Local government debt in China: implications for reform.

Author:Grewal, Bhajan
Position:Report
 
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  1. INTRODUCTION

    Although China is not a federation, it has a well-developed hierarchy of government levels. In addition to the central government, there are 31 Provinces, Autonomous Regions, and Municipalities; 333 Prefectures; 2854 Counties; and 40381 Townships (China Statistical Yearbook 2015). The term local government in China refers to all of these levels and units, except the central government. Together, local governments play an important role in China's public finances and are responsible for more than 70% of fiscal expenditure. In education, health care and social services, the local governments are responsible for more than 90% of total budgetary spending. Given their importance in national public finances, the soundness and sustainability of local government finances is of paramount importance for China's economy and society.

    Since the 1994 fiscal reform, China's national public finances have been in a strong position, but public finances of local government have been under stress. This is largely due to the mismatch between local expenditure responsibilities and local 'own revenues', and to the lack of local authority over taxation. Non-tax revenues from fees and charges of various types and fiscal transfers from the central government have always been important sources of revenue for local government.

    According to the 1994 Budget Law, subnational governments were also prohibited from borrowing [this prohibition was lifted only recently under the new Budget Law passed in late 2014]. In practice, however, it has been an open secret that all local governments undertook indirect borrowing through a variety of specially established companies or other entities for off-budget borrowing. Being outside the authority of the Budget law, these borrowings are not reported in local government budgets and the exact amount of these borrowings remains unclear. In the past, the central government not only ignored such borrowings, but also encouraged local governments to borrow for investment in infrastructure after the Asian Financial Crisis of 1997-98 and the post-Global Financial Crisis (GFC) fiscal stimulus of 2008-09.

    After two investigations on local government debt by the National Audit Office (NAO) in 2011 and 2013, and after experimenting with a pilot in 2012 allowing four city governments to issue bonds in their own names, the Chinese government has now removed the prohibition on local government borrowing under the 2014 Budget Law, making it possible for all local governments to issue bonds in their own names from 1 January 2015.

    In recent years, the size, composition and utilization of local government debt have attracted worldwide attention and a large body of literature has developed around this topic (e.g., Ma 2015; Tsai, 2015; ADB 2014; IMF 2014; Wong 2013; Pei, 2011; Naughton 2009;). Most of these observers are concerned with the overall size of local government debt and its macroeconomic risks. The focus of this paper, however, is on the provincial and sub-provincial incidence of China's debt, an aspect that has not attracted sufficient attention. As provincial economies differ from one another, local debt is likely to pose different risks and challenges to different provinces, and indeed to different counties and townships within the same province. The impact of the new authority to issue bonds will also be different across the provinces, because the revenue poor provinces (mainly in the central and western regions) would find it difficult to receive high credit ratings to borrow at favorable terms. In addition to drawing attention to these challenges, we also discuss Australia's experiences --in decentralizing its subnational borrowings and its system of fiscal equalization--that should provide helpful guidance at this stage of China's fiscal management.

    The paper is organized as follows. Section 2 provides background information about fiscal decentralization in China, highlighting the vertical fiscal imbalance that makes each layer of subnational governments heavily reliant on non-tax revenues and fiscal transfers from the level of government above itself. In the absence of a rule-based system of fiscal transfers, the current system generates perverse incentives for moral hazard of soft budget constraints and adverse selection of unsound investments that undermine the fundamental principles of sustainable public finances. In Section 3, information sourced from provincial audit reports on local debt at prefecture, city, county and township levels is discussed and attention is drawn to the plight of the revenue-poor provinces, many of which appear to be facing high levels of vulnerabilities. Section 4 discusses policy implications for fiscal management flowing from the new 2015 scenario of all provinces having the authority to borrow in their own right. Section 5 discusses the Australian experience in relation to decentralized subnational borrowings and Section 6 concludes.

  2. FISCAL DECENTRALISATION IN CHINA

    2.1 FISCAL GAP

    As noted above, public expenditure in China is highly centralized, but tax revenues are not decentralized to the same extent. China's taxes are classified --mainly for revenue collection and revenue sharing--into three categories: central taxes (revenue from which accrues exclusively to the central government); 'local taxes' (revenue from which accrues to local governments); and

    'shared taxes' (revenue from which is shared between central and local governments according to fixed proportions). For example, local governments receive 25% of VAT revenue and 40% of income tax revenue.

    The term 'local tax' in China is somewhat misleading and needs explanation. Virtually all taxes in China are imposed by the central government and local governments have no authority to either impose a tax or alter the rate or the base of a tax. Provincial governments do collect the so-called local taxes through their own provincial tax administration bureaus and no part of this revenue goes to the central government. But tax rates on even these 'local' taxes are determined by the central government.

    Altogether, local taxes provide provincial governments around 45% of total tax revenue. Because most of China's GDP is derived from industrial and urban centers, the revenue position of those provinces and counties is stronger as they have a high concentration of urban centers. For this reason, provinces in the central and western regions have generally weaker position in fiscal revenues as compared with the coastal provinces (Grewal & Ahmed 2011). Figures in Table 1 show that every province has a fiscal gap because 'own' revenue of every province is inadequate for financing its public expenditure. Thus, all provincial governments in China rely on fiscal transfers from the central government. Indeed, it was a key objective of the 1994 fiscal reform to recentralize China's tax revenues and provide the central government real control over the commanding heights of the nation's economy.

    Under the 1994 tax-sharing reform, it is permitted that the fiscal system below the provincial level can vary from one province to another. As a result, fiscal systems at the grass root (counties and townships) level in many provinces is a combination of the pre-1994 financial contract responsibility system and the new tax-sharing system. As county and township governments are at the bottom of government hierarchy, the chain of fiscal transfers is often too long to leave much of the fiscal transfers after they passed from one budget level to another. Thus, there is a fiscal gap (excess of local public expenditure over local own revenue) for every province (and the provincial status cities municipalities of Beijing, Tianjin, Shanghai and Chongqing) as shown in Table 1.

    2.2 FISCAL TRANSFERS

    The fiscal gap noted above is direct result of the 1994 fiscal reform, which also created for the central government a crucial role in supporting local public finances with annual fiscal transfers. The central government only makes direct payments to provincial governments, who in turn make fiscal transfers to sub-provincial governments (prefectures, counties and township) according to their own criteria.

    The amount of fiscal transfers varies from one year to next and the ability of central government to vary the rate of growth of fiscal transfers in accordance with the requirements of macroeconomic stabilization is considered by many to be a desirable feature of China's public finances. The 1994 fiscal reform enabled the central government to play such a leading role by recentralizing government revenue. While there is a considerable merit in this feature of the PRC's public finances, it also generates uncertainty and instability for local government budgets.

    There are three main types of fiscal transfers in China: tax rebates (also called returned revenue or compensation payments); general fiscal transfer, and specific purpose (or earmarked) transfers. The tax rebates have been a part of the new system of revenue sharing that commenced in the wake of the 1994 fiscal reform. Although with the passage of time their relative share in total fiscal transfers has been declining, tax rebates still account for around 36% of total transfers. The system subsidies refer to subsidies that were already paid from the central budget to local budgets before the 1994 fiscal reform, but were retained so as not to disadvantage local budgets. The distribution of tax rebates and system subsidies favors those provinces in which most of China's tax revenue is raised--the coastal provinces with high concentration of urban and industrial activity. General fiscal transfer (called transition transfer until 2002) accounts for about 46% of total fiscal transfers, but only a small proportion (around 7%) of it is distributed according to the principle of fiscal equalization. The specific-purpose transfers consist of payments for ethnic minority population...

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