Public finance reform vital

The Third Plenary Session of the 18th Communist Party of China's Central Committee in November will be historically significant as the Chinese leadership is expected to present its strategic vision for the country's socio-economic reform for the next decade.

In 1978, the Third Plenary Session of the 11th CPC Central Committee launched the reform and opening-up policy. In 1993, the Third Plenary Session of the 14th CPC Central Committee adopted the socialist market economy with Chinese characteristics, driven by growth, as its development model. The two plenums put the country on an unprecedented economic reform path and helped transform it into the world's second-largest economy.

The November plenary session has the historical responsibility of delivering a blueprint of reform to realize the Chinese Dream of establishing a moderately prosperous society by 2020. In this pursuit, China's reform initiatives will be challenged by the global economic slowdown, which could exacerbate the country's domestic imbalances.

The Chinese leadership is thus under greater pressure to implement comprehensive reforms to ensure sustainable growth amid the volatile international environment.

The leadership has already taken some important decisions to deepen the structural transformation of the economy. Chief among them is the recent establishment of a pilot free trade zone in Shanghai.

But more far-reaching reforms, especially in fiscal and financial sectors, are expected to be presented and discussed at the November plenum. A greater role for the market in the economy is also likely to be discussed.

While all areas are central for a prosperous China, I would like to highlight the importance of strengthening fiscal policy to support inclusive growth and improve people's living standards.

These important goals are reflected in the 12th Five-Year Plan (2011-2015). which acknowledges the key role fiscal policy plays in narrowing the income gap and supporting economic restructuring toward a more balanced pattern of growth. We at the Asian Development Bank share the Chinese government's vision to make the country's development more inclusive and balanced for the benefit of the Chinese people.

The challenge of designing an efficient fiscal policy has a long history worldwide. Decades ago, major international studies proved an optimal system should minimize distortion, maximize social welfare and correct negative externalities, especially those harming the environment and public health. This fundamental idea is still alive, and the topics are being actively debated in many countries, including China.

China has undergone significant fiscal reforms that have helped build the solid fiscal position it is in today. The current fiscal system is the result of a series of incremental reforms. From the late 1970s until the crucial fiscal reform of 1994, Chinese policymakers have experimented with different approaches to establish a fiscal model compatible with the country's fundamental ideology and its evolving economic model.

Formal nationwide fiscal reforms started in 1984 with the adoption of the Fiscal Responsibility System, which provided local governments with separate budgets and incentives to expand their own revenues. It was followed by the Fiscal Contracting System, designed in 1988 to address some of the issues that arose under the previous system, in particular decreasing fiscal revenue. However, because of its complexity it proved difficult to manage, leading to further drop in revenue collection.

In 1994, the successful Tax Sharing System was introduced, which was aimed at increasing fiscal revenue and the share accruing to the central government. It defined tax collection by central and local governments, and separated tax administration services at the central and provincial levels. It also introduced value-added tax (VAT) as a major source of government revenue. As a result, fiscal revenue has more than doubled as a percentage of GDP in the last 15 years.

But some relevant aspects of intergovernmental fiscal relations were not captured when the Tax Sharing System was designed, including the assignment of expenditure responsibilities and sub-national borrowing. In addition, new challenges have emerged.

Fiscal revenue is largely sourced from indirect taxes, which are regressive, undermining the efforts to balance income distribution. From the production point of view, taxes are biased in favor of manufacturing to the detriment of the service sector, which is subject to double taxation under the existing business tax.

The government has adopted a range of measures to address these challenges. Recent policy actions assigning more responsibility for social security at the central level are welcome. In ADB's view, ongoing pilot reforms - the replacement of business tax by VAT on selected services, and the introduction of a property tax in Shanghai and Chongqing - are important initiatives that need to be further developed.

But more needs to be done. The tax base should be broadened and taxation has to be made more progressive for the sake of social equity. The introduction of green taxation will make the growth model environmentally sustainable.

More importantly, revenue allocation to the local level needs to be aligned with expenditure responsibilities to curtail disparities in public social spending that could perpetuate inequality. Global experience shows that a clear assignment of expenditure responsibilities facilitates a more efficient organization and provision of public services, and helps address fiscal disparities.

Furthermore, increased spending on health, education, and pension will reduce pressure on low-income household budgets, encouraging consumption to balance the sources of growth, and provide the country with social stability and the economy with an important buffer against external shocks.

We at ADB are proud to be supporting ongoing government initiatives in China to develop a public finance strategy to promote inclusive balanced growth. We hope that joint efforts will effectively contribute to the realization of the Chinese Dream. And the Chinese Dream has to be financed through robust public finance reforms to be realized.

The author is director general of East Asia Department, Asian Development Bank.