefit from budgetary grants to finance investments on an even footing. Although this practice is being phased out slowly, it is still the prevalent system. Under the experimental system described in footnote 19, loan repayments are no longer admissible as a deductible expense.


As with enterprises, the quota is usually calculated as the revenue remitted in the year prior to the signing of the contract plus a fixed increment. There are however five types of contracts: (1) localities retain a specified proportion of any revenue that is within a certain percentage growth from the previous year and retain any excess of this growth rate; (2) a specific proportion of all revenue is remitted to the center; (3) a certain proportion of revenue is retained up to a quota, and then a usually higher proportion of revenue is retained in excess of the quota; and (4) a given transfer to the center is contracted for the first year. In subsequent years the initial amount is contracted without changes over time. In addition, the center has entered into contracts to provide specified transfers to deficit or poor provinces.


For further discussion on the fiscal dimension of regional decentralization, see Wong (1990).

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