ANNALS OF ECONOMICS AND FINANCE 13-1, 1{51 (2012) Fiscal Decentralization in China: History, Impact, Challenges and Next Steps Chunli Shen CEMA, Central University of Finance and Economics, Beijing, China E-mail: [email protected] Jing Jin CEMA, Central University of Finance and Economics, Beijing, China and Heng-fu Zou CEMA, Central University of Finance and Economics Shenzhen University Peking University Wuhan University The World Bank Fiscal decentralization has been a fundamental aspect of China's transition to a market economy, and the country has made substantial effort to break down its highly centralized fiscal management system with various forms of fiscal contracting systems (1978-1993) and later a tax sharing system (1994- present). This paper is aimed to provide a comprehensive review of China's ex- perience in fiscal decentralization, explore the impact of fiscal decentralization on economic growth and public expenditures, and to identify political as well as economic issues arising after the 1994 tax sharing reform. As the government is shifting the development policy towards building a harmonious society, the current fiscal system requires immediate policy attention for its opaque and in- appropriate expenditure assignment, particularly at the sub-provincial levels, the vertical fiscal gap and widening fiscal disparities, the complex and mal- functioning intergovernmental transfer system, the neglected sub-provincial fiscal arrangements, and the weakness in the vertical accountability of local governments to the Center as well as the horizontal accountability of local administrations to local needs and preferences. Key Words: Fiscal decentralization; Fiscal federalism; Public finance; Fiscal policy; Public expenditure; China. JEL Classification Numbers: H1, H2, H3, H5, H7, R5. 1 1529-7373/2012 All rights of reproduction in any form reserved. 2 CHUNLI SHEN, JING JIN, AND HENG-FU ZOU 1. INTRODUCTION The last decade has witnessed a world trend of fiscal decentralization in the developing countries as an escape from inadequate growth and ineffi- cient governance. Fiscal decentralization is widely recognized as an essen- tial component in China's transition to a market economy, and advocated by many for its contribution to the country's remarkable economic perfor- mance over the last 30 years. The country has made substantial effort to break down its highly centralized fiscal management system with various forms of fiscal contracting systems and later a tax sharing system. Although China remains a unitary political system, the current structure of governance bears prominent features of fiscal decentralization. Sub- national governments in China are organized in a four-level hierarchy, with each level of government reporting to the next highest level (see Figure 1). FIG. 1. China: Structure of Government (End of 2005) Source: China Statistical Yearbook 2006. In a comparative perspective, China is much more decentralized than most developing and transition countries, especially on the spending side (table 1). In 2005, more than 70 percent of the entire public expenditure was made at the sub-national levels, in contrast to the average 19.6 percent in developing countries and 22.3 percent in transition economies. This paper is aimed to provide a comprehensive review of China's experi- ence in fiscal decentralization, explore the impact of fiscal decentralization FISCAL DECENTRALIZATION IN CHINA 3 TABLE 1. Fiscal Decentralization Indicators: China vs. Other Countries Indicator China Developing Transition OECD Countries Economies countries Subnational share of 48 16.6 18.4 19 government revenue Subnational share of 74 19.6 22.3 32 government expenditure Note: Data for China are for 2005. Data for other countries are for various years and adapted from Shah (2004). on economic growth and public expenditures, and to identify political as well as economic issues arising after the 1994 tax sharing reform. The paper is divided into six main parts: the second section provides a historical overview of China's fiscal decentralization before 1994; the third section briefly summaries the economic and political background of the 1994 reform; the 1994 tax sharing reform and its impact are examined in the fourth section; the next section focuses on the existing expendi- ture and revenue assignments of the fiscal system; the in-depth analysis of the intergovernmental transfer system is presented in the sixth section; the following section addresses various issues related to local government financing, including local taxes and local borrowing; the eighth section as- sesses the shifting of fiscal power between the central government and local governments through decentralization; the debate over the impact of fiscal decentralization on economic growth is highlighted in the ninth section; the tenth section discusses political and economic issues induced by the fiscal decentralization reforms; and the paper concludes that the time is ripe for significant amendment and reforms of the existing fiscal arrangements, and lists potential policy options for consideration. 2. A HISTORICAL REVIEW OF FISCAL DECENTRALIZATION BEFORE 1994 A good knowledge of the history and process of China's fiscal decentral- ization is indispensable to understand the challenges facing the country's intergovernmental fiscal system today. This paper therefore opens with a thorough review of the major changes in China's fiscal system since the inception of the People's Republic in 1949. This survey is divided into three periods: the pre-reform fiscal system of 1949-1978; the ad-hoc decen- tralization of 1979-1993; and the tax assignment system, in operation from 1994 to the present. For each period, the fiscal system is reviewed under 4 CHUNLI SHEN, JING JIN, AND HENG-FU ZOU three themes|tax assignment, expenditure assignment, and the intergov- ernmental transfer system. (1) 1949 | 1978 Pre-Reform Fiscal System: Central Control System The centralization of planning, finance, and administration dominated the first 30 years of the People's Republic (1949-78). It was a system in which all decisions about what people needed were decided from the top. Revenues were collected by local governments and accrued to the center. The consolidated budget system forbad discretionary spending power for local governments. And in the context of the pre-industrial, agrarian, and under-developed conditions then prevailing in China, the central planning system worked (Lardy 1978; Oksenberg and Tong 1991; Riskin 2000; Wong 2000; Wong, et al. 1995). Tax System The tax system was crude, with no personal or corporate income taxes. Revenues were largely raised from the profit remittances of state-owned enterprises (SOEs), whose profitability was ensured by state-fixed prices. At the end of the 1970s, profits from SOEs accounted for nearly half of total government revenues. Although the provinces participated in raising revenues, their expenditures were budgeted by the center. Tax administration was simple since there were relatively few taxpayers, and those few were mainly SOEs. Tax collection was delegated to local governments. Given fixed prices and planned output and sales, the accounts of SOEs were easy to monitor and their revenues were easy to determine (Wong 2000). Expenditure and Budget Expenditures were essentially determined at the center. Under the con- solidated budget system, the central government set spending priorities, approved local budgets according to local spending needs, and determined civil service salary scales, pension and unemployment benefits, educational and health care standards, etc. In the absence of independent budgets, sub-national governments lacked discretionary spending power. They were budgetary units identical to SOEs | merely agents of the central govern- ment. With respect to expenditure assignment, the central government was re- sponsible for national defense, economic development (capital spending, R&D, universities and research institutes), industrial policy, and adminis- tration of national institutions. Sub-national governments were in charge of delivering day-to-day public administration and social services such as primary and secondary education, public safety, health care, social security, housing, and other local/urban services. FISCAL DECENTRALIZATION IN CHINA 5 The Intergovernmental Transfer System: Fiscal Gap Transfers Since local finance came from the central budget, intergovernmental transfers were set to finance the gap between locally collected revenues and permitted local expenditures. In other words, local income in excess of expenses was submitted to the central government, and shortfalls were automatically covered. This revenue-sharing system was highly redistribu- tive: for example, while Shanghai gave up 80-90 percent of its collected revenues, Guizhou was able to finance more than two-thirds of its expen- ditures from central subsidies (Wong 2000). The pre-reform fiscal system was simple and effective in the particular context, but it was completely lacking in fiscal incentives for local gov- ernments or enterprises. As China's leaders set their sights on a market economy from 1979 onward, the mechanisms of the planned economy | including monopoly state ownership of industry, administrative prices, and central economic planning | were dismantled, and accordingly the fiscal system quickly broke down. For example, the foundation of the pre-reform fiscal system | profits from state-owned enterprises | collapsed in the face of the burgeoning non-state sector, growing competition