China - Budgetary policy and intergovernmental fiscal relations (Vol. 1 of 2) : Main report

Report No. 11094-CHA China Budgetary Policy and Intergovernmental Fiscal Relations Volume I Main Report July 28, 1993 Country Operations Division China and Mongolia Department East Asia and Pacific Regional Office FOR OFFICIAL USE ONLY MICRPOGRAPHICS Report No: 11094 CHA Type: SEC V~~~ Of -the Worl &ank This document has a restricted distributi~on and nivay be used by recipients only in the performnance of their official duties. Its contentts may not otherwise be disclosed without World Bank authorization.  CURRENCY EQUIVALENTS Currency Unit: Yuan (Y) $1.00 Y5.46 Y 1.00 = $0.18 FISCAL YEAR January 1 - December 31 WEIGHTS AND MEASURES Metric system ACRONYMS AND ABBREVIATIONS AAPRC - Audt Admistrton of the People's MIS - Management Infonnation System Republic of China MOP - Ministry of Fiuance ABC - Agricultural Bank of China MOFERT - Ministry of Foreign Bconomic Relations ADB - Asian Development Bank and Trade BOC - Bank of China MR - Ministry of Railways BOF - Bureau of Finance MYE - Multiyear Expenditures CASS - Chinese Academics of Natural and Social NCGA - National Council on Government Sences Accounting Cc - Capital Construction NFEBR - Nonfiscal Extrabudgetary Revenue :CP - China's Communist Party OECD - Organi -iion of Econonmc Cooperation CDs - Certilicates of Deposit and Dv -lopment CEM - Country Economic Memorandum NPC - National People's Congress CESH - Culture, Education, Scie=e and Health PBC - Peopl's Bank of China CIECC - China International Engineering PCBC - People's Constucdon Bank of China Consuling Company PEMS - Public E1xpnditur Manaaent System CPA - Certified Public Accountant PIC - Provincial Investment Company CPE - Centrally Planned Economy PPC - Provincial Planning Commission CSY - China Statistical Yearbook PRC - People's Republic of China 1BR - Extrabudgetary Revenue PSBR - Public Setor Borrowing Requireme FEBR - Fiscal Extrabudgetary Revenue R&D - Resarch and Development PYP - Five-Year Plan RCCs - Rural Credit Coopeatives GAAP - Generally Accepted Accounting Prctc RIPS - Research bIsite of Fiscal Science GAO - General Accounting Office RMC - Resident Mission, China GFS - Govenment Fmance Statistics SAMB - State Asset Management Bureau GNP - Gross National Product SB - Specialized Bank GDP - Gross Domestic Product SEC - State Economic Commnision GVIAO - Gross Value of Industrial and Agricultur SIC - State Investmeat Corporation Output SNA - System of National Accounts IBRD - nternational Bank for Reconstruction and SOE - Stat-4Owned Enterprise Development SPC - State Planning Commission ICBC - Industrial and Commercial Bank of China SSB - State Statisdcal Bureau ICOR - Incremental Capital-Output Ratio STIN - State Fixed Investment IDA - International Development Association SWF - Social Welfare Function IOT - Investment-Orientation Tax TB - Tresury Bond IM - Inner Mongolia TVE - Town and Vilage Enterprise IMP - International Monetary Fund UB - Univend Bank (L/D) - LoansDeposit UCCs - Urban Credit Cooperatives ZBB - Zero-Base Budgeting  FOR OMcCIAL USE ONLV CONTENTS Phfwe ..... . . . . . . . . . . .. . . . . . . . . . . v Excutve Summary and ..R.onun.datlon. . ........ vii I Budgeta Polcy and Intergov nmental Fiscal Relatoun: An Introduction I . . .. . .. .. . I A. Chia'sBudget and theChangingRoleofGovnment I B. TrendsinExpenditures andRevenues .. 3 C. Issues... 9 D. Outline of the Rep ............................... 14 2 AFameworkfor Budgetary Reonn .............. ........... 15 A. Introduction . ......... I5 B. Ihe ScopeoftheBudget .............................. 17 Ismes . .... 17 ReoomnlnezKlationh ...................... . .24 C. TheB udgetasaPolicy Tool ............................ 28 Issues ............ ......... 28 Reconmmnendations ................ ......... 31 D. Thelnlr Role onitRheEudgRee t he e... 40 Issues ........ . . . ... . . 40 Reconnendat io.s.... 42 E. Concluding Remaks .................. 43 3 Eyxpdltur AsdgmnentIn aDecentralized Eonomy ............ .. 46 A. ntroduction ...................................... 46 D. An bternational Perspective on Expenditure Assignment Over Levels of Government ..................................... 46 Theoretical Considerations . ......................... 46 Some Internaiond Evidence ...... .................. 47 C. Expenditure Assignment in China . ........................ 50 The Istibuiona Framework ...... .............. . 50 Low Autnomy in China .. ......................... 54 Trends in Central and LocA Expenditures and Revenues ....5... S D. FincingExpenditures ........ ....................... 68 hemationd Experiee ....... .......................... 68 Central-LocalRevenueShang I China ............. .... 72 bItrgovermentalFinancial Flows . . ................... 78 This document ha a restrictd distribution and may be used by recipients only in the performance of their offlcial duties Its contents may not othervise be discksed without World Bank authofiation.  -il- 3 E -nditure Assdgmnat Ina Debo4ralued Ewnomy (cont!d) E. Expedir and nteproilnla Equity .. ................... 83 Cros-Prvi,iicWa Expenditure Patterns .. . ... .. . ... .. . .. .. 83 Culture,Education,SSdleneandTechnology, eadlh ......... 84 Pdice Subsidies .......... ....... 8S Does the FlscaSystem Equall? .......... ....... 86 F. Fiscal ncentivesandDysfunctlonalOuomes ................. 91 G. R......e.d.ton......... .. .. .....* . 95 ibllWraphy .. .... ........ ........ 99 1.1 Csfcannd DefintionofBudgetary Acwuts ... ... 108 1.2 Domnestic GovenmentDebt ...... . . .... . 113 1.3 Govnnmenes W'ageBill.. .. . .... .... 117 2.1 Thenstiudtonalando IganIzatlonal iaFramework ................ .... 120 2.2 RegulatlosonStatelBudget Mngement . ... .. 133 2.3 Financi Accountig and Reportg .. . ... 147 2.4 FinancingInvesment . ... 154 2.5 ForeIg Capita and Investmnt .. .... ......... . .. . 180 2.6 RailwayTransportInvemenmt aPming andtheBtdget . .187 .3.1 Expenditureand R eeAsslgnment in aM MLedE aoomy ............ 193 3.2 Aocation of Bank Credit Acas Provinces ..... .. .... ... 204 3.3 Paying for Price Subsie .......... ........... .. ... 209 3.4 Emprical Analyds of Denbaliaion . ................. 213 3.5 Pwivdal Finance in Ci bib ase o sses... ................ 217 asusulcalAnnas ..... .. ........... .. . 224 TAZ IN TErXT 1.1 Stae Budgetary E..x .......................... 6 1.2 Explic*ltFof State Budget Defiflct ....................... 13 3.1 Conceua Basis of Expedit Assignment . ................. ... 48 3.2 Expendr A nient in Selected Conis ............................... . 51 3.3 Provinci Shae In Local Expmfirs ad Reveues for Seected Prvinces . 57 3.4 Breakdown of Expendir on Culte, Educadon, Science, and H h ..... 60 3IS Adus iEnlsr...veExpendlt.r.s ............4444**4* **....4.4.4.4. 65 3.6 Nonx ieveorSelddOECDCoundtes,C1988 .....untrles,19........... 72 3.7 Chin: Central-Local RevnueShaig Contrt, 19880 ............ 79 3.8 EsdImeCed tra-Loca Trandss, 1990 ........ .... .. . . . . ..... . 81 3.9 ProvionI CESH ad CC Expendiu ...... ................... 85  Dow RN Tr 2.1 1990SEtrbugetar Funds . .............. 19 2.2 New Prna of the1 StatBudget . . . . . . ... .. .. . . . . . .. . . .. . 23 23 AtiU"e Budget Cledar. Tietable (o Compiig the Ste Budget ..... 30 2.4 JapmneBuodoPtoces .....*...............*. ............ 34 2X FomultIn of th Budget l Nehelands ..................... 36 2.6 Effimnymnd Ef ia Revienw: TheNethedands ..... 38 3.1 ntralzngEducatn In Chin . .......................... . 61 3.2 DeHalth Care In China .................................... . 63 3.3 Tax SSwing andFaEqu uao an Gtm .....ionlan.............. 70 3.4 Provinc Tax Eflb In China ................................. 73 3X RevemxShwingFormulas: SomStaegs ......77............... X !iGuI E N 1TxT 1.1 ShftsinBudgetaryExpendfltures ...... .................... .. 5 1.2 On d ise: R B ......RealBudgetarylevenuesaiExpenltu. ....... 9 1.3 ShiftsnP.enpios: Budgetary ExendinusAdjused .............. . 11 1.4 Cut of Control: Unplanned Exedtures ........................ 12 2.1 Stop In lpan'sBudgetPeo.es . . 33 3.1 Govrnumt StucW In Chin ....................... ..... 52 3.2 ntral Local Expnis: Shafg a SbinkInPg ................ 56 3.3 Keepg Cohntol: Centra and Locd Expendins and Earm d G .... A8 3.4 Cor Local Expeadibs: Second Courms ..................... 59 33 ranesa FinanlaiFlows ..... ....... ................ so 3.6 DwIdig Shaing: Central and Locd Revens and Net TaxShaig S....... 82 3.7 PeCapita xpendt andlvR es nC insProvenls,1990 ........ 87 3.8 Through the Budget, 1990 ....... .......... ... 88 3.9 eThunFiscalAlow: Fisca andResoure Transfer,1989 .......... 90  'tN * ri1  *1 I iIjP ill *1' Ir1di U 1i 0 a Iii IiiIJIji. jf;m; ii U *A*I IIIJI4IIIJJIIUII I I1jji Ijij IA' j j illhlill I  - vli - EXECUIIVE SummARY AND RECOMMENDATIONS IntroductIon L. Ecoomic rermn sInce 1978 signficandy danged the role and proffle of the governmet budgeL Th buge has evoved ftom an all-encompassing acounting for the Plan toward an accoun of genal government. Decentrizaton of decsion power Sratly reduced and altered the scope of the budget no e teeneura d tizo a pwved ctucial in te sucoess of CWs econmic ref'm d*cressed the budgeay presence of StateOwned Enmtrpie (SOEs). Decenization of govermet f ions e d the budgetary presen of local government, and the devolution of decision power Inrased th Importan of locad goveme In the budgetary process. These significat aDges in te govnme wer accompid by only margnd changes in the budget syotem and in Intergovenmel fiscal iStuon. i. ia's budgt system seved the oury wel under cenr plann but k incres y alls sbort of the demands which Chia's emerging socaist mart economy put on t, ad budgety praices I b the economic decentralizaon in the refrm period. The currt budget system does not adequately refect the preset and fiur fisca resoibilii of Chna's govem The budget is ot well oquipped for ita growing funcion as a onoic policy tool, and Ib still overly geared toward the taditiondal role as a resour mobilizer. tovnmental fiscal relatio have not fuly adapteDo the nw IndeenDence gained by loc nmen, leadg to a proliferation of extra- and ofibudgetary prc tbat uderm i budget controi and m o mic sablity. The dwindling fisa reces In the daing system led to an erosion of the fiscal equaizaton between provic. In. he main challen for the Chinese autries b to mabe the budget a mor effecte policy tool, both In its role os an indirect lever In manging m , a a bewer-deid Inrmen for meeting nw soci objectives. This report nalyzes the urent problems wih tie budget sysem and recmmens how t ca be transformed to meet the dhallenge. The rort ihat many of the recomdations can oily be Implementd as the overl reform progm unlds and the future role of governm Is clarified, but some chges can m Imprvwe the effecnss of the budget. iv. The report focuses on two crucial featu of the fiscal n (a) the stuctur and itudonal aspects of the budget system; and (b) China's intergoverunental financs with patar rferenc to expendue assimen by levels of government Chinas fisca systeq needs refm in other areas as wel, and earlier World Bank stUi hav  - viii - addrese theso in deil4/ Fiscal policy In a maket based economy aims to (a) promote stability, (b) enable officient allocation of scar=c resources, and (c) guaanty equitable outcomes of the economic process. The incaed openmess of Chia's economy will make fiscal policy die domiiant macroeconomic policy tool, but fiscal policy will also play the dominant role in allocaion and income redistribution, as the Importance of the Plan furher diminishes. Reforms to equip goverinment with the appropriate tools for fiscal policy in the market based economy are therefore a matter of urgency. v. Neco.sary reforms outside the scope of tis report Include (a) transforming China's revenue system into a tme tax system, (b) broadening China's tax base, and (c) modemizing tax collection. China's govermnent has recognized the need for reforms, but the Initiatives ta have not been without problems. The experiments of separating taxes and profits goes in the direction of a trme tax system, but Implementation is held up by reluctance to phase out the tau deductibilit of debts, an issue that could be solved by grantig these debts. Ithe ongoing extension of VAT and Business Tax to a wider category of goods and services is diveifyin the tax system, but the complicated rate structure remains a barrier to an e4uitable and efficient system. The reformed tax system wfll only be effectively enforced with a solid collecdon eanism and with the increased income flows across provinces, and the loosening of ties between SOEs and government, a nadonal tax system becomes neesary. Budgetary Trends Over the Reform Period VI. Chia's budget reflects the profound cunges in society tat have taken place since 1978. Following the overall retrenchment of the goverment from the economy, budgetary eedimes declined by over 10 percentage points of GNP over 1978-91. To a considerable degree, this is a reslt of conscious and desirable policy reform, as SOEs were allowed to keep more resources, and at the same time saw their excess profits decdine as competition increased. However, including thefiscal part of extrabudgetay funds (that is, funds that are essentaly of the same natre as budget resources), government stfill commands more than a quarter of GNP, a share comparable with that of other Asian developing economies. Priorities shifted away from resorce mobilization for production enterprises toward more traditional government tasks. The greatest cuts have been in capital expenditures, as Stat-Owned Enterpris (SOEs) were excluded from the state budget in the course of rerorm, as they now rened profits for reinvestment. Further sharp cuts took place in reported national defense spending, whereas socia expenditures, adminitation, and price subsidies all grew moderately, and debt service grew rapidly as a share of GNP. The trend toward soci expenditures is likely to continue as enterprise reforms will move so expeaditurs of enterprises to the budget, th enlargig governmet's share in GNP. Overall, the decline In goverment's revenue share of GNP outaced expendiure decline, leading to persistent budget deficit over the reform period, reaching 2.5 percent in 1992 (IMF definition). Vi. abudgetary revenue gained strongly in Importance, rising from a third of budgetay finds in 1978 to over 90 percent in 1990. However, in 1990 only one sixth of total extrabudgetay fiuds, or 2.6 percent of GNP, are Jiscal extrabudgetary fimds, related to government fiuctions. The bulk of extrabudgetary flunds consist of reined eanings and 1/ Word Bank, VW=ina Revenue Mobiliaian and Tax Policy," Washngton, D.C., 1990; and Cbihn Refoging nteroU FlFiscaldReatons,' WasgionD.C., NovemberZ7, 1991.  -ix- deprecito funds of SOBs, which have been growing fast In the course of increased indepndence of SOEs. viii. Responsibility for admisteing public expenditure shifted towards lower levels of govment over the reform period, ncem t with the genera decentralization. Cental governmet's share of tota govement expenditure is now below 40 percent. Although this may appear low in inationa coWmparison, it Is by no means exceptionally low for a country of China's size and development stage. Also, China's central government share is suppressed by the largely oftbudget finance of Social Security and Defence, usually central government functos. The downward shft of expenditures over the reform period can be attributed largely to: (a) the new emphasis on functions traditionally administered at local levels, such as social expenditure; (b) wage Increases and increases in admnisave expenses, which fell more heavily on local goverments; and (c) sbarp rises in locally administered, but centrally set price subies. Local governments' own sources of revenue did not keep pace with vising pendires, and they became increasingly dependent on earmarked grans from central govermnt, and strongly expanded their reliance on extrabudgetary funds to perform goverInment fucions. Tax sharing through the tax contcs decreased rapidly in importance, as central govemment gradually augmented its fixed revenue base through the reassignment of individual taxes or a chao in enterprise ownership. Such sharing now accounts for about 20 percent of local revenues and expenditure, and about a quarter of the center's. ix. Budgetary finace of Chinashigh investment share in GNP decreased btaily over the 1980s, a trend even more pronounced for investments in the sta sector. Budget finane was replaced by: (a) own funds, that rose with the growing independence of enterprs; (b) firein f bnd-increasingly in the form of direct foreign investment-as China opened up; (c) domestic loans; and, more receny, (d) new mechanisms of fnance such as stocks and bonds. The naue of budget finance of enterprs investments changed from direct capial grants to an annual lump sum allocation for the capital construction fund, managed by SPC. The decline b budgetary finnce of Imvestment was partclarly pronounced in local budgets, and consequently the recourse to altenative fiance sources was stronger at that level. x. In smmary, the expenditure composition of the budget has substamdiaUy changed over the reform period. In recent years, more of the budget has gone to the provision of public goods (social sves, infrstrture), while the share of enterprise finance has gone down, and the locust of experes has shifted to local government. The functional specialization between government and enterprises, as reflected in these numbers, has been the major dring force behind China's economic success. Moreover, the decentralization of ownership to local governmen has strongly enhanced competition among SOEs, and substnily reduced x-efficiencies. However, the fundamental changes in Chinas society have not been witho problems for the budgetary system. Mai Issues and Problems Xi. The Budget System. While many changes have occurred in the scope, coverage and size of govaement expendhre in recent years, and many fiscal reforms have been instied, budgetary processes and practces in China have not kept up with the accelerated pace of reform In the 1980s. The scope of the budget In China is lagging behind the changing role of govemnment oW vermUent activities ae not unified In the budge:, wbereas nongoven actvities sti remaIn on the budget. Entrpses still have a strong presence in the fiscal  -'- accounts, although financ indepndec b the stated policy. The prolifeaton of ofibudget and euxabudget funds blur,ed piority* seing and has weakened the budgetary contol medis essenal to a well-functioning fiscal system xli. Acal expen conistey supersede budget esm, by as much as 18 prcent in the mid-1980s, but In 1992 stll by over 8 peren of budgeted expendites. Multyear axeditu plang is hardly developed, and the curre method for budget plaing invtes incrementalism. Individual economic uits hawe resisted periodic program nd proJect aessmen and i-crementalism in the budget process has confbutd to Wee cOntrOl and Inreased presure on the budget. xiii. ne Chie governmen has moved away from detaied planning activities of oWer sectors in the economy to guiding these decisions. ITis should til accompanying budget rfdorMs, especly to ehance the budget as a provider of signals to economic agents, and as an instmen of momic poy, but this has yet to be seen. In pardcul, govements capacity to def a system of ienives through the budget is inibPted by the reticted publicity of the detied budget ad the late approva of the budget wbich impedes economic agets to take acount of govenmen plans in a timely way. Macoecontrol is weakene by the wide divergence between eed and actual experes and revenues as noted above. xIv. Recourse to bgaufnig and noncompliance with fiscal regulations have contbud to fiscal undiscipline across institons. Rules and codes regarding entprse tax liability are evolving, but entprises at tax liability Ughtly in an environment where the finnc bureaus play the double role of tax collector and owner, and in a sitWion where taxes are frequently contracted ther than aessed. Budgetay finance of SOE investmer_ is still virly fe, as repayment raio of the PCBC are extremely low, or as repaymens are canceled out against tax obligation. This bas negative oecoomic and macroeconomic onn, d work to the detimet of bankig sectr stability. The Chinese authorities have in ed a number of chages in the budget system to deal withis situation, but thes masures fdl short of preparingthe budget for its new role. Many of these problems are not unusual r an ecnomy in transition. However, futu budgetay refoxm needs to address them if macrconom difficuties w to be avoided In the fuue, and a number of acdons set out below can be tae Immediately to impove the funciing of the budget. xv. The recodations of ths report are therefore desigped to address these issues by suggestng ways in which the scope and coverage of the budget can be redesigned in order to make it more closely match the new role of governmen as it is emering in the course of reform. Similarly, such refrms of the budget are necessary if the government is to be equpped with a budget that will ass it to manage maecnomic policy, and pemit itot use the budget to guide the decisions of other economic agents. xi. lntu o n Jiance. China has not yet fundamently ched the sstem of intergovenmena ce despite the increased role and responsibility of local govnment, and this has given rie to a number of problems. Furthermore, the devolution of power to an already deconcntrated goverment has given local government de facto command over functons that determine macroeconomic stability. The lack of reform has driven central and local governMent to take actions that furher undennined the fiscl system. An incresing mismatch between local rvenue and expenditu assignment has occurred over the reform period, as local  -xi - gove ts took on ic resed responsiblities for, for eample, price subsidies, but wihout new sources of reve. Un aty incased In venm relations, due to cdang levd of ownership of entprs, pansion of central fixed taxes, and ceta 'borrowing from localities. Repeaed reoratig undemied the tax cotact which, in principle, wee well- designed to generae revenues; kt reduced revenue collections well below potential; and made fiscal planning at the local level more difficult As the resources In the tevenue-sharn system stagnathed centra pvemnt allowed the reditbutive element of the fiscal system to weaken, at tm when divergifg economic condion-a posle reat to reforms-would require moro equalization among regions. Fil reditbution now takes ple mail) through ad hoc, earmarked gran allocated on a one-by-one basis, often poorly targeted and too small to meet basic needs in ttie poorer regions. Moreover, the arbitry nature of centra grant allocations led to extensive negotiatons and rent-seeking by localities, tying up valuable administrative resources. xvii. Besides ineased rent-seking, local governments responded to the fiscal squeee in other ways that undermine the desired fiscal system and jeopardid macroeconomic stability. Ihe local reactions ilnclude- (a) exanding the local tax base at the cost of cent governmet; @b) tuing budgeay int getay fumds and tapping enteprises' xgetar finds for govnment puwposes; (c) pushing expendit" ofibudget, sometmes financed by indirect local borrowing that puts addional demands on local banis, and strais macroeconomic stanility; and (d) run arrears in payments or issue IOUs, a practice tiat fueisnftion. Loal gove have reduced effdve tax rates on entetpris proft below the stauory rae via entprise profit co ts. Loca govrnments offer tax concessions to enterprises ta affect the size of the taxable income to the detent of tax buoyancy, for insta by manipulating the rules for pretax repayment of investa loans. More , the resourcetrapped local governments depend on local entrpris for their revenues, and are tus tempted into inefficient regioa competiton and loca protctionism, made possible by voids in competition reguation. h Chinese autorities have repeatedly changed central-local fiscal contract, but without fundamentally altering the icentives the iegove fiscal relations ihat give way to the observed dysficional ouomes. mviii. Future refms in this area wil tiherefore need to focus on clarification of expenditure assignment, on formulation of crieria for fis d buon, on the menu rt of flsS need and on an apropriate system for assigning revenues to each level of govermen The rort contends that the prese system is creatg distotions and inefficiencies by its lack of clarity, and that, in patcular, the fist two issues need to be resolved before a detaied design of tax- sbaring can take place on a rational basis. A LngRun Budgetary Fmework xix. Within the cone of overl fisl reforms, China's budgetary process and itergover a relations noed fameal change to support fiscal policy that protes efficicy, equity and maeconomic stability. Ihe inc g mportance of fiscal policy in macroeconomic management urges for speedig up fiscal rdorms. Fisa roms can only be brought to success if al parties gan, which i more likely the more comprehensive the reoms ar. Budgetary refom and chang ingv rlations should threfore go hand in hand with a broadening of the tax base, the creation of a local tax base, a rationalized ta collection system, and a reblis of central ovenMets macroeconomic control. The evidence from the past with fiscal reforms suggests ta the experme , regioaly limited  - xii - pieceme reorm method, sucefl In many areas, may not work with fiscal refotms. A graual natiowde Implemtion of an established reform plan encompassing the varius aspects of fiscal refom promises to be the better method. xx. he Budget and the Scope of Governmet. Budget reforms must change the scope, conten and objectives of the budget and budgetary policy. In the long run, the budget should reflect the role Chiln's authorities see for govement in society in a unified and clear way. Nongovernment activities should be removed from the goverut budget and fiscal accounts, includingentprisextrabudgetary fund. Budgetaryinvestmentexpendituresshouldconcenate on govermnent functions. Fiscal watraudgetary funds should become an intgral part of the budget. Goverment actities now perfLrmed by enteprises, such as social security, sould be brought on the budget. Quasi-fiscal activiti3s of the banking system, such as subsidies to loss- making SOEs and for agriculral Inputs should be made transparent en the budget The establishment of separate policy bank to manage policy loans seems superfluous, if not damaging, and designatiot of an exosting institudon as the main policy bank seems preferable. Unifying government activities on the budget is a precondition for the budgetary process to become a meaningful mechanism for allocatng scarce resources over government objectives. A unified budget will reflect the macroeconomic significance of government action, a precondition for rational macreonomic policy. xxi. Govens share of the economy should be an outcome of the change in budgetary scope instead of being a goal in itself: there is no objectively opftim share of goverment in an economy. More Important is the ability to fiance the desired share of government in a non- Inflationary way: tax reforms and tax adminisaion reforms should in the long run achieve that goal, and eliminte rcourse to the balking system. xxii. China's authorities desire to keep a substantial state ownership of enterprises. A Nonfinaial Public Sector (NFPS) Account consolidating govermen and State Owned Enterprses would be a useful supplement to the government budget. The NFPS is based on the crterium of government control, instead of the criterium of govermTent functions. As long as China's government exerts considerable control over SOEs, and SOEs remain instruenbts for implementing govenmet policies, public sector accounts would yield a better picture of the overall govermsne. establishment. The public sector borrowing requirement (PSBR) would be more relevant than th8 government deficit in detrmining the overall macroeconomic stance of goveivmt. FinancW ianshtiutions owned and controlled by government should not be consolidated in the public sector accounts, becase this would eliminate information on which part of the PSBR Is fianced by banks. Government ownership does not pjclude a beneficial separati of functions within governmet. Separating the ownership function from the tax collector function Is indbspensable for the implementation of rule based policies, for the imposition of hard budget constrains, and therefore for improving SOE performance. xxii. TMe Budget as a Poley Tool. The budget's increased role as a macroeconomic policy tool could be emphasized by integrating the budget with macroeconomic developments. Th requires an explicit recognition of the macrnomic assumtions behind the budget in the form of a backgunddocument on the economic outlook to be published with the budget. xxiv. Chins wudget classificatiec and presentation needs adjustment such that the budget wi be usf lor multiple users and uses, and adoption of the Iational standard of budget categorizaon and presaions strongly reommended. The prentaton of the budgae oud  - xiii - allow economic analysis of goverment plas by means of an c onomic presentation, in additon to a functional and administrative classification that assigns spending authority to specific ministries, unit and levels of goverment. xxv. MOF could improve the quality of expenditure decision makng. 'rhe icementa bas mmber method should be abandoned, and more output and program-oriented budgeting techniques shoud be adopted. Introducing multiyear budgets and commitment budgets, together with crossreference between Plan and budget would improve expenditure planning, and recognize the multiyear nature of many government programs and policies. Capital budgeting capabilities of MOF need further strengthening. Ihe fiscal reporting system must be geared more toward policy analysis, and the AAPRC mandate should be expanded to include output and effectiveness audits. Institutional mecism , such as the expenditure review committes many countries have, should be established to raise efficiency of government expenditures. Such epeaditure zeviews would be Instrumenl in effectively increasing the tight fiscal envelope, and therefore contibute to overall fiscal reform. xvi. The legal basis for budgeting and expenditure control needs strengthening. The draft Budget Law should explicitiy assign responsibilities to units and ti ons concerning tigb and obligations on expenditure budgeting, approval, authorization, disbursement and audits. Procedures for redressing expenditure overnms should be made explicit, and sanctions in case of abuse should be codified. The budget law should be supplemented by a detailed budget manual, explaining in detail the rights and responsibilities of those involved in the budget process. xxvii. Intergovemntal F1nnce. China's authorities should assign functions clearly over levels of governent, with efficiency of service delivery and fisca equity as guiding principles. For erample, education and health care should be primarily a local responsibility with cenr government only settng general guidelines, whereas other functions, especially those of interl market regulation and competition policy should be assigned to central government. xxvii. Control over government functions crucial for macroeconomic stability should be eCen haized, including control over aggregate government borrowing, and overall tax burden. The increasing intergovermmentl flov-. of goods, production factors and income gives ctl govenment a comparative advantage in tax collection, and a Natonal Revenue Service (NRS) is highly desirable. Such a recentralization of control over =dmbnirra*on of revenue sources (boowing, taxes) may well coincide with a decentrization of the revenue acca from these sources. Mhe expenditure assignment should be the basis of a ew rmeme a ignment, and the exp ture necessary to perform the assigned fmctions efficienty should be covered by the revenue assignment-provided the overall fiscal envelope is suffrciently large due to China's tat reforms. The efficiency of government service delivery depends to a considerable exten on the autonomy a level of government has, on the financial Icentives it has for cost savings, and therefore on the memns with which the expenditures are financed. xxix. China's authorities should assign each level of government a substanti own tax base, with which it finances functions f which it has full responsibilities. China's authorities hould assign local governments a true local tax base-including significant control over tax rates-and exploit the opportunity for more accountability and the incentive for better and cheaper public services such a tax base gives. Own tax bases can futhermore serve to absorb vaiations in expenditure needs without a tiresome renegotiation of intergovernmental fiscal relations. Finally,  - xhv - extension of the local tax base contributes to brk the present deadlock in the system of intergho menW fiscal relations. To some exent, fiscal etudgetay funds are a de fact local tax base, but a legal basis for this should be provided, and as argued before, these fumds should be brought on the budget. For local govment, prope taxes would be an excellent own tax source, which is thus far hardly exploited in China. However, the subordination principle in income taxation distorts incentives for local government, and should be abandoned in further reforms of the tax system. xxx. Tax Sharing and Equaslzatdon. A full separation of tax bases in China is probably not feasible, nor desirable in the light of efficiency of collection, assuming that the NRS will be established. The fiscal gap between expenditure needs and revenues from the own tax base can be filled by tax sharing, general grants, specific grants, or a combination thereof. If tax sharing is chosen, a necessary condition for tax buoyancy is that the collecting agent has a large stake in the taxes it collects, i.e., its share of the tax should form a substantial part of total revenues for that agent. To accommodate for the increasing divergence in economic permmance among regions, and the consequential growing divergence in fiscal capacity, a fiscal system with equalizing properties is necessary. Horizontal equalization of fiscal capacity between localities can be achieved though tax sharing arrangements or through equalization grants. Whatver the mechanism chosen, China's authorities should desip horizontal equalization mechnLim that are resilient to inflation, and can accommodate substantial shifts in relative welfare positions of localities, which are likely to occur as reforms deepen. xxxi. Adminisatively, it is more complicated to incorporate equalzation cerations in tax sharing arrangements, and usually a separate equalization fund is set up, or centra government allocates funds directly too poorer provinces. Ihe latter solution would, however, require a larger share of tax revenues going to central govermnent, which seems difficult in the present Chinese situation. For China, an interprovincial equalization fimd could be the appropriate way to strengthen horizontal equalization. This closed-end fund could be filed by a certain percentage of taxes shared between central and local government: this eannaking will have no effect on tax effort in the cas.; of a NRS. The fund could for instance be adrnnsered by a body at arm's length of central govemment, with both local and central representatives. Disbursements from the equalization fund could be based on broad indicators of exendie need, such as popuation, area and urbanization, and on fiscal capacity of the locaity stemming from its own tax base. A variety of formula-based grants schemes or tax sharing arrangements can be found around the world, but China's authorities should make the primarily polta decisions on what factors should be given weight in the formula, and to what extent fiscal capacity should be equalized acs localities. xxxii. ITe elements of intergovernment fiscal relations as set out here need to be captured in a Local Government Finance law. The law would work out the constitutional division of labor between levels of government, and specify the financing mechanisms, including the above menioned tax sharing and equalization arrangements. The law would in part serve as a guantee for local govenment that the NRS will not be abused to reverse the devolution of the reform period, and would establish the increased local autonomy by means of codifying local taxation rights.  xv - Imediate Actions xxxiii. China's authorities can take a mnmber of immediate actions that clafy the scope of the budget, improve its function as a policy tool, and improve intergovernmental fiscal relations. xxidv. To restore budgetary unity, the various levels of govermentfiscal extrabudgetary funds should be reported as part of the budget, without necessarily changing the control over these fiuds. Enhrpise extrabudgetary funds should be removed from fiscal accounts, as they no longer fall widtn the scope of govenunent. xxxv. The budget should clearly differentiate between government and non government where already possible. Among ohers, this requires that the budget clearly distinguishes size and nature of government budgetary support to enterprises. To prepare a further delineation of government and nongovernment, MOF should prepare an inventory of those units and agencies that operate In the budgetary and pscal extrabudgetary sphere. Such a listing and the change therein as reforms proceed should be reported along with the budget. xxxvi. Tho Chinese authorities should consider a wider publication of a more detailed budget, togehr with a detailed descrption of the categories. This would enhance their capacity to guide decisions of other economic Ments. MOP should initiate a recoding of budgetary classifications, which would allow multii le users access to budgetary data for mltiple uses. This would require taining of all levels of government involved in budgeting. xxvii. MOF should facilkate a wider flow of information between levels of government, between ministries and even between its own departments. MOF should strengthen the capacity to analyze budgetary implications of economic data, both macroeconomic and microeconomic. Data and analytic capcity combined would enhance the accuracy of the budget forecasts, ngthen the programmatic effect of budgets, and would make the macroecnomic effects of budgetary decisions more transparent MOF, SSB and SPC should establish a working group on data reporting, which should work on consistency in reporting on budgetary data. xxxviii. MOF should adopt stricter measures to contain the impact of expenditure overuns. Inclusion of contingencies In the budget is a first step, but MOF should issue more detailed and stricter regulations concerning budget readjustment, including detailed rules on which instituton Is responsible for absorbing the expenditure overrun and sanctions for the case of noncowizpllance. Enforcement of this new reguation requires more regular monitorng of budget implementation by MOP, especially at local level. Announced and unanounced inspections may be ntrmental in enforcement. MOF's and AAPRC's audit capacity therefore urgently need strengthening. xxxix. The budget should clarify the size and nature of budgetary support for enteprises. A clearer di on between loans, grants and subsidies should be made. Policy loans hough the banking system should be registered as a contingent budgetary obligation. MOF shoud issue clear petformance and eligibility criteria for the various means of bu%igetary support. xi. The present tax sharing experiments do not match the fundamental revision of intergovernmentlfiscal relations as sketched above. Notably, the expeiments largely maintain the fical cotacting system, which lies at the heart of the present problems. Moreover, the  - xvi - experimens have not been implemented as designed by MOF, and therefore seem more and more irrelevant for the evolving situation in China. China's authorities should therefore consider substantily modifying, or even giving up these experiments altogether. xli. An intergovernmental committee to tackle the various issues in intergovernmental fiscal relations should be established. The committee, manned by both local and central representatives should solve the technical issues in implementing intergovernmental fiscal reform. The commuittee should make proposals for the criteria governing the equalization fund. They should be in charge of drafting the suggested Local Government Finance Law. The committee may evolve Into the administrative body that manages the interprovincial equalization fund. xdii. The erosion of equalization through the fiscal system should be stopped now. Government should consider to increase the lump sum transfers to poor provinces right away, without waiting for the fundamental revision of the system. Also, cofinancing requirements for earmarked grants could be differentiated among provinces, to account for the different fiscal capacity. Both measures could be financed with cutbacks in price and SOE subsidies. The equalization payments could be gradually enlarged as the new interprovincial equalization fund will be established. This fund should be built up gradually, starting with a low percentage of al shared taxes. This percentage would then gradually be increased until the structural level is reached. In this way, local governments could easily adjust to the small changes, and probably can pay their *contribution" to the fund out of overall revenue increase. Unks with Other Reforms xliii. The above recommendations could be implemented independent of other reforms, their impact would be enhanced by reforms in other sectors. ITe main linkages are spelled out below. xliv. Financial Reforms. The speed at which delineation of government f*om the rest of the secoors can proceed and thus the budget unification can be completed depends on the speed of reform in other sectors. In particular, financial sector reform and enterprise are essental for progress in the budgetary sphere. The further development of the emerging stock markets will yield better altrnatives to the financing of enterprise investment than the banidng system. Developing a long-term bonds market would equally improve enterprise funding, would reduce the need for bank finance of budget deficits, and would enable goverment to better spread debt repayments. A well functioning financial market could relieve the budget from the present task to mobilize resources for national investment programs. Finally, a reformed banking system will help imposing hard budget constraints on state owned enterprises, a necessary condition for entprise reform. Xlv. Enterprise Reform. Enterprise reform will substantially affet the budget, as it wfll reduce subsidies, and may increase revenues. Until SOEs operate on a for-profit basis, and are no longer used for implementing govenment policies, such as minimizing open unemployment in hef course of price reforms, the finamcial links between SOEs and government will go beyond those in other mixed econi nies. Ihese links, as long as they last, should appear on the budget, however, and not be hidden in the financial system. x1vi. Regulatory Framework. Cental government should fill the reguatory void that gives leeway to regiona protectionism. Government should prepare and isue nadonal laws  - xvii - regarding competition, company law and contract law to fill the instiutional void, which gives localities protonist leeway. Central govemment should strengthen its capacity to monitor local govenment's implementation of national tax laws and regulation. MOF should start the preparatons of a naton tax system. The system would curtail illegal and inefficient tax exemptions by local government, and would facilitate the introduction of a new tax and tax saing system  I. BUDGETARY POLICY AND INTERGOVERNMENAL FISCAL RELATIONS: AN iNTODUCIION A. CIINA's BuDGE A TE CANGING RoL OF GOVERNMENm 1.1 Govment budgets reflect the outcom of the political procs in which chois ars made among competing demands for limited resources, and the size of govenmet actvie In the econmy decided upo. Budget can be a powerl tool for allocating nadonal resours, set natonl priorides, determining the relative size of the prvate and pubic so. and expressing the naure of intergoermental rtions. To the tthat budget weig, articulate, and litmize the demands from all intested parties, trslag them Io a collective interest,' the budget could be seen as an expression of the country's 'reveaed 1.2 Toward a Mixed Ecnomy. In broad terms, the goal of economic refrm in China 2/ has been to isttute an economic system in which: (a) te government would continue to play a central role in econmic m _ageme in terms of fomdatng and implementing laws and regulations; formulating and applying economic policies, and establishing and readjust the management system. Insruments should focus more on m omic management and rule-based approaches with emphasis on market-determined pices in products and production factors; (b) the govement would participate in providig of social services and wdefre but hrough mecm and instons hat would citate efficiet risk pooling and service delivery, with more equitable burden sharing between individuals and the govement sector; (c) the govemment would continue to decentralize its participative role and enable the enterise sector to make fts own decisions on invesmet, products, and quantities to be produced and sold, responding to market forces. Martet forces 1I As discussed in sm of the pubic finance _tnstr dealing with h thoy of th public int_t It is ls elegant, but not less sietific, to tbk as a saiting point for etn_ of social acto tde oved objectives of soiety insted of the derived ones.' P.O. Sier, Public Expenditure Budgeting, in A.S. Blinder (ed.), 1ke Economics tf Publkc FThace, Washing, Brolpings, 1974. Z o Pw a eredv ew of the refor decade,'" se 0w Ceauy Ecum M. 1adur-plnbeg and Rq1n in dse ISM, Wodd Bank, Wasln D.C., 1992  - 2 - would Increasingly determine the allocation of resources, and the govenmenut would rely more on indirect policy instrumeuts;2/ (d) the government would decentralize operations within the government sector and enable locad governments at different levels to perform specified government functions, encouraging competition and performance comparisons in the provlsion of public goods; (e) planning, focusing on channeling of public investments to key sectors, and market principles would coexist in a complementary fashion. 1.3 Progress along these liaes are transfoming China into a "mixed-economy,*4I where public policies would be mainly conducted according to rules and indirect fiscal and monetary instruments common to industrial and developing countries. 1.4 Flscal Poficy and Fiscal Reform In China. Fiscal policy in a market based economy aims to: (a) promote macroeconomic stability; (b) enable efficient allocation of scarce rurcs ; and (c) guaranty equitable outcomes of the economic process. The increased openness of China's economy will make fiscal policy the dominant macroeconomic policy tool, but fiscal policy will also play the dominant role in allocation and income redistribution, as central economic planning firther recedes. Reforms to equip government with the appropriate tools for fiscal policy in the market based economy are therefore a mater of urgency. 1.5 This report discusses two crucial elements in the fiscal infrastructure: budgetary policy and intergovenmental relations, but China's fiscal system needs reforms in other areas as well, and earlier World Bank Studies have addressed these in detail.jI Necessary reforms iMnlude: (a) transforming China's revenue system into a true tax system; (b) broadeing China's tax base; and (c) modernizing tax collection needs to be modenized. The experiments of separating taxes and profits goes in the direction of a true tax system, but implementation is held up by reluctamce to phae out the tax deductibility of debts, and issue that could be solved by grandherg these debts. The extension of VAT and Business Tax to a wider categoy of goods and services is diversifying the tax system, but the complicated rate strucure remains a barrier to an equitable and efficient system. The reformed tax system will only be effectively enlforced with a solid collection mechanism, and with the rased income flows across provinces, and the loosenig of ties between SOEs and government, a national tax system becomes necessary. Proper arrangements of intergovernmental finance as discussed in this report will make it femsble as well. 1.6 China's budget system mirrors the profound changes that have taken place in society and the organization of the state since the late 1970s. Gradually the state budget has evolved from an all-encompassing account of the public sector into a reflection of the accounts , In the Chinese lHteature, this is usually referred to as 'the state regulating the market and the markt guiding the Lterrse z .4/ Sine th 14th patty congres, oe could ue the term 'socialist markt economy.' Wordd Bank, -China Rene Mobiltio and Tax Policy,- Washington, D.C., 1990; and China Refomingn vementFiscal Relatons,' Washington D.C., November27, 1991.  -3 - of the general government (central plus local governments). This redefinition of the scope of the fiucdons and economic activities of the government has been carried out through a process of devolution of ncions to financial and nfiancial public entrse and local governments. The budget lso reflects the changing gvvenme's economic role in carying out dvelopment objectives, while reducing its direct role in the production of goods and services. 1.7 In addition to the change In the coverage of governmental activities, the evolution of the budget also reveals the extent to which expenditure priorities have been altered during the years of reform, as a response to changing policies, for example, away from military expendiures and toward soci sectors like education and health. Ihe budget also summaizes the finanal implications of the compromises made during the.reform to achieve somedmes contradictory objectives: reforming relative prices in favor of the gicturlS sector, whie protecting urban standards of living; and giving a larger role to markets and competition, while at the same time shielding state-owned enterprises (SOEs) from those same forces. 1.8 OutUine of the Chapter. This chapter prese a brief overview of the main trends In budgetay revenues and expditures and in the fiscal deficit and its financing since the begining of the reforms. Then, it discusses the change in governmental expenditure priorities in a few main categories whose importance has increased or declined during the last yeas. Three annexes to this chapter include a detailed definition of the main expenditre items in the Chinese classification of the budgetary accounts (Annex 1.1), and a detailed discussion of the fstest growing budgetary expenditures (debt service, Annex 1.2 and the Government's wage bill, Annex 1.3). B. TRED IN EXPENDIUS AND REVENuES 1.9 Trends in aggregate budgetary revenues and expendiwres and in the fiscal deficit and Its financing in 1978-91 are reviewed below. 1.10 Budgetar ExpMenditures. Following the overall retrenchment of the government from the economy, budgetary expenditures declined from 31 percent of GNP in 1978 to 20.4 percent in 1991 51 Crable A-1.2). The greatest cuts have been in capital expenditures, from 12.6 percent of GNP in 1978 to 3.9 percent in 1991, as SOEs were excluded from the state budget in the course of reform. Further sharp cuts took place over those same years in national defense spending, from 4.7 percent of GNP to 1.8 percent. Against the general trend, nondefense current expenditres rse slightly, from 13.7 percent of GNP to 14.7 percent; social expenditures, adminisation, and price subsidies all grew moderately in terms of GNP, while debt service grew very rapidly (see Annex 1.2). 1.11 Budgetary Revenues. Over the reform period, China's budgetary revenues have declined significantly, from 31.3 percent of GNP in 1978 to 16.8 percent in 1991.71 While the decline in revenue in terms of GNP was intended, nonetheless, it became a major concern of the Chinese government, a main driving force in the decline in expenditures, and the cause of recrt changes in the fiscal system and in central-local fiscal relations. However, with the gi Chieso definiion Due to lack of dled atistics, it was not always posible to us dat compatible with tdo in onal pracdc 11 Chinm definition, excluding debt issued  -4- benefit of bldsigh, the decline In revenues Is not srprisng and can largdy be explained as a direct comeence of the govemens economic reform. The main fctor behind the decln in revenues has ben the reduced budgeay conribudons from SOEs-die tu paymentB ad profit mi -which fell fom 20.6 perct of GNP to Im ta S pacent dudrn dte peiod, whs entere loss-retred as negav revenue-grew strongly. Eneris inme rached 55 pent of total revenues through the mid-1970s before tax reorm reduced th compont to virtay zero in th mid-1980s.SI 1.12 The reduction in SOE contribuons was caused by a combinaon of refom InDiati tha transfrred resources from the govement to the enterrse sector and policies ng ety, reslting in increased competon.2/ Ihe profit-retenion scees enterprise rtenton of dercation fmds, and the deduction of pretax amortization before tax payments ga the SOEs more auonomy, but at the same time, reduced fscal control ovr resources. More pronounced was the erosion of the govenmens fisal capacity by maket forcs: Q) relaive price adjsment shfted proft from the havily txed industri secto to less axed secto, notaby agrice and rura eeaprises;1Q/ (increasing compedtion in th hxdustra setr, especially from town and village enterprises (Vs) and collective anterprises but also from abroad, depleted SOE monopoly rents and reduced govrnent revemes. During this period, taxes on namaonal trade and personal incomes did not increase nearly eno to offse the dedline In enterprise income taxation. 1.13 ExpedItre Shares.Uj In recent years more of the budget has gone to prvid *purer public goods and services (Inftructure and social services) and less iusrial nvesmn and production fincing, as the general govenme's scope and coverg ws nduced. With the notable exception of debt service, some of the most rapidly rsing expdo co ries have increaingly fallen on esource-saed local budgets, forcing them to look to other rabe sources of income to finance their curren and capital e (Cbt 3). The main changs in the rative r of the gods and seices financed by do budget between 1978 and 1991 were (Figure 1.1): (a) Capital Construction. A large portion of fixed capital formation could be decenrized from the budget to nonfmcial public entrprises. As a result of flI C. Wong, Fiscul Reform and LocAd l I M Probmatic Seuencing of Refm in Pout-Mao China, Modern Cina, VoL 8, No. 2, April 992, pp. 197-226. 2 aBrq Naughton, 'hmplcatio of the State Monopoly over hdustry and its Relaxation, Modem Cina, VoL 18, No. I (Januy 1992), pp. 1441. IW See Wodd Bapk, *aWda Rewaw MobIladon and Tax Poky,- Wahingt D.C. 1990; Chmne P.W. Woog, Ce*tl-Local Reations i an Era of Fisca Decline: the Patadox of Fiscal liCtn,QasaQi.iy (Decenbe 1991). ly, lb Chiwne classfication of buddgeay expenditures has not Impt pace with the ching natume oovege, and incesg complexity of publc activities. Te tradinad incldOs 13 andheads of acount Crab 1.1), combiing fimetional and ecomic rhie, nd wltdM distinguW etwee curen and captl exnditres. t a mo N& _ level (Annem 1.1), Cbines budSay e du lasifie ito 29 main item, with th _a woeomp mooticned above, which lmitsdte inbr otonal contet and uW of the budgetr incno fo antyeaG puspooe  .5- Pl%e : Sin IN 3VJM AItY v_it owwfo cum CESH -wedlem 47%% 2U I _ Mln _ w _ ~~~~~~10% udo Olh 8% OHM 4% 31% 11~17 Nob ad USINiGUpI or1vckmaTa M svao h1clessng dieHIaton betw th eonomic fimcto of the public secor.-I A pon o whih wa filanced by qtrabudgay fbads (aptes 2 and Amex 2.4-2.6). he share of capitl cons don jJ In tot budgetary oulays fel by half, fom over 40 percent of toWal qeadu in tie lat 1970s (almost 13 peet of GNP) to about 20 peret Om ha 4 percen of ahits G(NP) i 1991. A u*rher dedine s budgetd for 1992. The cag In the share of capia construcdon e spenurs in the stats budgot hides the drastc declw hi loca pgovemes shwe of thu exedtu in 1978 the centrallocal slit w about 56:44, In 1991 it was 74:26, nd it Is xpected to decin to 79:21 hi th 192 budget While theo s of capil mcdon wa cut In haf durn the refom yea, t o W be . an expenditure responsibt - concentaed at the cent. IV a smal tobmo mu.t nd loPlo g d ), nofnacl and fiac)d W,1 So ud 1am,inAm 1.1.  XtI W4SP '.dNLPD IW ma U'SNP6 (g. 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