People’s Republic of China: Selected Issues

This Selected Issues paper analyzes state-owned enterprise (SOE) development and reform in China. The paper discusses the role of state ownership in the Chinese economy, providing a “snapshot” of key features of the state sector, and a review of the growth, efficiency, and profitability of SOEs. The paper argues that economic performance in SOEs has declined in the last few years as evidenced by falling profitability, increasing losses, growing industrial inventories, and low rates of capacity utilization in some sectors. The paper also examines banking sector development and policy issues in China.


This Selected Issues paper analyzes state-owned enterprise (SOE) development and reform in China. The paper discusses the role of state ownership in the Chinese economy, providing a “snapshot” of key features of the state sector, and a review of the growth, efficiency, and profitability of SOEs. The paper argues that economic performance in SOEs has declined in the last few years as evidenced by falling profitability, increasing losses, growing industrial inventories, and low rates of capacity utilization in some sectors. The paper also examines banking sector development and policy issues in China.

IV. Intergovernmental Fiscal Relations: The Chinese System in Perspective1

A. Introduction

1. China’s recent economic experience underscores the importance of the structure of intergovernmental fiscal relations. As in many transition economies, the structure of subnational governments and their relation with the central government have emerged as important policy issues. The experiences of other countries suggest there are no “ideal” solutions to these problems, and the choice of a particular system of intergovernmental relations involves both advantages and disadvantages. The issue of the fiscal relations among different levels of government represents in a sense the domestic counterpart to the broader question of the constraints on national tax policies imposed by an increasingly globalized economy with closer integration between national economies.2

2. In most countries, the territorial structure of a government is determined primarily by historical, social and political considerations. This paper focusses, nevertheless, on the economic aspects of the Chinese reforms in this area. To enable a systematic assessment of the Chinese experiences and policies in this field, section B briefly lays out some key conclusions of the economic literature on intergovernmental fiscal relations, especially with regard to an efficient structure of government. Sections C and D discuss developments in China prior to the comprehensive fiscal reforms of 1994, and describe—on the basis of the limited data available—the main intergovernmental elements of that reform. Section E presents some of the main features of the experiences of other countries with regard to the economic implications of the system of intergovernmental fiscal relations. Finally, section F discusses how some of the weaknesses in China—including the erosion of central control over fiscal policy and limitations in the scope for fiscal policy—may be addressed.

B. Issues in Intergovernmental Fiscal Relations: A Conceptual Background

3. An important rationale for a decentralized government—one in which the subcentral levels have an appropriate degree of autonomy in fiscal decisions—is to improve economic efficiency with regard to the provision of public goods.3 There are two main arguments. First, some public goods, such as street lighting and fire protection, typically benefit only the local community, whereas the benefits of others, such as defense and the judicial system, are national by nature. Second, preferences for public goods usually differ across regions or groups of the population. Economic efficiency, and welfare, could increase if the supply of public goods of a local nature were provided through a decentralized system which adapted the provision of public goods in accordance with the preferences of the local populations.4

4. A decentralized system has several other benefits. It constitutes a competitive “market” for public goods, where the benefits of the public goods and services accrue mainly to the local population which also bears most of the burden, through local taxation, of financing provision of these goods and services.5 Further, fiscal decentralization ensures that local preferences for public services are revealed, and financed through benefit taxation imposed by local governments who are held accountable for the provision of the services and their financing. In this sense, it also contributes to resolving or alleviating the free-rider problem in public-good provisioning. A decentralized system may also increase efficiency by promoting competition among local governments to provide the best services at least cost. The existence of a multitude of local bodies also fosters experimentation and cost-effective innovations. Finally, in a decentralized system, local governments’ better knowledge of the local population, combined with the use of benefit taxation, may help to enhance local revenue mobilization.

5. While there is general agreement regarding the virtues of decentralization, it is also generally acknowledged that a decentralized system will only function well under strict and transparent conditions concerning expenditure and revenue assignment, and the design of transfers to local governments. While in practice the design of the fiscal tiers between levels of government must be tailored to the specific circumstances of each country, including their stage of development, the general conditions relating to tax and expenditure assignment and to the system of transfers may briefly be summarized as follows.

Expenditure assignment

6. The key principle concerning expenditure assignment is that assignment should be based on the “benefit principle.” (The responsibility for a function should be accorded to the level of government within whose jurisdiction the benefits of the function accrue.) A clear, consistent, and stable system of expenditure assignment to each level of government based on the spatial characteristics of the public goods in question is required in order to minimize externalities between local governments, and to ensure accountability and political responsiveness. Lower levels of government should be given clear and well-defined expenditure autonomy with respect to allowed variations in service levels and composition of expenditures, consistent with any minimum standards determined by the central government. The legal framework should also ensure that local governments do not engage in activities of a purely commercial nature (such as industrial production or banking).

7. An important implication of this principle is that stabilization policies aimed at achieving macroeconomic objectives (for example, those relating to inflation and unemployment) are most efficiently carried out by the central government. The rationale is that because of the “openness” of local and regional economies, locally implemented stabilization policies would lead to large spill-over effects on neighboring regions. Also, local governments do not have the range of policy measures (such as monetary policies) to carry out macroeconomic stabilization. The fact that the stabilization objective is often the overriding one in many developing and transition economies has been used to argue in favor of a centralized government structure and policies in such economies.6 The argument is often extended by pointing to the need in many cases for allocating the responsibility for investment in basic infrastructure to the center. In a similar vein, central governments are generally better suited to carry out general redistribution policies, since the active pursuit of such policies by local governments may lead to migration from and to other localities of the groups affected by such policies. Also, fiscal decentralization may contribute to regional (including rural-urban) disparities in income and wealth, because wealthier local governments will benefit most from greater local taxing powers.7

8. Subnational governments, on the other hand, are best given responsibility for the provision of local public goods that are of a clear regional or local nature, for reasons of allocative efficiency. Urban services such as street lighting and cleaning, sanitation, water provision, urban mass transit are the clearest examples, since most of their benefits accrue locally.8 Secondary education, specialized health care, and environmental protection are better provided by regional governments, since their benefits extend to a larger area.

Tax assignment

9. Tax assignment in a fiscally decentralized system should involve the central government maintaining appropriate taxing powers consistent with its macroeconomic responsibilities, but should include a system of local taxes with one, or at most a few, major tax sources allocated to lower levels of government. Lower levels of government should be allowed well-defined autonomy over the rate setting for the taxes they have been assigned. It should be noted that the question of tax assignment may be dealt with quite separately from the question of who administers and collects the taxes. The former issue should be addressed on the basis of which taxes constitute good central taxes and which are best suited as local taxes, while the latter functions may best be implemented under a strictly centralized regime because of administrative economies of scale.9 There are a number of generally recognized criteria that “good” local taxes must satisfy:

  • The base of taxes assigned to the local level should not be too mobile, or taxpayers will relocate from high-tax to low-tax areas, and the freedom of local authorities to vary rates will be constrained.

  • Tax bases of local taxes should not be unevenly distributed across jurisdictions, in order to allow a uniform level of provision of public goods and services across the country.

  • Local taxes should be visible: it should be clear to local taxpayers what the tax liability is, thereby encouraging local government accountability.

  • Local taxes should be able to raise sufficient and stable revenue to meet the needs of subcentral levels of government and to minimize vertical fiscal imbalances.

  • It should not be possible to “export” the tax to nonresidents thereby weakening the link between payment of the tax and services received.

  • Taxes and user charges based on the benefit principle can be adequately used at all levels of governments, but are particularly suitable at the local level since the benefits are “internalized” to the local taxpayers.

10. These broad criteria translate into more specific recommendations concerning the taxes that can appropriately be assigned to lower levels of government. Property taxes, including in particular land taxes, are usually local taxes because it is always clear which authority is entitled to the revenue; administration costs are generally moderate provided there is a cadastre; and the yield can be predicted with fair accuracy. However, property taxes are generally not very buoyant, and there are problems with the “correct” valuation of the tax base and its updating.

11. In a large number of countries, personal income taxes are shared between the central and the local governments. Among the main advantages of PITs is the fact that they generally are buoyant and thus capable of raising the necessary revenue. A cost-effective way of taxing a global income tax base in local jurisdictions, used in a number of countries, is to use the same statutory tax base for the local and the national income tax (i.e., overlapping taxes or “piggy-backing”). Because it requires an efficient administrative system with up-to-date recording of taxpayers’ residence, overlapping personal income taxes are used more often in industrial countries. Payroll taxes withheld at source are used in many countries as a benefit tax to finance (mainly) the social safety net. Generally, these taxes are seen as less appropriate as local tax sources, and are not assigned to the local level.

12. Retail sales taxes and excises levied on the final sale to the consumer can be assigned to local governments, but should not be levied at very different tax rates across localities, which would drive consumers away from high tax areas. In contrast, value-added taxes are most appropriately assigned to the central level of government because of the fairly extensive administrative capabilities required to operate the tax in combination with problems of allocating revenues appropriately between local areas.

13. Corporate profit taxes should be left to the national level (and to provinces or states only in countries where these are very large). The economic activities of corporations are typically diversified and complex, with factor inputs originating from a number of regions and from abroad, and with sales similarly going to a multitude of regions. Hence, local taxes on corporate profits would to a large degree be exported or shifted to other areas in a nontransparent way, thus rendering the associated tax burden almost imperceptible to local citizens. Finally, taxes on natural resources are generally considered poor candidates of local taxation, since their bases normally are very unevenly distributed across regions and revenues may be highly volatile.


14. A system of general and specific transfers should ensure that externalities are corrected and an acceptable degree of equity achieved by equalizing fiscal capacities and “objective” expenditure needs beyond the control of individual local governments. If this is done properly, differences in tax rates across subnational governments at the same level will reflect differences in expenditure policies and service levels decided by the local councils in accordance with local preferences, and not factors beyond their control, such as disparities in per capita income levels, demographic and social factors, and uncontrollable differences in unit costs. Only in this case will elected local councils be given equal opportunities to provide their constituencies with public services at a comparable tax price.

15. There are two broad categories of transfers: general purpose transfers and specific purpose transfers. With general purpose transfers, local governments are usually free to choose how to spend them, but the share that each subnational government receives is fixed by rules determined by the central government.10 These transfers are intended to reduced fiscal imbalances across levels of government or to reduce revenue disparities between jurisdictions at the same level. With specific transfers, the central government ultimately decides how the funds should be spent. The size of the transfer may be determined by the central government, or may depend upon the spending decisions of lower levels of government, under so-called matching or co-financing schemes. Specific purpose transfers are intended to correct interjurisdictional spillovers or to achieve specific national priorities and policies concerning the lower level of governments.11

16. Broad guidelines for the appropriate design of intergovernmental transfers are as follows.12 A fair distribution of transfers among subnational governments provides more equal opportunities for different local governments, and is often viewed as an important means of improving cooperation among different regions and levels of government. A fair distribution is best achieved by general purpose, equalization grants. These grants should enable individual subnational governments to provide public services at standards similar to those provided by other subnational units without imposing taxes and charges at levels appreciably different from those prevailing in other subnational governments. Also, general transfers should be allocated among subnational governments according to well-defined, non-negotiable formulas, based on objective factors over which individual governments have no discretionary control. Subnational governments should have predictable shares in total transfers, in order to allow them to formulate budgetary decisions on a medium term basis. Transfers should when possible provide incentives for sound management practices and discourage inefficiency, and should not encourage local governments to run budget deficits.

17. To summarize, a decentralized system of government, with well designed expenditure and revenue assignments, supported by an appropriate transfer and equalization mechanism will enhance economic efficiency and ensure budgetary discipline at the local level Most countries operating a multi-level government broadly satisfying these requirements have in addition found it necessary to establish mechanisms to ensure that the local governments as a whole are in compliance with broad macroeconomic targets and possibilities. The mechanisms range from negotiations and voluntary agreements between the national- and individual local governments to demands for strict compliance by local governments with quantitative targets (for example, ceilings for local government employment and local tax rates, and floors for expenditure cuts).

C. Intergovernmental Fiscal Relations in China, 1978–94

18. In the period since 1978, China’s economy has grown rapidly, against the background of reforms that have allowed market forces a greater role in resource allocation. Changes in the system of intergovernmental relations have included greater decentralization of fiscal authority, especially in terms of increasing the autonomy of local governments over taxation. Decentralization has been accompanied by a growth in off budget (or “extrabudgetary”) activities of local governments, contributing to a weakening in the center’s control over fiscal policy. A parallel development has been a trend decline in the ratio of budgetary tax revenue to GDP to very low levels, reflecting weaknesses in both central and local tax revenues. The declines in the central government’s control over fiscal policy and in the tax ratio have limited the role of fiscal policy in macroeconomic stabilization, redistribution to mitigate regional economic disparities, and fulfilling expenditure needs.

The institutional framework

19. In China, the fiscal administration consists of a central government and four subcentral levels of government referred to as “local governments.” The local governments are: (i) 31 provincial-level localities, consisting of 22 provinces, 4 municipalities with significant independent powers directly under the central government,13 and 5 autonomous regions;14 (ii) over 300 prefectures and municipalities at the prefectural level; (hi) over 2,100 counties, autonomous counties, and cities at the county level; and (iv) several tens of thousands of townships, towns, and city districts. The sub-provincial levels of government operate under the authority of the provincial level.

20. Intergovernmental fiscal responsibilities, in terms of revenue assignment and expenditure responsibilities, are not clearly delineated in China’s constitution. During most of the reform period, intergovernmental fiscal relations were based on a complex set of negotiated contracts between the central and local governments. Since 1994, wide-ranging reforms as well as legislative changes have clarified to some extent the fiscal responsibilities of different levels of government, but important areas—notably the system of intergovernmental transfers—remain to be fully addressed.

Developments in central and local revenues and expenditures

21. During the period 1978–94, local governments gained increasing influence over fiscal revenues. Unlike in most countries, the central government in China did not have a nationwide tax administration and tax collection was mainly the responsibility of local governments.15 While the central government controlled tax legislation, tax assignment evolved from a centrally controlled system to one based on revenue sharing.16 Revenue sharing was introduced in 1980, in part with the intention of raising the incentive for local governments to increase revenue collections.17 Under revenue sharing, all revenue no longer automatically accrued to the central government. The central government designated revenues from each tax as being “central fixed revenue” (accruing to the central government), “local fixed revenue”, or “shared revenue.” Shared revenue was divided between the central and local governments according to negotiated but flexible contracts.18 The revenue sharing system was subsequently modified: first (in 1985) with the intention of raising the share of revenue retained by poorer regions and then (in 1988), when the tax efforts of richer regions flagged, of raising the revenue share of these regions as well.19 As a result of the changes in 1985 and 1988, the terms under which revenue was divided between the central and local governments differed across localities, and began to include an element of bargaining.

22. The assignment of expenditure responsibilities among different levels of government remained largely unchanged; in particular, there was no decentralization similar to that in revenue assignment.20 Expenditure policy and legislation remained under the purview of the central government, while administrative functions overlapped between the central and local governments.21 The central government budget was responsible for expenditure on most capital outlays and on national defense, and for servicing government debt. Local government budgets were responsible for spending on social welfare (including health and education), and for most expenditures on administration and agricultural development. In addition, local budgets bore most of the costs of budgetary subsidies.22

23. Overall budgetary revenue and expenditure declined in relation to GDP, as did the share of the central government in expenditure (Tables IV.1 and IV.2). Overall budgetary revenue declined from 30 percent of GDP in the early 1980s to 12 percent in 1994, reflecting declines in both the central and local revenue ratios (to 6.7 percent and 5.3 percent, respectively, when measured before transfers).23 Budgetary expenditures declined by similar amounts (to 13.6 percent overall, and to 4.1 percent and 9.5 percent, respectively, for the central and local governments), reflecting cutbacks in often necessary expenditures and the shifting of others to off budget accounts. The central government’s share of “own revenue” (i.e., revenue before transfers) actually increased during the 1980s, before declining subsequently, but the recorded increase was more than offset by the negotiated revenue sharing and transfer arrangements.

Table IV.1.

China: Budgetary Developments, 1980-96

(Percent of GDP, GFS basis)

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Source: Chinese authorities.
Table IV.2.

China: Central and Local Government Shares of Own Revenue, 1957–96

(In percent)

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Source: Ministry of Finance. Data were available only for selected years. Data are classified according to national definitions.

Revenue before transfers (or “own” revenue).

Expenditure before transfers (or “own expenditure”).

24. A prominent feature of the fiscal landscape during 1978–94—as well as subsequently—was the growth of “extrabudgetary funds” (Table IV.3). These were funds outside the scope of the formal budget (including in terms of monitoring and approval) but subject to control by different levels of government. Most extrabudgetary funds were controlled by local governments. Revenues for these funds included initially the retained earnings of local SOEs,24 public utilities surcharges, transportation fees, rental income on public housing, and various social funds, as well as ad hoc fees and charges. Extrabudgetary expenditures were mainly directed toward priority capital projects of local governments. The balance of extrabudgetary revenue and expenditure remained in surplus. The size of extrabudgetary funds rose steadily in relation to budgetary funds, to nearly 100 percent (for revenues) and 80 percent (for expenditures) in 1992.25

Table IV.3.

China: Extrabudgetary Funds of Central and Local Governments, 1982-94 1/

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Source: China Statistical Yearbook 1996.

Does not include the social funds. There is a break in the series in 1993, when several items hitherto included in the authorities definition of extrabudgetary funds (including mainly the retained earnings of state enterprises) begain to be excluded.

25. Local governments in principle were not allowed to borrow, but the guidelines was often not followed. In practice, local budget deficits were often financed through extrabudgetary funds, grants from the central government, and arrears, as well as through various financial instruments.

26. Implementation of the complex, contract-based revenue system entailed a web of intergovernmental transfers. Local governments made revenue-sharing transfers to the center based on their contractual arrangements. The central government in turn made transfers to localities in the form of subsidies or grants.26 From 1989 onward, central government transfers to local governments were larger than local transfers to the center. This pattern reflected the central government’s efforts to redistribute a part of fiscal resources from surplus to deficit localities.

Key economic implications

27. The changes implemented in the system of intergovernmental fiscal relations were consistent with other structural reforms to move the economy from a centrally planned system to one based on decentralized decision making. Reforms in intergovernmental fiscal relations were incomplete, however, as the revenue sharing system was complex and retained a strong element of ad hoc bargaining, the expenditure assignment system was not decentralized, and the transfer system was broadly unchanged. These aspects of the system—as well as the occasionally perverse incentives that it posed to local governments—may at times have compromised macroeconomic stability, eroded the central government’s control over fiscal policy, widened regional fiscal disparities, and led to inefficiencies in resource allocation.

28. The intergovernmental system—both its revenue and expenditure aspects—contributed to expansionary pressures, especially at the local level. While the revenue contracts tended to fix for extended periods the level of revenue accruing to the central government, they contributed to local revenue being quite closely related to changes in economic activity.27 Increases in local revenues during periods of economic expansion tended to be followed by corresponding increases in local expenditures, rather than by budgetary surpluses. The expansionary (or pro-cyclical) bias may have existed partly because, unlike the central government, local governments did not have macroeconomic management responsibilities to constrain their spending plans. In addition, under the revenue contracts, local governments were often required to make larger remittances to the center if they started to run budget surpluses. Expansionary pressures at the local level did not tend to subside during periods of slow growth, since local deficits were partly financed by grants from the center.

29. At the same time, local budgets were exposed to greater uncertainty, as pressures from the center often spilled over, including in the form of arbitrary assignments of additional expenditure responsibilities ad hoc revisions to contracts. In part due to such uncertainty, local governments intensified efforts to promote industrial expansion as a source of both budgetary and extrabudgetary funds. Rapid local expansion had obvious benefits, but was also often a source of overheating.28

30. Elements of the intergovernmental system contributed toward limiting the scope for fiscal policy, especially at the central level. The nature of the fiscal contracts—especially the additional burdens placed on localities whose budgets performed well—gave local governments incentives both to reduce their overall tax efforts and to shift tax collection efforts away from revenues that had to be shared with the center toward those over which they had greater control. They provided generous ad hoc tax concessions, exemptions, and refunds to SOEs under their jurisdiction, increasing these SOEs’ retained earnings.29 Retained earnings were part of the extrabudgetary funds, on which local governments drew to finance local projects.30 Both the prevalence of tax breaks and the shifting of revenues from budgetary to extrabudgetary accounts contributed to the decline in the budgetary revenue ratio, which in turn reduced the ability of fiscal policy to perform its full range of functions. In addition, the increasing retention of budgetary revenue by the local governments (under the contracts) contributed to the decline in the share of the central government in revenue. The decline in this share, along with the lack of expenditure decentralization, led to an erosion specifically in the central government’s control over fiscal policy.

31. The central government was restricted by its fiscal weaknesses from undertaking redistribution in order to reduce regional economic disparities. In addition, grants from the center often went to relatively well-off provinces in the form of budgetary subsidies.31 As a result of these factors, the deterioration in the fiscal positions of the deficit provinces was larger than the improvement of the fiscal position of the surplus provinces.32 A related development was the emergence of regional protectionism. Fiscal uncertainties, as mentioned, induced local governments to develop their own sources of revenue, which led them to press for an expansion of local SOEs. Local governments also had the authority to restrict inflows of goods from other localities, and to approve the use of inputs produced in their own localities. The protection from competition of local SOEs was sometimes used as a justification to set up barriers to interprovincial trade. Regional protectionism contributed to inefficiencies in economy-wide resource allocation, including “duplicate investment”, whereby identical, large projects were established in several localities at once (a lack of specialization), and “irrational investment”, whereby investments were made in projects that quickly turned out to be unprofitable.33

D. Addressing the Problems: the 1994 Reform

32. As part of the wide-ranging fiscal reforms implemented in January 1994, the complex, contract-based intergovernmental revenue system was replaced by the transparent delineation of revenue sources for the central and local governments. In addition, the central government’s authority over tax collection was enhanced through the creation of a National Tax Service. These reforms were intended to raise the share of the center in fiscal revenue (to around 60 percent over the medium term), and to strengthen fiscal policy as an instrument for macroeconomic management and other national priorities such as the reduction of regional disparities. The clear delineation of revenue assignments was also expected to impose greater discipline on all levels of government in their expenditure decisions.34

33. Under the new system, as before, taxes were classified as central-fixed taxes, local-fixed taxes, and shared taxes.35 An important difference was that these assignments were explicit in the tax regulations and not subject to bargaining. The changed revenue assignment was supported by a new system of tax administration, with the newly established National Tax Service being made responsible for collecting all central and shared taxes and the local tax services being limited to collecting local taxes. In order to minimize the disruption to local government finances, the central government guaranteed the localities that local revenues would not be allowed to fall below a “basic amount” (based upon actual local revenues in 1993). The main means by which the guarantee was intended to be fulfilled was central transfers to local governments of part of VAT and excise revenue.

34. The system of expenditure responsibilities was essentially unchanged. It was envisaged that the central government’s share in total expenditure would remain at around 40 percent, and that a fiscal surplus would thus be recorded at the central level. The surplus was intended to be used to finance a system of grants. Grants were to be based on “objective criteria”, such as poverty levels and costs arising from natural disasters, which were not, however, established at the time. The need was recognized for the grants mechanism to be made transparent, and to avoid past problems such as using grants simply to fill gaps in local budgets (reducing the incentives for fiscal prudence at the local level) or basing grants on subjective criteria (opening the system to undue political influence, particularly from the local level, and possibly widening regional disparities).

35. Later in 1994, the authorities drafted the Budget Law, which further strengthened the basis for fiscal operations. Under the law, which was approved with effect from 1995, budgetary operations procedures were clarified, requiring the local and central budgets to be formulated in a coherent framework. Local governments were disallowed from financing any deficits through bond issues or bank borrowing.

E. Decentralization and Economic Stabilization: Selected Country Experiences

36. It is commonly held that stabilization policies are best implemented by the central government, and that the more centralized a country is, the easier it will be to implement such policies.36 The main reasons are that monetary policies (which together with fiscal policies are the main policies for stabilization) necessarily must be centralized; that subnational entities usually are fairly open, which implies that fiscal multipliers are small and local stabilization policies therefore relatively inefficient; and that tax competition between subnational entities to attract mobile tax bases may be destabilizing and may lead to a suboptimal level of taxation, particularly on capital. However, since many countries have in fact instituted some level of fiscal decentralization,37 the question arises how such a system can achieve the advantages of decentralization without having unwarranted effects on stabilization. There are no simple solutions, but the discussion in section B has covered some of the conceptual issues involved.

37. It is useful in addition to examine key elements of the systems of intergovernmental fiscal relations in other countries. This section discusses such elements in selected countries, focussing on five basic factors: (I) the structure of government (levels, number of entities at each level, and their internal division of powers), as defined in the constitution or other legal basis; (ii) the assignment of responsibilities to each level of government; (iii) the assignment of revenues—particularly taxes—to each level; (iv) the system of transfers; and (v) local borrowing. The following cases provide examples pertaining to each of these five factors.

38. Relating to the structure of government: in the former republic of Yugoslavia, the fiscal system was considerably decentralized through the Constitution of 1974, which granted the republics fiscal autonomy with respect to defining tax bases, setting tax rates, and other budgetary freedoms. Horizontal imbalances developed but, unlike in most countries, the deficit (own revenues minus expenditures) was at the federal level rather than at the state or local level. The federation thus relied in large measure on fiscal contributions from its constituent republics. In Russia, selected autonomous regions were given the right to negotiate with the center the amount of the tax payments accruing on their territories that should be handed over to the central government. Together with an overall decline in fiscal revenues, insufficient revenues at the center constrained to some extent the transfers that could be made to subnational governments.

39. As regards the assignment of responsibilities among different levels of government: in a number of Central and Eastern European transition economies subnational governments were given greater responsibilities than to provide local public services to their populations (the “core” responsibility). In Poland, for example, during the early phases of the transition, local governments were able to establish enterprises and commercial banks, in order to raise revenue and promote local economic activity.

40. On tax assignment: in Brazil, a comprehensive system of fiscal federalism includes assignment of the VAT to different levels of government is one part of a comprehensive system of fiscal federalism, albeit an important one. All three levels of government are assigned taxing powers on consumption, but using different tax systems, and with the broadest base (an income type VAT) assigned to state governments rather than the federal government. In addition, a large fraction of central consumption tax revenue is transferred to lower levels of government under a tax sharing arrangement. In some countries—including Argentina, Nigeria, and Russia—natural resource taxes (on oil, for example) are assigned to subnational governments rather than the federal government. Such taxes may provide subnational governments with revenue windfalls, which tend to be consumed locally.

41. Transfers to subnational governments are intended to promote national priorities and to correct for externalities at the local level, to equalize horizontal fiscal disparities between local governments, and to address problems of vertical fiscal imbalances (because, in most countries, the central government has been assigned a larger part of taxation powers than expenditure responsibilities). Transfers to subnational governments constitute the most direct instrument by which the central government can subordinate the local sector to national stabilization objectives. In some countries—for example, Australia and Korea—the general grants system is designed as a set of formula based equalization schemes that transfer a fixed percentage of the revenue from some central government revenue sources directly to provincial and local governments.38

42. Excessive borrowing by subnational governments, which has taken place in a number of countries at different points in time,39 can undercut stabilization objectives of a country as a whole, by increasing domestic demand; by crowding-out other important borrowing and private investment, and by undermining effective limits to money and credit growth. This is why in the large majority of countries (developing, transition, and developed), governments have imposed strict limits on borrowing by subnational governments. This takes many different forms,40 from outright repeal of all local borrowing, to less stringent regulations on the allowed purposes of local borrowing, and constraints on the allowed terms of such borrowing.

43. In conclusion, actual country experiences suggest that virtually all aspects of the design of a fiscally decentralized system have potentially important implications for the efficiency of the macroeconomic policies conducted by central governments. These experiences do not necessarily suggest a need for greater centralization, but simply for the system of intergovernmental fiscal relations to take appropriate account of the implications for macroeconomic policies.

F. Developments in China Since 1994 and Outstanding Issues


44. Since the reform of 1994, the overall revenue ratio has continued to decline, although it seems to have stabilized at about 11½ percent of GDP in 1996. However, the revenues of the local governments have continued to perform much better than the revenues of the central government, resulting in a renewed tendency toward decentralization of taxation (with regard to actual yields rather than the authority to tax). This is the outcome of much more buoyant local rather than central taxes, particularly as reflected in the yields of the personal income tax and the local elements of the business tax. In addition, the VAT, which hitherto performed better than taxes as a whole, has lost some of its momentum, in turn negatively affecting the relative performance of central government tax yields.

45. Although the available data are particularly scarce in this area, the activities of off-budget funds and operations seem to have further escalated, and may according to some estimates have reached almost 6 percent of GDP. Some, but far from all, of these off-budget activities relate to public utilities, and as such—following GFS principles—should remain as classified outside the general government. Most extrabudgetary activities take place at the responsibility of local governments. To increase the transparency and the central control of fiscal policy, the central government has recently taken a number of initiatives to counter this development by, inter alia, issuing strict regulations to central and local entities to repeal all nonauthorized funds and fees, and by including 13 large central funds in the budgetary process starting in 1997.41 These initiatives also aim at enhancing the legality of the actions of local governments. It is not clear to what extent the off-budget activities will simply be transferred to the local budgets, and to what extent they will be curtailed, and hence reduce the size of the general government.

46. Concerning the five social funds, the approach adopted by the authorities of conducting pilot experiments in selected cities and regions has continued, although the scope of these schemes has not been broadened. The authorities intend to establish a modern social safety net, including nationwide pension schemes and unemployment schemes, by the end of this century, which should significantly relieve the state owned enterprises from the costs of extensive social responsibilities. The social funds, as well as local governments, may need to assume substantial tasks in this regard.

Outstanding issues

47. The 1994 reform contributed importantly to alleviating the problems created by the previous system of intergovernmental fiscal relations, including for macroeconomic policy management. A continuation of the transformation to a market-based economy, and maintaining the present high growth performance with low inflation, will require ongoing improvements in the fiscal system, including strengthening of the buoyancy of central government taxes. In addition, the increasing economic disparities between coastal and inland regions remain to be addressed. Reforms are intended to continue in the state-owned enterprise (SOE) sector, and are to include relieving SOEs from most of their present social obligations, through social divestiture to local governments and/or to the social funds, based on the provision of the necessary funding. While reforms of the system of intergovernmental fiscal relations obviously cannot resolve all of the problems involved, they can contribute to making the process smooth.

48. Important outstanding issues in the area of intergovernmental fiscal relations include the following. A transparent and stable legal framework for the activities of subnational governments, that clearly delineates the degree of autonomy of local governments including with regard to expenditure responsibilities, has yet to be formulated; several extrabudgetary funds and operations remain outside the official budget framework, making fiscal management more difficult and limiting the transparency of the fiscal accounts; the transfer system, which was not changed during the 1994 reforms, retains elements of bargaining and unpredictability.42 The authorities intend to establish a transfer system based on “objective” criteria that would overcome these problems and also help in equalizing regional disparities in public goods provision; the buoyancy of central government revenues remains relatively low. The authorities are taking measures to strengthen these revenues, including by scaling back overly generous tax concessions to certain kinds of enterprises.


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Mr. Arora (ext. 36211) or Mr. Norregaard (ext. 36383) is available to answer questions related to this chapter before the Board discussion.


See, for example, Tanzi (1996), who argues that tax competition between nations to attract mobile tax bases (particularly enterprise profits through investment, and returns from financial saving instruments) may lead to so-called tax degradation or suboptimal levels of taxation.


See Oates (1992) and Musgrave and Musgrave (1989). It may be noted that while these papers, as well as the present one, deal with the division of fiscal responsibilities and the interactions among the different levels of government there is also much ongoing research into the appropriate scope for government activity as a whole. See Tanzi and Schuknecht (1997) for a brief discussion of some of the main issues in that literature.


This conclusion assumes that local public goods have limited externalities, which could be felt beyond the local population, and that the costs of providing the goods can be internalized to the local population.


See Tiebout (1956), who describes this market as the outcome of the choices of mobile voters of the localities that best satisfies individual demand for local public service (through “voting by their feet”).


Recently, however, some authors have suggested assigning at least some responsibilities for stabilization policies to subnational levels of government on the basis, inter alia, that economic cycles may not be highly correlated across regions (see, for example, Gramlich (1987)).


Other examples are kindergartens, primary education and basic health care.


Hence, a given tax may be administered (i.e., levied, audited, collected) by the central tax administration, while the yield ultimately accrues to the relevant local governments.


The amounts received by individual authorities may also depend on their own tax efforts, that is, the extent to which they actually exploit their tax sources.


For example, to promote preventive medicine or environmental protection, or to ensure equal national standards in the provision of certain basic public services like health or education.


See, for further background, Oates (1979).


Chongqing became the fourth such municipality on January 1, 1997 joining Beijing, Tianjin, and Shanghai.


On July 1, with the transfer of sovereignty over Hong Kong, the number of autonomous regions will increase to six.


There were a few exceptions. For example, customs duties and taxes paid by large centrally owned state enterprises were collected by the customs administration and the central government, respectively.


For a comprehensive discussion of the pre-1994 system, and subsequent developments, see Jun Ma (1997).


Before 1980, all taxes and profits were remitted to the central government, which then made transfers to local governments based on centrally approved expenditure priorities.


The contracts were sometimes altered at the discretion of the central government. In addition, a small part of shared revenue was divided in a fixed proportion. For example, the central and local governments received 50 percent each of the revenue from the urban land use tax.


In 1985, the system was revised so that if a locality raised local fixed revenue in excess of its expenditure, a part of that revenue had to be submitted to the center. If local fixed revenue fell short of local expenditure, a higher proportion of shared revenue could be retained by the locality. If even all of shared revenue did not suffice to balance the local budget, the locality usually received a grant from the center. While it limited increases in regional fiscal disparities, the revision reduced the incentive of faster-growing regions to increase tax collection. In 1988, the system was further changed to one consisting of six kinds of revenue-sharing contracts (i.e., with different terms), each adopted by a limited number of localities, that on the whole increased the portion of revenue that localities were allowed to retain.


However, after 1981 the central government stopped stipulating specific expenditures in local budgets, leaving these to be determined by local governments within the overall limits of the general government budget.


Most administrative functions were the responsibility of local governments. The main exclusively central functions were defense, foreign affairs and monetary affairs.


See Christine Wong (1991) for further discussion. While the distribution of the costs of price subsidies changed often, in the early 1990s local governments bore over two thirds of the costs. Essentially, the central government transferred a fixed amount to localities to cover the difference between the cost of grain procurement at controlled prices—the “grain quota”—and the market value of procurement. Localities were supposed to bear the cost of any consumption of subsidized grain above the quota. In practice, localities were sometimes compensated by the center, through “earmarked” grants, for a significant part of these costs.


See Vivek Arora and John Norregaard (1996) for a further discussion of the revenue decline.


In principle, SOEs’ retained earnings and depreciation funds do not belong in the budgetary domain. In 1993, SOEs’ retained earnings and depreciation funds ceased in principle to be under the control of the government. However, there continued to be reports of local governments imposing arbitrary charges on SOEs to tap into these funds. (See Ma (1997).)


Complete data are not available for the late 1970s, but Ma (1997) suggests that in 1978 the ratio of local extrabudgetary to budgetary funds was 66 percent. For the period after 1992, due to a change in the definition of extrabudgetary funds in the official data, comparable data are not available. A new time series suggests, however, that the size of extrabudgetary funds has remained relatively high in the last few years.


In addition, one of the contracts formulated in 1988 required the center to pay localities a revenue-sharing transfer. Central government transfers that comprised subsidies or grants were of three kinds. “Quota grants” compensated local governments for the local budget deficit in the base year (i.e., the year in which the contract was made). “Special purpose grants” were given to finance specific tasks of national priority that were undertaken by local governments. “Account-settlement grants” were in relation to revenue-sharing contracts, changes in the ownership of fixed assets, or general compensation to local governments (for example in response to any adverse effects on their budgets resulting from central government measures).


For example, the changes to the revenue-sharing system in 1988 allowed several local governments to retain a higher share of revenue if revenue growth was sufficiently strong. The changes included requiring ten provinces to share with the center a fixed proportion of revenue if revenue grew within a range of 3.5–6.5 percent in a year, but allowing them to retain all of the revenue in excess of 6.5 percent growth; and requiring three other provinces to transfer to the center a fixed proportion of revenue until a pre-specified level (in millions of yuan) was attained, beyond which a smaller proportion needed to be transferred.


Expansion was also often achieved through policies that were uncoordinated among regions, contributing to inefficiencies (discussed below).


Tax rates and bases, while legally determined by the central government, were thus increasingly influenced by local governments, who were responsible for tax collection.


Funds were shifted to extrabudgetary accounts for other reasons as well, such as to avoid central government scrutiny.


These consisted of price subsidies for “daily living necessities” and subsidies to cover the operating losses of SOEs.


See World Bank (1993), Table A–19, page 258.


Of course there were other reasons for duplicate and irrational investment. One reason was declining central authority and oversight with regard to investment planning. A second reason was that since capital markets were not well developed, and financial intermediation was thus limited, investible funds tended to be reinvested locally regardless of the rates of return in other regions. See Michael Bell and others (1993).


For a detailed description of the 1994 fiscal reforms, see Wanda Tseng and others (1994).


The central government was assigned revenue from the income tax on centrally-owned SOEs; the business tax on railways and the financial sector (including banks, nonbank institutions, and insurance companies); the excise tax; customs duties; and the value-added tax (VAT) on imports. Local governments were assigned revenue from the income tax on all enterprises that were not centrally owned (i.e., locally-owned SOEs, collectives, joint ventures, and private enterprises); personal and agricultural income taxes; the remainder of the business tax; the VAT on real estate transactions; urban land use taxes; stamp taxes; and minor transactions taxes. Except as above, the VAT was intended to be shared between the central and local governments in the ratio of 75 percent to 25 percent.


Usually for reasons (including historical, ethnical, cultural, and religious reasons) that are not purely fiscal in nature.


Problems of stabilization in the context of transfers may arise if the basis of the transfer includes progressive income taxes, which generally are the most buoyant and effective automatic stabilizers. Transfers of part of such revenue to subnational governments typically results in their being spent, since local governments are generally liquidity constrained due to restrictions on their borrowing (an effect known as the “flypaper effect”). In this way, transfer mechanisms may have a pro-cyclical and hence a potentially destabilizing effect. To the extent that transfers to subnational governments are purely “gap-filling”, that is, for each local government calculated as the difference between (centrally assessed) local expenditure norms, and local own revenue, local governments may engage in strategic behavior in order to maximize transfers from the center. Thus, the design of the transfer system per se may provide expansionary incentives with potentially adverse effects on stabilization.


Standard approaches are described in Ter-Minassian, op. cit.


In 1996, the authorities issued guidelines to both the central and local governments prescribing strict measures to curb the growth of extrabudgetary funds (see State Council (1996)).


A few preliminary measures have been taken, however. A modest equalization grant was introduced in 1996, and may be expanded in future years, in order to help reduce regional economic disparities.