Taxing Times for Local Government Debt

The central government will make up the shortfall in local governments' revenues by slashing specially earmarked funds and boosting rule-based transfers, instead of directly ceding fiscal powers, the vise finance minister said on Tuesday.

In a news briefing on the reform blueprint by the Third Plenum of the 18th Central Committee of the Communist Party of China, vice finance minister Wang Bao'an said the reform direction for China's public finance distribution system is to take back much responsibility for funds previously entrusted to local governments.

"Reducing formerly entrusted items is one direction," he said, "Without clarity of administrative authority, there is no basis upon which to discuss revenue division," Wang said.

This suggests Beijing will stabilize the current central-local revenue division paradigm while steering the transfer payment system toward a more rule-based one: filling the fiscal gap local governments faced through general transfer payments.

This is different from the previous reform advocated by some experts who believed local governments should have more fiscal power commensurate with their spending responsibilities.

This official direction is also evident in the recent policy statement calling for the establishment "of a system in which government's administrative authority and spending responsibilities were commensurate".

Previously there were calls to address the disparity between "administrative authority" and "fiscal power". "Why use the term 'spending responsibility' instead of 'fiscal power'? Because the former is only about 'money usage'," said Wang, saying local governments would not be able to have more independent fiscal revenue at their own discretion.

Under China's fiscal arrangement since 1994, the central government takes about 48 percent of the national tax revenue while the remainder goes to local government.

But central government shoulders only 15 percent of the spending responsibility while the local government shoulders 85 percent.

The gap is partially addressed by the central government transferring some funds to local governments, but local governments, especially at the county-level, are still heavily under-funded.

Much of the transfer payment system is made up of earmarked funds, the number of which, according to Wang, now stands at 219.

The arbitrary figure has prompted local governments to rely on lobby activities to win more earmarked funds from central ministries, a situation that has led to corruption.

The fiscal gap has also prompted local governments to raise their debts, which have surged in recent years, developing into a major source of worry.

Responding to questions over local debt, Wang said the risk of local debt is still "under control", emphasizing most of local governments' liabilities are based on productive projects, which produced sustained returns.

The Organization for Economic Cooperation and Development said in its latest report that China's downside risks mostly stem from local public debt.

In addition to central-local fiscal relations, Wang said the future reform would also take on the current budget and taxation system.

According to Wang, the country's fiscal power is constrained by many rigid spending responsibilities such as funding education and agriculture. Seven categories pegged with revenue growth accounted for 48 percent of fiscal expenditure.

"For example, education expenditure should be no less than 4 percent of GDP and many other expenditures should grow faster than total revenue growth. This rigidity has constrained the adjustment of fiscal policy in the economy," Wang said.