Central-local relations at heart of fiscal reform

Analysts expect rollout of general strategy during next Party meeting in November

Reforming the central-local public finance relationship will be the centerpiece of the nation's pending fiscal reform, which is set to be discussed at a key Party meeting in November, analysts said.

China is expected to roll out a broad strategy of economic reform in the Third Plenary Session of the 18th Central Committee of the Communist Party of China. Fiscal and taxation reform lies at the heart of the strategy, and many hopes are being pinned on it.

Finance Minister Lou Jiwei said during the strategic dialogue between China and the United States in July that one aspect of the pending reform is to adjust the expenditure responsibilities of the central and local governments, especially in terms of increasing the central government's spending responsibilities.

"The disparity between local governments' revenue sources and spending responsibilities is the root cause of many economic problems in China," said Ma Haitao, dean of the School of Public Finance at the Central University of Finance and Economics.

"Scholars have called for a change in this system for a long time."

A 1994 overhaul of the nation's fiscal system greatly strengthened the central government's position. A new tax system with a value-added tax at its core laid the foundation for larger and more rules-based transfers to provincial governments. But the change also left China among the most decentralized countries in the world when it comes to government expenditures.

According to a report by the World Bank, local governments take half of the nation's fiscal revenue but are responsible for 80 percent of the spending, in areas ranging from healthcare, education and housing to urban development.

Underfunded local governments have spared no effort to increase their revenue, either by selling land or by issuing de facto government-guaranteed bonds.

Heavy reliance on land sales has given local governments a big stake in the country's property market, which has in turn made them reluctant to rein in skyrocketing home prices.

Meanwhile, local government debt, usually issued without close scrutiny, has risen to a worrying level, although no one knows for certain exactly how much debt is involved.

Ma said that one approach to the reform is to transfer more spending responsibility from local governments to the central government. These responsibilities could include social security, some aspects of healthcare and education.

The central government should also shoulder expenses that involve cross-regional management.

Under the 1994 tax arrangement, the gap between local governments' revenue and spending was partly addressed by a system of intergovernment transfer payments.

But too many of the transfers are earmarked, which has given central ministries great latitude in allocating resources.

Moreover, provincial governments have considerable freedom when it comes to transferring resources to sub-provincial governments.

Besides moving more spending responsibility to the central government, another goal is to boost local governments' fiscal base. Jia Kang, director of the Institute of Research at the Finance Ministry, said at a recent forum that local governments will be given more revenue after the November meeting.

Beijing has already started to establish a solid tax base for local governments. A trial program that replaces the business tax (an important revenue source for local governments) with the VAT is expanding nationwide. The central government is also considering giving a larger share of VAT receipts to local governments, which now get only 25 percent.

Beijing also means to develop the property tax, consumption tax and resource tax into major revenue sources for local governments.

Lou has noted that the reform of the consumption tax is in sight, the property tax trial is due to expand and the resource tax on coal and metals, which had been levied on by volume, will be calculated on a price basis.

Beijing is also expected to open the door gradually for local governments to issue debt directly. That would be a major break from the current provisions of the budget law that bans local governments from borrowing directly from banks.

Reform won't be confined to central-local finance relationships. The November meeting is expected to herald a reform of the Budget Law and giving more discipline to the budget process.

"The motif of the reform is more discipline, more accountability and more transparency," Ma said.

Even with regard to the general budget, there's much room for improvement: The current disclosures are confined to functions, meaning that lawmakers only know how much is spent on "pensions" or "agriculture", without knowing which department spent how much on what.

Transparency-oriented reform demands more than that.