China has long been working to reform its highly centralized tax system, but it has been slow going. The country made an important step forward on Feb. 8, though, when the Chinese Cabinet released a plan to redistribute tax revenue and public expenditures among central and local governments. Under the plan, central and local governments will now share the cost of public services falling under eight broad categories, including compulsory education, basic employment services and basic health insurance. Before, local governments either relied on risky maneuvers to cover the costs of public services or depended on federal fiscal reallocations, giving the federal government in Beijing outsize influence but also causing considerable economic distortions.
The percentage breakdown of costs differs by region. In the underdeveloped western and central regions of China, such as Xinjiang, Yunnan and Gansu, the central government will be responsible for 80 percent of the costs associated with the applicable public services. In the northeastern and central plain regions, including Jilin, Henan and Hubei, the central government will be responsible for 60 percent of costs. In the relatively wealthy coastal regions, including Guangdong and the Yangtze River delta, the federal government's share drops to 10-30 percent.
The new rules, which go into effect Jan. 1, 2019, are an important step toward correcting the fiscal imbalances between the central and local governments, largely caused by the 1994 tax reform. Under the existing tax structure, local governments receive less than half of total tax revenues but must pay for more than two-thirds of total public service costs, which are believed to be increasing. To make up for their shortfalls, local governments must rely on the central government's fiscal reallocation efforts or on extra-budgetary means of financing. Though this system helped reinforce Beijing's fiscal authority over the local governments, which enjoyed significant political and economic autonomy in the two decades before the 1994 reform, it also has caused massive fiscal distortions, leading to myriad problems.
Under the existing tax structure, local governments receive less than half of total tax revenues but must pay for more than two-thirds of total public service costs, which are believed to be increasing.
For one thing, local governments have for the past two decades depended on lucrative land sales for revenue, which has contributed to soaring real estate prices and rampant property speculation. The problem was made worse by the global financial crisis, when cash-strapped local governments were forced to more heavily rely on methods of local financing to offset massive credit and investment obligations required by the central government. Local debt levels soared as a result, and local state-owned businesses, in particular, became enmeshed in various ways with risky assets, including off-balance assets and the property market.
This is not the first time Beijing has attempted to correct these imbalances, but it is its most significant try yet. Beijing has worked for the past three years to streamline fiscal responsibility to correct economic imbalances and to contain risky debt. It has allowed local governments to issue bonds, bolstered local financial bases through tax increases and has made changes to local versus central revenue sharing. But all of these efforts have either been limited or slow moving. By setting clear rules for cost sharing, the changes announced Feb. 8 will reduce the spending burden of local governments and will strengthen the local governments struggling the most.
China's fiscal reforms complement the country's sweeping changes to the political system, which have also worked to redefine power among central and local governments. But though power is being redefined and more evenly distributed, there should be no mistaking recent reforms as decentralizing. Over the past five years, Beijing has gradually moved away from the political and economic decentralization efforts that characterized its 30 years of reform and opening, which began in 1978, and has aggressively reasserted its political and economic authority over local governments, bureaucracies and entrenched industrial powers.
From Beijing's perspective, as China moves away from its previous growth-driven economic model to a more sustainable development model, there is a stronger incentive for more central resource reallocation and wealth redistribution to rebalance the disparities that accompanied accelerated growth. Though the most recent fiscal reforms have been designed to strengthen — and to some extent give autonomy to — local governments, more broadly they are meant to balance and order the economy under the central government's political oversight. Thus, they are an integral part of Beijing's overall economic and political rebalancing efforts.