The fiscal framework and urban infrastructure finance in China

WPS4051 THE FISCAL FRAMEWORK AND URBAN INFRASTRUCTURE FINANCE IN CHINA By Ming Su and Quanhou Zhao1 World Bank Policy Research Working Paper 4051, November 2006 The Policy Research Working Paper Series disseminates the findings of work in progress to encourage the exchange of ideas about development issues. An objective of the series is to get the findings out quickly, even if the presentations are less than fully polished. The papers carry the names of the authors and should be cited accordingly. The findings, interpretations, and conclusions expressed in this paper are entirely those of the authors. They do not necessarily represent the view of the World Bank, its Executive Directors, or the countries they represent. Policy Research Working Papers are available online at http://econ.worldbank.org. 1 The Research Institute for Fiscal Science, MOF. P.R.China 1  Since its economic reform and opening to the outside, China has experienced impressive economic development. Between 1978 and 2004, China's annual GDP growth rate averaged 9.4%, far above the world average of 2.8%. Economic growth has been accompanied by rapid urbanization. In 1978, only 17.9% of China's population lived in urban areas; by 2003, the urbanization rate was 40.5%. Although the urban infrastructure capital stock also has expanded swiftly--probably faster than anywhere else in the world--it has not kept pace with the rate of industrialization and urbanization. Until recently, China's urban infrastructure financing was heavily dependent on the fiscal budget. Fiscal capacity constraints, especially in the lower levels of government, have forced governmental authorities to make greater use of borrowing, introducing a new degree of risk into intergovernmental finance, but urban infrastructure construction continues to lag behind the rate that many experts believe is required to sustain China's extraordinary economic growth. To analyze the impact of the fiscal framework on urban infrastructure financing, we need first to understand the outline of China's fiscal system. This chapter summarizes the principal reforms that have led to today's fiscal framework, then considers the current situation and future options for urban infrastructure finance. 2  PART I CHINA'S FISCAL SYSTEM AND THE CHANGE OF FISCAL POLICY China's market-oriented economic reforms started in 1978. The nation gradually phased out the planned economic system, and shifted economic power to decentralized levels of government and companies. Reform of the fiscal system thus underlies national economic reform. The pre-reform fiscal pattern The pre-reform fiscal regime of China was adapted to the highly concentrated planning economy. Not only did the government do everything, but sub-national governments were totally dependent on the central government. It was a typical regulated fiscal regime, in which all taxes and profits were remitted to the center and then transferred back to the provinces and from there to the local level.2 Policymakers in the central government decided what type of revenues should be collected and how these revenues were to be reallocated for national and sub-national public goods. The pre-reform fiscal regime had the merit of generating broadly equal fiscal capacity among different regions. However, it provided no incentives for sub-national 2In China, the term "local" is commonly used to describe all sub-national units of government. In this chapter, "local" refers to sub-provincial units, including municipalities, townships, and counties. 3  governments to promote economic growth or collect budgetary revenues. The Fiscal Contracting System: 1980-1993 China began its fiscal decentralization reform in earnest in 1980, with the goal of giving sub national governments more and more power to finance their own needs subject to a budget constraint. The initial strategy involved a variety of contracting methods, whose basic spirit was to apportion revenues and expenditures between the central and local authorities while holding the latter responsible for their own profits and losses. The fiscal contracting system gradually evolved into 6 contracting categories by 1988--viz. contract sharing of incremental revenues, proportional sharing of base revenue, proportional base sharing plus incremental sharing, contractually designated incremental remittance amounts, fixed remittance, and fixed central subsidy. The fiscal contracting system gave sub-national governments a certain space to decide their own affairs (a kind of fiscal deregulation), encouraging them to develop the regional economy and collect revenues. From a national perspective, the system had two principal drawbacks. First, it caused the central government share of fiscal revenues to decline steeply. This phenomenon was due in part to the fact that provincial and municipal governments "gamed" the system by producing just enough on-budget shared revenue to satisfy their contract obligations, while shifting 4  further revenue generation to off-budget and other revenue sources that did not have to be shared. Central government revenue as a percentage of total fiscal revenue fell from 34.8% in 1985 to 22% in 1992. Second, the different contracting methods were complicated and inequitable, enlarging the fiscal differentials between regions. Rich provinces (such as Guangdong) had more bargaining power, and benefited from more favorable fiscal contracts. In addition, under the contracting system, the central government fell into an inefficient track of constantly bargaining with sub-national governments over revenue-sharing terms. "Tax assignment system" reform of 1994 In 1994, China undertook a fundamental intergovernmental fiscal reform called the tax assignment system reform. The objectives of the reform package were to: (1) simplify and rationalize the tax structure by reducing tax categories and tax rates thereby unifying the tax burden on taxpayers, and cutting down tax exemptions; (2) raise the overall fiscal revenue-to-GDP ratio; (3) raise the central government's share of total fiscal revenues; and (4) put central-local revenue sharing on a more transparent, objective basis by shifting from revenue-sharing contract negotiations to a tax and revenue assignment system. 5  Expenditure assignments between the central and sub-national governments The 1994 reforms concentrated solely on the revenue side of public budgets. No expenditure assignments were made. In fact, there still is no legislation in China that codifies the expenditure responsibilities of different tiers of government, either between the Central and Provincial level, or between Provinces and the Local level. Leaving intergovernmental expenditure responsibilities undefined has given upper tier governments more flexibility of offloading responsibilities to lower tiers, without compensatory transfers of revenue or fiscal autonomy. Table 1 identifies the key expenditure functions commonly understood to be sub-national functions. The list is extensive and costly. Most of the service delivery functions, along with the corresponding investment in urban infrastructure, are the responsibilities of local governments. The local level is also responsible for economic development and economic planning--which involves pro-active direction of the local enterprise sector. Local governments in China also have much greater responsibility for poverty alleviation and social protection of displaced workers than is true in the West, where these functions are assumed primarily by central government. 6  Table 1: Sub-National Expenditure Responsibilities Sub-national government administration Local Capital Construction Basic local services, including water supply and distribution, local and regional roads, and highways, wastewater collection and treatment, garbage collection and disposal; urban gas supply; mass transit Maintenance, repair, and operation of urban infrastructure Management of local State-Owned Enterprises (SOEs) Expenditure for Supporting Agricultural Production Primary and secondary schooling; large portion of higher education Health care and hospitals Price Subsidies Poverty alleviation Protection of laid-off workers from SOEs Cultural and heritage protection Environmental protection Local and regional economic development Physical planning Source : Author Revenue assignment: The principle of revenue assignment between the central and sub-national governments is that taxes concerning national interest or macroeconomic adjustment belong to the central government and those with regard to local economic development are under the jurisdiction of sub-national governments. Table 2 shows the specific situation after the 1994 reform. 7  Table 2: Revenue Assignment between Central and Sub-National Governments, 1994 The central Import Tariffs Revenues Consumption Taxes Income Taxes and Profits of SOEs under the jurisdiction of the central government Import-related consumption taxes and VATs Taxes imposed on banks, nonbank financial institutions and insurance companies (include business taxes, income taxes, and Urban Maintenance and Development Tax) Taxes on railroads. Sub-national Business Tax (excluding banks, nonbank financial institutions and insurance Revenues companies, and railroads) Company Income Tax (excluding local banks, foreign banks, and nonbank financial companies) Profits of locally owned SOEs Personal Income Tax Urban Land Use Tax Urban Maintenance and Development Tax (excluding banks, nonblank financial institutions and insurance companies, and railroads) Fixed Assets Capital Gains Tax House property taxes Stamp taxes Agriculture and Related Taxes Tax on Contracts Land value increment taxes Shared Value Added Taxes (the central 75%, sub-national governments 25%) Revenues Stamp Taxes on Security Exchange (50%-50%) Resource Taxes Source : Author A distinctive characteristic of this revenue assignment was that, while it initially boosted significantly the central government's share of total revenue (see below), it assigned to sub-national governments all or part of what turned out to be the fastest-growing major revenue sources--100% of the personal income tax, most of the company income tax, and 25% of VAT. 8  Central-to-sub-national transfer system The intergovernmental fiscal reform also defined a new intergovernmental transfer system. What is called "tax rebating" from the central to sub-national governments is actually a kind of transfer payment, a grant paid to provinces in relation to the growth in certain tax revenues since the last pre-reform year, 1993. Revenue increments from the consumption tax and value-added tax collected in a province are received by central government, then up to 30% is "rebated" to the province in the form of a tax-related return grant. A second type of transfer from the center was introduced. This is a formula-based grant based on the gap between a province's `standardized' fiscal expenditure and its `standardized' fiscal revenue. All central transfers are made to provincial governments. The provinces then transfer revenues to the local level, generally following grant arrangements modeled after the central-to-provincial design. General tax reform These changes in the intergovernmental fiscal system were made within the context of a general overhaul of the tax system. The most dramatic changes were establishment of a VAT-dominated turnover tax system, and unification of the various 9  elements of domestic income tax. The tax changes had the objective of increasing total fiscal revenues, assuring future growth of fiscal revenues in line with economic growth, and increasing the central government share of fiscal revenues. To ensure effective collection of the central government's portion of revenues, the central and sub-national governmental tax collection bureaus were separated. The national tax collection bureau now is in charge of collecting revenues from tax sources that are the exclusive domain of the central government, as well as revenues from shared taxes, while the local tax bureaus are in charge of collecting sub-national tax revenues. Changes in revenue rules after 1994 After 1994, further changes in the intergovernmental revenue system have been made, but more gradually. Most of the changes have taken the form of increasing central government's portion of shared revenues, increasing tax rates on centrally collected taxes, or eliminating various sub-national taxes and fees. First, in 1997, the sharing proportion of the revenue from Stamp Taxes on Security Exchange between the central and local governments was changed from 50%-50% to 88%-12%. Later, the sharing ratio was again adjusted, moving gradually from 88%-12% to 97%-3%. Second, the company tax rate on the finance and insurance industry was 10  increased from 5% to 8%, with all of the increase going to the central government. (The tax rate was reduced to the original level (5%) between 2001 and 2003, because of the economic slowdown.) Third, income tax revenue-sharing was introduced in 2002. Except for some special industries and companies (such as banks, China Gas Company, and China Oil and Chemical Company), the tax-sharing arrangement provided that central and sub-national governments would in the future share the combined revenues of company (business) income taxes and personal income taxes. The local governments would keep the income tax revenues collected in 2001 as a base, but increases would be shared between central and local governments. In 2002, the central government sharing rate was introduced at 50%. From 2003 to now, the central government's sharing rate has been 60%. This change has had the effect of converting the fastest-growing significant sources of tax revenue--the company and personal income taxes--from sub-national taxes to shared taxes, the majority of whose revenue goes to the central government. Fourth, starting from 2004, the government announced that China will progressively abolish the agriculture tax system over the next 5 years in order to lighten the farmers' tax burden. Several provinces have already totally eliminated the agricultural tax, while other provinces have lowered the agriculture tax rate from 3% to 1%. To partially compensate for the lost sub-national revenue, the central 11  government increased special transfer payments by RMB 9.1 billion as budget-gap coverage. Finally, from 1997 until now, the central government has issued a series of documents to cancel, regulate, or limit the fees and user charges that can be collected at the sub-national (mostly urban) level. Generally speaking, the tax assignment reform established a new fiscal framework for China. It set up a better-defined and rational arrangement of inter-governmental financing. The new system enables all levels of government to have their own exclusive revenue sources, clarifying the boundaries of revenue allocation between different levels. A formula-based transfer system was introduced. As was intended, the tax assignment system gives sub-national governments more power to develop their economies, and to collect their own taxes. The reforms carried out since 1994, however, have caused sub national governments a great deal of fiscal difficulty. They have re-centralized fiscal revenues without cutting back on sub-national governments' expenditure responsibilities. 12  THE REVENUE IMPACT OF FISCAL REFORM The 1994 fiscal reform had the desired effect of accelerating fiscal revenue collection. Before 1994, total fiscal revenue was growing between RMB 20 and 30 billion annually. After 1994, the annual fiscal revenue growth increased to more than RMB 150 billion on average. Figure 1 shows the trend of China's fiscal revenue. Figure 1: China's fiscal revenue and its structure g 25000 n) 20000 millio 15000 (100 10000 revenue 5000 national fiscal revenue central fiscal revenue fiscal sub national fiscal revenue 0 1978 1985 1990 1992 1994 1996 1998 2000 2002 fiscal year Source : Authors calculations The 1994 reform also had the intended effect of shifting fiscal revenues from sub-national governments to the central government. This impact can be seen clearly in Figure 1, where central revenues jump ahead of sub-national revenues for the first time in 1994. Subsequent changes in revenue-sharing rules have assured that central-government fiscal revenues continue to grow faster than sub-national fiscal revenues. Under the fiscal contracting system, the sub-national share of total fiscal revenue was very high, reaching a peak of 78.9% in 1993. After 1994, due to the newly introduced tax assignment system, and subsequent increases in the central 13  portion of shared taxes, the sub-national governmental revenue share steadily declined from 78% in 1993 to 45% in 2002. The tax assignment system has cut sharply into sub-national governments' own revenues and their share of fiscal revenue distribution. On the expenditure side of budgets, however, the share of sub-national government spending in total fiscal expenditure has kept stable, at roughly 70% (see Figure 2). Figure 2: National fiscal expenditure and its structure 30000 00 25000 (1 re national fiscal 20000 tu n) expenditure di io the central fiscal en 15000 ll expenditure xpe mi sbu national fiscal 10000 al expenditure sc fi 5000 0 1978 1985 1990 1992 1994 1996 1998 2000 2002 fiscal year Source : Authors calculations The widening fiscal gap between sub-national expenditure and sub-national fiscal revenue is shown dramatically in Figure 3. As a result of these trends, sub-national governments have grown more and more fiscally dependent on the central government. The tax rebating system has become a type of universal grant, which all sub-national governments need to receive. At the same time, regional disparities in income, fiscal revenue, and self-financing capacity have grown. Figure 4 shows that the sub-national `self-support' rate ranges from almost 90% in Beijing to 14  less than 40% in Qinghai (Tibet may be viewed as an exceptional case.) Figure 3: Sub-National Fiscal Revenue and Expenditure 18000 16000 14000 12000 10000 revenue 8000 expendi t ure 6000 4000 2000 0 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 Source : Authors calculations Figure.4: The sub-national governments' self-support rate % 100. 0 90. 0 88. 6 89. 0 80. 0 80. 6 83. 0 83. 7 79. 1 81. 1 78. 4 70. 0 71. 8 72. 0 70. 4 72. 1 73. 5 67. 2 68. 1 70. 5 64. 6 64. 8 65. 1 60. 0 62. 4 63. 9 61. 5 58. 3 50. 0 53. 3 53. 4 53. 7 50. 8 53. 0 49. 0 40. 0 39. 3 30. 0 20. 0 10. 0 12. 9 0. 0 Bei j i ng Ti anj i n bei ui nan ng nan Hei Shanximongul i a Li aoni ng Ji li n ang Shai hai Ji angsu hejiang Anh Fuj i an i angxi Henan Hubei Hunan Hai zhou ang Yun Ti bet Gansu Z J Shandong Guangxi Si chuan Gui Shaanxi Qi nghai Ni ngxi a i nji X Inner Hei l ongji Guangdong Chongqi Source : Authors calculations Note: The fiscal self-support rate is the share of own-source revenue in total revenue. 15  THE TRANSFER SYSTEM FROM CENTRAL TO SUB NATIONAL LEVEL Under the present fiscal system in China, transfer payments from central to sub-national governments are important, but quantitatively they do not offset the widening disparity in own-source revenue collection and qualitatively they do not fully incorporate the new norm of a formula-based standardized system. Reforms in the transfer system have been hampered by the political/economic power of high-growth regions. The largest part of intergovernmental transfers is still based on incremental revenue sharing (tax rebating) relative to 1993 base-year receipts. The tax rebating system After the 1994 reform, in order to compensate sub-national governments' revenue losses, the central government introduced the tax rebating system described above. The tax revenue rebating scale is decided directly by: first, upwardly transferring the amount that was transferred by sub-national governments to the center in 1993; second, the overall incremental revenue growth of VAT and Consumption tax revenue is computed; third, it is determined whether or not revenue collected within a particular province is at least as large as in 1993. Provinces that meet this hurdle receive tax rebates. The rebate system is scaled so as to enable the richer provinces to get more tax rebating, expanding fiscal disparities among regions. 16  The "standardized" fiscal transfer system: In 1995, a new "standardized" transfer system was introduced in addition to the above-described rebate system. Based on formula, the new system aimed to establish an objective, normative transfer mechanism. The amount of funds disbursed under the standardized transfer system has grown continually, from RMB 2.1 billion in 1995 to 74.5 billion in 2004, but the transfer amount under this method is still small compared to the magnitude of tax rebating. Up to now, the formula for the standardized fiscal transfer has been very simple and unstable. For example, the formula in 2002 was: The volume of transfer payment of province N = (the N regional standardized expenditure