## _wp0530

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---

### Introduction
- Since the 1980s, China’s system of intergovernmental fiscal relations (IFR) has evolved amid significant economic restructuring.
- Important modernization steps cited:
  - Establishment of a separate state tax administration.
  - Introduction of the Budget Law in 1994.
- Reforms in IFR have been gradualist and incremental; design and implementation have not kept pace with transition to a market economy.
- Past reforms often responded to immediate problems with ad hoc short-term fixes, which:
  - May create further distortions.
  - Require fiscal adjustments that are often not made.
  - Fail to capture interrelationships among expenditure and revenue assignments, intergovernmental transfers, and subnational borrowing and debt.
- Growing concern that the current system is unable to effectively:
  - Allocate resources in line with national goals.
  - Redress regional disparities.
  - Strengthen macroeconomic management.
- Paper objectives:
  - Review developments in IFR over the past two decades and assess previous reforms’ success.
  - Identify key existing weaknesses undermining objectives and analyze why reforms have been difficult.
  - Discuss how alternative instruments, procedures, rules, and incentives could yield better outcomes drawing on cross-country experiences.

### Background — Pre-1994 intergovernmental finance system
- Evolution described in two stages:
  - Decentralization in the early reform years (1980s).
  - Recent recentralization since the mid-1990s.
- Pre-reform period: revenue collection was highly centralized; local governments remitted most tax revenues to the center and received transfers for expenditures from the national budget.
- The 1980s reforms:
  - Decentralized the revenue sharing system.
  - Granted local governments greater autonomy in investment approval, entry regulation, and resource allocation.
  - Contributed to remarkable growth of township and village enterprises (TVEs), which:
    - Contributed to local economic development.
    - Played a crucial role in providing local public goods.
- Fiscal contracting system (“eating from separate kitchens”):
  - Intended to incentivize local governments to collect revenue and pursue economic prosperity.
  - Devolution of regulatory authority and high marginal revenue retention rates at provincial levels aligned local government and business interests.
  - Effectiveness varied geographically and sectorally; incentives worked especially in a handful of coastal provinces.
  - Empirical evidence on the decentralization–growth relationship over this period is mixed.

### Fiscal outcomes and imbalances (key statistics)
- Central government revenue share:
  - Fell from 39 percent to 22 percent in 1993.
  - This 22 percent share in 1993 is noted as much lower than the average for developing and industrial countries generally.
- Overall revenue collections:
  - Declined from a high of 31 percent of GDP in 1978 to 11.2 percent in 1994.
- Expenditure share of subnational governments:
  - Increased from about 49 percent in 1979 to over 67 percent in 1990.
- Regional/horizontal imbalances:
  - Per capita income convergence across provinces declined since 1985.
  - Net remittances from wealthier provinces declined sharply; example:
    - Shanghai in 1993 turned over only about 8.5 percent of its GDP.
- Additional figures and trends:
  - By 1993, the share of TVEs in national industrial output rose to 36 percent from 9 percent in 1978.
  - Rural fee reform raised agricultural tax from an average of 2 percent to 7 percent and added a surcharge of 20 percent earmarked for village associations.

### 1994 tax reform: measures and immediate outcomes
- Reform objectives: strengthen macroeconomic performance, achieve regional equalization and efficient public goods provision; arrest fiscal decline; simplify the tax system; eliminate distortions; modify revenue assignments; shift from ad hoc negotiated transfers to transparent rule-based revenue assignments.
- Key measures introduced in 1994:
  - Introduction of production-based value-added tax (VAT).
  - Reassignment of taxes to create “central fixed incomes,” “local fixed incomes,” and shared VAT revenue.
  - Establishment of a separate state tax administration to collect central and shared taxes.
  - Establishment of general purpose equalization transfers.
- Fiscal outcomes and key statistics post-reform:
  - Total revenue collections increased to over 18 percent of GDP in 2002.
  - Central government share of total budget revenue rose from a low of 22 percent in 1993 to around 50 percent in 2002.
  - Central transfers as a share of GDP rose from 1.5 percent in 1993 to about 6 percent in 2001.
  - In 2002:
    - Share of local governments in total budget revenue was about 45 percent, but they accounted for 70 percent of total budget expenditures.
    - Central government transfers financed 48 percent of local expenditures and over 43 percent of subnational revenues.
  - Revenue composition: VAT and EIT along with the business tax account for about 70 percent of total provincial government revenue.
  - In 2002, the ratio between the highest and lowest per capita budgetary revenue collections was 15.9.
  - Selected 2002 Income Per Capita (In RMB): Shanghai 33,285; Beijing 22,577; Tibet 7,760; Guanxi 5,092; National average 1/ 9,255.
  - Selected 2002 Per Capita Budget / Revenues / Expenditures (RMB): Shanghai Budget 4,362.8 / Revenues 5,307.0; Guangdong Budget 1,529.0 / Revenues 1,935.5; Sichuan Budget 336.5 / Revenues 809.0; Guizhou Budget 282.2 / Revenues 825.3; Beijing Budget 3,752.6 / Revenues 4,415.7.
  - Local government-controlled extrabudgetary funds averaged around 58 percent of local budget revenues in 2002.
  - Subsidies for civil service wage increases rose from RMB 89.2 billion in 2001 to RMB 175.5 billion in 2002.
  - Subsidies to local social security schemes increased from RMB 34.9 billion in 2000 to RMB 51.2 billion in 2002.
  - Government’s 2002 Audit Report: at the end of 2001, 49 cities and counties had a total of RMB 1.6 billion in debt, equivalent to 2.1 times their disposable financial resources for that year.
  - As of September 2002, 42 counties and townships had RMB 1.8 billion in arrears — more than three times their arrears in 1998.

### Key weaknesses in the current IFR system
- Expenditure assignments
  - No formal, legal assignment of expenditure responsibilities at the subprovincial level; high incidence of concurrent expenditure assignments.
  - Local governments carry heavy responsibilities for education, health services, unemployment insurance and social security while having limited revenue autonomy.
  - Ratio of provincial governments’ expenditures to their own revenue rose from about 103 percent in 1991 to around 180 percent in 2002.
  - Local governments account for over 90 percent of total spending in culture, education and health, and for virtually all social relief and welfare expenditure, including pensions decentralized to the county level.
- Revenue assignments
  - Marked differences in revenue generating capacity across provinces and within provinces at the local level.
  - “Revenue-returned” transfers and derivation-based revenue-sharing for VAT and EIT favor richest provinces.
  - The 1994 reform did not provide a specific revenue assignment structure at the subprovincial level; “ownership” principle dominates.
- Intergovernmental transfers
  - Specific purpose (earmarked) grants represent a growing share of transfers and are often ad hoc and discretionary.
  - Equalization fund averaged around 1 percent of GDP in 1997–2001.
  - Revenue-returned transfers remain dominant, accounting for over 40 percent of overall transfers.
- Fiscal management
  - Official coverage of subnational fiscal activities remains incomplete; lack of systematic comprehensive management of direct and contingent liabilities at local level.
  - Credible system of sanctions and penalties to enforce fiscal discipline is absent; deduction from central transfers undermined by bailouts and gap-filling transfers.
  - Subnational indirect borrowing and contingent liabilities through locally owned companies and SOEs are substantial and poorly monitored.

### Implications of the current system
- Vertical imbalances between the center and subnational governments widened during 1994–2001, with a notable negative vertical imbalance for subnational governments.
- The mismatch between expenditure and revenue assignments and inadequate transfers has:
  - Led to difficulties financing basic services, particularly in poorer provinces.
  - Reinforced regional disparities in fiscal spending and service provision.
  - Increased out-of-pocket expenditures:
    - Healthcare out-of-pocket share rose from 16 percent in 1980 to 61 percent in 2001.
    - Education out-of-pocket rose from 2.3 percent to 12 percent between 1990 and 1998.
- The informal system (extrabudgetary activities, off-budget financing, arrears, indirect borrowing) undermines transparency, accountability, and macroeconomic management; creates fiscal risks and soft budget constraints.

### Recommendations and policy options
- Institutional and strategic recommendations
  - Establish national consensus on decentralization objectives and core functions of different government levels; consider a high level commission including budget, tax, and planning authorities and local government representatives to set reform sequencing.
  - A comprehensive reform should ensure local revenue bases, intergovernmental transfers, and local borrowing authority are commensurate with expenditure responsibilities assigned to different levels of government.
  - Comprehensive and centralized monitoring of subnational operations is required.
- Expenditure assignment reforms
  - Clear and explicit assignment of expenditure responsibilities between levels of government.
  - Reassign pension and unemployment insurance responsibilities to national or provincial levels; at minimum, pool pensions at provincial level.
  - Relieve subprovincial governments of unfunded mandates; higher-level governments to finance mandates directly or provide compensating transfers.
  - Use performance monitoring, conditionality on block grants, and matching grants carefully; avoid open-ended gap-filling block grants.
  - Assign central and provincial partial financing responsibilities for education and health; consider formula-based equalization transfers that account for expenditure needs.
- Revenue assignment and tax reform
  - Reform VAT from production-type to consumption-type (C-VAT) to address export competitiveness, deduct capital expenditures, and eliminate cascading; Ahmad and others (2004b) estimate average provincial revenue loss from such a move to be in the 10 to 30 percent range depending on collection efficiency.
  - Compensation option: increase the share of VAT assigned to local governments; a revenue-neutral increase in provincial VAT share would need to be in the range of 30 to 36 percent, with severe budgetary implications for the center (center losing over a third of its current collections under this option).
  - Another option: extend VAT to all services and eliminate the cascading business tax collected by local governments; this could largely offset C-VAT losses but would have distributional consequences and change central/subnational revenue allocations.
  - Granting provinces and counties greater control over rates of assigned taxes at the margin can strengthen linkage between expenditure and revenue decisions and subnational fiscal accountability.
  - Personal Income Tax (PIT) reforms: split the current PIT into two different taxes and grant provinces bounded control over a number of percentage points above the uniform national tax rate; current share of PIT revenues in total tax revenues is around 3 to 4 percent (compared with 11 percent in countries of the former Soviet Union).
  - Property tax: strengthen the property tax at the county level, including enhanced valuation and recording mechanisms and basing annual taxes on the annual lease value equivalent.
- Intergovernmental transfers
  - Reduce reliance on ad hoc specific-purpose grants; expand and design equalization transfers to better address horizontal disparities.
  - Consider converting earmarked grants into equalization grants where appropriate.
  - Increase size and targeting of equalization fund beyond the previous average of 1 percent of GDP in 1997–2001.
  - Make transfers determined objectively and openly, ideally by well-established formulae rather than discretionary negotiation.
- Subnational borrowing and fiscal management
  - Allow fiscal-responsible borrowing for long-term investment if proper safeguards are in place: clear rules, comprehensive information, and credible sanctions.
  - Adopt rules-based approaches: borrowing only for capital purposes, overall debt and debt service limits, mandatory risk-based credit ratings, compulsory collateralization where appropriate.
  - Strengthen monitoring and oversight of local government operations and contingent liabilities to ensure fiscal discipline.
  - Extend budgetary and treasury management reforms comprehensively to subnational governments; improve reporting and management of extrabudgetary funds with the eventual aim of integrating them into the budget.
  - Use international precedents for enforcement where applicable: debt restructuring contracts with state participation in costs, legal bans on discretionary central guarantees, financial penalties, bankruptcy laws, and administrative takeovers.
- Political economy considerations
  - Political resistance to recentralization of significant revenue bases (e.g., VAT accounted for over 20 percent of total tax revenues in 2002) is likely and must be managed.
  - Options to increase equalization funding include eliminating or phasing out revenue-returned transfers, or freezing them while expanding equalization transfers; both choices carry distinct political economy trade-offs.
  - Center assuming inappropriate expenditure assignments (e.g., pensions) and granting more own-source revenues to subnational governments can reduce opposition.

### Tax assignment and revenue re-centralization (specific estimates and options)
- Eliminating VAT-sharing and recentralization of the VAT could provide the center with additional resources to the tune of 1.5 percent of GDP.
- A revenue-neutral increase in provincial VAT share would need to be in the range of 30 to 36 percent.
- Ahmad and others (2004b) estimate average provincial revenue loss from converting to C-VAT to be in the 10 to 30 percent range depending on collection efficiency.
- The business tax accounted for an average of 24 percent of local “own revenues” before tax rebates in 2000, but was as high as 37 percent in Beijing.
- The EIT accounted for an average of 13 percent of local revenues, but was 20 percent or more for a number of provinces including Beijing, Shanghai, Tianjin, and Zhejiang.

### Subnational borrowing, monitoring, and international precedents
- International enforcement and regulatory examples:
  - Brazil’s 1997 federal bailout required states to sign debt restructuring contracts, bear part of bailout costs, imposed interest penalties for noncompliance, and allowed states to use constitutionally mandated transfers as collateral for new bonds.
  - Mexico’s 2000 subnational debt regulatory framework included a legal ban on discretionary central government transfers and guarantees for states, mandatory risk-based credit ratings for all subnational loans, and compulsory collateralization of subnational loans.
  - Other enforcement mechanisms: financial penalties (Brazil’s Fiscal Responsibility Law, 2000), bankruptcy laws (Hungary, South Africa), administrative takeovers (Germany, US).
- Rules-based approaches (examples: United States, Japan) include strict rules and regulations for borrowing only for capital purposes, overall debt and debt service limits.
- Where debt ceilings are absent (examples: South Africa, Czech Republic), hard budget constraints enforced by legally prohibiting central government guarantees of subnational debt and state guarantees of public enterprise debt can be used.

### Conclusions and reform strategy
- Incremental reforms have fallen short of achieving a sound and effective system of intergovernmental fiscal relations (IFR); a comprehensive reform is needed to:
  - Recalibrate IFR to better align and formalize revenue and expenditure assignments at subnational levels.
  - Achieve greater equity in fiscal resource distribution.
  - Strengthen central fiscal management.
  - Increase accountability.
- A comprehensive reform would require:
  - Ensuring local revenue bases, intergovernmental transfers, and local borrowing authority are commensurate with expenditure responsibilities assigned to different levels of government.
  - Comprehensive and centralized monitoring of subnational operations.
- The failure of the 1994 reforms to provide adequate equalization and a transparent, efficient transfer system suggests that a comprehensive approach will make politically difficult reforms easier to undertake than isolated changes.
- A gradual approach may be warranted, but the overall reform package must be consistent and account for the interrelationships between IFR elements, the tax system, and institutional and technical capacities of different government levels.

*Source — Excerpt from the IMF working paper text provided in the content unit.*

### References..............................................................................................................

### _wp0530 - References..............................................................................................................

### Introduction
- Since the 1980s, China’s system of intergovernmental fiscal relations (IFR) has evolved amid significant economic restructuring.
- Important modernization steps cited:
  - Establishment of a separate state tax administration.
  - Introduction of the Budget Law in 1994.
- Reforms in IFR have been gradualist and incremental; design and implementation have not kept pace with transition to a market economy.
- Past reforms often responded to immediate problems with ad hoc short-term fixes, which:
  - May create further distortions.
  - Require fiscal adjustments that are often not made.
  - Fail to capture interrelationships among expenditure and revenue assignments, intergovernmental transfers, and subnational borrowing and debt.
- Growing concern that the current system is unable to effectively:
  - Allocate resources in line with national goals.
  - Redress regional disparities.
  - Strengthen macroeconomic management.
- Paper objectives (as described in the source):
  - Review developments in IFR over the past two decades and assess previous reforms’ success.
  - Identify key existing weaknesses undermining objectives and analyze why reforms have been difficult.
  - Discuss how alternative instruments, procedures, rules, and incentives could yield better outcomes drawing on cross-country experiences.

### Background — Pre-1994 intergovernmental finance system
- Evolution described in two stages:
  - Decentralization in the early reform years (1980s).
  - Recent recentralization since the mid-1990s.
- Pre-reform period: revenue collection was highly centralized; local governments remitted most tax revenues to the center and received transfers for expenditures from the national budget.
- The 1980s reforms:
  - Decentralized the revenue sharing system.
  - Granted local governments greater autonomy in investment approval, entry regulation, and resource allocation (Oi, 1995).
  - Contributed to remarkable growth of township and village enterprises (TVEs), which:
    - Contributed to local economic development.
    - Played a crucial role in providing local public goods (Qian, 2002).
- Fiscal contracting system (“eating from separate kitchens”):
  - Intended to incentivize local governments to collect revenue and pursue economic prosperity.
  - Devolution of regulatory authority and high marginal revenue retention rates at provincial levels aligned local government and business interests (Qian and Weingast, 1996; Qian and Roland, 1999).
  - Effectiveness varied: incentives worked especially in a handful of coastal provinces due to FDI flows, entrepreneurship traditions, and soft financial budget constraints on enterprises (Young, 2000; Tsai, 2004).
  - Empirical evidence on the decentralization–growth relationship over this period is mixed (Zhang and Zou, 1998; Lin and Liu, 2000; Jin, Qian and Weingast, 2003).

### Fiscal outcomes and imbalances (key statistics preserved)
- Central government revenue share:
  - Fell from 39 percent to 22 percent in 1993.
  - This 22 percent share in 1993 is noted as much lower than the average for developing and industrial countries generally (see Table 1 in source).
- Overall revenue collections:
  - Declined from a high of 31 percent of GDP in 1978 to 11.2 percent in 1994 (Ahmad and others, 2002).
- Expenditure share of subnational governments:
  - Increased from about 49 percent in 1979 to over 67 percent in 1990.
  - This share is characterized as much higher than in most federations (see Table 1 in source).
- Regional/horizontal imbalances:
  - Affluent provinces benefited disproportionately from the negotiated fiscal contract system.
  - Per capita income convergence across provinces declined since 1985 (Raiser, 1998).
  - Net remittances from wealthier provinces declined sharply; example figures:
    - Shanghai in 1993 turned over only about 8.5 percent of its GDP.
    - Guandong (Guangdong) exhibited a similar sharp decline in remittances (exact percentage for Guangdong not specified in the supplied excerpt).

### Analysis of systemic weaknesses (as framed in the source)
- Key weaknesses undermining IFR objectives include:
  - Piecemeal reform approach that neglects interdependencies across IFR elements.
  - Lack of a transparent, rules-based system that would instill sound incentives.
  - Constraints on the central government’s ability to conduct macroeconomic management due to reduced central revenue share and persistent deficits.
  - Exacerbation of regional fiscal disparities driven by the structure of revenue sharing and transfers.

### Agenda for reform (themes discussed in the source)
- The paper aims to explore how alternative:
  - Instruments,
  - Procedures,
  - Rules, and
  - Incentives
  could yield better outcomes, drawing upon cross-country experiences. Specific reform proposals and detailed prescriptions are presented in subsequent sections of the source beyond the provided excerpt.

*Source: Excerpt from the IMF working paper text provided in the content unit.*

### 0.4 percent of its GDP – over this period with a resultant decline in subsidies to poor regions

### _wp0530 - 0.4 percent of its GDP – over this period with a resultant decline in subsidies to poor regions

### Background and 1994 tax reform
- By 1993, the share of TVEs in national industrial output rose to 36 percent from 9 percent in 1978 (Chen and Qian, 1998).
- In 1985, half of the after-tax profits of TVEs were reinvested and the half were used for local public expenditure (Qian, 2000).
- The 1994 tax reform objectives: strengthen macroeconomic performance, achieve regional equalization and efficient public goods provision; arrest fiscal decline (raise the two revenue ratios), simplify the tax system, eliminate distortions, modify revenue assignments, and shift from ad hoc, negotiated transfers to transparent rule-based revenue assignments.
- Key measures introduced in 1994 included:
  - introduction of production-based value-added tax (VAT);
  - reassignment of taxes to create “central fixed incomes,” “local fixed incomes,” and shared VAT revenue;
  - establishment of a separate state tax administration to collect central and shared taxes;
  - establishment of general purpose equalization transfers.

### Fiscal outcomes and key statistics
- Total revenue collections increased to over 18 percent of GDP in 2002.
- Central government share of total budget revenue rose from a low of 22 percent in 1993 to around 50 percent in 2002.
- Central transfers as a share of GDP rose from 1.5 percent in 1993 to about 6 percent in 2001 (Ahmad and others, 2004b).
- In 2002:
  - share of local governments in total budget revenue was about 45 percent, but they accounted for 70 percent of total budget expenditures.
  - central government transfers financed 48 percent of local expenditures and over 43 percent of subnational revenues.
- Revenue composition and regional disparities:
  - VAT and EIT along with the business tax account for about 70 percent of total provincial government revenue.
  - In 2002, the ratio between the highest and lowest per capita budgetary revenue collections was 15.9.
- Table highlights (selected figures from source):
  - Income Per Capita (In RMB) 2002: Shanghai 33,285; Beijing 22,577; Tibet 7,760; Guanxi 5,092; National average 1/ 9,255.
  - Per Capita Budget / Revenues / Expenditures (RMB) 2002 (selected): Shanghai Budget 4,362.8 / Revenues 5,307.0; Guangdong Budget 1,529.0 / Revenues 1,935.5; Sichuan Budget 336.5 / Revenues 809.0; Guizhou Budget 282.2 / Revenues 825.3; Beijing Budget 3,752.6 / Revenues 4,415.7.
- Extrabudgetary funds:
  - Local government-controlled extrabudgetary funds averaged around 58 percent of local budget revenues in 2002 (World Bank, 2002).
- Arrears and indebtedness:
  - Subsidies for civil service wage increases rose from RMB 89.2 billion in 2001 to RMB 175.5 billion in 2002.
  - Subsidies to local social security schemes increased from RMB 34.9 billion in 2000 to RMB 51.2 billion in 2002 (World Bank, 2003).
  - Government’s 2002 Audit Report: at the end of 2001, 49 cities and counties had a total of RMB 1.6 billion in debt, equivalent to 2.1 times their disposable financial resources for that year.
  - As of September 2002, 42 counties and townships had RMB 1.8 billion in arrears — more than three times their arrears in 1998.

### Key weaknesses in the current intergovernmental fiscal relations (IFR) system
- Expenditure assignments
  - No formal, legal assignment of expenditure responsibilities at the subprovincial level; high incidence of concurrent expenditure assignments.
  - Local governments carry heavy responsibilities for education, health services, unemployment insurance and social security while having limited revenue autonomy.
  - Ratio of provincial governments’ expenditures to their own revenue rose from about 103 percent in 1991 to around 180 percent in 2002 (IMF, 2004).
  - Local governments account for over 90 percent of total spending in culture, education and health, and for virtually all social relief and welfare expenditure, including pensions decentralized to the county level.
- Revenue assignments
  - Marked differences in revenue generating capacity across provinces and within provinces at the local level.
  - “Revenue-returned” transfers and derivation-based revenue-sharing for VAT and EIT favor richest provinces.
  - The 1994 reform did not provide a specific revenue assignment structure at the subprovincial level; “ownership” principle dominates.
  - Rural fee reform raised agricultural tax from an average of 2 percent to 7 percent and added a surcharge of 20 percent earmarked for village associations in exchange for eliminating rural fees and charges.
- Intergovernmental transfers
  - Specific purpose (earmarked) grants represent a growing share of transfers and are often ad hoc and discretionary.
  - Equalization fund averaged around 1 percent of GDP in 1997–2001.
  - Revenue-returned transfers remain dominant, accounting for over 40 percent of overall transfers.
- Fiscal management
  - Official coverage of subnational fiscal activities remains incomplete; lack of systematic comprehensive management of direct and contingent liabilities at local level.
  - Credible system of sanctions and penalties to enforce fiscal discipline is absent; deduction from central transfers undermined by bailouts and gap-filling transfers.
  - Subnational indirect borrowing and contingent liabilities through locally owned companies and SOEs are substantial and poorly monitored.

### Implications of the current system
- Vertical imbalances between the center and subnational governments widened during 1994–2001, with a notable negative vertical imbalance for subnational governments shown in Figure 3 (in percent of GDP).
- The mismatch between expenditure and revenue assignments and inadequate transfers has:
  - led to difficulties financing basic services, particularly in poorer provinces;
  - reinforced regional disparities in fiscal spending and service provision;
  - increased out-of-pocket expenditures: healthcare out-of-pocket share rose from 16 percent in 1980 to 61 percent in 2001; education out-of-pocket rose from 2.3 percent to 12 percent between 1990 and 1998 (Kanbur and Zhang, 2003).
- The informal system (extrabudgetary activities, off-budget financing, arrears, indirect borrowing) undermines transparency, accountability, and macroeconomic management; creates fiscal risks and soft budget constraints.

### Recommendations and policy options
- Establish national consensus on decentralization objectives and core functions of different government levels; consider a high level commission including budget, tax, and planning authorities and local government representatives to set reform sequencing.
- Expenditure assignment reforms
  - Clear and explicit assignment of expenditure responsibilities between levels of government.
  - Reassign pension and unemployment insurance responsibilities to national or provincial levels; at minimum, pool pensions at provincial level.
  - Relieve subprovincial governments of unfunded mandates; higher-level governments to finance mandates directly or provide compensating transfers.
  - Use performance monitoring, conditionality on block grants, and matching grants carefully; avoid open-ended gap-filling block grants.
  - Assign central and provincial partial financing responsibilities for education and health; consider formula-based equalization transfers that account for expenditure needs.
- Revenue assignment and tax reform
  - Reform VAT from production-type to consumption-type (C-VAT) to address export competitiveness, deduct capital expenditures, and eliminate cascading; Ahmad and others (2004b) estimate average provincial revenue loss from such a move to be in the 10 to 30 percent range depending on collection efficiency.
  - One compensation option: increase the share of VAT assigned to local governments; a revenue-neutral increase in provincial VAT share would need to be in the range of 30 to 36 percent (Ahmad and others, 2004b), with severe budgetary implications for the center (center losing over a third of its current collections under this option).
  - Another option: extend VAT to all services and eliminate the cascading business tax collected by local governments; this could largely offset C-VAT losses but would have distributional consequences and change central/subnational revenue allocations.
- Intergovernmental transfers
  - Reduce reliance on ad hoc specific-purpose grants; expand and design equalization transfers to better address horizontal disparities.
  - Consider converting earmarked grants into equalization grants where appropriate; example cited: in 2001 around RMB 4 billion of subsidies for food in urban areas were transferred into transitory equalization grants.
  - Increase size and targeting of equalization fund beyond the previous average of 1 percent of GDP in 1997–2001.
- Fiscal management and oversight
  - Strengthen comprehensive budget reforms at subnational levels to control off-budget and extrabudgetary funds and consolidate them into the budget process.
  - Implement systematic monitoring and regulation of subnational indirect borrowing; create credible enforcement mechanisms and sanctions to prevent circumvention of central fiscal rules.
  - Improve coverage and transparency of subnational fiscal activities and contingent liabilities to reduce fiscal risks and soft-budget behavior.

*Italic: Source — _wp0530 - 0.4 percent of its GDP – over this period with a resultant decline in subsidies to poor regions*

### 1.3 to 2.7 percent of GDP. The additional revenues could then be redistributed to provinces

### _wp0530 - 1.3 to 2.7 percent of GDP. The additional revenues could then be redistributed to provinces

### Tax assignment and revenue re-centralization
- Eliminating VAT-sharing and recentralization of the VAT could provide the center with additional resources to the tune of 1.5 percent of GDP.
- Recentralization would:
  - Reduce economic distortions.
  - Improve inter-jurisdictional fairness.
  - Significantly increase central government share of revenues and enhance scope for redistribution and stabilization.
- Political resistance is likely because VAT accounted for over 20 percent of total tax revenues in 2002 and is relatively important to local government revenues.
- The business tax accounted for an average of 24 percent of local “own revenues” before tax rebates in 2000, but was as high as 37 percent in Beijing.

### Enterprise Income Tax (EIT) issues
- The EIT is currently shared between the center and provinces, is marked by tax preferences, and has large differences in the treatment of domestic and foreign enterprises, which:
  - Encourages unfair competition among enterprises.
  - Adds to the complexity of the tax system.
- The EIT is widely considered to be inappropriate for tax sharing.
- The EIT accounted for an average of 13 percent of local revenues, but was 20 percent or more for a number of provinces including Beijing, Shanghai, Tianjin, and Zhejiang.

### Subnational tax autonomy: PIT and property tax reforms
- Granting provinces and counties greater control over rates of assigned taxes at the margin can strengthen linkage between expenditure and revenue decisions and subnational fiscal accountability.
- International experience suggests limited marginal autonomy is often preferable to full recentralization (examples: Russia, Mexico).
- Personal Income Tax (PIT):
  - Arguments for standardizing the PIT base exist.
  - Piggybacking on the existing PIT, as is done in Brazil and Canada, would provide provinces greater flexibility.
  - Reform could split the current PIT into two different taxes and grant provinces bounded control over a number of percentage points above the uniform national tax rate.
  - The current share of PIT revenues in total tax revenues of around 3 to 4 percent compares unfavorably with the 11 percent share in the countries of the former Soviet Union.
  - In OECD countries, PIT represented 27 percent of total revenues in 1998 (noted as a less meaningful comparison for China).
- Property tax:
  - Strengthening the property tax at the county level, including enhanced valuation and recording mechanisms for leasehold policies and basing annual taxes on the annual lease value equivalent, should be considered.
  - Both PIT piggybacking and strengthened property taxation would provide significant revenues to wealthier coastal provinces and larger cities.

### Transfers and equalization
- The current intergovernmental transfer system in China has some equalizing elements but is not explicitly designed to reduce disparities in unmet expenditure needs or fiscal capacity.
- The funding for the current system of equalization grants in China is inadequate to address widening regional disparities.
- Options to increase equalization funding:
  - Eliminate revenue-returned transfers (inherently regressive) and replace them with equalization transfers — would give the central government the largest scope for redistribution but may be politically inopportune.
  - Freeze revenue-returned transfers at current levels without compensation through equalization transfers, with a view to phasing them out — partially offsets political economy drawbacks but provides less redistribution scope.
  - Political opposition could be reduced by the center assuming currently inappropriate expenditure assignments (e.g., pensions) and by granting more own-source revenues to subnational governments.
- Implementing equalization objectives at subnational levels:
  - Direct central transfers to county-level administrations is administratively feasible (example: Ukraine).
  - Alternatively, the central government could provide mandatory rules and frameworks to provincial governments to enable provinces to furnish county-level equalization grants.
- Transparency and formula-based allocation:
  - Transfers should be determined as objectively and openly as possible, ideally by some well-established formula, not by hidden political negotiation and discretion.
  - Accommodating all special purpose programs within the equalization framework or instituting more effective monitoring of existing special purpose programs would enhance transparency.
  - Specific purpose transfers provide central flexibility but can discourage subnational efficiency and make it easier for subnational governments to blame shortfalls on inadequate central funding.
- International examples:
  - Mexico and Brazil have eliminated most discretionary transfers; conditional grants used as incentives tied to result-oriented responsibilities.
  - Canada provides equalization transfers, program-specific transfers, and a block grant (the Canada Health and Social Transfer) that provides an equal per capita grant determined transparently by the central government.
  - In Brazil, the FPM – a special fund for municipalities – uses demographic and economic variables; specifically, 10 percent of the fund is distributed to the capital of each state, and the rest to municipalities; within these shares, the coefficient of each municipality is determined by two criteria: the state to which the municipality belongs and the size of its population.

### Subnational borrowing and fiscal management arrangements
- Allowing subnational borrowing depends critically on:
  - Proper incentives for local governments to comply with rules.
  - Availability of comprehensive information on subnational activities and borrowing.
  - Credible sanctions when criteria are breached.
- Fiscal-responsible borrowing for long-term investment could accommodate vast subnational infrastructure needs if appropriate safeguards are in place.
- Rules-based approaches (examples: United States, Japan) include strict rules and regulations for borrowing only for capital purposes, overall debt and debt service limits.
- Where debt ceilings are absent (examples: South Africa, Czech Republic), hard budget constraints enforced by legally prohibiting central government guarantees of subnational debt and state guarantees of public enterprise debt can be used.
- Strengthening monitoring and oversight of local government operations and contingent liabilities is required to ensure fiscal discipline.
- International precedents for enforcing discipline:
  - Brazil’s 1997 federal bailout required states to sign debt restructuring contracts, bear part of bailout costs, imposed interest penalties for noncompliance, and allowed states to use constitutionally mandated transfers as collateral for new bonds.
  - Mexico’s 2000 subnational debt regulatory framework included a legal ban on discretionary central government transfers and guarantees for states, mandatory risk-based credit ratings for all subnational loans, and compulsory collateralization of subnational loans.
  - Other enforcement mechanisms used internationally include financial penalties (Brazil’s Fiscal Responsibility Law, 2000), bankruptcy laws introducing judicial sanctions (Hungary, South Africa), and administrative takeovers by higher-level government or independent boards (Germany, US).
- Budgetary and treasury management reforms in China:
  - Ongoing reforms should be extended comprehensively to subnational governments, involving wider monitoring of fiscal activities and a more open and transparent budget process.
  - The current piecemeal approach compares unfavorably with reforms in Central and Eastern Europe and the former Soviet Union, where coordinated reform designs or budget codes were articulated for all public sector levels.
  - The current system makes it difficult for the central authority to monitor outlays and track use of intergovernmental fiscal transfers.
  - Given the size and importance of subnational extrabudgetary funds, eliminating them (as in Hungary and Kazakhstan) may be difficult; short run focus should be on improving reporting and management of these funds with eventual aim of integrating them into the budget.

### Conclusions and reform strategy
- Incremental reforms have fallen short of achieving a sound and effective system of intergovernmental fiscal relations (IFR); a comprehensive reform is needed to:
  - Recalibrate IFR to better align and formalize revenue and expenditure assignments at subnational levels.
  - Achieve greater equity in fiscal resource distribution.
  - Strengthen central fiscal management.
  - Increase accountability.
- A comprehensive reform would require:
  - Ensuring local revenue bases, intergovernmental transfers, and local borrowing authority are commensurate with expenditure responsibilities assigned to different levels of government.
  - Comprehensive and centralized monitoring of subnational operations.
- The failure of the 1994 reforms to provide adequate equalization and a transparent, efficient transfer system suggests that a comprehensive approach will make politically difficult reforms easier to undertake than isolated changes.
- A gradual approach may be warranted, but the overall reform package must be consistent and account for the interrelationships between IFR elements, the tax system, and institutional and technical capacities of different government levels.

*Source: IMF Working Paper content (extracted unit).*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2005/_wp0530.pdf_