Chapter

5 China1

Author(s):
Annalisa Fedelino
Published Date:
October 2010
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Fiscal decentralization since the early 1980s has supported economic growth and the process of transition to a market economy in China. However, China’s impressive performance has not benefited all subnational governments equally—income disparities across provinces have widened. Furthermore, the provision of public services is skewed in favor of richer provinces. The role of intergovernmental relations in perpetuating these disparities has come under increasing scrutiny.

Given China’s size, it is not surprising that the levels of subnational governments (four) and the number of jurisdictions (more than 40,000) are larger than in other countries. The first subnational tier consists of provincial-level authorities (22 provinces, five autonomous regions, and four municipalities—Beijing, Shanghai, Tienjin, and Chongqing). The second tier comprises prefecture-level authorities (333 prefectures and cities at the prefecture level). The third tier encompasses 2,859 counties and cities at the county level, while the last tier includes 40,813 villages and townships.2

Fiscal relations between the central and local governments in China since 1990 have evolved in two broad phases—decentralization in the early years, and recentralization since the mid-1990s. Fiscal reforms in the 1980s decentralized the revenue-sharing system, contributing to a sharp decline in the central government’s share of total revenue, from about 40 percent in 1985 to 28.3 percent in 1993; this drop in the center’s share was even more dramatic considering that national government revenue had declined over the period, from more than 22 percent to about 12 percent of GDP. By the early 1990s, the authorities considered central revenue to be seriously inadequate, especially for redistributive purposes. This prompted a new round of reforms in 1994, which included changing the revenue-sharing rules, introducing a central tax administration, and increasing the role of transfers.

Table 5.1.China: Indicators of Fiscal Decentralization
Type of governmentUnitary
Population (million, 2007)1,307.6
Area (million km2)9.3
Levels of government5
States and provinces31
Municipalities44,016
Average municipality size (population)29,706
Minimum municipality size (population)
IMF technical assistance missions on1993, 1994,
fiscal decentralization2002, 2004
Source: Authors.Note: … = data not available.
Source: Authors.Note: … = data not available.

Based on subnational expenditure shares, China is at the high end of the decentralization spectrum. Local governments are largely responsible for public service delivery and implementation of social policies, and account for nearly 80 percent of total spending (Table 5.2). However, a widening gap is emerging between the local governments’ expenditure mandates and the resources available to them. Local governments, particularly in poorer provinces, experience difficulties in financing basic services (Ahmad, Albino-War, and others, 2004).

Table 5.2.China: Summary of Subnational Governments’ Finances, 2007
Percentage

of general

government
Percentage

of GDP
Total subnational revenue83.514.6
Own-source revenue47.58.3
Transfers from the center36.06.3
Total subnational expenditure75.014.1
Overall balance (before transfers)n.a.-5.8
Overall balancen.a.0.5
Sources: Data from www.mof.gov.cn/yusuansi and authors’ calculations.Note: n.a. = not applicable.
Sources: Data from www.mof.gov.cn/yusuansi and authors’ calculations.Note: n.a. = not applicable.

The IMF has provided significant technical assistance to China on intergovernmental fiscal relations, initially on the new revenue-sharing, tax assignments, and transfer systems in 1994, and in 2003 through a diagnostic mission on the overall design of intergovernmental fiscal relations, followed by an assessment of fiscal risks associated with decentralization. Almost 15 years into the fiscal federalism reform, some aspects of intergovernmental fiscal relations need to be modified. In particular, the design and clarity of expenditure mandates (which were not addressed in the first round of assistance in the mid-1990s), and the tax assignments and transparency and efficiency of the transfer system, need to be revisited. Despite growing recognition that the current system of intergovernmental fiscal relations needs reform, the authorities have not yet signaled a clear intention to adopt a comprehensive strategy to address these issues.

The 1994 Fiscal Reform

Recentralization of Revenue

The core objective of the 1994 reform was to ensure a higher revenue-to-GDP ratio, while also boosting the share of the central government in total revenue. A new tax sharing system was introduced, which shifted revenue collection and distribution away from a negotiated basis to a mix of tax assignments and tax sharing. A new value-added tax was adopted, to be shared between the center and the local governments. The State (central) Tax Administration was made responsible for the collection of central and shared taxes, while local government agencies remained in charge of collecting local taxes. However, tax rate-setting authority remained largely with the central government; local governments had only limited powers to set rates for a few local taxes. These arrangements still broadly apply to date.

The 1994 reform was largely successful in achieving its objectives. Revenues recovered quickly from the trough of the mid-1990s, and the center’s share surged to above 55 percent—more than twice the level registered just before the reform. The reform also streamlined the tax system and enhanced tax administration, providing the center with institutional tools it previously lacked. However, important differences in revenue-generating capacity across provinces not only remained, but increased over time.

Broadened Expenditure Mandates

The “recentralization” of revenue was not accompanied by a corresponding shift in expenditure assignments. While local governments’ share of total expenditure have remained stable at about 70 percent since the late 1990s, their expenditure nonetheless became increasingly disproportionate to their own-resources, and considerable further spending pressures lie ahead on account of pensions, local investment needs, and industrial restructuring.

Various factors explain the proliferation of local governments’ expenditure responsibilities. The industrial restructuring process has transferred spending responsibilities of state-owned enterprises—especially in social areas, such as education and health—to subnational governments as such enterprises are reformed; rapid urbanization has created a need for subnational governments to provide basic infrastructure (such as electricity and transportation); and the administration of pensions remains largely decentralized, in most cases all the way down to the county level (where there are signs of difficulties in paying pensions). In addition, minimum service standards set by the center create challenges, particularly for poorer counties. For example, the provision of health care services in rural areas—to be partly covered by specially designed central subsidies—requires matching funds from recipient counties, further stretching their service provision capacity.

Inadequate Transfers

In addition to a clear redefinition of the tax assignments, the 1994 reform also redesigned the transfer system, moving away from one-time, negotiated transfers toward a more rules-based and transparent mechanism. The transfer system is currently based on two main pillars:

  • Specific-purpose grants (special transfer payments, Table 5.3). These grants are earmarked transfers allocated to special programs and uses, including transfers for capital construction, innovation funds, science and technology promotion funds, and agricultural support.
  • General-purpose grants aimed at providing each province with adequate resources. These grants are rules-based and depend on variables such as provincial GDP, student-teacher ratios, number of civil servants, and population density. They increased from 10 billion yuan in 1994 to 250 billion in 2007, and their share in total transfers reached 35 percent in 2007.
Table 5.3.China’s Transfers, 2007
Billions

of yuan
Share

(percent)
Fiscal-power transfer payments708.950.7
General transfer payments250.117.9
Ethnic minority area transfer payments17.31.2
Tax-for-fee reform transfer payments75.95.4
Adjusting-wage transfer payments223.416.0
Rewards or subsidies transfer payments33.92.4
Other108.37.7
Special transfer payments689.949.3
Education39.12.8
Technology7.50.5
Social security and employment196.114.0
Health63.04.5
Environment protection74.85.3
Agriculture, Forestry and Water Affairs96.16.9
Other213.315.2
Total transfer payments1,398.8100.0
Percentage of GDP5.4
Source: Data provided by the authorities.
Source: Data provided by the authorities.

In addition, other single-purpose transfers cater to specific needs and purposes. Among these, “tax-for-fee reform transfer payments” were introduced to compensate local governments when they lost important revenue handles as a result of the tax-for-fee reform;3 “adjusting-wage transfer payments” were introduced in 1998, targeting provincial governments that could not cover the increase in civil servants’ wages; and “minority ethnic areas transfer payments” are paid to a few entities, including the five autonomous regions.

Despite their large size, transfers have proved inadequate to provide sufficient financial support for the provision of essential services such as rural education and rural public health. General-purpose transfers, although growing, represent only one-third of the total. The system’s ability to redistribute fiscal revenues across provinces, therefore, remains limited. Specific-purpose grants comprise hundreds of different earmarked grants, allocated on a one-time negotiated basis. Their large share relfects the proactive regional policy that the center is carrying out. However, by their nature these grants make the transfer system less transparent and more difficult to monitor because the center lacks the ability to track the actual spending from earmarked transfers. These grants also undermine the rules-based character of the transfer system that the 1994 reform aimed to introduce.

Uncertainty about the size and timing of central transfers further complicates budgetary formulation and execution at the local government level. Where local governments do not have sufficient resources of their own to carry out important public functions, either expenditure cuts are effected or arrears accumulate.

Implications of the Current System

The current intergovernmental fiscal system poses a number of fiscal risks. Faced with widening financial pressures—in the presence of limited tax-setting powers, an inadequate transfer system, and a legal prohibition against borrowing—local governments have continued to raise revenue outside the budget system, mainly in the form of fees and charges that accrue to locally managed extra-budgetary funds. Extra-budgetary revenues also circumvent the borrowing prohibition. Although reported extra-budgetary funds managed by the central government declined significantly after the 1994 reform, those controlled by subnational governments continued to increase.

Financing constraints have also induced subnational governments to seek ways to circumvent their legal funding limits. This situation has led to the creation of channels for raising indirect financing and the shifting of some public functions to seemingly nongovernment entities. Large-scale infrastructure projects offer an example: most provinces have experienced intense activity in building highways, airports, and urban ring roads. Most of these projects have been financed by bank loans, with the expectation that the sale of appreciated land leases in the areas in which these projects are implemented will make the projects financially viable. However, these projects may also present significant fiscal risks if local governments, and ultimately the central government, are called upon to shoulder the associated fiscal costs. The shift of public functions to nongovernment entities to overcome legal borrowing constraints might also generate opportunities for waste and corruption without necessarily improving service delivery. The authorities are aware of these problems, as candidly described in a number of audit reports from the National Audit Office.

IMF Advice and Possible Reforms

The transfer system, designed to compensate local governments for revenue lost to the center and to promote equalization across regions, is in need of reform. First, it has proved to be inadequate to tackle the large regional disparities. Second, local governments’ expenditure mandates remain unclear and, in some cases, largely unfunded. A case in point is pension costs, for which local governments are ill-equipped to shoulder the related costs, and higher-level pooling is called for. Finally, indirect means of local government financing and creation of implicit liabilities at the local level may present significant fiscal risks, underscoring the need for comprehensive, centralized monitoring of subnational operations.

Staff technical assistance advice since 2002 has addressed these issues. Key considerations include the following:

  • The impact of increased control of local governments over tax rates, and changes in revenue assignments (including with reforms of the valueadded tax and income tax), should lead to a reconsideration of local spending responsibilities and financing arrangements.
  • Transfers should be tailored to facilitate the delivery of minimum standards of public services, and should reflect a rules-based equalization system.
  • The buildup of fiscal risks at the local government level should first be addressed by taking stock of these liabilities, for which estimates are not now available. A fiscal risk register could be built by consolidating information from several sources, including from the banking and securities sectors, and through the management of state assets. These “below-the-line” sets of information could be consolidated and maintained at the central treasury.

Staff also recommended that legal constraints on local government borrowing should replace the current informal arrangements, but cautioned that a number of structural reforms would have to occur first. These reforms include strengthening the recording and reporting of local government operations and enhancing the accountability and transparency of local government financial management. Reforms being implemented at the central government level in the public financial management area (which include the broadening of the treasury single account and the implementation of a new budget classification—also issues for which the IMF has provided extensive technical assistance) could help in such efforts, by setting a model for similar reforms at the subnational level.

These reforms are part of an extensive and interlocking package of measures that will take several years to implement fully. The pace of reform will depend on the speed at which the expenditure and revenue assignments can be adjusted. Chinese authorities have generally favored a pilot approach to implementing structural fiscal reforms. Thus, any important policy change is first tried out in a handful of carefully selected cities or provinces before nationwide implementation. This approach has helped garner support and allay concerns related to the possible risks of implementing full-scale reforms in a country as widely diverse as China.

Still, a comprehensive and systematic strategy for intergovernmental fiscal relations is needed. Although no major reforms toward fiscal decentralization have been implemented recently in China, the system of local-central fiscal relations has been affected by a number of fiscal policy changes. For example, taxation of agriculture (the main revenue handle in poorer provinces) has been eliminated to favor low-income farmers; and in rural areas, free education through ninth grade is guaranteed and health care coverage has been broadened. So far, most of these policy changes have resulted in increased expenditure mandates for local governments and, at least in the already less-favored rural areas, lower own-revenue; however, significant changes in the design of central transfers have not taken place, which leaves open the question of the sustainability of these policy changes for poorer local governments. Overall, tinkering at the margin with piecemeal measures—absent an overall and consistent fiscal decentralization framework—poses the risk of actually deepening tensions and inequalities that the current system has contributed to generating.

2

As of the end of 2007, according to the National Bureau of Statistics of China.

3

A provincial pilot project, launched in 2001, replaced numerous fees with a surcharge on the local agricultural tax. This “tax-for-fee” reform was gradually extended to all the provinces.

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