China in Transition

Fiscal Transfer System Reinforced to Correct Regional Disparities

Chi Hung KWAN
Consulting Fellow, RIETI

The administration of Hu Jintao and Wen Jiabao is shifting its policy stance from solely pursuing efficiency to placing more emphasis on equity. As part of this endeavor, it is trying to correct the regional disparities in income by enhancing the transfer of fiscal resources from rich to poor regions through the central government's budget.

The current fiscal transfer system was introduced in 1994 along with the tax assignment system (fenshuizhi), a revenue-sharing system between the central and local governments, in order to address the problem of fiscal imbalances of local governments and to provide adequate public services to areas that have been left behind. The fiscal transfer system has provided three key instruments: returned revenue, earmarked grants, and fiscal capacity equalization transfer payments.

  1. Returned revenue is a mechanism for guaranteeing the pre-reform level of tax revenue plus certain incremental revenue for local governments whose tax collection authorities were taken over by the central government. The mechanism was first implemented in 1994 upon the introduction of the tax assignment system, and again in 2002 when the incremental portions of enterprise and individual income taxes were integrated into a single shared revenue pool. The returned revenue system was established basically for the purpose of facilitating tax centralization, i.e. appeasing formerly revenue-affluent local governments by returning a portion of taxes collected as a national levy. Thus, the primary beneficiary of this system is not poor underdeveloped regions but wealthy developed regions.

  2. Earmarked grants are designed to direct government funds for expenditures on specific areas such as infrastructure development, social security, agriculture and education. Like the national treasury disbursements in Japan, the allocation of earmarked grants is made on a project-by-project basis. With the relevant government agencies -- the National Development and Reform Commission, the Ministry of Labor and Social Security, the Ministry of Agriculture, and the Ministry of Education -- having considerable discretion over the specific usage of funds allocated, the transparency of the system is low.

  3. Fiscal capacity equalization transfer payments are basically aimed at transferring funds to poor regions. Among them, general transfer payments, which represent the largest portion, are similar to Japan's local allocation tax grants in that the usage of allocated funds is left to the discretion of each local government and that standardized expenditures and standardized revenue are used for calculating the amount of funds for allocation (note).

In the period immediately after the transition to the tax assignment system, the scale of fiscal transfer from the central to local governments remained small, and returned revenue, which makes no contribution to the correction of regional disparities, accounted for a large portion of the central-to-local fiscal transfer. In 1995, returned revenue amounted to 186.9 billion yuan, accounting for some 75% of total central-to-local fiscal transfer worth 253.4 billion yuan, whereas earmarked grants and fiscal capacity equalization transfer payments stood at only 37.5 billion yuan and 2.1 billion yuan respectively.

Subsequently, however, fiscal transfers other than returned revenue -- earmarked grants, fiscal capacity equalization transfer payments, etc. -- began to increase in weight under the influence of the government's expansionary fiscal policies for boosting domestic demand, implemented from 1998 onward, as well as of the ensuing promotion of western and northeast development (figure). The 2002 tax reform, which changed the method of allocating income tax revenue between the central and local governments, provided the central government with a new source of revenue for fiscal transfers. Under the previous tax regime implemented upon the introduction of the tax assignment system in 1994, individual income taxes belonged to local governments while enterprise income taxes were designated as revenue for the central or relevant local government depending on jurisdiction for companies. Under the current system implemented in 2002, however, the incremental portions of all the individual and enterprise income taxes, except for those levied on enterprises in specific industries, are integrated into a single shared pool of revenue which the central and local governments split in a fixed proportion. The central government has been appropriating its share of such reform-generated incremental portions of revenue primarily for fiscal transfers to local governments in inland provinces. In the 2005 budget, central-to-local fiscal transfers totaled 1.1224 trillion yuan, of which earmarked grants (363.1 billion yuan) and fiscal capacity equalization transfer payments (309.3 billion yuan) together accounted for 60% reaching a combined amount of 672.4 billion yuan.

Figure: Changes in local fiscal revenue -- sincreasing portion of central-to-local transfers other than returned revenue

Despite all these efforts, however, signs of the equalization of fiscal expenditures among regions have yet to emerge. Apparently the central government, in the face of the continuing expansion of income and hence fiscal revenue disparities, is barely putting the brakes on the expansion of disparities in fiscal expenditures by increasing fiscal transfers to poor regions. In order to realize a harmonious society, the government needs to shift the weight of fiscal transfers from returned revenue and earmarked grants to fiscal capacity equalization transfer payments while further expanding the overall scale of central-to-local fiscal transfers. At the same time, it is necessary to increase the transparency of the criteria for calculating the amount of fiscal transfers and to enhance the equity of fiscal distribution.

November 7, 2005

"Fiscal capacity equalization transfer payments" include -- apart from general transfer payments -- non-purpose-specified funds called "ethnic region transfer payments" made to certain ethnic regions such as Tibet and the Xinjiang Uygur Autonomous Region, "wage adjustment transfer payments" whereby the central government partially bears the cost of salaries for local government employees, and "tax-for-fee reform transfer payments" whereby the central government alleviates the impact of reduced revenue for local governments resulting from the rural tax reform.

November 7, 2005