Chapter

4 Budget Policy in China

Editor(s):
Ehtisham Ahmad, Vito Tanzi, and Qiang Gao
Published Date:
September 1995
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Author(s)
Bert Hofman and Shahid Yusuf* 

Budget policy in conjunction with the planning mechanism was the most powerful instrument available to governments in socialist economies. Its importance was magnified by the passive role played by money and the degree to which credit management was an extension of the budget and the plan. Saving was to a large extent redistributed throughout the budget, according to plan priorities. With progressive decentralization and the spread of market institutions, the role of budgetary policy has changed. Moreover, the emergence of the socialist market economy has fundamentally altered the role of the budget in macroeconomic management. There is a need to redefine budgetary policy goals and to overhaul the making, as well as the implementation, of this policy.

This paper addresses the changing role of budgetary policy in China. It describes the main budgetary trends over the reform period and analyzes the various government functions performed with budgetary means. It then examines factors influencing the future direction of budgetary policy and the consequent need for change in scope and function of the budget. The paper concludes with policy recommendations.

Trends in Expenditures and Revenues over the Reform Period

Narrowing the scale of central government activities has brought about a decline in budgetary expenditures from 31 percent of GNP in 1978 to 20.4 percent in 1991 (Table 1). The deepest cuts have been in capital expenditures, from 12.6 percent of GNP in 1978 to 3.9 percent in 1991, as reforms transferred the bulk of investment responsibilities to state-owned enterprises. Further sharp cuts took place over those same years in budgetary defense spending, from 4.7 percent of GNP to 1.8 percent. Against the general trend, nondefense current expenditures rose slightly, from 13.7 percent of GNP to 14.7 percent; social expenditures, administration, and price subsidies all grew moderately in terms of GNP, while debt service grew very rapidly, albeit from an extremely small base. Decentralization of government functions enlarged the budgetary presence of local government, and the devolution of decision power increased the importance of local government in the budgetary process. The central government’s share of budgetary expenditure is now below 40 percent, down from a peak of 54 percent in 1981.1

Table 1.Revenues and Expenditures as Percent of GNP
19781979198019811982198319841985198619871988198919901991
Budgetary expenditures130.9631.8627.1323.3622.2122.2522.2121.5324.0421.6719.3519.2619.8420.39
Central14.2116.1914.5612.6211.0811.0610.619.769.929.137.587.007.898.05
Local16.7515.6812.5710.7411.1311.1911.611.7714.1112.5311.7712.2611.9512.34
Budgetary revenues231.2527.6024.2822.8321.6421.5021.5721.7823.3120.9618.7918.6719.0419.25
Central fixed revenue3.953.884.714.986.407.538.269.458.027.487.007.867.36
Central revenue after tax sharing13.9911.9011.4811.9411.2711.8210.919.408.949.77
Local revenue23.6520.3918.1216.6715.1014.0413.5213.8612.9511.3211.6711.1811.89
Local revenue after tax sharing8.839.7510.029.6410.5211.4910.059.409.739.27
Adjusted budgetary expenditures336.839.535.232.431.131.730.530.530.628.125.726.326.025.6
Central16.719.818.416.615.015.614.514.212.811.810.39.88.8
Local20.019.616.815.816.216.016.016.417.816.215.416.517.2
Adjusted budgetary revenues437.134.332.031.730.030.329.229.928.726.423.524.223.922.1
Central17.715.315.415.214.813.612.610.510.29.4
Local13.914.814.914.015.115.113.813.114.014.5
Source: China Statistical Yearbook, 1990 (English) Tables T6.13 and T6.14, and update from China Statistical Yearbook, 1991; Ministry of Finance data; authors’ calculations.

Expenditures refer to administration of expenditures.

Include debt issue.

Exclude debt issue.

For adjustments, see text.

Source: China Statistical Yearbook, 1990 (English) Tables T6.13 and T6.14, and update from China Statistical Yearbook, 1991; Ministry of Finance data; authors’ calculations.

Expenditures refer to administration of expenditures.

Include debt issue.

Exclude debt issue.

For adjustments, see text.

Some of the most rapidly rising expenditure categories have increasingly fallen on local authorities, which in turn have developed extrabudgetary sources of income to finance their current and capital expenditures. The decline of the public sector’s economic functions is reflected in the reduced share of investments (capital construction and technological transformation). This has been particularly sharp at the local government level: in 1978, the central-to-local split was about 56:44; in 1991, it was 74:26. Culture, education, science, and health enlarged their share of the budget, and price subsidies increased from nil to 10 percent of the budget. Budgetary revenues have declined in parallel largely because of price and enterprise reforms. By 1991, the ratio of revenues to GNP was little more than half the level in 1978 (Table 1).

Recasting the Budget

Chinese fiscal statistics do not follow international practice, and for meaningful comparison certain adjustments have to be made. The main ones of concern are (1) Subsidies to state-owned enterprises are treated as negative revenues rather than expenditures; (2) Debt issue is treated as revenue rather than as a financing item; (3) Debt repayment is treated as expenditures; (4) Extrabudgetary funds are a part of general government revenue because only about 20 percent are revenues of local finance bureaus and administrative or nonprofit units. Adjusted for these accounting differences, expenditures including fiscal extrabudgetary expenditures show a declining trend in terms of GNP, but government has a much higher share: this fell from 36.8 percent in 1978 to 25.6 percent in 1991. The decline in revenue is on the order of 10–22.3 percent of GNP in 1991. The adjusted figures for expenditures shed a different light on the scale of the government’s activities: a 26 percent share of GNP is comparable with other Asian developing countries, which averaged 27.0 percent in 1988 (Table 1).

Quasi-Fiscal Activities of the Central Bank

The incomplete delineation of the budgetary and monetary sector enabled the government to make ample use of quasi-fiscal activities of the central bank, and of para-fiscal activities of the specialized banks. Throughout the 1980s, seigniorage obtained was very high. Seigniorage from currency alone reached as much as 4.8 percent of GNP in 1988 and 1992. The seigniorage from reserve money—currency plus reserves of the banking system at the central bank—amounted to over 7 percent of GNP in 1990 (Table 2).

Table 2.Seigniorage in China
198419851986198719881989199019911992
(In billions of yuan)
Currency79.298.8121.8145.4213.3234.2264.1317.4432.9
Change in currency19.623.023.067.920.929.953.3115.5
Reserve money228.6282.7322.3405.5501.7657.2825.2971.1
Change in reserve money54.139.683.296.2155.5168.0145.9
CNP696.2855.8969.61,130.11,406.81,599.31,769.51,985.52,387.6
Inflation (in percent)4.59.04.85.111.88.96.34.27.3
(In percent of GNP)
Seigniorage from currency2.32.42.14.81.31.72.74.8
Inflation tax over currency0.80.50.51.21.20.80.61.0
Real currency expansion1.51.91.63.60.10.92.13.8
Seigniorage from reserve money5.63.55.96.08.88.56.1
Inflation tax over reserve money1.11.32.72.31.81.42.5
Real reserve money expansion4.52.23.23.77.07.13.6
Source: Bert Hofman, “Seigniorage in China” (mimeograph, Washington: World Bank, March 1993).Note: Seigniorage is estimated as the expansion of money as a percentage of GNP; end-of-year figures are used for money. The inflation tax is estimated as the money stock of the previous year times inflation in the current year. The real money expansion is calculated as a residual of seigniorage and inflation tax. Inflation is the percentage change in CNP deflator. All estimates should be considered as preliminary; the use of annual figures overestimates the amount of seigniorage.
Source: Bert Hofman, “Seigniorage in China” (mimeograph, Washington: World Bank, March 1993).Note: Seigniorage is estimated as the expansion of money as a percentage of GNP; end-of-year figures are used for money. The inflation tax is estimated as the money stock of the previous year times inflation in the current year. The real money expansion is calculated as a residual of seigniorage and inflation tax. Inflation is the percentage change in CNP deflator. All estimates should be considered as preliminary; the use of annual figures overestimates the amount of seigniorage.

Scope and Policy of the Budget

The scale of the budget and the policy environment are affected by several forces: revenue mobilization and budgetary balance, development function, and industrial restructuring.

Revenue Mobilization and Budgetary Balance

Until the early 1980s, revenue was raised primarily through the state-owned enterprises by way of tax payments and profit remittances. To facilitate the extraction of surplus, state-owned enterprise income was augmented by fixing relative prices so as to transfer resources from other sectors to industry. Control over industrial wages and enterprise spending served as additional implicit taxes, which helped to further raise the (taxable) profits of state-owned enterprises. This system of enlarging the pool of resources in one sector and using price, wage, and expenditure controls to maximize the state’s command over them was responsible for the high rates of saving in the socialist economies, most notably in China.

Reforms required a radical alteration in the scale of the budget and its role as a policy instrument. Fiscal decentralization, increased enterprise autonomy, and the emergence of a large nonstate sector have lessened both the mobilization and the allocation of resources through the budget, without significantly diminishing the resources at the command of various state entities. Over the reform period, China’s budgetary revenues have declined significantly, from 31.3 percent of GNP in 1978 to 16.8 percent in 1991.2 The main factor behind the decline in revenues has been the reduced budgetary contributions from state-owned enterprises—direct tax payments and profit remittances—which fell from 20.6 percent of GNP to less than 5 percent during the period, while enterprise losses—registered as negative revenue—grew strongly. Enterprise income reached 55 percent of total revenues through the mid-1970s before tax reform reduced this component to virtually zero in the mid-1980s.3

This shift of resources out of the budget was essential for sharpening incentives to reform and developing support for reforms at the provincial level, but it has curtailed the power of budgetary policy and reduced the volume of resources that the government can directly commit for building infrastructure. The budget now plays a minor part in resource mobilization and savings. Government savings are a small fraction of the total, as they are in other East Asian economies. However, China’s current tax system does not adequately serve even the government’s much narrower expectations regarding budgetary policy. The revenue base is shrinking for a variety of reasons having to do with tax coverage, exemptions, and collection problems. Further, tax revenue has a modest income elasticity. Access to funds from other sources has enabled the various levels of government to avoid a revenue crunch. But this makes budgetary planning very difficult and fiscal functioning is rendered inefficient.

Development Function

When the budget served as the conduit for the bulk of investment funding, budgetary policy defined the tempo and direction of development activity. In China, industrial development, which attracted a disproportionate share of resources for capital spending, was closely keyed to budgetary decisions, and the government’s sectoral or regional priorities could be implemented with minimal lags through budgetary initiatives. Allocational decisions, however, were concentrated in the hands of planners, and market forces were excluded from playing a vital part in investment allocation. On balance, the reduced scale of the budget, and within it a redistribution toward public services and away from capital spending, has been a healthy trend and makes China’s budget-driven development activities more nearly comparable with those of other East Asian countries. A further reduction at this stage would be disadvantageous because, as emphasized by several cross-country studies, capital spending, particularly on infrastructure, financed through the budget, can be vital for removing bottlenecks, encouraging investment in productive activities, and attracting foreign capital, all of which raise growth rates.

Industrial Restructuring

Budget policy had been used as an instrument for industrial development in the past, and it is inevitable that to some degree, postreform industrial restructuring must be financed through the budget. This is especially the case in the early stages of reform when the banking system is still immature and direct state intervention is necessary to motivate restructuring and absorb some of the shocks. A shrinkage in budgetary resources, however, has drastically curtailed the government’s ability to support restructuring directly, but budgetary funds continue to play a catalytic role. In China, as in other former socialist countries, they are supplemented by resources the government directs through extrabudgetary channels and the financial system. With industrial restructuring, the state is beginning to use mergers, group formation, and closure to far greater effect, as the buoyancy of the economy makes it easier to absorb redundant labor in other activities. As is inevitable given revenue trends, much of the transient costs of restructuring are being borne by the financial system, as are some of the long-term costs of industrial change. Together they absorb a large part of the seigniorage acquired by banks. Under the current decentralization procedures, industrial financing, which draws on seigniorage, cannot be differentiated adequately from other types of lending activities, directed or otherwise. The government is actively trying, however, to contain the cost of restructuring, and the trend of such expenditures is likely to be downward. But a clearer delineation of the banks’ quasi-fiscal expenditure and their incorporation into the budget would enhance the efficiency of budgetary policy and relieve banks of a considerable burden.

Regional Policy

Fiscal decentralization and a smaller resource envelope have reduced the scale of regional policy, whether for fiscal equalization or industrialization. This is to be expected given the spirit of reforms and the greater labor mobility now permitted. Development in China is more likely to proceed along lines of comparative advantage and is increasingly a provincially financed affair. Poverty alleviation and infrastructure building in the interior provinces, however, still require fiscal support from the center so that some of the benefits from past balanced growth can be sustained. While the central government has continued to assist the poorest provinces, it has been unable to arrange for an interprovincial resource transfer on a sufficient scale to meet their needs. Further poverty reduction and avoidance of a progressive widening in interprovincial disparities require larger transfers. To do this, the center must generate more budgetary resources and arrive at new central and provincial sharing arrangements (see Chapter 3).

Macromanagement

Prior to the start of reforms, macroeconomic balance and price stability were achieved through planning, administrative controls over spending, and price regulation. Budgetary policy did not make a significant independent contribution. Since the early 1980s, with the gradual dismantling of planning, budgetary policy has increased its actual and potential role in the sphere of macromanagement. Because of relatively prudent fiscal management, which has entailed scaling back government expenditures as revenues have fallen, plus the availability of resources from seigniorage averaging 5–6 percent of GNP, budgetary deficits were held to an average of 2 percent of GNP and financed in large part by noninflationary means. Thus, budgetary policy has not been a significant source of inflationary pressure. By the same token, it contributed little toward stabilizing the economy in 1985 or 1988–90. Direct controls over investment, credit, wages, and prices of consumer items and industrial intermediates were principally responsible for deflating the economy. The nature of tax-contracting arrangements and the rigidity of most expenditures in the short term has also meant that these have not served as automatic stabilizers. A number of developments described below, however, suggest that budgetary policy may need to be used more aggressively for macromanagement and that this function might come to dominate resource mobilization and developmental roles.

Factors Influencing the Future Role of Budgetary Policy

In spite of declining tax revenues, the various levels of government have been able to pay for capital construction, subsidies, and state-owned enterprise deficits by mobilizing extrabudgetary funds that utilize the resources yielded by seigniorage and drawing on abundant household savings. Demand shocks have been controlled by administrative means and through the application of price controls. Over the medium term, it is likely that extrabudgetary revenues will remain stable while resources from seigniorage decline. In addition, making full use of the market as an allocation mechanism requires reducing the use of administrative controls. The stripping away of administrative controls will affect the government’s ability to put a lid on demand pressures using its traditional instruments. Both of these trends signal the need for strengthening macromanagement through the budget.

Access to Extrabudgetary Funds

Local authorities were successful in raising extrabudgetary funds from the enterprise sector, because of the control they exercise over the burgeoning collective sector. With the spread of market institutions, a changing structure of ownership has increased the countervailing power of those owning or managing China’s nonstate enterprises. There is more resistance to the raising of rates and surcharges by local governments. With greater market integration and competition between localities for business, the share of extrabudgetary resources is unlikely to rise and may gradually decline.

Changing Money Demand

As indicated earlier, the Chinese government has augmented its fiscal resources through the seigniorage obtained by the People’s Bank of China and the specialized banks. Seigniorage derives from the increase in money balances and inflation, which erodes their value. During the early stages of reform, forced saving may have influenced the demand for money. But, by and large, demand for liquid assets, which has pushed monetary velocity from 1.65 in 1985 to 0.94 in 1992, is the outcome of precautionary and transactions needs linked to income growth.

Monetization of agriculture, marketization of state-owned enterprises, and strong growth in the less integrated nonstate sector increased the number of market transactions per unit of GNP, and thus fueled demand for money. Moreover, until very recently, monetary assets, such as cash and bank deposits, were the only assets available for a population eager to save in the light of increased income growth. Generally, positive real interest rates made this form of financial repression relatively benign and prevented flight into real assets. Increasing liberalization raised the consumption-based interest rate in China even higher than the measured real interest rate, because postponement of consumption not only yielded good returns, but delay allowed consumers the option to choose from a wider variety of goods, many of a higher quality.

Cross-country experience suggests that velocity might not decline much further. Financial liberalization, which is in itself highly desirable for efficient allocation of savings, has led to a rapid increase in the supply of alternative assets, besides bank deposits. Stocks, enterprise bonds, land, and foreign currency are beginning to provide alternatives for deposits in the banking system, and monetary expansion now triggers speculation in urban real estate and demand for foreign exchange, which pushes down swap market rates for the renminbi. Since early in 1993, these developments were fueled by disintermediation from the banking system, not least due to negative real interest rates on bank accounts. Such asset diversification is in principle desirable from the standpoint of resource allocation, as it provides a variety of financing instruments with a range of risk characteristics, but it can be destabilizing for the banking system in the short run. The message for monetary and fiscal policy is that to minimize inflationary pressure, much less reliance on seigniorage is mandatory, as asset diversification is likely to increase the level and variability of money velocity. Hence, China’s government must reduce its demands on the banking system to meet fiscal needs. Fiscal reform is thus a necessary complement to stricter monetary control.

Enterprise Independence

Although government control over state-owned enterprises is being curtailed, it remains fairly extensive. In times of macroeconomic instability, these regulatory powers have reinforced the effectiveness of administrative measures. Thus, state-owned enterprises have been rationed in large part by administrative means; whereas monetary measures have been used to check the growth of nonstate enterprises. With the adoption of “The Regulations for Transforming the Operating Mechanism of the State-Owned Enterprises,” direct government control of enterprises will erode further and provincial finance bureaus will be able to exert less influence than they currently can over the state-owned enterprises under their jurisdiction. At the same time, substantial efficiency gains will be realized, as investment and production decisions are delinked from political considerations. Further, a hardening of the budget constraint of enterprises will speed up adjustment and should in principle reduce the need for budgetary subsidies to cover losses of state-owned enterprise. The upshot of all this will be that government will be less and less able to use enterprise spending as a macroeconomic stabilization tool in the future. More of the burden of macroeconomic management will fall on the budget, but budgetary policy will also not be hamstrung by obligations to the state sector.

Changing Social Protection

With the acceleration of price reforms, and growing household income, budgetary subsidies will rapidly diminish. But, over time their place will be taken by new forms of social protection, as most of the social security and pension delivery is shifted off the enterprises’ books. Although, in principle, the finance for such functions is there—the enterprises have paid for it thus far—the central government, in conjunction with provincial authorities, will have to impose new levies to raise additional resources for social security payments.

Increasing Regional Disparities

Since 1992, cross-provincial growth rates have diverged even more than in the past, with poorer provinces registering lower growth and hence relatively weaker fiscal performance. Both for efficiency and for equity reasons, regional redistribution is a priority. The present fiscal system is ill-equipped for this increasingly important task, and new ways to redistribute fiscal resources among regions should be developed in the context of overall reform (see Chapter 3).

Policy Recommendations

China’s fiscal system served the country well under a regime of central planning. In the context of overall fiscal reforms, however, China’s budgetary process and intergovernmental relations need fundamental change to support fiscal policy that promotes macroeconomic stability, efficiency, and equity. Fiscal reforms are more likely to succeed if all parties perceive some gains. This argues for comprehensive reforms. Budgetary reforms and changing intergovernmental relations should therefore go hand in hand with broadening the tax base, creating a local tax base, rationalizing the tax collection system, and giving the central government greater macroeconomic control by way of indirect instruments. The experience with fiscal reforms over the recent past suggests that the experimental, regionally limited, piecemeal reform method, successful in many areas, may not work with fiscal reforms. A gradual nationwide implementation of an established reform plan might yield better results.

The Budget and Scope of Government

Budget reforms must change the scope, content, and objectives of the budget and budgetary policy. In the long run, the budget should clearly reflect the government’s role. Nongovernment activities should be removed from the government budget and fiscal accounts, including enterprise extrabudgetary funds. Budgetary investment expenditures should concentrate on government functions. As far as possible, fiscal extrabudgetary funds should become an integral part of the budget. Government activities now performed by enterprises, such as social security, should be included. Quasi-fiscal activities of the banking system should be made transparent in the budget. As soon as this is feasible, policy lending by the banks should be curtailed and to the extent possible handled through the budget. Unifying government activities in the budget is a precondition for the budgetary process to become a meaningful mechanism for allocating scarce resources across government objectives. A unified budget will also greatly increase the effectiveness of macroeconomic policy.

The government’s share of the economy should be an outcome of the change in budgetary scope instead of being a goal in itself: there is no objectively optimal share of government in an economy. More important is the ability to finance the desired share of government in a noninflationary way: tax reforms and tax administration reforms should in the long run achieve that goal and eliminate recourse to the banking system.

Broadening the Tax Base

For the government to find sustainable finance for its activities, the tax base needs broadening. China’s plans to unify the enterprise income tax and abolish repayment of debt before taxes, to accelerate the introduction of an economywide VAT, and to introduce various other taxes is a step in the right direction. However, for these plans to succeed, satisfactory arrangements in intergovernmental finance need to be found. China’s authorities should clearly assign functions over levels of government, with efficient service delivery and fiscal equity as guiding principles. Control over government functions crucial for macroeconomic stability should be recentralized, including control over aggregate government borrowing, and overall tax burden.

Own-Tax Base

China’s authorities should assign each level of government a substantial own-tax base, to finance those functions for which it has full responsibility. Assigning local governments a local tax base would raise the level of accountability and provide incentives for better and cheaper public services. Own-tax bases can also serve to absorb variations in expenditure needs without periodic renegotiation of intergovernmental fiscal relations. Finally, extension of the local tax base would iron out many of the current problems with the system of intergovernmental fiscal relations. For local government, property taxes would be an excellent own-tax source, which is thus far hardly exploited in China.

Tax Sharing and Equalization

A full separation of tax bases in China is probably not feasible, nor desirable in the light of efficiency of collection, given the establishment of the State Administration of Taxation. The fiscal gap between expenditure needs and revenues from the own-tax base can be filled by tax sharing, general grants, specific grants, or a combination thereof. The divergence in economic performance and fiscal capacity among regions calls for a fiscal system with equalizing properties. Horizontal equalization of fiscal capacity between localities can be achieved though tax-sharing arrangements or through equalization grants.

The Budget as a Policy Tool

The budget’s importance as a macroeconomic policy tool needs to be explicitly recognized. One way of doing this would be to issue a background document on the economic outlook along with the budget, which defines the macroeconomic assumptions underlying the budget and explicates their implications.

Multiyear budgeting, and a stronger coordination of the budget and the Development Plan, would improve assessment of the macroeconomic impact of government policy. Development of automatic stabilizers, both on the expenditure side and on the revenue side, would enhance the responsiveness of fiscal policy to fluctuations in output and employment.

Budget procedures and techniques should allow for shifts in expenditure categories, in line with the changing needs of China’s society. This requires abandoning the incremental “base number” technique of budgeting and adopting budgeting techniques that are program oriented.

China’s budget classification and presentation need adjustment to accommodate multiple users and uses. Adoption of the international standard of budget categorization and presentation is strongly recommended. The presentation of the budget should incorporate an economic analysis of government plans. In addition, the functional and administrative classification should be such as to assign spending authority to specific ministries, units, and levels of government. A wider publication of a more detailed budget would signal the government’s policy intentions, and the fiscal stance of the budget, to sectors that are no longer under direct government control. This would improve coordination and speed up desired adjustment to new policies in the rest of the economy.

The World Bank.

For a more thorough discussion, see World Bank, “Budgetary Policy and Intergovernmental Fiscal Relations,” Report No. 11094-CHA (Washington: World Bank, 1993).

Chinese definition, excluding debt issued.

C. Wong, “Fiscal Reforms and Local Industrialization: The Problematic Sequencing of Reform in Post-Mao China,” Modern China, Vol.8 (April 1992), pp.197–226.

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