A. Background

1. China is a unitary state with a highly complex intergovernmental fiscal system. There are five levels of public administration. Local governments are responsible for 85 percent of government spending, but have limited revenue autonomy. A recent intergovernmental fiscal reform plan, announced by the State Council, aims to address the misallocation of fiscal responsibilities and the associated imbalances and risks. This paper assesses the current state of China’s intergovernmental fiscal system, briefly describes the main elements of the authorities’ recent reform plan and provides recommendations for further improvement, with an emphasis on reforms needed to improve the social safety net.

Local Governments Share of Total Spending, 2014

(percent of GDP)

Citation: IMF Staff Country Reports 2017, 248; 10.5089/9781484314722.002.A008

Source: GFS; CEIC; IMF staff calculations.

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Local Governments Share of Total Spending, 2014

(percent of GDP)

Citation: IMF Staff Country Reports 2017, 248; 10.5089/9781484314722.002.A008

Source: GFS; CEIC; IMF staff calculations.

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Local Governments Share of Total Spending, 2014

(percent of GDP)

Citation: IMF Staff Country Reports 2017, 248; 10.5089/9781484314722.002.A008

Source: GFS; CEIC; IMF staff calculations.

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2. The current fiscal system was established following the major fiscal reform of 1994. The government introduced a value-added tax (VAT) and a large share of revenues was centralized. The previous intergovernmental fiscal system consisting of ad hoc and negotiated transfers was also replaced with rules-based revenue sharing and intergovernmental transfers (Wang and Herd 2013, Qiao and Liu 2013). While the reform was successful in increasing overall revenues from 12 percent of GDP in 1993 to 22 percent in 2016, it also caused local governments’ budgetary surpluses to turn into sustained and growing deficits.

Revenue Impact of the 1994 Fiscal Reform

Citation: IMF Staff Country Reports 2017, 248; 10.5089/9781484314722.002.A008

Source: CEIC; IMF staff calculations.

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Revenue Impact of the 1994 Fiscal Reform

Citation: IMF Staff Country Reports 2017, 248; 10.5089/9781484314722.002.A008

Source: CEIC; IMF staff calculations.

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Revenue Impact of the 1994 Fiscal Reform

Citation: IMF Staff Country Reports 2017, 248; 10.5089/9781484314722.002.A008

Source: CEIC; IMF staff calculations.

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3. Local governments are largely responsible for public service delivery and managing and financing the social safety net. While many federal countries rely on a decentralized social insurance system, China is unique in having both its public pension system and unemployment insurance managed at the local level (Escolano and others 2015). Public service delivery is improving and more people are covered by the social safety net, but gaps remain for urban migrants without residency permits and individual benefit levels are low. Consequently, social spending in China still lags other large emerging markets and advanced economies. Social assistance spending 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 worldwide and in Asia, and is much lower than advanced economies.

4. Local governments collect 60 percent of total taxes, including own and shared taxes. However, when considering only revenue sources over which they have authority to either set rates or define the base, their share becomes negligible (Wang and Herd 2013). This limits local governments’ ability to set tax policy in accordance with local structural and cyclical priorities. It can also limit the accountability of local officials, which can lead to inefficient uses of fiscal resources (Eyraud and Lusinyan 2012).

5. Local governments 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). While redistribution through intergovernmental transfers is improving, it still does not fully compensate for the increase in regional inequality and public spending disparities. There are in addition 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).

6. 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. Because of the prohibition on issuing debt, they have in turn resorted to selling land and using off-budget special-purpose vehicles to borrow and spend on infrastructure and other priority sectors. With risks from off-budget activity mounting, the government revised the budget law in 2014 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 off-budget debt to local government bonds (see Mano and Stokoe forthcoming).

B. Recent Government Reforms

7. In August 2016, the State Council announced a reform to address the long-standing misalignment of revenue and spending across levels of government. 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 such as the management of strategic natural resources, major national infrastructure projects, education, health and research and development; and (3) the consolidation and improvement of the transfer system, notably by increasing the fiscal resources of less-developed regions.

8. A new budget law was adopted in 2014 to improve the budgeting process as well as transparency and accountability of government operations. The new law requires the adoption of a multiyear budget and specifies the conditions for managing annual deficits and surpluses in a medium-term perspective. It also allows provincial governments to issue bonds for financing capital expenditure. Continued efforts have since focused on closing the “back-door” on off-budget activities of local governments by prohibiting guarantees and any source of financing other than through approved bonds.

C. Policy Recommendations

9. Determining the appropriate level of decentralization for social spending will be crucial. In terms of economic principles, financing of the social safety net should be established at the highest level possible given administrative and political constraints since it embodies elements of insurance and redistribution (Escolano and others 2015). This would reduce the cost of risk pooling, facilitate the portability of benefits, and ensure benefits are equalized across regions. Some decentralization of administrative functions and implementation can also be appropriate, since this can improve accountability and leverage the informational advantage of local governments.

• Pensions. Public pension systems are centralized in virtually all federal countries. They are also usually financed from a national-level payroll tax, with benefit levels harmonized irrespective of where individuals live (Escolano and others 2015). For China, consolidating pension systems at the provincial level could achieve some efficiency gains in terms of risk pooling and portability. However, full centralization would eliminate the need for central government “gap-filling” transfers to local administrations running pension deficits.

• Unemployment insurance. Like pensions, unemployment insurance programs are generally centralized. Beyond the importance of pooling labor market risks, unemployment insurance also acts as an automatic stabilizer. Centralization of unemployment insurance would therefore enhance the macroeconomic stabilization function of the central government. Merging local unemployment insurance program into a single nationwide system would also broaden coverage and enhance equity by ensuring migrant workers can be covered regardless of their places of residency and work. Currently, only around 10 percent of migrant workers covered by unemployment insurance, compared to 40 percent for all urban workers (OECD 2017).

• Healthcare. Determining the optimal level of decentralization for healthcare is not as clear cut. In many cases, some decentralization of spending coupled with centralized coordination of policy is both desirable and feasible. While several models could be considered for healthcare reform in China, the large majority of migrant workers that are still outside the medical insurance system constitute a serious impediment to reform. For China to catch up with OECD and other large emerging countries in terms of public spending on health, it will need to overcome fragmentation and low coverage rates.

10. The broad principles for optimal assignment of revenues are the same as for spending. On the one hand, decentralization of revenues allows for a better matching of the tax system to local preferences and promote more accountability for policy makers. On the other hand, economies of scale, risk-sharing, mobility of tax bases and externalities warrant more centralization of taxation (IMF 2009).

• Personal Income Tax. China could consider allowing provinces to impose a surcharge in addition to the national personal income tax (PIT). This would confer provinces with some degree of autonomy, which could be allowed within a centrally-approved upper limit (of say 5 to 10 percent). This would also be an efficient way to increase the revenue contribution of the PIT, which is low by international standards, while increasing the tax autonomy of provinces.

• Value-Added Tax. In principle, the VAT in China could be complemented by provincial level VATs. However, in practice there are significant difficulties in monitoring border flows between local jurisdictions and country experiences with subnational VATs have been mixed (Perry 2009). While the national scope of the VAT should be maintained, the revenue-sharing arrangements could be reviewed to reduce compliance costs for taxpayers with multiple business locations. Simple allocation rules such as population (Germany) or aggregate consumption (Japan) for example could be considered.

• Property tax. A recurrent market-value based property tax would be an ideal tax for local governments in China. Such a tax is closely tied to public service delivery through property values, its base is immobile and it’s also a highly visible tax since it must be paid by households on a recurrent basis, which can improve accountability of local officials. Property taxes are also broadly viewed as progressive, because high-income households tend to also have higher property wealth (Norregaard 2013). While the tax base should be defined following national guidelines, local governments could set tax rates within bands set by the central government.

11. There is a need to review the current system of intergovernmental transfers. For instance, a rules-based general transfer as opposed to the revenue-sharing and tax rebate transfers programs currently in place could lead to more clarity and predictability and a reduction of the pro-cyclicality of local government funding. Fiscal disparities across areas should also be reduced further. This could be achieved by increasing the size of the funding pool for equalization grants, which currently account for less than half of total transfers (World Bank and DRC 2014). Finally, targeted transfers should be rationalized and simplified. The current system, which has over 200 different transfers, is complex and costly to administer both at central and local levels (World Bank and DRC 2014). Establishing stronger conditionality on outputs or quality of services as opposed to inputs could promote more efficiency in public service delivery.

12. Borrowing quotas for local governments should be set high enough to ensure all fiscal spending can be brought onto the budget. Despite some important gains that have been made in the management of local government debt in recent years, there remains a need to improve transparency, resource allocation and medium-term fiscal planning. It is therefore important to ensure that all fiscal activities that might still be carried out by LGFVs and through government-guided funds are fully reflected in the budget. This will have the benefit of making explicit the fiscal and aggregate demand implications of current policies.