Tax structures should be rationalized to raise more revenue for social spending

Many of the ills and difficulties which affect China's economy today are connected to the way in which the government raises and spends money. The indebtedness of local governments, environmental degradation, corruption, weak and inadequate social security and healthcare, the bubble in Chinese real estate: all of these are major problems that China must address in order for the country to progress, and they are all connected with the need to raise tax for central and local governments to spend on public goods.

In 1994, China reversed some of the decentralization to local governments that had occurred in the 1980s during the first part of China's reform period. Local governments suddenly found that, although they continued to carry most of the responsibility for spending on local public goods such as education, transportation, social security and water conservation, there was a large gap between what they had to spend, and what the central government gave them. Local taxes and land sales to developers have filled the gap. In 2011, (according to Goldman Sachs research published in April) out of the total local Chinese government revenue of 13.1 trillion yuan (1.6 trillion euros, $2 trillion), 40 percent came from local government tax revenues, 35 percent from central government transfers, and the balance of 25 percent largely from land sales.

This funding gap has forced local governments to stand on their own feet. This financial independence has been reinforced by their budgeting process. Local governments start to spend on Jan 1 each year, but the local government budget approval process is completed only on March 31. This temporal disconnect encourages a casual treatment of budgets which are several months late in reflecting the actual situation on the ground, where spending is already well under way.

Economic growth still being the principal measure used by Beijing to evaluate and reward local officials, the financial independence has encouraged local governments to look to their own resources to fund projects which can help them to accelerate growth and gain recognition and promotion from the central government. Borrowing, often via special purpose vehicles such as local real estate or enterprise funds has become an important pillar of local government finances in recent years. The huge emergency spending stimulus unleashed by China in November 2008 in response to the Western debt crisis greatly increased the appetite of local governments for debt.

Fortunately for them, the memories of Chinese and foreign bankers did not stretch back as far as 1998, when local governments all over China had again built up huge debts in vehicles called international investment and trust companies (ITICs). When then premier Zhu Rongji was called upon to guarantee the debt that had been run up by one of the most free-wheeling of these ITICs in Guangdong, he famously refused to do so. Bankers in Hong Kong and elsewhere had assumed that the debts of local governments would be shouldered by the central government. They lost most of their money when government auditors arrived and Guangdong ITIC went bankrupt, revealing a trail of investments in karaoke bars, real estate and failed enterprises. GITIC's demise was followed by a succession of ITIC collapses all over China, with disastrous consequences for the mainland and Hong Kong-based banks that had supported them financially.

But a decade later, in 2009 after the financial crash in the West, it was as if the ITIC collapse of the late 1990s had never happened, as local governments once again started to run up debts financed both by local and foreign banks. In 2010, about 18 months after the stimulus plan was announced, an audit team sent out by Beijing estimated China's local government debt at about 30 percent of GDP. But when added to the debt of central government, China's overall debt/GDP ratio in 2010 came to about 43 percent - a much more comfortable position than many developed and indebted Western economies. So, even including over-borrowing by local governments, China does not have a serious debt problem - unlike many developed countries.

The solution this time to the local debt problem has been to roll over much of the debt, so that the projects that the borrowing financed will have started to generate the revenue that can repay it. In time, the debt overhang of local governments will be absorbed by new revenues and by the Chinese financial system. A pilot scheme for raising funds through the issue of local government bonds is underway. This would reduce dependence on local State-owned banks, and place local government finances on a sounder footing.

But the importance to local governments of the revenue from sales of land to developers encourages the illegal transfers of agricultural land which are often the subject of complaints by Chinese farmers. This practice also accounts for the large financial backhanders made by developers to local government officials to ease the progress of planning applications. China is certainly not the only country where applications to local authorities for planning permission for greenfield and brownfield sites is accompanied by graft, but it is one of the more significant. Also, as we know, Chinese planning grants for new industrial developments often ignore environmental regulations.

China's relatively weak tax-raising capacity accounts in part for the problems. Chinese tax revenue has grown strongly since 2002, largely as a consequence of the strong growth of the Chinese economy. But expenditure has also grown very fast. In 2011, total fiscal income in China came to 10.3 trillion yuan (against 3.2 trillion yuan in 2005), while expenditures totaled 10.9 trillion yuan (3.4 trillion yuan in 2005).

The Chinese economy will grow more slowly in future years. But an aging population and the increasing expectations of China's middle class will place heavy reliance on expenditures on public goods. The World Bank estimates that in order to bring Chinese spending on public goods in line with high-income countries, China will need to increase its annual spending on education by 1-1.5 percentage point, on healthcare by 2-3 points, and on pensions by 3-4 points - adding up to an extra 300-400 billion yuan of spending every year.

The central government will need to find ways to enhance its tax-raising powers. The pressure on fiscal revenues will increase, and the shortage of tax revenue will get worse - unless steps are taken to reform the system. This means placing more weight on indirect taxes like VAT, and less on income tax. The result will be to encourage household consumption and increase the economy's efficiency and underlying strength, as well as raise more tax. Taxes on vehicles and traffic congestion, on energy usage, and on properties, particularly at the upper end are all important ways of supplementing revenue.

As tax revenues increase, the central government should allocate an increased proportion to replace the revenue raising done by local governments from sales of land and local taxation. Local land sales are now being more strictly controlled at the central level, and many illegal land sales which were authorized by local governments have since been reversed. But it would be better to weaken the local incentive to sell land. Land sales are necessary and inevitable, but China needs to develop a fairer and more transparent way of authorizing and controlling them. Many local taxes, which are arbitrary and weigh heavily on some of the poorest members of local society need to be done away with.

Fiscal revenue-raising and expenditure lie at the heart of government. The transparency, fairness and thoroughness with which taxes are raised and spent underpins a government's ability to support its society and improve its people's living standards. China's growing middle class will increasingly demand more and better quality public goods, like education, healthcare, a cleaner environment and old age pensions. China's fiscal system needs to be reformed in order to meet these demands.

The author is a visiting professor at Guanghua School of Management, Peking University, and the author of China and the Credit Crisis: The Emergence of a New World Order. The views do not necessarily reflect those of China Daily.