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FISCAL
DECENTRALIZATION
THE CHINESE FINANCIAL SYSTEM, SPRING 2014
PV VISWANATH
LUBIN SCHOOL OF BUSINESS
P.V. Viswanath
LEARNING OBJECTIVES
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How did the tax system work prior to reform?
How did it work after reform?
What were the key elements of the 1994 Tax Reform?
What impact did these changes have on the Chinese economy?
How has the Chinese fiscal system affected the different areas of the country?
What is the difference between the center-local split in revenues versus expenditures?
What has been the impact of the fiscal system currently in place on local government
indebtedness?
P.V. Viswanath
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PRE-REFORM
• In the pre-reform period between 1949-1978, there was complete central control over what people
produced and consumed. Revenues were collected by local governments and accrued to the center.
Local governments were not allowed any spending power. This worked in pre-industrial, agrarian
China.
• There were no personal and corporate income taxes. Revenues were largely raised from the profit
remittances of SOEs, whose profitability was ensured by state-fixed prices. At the end of the 1970s,
profits from SOEs accounted for nearly half of total government revenues.
• The central government set spending priorities, approved local budgets according to local spending
needs, and determined civil service salary scales, pension and unemployment benefits, educational
and health care standards etc.
• Local income in excess of expenses was submitted to the central government and shortfalls were
automatically covered. Local governments had no discretionary spending power.
• The central government was responsible for national defense, economic development (capital
spending, R&D), universities and research institutes, industrial policy and administration of
national institutions. Sub- national governments were in charge of day-to-day public
administration and social services such as primary and secondary education, public safety, health
care, social security, housing and other local/urban services.
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EARLY POST-REFORM PERIOD
• After 1979, SOEs were faced with competition from the private sector and from TVEs.
Coupled with their innate inefficiencies, this led to reduced fiscal revenues for the
government.
• As a result, budget revenues reached a minimum at 10.8% of GDP in 1995, with budget
expenditures equal to 11.8% of GDP (at all levels of government) and a budget deficit
equal to 1% of GDP. This contrasts with government expenditures running an average of
32% of GDP for a sample of 22 developing countries (Hoffman, 1998).
• This led to a serious fiscal problem for the Chinese government.
• The government engaged in a series of ad hoc solutions marked by SOEs negotiating
separate revenue-retention with their supervising agencies on a case-by-case basis.
• Tax sharing between local and central governments were also negotiated separately.
• Although tax rates were generally set at the central level, each local government
provided subsidies and exemptions to favored enterprises and institutions.
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DISTORTIONS DUE TO TAX POLICY
• Since local governments had direct equity interests, or indirect interests in the form of special
local taxes or illegal side-payments to local officials, these governments engaged in the
expansion of local enterprises such as distilleries and cigarette factories. They also engaged
in wasteful duplication of industries, since controlled enterprises would contribute to the
local tax coffers, whereas non-local enterprises would not.
• Local banks were also forced to provide cheap financing to such enterprises, without
regarding to their desirability or profitability.
• The central government opportunistically increased taxes on wealthy provinces, which led to
decreased incentives to invest as also to hiding of revenues by local governments.
• The central government also shifted spending responsibilities to lower levels of government –
45% in 1981 to 72% of total spending in 1993.
• This led to a vicious cycle of jurisdictional competition and the central government’s share of
revenue fell from 33% in 1988 to 22% in 1993.
• In addition, rich provinces like Guangdong, Shanghai and Shandong did well due to their
political leverage, whereas poorer regions fared badly.
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CENTRAL GOVERNMENT REVENUE AND GDP
P.V. Viswanath
Source: Chunli Shen, Jing Jin and Heng-fu Zou, Fiscal Decentralization in
China
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THE 1994 TAX SHARING REFORM
• As can be seen from the previous figure, the efficiency of tax collection went from bad to
worse, down to about 12% of GDP in 1993.
• This led to a reform in the way taxes were reckoned and collected. As far as the actual
taxes, several changes were introduced.
• Value Added Tax (VAT) replaced the turnover-based (i.e. sales based) product tax and
was implemented at a uniform rate of 17%. Very small private enterprises without
regular bookkeeping systems paid a tax of 6% of gross sales in lieu of VAT.
• Corporate income tax was unified to include all domestic enterprises, and the top rate
was reduced from 55% to 33%. The previous system of negotiated annual transfers to the
government budget from SOEs was eliminated.
• Excise taxes (sin taxes) on tobacco, liquor and other luxuries were introduced; these
were very productive taxes and were assigned mostly to the central government.
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TAX REFORM AND TAX REVENUES
• The other important aspects of the new system were as follows:
• Negotiated contracts were replaced with a rule-based system of tax assignment; this put
central-local revenue-sharing on a more transparent, objective basis and reduced game
playing.
• In addition to the excise taxes, direct and indirect taxes on central-government controlled
sectors (e.g. railroads, financial institutions etc.) were assigned to the central government.
• Provincial governments had direct control over direct taxes on local enterprises, real estate
and property taxes, and pollution and resources fees.
• Most VAT revenues were designated as shared income, with 75% going to the central
government and 25% to the local government.
• A centralized revenue collection system was established in all provinces to collect centralfixed and shared revenues. This was the National Tax Service (NTS).
• The dramatic impact of this tax reform on central government budgetary revenues can
be seen in the next figure.
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TAX REFORM AND TAX REVENUES
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COMPOSITION OF GOVERNMENT REVENUE
• The following figure also shows how the sources of government revenue have changed
over time.
• At the beginning of reform, revenue from enterprises was as important as tax revenues.
• However, over time as competition from the private sector increased, this sources of
revenues dropped, until it dropped to almost zero around 1985.
• At the same time, government subsidies to loss-making enterprises increased, but with
the reforms in SOEs, these have also come down substantially.
• Tax revenues continue to be important, accounting in 2007 for about 90% of central
government revenues. This number has held steady until today.
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COMPOSITION OF GOVERNMENT REVENUE
Source:
Shuanglin Lin,
The Rise and
Fall of China’s
Government
Revenue, East
Asian Institute
Working Paper
no. 150
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CENTRAL & LOCAL GOVERNMENT EXPENDITURES
• However, the full story is not just about central government revenues.
• During the 1985-1993 period, the central government spent about the same share of
outlays, 30% or more , as the share of revenues it look in. Although there were transfers
in both directions between center and localities, they balanced out almost exactly. Since
the 1994 tax reform, the central government takes in a little over 50% of all revenues.
However, the central government spends directly about 30% of all expenditures.
• Local governments are now dependent on central government transfers that pass on
about 20% of total revenues to them. This can be seen starkly in the next figure.
• This arrangement enhances the central governments’ overall position and gives it a
stronger bargaining position vis-à-vis local governments.
• However, about half of the transfers in 2000 were discretionary, ad hoc payments from
the center. This caused great uncertainty and led to favoring of richer regions.
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CENTRAL & LOCAL GOVERNMENT EXPENDITURES
Source: Xiao
Wang and
Richard Herd,
The System of
Revenue Sharing
and Fiscal
Transfers in
China, OECD
Economics Dept.
Working Paper
no. 1030
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CENTRAL-LOCAL TAX REVENUE TRANSFERS
• Central transfers in China can be classified into two broad categories: general purpose and specific
purpose transfers.
• The general purpose transfers consist of a) the tax rebate designed to return a fraction of revenues by
origin (province of collection), and b) the equalization transfer (also called the general-purpose grant)
established in 1995 as part of an effort to ease widening regional disparities.
• Specific purpose grants include: a) grants for increasing wages, b) grants for rural tax reform, c)
grants for minority regions, d) subsidies for poor provinces carried over from the pre-1994 system,
and e) earmarked grants.
• Ear-marked grants have been allocated for specific purposes such as subsidizing agricultural
development, supporting infrastructure construction, assisting backward regions, and providing
emergency funding for natural catastrophes. As the pie-chart below shows, ear-marked grants were
one-third of total transfers in 2004 and many of the other transfers, too, are discretionary.
• In the last decade, however, transfers to local governments have been redistributive and has led to less
inter-provincial inequality. This can be seen in the graph below.
• Furthermore, the five-year plan publicized by the government in 2012 aims to improve basic public
services with the goal of equalizing basic public services for everyone by 2020. The Plan sets the scope,
standard and mechanism to deliver such services in public education, labor and employment services,
social security, social services, health care, population and family planning services and housing
services, as well as those related to culture and sports.
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IMPORTANCE OF CENTER-LOCAL TRANSFERS
Source: Chunli
Shen, Jing Jin
and Heng-fu Zou,
“Fiscal
Decentralization
in China”
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TRANSFERS TO PROVINCES AND INEQUALITY
Source: Xiao
Wang and
Richard Herd,
The System of
Revenue Sharing
and Fiscal
Transfers in
China, OECD
Economics Dept.
Working Paper
no. 1030
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LOCAL GOVERNMENT BORROWING
• The circumstances described above have led to excessive local government borrowing. In
fact, under China’s 1994 budget law, local governments are forbidden to incur either
domestic or foreign indebtedness unless otherwise permitted. However, the reality is that
many local governments are on the verge of bankruptcy due to debt services. Here are some
of the categories of local government debt.
• Direct borrowing and loan guarantees. In addition to direct borrowing, many local
governments in dire fiscal straits are unable to pay the full salaries of elementary and
secondary teachers and this becomes part of local debt. Similarly, some local governments
issue baitiao (白条, IOUs) to farmers in payment for their agricultural products. Local
governments also provide loan guarantees for SOEs directly or indirectly.
• Borrowing from commercial banks. Often local governments can pressure banks to provide
loans through the appointment of regional bank heads and through the supply of water and
electricity, housing, recruitment of bank employees and schooling of children.
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LOCAL GOVERNMENT BORROWING
• Indirect Borrowing. Sub-national governments take on indirect borrowing through local-owned
enterprises or through Trust and Investment Companies (TICs). TICs have been used as vehicles for
investment in various businesses, particularly construction companies. TICs receive government and
enterprise trust deposits, as well investments from wealthy individuals seeking a higher return for their
money. These deposits are popular because they are seen as risk-free due to a perceived implicit
government guarantee.
• According an article published in December 2013, Chinese TICs hold over 9 tr 元 in assets under
management! “Before 2010, trusts removed risky bank loans from bank balance sheets and repackaged
them as securities for banks to sell to customers. When this practice was banned, trusts continued to
extend loans themselves or through third parties and sell them to banks to bundle as wealth
management products.” The perceived government guarantee comes from the fact that these wealth
management products (WMPs) are being sold by banks.
• As of the second quarter of 2013, trusts had invested 35% of their funds in infrastructure and real estate
projects, and another 21% was invested in financial institutions and products. Only 29% of trusts’ funds
are invested in industrial and commercial enterprises—real economy firms that may stand a chance at
remaining profitable. For a recent TIC near-bankruptcy, see
http://www.forbes.com/sites/gordonchang/2014/01/19/mega-default-in-china-scheduled-for-january31/
• Though not all TICs are local government creations, they are certainly an important reason for their
indebtedness.
P.V. Viswanath
Source: http://triplecrisis.com/will-chinas-trusts-get-tic-ed/
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LOCAL GOVERNMENT BORROWING
• Foreign Borrowing: External borrowing by central and local government-owned financial
institutions requires a quota from the National Development and Reform Commission (NDRC), as
well as approval from the State Administration of Foreign Exchange (SAFE). Nevertheless, many
local governments have borrowed abroad using TICs or International Trust and Investment
Companies (ITICs, i.e. TICs involved in international borrowing).
• Many of these ITICs have gone bankrupt, including Guangdong ITIC in 1999, as well as Fujian ITIC,
Tianjin ITIC, Shanghai ITIC, Shenzhen ITIC etc. After the massive GITIC bankruptcy ($4.37 billion
in liabilities and only $2.6 billion in assets), foreign investments in ITICs dropped off. However,
foreign borrowings are believed to have increased in recent years (according to Soros, see
http://macrobits.pinetreecapital.com/continued-financial-stresses-china/)
• In any case, the total debt of local governments has soared to $3 tr or about 18 tr 元, which indicates
a serious problem! http://www.nytimes.com/2013/12/31/business/international/chinese-localgovernment-debt-up-13-in-6-months.html
• The skewed center-local fiscal relations is another aspect of financial repression in China. It also
further highlights the urban-rural divide, since as mentioned above, fiscal policy has tended to
benefit richer provinces and areas in China.
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THEMES
• Lack of access to sufficient resources in the form of taxes forces the central government to
extract resources through financial repression.
• The specific fiscal system currently in place engenders agency problems at the local level. Since
local governments have to fund local development, local resources are despoiled. There is
excessive dependence on debt, and since local government debt is illegal, various destabilizing
ways (such as the TICs) are dreamt up to raise monies.
• Sub-national responsibility for expenditures and the lack of a voice for the people means that
there is extreme myopia in the decisions of local politicians, including pushing farmers off their
land for real estate development.
• The availability or otherwise of tax revenues affects the amount of government expenditure on
social insurance and other needs of the people.
• The lack of sufficient tax revenues also means that the government extracts resources in the form
of lower bank deposit interest rates coupled with an underdeveloped financial securities market.
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