B & R Chapters
China’s Fiscal System: A Work in Progress
The Development of the Fiscal System
“Path Dependency”= How a country’s institutions develop depends critically upon where they
At the beginning of the Fiscal System (1959s), local governments were responsible for day-to-day
services, such as education, public safety, health care, housing, and social security. However, all
of the money came from through the revenue-sharing system, under which the Central
government had all the money.
Revenue came mostly from industrial taxes
The Decline of the Budget, 1978 – 1993
As SOEs profits declined so did the revenue to the central government.
The growth in the rural areas was great but at the time China had no real tax administration in
place that could have taxed rural-based growth.
A system was implemented in 1988 that made the provinces pay fixed amounts to the central
The 1994 Reform
This reform aimed to “recentralize” the fiscal reform and was composed of three elements:
Aimed to simplify the tax structure, eliminate distortionary elements, and increase
A single 17% VAT was implemented on manufacturing.
A Consumption Tax (CT) was implemented on a few luxury and sin goods.
A 5% business tax was implemented on banking and insurance, entertainment…etc.
The Tax-Sharing System (TSS)
The TSS changed the way revenues are shared between the central and provincial
governments by shifting from a negotiated system of general revenue sharing to a mix of
tax assignments and tax sharing.
The central government kept 75% of the VAT and the provinces kept 25%.
The reform established a national tax administration in China for the first time. This
removed opportunities for local governments to divert central revenues.
Unfortunately one problem with the TSS is that it disproportionately favors the rich regions.
A System in Transition
The largest problem China’s Fiscal policy faces today is the mismatch of expenditures and
revenues between levels of government resulting from the 1994 reform.
It is important to remember that China has already come pretty far with its fiscal reforms and that
it has done many things “right” as well as “wrong.” Mobilizing Public-Sector Resources
The Tax System
The VAT has some problems; it is an origin-based production-type tax, it does not credit capital
expenditures and thus penalizes new investment. This hinders export competitiveness.
Equally the EIT has large differences in the treatment of foreign/domestic investments.
The high taxes imposed on banking deter development of the financial system.
Tax administration remains weak and there appears to be substantial corruption.
Outside the Budget
In addition to extrabudgetary funds (EBF), there appears to be more hidden revenues, transfers,
and expenditures that come from the lack of any good formal local tax base.
What are EBF?
EBF=They constitute all resources managed directly or indirectly by administrative branches of
government outside the normal budgetary process.
EBF has been cited to be between 8 – 15% of GDP while budgetary revenues are only 12%.
China is extremely dependent on EBF. They provide for many public services.
Obviously EBFs are subject to abuse and corruption.