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Lecture 6 Fiscal Reforms -30- 1 Pure market economy without a government Output Market Firms Households Input Market -30- 2 Market failures Micro level 1. Incomplete competition. 2. Externality. 3. Insufficient public goods and merit goods. 4. Incomplete information and high transaction cost. 5. Risk and uncertainty. Macro level 1. Unequal income distribution. 2. Economic fluctuation. 3. International trade deficits. -30- 3 Circular Flow in a Mixed Economy Output Market Households Government Firms Input Market -30- 4 Government failures Politicians and bureaucrats are self-interested and they may not act in the interest of the society. Public and private sector share some common problems. Incomplete information, transaction cost, problematic performance measurement and incentive systems, and risk and uncertainty. Governmental institutions and political arrangements may not make the government responsive to the solution of the market failures. Political business cycle is one example of artificially made fluctuation. Bureaucratic empire building: absence of bottom line. For example, the log-rolling process may lead to budget expansion. Divided government reduces the efficiency of decision making. Decision making may be controlled by organized interest groups without reflecting median voter preferences. -30- 5 Basics of Public Finance The general economic goals of a government 1. Economic growth; 2. Stable price; 3. Balance in international trade; 4. Full employment. The major economic instruments of the government 1. Financial instruments: interest rates, deposit reserve ratio, credit provision, etc. 2. Fiscal instruments: taxation, debts, redistribution, spending 3. Other: industrial policies, regulatory policies, etc. Public finance serves purposes beyond efficient resource allocation 1. Providing public goods to overcome market failure 2. Balance different regions and social groups 3. Intra- and inter-governmental check and balance -30- 6 Sovereign credit rating by Standard & Poor's Foreign Rating in March 2013 Three major credit rating agencies: Standard & Poor’s, Fitch, and Moody’s. Dagong, a Chinese rating agency in Beijing. -30- 7 How can fiscal policies be used to stimulate economic growth? 1. Mobilize local initiatives. 2. Facilitate incentives of investment. Enterprise income tax Laffer Curve 3. Facilitate capital cumulation Structural inclination of taxation 4. Facilitate infrastructure construction 5. Stimulate innovation and export -30- 8 Pros and cons of centralized fiscal system Merits 1) Central fiscal management internalizes the cross-jurisdiction externality effects 2) Intergovernmental transfer redistributes wealth. 3) Restrain excessive local fiscal competition. 4) Central government grants/transfer payment empower its political control. Demerits 1) Federal grants may lead to overly reliance on federal finance. 2) The separation of revenue and expenditure creates fiscal illusion and offsets the policy purpose of the federal government. 3) Correspondingly, it gets more difficult to motivate local jurisdictions to match its revenues with local expenditure preferences. 4) Such system may encourage rent-seeking behavior. -30- 9 Pros and cons of a decentralized fiscal system Merits 1) Exit model: Tiebout’s model argues that local residents vote by feet according to their preferences and the local revenue-expenditure patterns. Decentralized system more directly links the local performances to the capacity of local officials who are driven by the pressure of local competition. When assets are mobile, local governments are reluctant to impose heavy taxes. This may result in a small government in general. 2) Voice model: local democratic process can help match the financial arrangements and local preferences. The demerits of a decentralized system is just the absence of the merits derived from a centralized system. Reduction of public goods supply to the bottom Externality problem is not well solved if high transaction cost exists Inequality -30- 10 The evolution of intergovernmental fiscal arrangement in China 1. Fiscal arrangement under planned economy United revenue and expenditure system A heavy reliance on enterprise profits of SOEs rather than on tax Local governments didn’t have fiscal power. They were the agents of central government, collecting revenues and retaining some for local expenditures according to central plans. In 1978, Shanghai had 1.1% of China’s population, but contributed 7.5% of national GDP and 15% of national fiscal revenues. It collected RMB 16.9 billion revenues, and kept RMB 2.6 Billion. The contribution rate is 85%. In 1985, SOE’s profit remittance was replaced by income taxation Major expenditures were on industry investment and infrastructure construction In 1978, expenditures on administration and services were only 11.6% of the fiscal expenditures. -30- 11 Fiscal revenue Structure of China: 1970-1993 (100 Million) Year Total Revenue Tax revenue Enterprise income revenue 1970 662.9 281 378 1973 783.94 348 427 1975 815 402 400 1976 776 407 338 1977 874 468 402 1978 1132 519 571 1979 1146 537 495 1980 1159 571 435 1981 1175 629 353 1982 1212 700 296 1983 1366 775 240 1984 1642 947 276 1985 2004 2040 43 (income tax began, 595 this year) -507 1986 2122 2090 42 -324 1987 2199 2140 42 -376 1988 2357 2390 51 -446 1989 2664 2727 63 -598 1990 2937 2821 78 -578 1991 3149 2990 74 -510 1992 3483 3296 59 -444 1993 4348 4255 49 (582 tax submission this year) -411 -30- Subsidies to SOEs 12 2. 1978 ~ 1994: discretion-based fiscal contracting and revenue sharing system Since 1978, decentralized fiscal management was gradually introduced. Fiscal contracts were signed between central and local governments There were 6 types of revenue-sharing arrangements Basically, local governments could retain a big portion or even 100% of the surplus revenues after they submitted the quota set by the contract. This essentially removed central government’s responsibility to provide local services. This drove local governments to maximize local revenues: LSC The emergence of a prosperous economy and a weak state -30- 13 3. 1994 ~ Present: rule-based revenue sharing system (A return to centralization) A reclassification of taxes and taxing authorities Fixed Central Revenues: Customs Duties; VAT and Consumption Tax collected by the Customs; Domestic Consumption Tax, Income Tax of Central Enterprises; Income Tax of Local Banks and Nonbank Financial Institutions; Revenues remitted by Railway Department, Headquarters of State-owned Banks and Insurance Companies; Profits remitted by Central Enterprises. Fixed Local Revenues: Business Tax; Income Tax of Local Enterprises; Profits remitted by Local Enterprises; Individual Income Tax; City and Township Land Use Tax; Fixed Assets Investment Orientation Regulation Tax; City Maintenance and Construction Tax; House Property Tax; Urban Real Estate Tax; Vehicle and Vessel Usage Tax; Stamp Tax; Slaughter Tax; Agriculture Tax; Animal Husbandry Tax; Farmland Occupation Tax; Deed Tax; Inheritance and Donation Tax; Land Appreciation Tax. Shared Revenues: a. Domestic VAT (17%): 75% for central government and 25% for local governments; b. Resource Tax: the part for the central government is the tax paid by offshore oil enterprises, and the rest is for local governments; c. Security Transaction Tax: Split by half between central and local governments d. In 2002, individual income tax was changed to be shared half by half, in 2003 the central government began to share 60% percent. -30- 14 Restructure the tax administration system Removal of local discretion in making tax breaks The banking sector reform in 1998 Building 9 branches of the Central Bank -30- 15 Improved extractive capacity 60% 50% 40% 30% 20% 19 78 19 79 19 80 19 81 19 82 19 83 19 84 19 85 19 86 19 87 19 88 19 89 19 90 19 91 19 92 19 93 19 94 19 95 19 96 19 97 19 98 19 99 20 00 20 01 20 02 20 03 20 04 20 05 10% 0% Revenue Share of Central Gov Total Revenue Share in GDP Expenditure Share of Central Gov -30- 16 The two ratios of China’s fiscal revenues 1978-2007 Year GDP (RMB billion) Ratio 1 1978 364.52 0.31 1979 406.26 1980 Ratio 2 Year GDP (RMB billion) 0.16 1993 3533.4 0.12 0.22 0.28 0.20 1994 4819.79 0.11 0.56 454.56 0.26 0.25 1995 6079.37 0.10 0.52 1981 489.16 0.24 0.26 1996 7117.66 0.10 0.49 1982 532.36 0.23 0.29 1997 7897.3 0.11 0.49 1983 596.27 0.23 0.36 1998 8440.23 0.12 0.50 1984 720.81 0.23 0.41 1999 8967.71 0.13 0.51 1985 901.6 0.22 0.38 2000 9921.46 0.14 0.52 1986 1027.52 0.21 0.37 2001 10965.52 0.15 0.52 1987 1205.86 0.18 0.33 2002 12033.27 0.16 0.55 1988 1504.28 0.16 0.33 2003 13582.28 0.16 0.55 1989 1699.23 0.16 0.31 2004 15987.83 0.17 0.55 1990 1866.78 0.16 0.34 2005 18386.79 0.17 0.52 1991 2178.15 0.14 0.30 2006 21087.1 0.18 0.53 1992 2692.35 0.13 0.28 2007 249530 0.21 0.54 -30- Ratio 1 Ratio 2 17 Tax revenue structure 1978-2008 Domestic Value-added Tax 1978 1980 1985 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 519.28 571.70 2040.79 2821.86 2990.17 3296.91 4255.30 5126.88 6038.04 6909.82 8234.04 9262.80 10682.58 12581.51 15301.38 17636.45 20017.31 24165.68 28778.54 34804.35 45621.97 54223.79 59521.59 73210.79 147.70 400.00 406.36 705.93 1081.48 2308.34 2602.33 2962.81 3283.92 3628.46 3881.87 4553.17 5357.13 6178.39 7236.54 9017.94 10792.11 12784.81 15470.23 17996.94 18481.22 21093.48 Domestic Consumption Tax 487.40 541.48 620.23 678.70 814.93 820.66 858.29 929.99 1046.32 1182.26 1501.90 1633.81 1885.69 2206.83 2568.27 4761.22 6071.55 Business Tax 211.07 515.75 564.00 658.67 966.09 670.02 865.56 1052.57 1324.27 1575.08 1668.56 1868.78 2064.09 2450.33 2844.45 3581.97 4232.46 5128.71 6582.17 7626.39 9013.98 -3011157.91 Corporate Income Tax 696.06 716.00 731.13 720.78 678.60 708.49 878.44 968.48 963.18 925.54 811.41 999.63 2630.87 3082.79 2919.51 3957.33 5343.92 7039.60 8779.25 11175.63 11536.84 12843.54 Individual Income Tax 413.66 659.64 995.26 1211.78 1418.03 1737.06 2094.91 2453.71 3185.58 3722.31 3949.35 4837.27 Tariffs 28.76 33.53 205.21 159.01 187.28 212.75 256.47 272.68 291.83 301.84 319.49 313.04 562.23 750.48 840.52 704.27 923.13 1043.77 1066.17 1141.78 1432.57 1769.95 1483.81 2027.83 18 National Government Revenue and Expenditure Revenue (100 million yuan) 1978 1980 1985 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 1132.26 1159.93 2004.82 2937.10 3149.48 3483.37 4348.95 5218.10 6242.20 7407.99 8651.14 9875.95 11444.08 13395.23 16386.04 18903.64 21715.25 26396.47 31649.29 38760.20 51321.78 61330.35 68518.30 83101.51 Expenditure (100 million yuan) 1122.09 1228.83 2004.25 3083.59 3386.62 3742.20 4642.30 5792.62 6823.72 7937.55 9233.56 10798.18 13187.67 15886.50 18902.58 22053.15 24649.95 28486.89 33930.28 40422.73 49781.35 62592.66 76299.93 89874.16-30- Revenue growth (%) Yearly balance (100 million yuan) 29.5% 1.2% 22.0% 10.2% 7.2% 10.6% 24.8% 20.0% 19.6% 18.7% 16.8% 14.2% 15.9% 17.0% 22.3% 15.4% 14.9% 21.6% 19.9% 22.5% 32.4% 19.5% 11.7% 21.3% 10.2 -68.9 0.6 -146.5 -237.1 -258.8 -293.4 -574.5 -581.5 -529.6 -582.4 -922.2 -1743.6 -2491.3 -2516.5 -3149.5 -2934.7 -2090.4 -2281.0 -1662.5 1540.4 -1262.3 -7781.6 -6772.7 19 Individual income tax Taxable income = income – pension deduction – medical insurance deduction – unemployment fee – housing accumulation fund Tax = (Taxable income-3500) * tax rate – fixed deduction Taxable income Tax rate Fixed deduction 1 0-4500 5 0 2 4500-7500 10 75 3 7500-12000 20 525 4 12000-38000 25 975 5 38000-58000 30 2725 6 58000-83000 35 5475 7 >83000 45 13475 -30- 20 Outstanding Debts of Central Government (100 million yuan) Total Domestic Debts External Debts 2005 32614.21 31848.59 765.52 2006 35015.28 34380.24 635.02 2007 52074.65 51467.39 607.26 2008 53271.54 52799.32 472.22 2009 60237.68 59736.95 500.73 2010 67548.11 66987.97 560.14 Year Local debts? It is reported that in 2010 local governments had 11 trillion debts. Shanghai by Jun 2013 had debts RMB 845 billion, including 519 direct debts, 52 debt guarantee, and 273 with some -30obligation to rescue. 21 SOEs and their profits In 2009, SOE made a profit of RMB 1339.22 billion, with an annual increase by 9.8%. Central SOEs made a profit of RMB 944.54 billion, with an increase by 10.3%; local SOEs made a profit of RMB 394.68 billion, with an increase of 8.4% Since 1994 tax-assignment reform, SOEs were in general not required to submit profits to the government. Now major SOEs only submit less than 10% of their profits to the state. -30- 22 China’s giant companies In 2008, 35 Chinese (Mainland) companies got into Fortune 500, according to revenues. These firms are many SOEs or stated controlled stock company. These firms are mainly in oil, gas, banking, electricity, railway, airline industries. Profits were concentrated to few super-large enterprises. -30- 23 In 2011, Mainland China had 61 companies on the list Three were among the top 10. -30- 24 Are they making or losing money? A report by Unirule Institute of Economics Between 2001 and 2008, compared to private companies, SOEs were waived interests of RMB 2.85 trillion, land rents of RMB 3.09 trillion, resource rent of RMB 0.5 trillion, and got RMB 0.12 trillion subsidies from governments. These lead to a cost saving of RMB 6.48 trillion. In the same period, SOEs made a profit of RMB 4.92 trillion. -30- 25 Fiscal control and efficiency Adjustment of the revenue structures. Budgetary reforms Extra-budgetary spending decreased from about half of the overall spending, to 32.6% in 1996, and 14.4 percent in 2003 Land sales revenues are still not incorporated into the budgetary system Increase the engagement of NPC in making and monitoring the budget The growing role of the Auditing Office Centralize the budgetary function of MOF Harden the making and implementation of budgets Strengthening the taxation system Modernize and enhance taxation institutions Increase the tax base but focus on taxation capacity Lower the taxation cost Cultivate the notion of tax-payer -30- 26 Use of public money is still weakly monitored. -30- 27 Spending management Change of spending focus: from efficiency to justice and social equality Introduction of governmental procurement Introduction of program performance management Clear definition of spending responsibilities The emphasis on the equalization in basic public services -30- 28 More active use of fiscal policies Anti-crisis fiscal expansion policy Since late 2008, the central government made a huge investment plan to stimulate domestic demands. The total investment plan reaches RMB 4000 billion, and is to be administered up to the end of 2010. Central government directly covers RMB 1180 billion, leaving the rest to the local governments. Many investments are earmarked, for example, for educational projects, central and local governments will invest with a 2:1 ratio. For building of low-rent housing, central and local government offer subsidy of RMB 300 and 400 for every squared meter. These investments suppose to create a big leverage/multiplier effect, although that may not be easy…(infrastructure, SOEs…) -30- 29 Areas of investment Urban livelihoods projects security-oriented housing like low-rent housing, renovation of old houses Rural livelihoods projects Planned Expenditures (RMB billion) 4000 3700 water, electricity, road, gas, housing Infrastructure 15000 railroad, highway, airport, irrigation, etc Public services 1500 education, health, culture, birth control, etc Energy preservation and anti-pollution 2100 Adjustment of industrial structure and technical upgrading 3700 Reconstruction of earthquake area in Sichuan 10000 Total 40000 -30- 30