In August 2016, China’s Ministry of Finance released an important guideline to promote the reform of the division of labor between the central and local governments in financing and providing public services.1 According to this guideline, the current intergovernmental fiscal system is going to be overhauled by 2020.
One of the major issues regarding the current central-local fiscal relation is the mismatch between local governments’ fiscal capacity and their expenditure responsibility. In recent years, local governments have been responsible for over 80 percent of government expenditure, while being assigned only about 50 percent of government revenue. Figure 1 shows this mismatch between revenue assignment and expenditure responsibility. In 2015, local governments accounted for over 86 percent of total government expenditure but received only about 54 percent of total government revenue.
Figure 1. Local Governments’ Share in Total Government Budgetary Revenue and Expenditure
Source: Finance Yearbook of China & Budget Reports, various years.
Mismatch between Local Fiscal Capacity and Expenditure Responsibility
The mismatch between local fiscal capacity and expenditure responsibility in China is extraordinary, as compared to other countries. The central government in many other countries usually has a larger expenditure responsibility. For example, in the United States, the share of subnational government expenditure including state and local government expenditure in total government expenditure was about 45 percent in 2010.2 The number was 56 percent in Switzerland, 48 percent in Sweden, 38 percent in Germany, 66 percent in Canada and 28 percent in Britain.3 Also, the expenditure responsibility of local government in many other countries is usually lower than the case in China. For example, the average share of local government in government expenditure in developing and transitional countries was estimated to be about 20 percent in 2004 (Shen et al., 2012).
The mismatch between local fiscal capacity and expenditure responsibility is a result of the intergovernmental fiscal system, defined by the fiscal reform in 1994. First, the current fiscal system highlights the importance of two ratios, the ratio of government revenue to GDP and the ratio of central government in total government revenue. To increase the ratio of central government in total government revenue, a tax sharing system has been established with clearly defined tax bases for the central and local governments. Major tax revenue has been assigned to the central government. The most important tax base, Value Added Tax, has been assigned as shared tax, with 75 percent going to the central government and 25 percent to local governments.
Second, the current fiscal system delegates the responsibility for providing and financing public services, upgrading infrastructure, funding administrative services, as well as maintaining local public security to the local governments. To a large extent, the current fiscal system has achieved the main objectives conceived in the 1994 fiscal reform. In particular, the 1994 fiscal reform redefined fiscal relations between the central and local governments, where central government has the major claim of fiscal revenue while the local governments shouldered the larger portion of expenditure. Also, central-local fiscal transfers have been increased very quickly to improve local governments’ fiscal capacity. In 2007, central-local transfers amounted to RMB 1.81 trillion while central-local transfers amounted to about RMB 5.5 trillion in 2015.4
Provision and Financing of Public Services under Current Fiscal System
To incentivise local governments to fulfil their expenditure responsibilities, the central government has employed a performance evaluation system for local officials known as the Target Responsibility System. Local officials have to sign target responsibility contracts with the upper level governments. The promotion or demotion of local officials is based on their achievement of these targets and tasks, as well as comparisons with their peers in other local governments. It is widely believed that this has affected the promotion of local officials as their performance is largely based on the growth of GDP or fiscal revenue (Li and Zhou, 2005; Shih et al., 2012).
Under this performance evaluation system, local governments are more likely to compete for the most rewarding indexes such as GDP growth. Local officials have largely resorted to boosting land sales and infrastructure construction to project a glorious picture of economic prosperity. To attract investments, local governments transfer land at below market rates to investors. Sometimes, local governments may also offer tax breaks of three years or five years to investors. In many cases, local fiscal capacity is not enough to finance all infrastructure projects and local governments have to borrow from banks and other investment platforms. Local government debt has now reached phenomenal levels, hitting over RMB 15.4 trillion (an increase of 41.3 percent from RMB 10.9 trillion in June 2013) by the end of 2014, which is equivalent to about 203 percent of local fiscal revenue in 2014.5
In this context, since public service provision is less rewarding in the performance evaluation system compared to the growth of GDP and fiscal revenue, local public services are likely to be under-financed and under-provided in localities with relatively low fiscal capacities. For example, a United Nations Development Program report published in August 2016 showed that regional inequality in public service provision including health, education, and poverty alleviation is very serious in China.6 For example, high school enrollment is particularly low in many western provinces, while the disparity in life expectancy is very large. The gap of life expectancy between Shanghai and Tibet was over 12 years in 2010.7
Government Initiatives to Reform the Fiscal System
In the August 2016 guideline, redefining the expenditure responsibilities for the central and local governments has been explicitly discussed. First, the expenditure responsibility of the central government for providing public services is going to increase moderately. Public services including national defense, foreign affairs, and prevention of national infectious diseases are considered as responsibilities of the central government. Second, local governments’ expenditure responsibilities include financing and providing public services including local public security, local transportation, and local community issues. Third, the shared expenditure responsibilities between central and local governments include financing and providing public services such as education, health care, social security, and environmental protection.
Importantly, in the future, the budget allocation among different levels of governments will be set based on their expenditure responsibilities. In other words, the central government is likely to allocate more funds from its budget for shared responsibilities such as education, pensions, and health care. Also, the reallocation of expenditure responsibilities is going to be implemented with other reforms in the areas of education, health, and pensions. The above reforms are expected to be implemented before 2020.8
Challenges for the Reform
There are two major challenges that need to be addressed in this reform. First, in the guideline, there is no concrete plan for reforming the tax sharing system. If the tax bases for the central and local governments remain the same in the future, this reform will have to be financed by central-local fiscal transfers. How to design the intergovernmental fiscal transfer system to match the expenditure responsibilities for the different levels of government is an important issue that needs to be addressed.
Second, to be compatible with the expenditure responsibilities of the different levels of government, how the performance evaluation system for local officials may be adjusted is another major concern. The provision and financing of public services are highly related to the local officials’ incentive structure, and the performance evaluation for local officials must take into account the responsibilities of the different levels of government.
1. Guideline clarifies fiscal responsibilities. (2016, August 25). China Daily. Retrieved from http://www.chinadaily.com.cn/china/2016-08/25/content_26589434.htm
2. The rest of the budget is allocated from the Federal Budget.
3. OECD database.
4. Ministry of Finance, China. (n.d.). Tax rebates and transfer payments in general public budget from central government to local governments, 2015. Retrieved from http://yss.mof.gov.cn/2015js/201607/t20160713_2354962.html
5. National People’s Congress approved the 2015 local government debt limit of 16 trillion yuan. (2015, August 29). Xinhuanet. Retrieved from http://news.xinhuanet.com/politics/2015-08/29/c_1116414320.htm
6. UNDP China. (2016, August 21). China national human development report 2016. Retrieved from http://www.cn.undp.org/content/china/en/home/library/human_development/china-human-development-report-2016.html
7. For a detail discussion about the inequality of accessing basic public services in China, see Qian (2014).
8.State Council, China. (2016, August 24). State Council guidelines on promoting the reform of central and local fiscal powers and expenditure responsibilities. Retrieved from http://www.gov.cn/zhengce/content/2016-08/24/content_5101963.htm
Li, H., and Zhou, L.-A. (2005). Political turnover and economic performance: The incentive role of personnel control in China. Journal of Public Economics, 89(9–10), 1743–1762.
Qian, J. (2014). Social cohesion and equalization of basic public services in China: Achievements and future challenges, in Hofmeister, W., Rueppel ,P. et. al. (eds.), Social Cohesion: Addressing Social Divide in Europe and Asia. Singapore: Select Books.
Shen, C., Jin, J. and Zou, H. (2012). Fiscal decentralization in China: History, impact, challenges and next steps. Annals of Economics and Finance, 13(1), 1–51.
Shih, V., Adolph, C. and Liu, M. (2012). Getting ahead in the Communist Party: Explaining the advancement of Central Committee members in China. American Political Science Review, 106(1), 166–187.