## wp1888 — Intergovernmental Fiscal Reform in China

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### Introduction and key challenges
- China is a unitary state with a highly complex intergovernmental fiscal system and an exceptional degree of expenditure decentralization.
- Since 1994 a large vertical imbalance between revenue allocation and spending responsibilities has prevailed, causing local governments’ budgetary surpluses to turn into sustained and growing deficits.
- Reform objectives highlighted by authorities include:
  - improve public service delivery;
  - reduce growing regional disparities;
  - promote inclusive growth.
- Structural deficiencies to address: population aging, continuing urbanization, unfunded mandates at subnational level, and proliferation of off-budget activities (especially since 2009).

### Political and administrative structure — implications for fiscal assignments
- Administrative tiers and counts:
  - 5 levels of public administration.
  - 31 provincial level governments (22 provinces, 5 autonomous regions, municipalities of Beijing, Chongqing, Shanghai and Tianjin).
  - 334 prefecture level governments.
  - 2,850 counties.
  - over 40,000 townships.
  - informal village level: 900,000 jurisdictions.
- County-level governments:
  - total expenditures amounting to 9 percent of GDP (largest among all levels).
  - are more reliant on transfers than other levels.

### Historical reforms, 2014 Budget Law, and fiscal decentralization
- 1994 fiscal reform actions:
  - introduced a value-added tax (VAT);
  - centralized a large share of revenues;
  - created the State Administration of Taxation;
  - replaced ad hoc negotiated transfers with rules-based revenue sharing and intergovernmental transfers.
- Revenue trends:
  - overall revenues increased from 12 percent of GDP in 1993 to 22 percent in 2016.
- 2014 Budget Law provisions (selected):
  - requires multiyear budgets and publication of budgets and outturns within 20 days after approval by the People’s Congress;
  - allows provincial governments to issue bonds for capital expenditure (subject to NPC approval);
  - prohibits guarantees and any source of financing other than approved bonds to close off-budget financing channels;
  - requires conditional transfers to be gradually replaced by general transfers.
- Limitation: 2014 law does not address the misalignment of expenditure responsibilities and taxing powers that sustain the vertical imbalance.

### Expenditure decentralization, service delivery and regional disparities
- Local governments account for 85 percent of general government budgetary spending.
- Including off-budget expenditures via LGFVs raises local share to 89 percent of total government spending.
- Key sectoral features:
  - pension system and unemployment insurance managed at the local level.
  - education and health care are extremely decentralized and are the fastest-growing public expenditure categories.
- Social spending coverage and gaps:
  - social assistance spending in China (including urban and rural “dibao”, medical assistance and other programs) is around 0.7 percent of GDP.
  - Emerging markets average: 1.6 percent of GDP.
  - OECD countries average: 2.1 percent of GDP.
  - government health and education spending in China lags other emerging markets and is much lower than advanced economies.
  - projected 300 million new migrants in cities in the next two decades will require removal of barriers from the fragmented system.
- Regional disparities:
  - national average of hospital beds per 1,000 population increased from 1.9 to 3.6 over the last decade.
  - statistical association: a one percent increase in GDP per capita at the county level associated with an extra 0.54 hospital bed in 2004 and 0.96 in 2014.
  - nine years of free public education is now universal; number of teachers per pupil increasing but variance across prefectures has grown.

### Revenues — structure, assignment, and tax-sharing (2015 data)
- Major tax structure points:
  - China relies heavily on the VAT and corporate income tax (CIT), which amount to almost 50 percent of total tax revenues.
  - personal income tax contributes around 5 percent of total revenue in China (compared to OECD average of 25 percent).
  - property and real estate taxes account for around 9.4 percent of total tax revenues, or 2.2 percent of GDP.
  - property taxes are based on physical area and transaction values rather than recurrent market-value assessments.
- 2015 tax-sharing highlights (Share of total taxes; Share of GDP; allocation where specified):
  - Central-only (100/0): Consumption tax — 9.8; 2.3; Vehicle purchase tax — 6.6; 1.5; Tariffs — 1.8; 0.4; Cargo tax — 1.6; 0.4; Intl trade-related consumption tax and VAT — 0.0; 0.0.
  - Shared taxes: Domestic VATa — 55.9; 12.9; allocation 50 / 50. Corporate income tax — 31.8; 7.3; allocation 60 / 40. Personal income tax — 17.1; 3.9; allocation 60 / 40. Stamp tax on securities — 5.4; 1.3; allocation 97 / 3.
  - Sub-national taxes (central 0 / local 100 unless noted): Social security contributions — 34.3; 7.9. Tax on deeds — 21.3; 4.9. Urban maintenance and development tax — 2.5; 0.6. Land appreciation tax — 2.4; 0.6. Urban land use tax — 2.4; 0.6. Tax on the use of arable land — 1.3; 0.3. House property tax — 1.3; 0.3. Resource tax — 1.3; 0.3. Stamp tax on property — 0.7; 0.2. Tax on vehicles and boat operation — 0.6; 0.1. Tobacco tax — 0.4; 0.1.
  - a Includes receipts from the Business Tax, which was replaced by the VAT in May 2016.
- Revenue policy implications:
  - rates and bases for major taxes set by central legislation, limiting local tax autonomy.
  - reliance on revenue sharing increases uncertainty and cyclicality versus rules-based transfers.

### Transfers — composition, trends, and issues
- Transfer types:
  - General-purpose transfers include tax rebate, equalization transfer (established 1995), and other general transfers (finance pension and social security obligations, government wages, public education).
  - Conditional transfers: over 200 programs (around 20 percent of local government revenues), targeting transportation, social housing, agriculture, forestry and water, energy saving and pollution abatement; perceived as opaque and complex.
- Distributional trends:
  - General transfers now account for around 60 percent of total transfers and have become more redistributive.
  - Correlation between transfers per capita and GDP per capita: positive in 2000 (mainly due to tax rebate), turned negative by 2010.
  - Equalization grants currently account for less than half of total transfers; increasing equalization funding could reduce fiscal disparities.
- Local revenue behavior:
  - local governments rely on land sales to finance growing deficits.

### Borrowing, LGFVs, and off-budget activity
- Local deficits and borrowing:
  - pre-transfer budgetary deficits of local governments increased from zero to 10 percent of GDP today.
  - local governments were theoretically forbidden to issue debt but used land sales and off-budget special-purpose vehicles (LGFVs) especially after the 2008/09 stimulus.
- Debt management actions:
  - 2014 budget law revision allowed provincial governments to issue bonds.
  - a debt swap program amounting to 22 percent of GDP converted LGFV debt to local government bonds.
  - since early 2015, provincial governments issued the equivalent of around 15 percent of GDP in government bonds.
  - less developed regions issued higher levels relative to the size of their economy and relied more on short-term debt.
- Emerging instruments and magnitudes:
  - PPP infrastructure projects: capital value around 27 percent of GDP; less than 20 percent were in implementation by end-2016.
  - Government Guided Funds (GGFs) and Special Construction Funds (SCFs) total assets estimated at around 5 percent of GDP.
- Concerns: opacity of GGFs and SCFs, interactions with other public sector units, and incomplete closure of LGFV borrowing “back-door”.

### State Council reform guidelines (August 16, 2016) — scope and projected impacts
- Overarching goals:
  - clarify expenditure responsibilities to minimize overlaps and improve accountability;
  - recentralize key functions currently under local control;
  - consolidate and improve the transfer system, increasing fiscal resources for less-developed regions.
- Timeline and legal framework:
  - authorities intend to complete reform by 2020 and introduce an Intergovernmental Fiscal Relations Act.
- Spending assignment review (2015 estimated shares, percent of budgetary general government spending):
  - Planned shares: Central mandate 13.1; Joint mandate 62.4; Local mandate 24.5.
  - Actuals (examples): Central mandate Total 5.8 central, 7.3 local. Joint mandate Total central 3.1, local 59.3. Local mandate Total central 1.9, local 22.6.
- Expected re-allocation under reform:
  - Re-allocate around 7 percent of government spending (2 percent of GDP) from local to central governments under central mandate.
  - Around 2 percent of total government spending reallocated from central to local under local mandate.
  - Joint mandates account for around 60 percent of total general government spending—about 20 percent of GDP.
  - Role of central government expected to increase from around 3 percent of total spending.
- Transfers under reform:
  - Several targeted transfers—around 40 percent of total transfers in 2015—will be rationalized and consolidated into general transfer payments.
  - Guidelines mention strengthening equalization transfers for least developed regions.
- Borrowing under reform:
  - guidelines largely silent on borrowing frameworks and off-budget LGFV activity; reiterate 2014 principle allowing local bond issuance without detail on limiting implicit guarantees.

### Policy recommendations — expenditures and social programs
- Overarching principle:
  - set policy and financing of social safety nets at the highest feasible level to maximize risk pooling, portability, and redistribution; decentralize administration and implementation where it improves accountability and leverages local information.
- Pensions:
  - consolidate pension systems at the provincial level with local administrative autonomy, or fully centralize financing to eliminate central “gap-filling” transfers.
  - bring legacy pension costs and social pensions onto the central government’s budget.
  - financing from the general budget rather than social security contributions would decrease the tax wedge and reduce labor costs.
- Unemployment insurance:
  - merge local unemployment insurance programs into a single nationwide system to broaden coverage and equity; current coverage: around 40 percent of urban workers and 10 percent of migrant workers.
- Healthcare:
  - reduce fragmentation and low coverage; only around 50 percent of health care spending in China is financed through individual contributions.
  - increase health insurance contributions and central transfers to reduce out-of-pocket expenses.
- Education and social assistance:
  - combine local management and financing with policy coordination and monitoring from central and provincial levels.
  - central/provincial governments should ensure minimum standards for social assistance benefit levels, eligibility, and targeting; central transfers to complement local funds.

### Revenue and transfer design recommendations
- Revenue assignment principles:
  - centralize large and elastic tax bases, relatively mobile bases, and bases that vary significantly across regions.
  - decentralize revenue sources tied to local services and stable bases.
- Specific tax recommendations:
  - Personal Income Tax (PIT): consider allowing provinces to impose a surcharge within centrally-approved upper limit (example cap of 5 to 10 percent mentioned).
  - Corporate Income Tax (CIT): maintain a single national CIT.
  - VAT: maintain national scope; review place-of-collection revenue-sharing and consider simple allocation rules (population or aggregate consumption).
  - Property taxes: ideally introduce a recurrent market-value based property tax; define tax base by national guidelines and allow local rate-setting within central bands.
- Transfers:
  - move toward a rules-based general transfer to reduce pro-cyclicality and improve clarity.
  - increase equalization grants and extend cost-sharing formulas; rationalize conditional transfers and focus conditionality on outputs or service quality.
  - Ministry of Finance reduced number of targeted transfers from 200 to 76 in 2017; further simplification recommended.

### Borrowing, disclosure, and fiscal management reforms
- Bring all off-budget fiscal activities onto the budget by increasing borrowing quotas sufficiently to absorb LGFV activity.
- Operational measures:
  - implement an MTEF to support realistic expenditure policies and clarify local resource envelopes.
  - announce annual quotas for provincial debt issuance earlier in the budget cycle and better communicate allocation criteria.
  - improve planning, disclosure, and early-warning systems that consider repayment capacity and diverse risk types.
- Local borrowing and insolvency framework:
  - when a rules-based framework is established, allow lower-level governments to borrow independently over the medium term.
  - provincial governments should on-lend to sub-provincial governments charging premiums differentiated by financial soundness indicators (publicly disclosed).
  - clarify ex post insolvency mechanisms: define triggers, provisions for collective debt resolution and restructuring, and fiscal adjustment plans to restore sustainability while maintaining essential services and protecting creditor rights.

### Expected outcomes and concluding priorities
- If implemented with clarity and credible funding:
  - reforms could improve social safety nets, raise social spending levels, reduce regional disparities, improve welfare, promote consumption and economic rebalancing.
  - clearer spending and borrowing responsibilities will increase budget transparency and fiscal policy effectiveness.
- Priority reform actions (summary):
  - centralize pensions and unemployment insurance financing (with local administrative roles);
  - enhance fiscal resources for urban areas via general transfers to cover urban migrants;
  - introduce a recurrent market-value property tax and consider provincial PIT surcharges;
  - replace revenue-sharing and tax rebate programs with a rules-based general transfer and expand equalization grants;
  - rationalize conditional transfers toward output-based conditionality;
  - increase borrowing quotas to absorb off-budget spending and bring LGFV activity onto-budget.

*Source: WP/18/88, Intergovernmental Fiscal Reform in China.*

### Section 1

### Intergovernmental Fiscal Reform in China — Section 1

### Introduction
- China is a unitary state with a highly complex intergovernmental fiscal system.
- Since 1994 a large vertical imbalance between revenue allocation and spending responsibilities across levels of government has prevailed.
- A recent intergovernmental fiscal reform plan was announced by the State Council aiming to alleviate this source of misallocation, imbalances and risks.
- A sound system of intergovernmental relations is crucial to:
  - improve public service delivery;
  - reduce growing regional disparities;
  - promote inclusive growth.
- Structural deficiencies in the social security system need to be addressed given population aging and continuing urbanization.
- Reforms to reduce unfunded mandates for subnational governments are essential for recent efforts to improve government borrowing frameworks and contain fiscal risks to succeed.

### Current Situation and Challenges — Overview
- The section provides historical context and highlights:
  - exceptional degree of expenditure decentralization;
  - increase of unfunded mandates at the subnational level;
  - proliferation of off-budget activities, especially since 2009.

### Political and Institutional Features
- China is a unitary state with a multi-tiered government structure; subnational governments are in principle agents of the central government and the appointment of all provincial or ministry level officials is decided by the center.
- Administrative tiers and counts:
  - 5 levels of public administration.
  - 31 provincial level governments (this includes 22 provinces, 5 autonomous regions and the municipalities of Beijing, Chongqing, Shanghai and Tianjin).
  - 334 prefecture level governments.
  - 2,850 counties.
  - over 40,000 townships.
  - An informal village level divides the country into 900,000 jurisdictions.
- County-level governments:
  - bear the largest fiscal mandate, with total expenditures amounting to 9 percent of GDP (the largest among all levels).
  - are more reliant on transfers than other levels of local government.

### Historical Reform Context and Revenue Trends
- The 1994 fiscal reform:
  - introduced a value-added tax (VAT) to replace a number of indirect taxes;
  - centralized a large share of revenues;
  - created the State Administration of Taxation;
  - replaced ad hoc negotiated transfers with rules-based revenue sharing and intergovernmental transfers.
- Revenue impact:
  - overall revenues increased from 12 percent of GDP in 1993 to 22 percent in 2016.
- Effect on local finances:
  - the reform caused local governments’ budgetary surpluses to turn into sustained and growing deficits.

### 2014 Budget Law
- Main goals: improve the budgeting process and the transparency and accountability of local government financing.
- Key provisions:
  - requires the adoption of a multiyear budget;
  - specifies conditions for managing annual deficits and surpluses in a medium-term perspective;
  - allows for the first time provincial governments to issue bonds for financing capital expenditure, subject to approval by the National People’s Congress (pilot programs existed in 2011 and 2014);
  - closes the “back-door” on off-budget activities of local governments by prohibiting guarantees and any source of financing other than through approved bonds;
  - consolidates all existing government budgets into the general government budget and requires publication of budgets and outturns within 20 days after approval by the People’s Congress;
  - requires conditional transfers to gradually be replaced by general transfers to support basic public service delivery and reduce regional disparities.
- Limitation: the 2014 law does not address the misalignment of expenditure responsibilities and taxing powers and the large vertical imbalance that has prevailed since 1994.

### Expenditures — Degree and Composition of Decentralization
- China is the most decentralized country in the world in terms of subnational spending shares.
- Local governments account for 85 percent of general government budgetary spending.
- Including off-budget expenditures financed through local government financing vehicles (LGFVs) raises the local share to 89 percent of total government spending.
- Despite constitutional unitary status, China’s budgetary decentralization ratio exceeds that of many federations.
- Spending assignment and composition:
  - local governments are largely responsible for public service delivery and managing and financing the social safety net;
  - China uniquely has both its public pension system and unemployment insurance managed at the local level;
  - education and health care are extremely decentralized and are the fastest-growing public expenditure categories given aging and urbanization dynamics.
- Without major realignment of expenditure responsibilities, the long-term trend of ever-rising deficits for local governments is likely to continue.

### Social Spending Levels and Coverage
- Coverage improvements:
  - public service delivery is improving and more people are covered by the social safety net, especially for pensions and health insurance.
- Remaining gaps:
  - gaps remain for urban migrants without a residency permit;
  - individual benefit levels are still low.
- Cross-country comparisons of social spending (percent of GDP):
  - Social assistance spending in China (including urban and rural “dibao”, medical assistance and other programs) is around 0.7 percent of GDP.
  - Emerging markets average: 1.6 percent of GDP.
  - OECD countries average: 2.1 percent of GDP.
- Government health and education spending in China lags other emerging markets and is much lower than advanced economies.
- Mobility and urbanization challenge:
  - projected 300 million new migrants in cities in the next two decades will require removal of barriers from the fragmented system.

### Regional Variation and Service Delivery Disparities
- Regional disparities in government spending per capita are increasing; richer counties see the fastest rises.
- Health service example:
  - national average of hospital beds per 1,000 population increased from 1.9 to 3.6 over the last decade.
  - dispersion across counties has grown significantly; more developed counties outpacing poorer ones.
  - statistical association: a one percent increase in GDP per capita at the county level was associated with an extra 0.54 hospital bed in 2004 and 0.96 in 2014.
  - poor access to qualified healthcare personnel is widespread in rural areas and contributes to higher child mortality rates in rural areas compared to urban China.
- Education:
  - nine years of free public education is now universal and the number of teachers per pupil has been steadily increasing;
  - variance across prefectures has increased.

### Revenues — Allocation and Structure
- According to Chinese authorities’ definition of local taxes, local governments collect around 60 percent of total taxes; however, when considering only revenue sources over which local governments have authority to either set rates or define the base, local governments’ share is negligible.
- Major tax policy features:
  - rates and bases for all major taxes are set by central government legislation, limiting local tax policy autonomy.
  - heavy reliance on revenue sharing exposes local governments to higher uncertainty and cyclicality compared to rules-based transfers.
  - reliance on revenue sharing limits autonomy and accountability and can lead to inefficient uses of fiscal resources.
- Revenue classification highlights:
  - consumption (excise) tax, vehicle purchase tax and other trade-related indirect taxes accrue to the central government.
  - the domestic component of the VAT and personal and corporate income taxes are shared according to fixed percentages between the center and local jurisdictions based on place of collection.
  - China relies heavily on the VAT and corporate income tax (CIT), which amount to almost 50 percent of total tax revenues.
  - the personal income tax contributes around 5 percent of total revenue in China, compared to an average of 25 percent among OECD countries, implying limited progressivity.
- Property and real estate taxes:
  - together account for around 9.4 percent of total tax revenues, or 2.2 percent of GDP.
  - this is higher than the average in emerging and developing countries and roughly equal to the average rate of 2 percent for advanced economies.
  - these taxes are based on physical area and transaction values of properties rather than recurrent assessments based on market value.
- Local social security contributions finance local social insurance systems.

*Source: WP/18/88, Intergovernmental Fiscal Reform in China, Section 1.*

### Section 2

### wp1888 - Section 2

### Tax sharing arrangement between central and local governments, 2015
- Tax categories with central collection (central share 100, local share 0):
  - Consumption tax: Share of total taxes 9.8; Share of GDP 2.3
  - Vehicle purchase tax: Share of total taxes 6.6; Share of GDP 1.5
  - Tariffs: Share of total taxes 1.8; Share of GDP 0.4
  - Cargo tax: Share of total taxes 1.6; Share of GDP 0.4
  - Intl trade-related consumption tax and VAT: Share of total taxes 0.0; Share of GDP 0.0
- Shared taxes (explicit center/local splits):
  - Domestic VATa: Share of total taxes 55.9; Share of GDP 12.9; allocation 50 / 50
  - Corporate income tax: Share of total taxes 31.8; Share of GDP 7.3; allocation 60 / 40
  - Personal income tax: Share of total taxes 17.1; Share of GDP 3.9; allocation 60 / 40
  - Stamp tax on securities: Share of total taxes 5.4; Share of GDP 1.3; allocation 97 / 3
- Sub-national taxes (central share 0, local share 100 unless noted):
  - Social security contributions: Share of total taxes 34.3; Share of GDP 7.9
  - Tax on deeds: Share of total taxes 21.3; Share of GDP 4.9
  - Urban maintenance and development tax: Share of total taxes 2.5; Share of GDP 0.6
  - Land appreciation tax: Share of total taxes 2.4; Share of GDP 0.6
  - Urban land use tax: Share of total taxes 2.4; Share of GDP 0.6
  - Tax on the use of arable land: Share of total taxes 1.3; Share of GDP 0.3
  - House property tax: Share of total taxes 1.3; Share of GDP 0.3
  - Resource tax: Share of total taxes 1.3; Share of GDP 0.3
  - Stamp tax on property: Share of total taxes 0.7; Share of GDP 0.2
  - Tax on vehicles and boat operation: Share of total taxes 0.6; Share of GDP 0.1
  - Tobacco tax: Share of total taxes 0.4; Share of GDP 0.1
  - a Includes receipts from the Business Tax, which was replaced by the VAT in May 2016.

### Transfers
- Transfer types and roles:
  - General-purpose transfers include:
    - The tax rebate (compensate local governments after the 1994 and 2001 tax reforms).
    - The equalization transfer (established in 1995 to reduce fiscal disparities across provinces).
    - Other general transfers (finance pension and social security obligations, government wages, public education).
  - Specific-purpose / conditional transfers:
    - Over 200 conditional grant programs.
    - Amount to around 20 percent of local government revenues.
    - Target sectors: transportation, social housing, agriculture, forestry and water, energy saving and pollution abatement.
    - Perceived as opaque and overly complex with high administrative costs.
- Trends and distributional effects:
  - General transfers now account for around 60 percent of total transfers and have become more redistributive.
  - Correlation between transfers per capita and GDP per capita: positive in 2000 (mainly due to tax rebate transfer), turned negative by 2010.
  - Redistribution through intergovernmental transfers improving but does not fully compensate for increase in regional inequality.
- Local revenue behavior:
  - Local governments have come to rely on land sales to finance growing deficits.

### Borrowing
- Post-1994 outcomes and methods:
  - Pre-transfer budgetary deficits of local governments increased from zero to 10 percent of GDP today.
  - Local governments were forbidden from issuing debt in theory, but took on unfunded mandates (notably after the 2008/09 stimulus).
  - Local governments resorted to selling land and using off-budget special-purpose vehicles to borrow and spend on infrastructure.
- Composition and audit findings:
  - By end-2014 total local government debt composition included bank loans, local government bonds, LGFVs bonds, trust loans and other funding sources.
  - Provinces with higher debt burdens relied more on LGFV off-budget financing for infrastructure investment, especially after the 2008/09 stimulus.
- Legal and policy developments:
  - 2014 revision of the budget law allowed provincial governments to issue bonds.
  - A debt swap program amounting to 22 percent of GDP converted LGFV debt to local government bonds.
  - Provincial governments can issue bonds subject to central government approval and can on-lend proceeds to lower levels of government.
  - Since early 2015, provincial governments issued the equivalent of around 15 percent of GDP in government bonds, with less developed regions issuing higher levels relative to the size of their economy and relying more on short-term debt than richer provinces.

### Ongoing challenges and new off-budget vehicles
- Emerging instruments and magnitudes:
  - Infrastructure investment increasingly relies on PPPs financed by policy banks, government funds and other sources.
  - Capital value of such projects is around 27 percent of GDP; less than 20 percent were in the implementation phase by end-2016.
  - Government Guided Funds (GGFs) and Special Construction Funds (SCFs) total assets estimated at around 5 percent of GDP.
- Concerns:
  - Activities of GGFs and SCFs are opaque, interact with other public sector units, and have a strong public policy drive.
  - Efforts to close LGFV borrowing back door remain ongoing and not fully resolved.

### Intergovernmental fiscal reform plans (State Council guidelines, August 16, 2016)
- Overarching goals (three):
  - Clarification of expenditure responsibilities to minimize overlapping mandates, improve service delivery and increase accountability.
  - Recentralization of key functions currently under local government control.
  - Consolidation and improvement of the transfer system, notably by increasing fiscal resources of less-developed regions.
- Timeline and legal framework:
  - Authorities intend to complete the reform by 2020 and introduce an Intergovernmental Fiscal Relations Act to ensure clarity, coherence and predictability and support reforms in education, social security and health care.
  - New legislative and regulatory framework to facilitate budgetary and accounting reforms and improve supervision of local government performance.

#### Expenditures: review of spending assignments
- Three broad categories (2015 estimated shares, percent of budgetary general government spending; details in Table 2):
  - Central mandate: Planned 13.1; Actual Total 5.8 central, 7.3 local
    - Examples: National defense 4.3 (central 4.2; local 0.1), Foreign affairs 0.2 (0.2; 0.0), Management of rivers and lakes in border areas 2.1 (0.1; 2.0), National transportation infrastructure 1.5 (0.1; 1.4), Use and protection of strategic natural resources 5.1 (1.2; 3.9).
  - Joint mandate: Planned 62.4; Actual Total central 3.1, local 59.3
    - Examples: Compulsory and higher education 12.4 (0.6; 11.8), Arts, science, research and development 4.2 (1.3; 2.9), Basic pension insurance 13.2 (0.0; 13.2), Primary medical care and public sanitation 5.7 (0.0; 5.6), Medical insurance 4.9 (0.0; 4.9), Unemployment insurance 0.3 (0.0; 0.3), Social Safety Net, employment and housing 11.7 (0.5; 11.2), Major infrastructure projects across provinces 1.5 (0.1; 1.4), Environment protection and governance 8.4 (0.5; 8.0).
  - Local mandate: Planned 24.5; Actual Total central 1.9, local 22.6
    - Examples: Public service delivery 7.7 (0.7; 7.0), Law and order 4.4 (0.7; 3.7), Municipal and rural transportation 2.9 (0.2; 2.7), Construction and management of public facilities 7.6 (0.0; 7.6), Other 1.8 (0.2; 1.6).
  - Note: The numbers are estimated shares for 2015, in percent of budgetary general government spending.

#### Impact on spending shares
- Expected re-allocation under reform:
  - Re-allocate around 7 percent of government spending (2 percent of GDP) from local governments to the central government (under central mandate), mainly via increased central spending on protection and management of the environment and natural resources and national transportation infrastructure.
  - Around 2 percent of total government spending would be reallocated from the central government to local governments under the local mandate.
- Current structure and uncertainties:
  - Joint mandates currently account for around 60 percent of current total general government spending—or about 20 percent of GDP.
  - The role of the central government is expected to increase from a very small share of around 3 percent of total spending.
  - The State Council’s guidelines provide few details on budgetary impacts; significant uncertainty remains on overall impact on spending shares.
- Transfers under reform:
  - Several targeted transfers—around 40 percent of total transfers in 2015—will be rationalized and consolidated into general transfer payments.
  - Guidelines mention strengthening fiscal resources for least developed and economically vulnerable regions through more reliance on equalization transfers.
  - No substantial changes foreseen in own-revenue allocation beyond new legislation to regularize funding responsibilities and ensure predictability through compliance with the rule of law.
- Borrowing under reform:
  - Guidelines largely silent on borrowing frameworks and off-budget activity through LGFVs.
  - Reiterate broad principle from 2014 revised budget law allowing local governments to issue bonds for approved investment projects; no further details on rules to ensure realistic financing arrangements or on limiting implicit guarantees and moral hazard.

### Policy issues and recommendations
- Focus: policies and design to improve social spending and support intergovernmental fiscal reform.
- Expenditures — Social spending: central considerations
  - Determine appropriate level of decentralization for social spending; distinguish among policy setting, financing, administration/implementation, and monitoring/evaluation.
  - Economic principle: policies and financing of the social safety net should be established at the highest level possible given administrative and political constraints because social safety nets embody insurance and redistribution.
    - Benefits: reduce cost of risk pooling, facilitate portability of benefits, ensure equalized benefits across regions.
  - Decentralization of administrative functions and implementation can improve accountability and leverage local information advantages.
  - Monitoring and evaluation (audits, performance/quality reviews) better performed by central government to ensure national standards—important due to sometimes weak accountability of local governments to residents.
- Social spending by program—international lessons and relevance for China:
  - Pensions:
    - Public pension systems are centralized in virtually all federal countries and usually financed from a national-level payroll tax with harmonized benefit levels.
    - For China: consolidating pension systems at the provincial level, with some local administrative autonomy, could improve risk pooling and portability.
    - Full centralization of financing would eliminate the need for central government “gap-filling” transfers to local administrations running pension deficits.
    - Legacy pension costs and social pensions (not directly tied to workers’ own contributions) should be brought onto the central government’s budget.
    - Financing from the general budget rather than social security contributions would decrease the tax wedge and reduce labor costs.
  - Unemployment insurance:
    - Generally centralized in most countries; exception noted: United States where states manage programs and set eligibility, benefit levels, and employer contribution rates, with federal government contributing financing including through a federal payroll tax.

*Italic source attribution: Sources: CEIC; de Mooij, Lam and Wingender 2017; World Bank and DRC 2014; Wang and Herd 2013; Lam, Wei, and van Eden 2017; Mano and Stokoe 2017; Dagong 2017; SC 2016 No. 49, August 16, 2016; Ahmad, Singh, and Fortuna 2004; Shah and Shen 2008; Shah 1999; Blöchliger and Vammalle 2010; Martinez-Vazquez and others 2008; Escolano and others 2015.*

### Section 3

### wp1888 - Section 3

### Social insurance and public services: pensions, unemployment, healthcare, education, social assistance
- Pensions and unemployment insurance
  - Pooling labor market risks and automatic stabilization functions make a strong case for centralization, stronger than for pensions (Musgrave 1959).
  - Coverage in China is low: around 40 percent of all urban workers and 10 percent of migrant workers covered by unemployment insurance (OECD 2017).
  - Removing residency-based eligibility requirements by merging local unemployment insurance programs into a single nationwide system would broaden coverage and enhance equity.
  - Recentralization of key spending programs—particularly pensions and unemployment insurance—will improve efficiency and welfare, reduce precautionary household saving, increase consumption, and support rebalancing (Barnett and Brooks 2010, Zhang and others forthcoming).  
  - Recentralization will also reduce spending pressures for local government, lower the large vertical imbalance, and reduce the need for off-budget borrowing by local governments.

- Healthcare
  - Optimal decentralization is less clear-cut; preventive and primary care typically provided locally while hospital and specialized facilities at higher levels.
  - Cross-country variation: subnational governments account for more than 80 percent of healthcare spending in Canada, Denmark, Italy, Sweden, Ireland and Finland; France, Greece, New Zealand and the United Kingdom have public healthcare spending almost entirely at the central level (OECD/KIPF 2016).
  - Central government spending shares for healthcare have been increasing since the mid-1990s in several OECD countries (OECD 2016, Saltman 2008).
  - Germany centralized important health care functions in 2009: pooling social health insurance contributions at the federal level, allocating them to private health funds, maintaining employment-based financing with premiums mandatory for pensioners, and using a general tax for some funding; resulted in universal health care coverage administered by subnational social security institutions and financed through national payroll taxes and general tax revenues (OECD 2016).
  - In China, majority of migrant workers remain outside medical insurance; only around 50 percent of health care spending is financed through individual contributions.
  - To catch up with OECD and large emerging countries, China needs to overcome fragmentation and low coverage, increase health insurance contributions, and increase central transfers to reduce out-of-pocket expenses.

- Education
  - Public spending on education is mostly by local governments in many federations; primary and secondary education often delegated to municipal governments, university education more centralized.
  - Harmonization of standards can be imposed by central government or coordinated among local governments; examples: Mexico and United States use central funding to ensure compliance, Germany monitors implementation via independent institutions (Escolano and others 2015).
  - Recommendation: combination of local management and financing with policy coordination and monitoring from central and provincial government levels for China.

- Social assistance
  - Institutional arrangements differ: Australia, Austria, Belgium, and Germany have centrally administrated programs; Brazil’s Bolsa Família managed by the federal government; Canada and Switzerland rely on largely decentralized systems (Escolano and others 2015).
  - In the United States, the federal government sets minimum spending levels and maximum benefit durations; federal transfers fund harmonization.
  - Local administration in China likely benefits from decentralization due to local knowledge, but central and provincial governments must ensure minimum standards for benefit levels, eligibility requirements and targeting, with transfers complementing local funds to promote compliance with national objectives.

### Fiscal implications and resource needs
- Additional fiscal needs and central role
  - Extending access to basic healthcare and social security estimated to require additional spending between 1 and 4.5 percent of GDP (World Bank and DRC 2014).
  - More fiscal resources needed for subnational governments from own-revenues and increased equalization grants, especially in less developed regions and for urban areas to cover costs of public service delivery to urban migrants without residency permits.
  - Reallocation of expenditure responsibilities, if accompanied by appropriate funding, will improve social insurance provision, welfare, consumption, human capital investment, and equity (Jain-Chandra and other forthcoming).

### Need for further clarification on joint mandates
- Some activities better assigned to central government due to economies of scale, externalities, or inefficiencies from decentralization: arts, science, research and development, environmental protection, certain infrastructure projects, income redistribution.
- Clarity of function can matter more than optimal assignment rule; concurrent assignments are common.
- Reform guidelines need further clarity along three dimensions:
  - Determine the level responsible for formulation of policies.
  - Determine appropriate sources of financing.
  - Clarify which level is responsible for implementation and service delivery.
- Unclear delineation can lead to duplication, weak coordination and accountability, excessive spending and waste, or large gaps in services for vulnerable populations (IMF 2009).

### Revenues: principles and specific tax assignments
- Broad principles
  - Centralization recommended for: (1) large and elastic bases for macroeconomic stabilization and income redistribution, (2) relatively mobile tax bases (e.g., corporate profits) to minimize tax competition, (3) tax bases that vary significantly across regions to minimize fiscal imbalances (IMF 2009).
  - Decentralization recommended for revenue sources tied to local services and relatively stable to provide steady predictable streams.

- Specific tax recommendations for China
  - Personal Income Tax (PIT)
    - Consider allowing provinces to impose a surcharge in addition to the national PIT (Ahmad 2011).
    - Potential central cap example: within a centrally-approved upper limit of 5 to 10 percent.
    - Would increase PIT revenue share and tax autonomy of provinces.
  - Corporate Income Tax (CIT)
    - Maintain a single national CIT given high elasticity, pro-cyclicality and volatility of the corporate tax base.
  - Value-Added Tax (VAT)
    - Maintain national scope of VAT.
    - Review revenue sharing arrangements based on place-of-collection to reduce compliance costs for taxpayers with multiple locations.
    - Consider simple allocation rules such as population (Germany) or aggregate consumption (Japan).
  - Property taxes
    - A recurrent market-value based property tax ideal for local governments: immobile base, tied to public service delivery, visible and broadly progressive (Norregaard 2013).
    - Define tax base following national guidelines; allow local governments to set rates within central government bands.

### Vertical fiscal imbalance and own-revenues
- High vertical fiscal imbalance can impair fiscal discipline and efficiency (Eyraud and Lusinyan 2013, European Commission 2012, Sow and Razafimahefa 2015).
- When local governments depend heavily on transfers, harder to impose hard budget constraints; markets may expect central bailouts (Dahlby, 2001).
- China’s exceptional expenditure decentralization calls for larger assignment of own revenues to local governments to maximize decentralization gains.
- Main channels: higher reliance on provincial PITs and local property taxes.

### Transfers: general and conditional
- General transfers
  - Equalization transfers are needed to compensate regions with low tax revenue capacity and enforce national minimum standards (Escolano and others 2015).
  - State Council reform envisages consolidation and simplification of the transfer system and more reliance on general transfer payments.
  - A rules-based general transfer could reduce pro-cyclicality and improve clarity versus current revenue-sharing and tax rebate programs.
  - Current revenue-sharing and tax rebate programs account for around 60 percent of central government transfers to local governments.
  - Equalization grants currently account for less than half of total transfers (World Bank and DRC 2014); increasing the size of the equalization funding pool could reduce fiscal disparities.
  - Cost-sharing formulas recently published by the State Council are a positive step and should be extended.

- Conditional transfers
  - Targeted transfers are complex and costly to administer; Ministry of Finance reduced the number of targeted transfers from 200 to 76 in 2017 (World Bank and DRC 2014).
  - Further rationalization and simplification needed, with conditionality focused more on outputs or quality of services rather than inputs.
  - Central government should improve monitoring capacity and reporting requirements to ensure local delivery meets national minimum standards and objectives.

### Borrowing and expanding the perimeter of government
- Progress has been made in local government debt management, but need to ensure fiscal discipline by minimizing excessive borrowing.
- Borrowing quotas
  - Quotas for local governments should be set high enough to ensure all fiscal spending carried out by LGFVs can be brought onto the budget.
  - Significant increases in borrowing quotas likely necessary to fully absorb off-budget spending given their scale.
  - Recognizing off-budget fiscal activities will improve transparency and make fiscal and aggregate demand implications explicit.
- Operational and institutional measures
  - Improvements in planning and disclosure will align incentives to respect borrowing limits.
  - Operationalization of a medium-term expenditure framework (MTEF) could support realistic and targeted expenditure policies, clarify local resource envelopes, and reduce reliance on off-budget financing.
  - Annual quotas for provincial governments’ debt issuance should be announced earlier in the budget cycle to facilitate planning.
  - Government should better communicate debt issuance allocation criteria for provincial and sub-provincial levels in the annual budget process.
  - Further refine early warning systems to better consider repayment capacity and various types of risk.

*Source: wp1888 - Section 3.*

### Section 4

### wp1888 - Section 4

### Local government borrowing and disclosure
- Over the medium term, when a sound, rules-based framework is established, lower-level governments, such as prefectures and cities, could be allowed to borrow independently.  
- Timely and credible disclosure of local government finances, preferably in the context of the MTEF, would improve oversight and strengthen market discipline by investors and rating agencies.  
- In the meantime, provincial governments should charge sub-provincial level governments premium for on-lending.  
- The rates should be differentiated based on financial soundness indicators, which should also be made public.  
- Footnote: An MTEF is a macroeconomic and institutional framework for setting fiscal and budgetary policies within a multiyear perspective. MTEFs also usually include mechanisms and procedures for ensuring these policies are respected in budget formulation, approval, and execution. See van Eden, Gentry, and Gupta 2017 for further details.

### Insolvency mechanism
- The central government will need to clarify ex post measures to deal with local government insolvency. Key elements should include:
  - (1) the definition of a trigger for the procedure,
  - (2) clear provisions to resolve local government debts collectively and to negotiate debt restructuring, and
  - (3) plans for fiscal adjustment to bring expenditure into line with revenue (IMF 2009).
- The framework must ensure insolvent subnational governments remain able to deliver essential public services during a debt restructuring procedure and eventually regain some level of creditworthiness.
- An insolvency mechanism must also protect creditor rights to reduce borrowing costs and encourage financial market development.

### Conclusion and recommended reforms
- Comprehensive fiscal reform is necessary to ensure China’s government can improve service delivery, increase social spending levels and reduce regional disparities. The State Council’s intergovernmental fiscal reform plan addresses the long-standing misalignment of revenue and spending across levels of government, but further clarity is still needed on a number of spending programs and revenue items.
- In particular, the following reforms should be considered:
  - Pensions and unemployment insurance policies and financing should be centralized, with some degree of local autonomy for administrative functions. This will reduce the cost of risk pooling, improve portability of benefits, and ensure equal benefits across regions.
  - Enhancing fiscal resources for urban areas, notably through increased general transfers, to cover the costs of public service delivery for urban migrants is needed.
  - A recurrent market value-based property tax would be an ideal tax for local governments. China could also consider allowing provinces to impose a surcharge in addition to the national personal income tax.
  - A rules-based general transfer could eventually replace both the revenue-sharing and tax rebate transfers programs. Fiscal disparities across areas could also be reduced further by increasing the size of the equalization grants.
  - Targeted transfers should be rationalized and simplified, with stronger emphasis on outputs or quality of services as opposed to inputs.
  - Borrowing quotas for local governments should be increased while ensuring that all off-budget fiscal spending is brought onto the budget.
- If successful, these reforms will allow China’s government to improve social safety nets and better protect citizens from adverse economic and health shocks. In turn, this would improve welfare and promote consumption and economic rebalancing.
- More clarity in spending and borrowing responsibilities by local governments will also increase transparency of the budget and the effectiveness of fiscal policy. These reforms are challenging, but are crucial to ensure China’s continued development and prosperity.

*Source: wp1888 - Section 4*

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_Source: https://www.imf.org/-/media/files/publications/wp/2018/wp1888.pdf_