Breaking the Administrative Subordination of the Tax Sharing System: How to Change China's Economic Landscape - Huxiu#
#Omnivore
Highlights#
First, the advantageous tax types were all allocated to central fiscal revenue, such as tariffs, consumption taxes, and 75% of value-added taxes, while some less important taxes, such as business tax and income tax, were left to local finances.
Second, the fiscal gap was inverted. Before the reform, the central fiscal gap required local finances to remit income, but after the implementation of the tax-sharing system, almost all local finances experienced a gap, requiring the central government to compensate through transfer payments, reversing the fiscal status between central and local governments.
Finally, the rules were unified, leaving no room for negotiation. During the fiscal contracting period before the reform, the rules varied across regions, leading localities to seek more favorable sharing rules, while the tax-sharing system established uniform rules for all provinces. This principle has been upheld to this day, regardless of the regional development strategies implemented, the tax-sharing system between the central and local governments has not been adjusted. ⤴️ ^7d0ad32a
This is a typical policy that increased centralization; what Premier Zhu Rongji did at that time seems very difficult now, but it was also very important.
The final tax-sharing plan fully considered local interests, mainly reflected in two aspects. First, for the income lost by localities, the central government subsidized them in the form of tax refunds, and also set a growth rate for tax refunds, meaning that for every 1% increase in the national "two taxes," local tax refunds would increase by 0.3%. On the other hand, the tax refund base in the draft was set in 1992, determining the tax refunds localities received after the tax-sharing system was implemented. However, local finances demanded that the base be set in 1993 and artificially inflated the base by over 60 billion yuan in the last quarter. Considering long-term and overall interests, the central government accepted this inflated base "as is." ⤴️ ^991d526e
In today's stable social environment, there are still inconsistencies between the central and local governments, and they will still compete; this is a point we often overlook, and various information channels rarely discuss it.
Concentrating efforts to accomplish major tasks ⤴️ ^2b2b46bb
After fiscal centralization, the first task of the central government was to equalize fiscal capacity among regions. ⤴️ ^7cbf59e9
The second task of the central government was to narrow the urban-rural gap. ⤴️ ^1f545b4e
Authority lies with localities, financial power lies with the central government ⤴️ ^043c8121
When military orders are not respected outside, but provisions are supplied by the ruler, contradictions arise.
Local governments thus shifted from "operating enterprises" in the 1980s to "managing cities" after 2000, turning land finance into a "second finance." As a result, local governments were more inclined to increase industrial and commercial land supply when deciding on urban construction land use, to attract investment, while restricting residential land supply to gain land transfer income. ⤴️ ^2dc90b99
The cornerstone of real estate soaring.
To this day, none of the top four taxes in China are local taxes. ⤴️ ^806409a8
Central financial power is unshakeable.
First, there is the issue of time lag. Local tax revenue can be reflected as local fiscal income in the current period, which can cover current fiscal expenditures. However, central fiscal transfer payments need to be allocated step by step to the grassroots, which takes several months of delay, accumulating a large amount of fiscal funds by the end of the year. The more transfer payments a locality receives from the higher-level fiscal authority, the more funds are piled up at the end of the year, leading to a rush to spend at year-end.
Second, there is the "public pool" issue. Local fiscal tax revenue has costs, including both tax collection costs and efficiency losses to the local economy caused by taxation, so local governments pay more attention to efficiency when spending. Transfer payments received from the central government mostly come from tax sharing with other regions, which do not incur tax collection costs and do not cause losses to the local economy, so the use of these funds does not focus on efficiency. Research has found that fiscal transfer payments from the central government are more likely to be used by local finances to support inefficient "zombie enterprises." ⤴️ ^8e35913f
Shanghai People's Publishing House really dares to speak.
As fiscal power decreases step by step, authority increases step by step, with almost all locally managed authorities ultimately pressed onto county and district governments, such as education and social security. ⤴️ ^d61cdfe7
During the COVID-19 pandemic in 2020, the pressure on grassroots finances in China surged, even to the point of affecting the operation of grassroots governments. The central government innovatively introduced the direct fiscal funding mechanism, directly allocating newly added funds to county and district finances. ⤴️ ^5b854e9a
Even in such a large country, all systems are constantly adjusting and evolving; everyone is always feeling their way across the river, reflecting the role of Bayesianism.
Breaking the Administrative Subordination of the Tax Sharing System: How to Change China's Economic Landscape#
This article is excerpted from "Economics of Great Powers: Towards Long-term, Overall, and Multi-dimensional Development of China," discussing the impact of the tax-sharing system reform on China's economic landscape. The tax-sharing reform allocated advantageous tax types to central fiscal revenue, achieving an inverted fiscal gap and unified rules. The tax-sharing reform increased the proportion of central fiscal revenue and the proportion of national fiscal revenue to GDP, breaking the administrative subordination relationship and establishing a vertically subordinate tax collection agency under the central government. The tax-sharing system constructed a flat fiscal system, decoupling fiscal revenue from enterprise development and changing the fiscal incentives for local governments. After fiscal centralization, the central government implemented measures to equalize fiscal capacity, narrow the urban-rural gap, and increase spending on people's livelihoods. However, the tax-sharing system also led to vertical fiscal imbalances, with imbalances in revenue and expenditure between central and local finances, resulting in increased pressure on local finances.
• The tax-sharing reform broke the administrative subordination relationship, achieving an inverted fiscal gap and unified rules.
• The tax-sharing system constructed a flat fiscal system, decoupling fiscal revenue from enterprise development and changing the fiscal incentives for local governments.
• The central government implemented measures to equalize fiscal capacity, narrow the urban-rural gap, and increase spending on people's livelihoods, alleviating pressure on grassroots finances.
- Enhancing Central Financial Power
Looking back today, the tax-sharing reform implemented in 1994 was forward-looking, and its mechanism design was very scientific. On the one hand, it did not focus on immediate gains and losses; the central government made some concessions to localities to ensure consensus on the reform. On the other hand, it was based on medium- and long-term fiscal benefits, and some principled issues were never adjusted until seven years after the tax-sharing system was implemented, when the central government achieved a significant surplus. Finally, other fiscal reforms implemented during the same period directly or indirectly ensured the increase of the "two proportions"—the proportion of central fiscal revenue in national fiscal revenue and the proportion of national fiscal revenue to GDP.
Compared to the fiscal contracting system, the tax-sharing system brought three significant changes to the fiscal system.
First, the advantageous tax types were all allocated to central fiscal revenue, such as tariffs, consumption taxes, and 75% of value-added taxes, while some less important taxes, such as business tax and income tax, were left to local finances.
Second, the fiscal gap was inverted. Before the reform, the central fiscal gap required local finances to remit income, but after the implementation of the tax-sharing system, almost all local finances experienced a gap, requiring the central government to compensate through transfer payments, reversing the fiscal status between central and local governments.
Finally, the rules were unified, leaving no room for negotiation. During the fiscal contracting period before the reform, the rules varied across regions, leading localities to seek more favorable sharing rules, while the tax-sharing system established uniform rules for all provinces. This principle has been upheld to this day, regardless of the regional development strategies implemented, the tax-sharing system between the central and local governments has not been adjusted.
After all this, what exactly did the tax-sharing system do? The main content of the tax-sharing reform consists of three aspects. First, it redefined fiscal revenue and expenditure. Relatively speaking, changes in fiscal expenditure were not significant; the main adjustment was in the allocation of fiscal revenue. As shown in Table 3-1, central fixed revenue includes three categories: consumption tax, import and export tax, and state-owned enterprise tax revenue; local fixed revenue includes not only business tax and income tax but also land-related taxes, especially leaving land transfer fees to local finances; the main shared revenue is value-added tax, with the central government sharing 75%.
Second, it established a vertically subordinate tax collection agency to ensure that central revenue is not interfered with by localities. Before 1993, China only had local tax bureaus, which were completely subordinate to local governments. Starting in 1994, the original tax bureaus were split into the State Taxation Administration and local tax bureaus. The State Taxation Administration operates under a vertical management system, responsible not only for collecting central fixed revenue but also for collecting all shared taxes, such as the entire revenue from value-added tax, which is a shared tax.
Finally, it restructured China's tax system. The value-added tax replaced the original product tax, becoming China's largest tax, and on this basis, a consumption tax was added to make up for the rate difference between value-added tax and product tax. The income tax for domestic enterprises was unified, merging public and private enterprise income tax into 33%. The tax structure was simplified, reducing the number of tax types from 37 to 23.
These three parts are interconnected; the tax system reform increased the concentration of tax types, making the value-added tax the largest tax, and expanded the tax base related to central fiscal revenue. Subsequently, the management authority of these tax types was entirely incorporated into the State Taxation Administration, ensuring operational independence in tax collection. Finally, the collected revenue was divided according to rules favorable to central finances. The effect of the tax-sharing reform on increasing the "two proportions" was immediate. The proportion of central fiscal revenue in national fiscal revenue increased from 22% in 1993 to 56% in 1994, and the proportion of national fiscal revenue to GDP gradually rose from a low of 10% to 20%.
Of course, such a significant reversal required the support of local governments and local finances. In 1992, nine provinces and cities nationwide first piloted the tax-sharing system. In the first half of 1993, the design of the tax-sharing plan was officially launched, and the first plan released in July that year was very radical, planning to allocate all major tax types to central finances, such as the entire value-added tax as central fixed revenue, while most of the remaining tax types were also allocated to the central government. This plan faced unanimous opposition from localities, leading to the introduction of a revised plan in August. Even with the revised plan, gaining full support from localities was still relatively difficult. Then Vice Premier Zhu Rongji and relevant ministries went to localities to "do the work," with Premier Zhu visiting a total of 17 provinces and cities, while other provinces and cities were communicated with by the Minister of Finance.
The final tax-sharing plan fully considered local interests, mainly reflected in two aspects. First, for the income lost by localities, the central government subsidized them in the form of tax refunds, and also set a growth rate for tax refunds, meaning that for every 1% increase in the national "two taxes," local tax refunds would increase by 0.3%. On the other hand, the tax refund base in the draft was set in 1992, determining the tax refunds localities received after the tax-sharing system was implemented. However, local finances demanded that the base be set in 1993 and artificially inflated the base by over 60 billion yuan in the last quarter. Considering long-term and overall interests, the central government accepted this inflated base "as is."
- Flat Fiscal System: Decoupling Fiscal Revenue from Enterprise Development
During the fiscal contracting period, the central government had to share revenue from the provincial fiscal pool, which relied on local finances. However, in the tax-sharing phase, the central government directly linked to enterprises at the micro level. As shown in Figure 3-6, when any enterprise pays taxes, the destination of each tax type's revenue is already clear. If this enterprise pays consumption tax, all revenue from this tax goes directly into the central treasury; if it is value-added tax, 75% goes to the central treasury.
Although the tax-sharing system nominally divides revenue between the central and provincial governments, it has completely bypassed local finances, placing the central, provincial, and local finances at the same level, with each level of finance directly facing enterprises at the micro level. This rule applies to any enterprise's location, ownership, size, etc. Thus, the tax-sharing system constructed a flat fiscal system, replacing the vertical fiscal system under the fiscal contracting system.
The ability to achieve flattening is because the central government shares specific tax types rather than local revenue. At that time, the revenue allocation of 23 tax types was very clear; they were either completely central or completely local. If it was a shared tax, the sharing ratio between central and local was also clear, with specific sharing ratios set by tax type. Since the central finances are directly linked to specific tax types, and tax types are implemented at specific enterprises, the central finances are thus directly linked to micro-level enterprises. Enterprises and multi-level finances form a "many-to-many" relationship.
Compared to the fiscal contracting system, the tax-sharing system fundamentally changed the fiscal incentives for local governments. During the fiscal contracting period, the profits and taxes of local enterprises first had to be collected into local finances, and the scale of local fiscal revenue was directly related to the scale of local enterprises, leading the government to protect local enterprise development. After the implementation of the tax-sharing system, the main tax types for enterprises became value-added tax and corporate income tax.
Before 2000, the scale of corporate income tax revenue was very limited, with only 25% of value-added tax revenue left for local finances. Considering further sharing with lower-level finances, even less value-added tax would be left for grassroots finances. Against this backdrop, the fiscal enthusiasm of local governments for developing manufacturing decreased significantly compared to the contracting system period. Local governments began to gradually reduce interventions from various aspects, highlighting their regulatory role, and market segmentation also decreased.
The construction of a unified domestic market through fiscal incentives is actually well reflected in the documents promoting the tax-sharing system. For example, when discussing the necessity of implementing the tax-sharing system, it was pointed out that "the current fiscal contracting system... its drawbacks are becoming increasingly evident, mainly manifested in: the weakening of the tax adjustment function, affecting the formation of a unified market and the optimization of industrial structure."
However, the 1994 tax-sharing reform left a "tail." The income tax was left to local finances, maintaining the previous division of administrative subordination, and this tax type was subject to local enterprise development. After 2000, the scale of this tax type grew larger, and local governments paid more attention to income tax.
Thus, similar to the 1980s, regions began to compete for the income tax base, such as attracting the establishment of corporate headquarters, as corporate income tax is aggregated at the headquarters for taxation, or requiring out-of-town group enterprises to establish economic entities locally to retain income tax locally. In 2002, the central government also moved income tax from local tax to shared tax, sharing 50% in that year, and starting from 2003, sharing 60%, further weakening the correlation between local enterprise development and local fiscal revenue. This point is also reflected in the documents regarding income tax sharing reform: "The drawbacks of the current division of central and local income tax revenue based on enterprise affiliation are becoming increasingly evident... objectively fostering redundant construction and regional blockades, hindering fair competition in the market and the formation of a unified national market."
According to the efficiency principle, mobile tax bases should all be allocated to central finances. Recent adjustments to the fiscal system, while showing significant improvements compared to before 1993, have not reached a perfect state. For example, before 2016, the business tax collected from the service industry was local revenue, but after the business tax was converted to value-added tax in 2016, the local sharing ratio of value-added tax was increased from 25% to 50%. The intention was to balance local "tax revenue," but it instead incentivized localities to compete for manufacturing tax bases, which in some respects also buried the hidden dangers of market segmentation.
Fiscal system reform requires localities to have the enthusiasm to develop the economy while not wanting local governments to overly intervene in enterprises, necessitating a balance between the two. These two aspects are inherently contradictory, and fiscal system adjustments aim to maintain a balance between them.
- Fiscal Unity: Concentrating Efforts to Accomplish Major Tasks
Between 1994 and 2000, the central government nominally concentrated half of the national fiscal revenue, but the actual disposable fiscal capacity was very limited, as a large amount of central fiscal power had to be allocated to local fiscal tax refunds. For example, in 1995, the central fiscal revenue was 325.66 billion yuan, of which 186.7 billion yuan was used for tax refunds to localities, accounting for 57% of the central fiscal revenue that year. However, the entire mechanism design of the tax-sharing system was aimed at long-term benefits, with the central government receiving most of the fiscal increment. By around 2000, the situation of the central government began to fundamentally improve, with the portion used for tax refunds only accounting for 32%, while the disposable fiscal capacity accounted for 68%.
After fiscal centralization, the first task of the central government was to equalize fiscal capacity among regions. Between 2001 and 2015, after adjustments through central fiscal transfer payments, the Gini coefficient of per capita fiscal capacity among provinces decreased from 0.33 to 0.25.
Currently, the provinces with the highest per capita fiscal expenditure fall into two categories: either they are particularly economically developed, like Shanghai and Beijing, or they are particularly underdeveloped, receiving more from the central government, while also having poor geographical conditions, higher costs for providing public services, and low population density lacking economies of scale, such as Qinghai and Tibet.
The second task of the central government was to narrow the urban-rural gap. Starting in 2000, pilot agricultural tax and fee reforms were initiated, integrating some fees charged to farmers into the newly reformed agricultural tax, attempting to replace informal charges with standardized taxes. In 2006, on this basis, the agricultural tax was completely abolished, marking the end of the agricultural tax that had lasted for over 2,000 years in China.
After the abolition of the agricultural tax, the operation of grassroots governments and the provision of public services such as education completely relied on transfer payments from the central government. For instance, during the rural tax and fee reform period, the central government specifically set up transfer payment subsidies for rural tax and fee reform and for lowering agricultural tax rates. After the abolition of the agricultural tax in 2006, the central government also set up corresponding transfer payment subsidies to alleviate fiscal difficulties at the county and township levels.
To support agricultural and rural development, the fiscal department not only refrained from taxing agriculture but also provided a large number of subsidies. These subsidies include grain subsidies, agricultural machinery purchase subsidies, and subsidies for major grain producers. Additionally, substantial subsidies were provided for rural water conservancy and transportation construction. These equalizing fiscal measures reflect overall and multi-dimensional considerations, embodying socialism with Chinese characteristics and aligning with the vision of common prosperity.
The third task of the central government was to increase spending on people's livelihoods. Since the concept of public finance was proposed in 2003, China's fiscal policy has gradually shifted from construction-oriented finance to livelihood-oriented finance. Previously, the livelihood sector was a direction that local finances were reluctant to invest in. First, it has a long cycle and slow results, and more often involves consumptive expenditures, requiring a long time to translate into economic growth, while local officials' terms are often only a few years. Second, the "cross-regional externalities" are too significant; the cross-regional flow of labor makes underdeveloped areas less willing to invest in "people." The livelihood sector mostly falls under the shared authority of central and local governments, and relying solely on local finances would lead to severe underinvestment, necessitating coordination and compensation from central finances.
Therefore, the central government must pay more attention to long-term, overall, and multi-dimensional development. The most typical example is the free policy for compulsory education, known as "two exemptions and one subsidy." This policy began piloting in 2001 and achieved full implementation of free nine-year compulsory education by 2008. Subsequently, all funding for compulsory education was borne by the fiscal budget, with the central government covering 80% of the funding in western regions and 60% in central regions. Social security is similar; each year, the central government invests a huge amount of funds. For example, in 2015, fiscal spending on social security and employment reached 1.9 trillion yuan, of which 659.6 billion yuan was subsidies for social insurance funds, especially for pension funds in certain regions.
- Vertical Fiscal Imbalance: From Tax Sharing to Revenue Sharing
In terms of revenue allocation, the tax-sharing system is undoubtedly very successful. However, the tax-sharing system did not adjust fiscal expenditures, leading to a vertical imbalance in fiscal authority and financial power, with "authority at the local level and financial power at the central level." To alleviate the pressure on local finances, local governments either actively sought subsidies from above or "self-reliantly" sought other sources of income. The tax-sharing system left land-related revenues, including land transfer fees and business taxes from real estate, to local finances. As a result, local governments shifted from "operating enterprises" in the 1980s to "managing cities" after 2000, turning land finance into a "second finance." Consequently, when deciding on the use of urban construction land, local governments tended to increase industrial and commercial land supply to attract investment while restricting residential land supply to gain land transfer income.
The tax-sharing system underwent several adjustments after 1994, transforming a tax-sharing system into a revenue-sharing system. Within the 1994 framework, both central and local finances had their own main tax types, but subsequent reforms brought about two changes.
First, some tax types belonging to local finances were abolished, such as banquet tax, slaughter tax, and more importantly, agricultural tax and agricultural specialty tax. Although the abolition of these tax types has far-reaching significance, it reduced the tax types available to local finances.
Second, several major local tax types were adjusted to shared taxes, including income tax sharing and "business tax to value-added tax" reform. Income tax sharing occurred in 2002, integrating local corporate income tax and personal income tax into shared taxes. The "business tax to value-added tax" reform occurred in 2016, converting the business tax, which was entirely local revenue, into a shared value-added tax. Although the sharing ratio of value-added tax was changed from 75:25 to 50:50, maintaining local fiscal revenue, it fundamentally altered tax management authority. To this day, none of the top four taxes in China are local taxes.
Currently, 70% of the government's total tax revenue comes from shared tax revenue, so it can be considered that both central and local finances share this 70% of tax revenue. Under the "revenue-sharing" system, the tax sources of each level of finance are highly similar, greatly weakening the role of the multi-level fiscal system. Each level of finance also lacks corresponding tax management authority, making it impossible to adopt suitable tax development policies based on local conditions.
Fiscal revenue is concentrated at the central level, while expenditures are decentralized to local levels, resulting in a large amount of funds flowing back and forth between the central and local governments each year. Although tax revenue and central transfer payments are both fiscal funds for local finances, there are two essential differences.
First, there is the issue of time lag. Local tax revenue can be reflected as local fiscal income in the current period, which can cover current fiscal expenditures. However, central fiscal transfer payments need to be allocated step by step to the grassroots, which takes several months of delay, accumulating a large amount of fiscal funds by the end of the year. The more transfer payments a locality receives from the higher-level fiscal authority, the more funds are piled up at the end of the year, leading to a rush to spend at year-end.
Second, there is the "public pool" issue. Local fiscal tax revenue has costs, including both tax collection costs and efficiency losses to the local economy caused by taxation, so local governments pay more attention to efficiency when spending. Transfer payments received from the central government mostly come from tax sharing with other regions, which do not incur tax collection costs and do not cause losses to the local economy, so the use of these funds does not focus on efficiency. Research has found that fiscal transfer payments from the central government are more likely to be used by local finances to support inefficient "zombie enterprises."
Many news reports have also disclosed the phenomenon of a large amount of funds being used for local government image projects.
To incentivize local governments to allocate funds to specific areas, the central government has increasingly adopted special transfer payments, but inefficiencies still persist. Among the three main types of existing transfer payments in China, tax refunds were established in the 1994 tax-sharing system and the 2002 income tax sharing reform, representing local interests. General transfer payments are calculated based on the fiscal capacity of each locality, allowing local governments to freely allocate these two types of subsidies received from the central government. However, special transfer payments generally designate specific areas of use, prohibiting repurposing, and often require local matching funds. Yet, special transfer payments also exhibit severe inefficiencies.
First, there are numerous overlapping and cross-cutting project types, with different ministries often setting up similar special projects for the same area; second, the rules for project allocation are not transparent, and human factors also influence fund distribution; third, they often contradict local needs, as special transfer payments require local matching, and only relatively developed regions have the fiscal capacity to match, while truly underdeveloped regions that need central subsidies lack the ability to match.
In recent years, there has been an increasing call to raise the proportion of general transfer payments. As shown in Figure 3-7, since 2011, general transfer payments have exceeded special transfer payments, but in reality, this only adjusted their statistical criteria, and a large amount of transfer payments are still designated for specific purposes. Special transfer payments have certain rationality at this stage, especially in constraining local behavior and coordinating central-local relationships.
Vertical fiscal imbalance has also transmitted from the central to sub-provincial levels, leading to increased pressure on grassroots finances. At the sub-provincial level, provincial and municipal finances also concentrate fiscal power, allocating some advantageous tax types or advantageous enterprises to their own finances while leaving smaller tax types to county and district finances. Therefore, the lower the level of finance, the smaller its fiscal power. As fiscal power decreases step by step, authority increases step by step, with almost all locally managed authorities ultimately pressed onto county and district governments, such as education and social security.
The fiscal revenue and expenditure gap varies at different levels; the central government has a surplus, provincial and municipal finances have gaps, but they are relatively small, while grassroots finances face the largest fiscal capacity gap. During the COVID-19 pandemic in 2020, the pressure on grassroots finances in China surged, even to the point of affecting the operation of grassroots governments. The central government thus innovatively introduced the direct fiscal funding mechanism, directly allocating newly added funds to county and district finances. In 2021, this direct mechanism was normalized, allowing a portion of central fiscal funds to reach grassroots levels directly, alleviating grassroots pressure.
Authors: Lu Ming / Yang Ruidai / Xu Xianxiang / Fan Ziying / Luo Zhi / Chen Zhao / Zhong Ninghua / Xi Xican / Chen Binkai / Li Huiwen
Publisher: Shanghai People's Publishing House
Produced by: Century Wenjing
Subtitle: Towards Long-term, Overall, and Multi-dimensional Development of China
Publication Year: 2023-5-31