For more than a decade, China’s total government revenues have been rising faster than GDP, recording 19.9% growth in 2005 alone. This sounds like great news for the government’s efforts to promote more equitable development with greater equality of opportunity and more robust social protections for the poor. But, as Chang Tianle (常天乐)reports, although reform efforts are gathering pace,the fiscal system is fraught with problems that tend to perpetuate, rather than reduce, inequalities.

In 1994 China’s total government revenue was just 10.8% of GDP. By 2005 it had risen to 17.3% of GDP—a larger share of a much larger cake, but still well below international norms of 30-50%. Nevertheless, the steady rise in revenues brings into sharper focus the issue of how those revenues are distributed across regions and sectors. Chinese officials, economists and development specialists are engaging in important debates on this topic, and international agencies are also flagging it as critical to China’s sustainable and harmonious development.

The World Bank and Asian Development Bank have both produced reports and recommendations on China’s fiscal system, and UNDP, with funding support from the UK Development for International Development (DFID), recently embarked with Chinese government partners on a four-year capacity building programme to support pro-poor fiscal reform. As part of this USD 10 million programme, a high-level forum on fiscal reform was held in Beijing in November 2006. Senior officials from the United Nations, the Ministry of Finance, the State Administration of Taxation and renowned economists debated how China’s fiscal reforms can be made most beneficial to the poor.

Other, relatively recent initiatives include a Public Budget Reform Programme carried out by the Development Research Foundation (which operates under the State Council’s Development Research Centre think tank) with funding from the Ford Foundation, DFID and Canada’s International Development Research Centre. Alongside various research studies the two-year programme, which concludes in March 2007, has published a handbook explaining budget processes for People’s Congress Deputies, hosted international symposia on “government performance” and conducted a series of “participatory budgeting” training activities—including a study tour to Brazil—for officials and community leaders in the cities of Wuxi (Jiangsu Province) and Harbin (Heilongjiang).

See-sawing centralization

After the People’s Republic of China was founded in 1949, it created a highly centralised fiscal system in which the great majority of revenues, including state owned enterprise profits, went to the central government and were then re-allocated across government departments and localities.

A 1980 fiscal reform introduced some degree of decentralisation, giving provincial authorities more powers to retain and allocate resources. This was designed increase the provinces’ capacity for planning and developing their local economies. However, the move left central government cash-strapped while also reducing its fiscal control over local authorities.

In 1994, a tax-sharing scheme was introduced to increase the centre’s share of total government revenue. Twenty eight kinds of tax were divided into three streams: those that would flow to central government, those that would go to sub-national government, and those that would be divided between the centre and the localities. Under this scheme, value added tax (which is charged on goods and services and is the single largest source of Chinese government revenue) was shared between the central government (75%) and local governments (25%).

In the first year that the tax-sharing arrangement was introduced, the central government’s share in total revenue more than doubled to 55.7%, up from 22% in 1993. The proportions have since varied slightly, but the centre’s share has not dropped below 48.9%.

Many international and Chinese analysts argue that the 1994 fiscal reform had positive impacts, rationalising the overall distribution of revenue and improving efficiency and transparency of the tax administration. By giving the centre a larger slice of the total revenue cake, it also made it possible for the national government to redistribute resources to sub-national jurisdictions to achieve national objectives.

However, the capacity for redistribution is limited by a complex transfer system that favours richer provinces, leaving poorer areas with onerous, expenditure responsibilities.

Revenue-expenditure mismatch

Although more revenue flows to the centre under the tax-sharing system, the national expenditure structure and budgetary responsibilities of provincial governments have remained basically intact. Local governments still have many expenditure duties, but do not have the revenues to meet them. The system, in the words of one analyst, “ignores the basic principle that revenue powers should match with expenditure duties.

Sub-national governments, especially county and township governments in poor regions, face increasingly serious financial constraints. Many counties in central and western China are subsisting on what is ironically called chifan caizheng (吃饭财政, “finance for food”—but nothing else), with revenues barely sufficient to cover government payrolls and routine operations. Delayed payment of teachers’ wages has been commonplace in poorer areas. In some extreme cases, the tax collected is not even enough to cover the running costs of the local tax bureau. This makes it extremely difficult to maintain local infrastructure and sustain social services.

As Table I shows ( see attachment at end of article), the expenditure of local (especially, county-level) governments is much higher than their revenue. The fiscal gap for county and township governments has in fact been worsening since 2000: their relative share of national revenue is declining while their share in national expenditure is increasing.

To meet the gap between expenditure responsibilities and available resources, local governments have to depend on transfers from central government and on “extra-budgetary revenue.” This includes proceeds from land sales and real estate development, which amounted to CNY 650 billion (USD 81 billion) in 2004, according to the Development Research Foundation.

To fund government operations, officials in some areas also create local charges and “fees,” many of which are illegal, and that cause serious conflicts between officials and local populations.

Many township and county governments have also borrowed heavily, even though they are not supposed to run a budgetary deficit. In fact, total local government debt in China is variously put at between 800 billion and one trillion yuan (USD 100-120 billion)

Fiscal transfer roundabouts

Fiscal transfers from central to sub-national governments help the localities meet their expenditure needs and reduce financial disparities across regions. These transfers have been increasing substantially in net value. In 2005, the central government assigned CNY 1,148 billion (USD 143.5 billion) to sub-national governments, a 21.6% increase over 2004. This amounted to 57% of central government expenditure, or 46% of provincial (and municipal) government spending. Over the last ten years, transfers from central government to the provinces have averaged around 40% of the combined expenditure of the provinces.

It is nonetheless clear that inter-governmental payments, despite the growing sums transferred, do not sufficiently offset the disparities across regions and between rural and urban areas. Other effects of the transfer system are also far from satisfactory.

The payments from the central government fall into two broad categories— general transfers and special (earmarked) transfers.

General transfers are calculated according to a formula that takes 1993 as a base year, and so are relatively transparent and more predictable. However they are based on a tax rebate system, such that the more you pay, the more you get back. Thus, the richer provinces receive larger transfers than the poorer provinces, and this clearly reinforces rather than reduces horizontal revenue disparities. ( See Figure I, in attachment at end of article.) About 40% of fiscal transfers are through tax rebates. This system tends to leave the poorer areas using transfers to cover administrative expenses, including staff salaries, and encourages them to prioritise economic development that will increase government revenues over investments in social services and development.

In addition to the general transfers, there are more than 200 kinds of special or earmarked transfer for which provincial governments may apply. In 2005, these earmarked transfers reached CNY 352.9 billion, amounting for 31% of total transfers from central government.

The process of allocation is highly complex and lacks transparency.

Provinces frequently send officials to Beijing to lobby the central government for the earmarked transfers, and this “affects the integrity of the government and increases the administration costs,” Auditor General Li Jinhua (李金华) told the China Economic Weekly (中国经济周刊) last July.

To make matters worse, more than a dozen government ministries are involved in transferring funds, yet they do so in a way that is largely independent, with no centralised review and co-ordination of the process.

The transfers are made by executive order, without formal legislative approval by the People’s Congress to introduce some degree of transparency and accountability.

According to a National Audit Office report, based on a 2005 survey of 20 provinces and municipalities, only 44.5% of transfers from centre were included in sub-national governments’ budget reports.

The system also makes it hard for provinces to set and stick to accurate budgets. For they first have to prepare their budgets, then send them up to the centre for approval and consolidation. But only when the Ministry of Finance approves the central budget is the total sum set aside for transfers decided, and even then it is allocated in a piecemeal manner, an under the pressure of provincial lobbying. As a result, sub-national governments are not able to accurately estimate receipts from inter-government transfers until the central budget execution starts.

Finally, for some special transfers the central government often requires counterpart funding from localities, thus imposing new financial obligations on already overstretched local governments. If they are not able to meet those obligations, the projects supported by these special transfers may fail.

These complicated and problematic fiscal relations between central and provincial (municipal) governments also mark the relations between the tiers of sub-national government. The provinces have their own tax-sharing and fiscal transfer systems, with significant variation between provinces.

With each tier of sub-national government relying on transfers from above to bridge their own expenditure gap, it is very hard for them to allocate part of their own resources to transfers downwards. As a result, transfers from the central government which are intended to reach down to benefit lower levels are in fact sometimes retained by provincial authorities. This inevitably aggravates the fiscal constraints at county and township levels.

Auditor General Li describes the the transfer payment system as “like a long ditch from the central government to villages that leaks along the way. Sometimes it runs dry before reaching the end.”

Another weakness in current transfer arrangements is the lack of transfers to support the migrant population’s access to services. A recent UNICEF study(China’s Budget System and the Financing of Education and Health Services for ChildrenI) describes how this is exacerbated by poor data on the migrant population, due to inadequate coordination among government agencies and reliance of budget planners on population data that does not take account of population shifts caused by migration.

New policy swings

Since the 1994 tax reform, some significant changes have been introduced as pilots and at national level. Notable among these have been a “fees to taxes” reform, intended to prevent local governments from levying illegal fees and charges, and the phasing out of agriculture taxes that were a heavy “peasants’ burden” but that in fact contributed relatively little to total government revenues.

Measures have also been taken to improve tax and fiscal management and divert more resources to rural areas and social services. In addition to pledges for increased spending on health and education, CNY 339.7 billion from central government was allocated to “supporting agriculture and farmers” (支农资金) in 2005, an increase of 15% on the previous year.

Incentives for improved local performance have also been introduced. In 2005 and 2006, under a “three prizes, one subsidy” (三奖一补) scheme, the central government allocated CNY 15 billion and 23.5 billion respectively as bonuses to reward provincial governments that have made good progress in generating more revenue or cutting administrative costs.

But most experts agree that simply raising spending will not be enough to resolve weaknesses in the budget system itself.

Fragmentation of the budget process, both between vertical tiers and horizontal departments, is frequently identified as a key problem that reduces the rationality and transparency of allocation decisions.

Links between policy, planning and the budget process are weak, such that many policy pronouncements and spending pledges fail to specify how funding is to be mobilised and shared by the different levels of government, and this undermines the effective implementation of policy.

There are also strong calls for revenue sharing and inter-governmental transfers to be consolidated, with calculations made more simple, transparent, and standardised. This needs to happen both for centre-provincial and also for intra-provincial arrangements, to allow more effective budget planning and to reduce the pressure on local governments to raise illegal taxes or run large deficits.

Without tackling these problems it will be difficult for the central government to implement its new emphasis on social development and the reduction of geographical disparities.

There have been some important improvements in the budget system in recent years and more are in the pipeline.

A “Golden Fiscal Project” (金财工程) was launched in 2006, aiming over the next five years to build a computerised information system to support budgeting and public expenditure management. This year sees the introduction of a new budget classification system which is expected to make it easier to analyse the effectiveness and efficiency of expenditure.

Ongoing administrative reform, in which some localities are being merged, may bring substantial savings in the cost of government administration and also simplify fiscal responsibilities and relationships by reducing the number of government tiers. Some provinces and counties have launched pilot programmes that involve abolishing prefectural and township levels as separate budgetary units, and this is reported to be freeing up funds for better public services.

Meanwhile, the Ministry of Finance is preparing, with the Budget Committee of the National People’s Congress, revisions to the Budget Law along with a new law on inter-government fiscal transfers.

There is quite widespread agreement that the respective fiscal powers of central, provincial and local governments need to be carefully balanced in ways that create more opportunities for progressive redistribution but that also—as a 2005 OECD report, Governance in China, emphasises—improve transparency and accountability throughout the government system. But these things are much easier to call for than to implement, especially when the competing interests of different regions are at stake. This is, therefore, a set of serious challenges for the government of the world’s fastest growing national economy.

Sources:

This article has drawn on the following published sources and presentations, as well as interviews with Chinese specialists. Special thanks are due to Mr. Peng Longyun, Senior Economist at the Asian Development Bank in Beijing. Additional reporting contributed by Nick Young.

Presentations by Christine Wong of University of Washington, Wang Weixing from Ministry of Finance, at the Conference on Pro-poor Fiscal Reforms and Building New Socialist Countryside in China, November 2006

Anwar Shah and Chunli Shen, The Reform of the Intergovernmental Transfer System to Achieve a Harmonious Society and a Level Playing Field for Regional Development in China, World Bank Policy Research Working Paper 4100, December 2006

Mei Hong and Wang Xiaolin, China’s Budget System and the Financing of Education and Health Services for Children, UNICEF and the National Working Committee on Children and Women, November 2006

Study on Sub-Provincial Intergovernmental Fiscal Transfer System in China, Sponsored by Asian Development Bank, May 2005

National Audit Office: CNY 30 Billion Fiscal Transfer Opaque, China Economic Weekly, July 2006