[MUSIC] The decentralization of the Fiscal System led to problems which necessitated further reforms. In this presentation, I want to talk about the problems that China was experiencing as of the mid 1990s. And then, discuss what happened with the major reform of the system in 1994. And finally, discuss the current challenges facing China's fiscal system. In the mid 1990s, there were several key challenges facing the government taxation and spending system. The first was overall revenue scarcity. Remember that before the reform period, China did not have a tax collection system. And so that caused a pretty long process that was required for developing the capabilities to collect taxes. And this led to falling revenues as share of GDP over time. The second challenge was that there was great inequality across regions in the amount of public goods and services provided. And in poor regions in particular, that had very little sources of revenue, they couldn't even meet their basic expenditure needs, such as paying school teacher's salaries. So this required urgent attention. Finally, the tax system was very complex. It had been inherited from the old soviet model and featured lots of different turnover taxes and other taxes on different types of economic activities, as well as differential treatment of foreign and domestic firms. And finally, the decentralization have led to regional competition that fuelled excessive investment and protection. Now, in 1994, the key features of the tax reform were first that taxes were simplified. There were just a few taxes assessed across broad ranges of activities. And this created much better horizontal equity in the system. The main tax was a value-added tax of 17%, which was shared. 70% going to the central government, and 30% going to the local government. Now, this value added tax applied immediately to the manufacturing sector where was relatively easy to keep track of the inputs use in production in the upward sold. A lot of other activities like service sector activities were taxed through a business tax that was a 100% local. But over time, these activities also were converted to the value tax system. So that today, China has a very modern value-added tax system which covers all economic activity. In 1994, the government increased substantially the share of total government revenues that was controlled by the central government. In principal, this would allow it to do a better job redistributing resources to poorer provinces or to support activities that the central government felt were more important. To make sure that they got their fair take of the tax pie, the central government actually set up separate tax collection agencies at local levels to collect their share of the revenue. The effects on the revenues and expenditure patterns were quite dramatic. You can see that in the 1980s and into the mid-1990s, the share of government revenue and expenditure as a share of GDP declined very steadily. But after the tax reform in 1994, this pattern was reversed completely, so that taxes increased substantially and spending along with it, reaching a much higher level by the current period. In addition, the share of central government revenue in total government revenue jumps dramatically in 1994 by about 20 percentage points. Where as the expenditure share of the central government didn't really change very much. So, this allowed the central government to redistribute resources by providing subsidies to local governments from its larger revenue share to support activity. Now, what are the current challenges facing the fiscal system? The first is that despite greater central control, there's still a great deal of inequality that characterizes the provision of public goods and services. So the quality of schools and the amount of money spent on schools in Shanghai is multiples greater than those spent in the poorest provinces in China. In principle, the tax revenue centralization should have improved this. But in practice, there are not very clear rules of equalization to guarantee an equal rates of spending across provinces, and many of the funds of the center actually get returned back to richer provinces, leading to persistent inequality. In addition, although there were reforms which reduced the share revenues going to local governments. There were still incentives for local governments to try to protect enterprises and attract businesses to local areas. Because of course they still got the 30% share of the value-added tax as well as some other sources of revenue. And finally, the lack of local government revenue sources has led to the greater use of non-budgetary and extra budgetary revenue sources by local governments. So in China, a city government or a county government really does not have the authority to charge its own taxes to raise revenue to meet what it thinks are important local needs. And that's because the central government is worried that such tax raising authority will be abused. But as a result, local governments that want to be aggressive and promote development or provide other types of public goods and services have to find other resources. And what they do is, they can charge non-budgetary revenue, they can raise non-budgetary revenues by assessing some fees that the central government actually allows them to do of the kind of budget. But they can also reach outside of the entire budgetary system and engage in activities which are really not discussed at all by the budgetary authorities. And in particular, there's been a lot of activity related to land development because local governments control land, and they can raise revenue through land by leasing land to developers. And they can also create vehicles to promote urban development projects that can also borrow indirectly from banks. And this has created a mechanism where local governments engage in a lot of activities that are not really part of the budget but are an important part of local public finance. How can this kind of difficulty facing local governments to raise revenues be improved? A lot of countries have local property taxes that go to local governments. And this is the way in which they can meet the needs of local communities. In China, however, most homeowners are very opposed to having to pay new taxes that had never been charged in the past. So it may be very difficult for China establish a property tax system. In addition, in order to make the central government and citizens feel more confident that local officials will not abuse their tax raising authority, one thing to do is to try to increase the local accountability of officials, either through elections or other means of public checks and balances.
