Fiscal decentralization

Fiscal decentralization The Chinese financial system, spring 2014 PV Viswanath Lubin school of business P.V. Viswanath

Learning objectives • How did the tax system work prior to reform? • How did it work after reform? • What were the key elements of the 1994 Tax Reform? • What impact did these changes have on the Chinese economy? • How has the Chinese fiscal system affected the different areas of the country? • What is the difference between the center-local split in revenues versus expenditures? • What has been the impact of the fiscal system currently in place on local government indebtedness? P.V. Viswanath

Pre-reform • In the pre-reform period between 1949-1978, there was complete central control over what people produced and consumed. Revenues were collected by local governments and accrued to the center. Local governments were not allowed any spending power. This worked in pre-industrial, agrarian China. • There were no personal and corporate income taxes. Revenues were largely raised from the profit remittances of SOEs, whose profitability was ensured by state-fixed prices. At the end of the 1970s, profits from SOEs accounted for nearly half of total government revenues. • The central government set spending priorities, approved local budgets according to local spending needs, and determined civil service salary scales, pension and unemployment benefits, educational and health care standards etc. • Local income in excess of expenses was submitted to the central government and shortfalls were automatically covered. Local governments had no discretionary spending power. • The central government was responsible for national defense, economic development (capital spending, R&D), universities and research institutes, industrial policy and administration of national institutions. Sub- national governments were in charge of day-to-day public administration and social services such as primary and secondary education, public safety, health care, social security, housing and other local/urban services. P.V. Viswanath

Early post-reform period • After 1979, SOEs were faced with competition from the private sector and from TVEs. Coupled with their innate inefficiencies, this led to reduced fiscal revenues for the government. • As a result, budget revenues reached a minimum at 10.8% of GDP in 1995, with budget expenditures equal to 11.8% of GDP (at all levels of government) and a budget deficit equal to 1% of GDP. This contrasts with government expenditures running an average of 32% of GDP for a sample of 22 developing countries (Hoffman, 1998). • This led to a serious fiscal problem for the Chinese government. • The government engaged in a series of ad hoc solutions marked by SOEs negotiating separate revenue-retention with their supervising agencies on a case-by-case basis. • Tax sharing between local and central governments were also negotiated separately. • Although tax rates were generally set at the central level, each local government provided subsidies and exemptions to favored enterprises and institutions. P.V. Viswanath

Distortions due to tax policy • Since local governments had direct equity interests, or indirect interests in the form of special local taxes or illegal side-payments to local officials, these governments engaged in the expansion of local enterprises such as distilleries and cigarette factories. They also engaged in wasteful duplication of industries, since controlled enterprises would contribute to the local tax coffers, whereas non-local enterprises would not. • Local banks were also forced to provide cheap financing to such enterprises, without regarding to their desirability or profitability. • The central government opportunistically increased taxes on wealthy provinces, which led to decreased incentives to invest as also to hiding of revenues by local governments. • The central government also shifted spending responsibilities to lower levels of government – 45% in 1981 to 72% of total spending in 1993. • This led to a vicious cycle of jurisdictional competition and the central government’s share of revenue fell from 33% in 1988 to 22% in 1993. • In addition, rich provinces like Guangdong, Shanghai and Shandong did well due to their political leverage, whereas poorer regions fared badly. P.V. Viswanath

Central government Revenue and GDP Source: Chunli Shen, Jing Jin and Heng-fuZou, Fiscal Decentralization in China P.V. Viswanath

The 1994 tax sharing reform • As can be seen from the previous figure, the efficiency of tax collection went from bad to worse, down to about 12% of GDP in 1993. • This led to a reform in the way taxes were reckoned and collected. As far as the actual taxes, several changes were introduced. • Value Added Tax (VAT) replaced the turnover-based (i.e. sales based) product tax and was implemented at a uniform rate of 17%. Very small private enterprises without regular bookkeeping systems paid a tax of 6% of gross sales in lieu of VAT. • Corporate income tax was unified to include all domestic enterprises, and the top rate was reduced from 55% to 33%. The previous system of negotiated annual transfers to the government budget from SOEs was eliminated. • Excise taxes (sin taxes) on tobacco, liquor and other luxuries were introduced; these were very productive taxes and were assigned mostly to the central government. P.V. Viswanath

Tax reform and tax revenues • The other important aspects of the new system were as follows: • Negotiated contracts were replaced with a rule-based system of tax assignment; this put central-local revenue-sharing on a more transparent, objective basis and reduced game playing. • In addition to the excise taxes, direct and indirect taxes on central-government controlled sectors (e.g. railroads, financial institutions etc.) were assigned to the central government. • Provincial governments had direct control over direct taxes on local enterprises, real estate and property taxes, and pollution and resources fees. • Most VAT revenues were designated as shared income, with 75% going to the central government and 25% to the local government. • A centralized revenue collection system was established in all provinces to collect central-fixed and shared revenues. This was the National Tax Service (NTS). • The dramatic impact of this tax reform on central government budgetary revenues can be seen in the next figure. P.V. Viswanath

Tax reform and tax revenues P.V. Viswanath

Composition of government revenue • The following figure also shows how the sources of government revenue have changed over time. • At the beginning of reform, revenue from enterprises was as important as tax revenues. • However, over time as competition from the private sector increased, this sources of revenues dropped, until it dropped to almost zero around 1985. • At the same time, government subsidies to loss-making enterprises increased, but with the reforms in SOEs, these have also come down substantially. • Tax revenues continue to be important, accounting in 2007 for about 90% of central government revenues. This number has held steady until today. P.V. Viswanath

Composition of Government Revenue Source: Shuanglin Lin, The Rise and Fall of China’s Government Revenue, East Asian Institute Working Paper no. 150 P.V. Viswanath

Central & local government expenditures • However, the full story is not just about central government revenues. • During the 1985-1993 period, the central government spent about the same share of outlays, 30% or more , as the share of revenues it look in. Although there were transfers in both directions between center and localities, they balanced out almost exactly. Since the 1994 tax reform, the central government takes in a little over 50% of all revenues. However, the central government spends directly about 30% of all expenditures. • Local governments are now dependent on central government transfers that pass on about 20% of total revenues to them. This can be seen starkly in the next figure. • This arrangement enhances the central governments’ overall position and gives it a stronger bargaining position vis-à-vis local governments. • However, about half of the transfers in 2000 were discretionary, ad hoc payments from the center. This caused great uncertainty and led to favoring of richer regions. P.V. Viswanath

Central & local government expenditures Source: Xiao Wang and Richard Herd, The System of Revenue Sharing and Fiscal Transfers in China, OECD Economics Dept. Working Paper no. 1030 P.V. Viswanath

central-local tax revenue transfers • Central transfers in China can be classified into two broad categories: general purpose and specific purpose transfers. • The general purpose transfers consist of a) the tax rebate designed to return a fraction of revenues by origin (province of collection), and b) the equalization transfer (also called the general-purpose grant) established in 1995 as part of an effort to ease widening regional disparities. • Specific purpose grants include: a) grants for increasing wages, b) grants for rural tax reform, c) grants for minority regions, d) subsidies for poor provinces carried over from the pre-1994 system, and e) earmarked grants. • Ear-marked grants have been allocated for specific purposes such as subsidizing agricultural development, supporting infrastructure construction, assisting backward regions, and providing emergency funding for natural catastrophes. As the pie-chart below shows, ear-marked grants were one-third of total transfers in 2004 and many of the other transfers, too, are discretionary. • In the last decade, however, transfers to local governments have been redistributive and has led to less inter-provincial inequality. This can be seen in the graph below. • Furthermore, the five-year plan publicized by the government in 2012 aims to improve basic public services with the goal of equalizing basic public services for everyone by 2020. The Plan sets the scope, standard and mechanism to deliver such services in public education, labor and employment services, social security, social services, health care, population and family planning services and housing services, as well as those related to culture and sports. P.V. Viswanath

Importance of center-local transfers Source: Chunli Shen, Jing Jin and Heng-fuZou, “Fiscal Decentralization in China” P.V. Viswanath

Transfers to provinces and inequality Source: Xiao Wang and Richard Herd, The System of Revenue Sharing and Fiscal Transfers in China, OECD Economics Dept. Working Paper no. 1030 P.V. Viswanath

Local government borrowing • The circumstances described above have led to excessive local government borrowing. In fact, under China’s 1994 budget law, local governments are forbidden to incur either domestic or foreign indebtedness unless otherwise permitted. However, the reality is that many local governments are on the verge of bankruptcy due to debt services. Here are some of the categories of local government debt. • Direct borrowing and loan guarantees. In addition to direct borrowing, many local governments in dire fiscal straits are unable to pay the full salaries of elementary and secondary teachers and this becomes part of local debt. Similarly, some local governments issue baitiao (白条, IOUs) to farmers in payment for their agricultural products. Local governments also provide loan guarantees for SOEs directly or indirectly. • Borrowing from commercial banks. Often local governments can pressure banks to provide loans through the appointment of regional bank heads and through the supply of water and electricity, housing, recruitment of bank employees and schooling of children. P.V. Viswanath

Local government borrowing • Indirect Borrowing. Sub-national governments take on indirect borrowing through local-owned enterprises or through Trust and Investment Companies (TICs). TICs have been used as vehicles for investment in various businesses, particularly construction companies. TICs receive government and enterprise trust deposits, as well investments from wealthy individuals seeking a higher return for their money. These deposits are popular because they are seen as risk-free due to a perceived implicit government guarantee. • According an article published in December 2013, Chinese TICs hold over 9 tr元 in assets under management! “Before 2010, trusts removed risky bank loans from bank balance sheets and repackaged them as securities for banks to sell to customers. When this practice was banned, trusts continued to extend loans themselves or through third parties and sell them to banks to bundle as wealth management products.” The perceived government guarantee comes from the fact that these wealth management products (WMPs) are being sold by banks. • As of the second quarter of 2013, trusts had invested 35% of their funds in infrastructure and real estate projects, and another 21% was invested in financial institutions and products. Only 29% of trusts’ funds are invested in industrial and commercial enterprises—real economy firms that may stand a chance at remaining profitable. For a recent TIC near-bankruptcy, see http://www.forbes.com/sites/gordonchang/2014/01/19/mega-default-in-china-scheduled-for-january-31/ • Though not all TICs are local government creations, they are certainly an important reason for their indebtedness. P.V. Viswanath Source: http://triplecrisis.com/will-chinas-trusts-get-tic-ed/

LOCal government borrowing • Foreign Borrowing: External borrowing by central and local government-owned financial institutions requires a quota from the National Development and Reform Commission (NDRC), as well as approval from the State Administration of Foreign Exchange (SAFE). Nevertheless, many local governments have borrowed abroad using TICs or International Trust and Investment Companies (ITICs, i.e. TICs involved in international borrowing). • Many of these ITICs have gone bankrupt, including Guangdong ITIC in 1999, as well as Fujian ITIC, Tianjin ITIC, Shanghai ITIC, Shenzhen ITIC etc. After the massive GITIC bankruptcy ($4.37 billion in liabilities and only $2.6 billion in assets), foreign investments in ITICs dropped off. However, foreign borrowings are believed to have increased in recent years (according to Soros, see http://macrobits.pinetreecapital.com/continued-financial-stresses-china/) • In any case, the total debt of local governments has soared to $3 tr or about 18 tr元, which indicates a serious problem! http://www.nytimes.com/2013/12/31/business/international/chinese-local-government-debt-up-13-in-6-months.html • The skewed center-local fiscal relations is another aspect of financial repression in China. It also further highlights the urban-rural divide, since as mentioned above, fiscal policy has tended to benefit richer provinces and areas in China. P.V. Viswanath

Themes • Lack of access to sufficient resources in the form of taxes forces the central government to extract resources through financial repression. • The specific fiscal system currently in place engenders agency problems at the local level. Since local governments have to fund local development, local resources are despoiled. There is excessive dependence on debt, and since local government debt is illegal, various destabilizing ways (such as the TICs) are dreamt up to raise monies. • Sub-national responsibility for expenditures and the lack of a voice for the people means that there is extreme myopia in the decisions of local politicians, including pushing farmers off their land for real estate development. • The availability or otherwise of tax revenues affects the amount of government expenditure on social insurance and other needs of the people. • The lack of sufficient tax revenues also means that the government extracts resources in the form of lower bank deposit interest rates coupled with an underdeveloped financial securities market. P.V. Viswanath

Fiscal decentralization