FOCUSED AND QUICK (FAQ) Issue 49
Unraveling China's Fiscal Anatomy
Natta Piyakarnchana & Noppon Boonyaanant Sagnanert
Despite three fundamental reforms in the fiscal structures since its founding in 1949, the PRC continues to suffer from a number of fiscal problems. The current decentralized fiscal system gives considerable autonomy to local governments in deciding its expenditure; however, fiscal resources are concentrated at the central government level. This leads to a mismatch between revenue and expenditure assignments at local levels. As a result, cash-starved local governments often borrow funds off-the-books from the financial system to finance their spending, causing a rapid rise in local government debt and posing risks to the banking sector if the Chinese economy were to slow down. Summary
Fiscal policy, like anything, doesn't always achieve its aim without unintended consequences - especially in China. The Asian juggernaut's decentralized fiscal system and complex intergovernmental relationships complicate policy outcomes and raise questions about the effectiveness of macroeconomic management and fiscal sustainability for the large, but arguably fragile, emerging economy.
In order to understand the evolution of the current fiscal system, it is helpful to touch briefly upon a history of China's fiscal reforms and its intergovernmental structure prior to and following a major tax reform in 1994.
There are roughly three distinct stages in People's Republic of China's fiscal reforms. In the first phase prior to the reform of 1979, the fiscal system was highly centralized with centralized control over sub-national revenue and expenditure assignments. This system was essentially nicknamed "Eating from One Big Pot", an analogy that captures its centralized characteristic (Jin et. al 2004).
During the second phase , the Chinese fiscal system was significantly decentralized from 1979 to 1993 in accordance with a national development strategy that promoted the autonomy of Township and Village Enterprises (TVEs). Local governments were permitted to have more autonomy in investment decisions, commercial regulations, and resource allocations. On the revenue side, there were arbitrary revenue sharing negotiations between the central government and TVEs under a "Fiscal Responsibility System" nicknamed "Eating from Separate Kitchen."
Although this reform enhanced the efficiency of fiscal administration, severe horizontal imbalances occurred when economically advanced coastal provinces could retain a larger share of their wealth than the less affluent neighbors. Additionally, the central government saw a sharp decline in its own revenue as a share of GDP, limiting its powers of fiscal and macroeconomic management.
In the third phase of fiscal reform, the central government sought to remedy regional inequalities and improve economic performance with an overhaul of the tax system in 1994. The reform successfully increased central revenue collection from a low 22% of total budget in 1993 to about 50%.
This time around, reform left expenditure assignments largely decentralized. It is this mismatch of of centralized revenue and decentralized expenditure that is responsible for many of China's fiscal problems today.
The tax reform of 1994 simplified the tax code by specifying revenue assignments to 3 broad categories: taxes exclusive to the central government, shared taxes between central and provincial governments, and taxes exclusive to provincial governments.
The scheme fundamentally shifted the focus of the revenue system away from negotiations to a more standardized tax regime. The result has been a dramatic improvement in revenue collection for the central government since 1994. Moreover, China's fiscal revenue grew at an annual pace of 20% in the last decade and its share of GDP rose steadily from 16% in 2000 to 22% in 2010 (BoA Merrill Lynch, 2011).
While the Chinese fiscal system appears centralized on the revenue side, its expenditure assignments are among the most decentralized in the world. Spending on education, health care, pensions, and unemployment insurance are assigned to governments in prefecture (city), county, and township levels. Local governments are also responsible for investment in infrastructure that supports national economic and social development goals.
Therefore, the central government is responsible for about 20% of public expenditures while 80% are assigned to and implemented by provincial, municipal, and local governments. By comparison, average sub-national government spending accounts for only 32% of total expenditure for developed countries and 16% for developing countries (Dabla-Norris, 2005). Incidentally, public expenditures at subnational levels in China are much higher than in other large federal states such as India, the US, Australia, and Russia.
In theory, decentralization should help governments customize public services more suitably to local needs. However, in practice, decentralized public service provision often yields substandard public services for the populace in underdeveloped regions.
Moreover, this unusual degree of expenditure decentralization combined with a dearth of clearly defined legal responsibilities for each level of government make the Chinese fiscal system rather chaotic. Spending responsibilities tend to be "pushed" downward from higher levels while revenues are "grabbed" by the top. As a result, local governments often suffer from a mismatch between income and expenses. This mismatch has become particularly severe in recent years as local governments' share of total expenditure approached 80% during the aggressive fiscal stimulus in the aftermath of the 2007 global credit crisis.
Local governments in less affluent regions often lack the revenue to meet the fiscal obligations imposed from the center. With limited taxing authority and prohibition from borrowing from the private sector, their only alternative is to borrow from the central government via state-owned development banks, making them dependent on central government lending and transfers.
The differences between high expenditures at the local level and low retained revenue are often made up by intergovernmental transfers. This structure was designed to give the central government tighter fiscal control over subnational entities.
Intergovernmental transfers in China are top-down and can be grouped into 3 broad categories: tax rebates , which favor economically advanced regions; equalizing grants , meant to reduce regional inequality; and earmarked grants , intended to further national development objectives. Over time, the prominence of earmarked grants has effectively increased the central government's control over the funding of sub-national expenditures (World Bank, 2002). However, the topdown structure in which national objectives are imposed on local players suffers from holes in accountability and transparency, leading to a poor assessment of grass-roots fiscal needs.
While the budgetary process is centralized at the Ministry of Finance (MOF), initial estimates come from local and provincial governments. At the planning stage, local governments are responsible for forecasting revenue collection and spending needs. This structure makes sense for practical reasons: the local agents who administer programs have intimate knowledge of their true costs. Budgetary information on revenues and expenditures are aggregated at each level and transferred upward - starting from towns, prefectures, provinces, and finally reaching the central level.
Each layer of budget information, however, adds a new layer of information asymmetry between different levels of government. Because China's fiscal expenditure assignments are considerably decentralized, the consequences of that asymmetry are particularly severe and give local governments incentives to misreport budgetary data. By the time the budget is formed at the central level, detailed accounts of expenditure or revenue at local levels have been lost.
At the review and adoption stage, the MOF combines budgetary needs from lower levels with fiscal mandates from the National Committee of Development and Reforms (NCDR), the state entity that coordinates national development strategy. National investment policy, for example, is incorporated into the budget at this stage. Once a national budget plan that incorporates local needs and broad development goals is finalized, it is submitted to the State Council for approval and then to the National People's Congress (NPC) to legislate.
Most democratic legislatures play a crucial role in analyzing and amending the budget to ensure proper allocation of public funds. The NPC, on the contrary, does not have the resources, information, or authority to amend the budget. It merely legislates what has already been approved by the State Council, the highest governing body in the Chinese government. In other word, the MOF and the NCDR in effect formulate a national budget for themselves without legislative oversight .
Budgetary violations, extrabudgetary activities by local governments, and off-balance sheet financing are among the worst problems emanating from informational asymmetries during budget formulation. Extra-budgetary activities occur when local governments pursue revenue and expenditure activities beyond the activities authorized by the official annual budget.
Year after year, the China's National Audit Office (CNAO) has found that the MOF either did not allocate the entire authorized fund or allocated more than the budgeted amount (Deng and Peng, 2008). For example,
- From 2004 to 2006, the MOF authorized 5.5 billion RMB in unemployment benefits to be sent to state owned enterprise workers that had been laid off but only allocated 285 million RMB (Deng and Peng, 2008);
- In 2006, the MOF added another 81.65 billion RMB (accounting for 12% of total budget) of departmental budget without approval from the legislature. Furthermore, when the CNAO conducted a random test of 9 departments, it found 9.685 billion RMB of the additional fund un-itemized, accounting for as much as 35% of the budgeted expenditure in these departments (CNAO, 2007).
The existence of budgetary violations and extra-budgetary activities undermines fiscal control and lessen the effectiveness of national macroeconomic management. These, however, are not the only things troubling China's finances. Subnational governments in China also engage in off-balance sheet financing, or informal borrowing via state-owned enterprises. Cash-starved local governments commonly borrow funds off-the-books to satisfy expenditures unmet by tax revenue and central government transfers. Although constitutionally prohibited from issuing debt, local governments set up what are called Local Government Funding Vehicles (LGFV) - analogous to special purpose vehicles - to skirt legal constraints and carry on their investment and infrastructure projects. These LGFVs then receive lands from local governments which can be used as collateral to borrow from the financial system.
Several issues have arisen with the prevalence of off-balance sheet financing. First , because the financing activities do not borrow directly the government, they do not appear in the official government accounts, making the actual amount of this debt unknown. Local government debt has been rising rapidly in recent years as a result of China's post-crisis fiscal stimulus package. It is estimated by the CNAO that local government debt including offbalance sheet financing totaled 10.7 trillion RMB ($1.65 trillion) or 27% of China's GDP in 2010. However, some analysts believe that the actual amount could even be higher.
Second , this situation could become a serious problem for the banking sector if the Chinese economy were to slow down. In a cooling Chinese economy, LGFVfinanced investment projects might not generate enough cash flows to cover their debt obligations and the amount of nonperforming loans would increase. It is speculated that 20%-30% of these loans are at high risk of default, particularly loans to smaller localities (Orilik, WSJ, 2011).
Despite its incredible growth in the last two decades, gaps in transparency and accountability reveal the general weakness and fragility of China's fiscal system. While China has undergone a number of remarkable fiscal reforms, more work is needed to reduce the scale of budgetary mismatches and information asymmetries between the national and local levels. Because fiscal policy has been and will continue to be an important driver of the Chinese economy in the foreseeable future, it will be in the interest of the central government to work towards a sound fiscal system by improving its ability to check, balance, and enforce its national budget.
Natta Piyakarnchana Team Executive [email protected]
Noppon Boonyaanant Sagnanert Student intern
International Economics Department Monetary Policy Group
Asian Development Bank, 2010. "The Role of Fiscal Policy in Rebalancing the People's Republic of China"
Bank of America Merrill Lynch. June 2011. "Asia Macro Weekly: China Fiscal Data Supports Proactive Policy"
Bank of America Merrill Lynch. April 2010. "China Economics: LGFV and Government Debt: This Time Is Not That Different"
Bank of America Merrill Lynch. June 2011. "China Macro Watch: China Released Its Audit Result of Local Government Debt"
Dabla-Norris, Era. 2005. "Issues in Intergovernmental Fiscal Relations in China"
Deng, Shulian, and Jun Peng. 2008. "Reforming the
Budgeting Process in China"
Gordon, Roger H., and Wei Li. 2010. "Provincial and Local Governments in China: Fiscal Institutions and Government Behavior"
HSBC Global Research. May 2011. "China Inside Out: Three Big Myth on Credit"
International Monetary Fund (IMF). 2010. "Staff Report for the 2010 Article IV Consultation with the People's Republic of China"
Jin, Jing, and Heng-fu Zuo. 2000. "Soft-Budget Constraint on Local Governments in China"
Kang, Jia, and Liu Wei. 2010. "China's Fiscal Policies during the Post-Crisis Era"
Kuijs, Louis, and Gao Xu. 2008. "China's Fiscal Policy -Moving to Center Stage"
National Audit Office of China. 2010. "Audit Results on the 2009 Annual Budget Enforcement and Other Implementations of Fiscal Revenue and Expenditure of 56 Departments and Units"
National Audit Office of China. 2007. "Audit Work Report on the 2006 Central Budget Implementation and Other Fiscal Revenues and Expenditures"
Orlik, Tom. Wall Street Journal. 27 June 2010. "China Puts a Number on Local Debt"
Shen, Chunli, and Heng-fu Zou. December 2006. "Fiscal Decentralization in China - Potential Next Steps"
Wong, Christine. 2007. "Fiscal Management for a Harmonious Society: Assessing the Central Government's Capacity to Implement National Policies"
Wong, Christine. 2005. "Public Sector Budget Management Issues in China"
World Bank. 2002. "China National Development and Sub-National Finance: A Review of Provincial Expenditures"
Source: Bank of Thailand