China - Fiscal Technical Assistance Project

Document of The World Bank Report No. T-6552-CHA TECHNICAL ANNEX TO THE MEMORANDUM OF THE PRESIDENT CHINA FISCAL TECHNICAL ASSISTANCE PROJECT APRIL 3, 1995 Country Operations Division China and Mongolia Department East Asia and Pacific Region  CURRENCY EQUIVALENTS (as of February 1995) Currency Unit = Yuan (Y) $1.00 = Y 8.50 Y 1.00 = $0.12 WEIGHTS AND MEASURES Metric System ABBREVIATIONS AND ACRONYMS ADB - Asian Development Bank CS - Consultancies The Decisions - Decisions of the Third Plenary Session of the Fourteenth Central Committee of the Communist Party of China EDP - Electronic Data Processing EIT - Enterprise Income Tax GNP - Gross National Product IBRD - International Bank for Reconstruction and Development ICB - International Competitive Bidding IDA - International Development Association IMF - International Monetary Fund IT - Information Technology LTS - Local Tax Service MOF - Ministry of Finance NCB - National Competitive Bidding NTS - National Tax Service PBC - People's Bank of China PHRD - Policy and Human Resource Development PIT - Personal Income Tax SAT - State Administration of Taxation SOE - Statement of Expenses SE - State-Owned Enterprise SRC - Systems Reform Commission SSB - State Statistical Bureau TA - Technical Assistance TIN - Taxpayer Identification Number TOR - Terms of Reference UNDP - United Nations Development Program VAT - Value Added Tax FISCAL YEAR January 1 - December 31  CONTENTS Section A: Detailed Project Description .1...... . . . . . . . . . . . . . . . . . I 1. Background ........... .. .. .. . .. .. .. . .. .. .. .. . . . 1 2. Project Objectives and Description ....... . . . . . . . . . . . . . . . 7 3. Project Costs and Financing ........ . . . . . . . . . . . . . . . . . . 12 4. Other Donor Assistance ........ . . . . . . . . . . . . . . . . . . . . 12 Section B: Project Administration and Implementation .... . ....... . . . 14 1. Project Implementation ........ . . . . . .. . . . . . . . . . . . . . . 14 2. Procurement ........... . .. . .. .. . .. .. . .. . .. .. . . . 17 3. Disbursement .................................. . 18 4. Accounting and Audit Arrangements ...... . . . . . . . . . . . . . . 19 5. Monitoring and Progress Reporting ...... . . . . . . . . . . . . . . . 19 6. Supervision .......... .. . .. . .. . .. . .. . .. . .. . .. .. . 20 7. Lessons Learned from Previous Bank Group Involvement ..... . . . 21 8. Rationale for Bank/IDA Involvement ...... . . . . . . . . . . . . . . 21 9. Project Benefits .......... . . .. . .. . . .. . .. . . .. . . .. . 22 10. Agreements Reached at Negotiations ...... . . . . . . . . . . . . . . 22 11. Risks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22 ArrACHmEwS 1 Detailed Project Costs by Subcomponent ....... . . . . . . . . . . . 25 2 China: Developments in Government Revenues ...... . . . . . . . 30 3 Changes in Tax Structure in China, 1994 ....... . . . . . . . . . . . 31 4 Project Activities ................................ 33 5 Tax Administration Component ......... . . . . . . . . . . . . . . . 41 6 Training Plan ........... ........................ 46 7 Preliminary Mission Supervision Plan ....... . . . . . . . . . . . . . 49 TABLEs iN TEXT 1. China's Tax Administration Offices and Personnel, 1993 ..... . . . 3 2a. Project Costs by Objectives .......... . .. . . .. . . .. . . .. . 13 2b. Project Costs by Cost Categories ........ . .. . . . . . . . . . . . . 14 3. Project Financing Plan ............ .. . .. .. .. .. .. .. . . 15 4. Proposed Procurement Arrangements ....... . . . . . . . . . . . . . 18 5. Projected Disbursement Schedule ........ .. . . . . . . . . . . . . . 19 FIGURE IN TEXT 1. Project Implementation Structure ....... . . . . . . . . . . . . . . . . 15 2. Tax Administration Component ....... . . . . . . . . . . . . . . . . . 16   TECHNICAL ANNEX 1/ SECTION A: DETAILED PROJECT DESCRIPTION 1. BACKGROUND 1. Introduction and Overview. China's fiscal system has come under stress over the reform period since 1978. The reforms initiated a major shift of the tax base away from the sectors traditionally tapped by the tax system, and government revenues declined from over 34 percent of GNP in 1978 to less than 16 percent in 1993. Tax buoyancy was undermined by loose collection and tax exemptions that were induced by intergovernmental fiscal contracts, and facilitated by the decentralized tax administration system. The reduced budgetary resources were handled by a budget system that was still geared toward financing the State Plan, and a proliferation of extra- and off-budget funds increasingly undermined the macro- and microeconomic functions of the budget. 2. Against this backdrop, China's authorities have recently introduced sweeping reforms of their fiscal policies and practices, which the proposed project would support. The reforms were endorsed in the "Decision of the Third Plenary Session of the Fourteenth Central Committee of the Communist Party of China" in November 1993. The reforms can be broadly divided into four parts: (a) a major overhaul of the tax system; (b) the creation of separate tax administrations for central and shared taxes (National Tax Service, NTS) and local taxes (the Local Tax Service, LTS); (c) a restructuring of intergovernmental fiscal relations; and (d) the passing of an organic Budget Law. This section presents the reforms and their background in more detail. Key Issues in Fiscal Policy 3. Tax Policy. China's tax structure has become increasingly incapable of raising sufficient revenues. At the beginning of the reform period, the decline in government revenues was mainly caused by increased independence of state-owned enterprises (SEs), which were no longer obliged to submit all their profits to the budget. In 1984, a separation of taxes and profits was established with the introduction of SE income taxes. Increased competition from the nonstate sector rapidly eroded both profits I/ This report is based on the findings of an appraisal mission in January 1995, consisting of Zafer Ecevit (Chief, EA2CO, mission leader), Bert Hofian (Economist, EA2CO; Task Manager), and Ike Ikamuullah (Senior Technology Specialist, IENTI). The appraisal mission cooperated with a parallel IMF mission, consisting of: Carlos Silvani (Advisor, mission leader), John Brondolo (Tax Systems Information Officer), Tony Pellechio (Economist, IMF), and Alan Landsberg (Panel Expert).  - 2 - and taxes from SEs. The buoyancy of the tax system was further undermined by the contracting of profits and taxes between government and SEs since 1988, and the practice of debt repayment deduction from taxes. These practices also provided the impetus for strongly procyclical SE behavior, and recurrent excess investment demand. Furthermore, tax contracting distorted competition among SEs, as the terms of their contract depended on the financial strength of their local government. In the early 1990s the practice of tax contracting was increasingly extended to the turnover taxes, eroding further the tax share in GDP. 4. Competition was further distorted by the complexity of the tax system, which, despite a number of reforms, had 33 taxes, a multitude of rates for every tax, and high marginal statutory tax rates on enterprise income, that varied by ownership. The turnover taxes-mainly business tax, value added tax (VAT), and product tax-had a myriad of rates, in part to compensate for the incomplete price reforms, and in part to penalize "undesirable" consumption. The VAT, introduced in 1984, was gradually extended to more products and sectors, and by 1993 had become the main revenue source (Attachment 2). 5. Tax Administration. Until recently, the decentralized tax administration acted on behalf of both central and local governments. In principle, the tax administration was under the "dual leadership" of local governments and the State Administration of Taxation (SAT), the central tax authorities. SAT was established in 1988. Before that, the administration was a department under the Ministry of Finance (MOF). The tax administration is large by any international standard, with over 30,000 offices at four levels (Table 1).2/ The district/county-level offices have primary responsibility for the tax collection at larger enterprises, whereas tax collection stations focus on small enterprises. Total personnel is now over 600,000, and is rising fast. The collection of taxes on imported goods is delegated to Customs, and the agricultural taxes are collected by Finance Bureaus. SAT has two training colleges, with about 400 teachers, mostly specialized in basic tax theory. 6. Over the 1980s and early 1990s, tax administration has increasingly become an arm of local government. To attract investment, local government granted legal and illegal tax exemptions, which contributed to the lack of buoyancy in tax revenue, and central revenue in particular. Besides such political pressures, the tax administration has faced a growing number of taxpayers, now amounting to 33 million, with over 1 billion of transactions with taxpayers annually. The administration increasingly failed to manage these numbers, despite the growth in the number of tax administrators. Efficiency has been hampered by the lack of specialization of tax administrators, the concentration on tax assessment and collection, instead of audit, and by the widespread system of "resident' tax administrators in enterprises, which encourages a negotiated approach to paying taxes. Moreover, the tax administration practices differed from locality to locality, distorting competition, and undermining equality. Z/ The tax collection station falls directly under the city/prefectural level, and is considered a branch of that level.  - 3 - Table 1: CHNA'S TAX ADMWNSTTION OFmcEs AND PERSONNEL, 1993 No. of Offices Personnel Central (SAT) 1 n.a. Provinces and Provincial Level Cities 36 8,875 City/Prefecture Level 490 34,676 District/County Level 2,770 207,857 Tax Collection Stations 28,214 301,503 Training Colleges and Schools n.a 4,032 Total 545507/a /a SAT reported that total personnel exceeded 600,000 by mid-1994. 7. China has made tax computerization efforts since 1986, with investments of over $150 million in about 5,000 offices. There are some 4,000 technicians working in the administration, and over 20,000 operators. Most of the computer applications developed have been less than fully effective because they concentrated on computerizing existing procedures instead of first reforming the tax administration procedures to increase overaUl efficiency. Moreover, the computerization that took place has not been coordinated centrally, leading to a proliferation of systems and procedures among localities. Computerization of some administrative functions was further hindered by the absence of unique taxpayer's identification numbers (TlNs). 8. Intergovermnental Fscal Relations. China's intergovernmental fiscal relations have changed considerably during the reform period. The most fundamental change occurred in 1980, when the principle of "eating from separate kitchens" was introduced, giving local governments more autonomy over their fiscal affairs by means of what amounted to a contracting system. The fiscal contracts were formalized in 1988. The contract system assigned taxes and tax shares to either central or local government. The excess of local revenues over 1987 "base number" expenditures was to be remitted to the central government according to a contracted rate, and a shortfall of revenues over 1987 expenditures was financed by a transfer from the center. The contracted local retention rates were high, and bolstered local revenues in times of high growth and inflation. In addition to the contracted revenues, local governments received a number of earmarked transfers, predominantly for covering losses of SEs and for price subsidies. 9. The intergovernmental fiscal arrangements gave local governments high incentives for promoting growth, but also caused central tax buoyancy to decline. The decline in tax buoyancy-accelerated by legal and illegal tax exemptions-hampered central government's control over total budgetary expenditures, and reduced its role in equalization among provinces. The contract system added to the procyclical tendencies of China's economy, as the budget rules allowed local governments to spend their actual revenues, which were higher in times of boom and lower in times of growth recessions. Revenue  - 4 - assignments also introduced distortions in investment behavior by local governments. Local shares in the product taxes encouraged investment in those industries that were meant to be discouraged. 10. Budget System. China's budgetary system has been an efficient resource mobilizer for the Plan, but the system has not kept up with the reforms in the rest of the economy, and is insufficiently equipped for its emerging role as an allocation and macroeconomic stabilization instrument. The budget no longer fully reflects the fiscal responsibility of the government, due to a proliferation of extra- and off-budget funds that remain outside budget controls. The budget classification system is less suited for policy analysis, cost computation, and for internal management. The budget compilation process is largely incremental, projections are less than accurate, and the control over outlays is weak, which contributes to economic cycles and weakens allocation through the budget. The effectiveness of audits is restricted by lack of detail in the budget classification and reporting procedures. 11. The People's Bank of China (PBC) treasury department manages the vault function well, and once in the treasury accounts, money is transferred relatively efficiently. However, cash management has not been fully developed since the treasury had until recently access to funding from PBC for short-term needs. Expenditure control, which should be exercised by the MOF-Budget Department, suffers from lack of a detailed budget and lack of an efficient information system. Capital budgeting techniques are hardly present in the MOF and Finance Bureaus, as the public investment process used to be handled largely by the State Planning Commission (SPC). Planning and budgeting are virtually separated, as most of the public investments are handled by SPC, and recurrent costs of the investments have increasingly been funded from extrabudgetary sources. Recent Reforms 12. The decline in the share of government revenues in GNP and central share in the revenues in particular caused loss of macroeconomic control, because government expenditures were not reduced in line, but were increasingly financed through policy lending of the banking system. This loss of macroeconomic control led to sweeping reforms in financial and fiscal policies and institutions that were announced in November 1993. The fiscal reforms are aimed at halting the decline of government revenues through tax and tax administration reforms, and a gradual centralization of the revenues through a rearrangement of intergovernmental fiscal relations. The Budget Law, which passed the National People's Congress (NPC) in March 1994, should lead to better control over expenditures. 13. Tax Policy. The reforms announced at the beginning of 1995 aim for a major restructuring of the tax system, which reduces the number of taxes from over 30 to 18, and greatly improves the overall structure (Attachment 3). The main reforms consist of: (a) a broadening of the VAT to include parts of the Product Tax and Business Tax, a reduction of the rates to two (17 and 13 percent) and a switch to the credit invoice method; (b) a unification of the EIT for all domestic enterprises, with a standard rate of  33 percent,3/ and the abolition of tax contracting and debt principal repayment deduction; (c) abolition of the Energy and Transportation Tax and the Budget Adjustment Tax for SEs; and (d) a unification of the PIT. Various minor taxes are or will be merged or abolished, the Resource Tax will be expanded, and a Securities Trading Tax will be introduced. 14. The State Council has assigned MOF principal responsibility for the formulation of tax policy while SAT will concentrate more on tax administration. The provinces have gained a very limited autonomy in setting rates for certain business taxes, and the authorities are considering the possibility of gradually extending this autonomy. 15. Over the first seven months of 1994, revenues from industrial and commercial taxes (including VAT, Consumption Tax and EIT) grew at about 30 percent in nominal terms over the same period in 1993. However, overall budgetary revenues grew only by 18 percent, thus still lagging behind nominal GNP growth. The authorities realize that further tax reforms will be necessary to reverse the decline in government's revenue share in GNP. 16. Tax Administration. To implement the tax reforms and the new intergovernmental fiscal relations, China's authorities intend to fundamentally reform the tax administration. The tax administration will be reorganized in NTS and LTS. SAT is the headquarters for NTS, but also has responsibility for guiding LTS. As of July 1, 1994, NTS collects all central taxes and shared taxes, amounting to the bulk of all taxes. The split of NTS and LTS has now been enacted in all 30 provinces. NTS will retain about 350,000 personnel, the rest remaining in the local tax bureaus. 17. With the help of technical assistance (TA) from the International Monetary Fund (IMF), a reform strategy and an implementation plan have been drafted.4/ The strategy for reforms rests on: (a) a gradual move to self-assessment; (b) increased reliance on tax advisors outside the administration; (c) increased computerization; and (d) a strengthening of taxpayer information. SAT has decided to reform its procedures and the internal organization of the offices, in line with the core tax administration functions (registration; collection and accounting; audit and inspection; and taxpayer's information). The district level will be the focus of computerization, but in the long run, SAT plans a national system, with city-level and national-level processing capacity as well. 18. Intergovernmental Fiscal Relations. The reforms in intergovemmental fiscal relations will gradually increase central government's share in budgetary revenues. The new system assigns most taxes to either central government or to local govemment. The VAT and the Securities Trading Tax (to be introduced) are shared between central and 2/ However, the Energy and Transportation Tax, a tax on retained earnings, is abolished for SOEs but not for nonstate enterprises. 4/ SAT (June 1994), 'The (Draft) Programme for the Reform of Tax Administration," and 'Key Points of the Implementation Plan on Experimental Computerization of Tax Collection and Management."  - 6 - provincial government, with central shares of 75 and 50 percent, respectively. Offshore resource taxes accrue to central government and other resource taxes to provincial government. Central govemment's revenue share will gradually increase to about 60 percent of revenues, from about 40 percent in 1993. However, provinces are guaranteed the 1993 level of revenues, and the new system will be gradually phased in, starting with the increase in shared taxes over the 1993 level. The incremental revenues that will build up at the central-government level is to be distributed to provincial governments by means of a grant system. Until such a system is designed and approved, extra central revenues from the VAT and Consumption Tax are in part returned to the provinces, predominantly on a derivation basis. 19. The State Council has established a Working Group to prepare a conceptual design of a central-provincial grants scheme by June 1995. The Group, consisting of MOF, Systems Reform Commission (SRC) and SAT officials, builds on technical assistance by IMF, and is currently exploring a scheme that takes both revenue capacity and expenditure needs into account. A "standard budget approach" used by Australia is currently under study. The Group's efforts are supported by a Japanese Policy and Human Resource Development (PHRD) grant, which finances regular visits of experts for workshops on various aspects of the grants scheme design. After the State Council has approved the conceptual design next year, the Budget Department of MOF is to develop a detailed design, and will be responsible for implementation of the grants scheme. 20. Budget Systems. An organic budget law was passed by the March 1994 NPC, codifying the 1991 budget regulation system. The law specifies a number of principles and practices that may lead to a better allocation of public resources, and better expenditure control. The law sets out the role and responsibilities of the various actors in the budgetary process, codifies the new tax assignment and sharing system, and the separation of central and local budgets, which de facto was already in place. The law only allows borrowing for construction expenditures. Since 1993, the central budget is compiled according to the "dual budget" method, which divides the budget into a 'regular' and "construction" budget. The PBC Law excludes overdrafts from PBC, a practice already in place since the beginning of 1994. Local governments are, as before, not allowed to borrow. 21. Both the "dual budget" and the new intergovernmental fiscal relations require fundamental changes in the budget accounting system. The "dual budget" reporting can only be fully implemented if the accounting system corresponds with the "dual budget' structure. The new intergovernmental fiscal relations put additional demands on the information to be contained in the budget. The "standardized expenditure needs" basis of the grants scheme requires adequate information on the costs of government programs, which is at present hard to obtain from the budget. 22. The preclusion from access to PBC financing increases the need for sound and efficient treasury management, in order to minimize short-term debt obligations. Improved treasury management would also be necessary to achieve the goals of expenditure control as stated in the Budget Law. Finally, the new intergovernmental fiscal relations  - 7 - have led the State Council to the decision that central and local government treasuries in PBC need to be separated. 2. PROJEcr OBJEcTIvEs AND DESCRIPTION 23. The Government has asked the Bank Group and IMF for assistance in implementing the current fiscal reforms and preparing future reforms. The project would support the fiscal reforms by: (a) developing and implementing a new tax administration; (b) strengthening capacity for tax policy analysis; (c) developing and implementing a central-provincial grants scheme; and (d) improving budgetary processes and practices. The project would contribute to improved management of public resources. Tax Administration 24. The tax administration component would support SAT with the development and implementation of an NTS that is capable of implementing current and future tax reforms. The project would support the development and implementation of new administrative procedures, organizational arrangements, and information systems. SAT's implementation plan, developed with IMF assistance, calls for a phased implementation of the reforms. During Phase I, the new tax administration will be tested on a pilot basis in four cities (Beijing Haidan District, Wuxi, Xiaoshan, Shenyang). After a systems assessment, the reforms will be rolled out to 14 other cities (Phase II). Subsequently, the reforms would be implemented nationally, with over 200 cities planned to be in the NTS network by the year 2000. The project will support Phases I and II. During negotiations, assurances were obtained that no roll-out will take place before satisfactory systems assessment, and implementation of agreed improvements. 25. SAT has established a Steering Committee, and has drafted new procedures and organizational arrangements for the tax administration, which were reviewed by the appraisal mission, and are expected to be finalized by August 1995. On the basis of this, an information systems design and architecture would be developed, supported by a PHRD grant, and the project. Selection of a consulting firm that would assist SAT in systems design is expected to be finalized by April 1995. 26. The information systems would be developed and implemented in one development site, Haidian District in Beijing. China's priorities for computerization are the VAT, the EIT and the PIT. The PIT is a local tax, but SAT plans to use the information system of the NTS to process data for local taxes with high dataprocessing requirements (PIT and EIT for locally owned enterprises). A PHRD grant will finance systems design and specification covering the requirements of a nationwide information system, database structures, dictionaries and overall hardware architecture. SAT plans to first implement functions more closely related to collection (registration, filing, accounting, stopfiler detection, etc.), whereas at a later stage information systems for audit, audit selection, and internal management would be implemented.  - 8 - 27. A preliminary architecture of the system includes data processing capacity at three levels: (a) District. The district level would become the main operational level. Databases and processing capacity for, among others, registration, filing, collection, stopfiler control, accounting, refunds, and appeals would be maintained at this level. (b) City. The city-level databases would maintain summarized taxpayers' records for audit, audit selection, and statistical reporting, and information for internal management purposes. (c) National. The national-level database would contain summarized historical time series and sample individual data for tax policy analysis, and summarized data on the tax administration organization for management and strategy development purposes. 28. In small cities, SAT intends to experiment with data processing capacity centralized at the city level. In this architecture, the districts would retain the taxpayer's files and would access the city-based database with terminals. 29. SAT has decided to opt for an "open systems" concept, portable among hardware platforms, and expandable according to needs. The information system should be able to accommodate likely changes in the tax administration, including changes in tax policy, changes in organizational setup, number of taxpayers, and changes in tax administration policies, procedures and controls. SAT intends to use CASE, Relational Database Management Systems, UNIX, and a Standard Systems Development Methodology. 30. The project would support: (a) CS for tax administration procedures and information systems development; (b) training in administrative and managerial functions and in systems development; and (c) equipment for the information system. 31. Consultancies. The CS will focus on tax administrative functions and on the development and implementation of the computer systems design. The systems design will predominantly be implemented by SAT personnel, with assistance from programmers financed under the project, and under guidance from the technical advisor and the electronic data processing (EDP) advisor. Assistance will also be provided in the procurement and installation of equipment. China's authorities have decided against resident advisors and intend to obtain advice through regular short-term consultations. The main experts expected to be financed under the project are: (a) The Technical Advisors who would advise SAT on all aspects of the development of the new tax administration system. SAT would hire one foreign and two local experts. The advisors would assist SAT in project management, notably in supervision of the systems design consultants, the  development of an installation plan for Phase I equipment and software, and a roll-out plan for Phase II; (b) Systems Design Experts who would assist SAT in detailed design of the data processing system; (c) Programmers who would assist SAT in construction of the data processing system; (d) A Procurement Advisor who would assist SAT in the acquisition of hard- and software for the new tax administration; (e) A Training Expert who would assist SAT in the development of a national training plan, and on the development of key courses for the new tax administration. 32. Short-term CS will be financed for several management issues faced by SAT, including personnel policy, cooperation with banks and Customs, and investment and efficiency analysis for the tax administration. 33. Training. Training will concentrate on those functions that are emphasized by the new administrative procedures: audit and inspection; management and taxpayer's information. SAT wants to build up local training capacity in those new functions, but deems it necessary that local trainers for those functions be trained abroad. Information technology (iT) training will strengthen SAT's in-house capacity for systems development, implementation and maintenance. The project will also finance SAT's large training program for new users of computers. A limited number of study tours would provide comparative experience on some policy issues for the tax administration, including: cooperation with banks and Customs; tax management systems, and city- and national-level information systems; and tax enforcement measures. Several SAT staff will be seconded to foreign tax administrations to obtain in-depth exposure to state-of-the-art-practices, notably in audit, audit selection, and management. 34. Equipment. Equipment and software acquisition will concentrate on the district level, the main operational processing level. City-level and national-level computers would also be financed, as well as a district-level computer for one of SAT's training schools. Tax Policy Analysis 35. China's authorities aim to improve China's tax policy analysis capacity in order to perfect current tax reforms and to prepare future tax reforms. The tax policy component will support this objective by: (a) improvements in the capacity for quantitative tax policy analysis; (b) facilitating the gradual transfer of responsibility for tax policy analysis from SAT to MOF; (c) the creation of tax policy analysis capacity at the provincial level; and (d) the preparation of future tax reforms.  - 10 - 36. The project expands the capacity for quantitative tax policy analysis by improving the MOF enterprise survey and the State Statistical Bureau's (SSB) household survey, making them more suited for tax policy analysis. The project would support training in tax policy analysis for central government officials to enhance their capacity to analyze the revenue impact of policy changes, and to conduct revenue forecasts. The more advanced courses would be held overseas. The project would support the development of an information system for the MOF-Tax Policy Department and the SAT Tax Policy and Legislation Department for the processing of the survey data, and other policy-related data. MOF staff would obtain IT training under the project. 37. The project would support the gradual transfer of the tax policy function from SAT to MOF. Currently, tax policy analysis is principally based within SAT, and MOF comments on and clears SAT proposals on tax policy. The State Council has recently assigned the tax policy formulation function to MOF, while SAT will concentrate more on the administration of taxes. This division of labor is in line with intemational experience. The project furthers this objective by supporting a number of joint studies in tax policy, which would contribute to the transfer of knowledge from SAT to MOF, and by financing training for MOF and SAT officials. 38. Provinces have until now hardly any tax policy analysis capacity, as all authority on tax rates and bases is vested in central govemment. With the emergence of new intergovemmental fiscal arrangements, the authorities anticipate the need for increased participation of subnational-level govemments in tax policy, and therefore for tax policy analysis capacity at provincial level. The project would support this by financing training in tax policy analysis for provincial-level assistance, and by providing personal computers to each provincial-level fiscal authority for analysis, and for data collection for the national survey. The project would finance studies on local taxes and tax assignment. Finance Bureau staff would obtain IT training under the project. 39. The joint MOF/SAT studies would refine the current reforms and prepare for future tax reforms. Current reforms have moved China's tax system considerably in the direction of a system suited for a market economy, but in several respects, the current structure still requires adjustments. Moreover, early figures on 1994 tax collection suggest that the current reforms will not increase the tax share in GNP, and future reforms would seek a broadening of the tax base. The project would finance studies in the areas of: (a) the VAT; (b) the EIT; (c) the PIT; (d) local taxes; (e) social security taxes; and (f) environmental and resource taxes. The studies are part of the work plans of MOF and SAT for the Ninth Five-Year Plan. The studies will be performed predominantly by Chinese officials and researchers, but the project supports CS to provide the methodological framework, assist in drafting outlines for the studies and control the quality of the studies after draft final reports have been prepared. Intergovernmental Fiscal Relations 40. China's authorities aim to develop and implement an efficient and equitable central-provincial grants scheme that would, according to objective criteria, redistribute  - 11 - part of the increase in central government revenue to the provinces. The intergovernmental fiscal component supports this goal. The grants scheme is an essential complement to the new revenue assignments. The authorities plan to implement the grants scheme on a pilot basis in 1997. A date for nationwide implementation has not been decided upon. Currently, the State Council Working Group is working on a conceptual design for a grants scheme, an effort supported under a PHRD grant. Following the State Council's approval of the conceptual design, the MOF Budget Department will assume the responsibility for detailed implementation of the conceptual design. Implementation requires a substantial effort in data gathering and analysis, and the training of people at central- and provincial-level govemments. 41. After the State Council Working Group produces the conceptual design, the project will support detailed studies for the implementation of the grants scheme. This will include the detailed norms and criteria on revenues and expenditures to be used in the grants scheme, and the data and data reporting necessary to operationalize the grants scheme. The project would support the pilot implementation of the grants scheme in several provinces. The pilot would serve the development of administrative processes and computer system to support the grants scheme. The project would support a number of workshops to disseminate the results of the studies, to discuss the design of the pilot, and to evaluate the plans for nationwide implementation. The project has earmarked resources for nationwide implementation, once this has been decided upon by the State Council. The project would finance extension of the computer system to all localities and a number of seminars for the dissemination of the national grants scheme design. 42. The project would support training at central and local level to enhance the understanding of the grants scheme and to build implementation capacity. The project will support a number of secondments of central officials to grants implementing agents in various countries to provide MOF personnel with in-depth exposure to the day-to-day administration of a grants scheme. Budget System 43. The Govemment aims to operationalize the 1994 Budget Law. The budget systems component supports this goal by strengthening MOF's institutional capacity for implementing reforms in the budget system. The component would enhance MOF's understanding of best-practice budget procedures, practices and systems, and support the formulation of a budget systems reform strategy appropriate for China. 44. In a number of diagnostic studies, the budget systems component would identify strengths and weaknesses in: (a) the budget accounting system; (b) treasury management; (c) budget preparation and analysis; and (d) audit and inspection. The studies would be performed primarily by Chinese officials assisted by foreign and local consultants. In-country CS will be primarily provided in short-term consultations, to avoid overburdening the key people within MOF.  - 12 - 45. Study tours, training and international workshops would provide MOF with exposure to best-practice budget systems. The international comparison and the diagnostic studies would provide input for a budget systems reform strategy to be drafted by MOF. The strategy would establish a long-run view for the development of an efficient budget system that can support China's budgetary processes and practices. The strategy would identify priority areas for implementation. Domestic workshops would disseminate and discuss the findings of the studies. 46. The project would also finance an expansion and improvement of the existing treasury network of PBC. This high-priority investment would be done after an assessment of the existing data processing system and implementation of agreed-on improvements in software. Assurances were obtained during negotiations that no procurement of equipment for the treasury network would be initiated before a systems assessment has been implemented, and agreed improvements have been implemented. 3. PROJEcr COSTS AND FINANCaNG 47. Total project base costs are estimated at about $88.2 million. Including contingencies, total costs are estimated at $105.5 milion.5/ The base costs of the various components are: (a) tax administration $76.3 million; (b) tax policy $4.8 million; (c) intergovernmental fiscal relations $2.9 million; and (d) budget systems $4.3 million (Table 2). Of the total base costs, 14.8 percent supports institutional development, 0.9 percent project implementation, 2.5 percent policy support, 45.4 percent automation, and the remaining 36.3 percent consists of (five-year) incremental operating costs. In terms of cost categories, 42.9 percent is devoted to equipment, 36.3 percent to incremental operating costs, 6.2 percent to consultants' services, and 14.2 percent to training, seminars and study tours. Detailed cost estimates can be found in Attachment 1. 48. The Bank Group will finance 92 percent of foreign exchange costs, the balance consisting of counterpart funding of computer equipment. The Bank Group will finance 5.3 percent of local costs consisting of expenditures for CS. The total Bank Group finance share is 47.4 percent. Two thirds of counterpart funding consists of incremental operating costs for the investment in equipment.6/ Table 3 provides an overview of financing arrangements; Attachment 1 provides a detailed financing plan. 4. OTHER DONOR ASSISTANCE 49. In addition to the assistance provided by the project, IMR and UNDP have an ongoing TA program with SAT (about $400,000), under which advice on tax policy and administration reforms is provided in specific areas, such as transfer pricing and VAT S/ The current high domestic inflation in China inflates the domestic price contingencies in dollar terms, as a constant nominal exchange rate is assumed in the calculations. 6/ The costs were estimated at 5 percent of the investment per year for PC-based systems, and 8 percent for mini/medium-size computers. Five years of incremental operating costs were taken into account.  - 13 - Table 2a: PtOJECT COSTS BY OBJECTIES Y Million S Million Local Foreign Total Loal Forcigp Total Tax Adminisftrtio 320. 327.7 648 1 m 23. 76. Institutional Development 38.8 16.6 55.3 4.6 2.0 6.5 Project Implementation Support 3.7 3.5 7.2 0.4 0.4 0.8 Automation 10.6 307.6 318.2 1.3 36.2 37.4 Incremental Operating Costs 267.4 0.0 267.4 31.5 0.0 31.5 Tax Policy 11.0 29.6 405 1. 3. 4. Institutional Development 2.8 18.2 21.0 0.3 2.1 2.5 Policy Support 5.9 7.5 13.4 0.7 0.9 1.6 Automation 0.6 3.9 4.5 0.1 0.5 0.5 Incremental Operating Costs 1.7 0.0 1.7 0.2 0.0 0.2 Intergovermental Fiscal Relations 9i 16.0 21.