China in Transition
Adjusting the Fiscal Relationship between Central and Local Governments
- China gropes for centralization, while Japan heads toward decentralization
Chi Hung KWAN
Consulting Fellow, RIETI
The income gap between regions within China is large and threatens to become a factor for social instability; and having the central government transfer tax revenue among regions may be an effective means to correcting this. However, as Japan's experiences show, excessive centralization can lead to a decline in economic efficiency. How to compromise between efficiency and equity through striking a balance between centralization and decentralization of fiscal resources has become a common policy issue for the two countries. Both China, which has placed priority on efficiency and proceeded with decentralization, and Japan, which has established a centralized system to focus on equity, are now seeing the need to adjust their systems.
Compared to China, the inter-regional gap in Japan is small, thanks largely to the transfer of fiscal resources among regions through such means as the system for allocating taxes to local governments. Under this tax allocation system, the government collects a portion of taxes as a national levy and then redistributes it based on certain rules to local governments. The aim of this is to correct the revenue gap among local governments such as prefectures and municipalities, and ensure that they can provide public services up to a certain common national standard.
In China, also, tax income is transferred from the central government to local governments, but this so far has hardly helped in correcting the inter-regional gap. Of the expenditures transferred to local governments, 'tax transfer payments' comprise the largest portion, estimated at some 50 percent of the total. This tax return system was introduced as part of the tax reforms of 1994 that clearly divided tax collection rules between the central and local governments. In an effort to protect the interests of regional governments, the amount of tax revenue returned to each of them is calculated based on the income each submitted in 1993. The system works to the advantage of coastal regions, which secured much tax income through the real estate and stock investment boom at that time. As a result, the wealthier provinces get more tax revenue back, and the poorer ones less. The redistribution mechanism cannot function if virtually all of the tax revenue sucked up from Shanghai by the central government is returned to the city. Although there is another item in the budget called 'transitional transfer outlays', appropriated for poor areas and regions with ethnic minorities, the amount of funds so transferred is small and in reality it barely works.
As this shows, China's tax system has so far served to widen, rather than help reduce, the inter-regional income gap. Wealthy areas are able to actively invest in infrastructure because, with the inclusion of the refund from the central government, they have ample tax revenue. Indeed, Shanghai has taken advantage of the merits of this decentralized tax system to achieve high growth. In contrast, some cash-strapped regional governments try to reduce their fiscal expenditures by shifting the responsibility of handling expenses to subordinate governments such as counties and towns. In fact, the fiscal burden of such matters as compulsory education and medical care is so great that town governments often collect money under the guise of a myriad of non-tax contrivances, such as fees and fines, using various pretexts to boost revenue, and this is a de facto heavy tax burden for farmers.
The Chinese government has embarked on fiscal reforms in an effort to correct the situation. As from 2002, it has introduced a new framework to divide revenue from corporate and individual income tax. Any revenue that exceeds the benchmark amount based on 2001 revenue will be split 50-50 by the central and local governments in 2002, with the central government receiving more in 2003 through a 60-40 split. All of the central government's portion of the revenue will be allocated to the central and western regions to bolster assistance to these less developed areas. Since income tax is an area where revenue is likely to increase, this reform is expected to have a greater effect in redistributing tax revenue among regions than the tax reforms of 1994.
In contrast to China's moves toward centralization, Japan is striving to decentralize its finances, as symbolized by the so-called trinity reforms currently in progress. It is true that the transfer of fiscal resources to local governments through the central government has contributed to the balanced development of the country. However, now that the national minimum has been secured in most areas, the system for allocating taxes to local governments needs to be changed. This is because by guaranteeing that local governments will be able to cover their expenditures, it weakens their sensitivity to cost and increases unnecessary public works projects, as well as making them dependent on the central government. Indeed, the aim of the trinity reforms, which simultaneously abolishes or reduces state subsidies, cuts back on tax allocations to local governments, and transfers tax collection authority from the central to local governments, is to correct such ill effects of excessive centralization.
Be it centralization or decentralization, it is a redistribution of power and the benefits that come with it. As such, it is likely that those with a vested interest and something to lose will oppose such efforts. Thus, as in the case of other reforms, fiscal reform can only be pushed forward through repeated conflict and compromise with those with vested interests. While there are many hurdles that still need to be overcome, it can be said that both Japan and China have taken the first step toward their respective goals.
June 27, 2003
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