Intergovernmental Fiscal Reform in China*

Philippe Wingender

doi:10.5089/9781484351109.001.A001

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Intergovernmental Fiscal Reform in China^*

Author: Mr. Philippe Wingender

Contributor Notes

Author’s E-Mail Address: pwingender@imf.org

Publication Date:: 13 Apr 2018

eISBN:: 9781484351109

ISBN:: 9781484351109

Language:: English

Keywords:: WP; government; local government; central government; reform plan; unemployment insurance

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China is the most decentralized country in the world in terms of expenditures shares, with subnational governments responsible for 85 percent of government spending. Limited revenue autonomy and insufficient intergovernmental transfers have led to large unfunded mandates and a build-up of debt outside the budget. The government has recently announced an ambitious intergovernmental fiscal reform, which will increase the role of the central government. Comprehensive reform is needed to improve public service delivery, increase overall social spending levels and reduce regional disparities. Revenue reforms are also necessary to improve efficiency and reduce vulnerabilities from excessive subnational borrowing. These reforms are challenging, but are crucial so that the government can support China’s continued development and prosperity.

Abstract

I. Introduction

China is a unitary state with a highly complex intergovernmental fiscal system. Since 1994, when China underwent its last major fiscal reform, a large vertical imbalance between revenue allocation and spending responsibilities across levels of government has prevailed. A recent intergovernmental fiscal reform plan was announced by the State Council, which aims to alleviate this important source of misallocation, imbalances and risks. This paper assesses the current state of China’s intergovernmental fiscal system, describes the main elements of the State Council’s recent reform plan and provides recommendations for further improvement based on international experience, with an emphasis on intergovernmental reforms needed to improve the social safety net.

A sound system of intergovernmental relations is crucial to China’s continuing development and rebalancing progress. Appropriate allocation of spending responsibilities and funding will be necessary to improve public service delivery, reduce growing regional disparities and promote inclusive growth. While China’s social spending levels are increasing, structural deficiencies in the social security system will need to be addressed, especially given the challenges posed by population aging and continuing urbanization. Finally, recent efforts to improve government borrowing frameworks and contain fiscal risks will only succeed if supported by reforms to reduce unfunded mandates for subnational governments.

II. Current Situation and Challenges

This section provides an overview of the current intergovernmental fiscal system in China. It also provides some historical context, highlighting the exceptional degree of expenditure decentralization, the increase of unfunded mandates at the subnational level and the proliferation of off-budget activities that have been especially prevalent since 2009.

Political and Institutional Features

China is a unitary state with a multi-tiered government structure. Subnational governments are in principle agents of the central government, tasked with carrying out national policy objectives within their own jurisdictions. In practice, this also means that the appointment of all provincial or ministry level officials is decided by the center. Historically, subnational governments in China have had de facto a high degree of autonomy, partly because of the size and complexity of the country. There are 5 levels of public administration. Beyond the central government, there are 31 provincial level governments¹, 334 prefecture level governments, 2850 counties and over 40,000 townships.² County-level governments bear the largest fiscal mandate, with total expenditures amounting to 9 percent of GDP, the largest among all levels (Figure 1). Counties are also more reliant on transfers than other levels of local government.³

The fundamental features of the current fiscal system date back to the fiscal reform of 1994. The government introduced a value-added tax (VAT) to replace a number of indirect taxes, a large share of revenues was centralized and the State Administration of Taxation was created (Brondolo and Zhang 2017). The previous regime consisting of ad hoc and negotiated transfers was replaced with rules-based revenue sharing and intergovernmental transfers (Wang and Herd 2013, Qiao and Liu 2013). The reform was successful in increasing overall revenues from 12 percent of GDP in 1993 to 22 percent in 2016 (Figure 2). A larger share for the central government also improved its ability to conduct fiscal policy and increase fiscal redistribution across regions. However, the reform also caused local governments’ budgetary surpluses to turn into sustained and growing deficits (Figure 3).

The last major reform of China’s fiscal system occurred in 2014, with the adoption of a new budget law. The main goals of the law are to improve the budgeting process and the transparency and accountability of local government financing. To achieve this, it requires the adoption of a multiyear budget and specifies the conditions for managing annual deficits and surpluses in a medium-term perspective. In principle, moving beyond annual budgeting will improve planning and allow the government to better manage fiscal policy across economic cycles. The new law also allows for the first time provincial governments to issue bonds for financing capital expenditure, subject to approval by the National People’s Congress.⁴ Crucially, it also closes the “back-door” on off-budget activities of local governments by prohibiting guarantees and any source of financing other than through approved bonds.

The 2014 budget law also seeks to improve coverage and reporting of the budget by consolidating all existing government budgets⁵ into the general government budget and by requiring publication of budgets and outturns within 20 days after approval by the People’s Congress. Finally, the law requires conditional transfers to gradually be replaced by general transfers to support basic public service delivery and reduce regional disparities. However, it does not address the fundamental misalignment of expenditure responsibilities and taxing powers and the large vertical imbalance that has prevailed since 1994 (Lam, Wei, and van Eden 2017).

Expenditures

China is the most decentralized country in the world in terms of subnational spending shares.⁶ Local governments account for 85 percent of general government budgetary spending. Taking into account off-budget expenditures financed through local government financing vehicles (LGFVs) raises this ratio to 89 percent of total government spending (Figure 4). While the central government retains some control over subnational spending, notably through the use of binding expenditure laws and mandates (Bahl and Martinez-Vazquez 2006), this ratio is much higher than even the most decentralized federations, even though China is constitutionally a unitary state.

Spending Assignment and Composition

Local governments are largely responsible for public service delivery and managing and financing the social safety net. Many large federal countries also rely on a decentralized social insurance system, but China is unique in having both its public pension system and unemployment insurance managed at the local level (Escolano and others 2015). Education and health care are not only extremely decentralized in terms of spending and financing, but they are also the fastest-growing public expenditure categories given aging and urbanization dynamics. This suggest that without a major realignment of expenditure responsibilities, the long-term trend of ever-rising deficits is set to continue for local governments.

Public service delivery is improving and more people are covered by the social safety net, especially for pensions and health insurance (Jain-Chandra and others forthcoming). However, gaps remain for urban migrants without a residency permit and individual benefit levels are still low. Consequently, social spending in China still lags other large emerging markets and advanced economies (Figure 5). Social assistance spending, which in China includes urban and rural “dibao”⁷, medical assistance and other programs, is around 0.7 percent of GDP in China, compared to 1.6 percent of GDP on average for emerging markets and 2.1 percent in OECD countries. Government health and education spending similarly lags other emerging markets and is much lower than advanced economies. Not only will China need to increase the levels of social spending further to support economic rebalancing and promote household consumption, it will also have to address the disparities in public service delivery and access. Barriers to mobility from the current fragmented system will have to be removed in order to support the projected 300 million new migrants in cities in the next two decades (World Bank and DRC 2014).

Regional Variation

Regional disparities are also growing fast. For instance, the disparity of government spending per capita is increasing, with richer counties seeing the fastest rises. This is also reflected in other indicators of public service delivery:

- Health. While the national average of hospital beds per 1,000 populations increased from 1.9 to 3.6 over the last decade and is catching up to the OECD average, the dispersion across counties has grown significantly (Figure 6). More developed counties are outpacing poorer ones. A one percent increase in GDP per capita at the county level was associated with an extra 0.54 hospital bed in 2004. In 2014, this association was 0.96 (Figure 7). Poor access to qualified healthcare personnel is particularly widespread in rural areas, which is a contributing factor to the much higher child mortality rate in rural areas compared to urban China (OECD 2017).
- Education. Nine years of free public education is now universal in China and the number of teachers per pupil has been steadily increasing. However, this has also been accompanied by an increase in the variance across prefectures.

Revenues

This section examines the allocation of revenues across levels of government in China. According to the Chinese authorities’ definition of local taxes, local governments collect around 60 percent of total taxes. However, when considering only revenue sources over which local governments have authority to either set rates or define the base, local governments’ share is negligible (Wang and Herd 2013).⁸ The rates and bases for all major taxes are set by central government legislation. This limits the local governments’ ability to set tax policy in accordance with local structural and cyclical priorities. The heavy reliance on revenue sharing also exposes local governments to higher uncertainty and cyclicality in their revenue compared to rules-based transfers, which can be adjusted by the central government to smooth local shocks if needed. It also limits autonomy and accountability, which can lead to inefficient uses of fiscal resources (Eyraud and Lusinyan 2013).

Revenue Classification

Taxes in China can be classified into three different types based on the sharing arrangement between the central and local governments (Table 1). The consumption (excise) tax, vehicle purchase tax and other trade-related indirect taxes all accrue to the central government. The domestic component of the VAT and the personal and corporate income taxes are shared according to fixed percentages between the center and local jurisdictions based on place of collection.⁹ China stands out in comparison to advanced economies by its heavy reliance on the VAT and corporate income tax (CIT), which amount to almost 50 percent of total tax revenues. On the other hand, the personal income tax’s contribution to total revenue is much lower at around 5 percent, significantly less than the average among OECD countries of 25 percent. The drawback of such a revenue structure is very limited progressivity of the tax system.

Table 1.

Tax Sharing Arrangement between Central and Local Governments, 2015

^{^a}Includes receipts from the Business Tax, which was replaced by the VAT in May 2016.

Sources: CEIC; de Mooij, Lam and Wingender 2017.

Table 1.

Tax Sharing Arrangement between Central and Local Governments, 2015

		Central	Local	Share of total taxes	Share of GDP
Central taxes				9.8	2.3
	Consumption tax	100	0	6.6	1.5
	Vehicle purchase tax	100	0	1.8	0.4
	Tariffs	100	0	1.6	0.4
	Cargo tax	100	0	0.0	0.0
	Intl trade-related consumption tax and VAT	100	0	−0.2	0.0
Shared taxes				55.9	12.9
	Domestic VAT^a	50	50	31.8	7.3
	Corporate income tax	60	40	17.1	3.9
	Personal income tax	60	40	5.4	1.3
	Stamp tax on securities	97	3	1.6	0.4
Sub-national taxes				34.3	7.9
	Social security contributions	0	100	21.3	4.9
	Tax on deeds	0	100	2.5	0.6
	Urban maintenance and development tax	0	100	2.4	0.6
	Land appreciation tax	0	100	2.4	0.6
	Urban land use tax	0	100	1.3	0.3
	Tax on the use of arable land	0	100	1.3	0.3
	House property tax	0	100	1.3	0.3
	Resource tax	0	100	0.7	0.2
	Stamp tax on property	0	100	0.6	0.1
	Tax on vehicles and boat operation	0	100	0.4	0.1
	Tobacco tax	0	100	0.1	0.0

^{^a}Includes receipts from the Business Tax, which was replaced by the VAT in May 2016.

Sources: CEIC; de Mooij, Lam and Wingender 2017.

Table 1.

Tax Sharing Arrangement between Central and Local Governments, 2015

		Central	Local	Share of total taxes	Share of GDP
Central taxes				9.8	2.3
	Consumption tax	100	0	6.6	1.5
	Vehicle purchase tax	100	0	1.8	0.4
	Tariffs	100	0	1.6	0.4
	Cargo tax	100	0	0.0	0.0
	Intl trade-related consumption tax and VAT	100	0	−0.2	0.0
Shared taxes				55.9	12.9
	Domestic VAT^a	50	50	31.8	7.3
	Corporate income tax	60	40	17.1	3.9
	Personal income tax	60	40	5.4	1.3
	Stamp tax on securities	97	3	1.6	0.4
Sub-national taxes				34.3	7.9
	Social security contributions	0	100	21.3	4.9
	Tax on deeds	0	100	2.5	0.6
	Urban maintenance and development tax	0	100	2.4	0.6
	Land appreciation tax	0	100	2.4	0.6
	Urban land use tax	0	100	1.3	0.3
	Tax on the use of arable land	0	100	1.3	0.3
	House property tax	0	100	1.3	0.3
	Resource tax	0	100	0.7	0.2
	Stamp tax on property	0	100	0.6	0.1
	Tax on vehicles and boat operation	0	100	0.4	0.1
	Tobacco tax	0	100	0.1	0.0

^{^a}Includes receipts from the Business Tax, which was replaced by the VAT in May 2016.

Sources: CEIC; de Mooij, Lam and Wingender 2017.

China also collects several taxes on properties and the real estate sector.¹⁰ Together, these taxes account for around 9.4 percent of total tax revenues, or 2.2 percent of GDP. This is much higher than the level observed in emerging and developing countries on average and roughly equal to the average rate of 2 percent for advanced economies (World Bank and DRC 2014). However, the taxes are based on physical area and transaction values of properties as opposed to recurrent assessments based on the market value of property. Finally, local governments also collect social security contributions, which are used to finance local social insurance systems.

Transfers

In addition to shared taxes, local governments in China also rely on transfers from the central government to finance their budgets. Transfers from the center can be classified in two broad types: general-purpose and specific-purpose or conditional transfers (Shah and Shen 2008). General-purpose transfers include: 1) the tax rebate, which was designed to compensate local governments for lost revenues after the 1994 and 2001 tax reforms, 2) the equalization transfer, which was established in 1995 to reduce fiscal disparities across provinces, and 3) other general transfers mainly used to finance pension and social security obligations, government wages, and public education. The relatively large centralization of revenues means that resources can be transferred from richer provinces to poorer ones in the central and western regions in order to support their socioeconomic development, increase their fiscal resources, and promote equity in provision of basic public services. The general transfers have been increasing over time and now account for around 60 percent of total transfers. They have also become more redistributive. The correlation between transfers per capita and GDP per capita, which was positive in 2000 mainly because the tax rebate transfer, had turned negative by 2010 (Wang and Herd 2013). While redistribution through intergovernmental transfers is improving, it still does not fully compensate for the increase in regional inequality.

The central government also uses specific-purpose or conditional transfers to subsidize local programs. In certain cases, these grants are subject to matching requirements by recipient governments. There are over 200 conditional grant programs which amount to around 20 percent of local government revenues (World Bank and DRC 2014). These grants mainly target transportation, social housing, agriculture, forestry and water, and energy saving and pollution abatement (Wang and Herd 2013). The system is perceived as opaque and overly complex, with high administrative costs both at central and local levels (Shah 1999, World Bank and DRC 2014). The relative importance of conditional transfers also contrasts with recent trends in advanced economies towards more general transfers to improve fiscal autonomy and accountability of local governments (Blöchliger and Vammalle 2010). Finally, local governments have also come to rely on land sales to finance growing deficits.

Borrowing

Following the 1994 reform, pre-transfer budgetary deficits of local governments increased from zero to 10 percent of GDP today. In theory, transfers from the central government were supposed to fully finance local government deficits since they were forbidden from issuing debt. In practice, however, local governments were given increasingly large unfunded mandates, especially following the large-scale stimulus of 2008/09. Because of the prohibition on issuing debt, local governments resorted to selling land and using off-budget special-purpose vehicles to borrow and spend on infrastructure and other priority sectors.

A national audit was conducted in 2013 to assess the extent to which local governments had resorted to extra-budgetary borrowing to finance their spending (Lam, Wei, and van Eden 2017). By end-2014, when the new budget law was set to take effect, the composition of total local government debt included a combination of bank loans, local government bonds, LGFVs bonds and trust loans and other funding sources (Figure 8). Provinces that faced a higher debt burden also relied more on LGFV off-budget financing to support infrastructure investment, especially following the 2008/09 fiscal stimulus that relied on local governments to execute a large infrastructure investment program to support growth (Figure 9).

With risks from off-budget activity mounting, the government in 2014 revised the budget law to allow provincial governments to issue bonds. A debt swap program amounting to 22 percent of GDP was rolled out to facilitate the transition by converting LGFV debt to local government bonds (Mano and Stokoe 2017). Provincial governments can now issue bonds, subject to approval by the central government. The proceeds can also be on-lent to their lower levels of government. Since early 2015, when the new law came into effect, provincial governments have issued the equivalent of around 15 percent of GDP in government bonds, with less developed regions having issued higher levels relative to the size of their economy (Figure 10). They have also relied more on short-term debt than richer provinces.

Ongoing Challenges

With efforts to close the “back door” of LGFV borrowing still ongoing and not fully resolved, new sources of off-budget funding are also emerging. Infrastructure investment is relying increasingly on PPPs, financed by policy banks, government funds and other sources. The capital value of such projects is around 27 percent of GDP, less than 20 percent of which were in the implementation phase by end-2016. Government Guided Funds (GGFs) and Special Construction Funds (SCFs) are also being used to finance public investment projects. The total value of the assets of GGFs and SCFs is estimated at around 5 percent of GDP. The activities of these funds are opaque, interact with other public sector units and have a strong public policy drive (Mano and Stokoe 2017).

III. Intergovernmental Fiscal Reform Plans

In August 2016, the State Council announced a major intergovernmental fiscal reform to address the long-standing misalignment of revenue and spending across levels of government (SC 2016 No. 49, August 16, 2016). The three overarching goals of the guidelines include (1) the clarification of expenditure responsibilities to minimize overlapping mandates, improve service delivery and increase accountability; (2) a recentralization of key functions that are currently under local government control; and (3) the consolidation and improvement of the transfer system, notably by increasing the fiscal resources of less-developed regions.

The authorities intend to complete the reform by 2020, at which time they plan to introduce an Intergovernmental Fiscal Relations Act. This new intergovernmental framework is intended to ensure more clarity, coherence and predictability and will support ongoing reforms in other areas such as education, social security and health care. A new legislative and regulatory framework should also facilitate budgetary and accounting reforms and improve the supervision of local government performance.