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|Fiscal decentralization is widely recognized as an essential component in China’s remarkable transition to a market economy. However, the intergovernmental fiscal system is now hitting a few snags—increasing regional disparities, proliferation of off-budgetary funds, deficient and unequal public services delivery, farmers’ financial burden, and rural unrest. What happened? And what happens now?|
In his report to the Tenth National People's Congress in March 2006, Premier Wen Jiabao stressed the importance of hexie shehui (harmonious society). This shift toward fairness and equity among the poor and economically marginalized was the topic of a June 2006 forum organized by the government in partnership with the World Bank in Beijing on "Public Finance for a Harmonious Society." The conference, with its main focus on reshaping intergovernmental fiscal relations, reflects the commitment from China's leadership to revamp fiscal decentralization system as key policy areas in building a harmonious society. 
A retrospective view
China has made substantial efforts to break down its highly centralized fiscal management system (1949-1978) using various forms of fiscal contracting systems (1979-1993) and later a tax-sharing system (1994-present). Reforms in the 1980s and early 1990s were aimed at promoting local economic local governments' responsibilities and their autonomy in carrying out fiscal functions. The strategy did boost local growth in many regions, but it also brought many unintended problems including declining general government revenues, waning fiscal position of the overall government, weakening macroeconomic management, and rising regional disparities.
The 1994 Tax Sharing Reform was initiated as the first attempt to fix the problems of the intergovernmental fiscal system through the introduction of the Tax Assignment System (fenshuizhi), which explicitly defined central taxes, shared taxes, and local taxes. The tax structure was also simplified, and tax administration was split into National Tax Services and Local Tax Services.
China is much less decentralized than it appears
The government of China is organized in a five-tier hierarchical structure (central, provincial, prefecture, county, and township) with each level of government reporting to the next highest level. Sub-national governments have been given considerable latitude in shaping local policies and managing fiscal resources. About 70 percent of the entire public expenditure was made at the sub-national levels and over 55 percent at sub-provincial levels in 2004.
However, China is much less decentralized than what appears on the surface. The center exerts substantial control over localities through an intergovernmental fiscal system, several binding expenditure laws, and numerous expenditure mandates, as well as its political control. After the 1994 reform, sub-national governments became largely dependent on their shares of central taxes and grants. In 2003, they financed 67 percent of provincial, 57 percent of prefecture, and 66 percent of county and lower-level government expenditures.
Fiscal dependence at the local level, combined with a hierarchical party structure and the absence of national elections, has emboldened predatory behavior by the upper-level governments. The resulting local fiscal stress and deficient, unequal public service delivery have attracted massive attention.
Financial pressures on local governments have intensified since the introduction of the tax-sharing system in 1994
The 1994 Tax Sharing Reform re-centralized revenues without cutting local expenditures. The centralizing of revenues upward and devolving of expenditures downward occur at each level at the expense of the subordinate governments.
The regressive outcome contributes to deteriorating fiscal vertical imbalances and leaves the lowest level of government—particularly those in the rural sector and poor regions—financially starved. The vertical fiscal gap by administrative levels in 2003 is shown in figure 1.
Local governments play an essential role in providing social services such as education, health care, social security, housing and urban/local services. In 2004, sub-national governments together financed 90 percent of public spending on education, 95 percent on health care, and 85 percent on social security. Many local governments, especially those in poor western regions, are providing fewer and lower quality public services and passing along a higher proportion of these costs to their constituents.
The current system of intergovernmental transfers is failing to address the financing of local public services and regional fiscal disparities
The composition of central to local transfers in 2004 is depicted in figure 2. The three largest transfers—revenue sharing transfers (469.5 billion yuan), tax rebate (404.97 billion yuan) and earmarked grants (322.33 billion) amounting to more than 80 percent of total central-provincial transfers—were largely designed to recognize the vested interests of localities.Meanwhile, the equalization grant (74.5 billion yuan), equal to about 5 percent of the total, was not sufficient to address public service delivery needs at the local level.
The distribution of per capita central transfers by province in 2004 (figure 3) shows that Shanghai, the richest province, was the highest recipient of central transfersper capita(5,079 yuan) and Henan was the lowest (646 yuan), with the national per capital averagein between at1,117 yuan.
Potential next steps in building a harmonious intergovernmental fiscal system
Given the objectives of easing local fiscal stress and promoting sufficient and equitable local public services, the way forward will require significant modification and reforms of the existing intergovernmental fiscal system.
A healthy and wide public debate on potential steps forward could include the following steps [ 3]:
Setting up formal and stable expenditure assignments to clarify the responsibilities of governments might include ensuring that local government expenditures focus on public services and social affairs while central government expenditures focus on national issues such as national defense, foreign affairs, economic development, and mitigating regional inequalities in public services and social affairs; and building broad and formal coordinating institutions to deal with concurrent and overlapping assignments.
Aligning the fiscal system to guarantee all citizens access to basic public services might include making it the central government's responsibility to guarantee all citizens access to basic public services by setting national service standards (Canada shows national minimal standards of public services can significantly improve national cohesiveness); and equalizing transfers to address regional disparities in the ability of lower-level of governments to provide services.
Providing sound local autonomy to improve local fiscal capacity might include building revenue autonomy around a balance between devolution of responsibilities according to economies of scale, the internalization of costs, and available administrative capacity; exploring an asymmetric approachthat allows major cities and other local governments with more developed capacity to introduce reforms; increasing the share rates of local government in major taxes such as the value added tax and income taxes; and continuing to reform the tax system such that each level of government has a stable tax base and main taxes, either exclusively or shared with other governments.
Formalizing the local borrowing system to support sustainable development might include decentralizing the authority of local borrowing to jurisdictions with reasonable fiscal capacity; and applying central control on local borrowing. Standardizing intergovernmental transfer to meet the goals of governments might include focusing central transfers on improving the quality of public services against national standards and focus provincial transfers on achieving equity of local service provision; and improving the transparency of transfers.
The findings, interpretations, and conclusions expressed in this brief are entirely those of the authors. They do not necessarily represent the view of the World Bank, its Executive Directors, or the countries they represent.
Heng-fu Zou is a Senior Economist in the Development Research Group (Human Development and Public Services Team). His current research interests include public economics, economic growth, savings, and income distribution in China, India, Nepal, Sudan, and African countries. Email c/o firstname.lastname@example.org
Chunli Shen is a World Bank consultant. She has written on budgeting and fiscal decentralization and co-edited Fiscal Federalism and Fiscal Management (CITIC China 2005), Local Public Finance and Governance (CITIC China 2005), and Regional Disparities in China (People's Publishing House China 2006).
1. This article is based on Chunli Shen, Jing Jin, and Heng-fu Zou, “Fiscal Decentralization in China: History, Impact, Challenges, and Next Steps,” processed, 2006. [draft]
2. Anwar Shah and Chunli Shen, "Fine Tuning the Intergovernmental Transfer System to Achieve a Harmonious Society and A Level Playing Field for Regional Development in China," processed, 2006.
3. Jorge Martinez, Baoyun Qiao, Shuilin Wang, and Heng-fu Zou, “China Decentralization Finance Issues: Lessons from International Experiences,” Development Research Group, World Bank, Washington, D.C., processed, 2006.