The Contract Management System

As market-oriented reforms to the centrally planned economy were initiated during the late 1970s and early 1980s, particularly with the replacement of 100 percent profit taxation (the main source of revenue in the prereform era) by a more standard system of corporate income taxation, China experienced a sharp decline in revenues, which was only partially offset by reductions in public expenditures. In order to provide greater autonomy, the introduction of the contract management system with enterprises was mirrored by contracts between different levels of government during the 1980s and early 1990s.

The Chinese intergovernmental fiscal system in the early 1990s is described in detail in a number of reports.³ Tax arrangements between the central and provincial governments in China were based on a tax or transfer contract system that varied by province. The provinces were distinguished as either remitting revenues to the center or receiving transfers. Contracts remitting revenues to the central government were of three basic types: fixed, incremental, and proportional. Shanghai fell under the first type; Guangdong under the second type with an annual rate of increase of the remittance of 9 percent; and Anhui under the third type with a proportional rate of payment at 22.5 percent of revenues. Most remitting provinces belonged to the second type, with an annual rate of increase of the remittance of 4 percent to 5 percent.

China experimented with a new tax-sharing system for nine provinces during the second half of 1992. The intention was to abandon the contracting mechanisms and move rapidly to a “normally” functioning tax system. A revised tax legislation, creating a level playing field along with new tax assignments, which replaced the previous contracting system, has been in effect since January 1994 (for details see Xu Shanda and Ma Lin, 1995). The establishment of a separate central tax collection capability through the creation of the State Administration of Taxation is a key step in ensuring that central and shared tax bases are not subject to the de facto control and manipulation by local governments.

Grants

During the 1980s and early 1990s, the emphasis in China was more on specific grants than on equalizing or general grants. In 1992, 18 provinces received general grants from the center totaling Y 10 billion (roughly 3 percent of total revenues). There has been a special arrangement for eight of the poorest minority regions including Xinjiang, Inner Mongolia, and Tibet. For these provinces, grants increased by 10 percent annually during 1982–87, and the total amount doubled during this period. For Xinjiang and Nei Mongol the grants covered roughly one third of provincial expenditures in 1992. Since 1988, and the increasing stringency of central resources, these grants were frozen in nominal terms, although local expenditures continued to grow.

In addition, there were transfers to the poorest counties. The transfer criterion, established in 1985, was that eligible counties should have average per capita incomes of less than Y 200 per annum, with less than 200 kilograms per capita of grain available. This criterion remained unchanged in nominal terms. Relatively prosperous provinces, such as Zhejiang, have recognized that this criterion is inadequate, and raised the criterion for transfers from the provincial government to Y 300 per capita to account for price changes. It is not evident that the poorer provinces had the resources to top up the central grant to poor counties within their jurisdictions.

Specific grants amounted to three times the amount spent on general grants and were earmarked for special purposes, such as financing economic and social sector development and natural disaster relief. Information on the distribution of specific grants for 1990 suggests that richer provinces received substantial transfers (for example, Shanghai and Guangdong received Y 171 and Y 57.5 per capita, respectively), whereas poor provinces received less (for example, Guizhou and Guangxi both received Y 28.3 per capita).⁴ This pattern is common with specific or earmarked grants, which often have a matching element, in that better-endowed or faster-growing provinces tend to benefit more.

All the central grants were allocated by a baseline adjustment method, using 1979 revenues and expenditures. The baseline year was 1979, and provinces with deficits at that date received grants, while others paid remittances to the center (as described above). This incremental approach was increasingly outdated, given the considerable structural changes that have taken place in China since 1979, in particular the increasing disparity between regions. In addition, the pattern of specific grants would appear to accentuate the differences between regions. Another difficulty with the transfers to poor counties was that it was assumed that the cause and nature of poverty are essentially regional. While this may have been the case in the past, when within-region incomes were fairly equally distributed, there is ample evidence that within-region inequality has increased, and need is apparent even in the better-off regions.⁵

Regional Inequalities

The contract system exacerbated regional fiscal disparities. Richer provinces were better able to meet the devolved expenditure responsibilities than the poorer provinces. For instance, Shanghai and Guangdong had a substantial and growing revenue base, but Tibet’s revenues remained limited. Moreover, general grants received by poorer provinces from the central government have had to be restricted in recent years because of the falling revenue base of the center.

In the early 1980s, the central government received more from the surplus provinces than it paid out in transfers and grants. However, with the contract-based system, transfers from the central government in 1989–93 exceeded remittances from the surplus provinces. The center lacked the resources to narrow the growing regional disparities. Thus, horizontal imbalances increased as a consequence of the contracting arrangements.

Many of the poorer regions in China are fairly well endowed with natural resources. To some extent, the limited development of the resource base in these provinces is a result of administered pricing mechanisms that are being only gradually reformed. While price reform is not addressed in this chapter, it would have major implications for the resource base of the poorer provinces, if accompanied by appropriate resource taxation and sharing of royalties that accrue to the local government (natural resource taxation is discussed further below).

Public Expenditures and Regional Growth

The implication of contracting arrangements for horizontal equity between regions is substantial. A World Bank report suggests that the poorer provinces spend a larger proportion of their budgets on social expenditures, yet their lower revenue base means their per capita spending on such items remains significantly below that of the richer regions (see World Bank, 1993). Meanwhile, there is evidence that the shares of spending on social items and on capital items are inversely related. Richer provinces use their higher revenue capacities to finance more capital spending. Such arrangements have three important implications:

• Lower capital spending may perpetuate slower growth in poorer provinces.

• Lower economic growth means that revenue capacities of poorer provinces will continue to lag behind those of richer provinces.

• In the absence of an adequate system of equalization transfers, lower revenue capacities would doom poorer provinces to inadequate social spending and poor development of human capital, reinforcing the lower growth prospects in the future.

The importance of these horizontal imbalances is magnified by the absence of an effective personal income tax or nationwide social security system, capable of handling inequalities, and by restrictions on the population moving to other regions where they can improve their access to higher standards of government service.

Declining Revenues

Revenue Trends

As in many other countries that have moved from a centrally planned economy toward a market-based system, in China the tax-to-GDP ratio has fallen sharply since the beginning of the reforms. This partly reflects a changed role for the state, and public expenditure has been reduced to match the fall in the revenue-to-GDP ratio. However, unlike in other former centrally planned economies, where the drop in the revenue-to-GDP ratio has been partly attributed to negative or stagnant growth, China’s growth performance since 1978 has been among the best in the world. Table 1 shows the consolidated budgetary revenues of the central and local governments.⁸

Table 1.

China: Consolidated Budgetary Revenues of the Central and Local Governments¹

(In percent)

Sources: Ministry of Finance; and IMF staff estimates.

¹Revenues do not include the proceeds of government debt, but include subsidies to state-owned enterprises as negative revenue item.

Table 1.

China: Consolidated Budgetary Revenues of the Central and Local Governments¹

(In percent)

Year	Share of Revenue in GDP
1978	31.6
1979	28.7
1980	25.9
1981	24.6
1982	23.4
1983	23.6
1984	23.7
1985	23.5
1986	21.9
1987	19.5
1988	16.7
1989	16.7
1990	16.6
1991	14.6
1992	13.1
1993	12.7
1994	11.9
1995	11.2
1996	11.1

Sources: Ministry of Finance; and IMF staff estimates.

¹Revenues do not include the proceeds of government debt, but include subsidies to state-owned enterprises as negative revenue item.

View Table

Table 1.

China: Consolidated Budgetary Revenues of the Central and Local Governments¹

(In percent)

Year	Share of Revenue in GDP
1978	31.6
1979	28.7
1980	25.9
1981	24.6
1982	23.4
1983	23.6
1984	23.7
1985	23.5
1986	21.9
1987	19.5
1988	16.7
1989	16.7
1990	16.6
1991	14.6
1992	13.1
1993	12.7
1994	11.9
1995	11.2
1996	11.1

Sources: Ministry of Finance; and IMF staff estimates.

¹Revenues do not include the proceeds of government debt, but include subsidies to state-owned enterprises as negative revenue item.

As seen in Table 1, the ratio of budgetary revenue to GDP dropped from 31.6 percent in 1978 to under 20 percent in 1987.⁹ It declined sharply further to about 13 percent in 1992, following the contract system negotiated with provinces in 1988. Although this phenomenon is common to former centrally planned economies,¹⁰ in China the problem was exacerbated by the contracting arrangements as they applied to enterprise taxes and was reflected in the revenue-sharing arrangements at different levels of government. The decline continued after the implementation of the new revenue-sharing system to 11.9 percent in 1994 and to an estimated 11 percent in 1996—during a period of exceptionally high growth.

The 11 percent of GDP in budgetary revenues does not, however, convey a full picture of the true extent of consolidated government revenue. Excluded from the above figure is around 5 percent of GDP collected from fees and contributions for extrabudgetary funds mainly controlled by local governments—such as the Energy, Transportation, and Construction Funds.

In most countries, obligatory social security contributions would be considered part of consolidated revenues. China’s social security policy, including provisions for social assistance, is governed by a number of distinct central agencies, with administration and financing at local levels. Since the late 1980s, attempts have been made to unify the system upward, and at present some provinces have unified policies for pensions and unemployment insurance. It is difficult to be specific about the aggregate amounts collected for social security contributions, but the overall figure is roughly estimated to be in the range of 1 percent to 2 percent of GDP.

Thus, a more complete accounting of revenues in China could put the present overall collection in the range of 17 percent to 18 percent of GDP. This figure would not be much out of line with that of other countries and China’s level of development. However, a revenue-GDP figure on its own is no more than suggestive; it has to be evaluated in comparison with expenditure outlays. While expenditures have indeed declined in China, reflecting the changing nature of the state as greater market orientation is achieved, pressures on budgets continue to be significant, particularly at the central level. The severe constraints on policymaking at the central government level are largely due to the fact that revenues from relatively buoyant sources accrue mainly to lower levels of government (Gao Qiang, 1995).

Rising Expenditures

A devolution of expenditure authority from central to local governments, down to the township level, led to a rapid increase in local expenditures, particularly administrative costs and health, education, and science expenditures. The increase in local government expenditures was partly financed by the expansion in extrabudgetary funds under the control of the local authorities, agencies, and SOEs. Extrabudgetary funds in China include (1) revenues managed by local finance bureaus—such as surcharges on various taxes, profit remittances from enterprises, and government project income; (2) user charges and income from nonprofit and administrative units; and (3) income received from SOEs and bureaus from depreciation accumulation and renovation funds and management income from other funds.¹¹ However, the expansion in such funds has been, to some extent, at the expense of regular tax revenues accruing to the formal budgets of provinces and the central government. This, in turn, has put pressures on the budgets of several provincial governments (as the formal expenditure requirements to be met out of the budget have increased). Thus, even governments of relatively prosperous regions, such as Zhejiang, faced deficits in 1992. In general, this results in either reduced transfers to the central government or an increased requirement for support from the center.

Despite a reduction in certain own expenditures of the central government, such as for defense, the increased demand for financing lumpy investments and for meeting the needs of poorer provinces continued to exert an upward pressure on the expenditures of the center. Moreover, with vaguely defined expenditure responsibilities, some local governments have been tempted to “pass the buck upward” to the central government (see Gao Qiang, 1995). The net effect is that reduced central revenues are inadequate to meet the continued expenditure needs of the central government. However, there is little scope for additional central government expenditures (for example, for a greater degree of horizontal redistribution) without a major restructuring of the vertical imbalances.

Overall Deficits

Reported budget deficits in China have been relatively small and have been generally maintained at under 3 percent of GDP (Table 2). However, the inclusion of quasi-fiscal activities of the banking sector suggests a less favorable picture. Thus, “policy lending” by the banking sector to cover the deficits of the SOEs suggests that the actual budget deficit may have been substantially greater than the “reported” deficit. If such quasi-fiscal operations of the banking system, covering the losses of the SOEs, are taken into account, the consolidated deficit would have exceeded 5 percent of GDP in 1991 at a time when the reported deficit was 2.2 percent of GDP. As with the revenue decline, there are formidable data difficulties in establishing the full extent of the deficit in China.

Table 2.

China: Revenues, Expenditures, and Deficits¹

(In percent of GDP)

Source: IMF staff estimates.

¹The data reflect the consolidated budgets of the central government, provinces, municipalities, and counties, and transfers between levels are netted out. Extrabudgetary financial operations are excluded, as is seigniorage revenue of about 2.5 percent of GDP in recent years.

Table 2.

China: Revenues, Expenditures, and Deficits¹

(In percent of GDP)

		1990	1991	1992	1993	1994	1995
Total revenue		19.2	17.0	14.7	13.8	12.4	12.1
	Tax	16.9	15.3	13.0	11.6	10.3	11.2
Current expenditures		21.1	19.2	17.0	15.8	14.1	13.8
Overall balance		−2.0	−2.2	−2.3	−2.0	−1.6	−1.7

Source: IMF staff estimates.

¹The data reflect the consolidated budgets of the central government, provinces, municipalities, and counties, and transfers between levels are netted out. Extrabudgetary financial operations are excluded, as is seigniorage revenue of about 2.5 percent of GDP in recent years.

View Table

Table 2.

China: Revenues, Expenditures, and Deficits¹

(In percent of GDP)

		1990	1991	1992	1993	1994	1995
Total revenue		19.2	17.0	14.7	13.8	12.4	12.1
	Tax	16.9	15.3	13.0	11.6	10.3	11.2
Current expenditures		21.1	19.2	17.0	15.8	14.1	13.8
Overall balance		−2.0	−2.2	−2.3	−2.0	−1.6	−1.7

Source: IMF staff estimates.

¹The data reflect the consolidated budgets of the central government, provinces, municipalities, and counties, and transfers between levels are netted out. Extrabudgetary financial operations are excluded, as is seigniorage revenue of about 2.5 percent of GDP in recent years.

Borrowing by Local Governments

Legally, local governments are not permitted to run deficits,¹² and borrowing from the local branches of the People’s Bank of China is not permitted. However, there have been clear examples of expenditure overruns. In general, four avenues are available for financing such overruns: (1) increased transfers from the Ministry of Finance; (2) borrowing from commercial banks; (3) indirect borrowing, including a buildup of arrears; and (4) foreign borrowing. Financing by the Ministry of Finance has been rather limited owing to the tight fiscal situation of the center. However, borrowing from local commercial banks occurs. Local governments undertake “indirect borrowing” mainly by creating dummy financial companies that are able to borrow to provide resources for local government expenditures. Another method of indirect borrowing has been through a buildup of arrears, as well as IOUs on the procurement of agricultural products. The government has been taking steps to prohibit the issue of IOUs to farmers, but the control of arrears is a more complex task. Foreign borrowing is made through joint ventures, the issuance of bonds, bilateral agreements with foreign financial institutions, and international organizations such as the World Bank and Asian Development Bank.

The most important source of financing has been through commercial banks, and local authorities have exercised the discretion to sanction projects below Y 50 million (above this amount, the project needs to be referred to the State Planning Commission) through commercial and indirect borrowing. This is a consequence of the current system of “fuzzy property rights,” where the distinction between government functions and the private sector are blurred. During 1991–92, the People’s Bank set aside 7 percent of total credit in a stabilization fund in order to supplement and facilitate credit flows to special banks.

The People’s Bank has been required to engage in “policy lending” (later taken over by so-called policy banks) at subsidized interest rates to designated enterprises, to support the poorer provinces, and to perform a quasi-fiscal function. Although the Ministry of Finance was to reimburse the interest differential, this form of transfer is opaque at best, is discretionary, and adds to the difficulties with the reform of the financial sector. It is preferable to reform the system of grants to provide support explicitly to deserving regions.

Reforms to Tax Policy and Administration

In the early 1990s, China began to experiment with reforms to tax policies and assignments. A tax-sharing experiment was initiated in 1992, and, after assessing the difficulties faced in the interim period, a new set of tax laws was promulgated in 1994, which affected tax assignments as well as revenue sharing. Tax administration arrangements were also completely overhauled.

Tax-Sharing Experiments

In 1992, a tax-sharing experiment was introduced in three provinces (Zhejiang, Xinjiang, and Liaoning) and six large cities (Tianjin, Chongqing, Wuhan, Qingdao, Shenyang, and Dalian). The basic precept was to replace the contract-based system of revenue sharing by assigning taxes to particular levels of government—that is, the center and the provinces. There was, in addition, a shared tax category, and the revenues generated from five major taxes—the product tax, the VAT, the business tax, the consolidated industrial-commercial tax, and the resource tax—were divided on a 50:50 basis between the central government and the local government. Another five shared sources of income were characterized as “fixed rate shared incomes.”

The tax-sharing experiment suffered from a number of drawbacks. Some provincial governments, particularly along the coast, feared that they would lose revenue from the new system. For instance, in two provinces, Zhejiang and Liaoning, the local retention rate decreased from 61.5 percent and 58.5 percent, respectively, under the previous contract system, to 50 percent for shared revenues—which accounted for a major part of total provincial revenues. In addition, local government control over rates and bases for taxes assigned to them had not been introduced. Moreover, local fixed revenues mainly comprised SOE income taxes, and these were limited by the low efficiency of SOEs, the contract system for enterprises, and the wide range of tax deductions. The buoyancy of the main local taxes was low relative to that of shared revenues. However, provinces such as Zhejiang were guaranteed revenues—no less than under the previous contracting arrangement—thus reducing the incentive to improve tax collections.

A number of problems associated with tax policy and administration arose during the experimental period (see, for example, the discussion in Tanzi, 1996). These included, inter alia:

• Lack of standardization. While the lines of demarcation used to be reasonably clear, the growth of share ownership vitiated the distinction between foreign and domestic enterprises and between central and locally owned firms. Thus, taxation and assignment of revenues by ownership type became cumbersome.

• Variations in rate structure. Varying rates for the same tax (for example, the personal income tax) for different groups or individuals were anomalous and a source of distortions, while complicating administration. Another case in point was the excessive differentiation of the VAT.

• Variations by region. The use of differential incentives, such as those for the special enterprise zones, caused distortions and excessive tax competition across regions, leading to an overall loss of revenue.

The 1994 Reforms

In 1994, China undertook a major tax reform with the intention of increasing the central share of revenues (before transfers to lower levels) from around 35 percent of total revenue collection to around 58 percent (see Gao Qiang, 1995). The reform had two main elements: policy changes (for the VAT, enterprise income taxes, and revenue sharing between different levels of government) and the establishment of the State Administration of Taxation, with responsibility for administering the taxes assigned to the central government, as well as the shared taxes, including the VAT. The establishment of a national tax administration was achieved by splitting the existing tax administrations largely under the control of local governments into the national and local components.

Tax Assignments

The revenue assignments follow the basic principles set out in the experiments—with central and local taxes and shared revenues. Unlike in the experiments, the VAT is the main major tax to be shared—on a 75:25 basis—with the subnational levels of government. This will reduce the incentives to “play strategic games” that are evident in other countries, such as India, where different sharing ratios apply to various taxes. However, some features of the new tax assignments in China might need to be revisited in the years to come. The 1994 tax assignments are set out in Table 3.

Table 3.

China: Tax Assignments Under the 1994 Revenue-Sharing Arrangement

Source: Mihaljek (1997).

Table 3.

China: Tax Assignments Under the 1994 Revenue-Sharing Arrangement

Central fixed revenues

Enterprise income taxes on centrally owned enterprises Customs duties Consumption tax (excises) VAT on imports Business turnover taxes on railways, banks, nonbank financial institutions, and insurance companies

Local fixed revenues

Enterprise income taxes on locally owned enterprises, collectives, private enterprises, and joint ventures Personal income taxes Agricultural income tax Business turnover taxes (except on railways, banks, nonbank financial institutions, and insurance companies) Urban maintenance and development tax City and town land use taxes VAT on real estate transactions Stamp taxes Transactions taxes

Shared revenues

VAT on domestic transactions, other than real estate (75 percent central government, 25 percent provinces) Securities and exchange tax (50:50 sharing) Resource taxes

Source: Mihaljek (1997).

View Table

Table 3.

China: Tax Assignments Under the 1994 Revenue-Sharing Arrangement

Central fixed revenues

Enterprise income taxes on centrally owned enterprises Customs duties Consumption tax (excises) VAT on imports Business turnover taxes on railways, banks, nonbank financial institutions, and insurance companies

Local fixed revenues

Enterprise income taxes on locally owned enterprises, collectives, private enterprises, and joint ventures Personal income taxes Agricultural income tax Business turnover taxes (except on railways, banks, nonbank financial institutions, and insurance companies) Urban maintenance and development tax City and town land use taxes VAT on real estate transactions Stamp taxes Transactions taxes

Shared revenues

VAT on domestic transactions, other than real estate (75 percent central government, 25 percent provinces) Securities and exchange tax (50:50 sharing) Resource taxes

Source: Mihaljek (1997).

The assignment of the corporate income tax. The corporate income tax on central enterprises is designed to be part of central fixed revenue, under the jurisdiction of the State Administration of Taxation, while that on local enterprises would form part of fixed local revenues and be collected by the local tax administrations. While this assignment is understandable in the light of underdeveloped alternative local tax bases, it creates a number of problems. The assignment could perpetuate the anachronistic division of tax revenues by ownership types and would become impossible to administer as increasing share-ownership blurs the distinctions between different levels of government. It may in the future also inhibit the development of national markets and privatization of enterprises. Furthermore, with local variations in the effective rates of tax, there would be an added tendency to create subsidiary companies in various localities to reduce tax payments. It would also be unnecessarily expensive to duplicate the administrative arrangements for the corporate income tax at different levels of government.

In the future, the corporate income tax should be treated as a unified tax, administered by the central tax administration, in order to minimize tax competition across regions and reduce collection costs. Revenues could be allocated to the central pool for division according to a grants formula or be treated as shared on a derivation basis (that is, a share would accrue to the locality in which the income is generated). But this reform would require a reassignment of revenues or an adequately functioning transfer mechanism to compensate for the loss of own revenues that might be entailed.

The reformed personal income tax. The personal income tax is to be part of local fixed revenue. There may be some merit in allocating 100 percent of the personal income tax revenues to the local level in the medium term in China. The problems associated with the administration of a tax with incomes derived from different regions would be offset in China by the limited mobility of labor and greater information on incomes at the local level. It is important to note, however, that the personal income tax has important stabilization and redistributive properties and should be among the most rapidly increasing taxes in the future.

An alternative assignment would permit collection of the personal income tax by the State Administration of Taxation, with revenues from a central rate structure accruing to the central government. Local governments could be allowed some control over rate structures by a surcharge (within a predetermined range) to be levied on the central tax rates, with collection by the State Administration of Taxation. Another option is to share the personal income tax, with administration by the State Administration of Taxation. However, this variant does not easily permit the setting of marginal tax rates by the subnational level of government, and is thus less attractive than the piggybacking of a local income tax on a central tax base.

The natural resource tax. Given the potential revenues that are likely to be generated, it may be advisable to treat a natural resource tax as a shared tax, with a number of components. First, there could be a charge to pay for the environmental cleanup that is often needed. This should be paid directly to the local government where the resource extraction is based and should be treated as a cost item. Second, there could be an excise, which would provide much of the revenues from natural resources to the central government. Finally, there should be a royalty that would also normally accrue to the region that claims ownership rights and would form the basis of local revenues.

The need for regional transfers would be greatly reduced in China as price reform, particularly for energy products, proceeds apace. Many of the poorest regions of China are rich in natural resources, and appropriate pricing, together with the introduction of resource taxation, would allow the development of natural resources, which could narrow the gap between rich and poor regions considerably.

Payroll contributions. While the move toward a level playing field is a major step, the local setting of payroll contributions for pensions, in particular, presents a significant lacuna. At present there is city-level pooling of payroll contributions for pensions, with considerable variation in exemptions and differences in payroll contribution burdens across enterprises.

In order to avoid tax competition across regions, the payroll contribution for pensions should be set and the revenue pooled on a national basis. This would parallel the efforts to standardize and simplify other taxes. A national pool would encourage solidarity between current workers and those who have already made their contributions to society. Interregional equity issues would be addressed through the grants mechanism (see below). Provincial pools, on the other hand, may be more acceptable to local governments, but could exacerbate more parochial interests.

Other local taxes. These consist of property taxes, a capital gains tax, and a variety of other levies.

Property taxes. In order to establish a proper base for the main local taxes, such as the land tax and property tax, it would be necessary to begin work on a property registry, as well as a valuation mechanism. In the interim, as ownership rights and the registry are being established, appropriate rentals for the use of local state property may constitute an important source of local revenue. The increasing use of land rentals has begun to provide a major source of own revenues for cities such as Shanghai.

Capital gains. While a capital gains tax on property transfers and sale of securities is needed to close an important loophole in the personal income tax, the implementation of such a tax would need to follow the work on the property register and valuation mechanisms.

Other levies. Ad hoc levies imposed by subprovincial governments have proliferated, and the central government has attempted to rescind some of these. Such levies should be subject to legislation by the People’s Congress at the appropriate level of government. In order to avoid abuse by administrators, all such measures should be properly announced to the public, explicitly form part of the local budget, and be subject to the normal audit procedures.

While the reforms introduced in 1994 standardize VAT and personal and corporate income tax rates and bases, approximating standard international practices, a number of problems remain particularly relating to the design and assignment of the main taxes. Specific issues to be addressed in the future include the following:

• Revise corporate income tax assignments. The assignment of corporate taxes to the level of government that owns the enterprise is anachronistic and unworkable in the longer term (see Tanzi, 1996; and Shi Yaobin, 1995). It would be important to review the options for a more efficient assignment of the corporate income tax, to facilitate administration and generate revenues.

• Unify the domestic and foreign enterprise income taxes.

• Reduce tax exemptions.

• Examine improvements in the design of the personal income tax, so as to tap a growing tax base. As discussed above, this may involve the State Administration of Taxation in administering the personal income tax and could lead to a reconsideration of the assignment of this tax to subnational levels of government. A surcharge on a centrally administered personal income tax would be a more effective assignment for lower levels of government.

• Assign local government authority for legislative powers, especially over rate structures for locally assigned taxes. This is an issue of great importance if local governments are to achieve a degree of accountability in their budgetary processes (see Brosio, 1995).

Tax Administration

A key feature of the 1994 reform was the establishment of the National Tax Service—a central agency—to collect central and shared revenues. Subnational governments were permitted to establish their own collection agencies—or local tax services—for their assigned taxes.

Concern has been expressed that the overall budgetary revenue has continued to decline. This raises questions as to the effectiveness of the newly established administrative structures, as well as of the performance of taxes under the control of the National Tax Service. The new administrative procedures are still at an early experimental stage; thus, the revenue performance for the central taxes should be viewed as the efforts of the National Tax Service based on traditional collection methods—with all the inefficiencies involved. The main taxes under its control are the VAT and excises on the industrial and commercial sectors and the enterprise income tax on centrally owned SOEs.

Table 4 presents an estimate of gross revenue collections for the indirect taxes for 1993 and 1994. Since 1993 had been declared to be the base year for guaranteed transfers to provinces (see below), there was an extraordinary effort to boost revenues during the fourth quarter of the year. Despite this effort, the 1994 outcomes for the main indirect taxes suggest revenue outcomes that kept pace with the growth of the revenue base, or exceeded it, as with the VAT and business taxes on the tertiary sector and construction.

Table 4.

China: Growth of Central Indirect Taxes, 1993/94

(In percent)

Table 4.

China: Growth of Central Indirect Taxes, 1993/94

(In percent)

Sector		Value-Added Tax (VAT)	VAT/Excise	Business Tax	Buoyancy
Industry		29.8	31.9		>1
Commercial		31.2	31.9		1
Tertiary		28.0		32.8	>1
Construction		38.7		29.9	<1
Transportation		18.2		20.3	>1
	Total				−1

View Table

Table 4.

China: Growth of Central Indirect Taxes, 1993/94

(In percent)

Sector		Value-Added Tax (VAT)	VAT/Excise	Business Tax	Buoyancy
Industry		29.8	31.9		>1
Commercial		31.2	31.9		1
Tertiary		28.0		32.8	>1
Construction		38.7		29.9	<1
Transportation		18.2		20.3	>1
	Total				−1

The 1994 reform reduced the tax burden on enterprises, and direct tax revenues (of which only the enterprise income tax on centrally owned enterprises is the responsibility of the National Tax Service) grew considerably slower than nominal GDP. Together with the disappointing outcome for tariffs—which was mainly policy induced—the overall ratio of tax to GDP declined during 1994. The year 1994 was the first year of the National Tax Service’s operations, involving the splitting of the tax administrations. It appears that the taxes under its control performed better than the others, and that there should be room for further improvement as the new tax administration procedures being tested by the National Tax Service at four experimental sites are extended in the future.¹³

The estimations above for the VAT are gross of rebates to exporters. It is believed that these rebates are posing great difficulties because of irregularities and fraud that are difficult to combat with the current procedures. However, the overall net VAT collection in excess of 5 percent of GDP is comparable to that of other countries, given China’s existing rate structure. This percentage was achieved during a year of major reform.¹⁴

The separation of the central and provincial tax administrations has been pursued with relative success by all provinces, except for Shanghai and Zhejiang, where no separation had taken place by mid-1995. However, in the latter two provinces, designated officials collect central taxes, which are directly credited to central treasury accounts with the People’s Bank of China. Hainan Province has yet another formulation, with three tax authorities—the central, the local, and the computerized tax collection agency. The central agency only has the right to audit information collected by the computer center, and the formulation is not approved by the State Administration of Taxation. In general, the wealthier provinces had been able to attract the best officials through incentives including promotions and benefits.

The main issues relating to tax administration are as follows:

• Clarification of the roles of the national and local tax services, for example, for the joint ventures and foreign enterprises.

• Joint audits leading to coordination between the National Tax Service and local tax authorities.

A major objective of the tax reform was to create a level playing field, so as not to generate disincentives for labor or capital in different parts of the country. However, the sharp differences in payroll contributions for pensions, in particular across provinces (and still in some cases within provinces), vitiate the efforts in this regard. The reform of the social security system would have important implications for revenue assignments, as well as expenditure responsibilities across regions. Thus, a reformed social security system will have a significant impact on public finances, net revenue positions, and the adequacy of benefit levels, and consequently on the need for special purpose transfers from the central to local governments. A payroll tax, with pooling at the central level, for a minimum benefit, would have a major redistributional impact and could provide a mechanism for tapping a growing resource base. One could then consider a supplementary funded system that could be organized locally, if so desired.

Expenditure Assignments

A distinction could be drawn between the level of government responsible for expenditure policies, the financing agency, and the level at which the expenditure is administered. Under the Constitution there are broad guidelines for expenditure responsibilities. Central responsibilities include defense, foreign affairs, foreign aid, fixed-asset investment for large and key projects, and technological transformation and experiments for SOEs. For education, in particular, primary and secondary education fall under local responsibilities, but responsibilities for higher education are shared between the central and local governments. Extensive social benefits are still provided by enterprises, particularly SOEs, but the scope of the pension and unemployment insurance funds is under review. There is considerable scope for overlapping responsibility at the present juncture.

In China, the administration of expenditures generally follows a sound benefit principle. There is, however, less clarity in the determination of policy—for example, standards for education or health are mandated by higher levels of government but are administered by counties and townships. Financing such expenditures also poses problems, given spatial externalities, as well as crucial implications of the distributional or equity objectives of the central government. In Sichuan and Zhejian, for example, the administrative responsibilities for expenditures¹⁵ appear to be quite sensibly based on the benefit principle, with local governments catering for those expenditures that benefit local residents—and higher level governments becoming involved as the benefits spill over into other jurisdictions.

The trade-offs between central policies and local administrations are brought out clearly in relation to the social safety net. The central government might consider that its responsibility extends to ensuring the establishment of minimum standards. In this regard, national basic standards for pensions and unemployment benefits, financed by a national earmarked fund, are an important element. Local social assistance could be designed to cater for varying provincial standards, subject to the national minimum for transfers to poor areas. Such a minimum has to be established (such as the minimum Y 200 per capita poverty standard established in 1985 to identify poor counties) but would need to be adjusted for price changes. The pattern of redistribution (for example, across generations—pensions, or to the unemployed) through nationwide institutions may benefit more individuals living in better-off regions, given demographic patterns. Thus, safety nets within a province would be addressed not only through the centrally mandated social security institutions, but more importantly with locally based social assistance (such as with wu bao—or five guarantees for basic needs, including inter alia, housing, clothing, and nutrition). However, financing for the latter may be an important constraint.

A major difficulty arises with the financing of local expenditures, particularly as more responsibilities for administration are assigned to lower levels of government. Thus, pleas for financial assistance for some worthy primary education project in various townships are heard in provincial capitals, but requests for assistance are often referred to higher levels of government on an ad hoc basis. Greater problems are observed with the provision of basic facilities in the poorer regions than in the coastal districts. This points to the need for a more effective transfer mechanism to ensure adequate provision of basic public services.

A detailed evaluation of expenditure assignments in China is a major task, one that will take a considerable time given the “fuzzy” nature of property rights and the provision of social benefits by state-owned-enterprises, which will be resolved over time. For this reason, the Chinese authorities focused on reforming revenue assignments, tax policies, and administration before resolving the expenditure assignment problem. The interim arrangements concerning grants have been based on the current rough allocation of expenditure responsibilities. As these expenditure responsibilities develop, with an evolving role of the state, it may be more efficient to vary the transfers rather than to adjust the revenue assignments or administration in tandem. There is some merit in keeping the revenue system stable for a period of time (once the immediate policy reforms have been completed). Nonetheless, clarifying the responsibilities of the state and consequent allocation of expenditure assignments among different levels of government remains a major task that should not be delayed.

Public Expenditure Management

A difficulty in China is that a significant proportion of public expenditures are met through extrabudgetary accounts, particularly at the local levels. It is important that all expenditures of agencies be included as part of the budget at a given level of administration, so that the necessary trade-offs between policy options at that level of government might be assessed. This issue is also inextricably linked with the financing of expenditure responsibilities relative to resource constraints, including transfers from higher levels of government.

China promulgated an organic budget law in 1995. However, further work needs to be instituted to formulate additional rules and regulations. As discussed in Ahmad, Kennedy, and Klering (1995), budgetary mechanisms are needed to achieve fiscal discipline, including effective controls on borrowing by subnational levels of government agencies. Classifications need to be reformed urgently, and while work has been initiated on a refinement of budget classification, along the lines of the IMF’s Government Finance Statistics, much more needs to be done for implementation at the central and local levels. Also, rules for accounting and auditing, together with the requirements of proper cash management, need to be clarified. A redefined role for the Treasury is also crucial in establishing instruments for effective budget execution, information flows, expenditure control, management of cash, assets and liabilities, and accounting.

Although a new budget law delegates an important role to the Ministry of Finance, the ministry at present lacks the means to induce spending agencies to provide the needed information and to follow the required procedures. Appropriate information flows on budget execution available to the central agencies responsible for audit and control, and to the Ministry of Finance, will be essential to underpin the reformed system of intergovernmental fiscal relations in China, particularly the administration of the new transfer arrangements.

A problem to be addressed with regard to intergovernmental fiscal arrangements is that while those between the center and provinces are moving toward a unified format, those between the province and lower level governments continue to be administered on a piecemeal basis. In Beijing, for instance, four “poor” counties (defined as those where expenditures exceed revenues) retained all their revenues and received grants from the Beijing Municipal Government. Four districts and six urban counties that were defined as rich (revenues exceed expenditures) remitted all their revenues to Beijing Municipal Government, which allocated their expenditures. This divorce between revenue collection and expenditures could promote fiscal irresponsibility.

In Zhejiang province and its 70 counties, four different sharing rates—30, 50, 70, and 100 percent—were applied to four groups of counties that are classified in an indeterminate manner. Further, in Sichuan, four different remittance arrangements obtain based on whether revenues R exceed expenditures E in 1987. Eight cities with R₈₇ > E₈₇ were required to increase remittances to the provincial government by 6.6 percent annually, whereas five cities and prefectures remitted a fixed nominal amount. Four municipalities received subsidies from the province, equivalent to the gap between 1987 expenditures and revenues, and for three minority prefectures, the 1987 subsidy was increased 5 percent annually.

Ill-defined and variable rules for management of public resources and expenditures at the subnational level can open the way for “creative” accounting by local officials, a process that could facilitate corrupt local practices (see also Tanzi, 1996). Thus, the importance of both national and local public expenditure management procedures cannot be underestimated—but this is an area where there has been relatively little progress in China.