WP/04/98
Toward More Effective Redistribution:
Reform Options for Intergovernmental
Transfers in China
Ehtisham Ahmad, Raju Singh, and
Mario Fortuna
© 2004 International Monetary Fund
WP/04/98
IMF Working Paper
Fiscal Affairs Department
Toward More Effective Redistribution: Reform Options for
Intergovernmental Transfers in China
Prepared by Ehtisham Ahmad, Raju Singh, and Mario Fortuna1
June 2004
Abstract
This Working Paper should not be reported as representing the views of the IMF.
The views expressed in this Working Paper are those of the author(s) and do not necessarily represent
those of the IMF or IMF policy. Working Papers describe research in progress by the author(s) and are
published to elicit comments and to further debate.
Full implementation of an intergovernmental transfer system based on revenue capacities and
expenditure needs could significantly improve both redistribution and equity objectives of
the Chinese authorities. This was envisaged in the 1994 fiscal reforms, but the authorities
were unable to implement the measures fully. This paper examines mechanisms that might
facilitate effective implementation.
JEL Classification Numbers: H70, H77
Keywords: Fiscal Policy, Intergovernmental Fiscal Relations, China
Author’s E-Mail Address: eahmad@imf.org; rsingh2@imf.org; fortuna@notes.uac.pt
1
Ehtisham Ahmad and Raju Singh are Division Chief and Senior Economist, respectively, with
the Fiscal Affairs Department at the IMF, and Mario Fortuna is Professor of Economics at the
University of Azores. This paper is part of a larger project that also included Hana Brixi (World
Bank) and Ben Lockwood (University of Warwick).
-2-
Contents
Page
I. Introduction ............................................................................................................................3
II. The Current System...............................................................................................................3
A. Description of the 1994 Reforms ..............................................................................3
B. Assessment ................................................................................................................4
III. Redesigning the Transfer System ......................................................................................11
A. A New Transfer System..........................................................................................11
B. Simulation Results...................................................................................................19
C. Assessment ..............................................................................................................22
IV. Conclusions........................................................................................................................24
References................................................................................................................................26
Figures
1.
Budget Revenue .............................................................................................................7
2.
Central Government Revenue........................................................................................7
3.
Transfers Per Capita to Provinces................................................................................10
4.
Extrabudgetary Funds ..................................................................................................12
Tables
1. Share of Central and Local Administration in Selected Budgetary Expenditures.............6
2. Central, State, and Local Finances (Official Definition) and Imbalance...........................7
3. Central to Local Government Transfers ............................................................................9
4. Revenue Capacity and Tax Effort....................................................................................14
5. Factors for the Determination of Expenditure Needs........................................................15
6. Average Provincial Expenditure by Category...................................................................16
7. Actual and Standard Expenditure Needs .........................................................................20
8. The Base Scenario Needs for 2000..................................................................................21
9. An Equalization Framework for China............................................................................23
10. Effects of Different Equalization Assumptions ...............................................................24
-3-
I. INTRODUCTION
In 1994, China carried out far-reaching fiscal reforms. Revenue bases were assigned to different
levels of government, and a more transparent and rules-based transfer system was designed to
replace the various ad hoc bilateral agreements that had defined intergovernmental fiscal
relations up to then. However, while succeeding in improving the buoyancy of the tax system
and providing the central government with additional resources, the reforms did not provide
each province with sufficient resources to deliver a minimum standard of public services,
leading to a proliferation of illegal fees and charges and to indirect borrowing. The scope of
equalization and special purpose transfers was considerably limited by the revenue returns that
provided resources to the areas where they were generated.2
This paper argues that effective and full implementation of the general transfers system included
in the 1994 reforms, in which general purpose transfers were defined primarily on the basis of
local revenue capacity, and expenditure needs would allow a better redistribution of resources
among provinces than the framework that had evolved at the beginning of 2000. The
simulations in this paper, based on information for 2000, indicate that, together with special
purpose transfers, such a redesigned system could contribute also toward attainment of a
minimum standard of public services in each province.
II. THE CURRENT SYSTEM
A. Description of the 1994 Reforms
The 1994 fiscal reforms were comprehensive on the revenue-sharing side, clearly assigning
some taxes to the central or the local governments3 and introducing other taxes such as VAT,
that would be shared between the center and lower levels. In carrying out this reform, the
authorities had four main goals, namely to simplify the tax system, raise the revenue-to-GDP
ratio, raise the share of the central government in total revenue, and achieve a more stable fiscal
federal system by shifting from ad hoc, negotiated transfers to rule-based revenue assignments.
There were no changes to the expenditure responsibilities, which remained consistent with the
very broad guidelines under the constitution.
Under the new revenue arrangements, tax revenue assigned to the central government included:
75 percent of the (newly introduced) VAT; excise and trade-related taxes; and the enterprise
income tax collected from central state-owned enterprises (SOEs). Revenue assigned to local
governments included: 25 percent of the VAT; the business tax; the enterprise; income taxes
2
See Ahmad, Ehtisham, Gao Qiang, and Vito Tanzi (1995) for the 1994 reforms, and Ahmad, E., Li Keping, R.
Singh, and T. Richardson (2003).
3
The term local government in China is taken to refer to all four levels of subnational administration. At the second
tier there are 22 provinces, five autonomous regions, and four municipalities (Beijing, Shanghai, Tienjin,
Chongqing). The third tier consists of 331 prefectures. The fourth tier consists of 2,109 counties/cities. The fifth
tier consists of 44,741 villages/townships.
-4-
levied on local SOEs, as well as on foreign financed enterprises; and the personal income tax.
At the same time, a national tax service was established to administer the new central and
shared revenue system. However, tax policy remained under the control of the center, and the
subnational jurisdictions had very limited legal means of varying rates even for taxes for which
revenues were entirely assigned to them.
In addition, the system of transfers was redesigned, moving away from ad hoc, negotiated
transfers toward a more rules-based mechanism. The new system of transfers from central to
local governments comprised four main parts:
•
•
•
•
“fixed subsidies” were designed to ensure that every province would have total nominal
revenues no lower than in 1993;
“revenue returned” provided each province with 30 percent of the increase in VAT and
excise tax collection in its province over the 1993 base;
“specific-purpose grants” or earmarked transfers were allocated on an ad hoc basis; and
“subsidy transfers” or general purpose grants were meant to help equalize the resources
of the provinces. These were rules-based and depend on variables such as provincial
population or land area.
The spending assignments between the different levels of government were, however, not
revised. They remained, as under the centrally planned system, where local governments
provided a wide range of services as agents of the central government. There was an unclear
expenditure assignment and the pressure to devolve expenditures to lower administrative units
was inconsistent with the revenues available at these lower levels of government.4
B. Assessment
Vertical imbalances
The 1994 fiscal reform managed to reverse the decline in the collection of budget revenue.
From a low 11.1 percent of GDP in 1995, budget revenue has increased to 18.7 percent
in 2002.5 Similarly, the central government’s share of total budget revenue increased from a low
22 percent in 1993 to nearly 56 percent in 1994 but has hovered around 50 percent since then.
4
5
See World Bank (2002).
Using the IMF definition which excludes subsidies to loss-making SOEs. The official definition includes this item
as negative revenue.
-5-
Figure 1. Budget Revenue 1979-2002
(In percent of GDP)
19
80
19
82
19
84
19
86
19
88
19
90
19
92
19
94
19
96
19
98
20
00
20
02
35
30
25
20
15
10
5
0
Figure 2. Central Government Revenue Share
1979-2002
(In percent of budget revenue)
60
50
40
30
20
10
20
02
20
00
19
98
19
96
19
94
19
92
19
90
19
88
19
86
19
84
19
82
19
80
0
While revenue was recentralized, spending responsibilities became increasingly decentralized.
Local governments bear very heavy expenditure responsibilities. In 2001, the share of local
governments in total budget revenue was 48 percent, but they accounted for 69 percent of total
budget expenditure. Not only are local governments responsible for providing health and
education, but they are also responsible for unemployment insurance, social security, and
infrastructure. In 2001, provincial governments accounted for about 90 percent of total spending
-6-
in culture, education and health, and for practically all the social relief and welfare expenditure
(Table 1).
Table 1. Share of Central and Local Administration in Selected Budgetary Expenditures, 2001
(In percent)
Total
Capital construction
Working capital
Technological upgrading and R&D
Geological prospecting
Industry, transport and commerce
Agriculture
Culture, education, science and health
Social relief and welfare
Defense
Government administration
Government debt service
Policy subsidies
Central
Local
31
34
59
25
31
28
11
11
1
99
3
100
40
69
66
41
75
69
72
89
89
99
1
97
0
60
Source: Ministry of finance data. The local expenditures include the earmarked transfers from the central
government.
During the 1990s, the vertical imbalance widened. The 1994 fiscal reform, by centralizing
revenue, has provided the central government with a surplus (before transfers), but created a
deficit at the subnational level. Such imbalances are not uncommon in large federations, such as
Australia or India for instance, and allow the center to play a greater role in macroeconomic
stabilization. The vertical imbalance also provides potential room for equalization transfers. In
China, these imbalances have tended to widen, especially since the start of the pro-active fiscal
policy in 1998 (see Table 2).
However, the effective vertical imbalance in favor of the center has been negated by the revenue
returned on a derivation basis. While the revenue-returns are treated in the formal Chinese
budget as transfers, they effectively reduce the central government share in the main revenue
sources. The central government is thus left with only limited untied resources. Adjusting for
the returned revenue, the vertical imbalance between the central and local governments appears
therefore significantly smaller, hampering the ability of the central government to carry out its
stabilization and redistribution roles.
Horizontal imbalances
Local governments are assigned heavy spending responsibilities without the capacity to
generate adequate own-revenue nor a transfer system that will provide them with the needed
-7-
resources to deliver minimum standards of public services. As a result, local governments have
turned to off-budget sources of revenue and indirect borrowing to meet priority expenditures
including unfunded mandates.
Table 2. Central, State, and Local Finances (Official Definition) and Imbalance, 1990–2001
(In percent of GDP)
1990
1994
1995
1996
1997
1998
1999
2000
2001
5.4
5.4
0
6.2
3.8
2.4
5.5
3.5
2
5.4
3.2
2.2
5.7
3.4
2.3
6.2
4.0
2.3
7.1
5.1
2.1
7.8
6.2
1.6
8.9
6.0
2.9
Subnational governments
Own local revenue
Own expenditure
Own balance
10.5
11.2
-0.7
4.9
8.6
-3.7
5
8.2
-3.2
5.5
8.5
-3.1
5.9
9.0
-3.1
6.4
9.8
-3.4
6.8
11.0
-4.2
7.1
11.6
-4.4
8.1
13.6
-5.5
Total imbalance
-0.7
-1.3
-1.2
-0.8
-0.8
-1.2
-2.1
-2.8
-2.6
Adjusted balances for
revenue returned
Central government
Subnational government
...
...
...
...
...
...
-0.7
-0.1
-0.4
-0.4
-0.5
-0.7
-0.5
-1.6
-1.0
-1.8
0.7
-3.2
Pro memoria
Revenue returned
...
...
...
2.9
2.7
2.7
2.6
2.6
2.3
Central government
Own revenue
Own expenditure
Own balance
Sources: Ministry of finance; and IMF staff estimates.
Subnational levels of government widely diverge with respect to their revenue generating
capabilities. In 2000, the ratio between the highest and the lowest budgetary revenue collection
in per capita terms among provinces was 12.8—with some of the coastal provinces far
outstripping others. Although the transfer system helps to deal with these differences in revenue
mobilization, it does not adequately distribute resources to allow all subnational levels of
government to adequately deliver minimum standards in public services.
The “revenue returned” principle has perpetuated a regressive character of the current system,
whereby richer provinces receive most of the transfers (Figure 3)—the regressivity is due
largely to the transfers to the richest coastal provinces. Although declining, the share of these
transfers still represented in 2001 about 40 percent of the total transfers from the central to the
local governments. The predominance of the revenue returned continues to hamper the system’s
ability to redistribute fiscal revenues.
-8-
Figure 3. Tranfers Per Capita to Provinces, 2000
(In yuan)
2000
1500
1000
500
0
0
5000
10000
15000
20000
25000
30000
GDP per capita
Despite the 1994 reform, the transfer system has also grown less transparent. The specific
purpose grants represent a growing share of total transfers, amounting to over a third in 2001.
There are hundreds of different earmarked grants, all of which are allocated on an ad hoc,
negotiated basis. The increasing importance of this type of transfers reflects the proactive
regional policy that the center is carrying out, but which undermines the rules-based and
transparent character the new system aimed to introduce.
Although special-purpose transfers could help alleviate specific short-term problems, their
ad hoc nature undermines the aim of greater transparency and reliability in intergovernmental
fiscal relations. It is also unclear whether the special purpose grants in sum actually lead to
overall equalization. Most of these earmarked grants have been responses to high priority
emergencies—such as the fiscal stimulus packages, bail-outs for local government social
protection programs, and partial payments for increases in pension benefits. The central
government may also have been tempted to use special purpose grants in order to achieve
equalization objectives. But it is not evident that these grants have been equalizing in the
aggregate.
Furthermore, the center currently lacks the monitoring mechanisms to ensure the effective use
of these resources. Without the mechanisms to monitor compliance with the objectives of
special purpose programs, earmarked resources could be diverted to the own-priorities of the
local governments. Ongoing efforts by the ministry of finance (MOF) to create an effective
treasury system should assist in improving the transparency of central and subnational
expenditure in the future.
General purpose transfers, although growing, still represent a tiny share of total transfers. The
fixed subsidy to guarantee that every province maintained revenues no lower than that of 1993
is fading away in relative terms and is being gradually replaced by general purpose transfers.
-9-
From 4 percent of total transfers in 1997, the fixed subsidy transfer only represented 2 percent
in 2001, while the share of general purpose grants has increased over the same period from
7.5 percent to 24.5 percent (see Table 3). These transfers include equalization grants, transfers
in favor of minority regions, and subsidies to cover part of the costs implied by the recent
successive increases in the basic wage of civil servants.
Table 3. Central to Local Government Transfers, 1997–2001
1997
1998
1999
2000
2001
1997
1998
1999
2000
2001
Share of Total Transfers
(In percent)
(In percent of GDP)
Transfers from central to local
governments
Revenue returned
Fixed subsidy under old system
General purpose 1/
Specific purpose
3.8
2.7
0.2
0.3
0.7
4.2
2.7
0.1
0.3
1.1
5.0
2.6
0.1
0.5
1.7
5.2
2.6
0.1
0.9
1.6
5.8
2.3
0.1
1.4
2.0
Transfers from local to the
central government
Fixed subsidy under old system
0.8
0.8
0.7
0.7
0.6
100.0
70.5
3.9
7.5
18.1
100.0
62.7
3.4
7.5
26.4
100.0
53.0
2.9
10.2
33.8
100.0
48.9
2.7
17.9
30.6
100.0
38.9
2.0
24.5
34.6
Sources: Chinese authorities; and IMF staff estimates.
1/ Includes transfers for income equalization.
However, equalization grants, sometimes also called transitional grants, still represent a small
share of general purpose transfers (about 10 percent in 2000). They are calculated on the basis
of the gap between standard current expenditures and standard current needs, adjusted for
coefficients that take into account the size of the gap. Revenue capacity is estimated using the
tax bases and standard tax rates. Expenditure needs are calculated using standard expenditure
needs in a myriad of categories including spending on administration services, public safety,
education, urban maintenance, social assistance, and heating.
It is significant that local governments continue to have very limited tax setting ability after
the 1994 fiscal reform, at least in a formal sense. They can only modify the rates of a few minor
taxes. The inability to raise own-revenues at the margin has given rise to continued incentives
for local governments to raise revenue outside the budget system, in the form of fees and
charges which accrue to locally managed extrabudgetary funds, over which the local officials
have complete control and face virtually no oversight, or to resort to indirect borrowing (e.g.,
through dummy companies).6
6
Note that local governments are prohibited from borrowing directly from commercial banks, but do so through
various indirect mechanisms.
- 10 -
The extrabudgetary funds continue to generate a significant portion of total revenue at the local
level. While reported extrabudgetary funds managed by the central government declined
significantly after the 1994 reform, those controlled by local governments have risen
(Figure 4).7 This proliferation of fees and charges instituted by various local governments is
causing considerable hardship for the population in various regions and has the potential to
cause social unrest and political difficulties for the center.
Figure 4. Extra-Budgetary Funds, 1982-1999
(In billions of yuan)
Central
19
98
19
96
19
94
19
92
19
90
19
88
19
86
19
84
19
82
350
300
250
200
150
100
50
0
Local
Despite the introduction of general purpose transfers, provincial spending per capita has
therefore remained closely linked to local revenue bases, given the high proportion of revenues
shared or returned on a derivation basis. As a result, regional disparities in public spending and
service provision have continued to grow. Given this pattern, the provision of government
services varies sharply across localities, depending on the level of local economic development.
As regional growth rates have diverged since the 1990s, this also has affected local public
expenditures. Among provinces, the ratio between the highest and the lowest in terms of per
capita budgetary expenditures has increased from 5.9 in 1990 to 8 in 2000.
The provision of basic public services has deteriorated in poorer areas. For example, the World
Health Report 2000 ranked China 61st of 191 countries in overall quality of health, but 188th in
terms of fairness in financial contribution. This assessment—placing China nearly at the bottom
7
The decline in the recorded central government revenue collected off-budget was in part due to the exclusion of
SOE profits from extrabudgetary accounts after 1993.
- 11 -
of all countries assessed—is an indication of the unequal access to public health care in China.
A similar situation exists in education.
China’s intergovernmental system has also led to indirect local borrowing, skirting a provision
in the budget law that forbids direct borrowing or issuance of guarantees by local governments.
However, local governments freely establish companies that then borrow from the banks. There
is an expectation that the state would eventually bear responsibility for borrowing for public
purposes by such companies. Such borrowing is also poorly monitored at both the provincial
and central levels. This leads to a system in which any systematic design or redistribution of a
well designed intergovernmental framework could be undermined.
III. REDESIGNING THE TRANSFER SYSTEM
A. A New Transfer System
The method used to calculate the provincial revenue capacities and expenditure needs in this
section is simplified and mainly illustrative, and the quality of data can certainly be improved.
This provides an illustrative example of how to construct an equalization transfer formula (for
general allocations to provinces), with a minimum data requirement, rather than to provide the
exact model to be used for China. The following sections discuss the methodology and the results.
Formulas for equalization transfers
Roughly speaking, there are four possible types of formulas for equalization transfers: (1) those
that consider revenue capacities, as well as the expenditure needs of different regions; (2) those
that consider only the equalization of revenue capacities; (3) those that are based on some “needs”
indicators; and (4) those that distribute untied transfers on an equal per capita basis.8
In the current exercise, we use a formula based on revenue capacities and expenditure needs of
different regions. The 1994 reform also envisaged that such a formula would be the main
mechanism to implement redistributive transfers, although full equalization was not foreseen in
the short term.9
8
See Ehtisham Ahmad (ed) 1997, Financing Decentralized Expenditures: an international comparison of grants,
Edward Elgar.
9
See Lou Jiwei, 1997.
- 12 -
A typical formula of this type could be written as follows:
TRi = Ni - Ci - OTRi,
(1)
where Ni is the standard expenditure need of the ith region, and Ci is the standard revenue capacity
of the ith region. Ni - Ci measures the gap between the standard expenditure need and revenue
capacity. OTRi represents other transfers (e.g., specific purpose transfers) the ith region receives
from the center that are used to meet part of the expenditure needs assessed by the model. This
formula states that the central government transfer will cover the difference between each region’s
standard expenditure needs and revenue capacity, to ensure that a region with standard tax effort
will be able to provide a standard level of public services.
There is a question of how to match the sum of the entitlements (ΣiTRi) calculated from the above
formula with the available pool for transfers. In theory, the pool can either be larger or smaller
than the total entitlement. A commonly used method is to adjust the size of the transfer
proportionally according to the size of the pool. Let TT be the size of the pool for transfers. Then
the actual transfer to the ith region is:
ATRi = (TT/ΣiTRi)TRi
(2)
where ATRi stands for actual transfer to the ith region, and TRi is calculated using Equation 1.
Measuring revenue capacity
Revenue capacity (Ci) is defined as the ability of a government to raise revenues from its own
sources and revenue-sharing arrangements. There are several ways to measure the revenue
capacity of a subnational government. In many developed countries, revenue capacity is measured
using data on major tax bases and standard (average) tax rates. This method measures the revenue
capacity of a region by the revenue that could be raised in that region if the regional government
taxes all the standard tax bases with a standard tax effort. The formula is as follows:
Ci = ΣjBij*tj,
(3)
where Ci is the ith region’s tax capacity, Bij is the ith region’s jth tax base, and tj is the standard
(e.g., national average effective) tax rate on the jth tax base. It is important to apply the standard
tax rate to the region’s tax base rather than the region’s own effective tax rate, in order to ensure
that the regions with a high tax effort are not penalized and regions with a low tax effort are not
rewarded. In other words, if the region’s effective tax rates are higher than the national averages,
the transfer it receives does not decrease as a result; and if the region’s effective tax rates are
lower than the national average, the transfer it receives does not increase as a result.
This method requires detailed and accurate information on major tax bases, which may not be
readily available for all regions. Revenue capacities may be also measured indirectly by
employing some income or output indicators. The frequently used indicators include: (a) the gross
- 13 -
domestic product (GDP) of the region; (b) personal income (sum of all incomes received by the
residents) or disposable personal income of the region; (c) total retail sales of the region. In the
current exercise, provincial GDP levels are used as a proxy of the tax bases. More elaborate
models might be tried using additional variables.10
Revenue capacity, REVi , was estimated using the coefficients of the regression of own
revenue11 on own GDP for region i. The results are the following:
REVi = 0.0651288 GDPi ;
R2 = 0.894 ;
N=31; Df = 30
(4)
On the basis of this regression, the series presented in Table 4 were derived The simulated
revenue capacity assumes that tax effort is based on a linear relationship linked to GDP.12
Caution should be taken, however, in using these results since a significant portion of
contributions of residents are made in the form of fees instead of taxes. This could introduce a
potential distortion in the estimates below if the pattern is not homogeneous across the country.
Eliminating fees and converting these into taxes that are accounted as budget revenue sources
will clarify this situation and should be subject to further analysis.
Expenditure needs
This section discusses a commonly used method to determine expenditure needs of subnational
governments. It divides the total expenditures of a subnational government into many different
categories and for each category estimates the corresponding needs. The total expenditure needs
of a subnational government are the sum of the estimated needs for all these categories.
In this exercise, the expenditure needs of each province are broken down into seven categories:
education, health, social welfare, government administration, law and order, economic
development and other. These seven categories are constructed by consolidating various
expenditure items in the Chinese economic classification. For each category, a formula is
developed to estimate the expenditure needs of the provinces. The variables used in these
10
For a discussion and an alternative approach to calculating revenue capacity, see World Bank Report No. 20342CHA on “Managing Public Expenditures for Better Results,” April 25, 2000, p. 140.
11
Own revenue was obtained from the 2001 Statistical Yearbook. Revenue was adjusted by subtracting the
negative value under transfers for SOEs. The same value was then added to expenditures on economic
development.
12
One might test the hypothesis that the tax effort is not linear. Regressions with nonlinear forms of the regressor
did not provide better explanation of the variation of the dependent variable. More work could, however, be carried
out on this issue.
- 14 -
Table 4. Revenue Capacity and Tax Effort
Beijing
Tianjin
Hebei
Shanxi
Inner Mongolia
Liaoning
Jilin
Heilongjiang
Shanghai
Jiangsu
Zhejiang
Anhui
Fujian
Jiangxi
Shandong
Henan
Hubei
Hunan
Guangdong
Guangxi
Hainan
Chongqing
Sichuan
Guizhou
Yunnan
Tibet
Shaanxi
Gansu
Qinghai
Ningxia
Xinjiang
Total
Revenue
(In billions of Yuan)
Actual Capacity
Difference
34.5
16.1
-18.4
13.4
10.7
-2.7
24.9
33.1
8.3
11.4
10.7
-0.7
9.5
9.1
-0.4
29.6
30.4
0.8
10.4
11.9
1.5
18.5
21.2
2.7
48.5
29.6
-18.9
44.8
55.9
11.1
34.3
39.3
5.0
17.9
19.8
1.9
23.4
25.5
2.1
11.2
13.0
1.9
46.4
55.6
9.3
24.6
33.5
8.8
21.4
27.9
6.4
17.7
24.0
6.3
91.1
62.9
-28.1
14.7
13.4
-1.4
3.9
3.4
-0.5
23.4
10.4
-13.0
8.7
26.1
17.4
8.5
6.5
-2.1
18.1
12.7
-5.3
0.5
0.8
0.2
11.5
10.8
-0.7
6.1
6.4
0.3
1.7
1.7
0.1
2.1
1.7
-0.4
7.9
8.9
1.0
640.6
633.1
-7.5
Actual
13.9
8.1
4.9
7.0
6.8
6.3
5.7
5.7
10.7
5.2
5.7
5.9
6.0
5.6
5.4
4.8
5.0
4.8
9.4
7.2
7.6
14.7
2.2
8.6
9.2
4.6
6.9
6.2
6.3
7.8
5.8
Tax Effort
(In percent)
Simulated
Difference
6.5
7.4
6.5
1.6
6.5
-1.6
6.5
0.5
6.5
0.3
6.5
-0.2
6.5
-0.8
6.5
-0.8
6.5
4.2
6.5
-1.3
6.5
-0.8
6.5
-0.6
6.5
-0.5
6.5
-0.9
6.5
-1.1
6.5
-1.7
6.5
-1.5
6.5
-1.7
6.5
2.9
6.5
0.7
6.5
1.0
6.5
8.2
6.5
-4.3
6.5
2.1
6.5
2.7
6.5
-1.9
6.5
0.4
6.5
-0.3
6.5
-0.2
6.5
1.3
6.5
-0.7
Sources: China Statistical Yearbook, 2001; and staff projections.
1/ Revenue capacity and tax effort are derived from Equations 3 and 4.
formulas are considered important determinants driving the public expenditures and for which
data are readily available. Other variables could be used depending on policy options.
- 15 -
The variables used to determine the needs under the seven categories and the weights13
attributable to each one of them are described in Table 5.
Table 5. Factors for the Determination of Expenditure Needs
Expenditure Categories
Factors
Education
share of population up to 14
share of minority population on total China
share of population 64 or greater
share of minority population on total China
share of population 64 or greater
share of urban population on total China
share of minority population on total China
share of total population
share of urban population on total for China
share of minority population on total for China
share of total population
share of urban population on total for China
share of minority population on total for China
share of total population
share of urban population on total for China
share of minority population on total for China
share of total population
Health
Social welfare
Government administration
Law and order
Economic development
Other
Weights
0.8
0.2
0.8
0.2
0.4
0.4
0.2
0.3
0.5
0.2
0.3
0.5
0.2
0.3
0.5
0.2
1
In this exercise, total spending needs were calculated imposing the budget restriction and the
structure of expenditure for 2000. Determining the expenditure needs of each province involves
three steps:
Step 1: Determine the share of each expenditure category in total expenditure. The share of each
expenditure category in total expenditure (including routine and development expenditures) is
calculated using actual expenditure data for 2000, as shown in Table 6.
13
These weights were determined in an arbitrary manner. A more detailed analysis should be based on estimates
that more closely reflect the policy framework for each factor.
- 16 -
Table 6. Average Provincial Expenditure by Category, 2000
Expenditure Categories
Education
Expenditures 2000
Yuan (000 m)
Share of expenditure (αk)
20,891,834
0.195535
4,823,944
0.045149
Social welfare
11,990,632
0.112225
Government administration
14,230,152
0.133186
7,362,913
0.068913
Economic development
37,468,581
0.350684
Other
10,076,179
0.094307
Total
104,542,771
Health
Law and order
The total expenditure needs of 31 provinces in category k (k = education, health, etc.) equal the
weight (αk) multiplied by the total expenditure needs of all categories. Expressing total provincial
needs of all categories by TN, the total expenditure needs in category k is
TNk = αk*TN
Step 2: Determine the standard expenditure need of each province in category k.
For education (k=E), the standard expenditure need of province i is calculated using the
following formula:
NiE = TNE*( .8*UiE /UE + .2*Mi/ M)
= αE*TN*( .8*UiE /UE + .2*Mi/ M)
where NiE is province i’s standard expenditure need for education,
TNE is the 31 provinces’ total expenditure need for education,
UE is the total population up to 14 years of age14 in the 31 provinces,
UiE is the population up to age 14 in province i,
M is the total minority population in the 31 provinces,
Mi is the minority population in province i,
αE=0.195 is the weight assigned to education,
14
This is a proxy for school age children.
(5)
- 17 -
TN is total national expenditure on all categories.
For health (k = H), the standard expenditure need of province i is calculated using the following
formula:
NiH = TNH*(.8*Pi64+ /P64+ + .2*Mi/ M)
= αH*TN*(.8*Pi64+ /P64+ + .2*Mi/ M)
(6)
where NiH is province i’s standard expenditure need for health,
TNH is the 31 provinces’ total expenditure need for health,
P64+ is the total population 64 or more years of age in the 31 provinces,
Pi64+ is the population 64 or more in province i,
M is the total minority population in the 31 provinces,
Mi is the minority population in province i,
αH=0.045 is the weight assigned to health,
TN is total national expenditure on all categories.
For social welfare (k=W), the standard expenditure need of province i is calculated using the
following formula:
Niw = TNw*(.4*Pi64+ /P64+ + .4*PiU /PU + .2*Mi/ M)
= αw*TN*(.4*Pi64+ /P64+ + .4*PiU /PU + .2*Mi/ M)
(7)
where NiW is province i’s standard expenditure need for social welfare,
TNW is the 31 provinces’ total expenditure need for social welfare,
P64+ is the total population 64 or more years of age in the 31 provinces,
Pi64+ is the population 64 or more in province i,
PU is the total urban population in the 31 provinces,
PiU is the urban population in province i,
M is the total minority population in the 31 provinces,
Mi is the minority population in province i,
αW=0.112 is the weight assigned to social welfare, and
TN is total national expenditure on all categories.
For government administration (k=G), the standard expenditure need of province i is calculated
using the following formula:
NiG = TNG*(.3*Pi /P + .5*PiU /PU + .2*Mi/ M)
= αG*TN*(.3*Pi /P + .5*PiU /PU + .2*Mi/ M)
where NiG is province i’s standard expenditure need for government administration,
TNG is the 31 provinces’ total expenditure need for government administration,
P is the total population in the 31 provinces,
Pi is the population in province i,
(8)
- 18 -
PU is the total urban population in the 31 provinces,
PiU is the urban population in province i,
M is the total minority population in the 31 provinces,
Mi is the minority population in province i,
αG=0.133 is the weight assigned to government administration,
TN is total national expenditure on all categories.
For law and order (k=L), the standard expenditure need of province i is calculated using the
following formula:
NiL = TNL*(.3*Pi /P + .5*PiU /PU + .2*Mi/ M)
= αL*TN*(.3*Pi /P + .5*PiU /PU + .2*Mi/ M)
(9)
where NiL is province i’s standard expenditure need for law and order,
TNL is the 31 provinces’ total expenditure need for law and order,
P is the total population in the 31 provinces,
Pi is the population in province i,
PU is the total urban population in the 31 provinces,
PiU is the urban population in province i,
M is the total minority population in the 31 provinces,
Mi is the minority population in province i,
αL=0.069 is the weight assigned to law and order,
TN is total national expenditure on all categories
For economic development (k=D), the standard expenditure need of province i is calculated
using the following formula:
NiD = TND*(.3*Pi /P + .5*PiU /PU + .2*Mi/ M)
= αD*TN*(.3*Pi /P + .5*PiU /PU + .2*Mi/ M)
(10)
where NiD is province i’s standard expenditure need for economic development,
TND is the 31 provinces’ total expenditure need for economic development,
P is the total population in the 31 provinces,
Pi is the population in province i,
PU is the total urban population in the 31 provinces,
PiU is the urban population in province i,
M is the total minority population in the 31 provinces,
Mi is the minority population in province i,
αD=0.35 is the weight assigned to economic development,
TN is total national expenditure on all categories
For other expenditures (k=O), the standard expenditure need of province i is calculated using
the following formula:
- 19 -
NiO = TNO*Pi /P
= αO*TN*Pi /P,
(11)
where NiO is province i’s standard expenditure need for other expenditures,
TNO is the 31 provinces’ total expenditure need for other expenditures,
P is the total population in the 31 provinces,
Pi is the population in province i,
αO=0.094 is the weight assigned to other expenditures,
TN is total national expenditure on all categories
Step 3. Sum up province i’s needs in the seven categories to get the total standard expenditure
needs of the province:
Ni = NiE + NiH + NiW + NiG + NiL + NiD + NiO
(12)
where Ni is the total standard expenditure need of province i.
Table 7 presents the calculated results of provincial level standard expenditure needs for the seven
expenditure categories. The standard expenditure needs differ significantly from the actual
amounts spent in some provinces. This might be due to specific policies of the province. A
national program should not account for the specificities resulting from local policy decisions.
B. Simulation Results
Using equation (1) and assuming that the total transfer to province i (Ti ) consists of a general
purpose transfer and specific transfers that meet certain needs assessed by the formulas and that
there are no other transfers, the entitlement of province i is:
Ti = Ni - Ci
(13)
where Ni is given by Equation 12. Since the available funds for distribution (TT) are normally
different from the sum of all provinces’ entitlements (ΣiTi), a coefficient ε is applied to each Ni
so that TT=Σi (ε Ni – Ci). The amount of transfer that should be received by province i is given
by:
Ti = ε Ni - Ci
(14)
Table 8 shows the amount of equalization transfers calculated using the above formula. A few
provinces receive however negative transfers, as their revenue capacities exceed their expenditure
needs. Beijing, Shanghai, Jiangsu, and Zhejiang have revenues in excess of their calculated
expenditure needs. Given political economy considerations, the imposition of negative transfers
is not a feasible option, and it is assumed that these provinces will receive no additional
transfers.
- 20 -
Table 7. Actual and Standard Expenditure Needs, 2000 1/
(In millions of Yuan)
Beijing
Tianjin
Hebei
Shanxi
Inner Mongolia
Liaoning
Jilin
Heilongjiang
Shanghai
Jiangsu
Zhejiang
Anhui
Fujian
Jiangxi
Shandong
Henan
Hubei
Hunan
Guangdong
Guangxi
Hainan
Chongqing
Sichuan
Guizhou
Yunnan
Tibet
Shaanxi
Gansu
Qinghai
Ningxia
Xinjiang
Total
Actual
4,971,776
1,920,521
4,193,816
2,281,852
2,479,481
5,277,411
2,670,554
3,848,655
6,457,946
5,988,172
4,860,928
3,261,431
3,245,392
2,237,367
6,193,951
4,475,888
3,737,737
3,527,476
10,862,875
2,594,286
646,329
4,551,417
1,901,812
2,022,000
4,168,285
609,849
2,744,487
1,895,581
682,988
609,347
1,924,625
106,844,235
Standard
1,498,799
1,535,235
4,603,344
2,306,117
3,172,007
4,803,323
2,395,685
3,065,744
1,675,698
5,256,208
3,468,476
3,620,894
2,720,241
2,555,419
5,944,234
5,526,728
4,624,544
5,454,912
7,036,039
5,971,293
1,214,938
2,433,805
5,946,083
4,803,934
5,383,634
600,002
2,413,860
1,946,389
775,294
726,711
3,364,646
106,844,235
Difference
-3,472,977
-385,286
409,528
24,265
692,526
-474,088
-274,869
-782,911
-4,782,248
-731,964
-1,392,452
359,463
-525,151
318,052
-249,717
1,050,840
886,807
1,927,436
-3,826,836
3,377,007
568,609
-2,117,612
4,044,271
2,781,934
1,215,349
-9,847
-330,627
50,808
92,306
117,364
1,440,021
0
Sources: China Statistical Yearbook 2001; and staff calculations.
1/ Standard expenditures refer to a reallocation of total expenditures according to
Equation (12).
- 21 -
Table 8. The Base Scenario Needs for 2000
(In billions of Yuan)
Beijing
Tianjin
Hebei
Shanxi
Inner Mongólia
Liaoning
Jilin
Heilongjiang
Shanghai
Jiangsu
Zhejiang
Anhui
Fujian
Jiangxi
Shandong
Henan
Hubei
Hunan
Guangdong
Guangxi
Hainan
Chongqing
Sichuan
Guizhou
Yunnan
Tibet
Shaanxi
Gansu
Qinghai
Ningxia
Xinjiang
Source: China Statistical Yearbook.
Revenue Capacity
Expenditure Needs
16.1
10.7
33.1
10.7
9.1
30.4
11.9
21.2
29.6
55.9
39.3
19.8
25.5
13.0
55.6
33.5
27.9
24.0
62.9
13.4
3.4
10.4
26.1
6.5
12.7
0.8
10.8
6.4
1.7
1.7
8.9
15.0
15.4
46.0
23.1
31.7
48.0
24.0
30.7
16.8
52.6
34.7
36.2
27.2
25.6
59.4
55.3
46.2
54.5
70.4
59.7
12.1
24.3
59.5
48.0
53.8
6.0
24.1
19.5
7.8
7.3
33.6
Shortfall/Excess
1.16
-4.68
-12.89
-12.36
-22.60
-17.62
-12.10
-9.47
12.88
3.34
4.63
-16.42
-1.67
-12.51
-3.81
-21.81
-18.39
-30.50
-7.43
-46.36
-8.77
-13.99
-33.34
-41.57
-41.10
-5.24
-13.32
-13.06
-6.04
-5.54
-24.76
- 22 -
C. Assessment
In order to assess the new transfer design, three scenarios have been considered:
•
•
•
Base case equalization applies the entire amount of resources available for transfers in
2000 (Y 475 billion) to equalization, using the formula as designed, subject to zero
transfers to the rich provinces. This implies the elimination of the revenue returned, and
places all equalization transfers on a consistent basis.
Partial equalization at 20 percent, the equalization is based on 20 percent of the total
transfers, with 80 percent distributed according to the total transfer pattern observed in
2000. This closely approximates the current situation.
Partial equalization at 60 percent, the equalization is based on 60 percent of the total
transfers, with 40 percent distributed according to the transfer pattern in 2000. This is an
intermediate case that simulates retention at the current level of the “revenue returned.”
The resulting simulations are summarized in Table 9. To test the equalizing effects of the new
formula, per capita transfers were regressed against per capita provincial GDP. The coefficient
of the explanatory variable should be negative if an equalizing effect exists. An insignificant or
positive coefficient means that there is little impact or correlation with income levels. Whether
the minority province policy reduces disparities was also examined. To this effect, a dummy
variable was introduced. The results are summarized in Table 9.
The results reported in columns 1 and 2 indicate that under the current system there is no
significant relation between the transfers from the central government and the income levels in
different provinces. If any, the relation would be positive, suggesting that richer provinces got
more. Controlling for the policy favoring “minority” provinces does not result in a significant
coefficient for the dummy variable, implying that there is no significant impact arising from the
policy of equalization across “minority provinces” (column 2).
These results are consistent with those reported in World Bank (2000), which were based on
1994 data. This leads to conclude that there has been little improvement in the equalization
effect of transfers since the 1994 reforms, in spite of the increasing amount of resources
available for redistribution (through both special purpose and general purpose grants).
Keeping the revenue returned and distributing only the remaining resources according to the
proposed formula would improve the equalization effect of the transfer mechanism (column 4).
However, although the coefficient for GDP is negative (desired sign), it remains nonsignificant.
Only if the entire amount of resources currently earmarked for transfers (including the revenue
returned) would be distributed according to the proposed transfer mechanism, would the
equalization of the system be both positive and significant (column 5).
- 23 -
Table 9. An Equalization Framework for China
Actual
Transfers
2000
Base Case
20 percent
60 percent
Actual
Under
Under
Transfers
Equalization Equalization
2000 per
Formula
Formula
capita
(In billions of Yuan)
Beijing
Tianjin
Hebei
Shanxi
Inner Mongolia
Liaoning
Jilin
Heilongjiang
Shanghai
Jiangsu
Zhejiang
Anhui
Fujian
Jiangxi
Shandong
Henan
Hubei
Hunan
Guangdong
Guangxi
Hainan
Chongqing
Sichuan
Guizhou
Yunnan
Tibet
Shaanxi
Gansu
Qinghai
Ningxia
Xinjiang
Total
0.0
4.9
13.4
12.8
23.5
18.3
12.6
9.8
0.0
0.0
0.0
17.1
1.7
13.0
4.0
22.7
19.1
31.7
7.7
48.2
9.1
14.5
34.6
43.2
42.7
5.4
13.8
13.6
6.3
5.8
25.7
9.1
7.8
17.2
11.7
17.6
25.9
15.6
19.2
19.4
17.4
13.0
16.4
7.7
12.0
16.1
21.0
18.5
21.6
19.9
19.6
4.1
12.5
25.3
18.6
27.1
6.2
16.3
12.9
5.7
5.1
14.7
4.6
6.3
15.3
12.3
20.5
22.1
14.1
14.5
9.7
8.7
6.5
16.7
4.7
12.5
10.0
21.8
18.8
26.7
13.8
33.9
6.6
13.5
30.0
30.9
34.9
5.8
15.1
13.2
6.0
5.4
20.2
475.0
475.0
475.0
475.0
1/ Subject to the restriction of using Y 470 billion in total.
Equalization Equalization
20 percent 60 percent
per capita per capita
(In Yuan per capita)
11.4
8.5
18.2
11.4
16.1
27.8
16.3
21.5
24.3
21.8
16.2
16.2
9.2
11.8
19.1
20.6
18.3
19.1
22.9
12.5
2.9
12.0
23.0
12.4
23.2
6.4
16.9
12.7
5.5
4.9
11.9
Sources: Ministry of Finance; and staff calculations.
Base Case
per capita
1/
824.9
849.2
269.9
345.8
677.6
656.0
597.5
582.8
1451.6
293.1
346.4
270.6
265.1
285.0
210.4
222.6
303.6
296.6
265.0
278.5
368.5
388.3
276.1
351.8
541.0
2442.7
468.8
495.7
1061.8
871.9
618.2
0.0
485.1
198.5
389.2
987.8
432.0
460.5
266.7
0.0
0.0
0.0
284.9
50.0
313.8
43.5
244.7
317.0
492.0
89.3
1072.7
1157.8
470.2
415.8
1224.9
995.7
2075.4
383.8
529.5
1210.4
1023.5
1336.0
659.9
776.4
255.6
354.5
739.6
611.2
570.1
519.6
1161.3
234.5
277.1
273.5
222.0
290.8
177.0
227.0
306.3
335.7
229.9
437.3
526.4
404.7
304.1
526.4
632.0
2369.3
451.8
502.5
1091.5
902.2
761.8
330.0
630.7
227.1
371.9
863.7
521.6
515.3
393.1
580.6
117.2
138.6
279.2
136.0
302.3
110.3
235.8
311.6
413.8
159.6
755.0
842.1
437.4
359.9
875.6
813.8
2222.4
417.8
516.0
1150.9
962.8
1048.9
- 24 -
Table 10. Effects of Different Equalization Assumptions
Intercept
GDPpc
Actual
Actual 2/
w/Minority
Dummy
Partial
Equalization
20 percent
Partial
Equalization
60 percent
Base Case
Equalization
1
2
3
4
5
379.87
(2.53) 1/
380.15
(2.04) 1/
491.90
(3.39) 2/
720.52
(5.08) 2/
947.00
(6.31) 2/
0.02
(1.37)
0.02
(1.34)
0.01
(0.49)
-0.02
(-0.142)
-0.05
(3.14) 2/
…
…
- 0,00
(-0.00)
…
…
…
…
…
…
0.061
0.061
0.008
0.065
0.254
DumGDPminority provs
R2
Note: t ratios in parentheses.
1/ Significant at the 5 percent.
2/ Significant at the 1 percent level.
IV. CONCLUSIONS
The 1994 reforms correctly designed an equalization transfer system, based on expenditure
needs and revenue capacities. However, the resources subsequently available were inadequate to
make any significant equalization impact or allow provinces to deliver a minimum standard of
public services. The “revenue returned” element still dominates the system, making the overall
equalization effect of the transfer system by 2000 little different than in 1994. Coupled with the
inability of lower level governments to raise own revenues at the margin, this situation has led
to a proliferation of illegal fees and charges and widespread indirect borrowing.
The revenues returned principle was designed to convince the richest provinces to adopt the
1994 reforms package and were premised on avoiding major disruptions to economic activity in
the richer provinces. A more complete and effective solution might lie in a complete overhaul of
the intergovernmental system—recall that the 1994 reforms did not address expenditure
responsibilities. An alternative solution would lie in a joint reassessment of expenditure
responsibilities together with a revamped revenue assignment and transfer system. Tax reforms,
such as the provision of additional own source revenues, would be beneficial to the more
developed provinces, and social security reforms would remove a potential liability that could
be extremely detrimental to the coastal provinces in the not too distant future.15
15
For further details on this, see Ahmad, Lockwood, and Singh (forthcoming).
- 25 -
Currently, almost all rates and bases are nationally set, even for those taxes where revenue
entirely goes to local governments. Tax reforms are needed to provide provinces and counties
with some control over rates of assigned taxes at the margin. This is a key element of fiscal
accountability. The choice of taxes, where some local control is envisaged, should be such as
not to lead to excessive economic distortions and tax competition.
There are strong arguments for standardizing the base for the personal income tax. However,
bounded control over a number of percentage points for provinces (piggybacking) should
provide them with much greater room for maneuver than at present. Such reforms will also
provide significant revenues to the more advanced coastal provinces—also reducing the
political pressures for revenue returned. More extensive use of property taxes at the county
level, including enhanced valuation and recording mechanisms for leasehold properties, and
basing annual taxes on the annual lease value equivalent should also be considered.
On the spending side, subnational expenditure assignments are incommensurate with their
available resources. Even some middle income counties face difficulties in meeting pension
liabilities, and unfunded mandates from the center continue to pose difficulties, including for
key priority issues such as basic education or health care. The recentralization of pension
liabilities and unemployment insurance should be considered.
Pensions should at a minimum be pooled at the provincial level. This would eliminate the need
for central government “gap-filling” transfers to subprovincial administrations running pension
deficits. However, provincial pooling would not address the higher burdens borne by the coastal
provinces, which have adverse demographic characteristics (e.g., in Shanghai). Central pooling
of pensions should reduce the political case for revenue returned made by influential provinces,
such as Shanghai, while at the same time help in the standardization of contribution rates across
China—needed to establish a level playing field for investment.
The case for centralization of unemployment insurance is even stronger. Given the factors that
give rise to unemployment, a wider pooling of risk is highly desirable. Moreover,
unemployment benefits act as an automatic stabilizer and thus have a macroeconomic function
that would be enhanced by centralization.
In addition, the ability of local governments to bypass the existing constraints on bank
borrowing need to be addressed. Without a more orderly allocation of overall borrowing limits,
other reforms to ensure redistribution might be negated.
While the redesigned transfer system has the potential to achieve more effective redistribution,
it cannot do so in isolation of the other reforms highlighted. The reforms described above form
part of an extensive and interlocking package of measures that will take several years to
implement fully. China clearly cannot move on all these fronts simultaneously and rapidly.
While the pace of the reforms may be gradual, the scope should be comprehensive. The design
of the ultimate overall reform package should be consistent, and it will be important to keep this
medium-term goal in sight.
- 26 -
REFERENCES
Ahmad, Ehtisham, 1997, “China” in Fiscal Federalism in Theory and Practice, ed. by T. TerMinassian (Washington: International Monetary Fund).
_____, 1997, “Intergovernmental Transfers—An International Perspective,” in Financing
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