COVID-19 has put massive pressure on China's local governments. Fiscal revenue growth has slumped as a result of the slowing economy, the property crisis and tax cuts, while spending has surged to pay for pandemic controls and testing and to finance infrastructure investment to shore up growth.
Data released by the Ministry of Finance on Jan. 30 show that in 2022, revenue in China's general public budget grew just 0.6% to 20.4 trillion yuan ($3 trillion). Notably, revenue from taxation fell 3.5% and revenue from the sale of land-use rights fell 23.3%, while nontax revenue jumped 24.4%. Meanwhile, expenditures from the general public budget grew 6.1% from 2021 to 26.1 trillion yuan.
These stresses have highlighted a thorny and long-standing challenge: how to overhaul the fiscal, budget and taxation systems to put local government finances on a sustainable footing. It is an arduous task that includes unexciting but important changes such as making budgets more transparent, strengthening management of fiscal resources such as assessing the affordability of projects, and improving control over on-budget and off-budget debt and spending.
Although reform of these complicated systems and practices has progressed since the Politburo approved a plan to deepen reform of the fiscal and taxation systems in June 2014, the pandemic and a property market slump have underscored the need to do more and faster as revenue growth has slowed.
In a commentary published in Qiushi, the official Communist Party journal, earlier this month, Finance Minister Liu Kun said managing the fiscal budget became increasingly difficult in 2022 and called for better use of fiscal resources this year with an emphasis on sustainability.
President Xi Jinping's report to the party's 20th National Congress in October contained a pledge to "improve the modern budget system, optimize the tax structure and improve the system of transfer payments," which refer to payments made from the central authorities mainly to county and city governments as well as for certain facilities such as schools and drug rehabilitation centers.
The "common prosperity" initiative to reduce inequality and improve income distribution has also added urgency to the need for change, with Xi's report vowing to "enhance the roles of taxation, social security and transfer payments in regulating income distribution" and to "improve the personal income tax system and keep income distribution and the means of accumulating wealth well-regulated."
Policymakers are grappling with deep-rooted problems ranging from inefficiency, poor budget coordination and overlapping spending among different budgets to imbalances in revenue and spending obligations between the central government and local authorities, and financial risks stemming from trillions of yuan of hidden local government debt.
The finance minister outlined some of the key pain points and remedies in an article included in an official study guide to Xi's report to the 20th Party Congress published in October. The guide is an anthology of articles from senior officials including Vice Premier Liu He and Zhao Leji, a member of the Politburo Standing Committee, covering various aspects of the report.
Over the last few years, slowing economic growth, an overhaul of the tax system that has included raising personal allowances and lowering value-added tax (VAT) rates, along with COVID-related tax cuts and subsidies, have eaten into tax revenue. The tax-sharing system (TSS) introduced in 1994 has also left local governments with less of the tax revenue pie while shouldering most of the spending burden, making many of them heavily dependent on transfers from the central government.
The main taxes in the TSS include VAT, corporate income tax and personal income tax, levies that are unevenly distributed on a regional basis and can be unpredictable in terms of the amount raised. The proportion of overall tax revenue shared by central and local governments is relatively high compared with other countries. But Liu defended the system, saying it is necessary to help resolve unbalanced economic development between different regions, although he acknowledged that the division needs to be improved.
He also called for more revenue to be raised from direct taxation, highlighting two specific areas: income tax and property tax, which includes a controversial and unpopular real estate levy that the government has been promising to introduce for many years to give local authorities a stable source of revenue. To help secure more revenue, local tax systems should be improved and new sources of tax cultivated, he said.
Liu's article echoed some of the measures put forward by the State Council in regulations updated in 2020 after the updated Budget Law went into effect on Jan. 1, 2015. The amended law, which took 11 years to go through the legislative process, was aimed at enhancing transparency and risk management of debt by setting rules on disclosure of local budgets and borrowing, bringing in a system to track debt risks and improving the system of transfer payments from central to local governments.
Provincial-level authorities were allowed to issue bonds to fund their operations and reduce their dependence on local government financing vehicles (LGFVs). Spending was subject to additional scrutiny, and medium-term budgeting was introduced to create a more sustainable and forward-looking system.
All government funds were to be put into and spent from four budget pots -- the general public budget, government-managed funds, state-owned capital operations and social insurance funds -- which the law required to be made publicly available for scrutiny.
The four budgets in China's fiscal system
The general public budget:
(This usually accounts for more than half of the total revenue and spending of the four budgets)
-Revenue: tax revenue (often more than 80%), nontax revenue
-Expenditures: national spending including defense, disaster prevention and emergency management, education and central government functions; local spending including infrastructure and public services such as education, health, utilities and sports
Government-managed funds:
-Revenue: mainly sales of land-use right to property developers
-Expenditures: include public works projects such as transportation, water conservancy and social welfare
State-owned capital operations:
-Revenue: mainly profits paid by state-owned enterprises (SOEs)
-Expenditures: mainly capital injections into SOEs
Social insurance funds:
-Revenue: contributions to the state-run social insurance system that covers basic medical, basic pension, unemployment and work-related injury insurance
-Expenditures: payments to individuals who have contributed to the system
Note: Proceeds from central and local government bond sales, including special-purpose bonds, are recorded separately.
With fiscal revenue under pressure and the structure of the economy changing, more focus is being put on improving budget management and efficiency. Liu's article put forward a range of proposals to enhance planning, control, spending and supervision of budgets. These were necessary, he said, to meet the government's priorities, which include shifting to high-quality development, implementing the new development pattern, reducing regional inequality, narrowing the wealth gap and promoting common prosperity.
Liu called for greater coordination among the four budgets and for them to be managed solely by the Finance Ministry and local finance departments, which would also disburse the funds. Currently, authorities including the National Development and Reform Commission can also distribute some budget funds. He urged full implementation of the State Council's 2015 decision to scrap the principle that for the general public budget, spending should be dependent on revenue, and called for an increase in central government management over social insurance funds and a reduction in overlapping spending between the different budgets.
The proportion of income from state-owned capital, which includes state-owned enterprises' profits, that is handed over to the state should be "reasonably determined," Liu said, without elaborating. Official data show that the ratio has been increasing and stood at more than 30% in 2020.
Liu also highlighted potential new sources of revenue for local governments to counter a slump in tax receipts, notably the revitalization or offloading of idle assets. The Ministry of Finance issued a notice in October ordering central and local government departments and public institutions to take an inventory of inefficient and idle assets, compile a list of assets to be revitalized and formulate a revitalization plan. Liu also called for fully integrating revenue from state-owned resources and assets into the fiscal management system.
Many local governments have already turned to nontax sources, notably the disposal of state-owned assets, to bolster their fiscal resources. In provincial-level regions including Guangxi, Fujian, Guizhou, Jiangxi, Heilongjiang, Anhui and Yunnan, nontax revenue accounted for more than 40% of revenue in their general public budget in the first six or seven months of 2022. The increase in nontax revenue mainly came from the disposal of state-owned assets.
Transfer payments from central to local governments have become an increasingly important part of the fiscal system. They are used to plug local deficits and redistribute revenue from richer to poorer areas. Local governments hand over part of their tax revenue to the central government, which then distributes it to help localities balance their budgets. The revenue related to these transfer payments is not reflected in local general public budgets, which usually show a deficit.
The central government has been increasing transfer payments to governments at county and district levels that are in financial difficulty. But Liu indicated in his most-recent commentary that an overhaul of the whole fiscal system at lower levels of government is needed, echoing a State Council document issued in June.
Policymakers have indicated that the TSS is unlikely to change fundamentally and that the emphasis will be more on improving revenue distribution, winding down or stopping some types of transfer payments, making transfers based on need and improving the way payments are evaluated.
Turning to the problem of local government debt -- both on the books and hidden -- Liu's October article called for these financial liabilities to be subject to unified regulation and supervision, although he didn't elaborate. Management of LGFVs should be strengthened to "break the expectation of government bailouts," debt risks must be strictly regulated and the increase in hidden debt "resolutely curbed," he said.
Reining in hidden local government debt has been on the central government's agenda for years. No official figure for the scale of the liabilities has been published, although some analysts have put the figure as high as 50 trillion yuan.
The finance minister's article signaled that a renewed push to further clean up these off-the-books liabilities is coming, Zhao Quanhou, director of the financial research center of the Chinese Academy of Fiscal Sciences, a think tank linked to the ministry, told Caixin. The next steps for unified supervision are likely to include disclosure of local governments' hidden debts among regulatory departments such as finance and auditing, Zhao said.
Some local governments have already put the issue on their radar. Song Guoquan, a deputy director of the standing committee of the legislature in east China's Anhui province, said that the government should explore the unified regulation of government debts both on and off the books during a meeting with the provincial finance department in August 2021.
A number of local governments, including the province of Guangdong and the municipality of Shanghai, have launched pilot programs to eliminate their hidden debts. Guangdong said it has achieved the goal of "zero hidden (government) debt" by January 2022, without detailing the amount of hidden debt paid off or moved onto the books.
