Intergovernmental fiscal relations in China

Policy Research WORKING PAPERS Public Economics Country Economics Department The World Bank February 1992 WPS 863 Intergovernmental Fiscal Relations in China Roy Bahl and Christine Wallich Is there a "best" way to divide fiscal responsibilities between China's central and local governments in China's three-tiered fiscal system? Policy Research Worcing Papers disseminate the findings of work in progrss and encourage the exchange of ideas among Bank staff and all others interested in developrnentissues.Tbesepapers.disLributed by thc Research Advisory Staff,carry thenamnesoftheauthors,reflect onlytheirviews,andshouldbeused and cited accordingly. befindings, interpretations, andconclusions aretheauthors'own.Tneyshould not be attributed to the Wodd Bank, its Board of Directors, its management, or any of its member countries.  Policy Research - Public Economics WPS 863 This paper-a product of the Public Economics Division, Country Economics Department -is part of a larger effort in the department to explorc interg(vemrnmcntal fiscal rclations in developing and formerly socialist economies. Please contact Ann Bhalla, room NIO-053, extension 37699 (February 1992, 58 pages). The choice of the "right" fiscal relationship Centralizing the fiscal system nevertheless between central, provincial, and local govem- reduces the potcntial for vesting more budgetary ments depends on how a govemment weighs the decisionmaking powers in iocal govemments benefits of decentralized economic development and can crode local and provincial governments' policies against the costs of having less effective incentives for raising revenues, another goal of central fiscal management. system reform. Moreover, there are major problems with introducing fiscal centralization in Three strong forces justify more fiscal a country with a heterogeneous population of I centralization in China's highly decentralized billion and relatively little tnidition of central fiscal system at the present time: govemment fiscal administration. * Bouts of inflation and recurrent fiscal Bahl and Wallich conclude that a reformed deficits can be seen as calling for more central system ol intergovernmental finance must meet control over the budget. the center's necds for stabilization and the provinces' necds lbr revenue and equalized - Reform of an economic system relies spending capacity. They argue that such equal- heavily on the use of tax policy as an allocative ization should be based on objective indicators instrument to influence economic decisions. of need and that a formula-based grant system Local control of the implementation of the tax best meets this latter objectivc. A rcformed system can and probably has compromised some system must also underpin price and enterprise objectives of the central government's tax reform - and should be designed so as not to policy. Gaining tighter control over the revenue require major rccalibration or adjustments while system will probably require reducing if not such rcforms are taking place. eliminating local govemment discretion in providing special tax concessions. Bahl and Wallich also conclude that reformn of the rclationishlip of central and local govem- * If the center wants to movc ahead with price ments should be supplemcnted by an improved reform and to encourage entcrprise reform, it system of Financing local capital expenditures needs a more centrally controlled revenuc through borrowing, a system of benefit charges, sharing or assignment system that reduces the and improved financial planning and tax admin- dislocating effects of such reforms. istration. Thc Policy Research Working Papcr Series disseminates the findings of work inder way in the Bank. Anobjective of the series is to get these fuidings out quickly, even if presenations are less than fully polished. The findings, interpretations, and conclusions in tlJ.se papers do not necessarily represent official Bank policy. Produced by the Policy Research t)isseniination Center  CHINA CENTRAL-LOCAL FISCAL RELATIONS Table of Contents Page No. Introduction.. .1 China's Fiscal Reforme a n d Revenue Trends 2 A. THE PRESENT SYSTEM OF SUBNATIONAL FINANCE IN CHINA . . . . . . . . . 4 Provincial Government Finances . . . . . . . . . . . . . . . . . 5 Budgeting and Financial Planning. 8 Tax Administration . . .. 8 Provincial and Local Revenues .9 Intergovernmental Fiscal Relations . . . . . . . . . . . . . . 11 B. PROBLEMS AND ISSUES IN CENTER/LOCAL FINANCES IN CHINA . . . . . . . . 16 Compatibility with System Reforms. . . . . . . . . . . . . . . . 16 The Macroeconomic Perspective . . . . . . . . . . . . . . . . . . 18 Revenue Adequacy . . . . . . . . . . . . . . . . . . . . . . . . 19 Incentives for Tax Avoidance ... . . . . . . . . . . . . . . . 23 Provincial Tax Effort . . . . . . . . . . . . . . . . . . . . . . 23 Incentives for Infrastructure Development . . . . . . . . . . . . 23 Equalization Properties. . . . . . . . . . . . . . . . . . . . . 25 C. OPTIONS FOR REFORM. . . . . . . . . . . . . . . . . . . . . . . . . . 27 Some Alternativesn.ative .. . . 27 Principles of Tax Tax Sharing and Tax Assignment . . . . . . . . 30 Considerations in Weighing the Options . . . . . . . . . . . . . 32 Options: 33 (i) Tax Reassignment: A Centralized Version . . 33 (ii) Tax Reassignment: Decentralized Version ... . . . . 35 (iii) The "Local Surcharge" or Tax Base Sharing Option . . . 36 (iv) Higher Provincial Retention Rates . . . . . . . . . 38 (v) Lower Provincial Retention Rate. . . . . . . . . . . . 38 (vi) Reforming the Present System . . . . . . . . . . . . . 38 Other Essentials for Center-Local Fiscal Reform ... . 40 A System of Transfers . . . . . . . . . . . . . . . 40 Borrowing Powers . . . . . . . . . . . . . . . . . . . . . . . 43 Benefit Charges . . . . . . . . . . . . . . . . . . . . . . . 43 Tax Administration . . . . . . . . . . . . . . . . . . . . 44 Conclusions. . . . . . . . . . . . . . . . . . . . . . . . . . . 45 Valuable comments from Peter Harrold, Ram Agarwala, Raja Chelliah, and Anwar Shah are gratefully acknowledged. Errors and omissions remain those of the authors.  TABLES IN TEXT 1. China: Developments in Government Revenue - Consolidated Government 1978-89 . . . . . . . . . . . . . . . . . . . . . . . . 4 2. Tax Collection and Expenditure of Central and Local Governments, 1980-89 ... . 6 3a. China: Revenue-Sharing System Between the Central and Provincial Governments, 1985-1987 . . . . . . . . . . . . . . . . . . . . 13 3b. China: Revenue-sharing System Between the Central and Provincial Governments, 1988-1990 . . . . . . . . . . . . . . . . . . . . 14 4. Chinat Price Ccntrolled Products: Shares of GVIO of the Largest Producing Provinces in 1989. . . . . . . . . . . . . . . 17 5. Tax Collection and Expenditure ................ . 21 BOXES IN TEXT 1. Principles of Revenue Allocation and Tax Sharing 1985 Reforms 10 2. Provincial Tax Effort . . . . . . . . . . . . . . . . . . . . . . 24 3. Equalization Properties of China's Provincial Contracting . . .. 26 4. Fiscal Federalisms and Centralized Systems . . . . . . . . . . . 28 5. Principles of Tax Assignment . . . . . . . . . . . . . . . . . . 32 6. Profit and Sales Tax Sharing Under a Base-Sharing Model . . . . . 36 7. Weighing the Six Options in China ............... . 41 8. Formula Grants ........................ . 43 CHARTS IN TEXT 1. Government Structure in China .... . . . . . ...5... . . S 2. China: Ratio of Revenue to GNP .... . . . ....... . . 20a 3. China: Ratio of Revenue to GNP (Adjusted) . . . . . . . . . . 20a 4. China: Ratio of Expenditure to GNP . . . . . . . . . . . . . . 20b 5. China: Budget Balance: Central and Local . . . . . . . . . . . 20b ANNEXES 1. Procyclical Effects of Contracting with Provinces . . . . . . . . 46 2. Counterequalizing Properties of Provincial Tax Contracting . . . 48 STATISTICAL ANNEX Table 1: Tax Collection and Expenditure Table 2a: Sharing Arrangements in 1987 by Type of Tax Table 2b: Sharing Arrangements in 1988 by Type of Tax Table 3: Revenue-Sharing System Between the Central and Local Governments, 1985-87 Table 4: Revenue and Expenditure Disparities Among Provinces Table 5: Budgetary Expenditure by Province Table 6: Percent Increase in Revenues and Expenditures, by Province for 1983-86 Table 7: Changes in the Ratio of Expenditures to Collections: for 1983-86 by Province Table 8: OLS Regression Results for Chinese Revenues and Expenditures Against Selected Independent Variables: By Province BIBLIOGRAPHY  CHINA CENTRAL-LOCAL FISCAL RELATIONS Introductlon 1. The purpoee of this paper is to analyze options for reform to the system of subnational finance in China--the central-local revenue-sharing system-- with a focus, inter alia, on the support to system reform, macrostabilization, equalization and allocative effects. 2. Both the government and outside observers have come to realize that China's system of public financing requireo change in order to better support the system reform. Under the previous system of strict central planning, the objectives of fiscal policy were limited: its allocative function was to administratively redistribute resources--derived mostly from enterprise surpluses--through the budget to enterprises and government units; its role in stabilization consisted mostly of expenditure or investment cutbacks to reduce aggregate demand pressures. Under the system reform, tax policy plays a role in both mobilizing resources for government spending purposes and for indirectly controlling the economic decisions of enterprises.l/ 3. Matters such as central government tax reform are usually a concern of the national treasury. This is not the case in China. Perhaps more than in any other country in the world, China's national tax structure and system of intergovernmental fiscal relations are linked. The success of any central government tax reform will be determined by the policy reactions of local governments, and by local implementation of central policy. While uniform national tax laws are laid down in Beijing, subnational governments are responsible for tax administration, share in revenue collections, and may make policy by giving tax incentives to enterprises. 4. By the same token, any reforri in the system of intergovernmental relations must be evaluated in a context of the objectives of the system reform. Enterprise and price reforms affect the tax base available for sharing in each province, revenues mobilized for each level of government must reach some prescribed target, and fiscal disparities among provinces must stay within some prescribed range. Finally, and underneath much of the clamor for a reform of the intergovernmental system, is to move government fiscal decisions "closer to the people." There is no question but that this goal of the systen, reform argues for a stronger local government sector. S. The choice the "right" central-local fiscal relationship will depend on how the govf ..ient weighs the benefits of decentralized economic develop- ment policies a ainst the costs of having less effective central fiscal management. There are three strong forces justifying more fiscal centralization in China at the present time: (a) inflation and recurrent deficits are interpreted by some government policymakers as calling for more central control over the budget; (b) if the center wants to move quickly with price reforms and to encourage enterprise reform, it will need a centrally controlled revenue system which reduces the dislocating effects; (c) the economic svstem reform relies heavily on the use of tax policy as an allocative instrument to influence economic decisions, and local control over the implementation of the tax system can (and probably has) compromised some of the objectives of central government tax policy. In order to gain tighter control over the revenue system, it will be necessary to reduce if not eliminate local government discretion in providing special tax concessions. To centralize the fiscal system, however, sacrifices possibilities of vestilug 1/ See Revenue Mobilization and Tax Policy, World Bank Red Cover Report, 1989, for a fuller treatment of tax reforms in China, and Finance and Investment, World Bank, Red Cover Report, 1988, for a description of China's fiscal system in the 1979-83 period.  more budgetary decision-making powers in local governments and can erode the revenue-raising incentives of provincial and local governments, which are also goals of system reform. Moreover, there are major problems with