1. From China’s fiscal architecture to the outlook for reform under Xi Jinping Christine Wong Centre for Contemporary Chinese Studies China Agricultural University Beijing October 22, 2015

2. Fiscal reform is a key part of the Xi Jinping reform program Ambitious, comprehensive program mapped out in the Decisions of the Third Plenum of the 18th Party Congress in November 2013 Aimed at –National rejuvenation – harnessing economic growth to be “smarter” –Providing citizens with a happy life: clean air, good schools, reliable health care, a social safety net –Fairness – access to equal opportunities –Clean government

3. Minister Lou Jiwei has outlined a comprehensive reform of the fiscal system Phase 1: public financial management reforms – started 2014 –Rein in extrabudgetary resources –Rein in local government borrowing –Improve transparency –Strengthen accountability, etc. Phase 2: reform of the tax system – implement in 2015 –VAT reform, property tax, resource taxes, etc Phase 3 to start in 2016: intergovernmental reform – a reallocation of revenues and responsibilities

4. The current fiscal architecture China is a unitary state where local governments play important roles The government has maintained a top- down, four-five tier structure of administration since 1949

5. China’s administrative structure China had a total of 43,714 local governments in 2013.

6. What is the intergovernmental fiscal system? The assignment of expenditure and revenue responsibilities to different levels of government A well-functioning intergovernmental fiscal system channels resources to each unit of government to enable the financing of responsibilities

7. The fiscal system is highly decentralized - local governments provide almost all services

8. Responsibilities are disbursed throughout the administrative hierarchy

9. Local governments also finance most of the investment in infrastructure Local government share of total expenditure and investment (%) Of the 3 million km of road network, only 175,000 km are national level roads Even for the major highways, central funding comprised less than 10% of total investment through the mid-2000s Responsibilities are shared among all levels of government

10. Mechanisms for matching resources to responsibilities The vertical distribution of revenue has been fairly stable over past decade (% of total):

11. Background: Rapid growth of economy –GDP grew from $1.2 trillion (USD) in 2000, to 8.23 trillion in 2012 –Per capita income (RMB terms) grew 5.1- fold during 2000-2012 Government revenues and expenditures grew even faster than GDP –Budgetary revenues grew 8.8-fold (from ¥1.34 trillion to 11.7 trillion) –Expenditures grew 7.9 times (from ¥1.59 trillion to 12.6 trillion)

12. While expenditure shares changed dramatically 总支出的百分比

13. A sample of big rural programs

14. The vertical imbalance Central surpluses are financing some portion of expenditures at all subnational levels through transfers: to the provinces, prefectures, and counties In aggregate, every level of local government faces a budgetary shortfall (= revenue share - expenditure share) % of national budget expenditures

15. The mechanics Resources are transmitted level-by-level downward through the hierarchy Central Government  Provinces Provincial Government  Prefectures Prefectures  Counties....  Villages/Farmers This is a unique, core feature of China’s decentralized system Treasury system works the same way: transfers are sent from the central treasury to the provincial treasury, from the provincial treasury to the prefectural, and onward to the county treasuries. Creation of the welfare state over the past decade has brought much greater strain to the fiscal structure

16. System depends critically on incentives for local governments Local officials embrace the promotion of economic growth as their top priority mission Investing in infrastructure has been vital to supporting urbanization and economic growth This has been mostly financed by local (urban) governments –Lacking resources in the budget, local governments have turned to land revenues and borrowingland revenues –Prohibited from borrowing, they used special financial vehicles - “financial platforms” or “local investment corporations”“local investment corporations”

17. Composition of revenues for an average prefectural city (2013)

18. Special financial vehicles – the local investment corporations (LICs) Set up as enterprises under municipal departments, LICs are a workaround to the prohibition on local government borrowing –Local governments acquire farmland and transfer it to an LIC –The LIC uses it as collateral to borrow from banks –Funds are used to prepare the land for development –Land is sold to developers –Profits are turned over to the local government At the peak, there were more than 10,000 LICs and existed in all cities and even some towns They operated “below the radar” of central authorities until the fiscal stimulus program of 2008-2010

19. China has been working with a broken intergovernmental fiscal system The intergovernmental system asks local governments to do the impossible – … but leaves the backdoor open for them to find extra-budgetary resources and ways LICs were the natural outcome of strategy of muddling through –… tolerated because they produced results consistent with broad objectives of government – growth and infrastructure Accountability was very poor for these extra- budgetary, shadowy revenues

20. 2014 National audit of land revenues found no clear accounting standards used Receipts of RMB 20 trillion over 13 years, even with massive under-reporting in most years 2008 audit found under-reporting by more than 70% during 2004-2006 in 11 cities/provinces Reporting on expenditures of land revenues even messier – frequent diversions and falsifications

21. Local government borrowing is out of control Local government debt came to national attention only in 2010 2 nation-wide audits – 2011 and 2013, and recent NPC report Even through the national clampdown on local borrowing, local government debt continues to grow!

22. Reform challenges for Xi Jinping The broken intergovermental fiscal system and the use of back door practices were the systemic roots that gave rise to a soft budget constraint for local governments They in turn gave rise to the current problems of declining capital efficiency, a mountain of local government debt, and widespread corruption Fixing the intergovernmental assignment of responsibilities and revenues is a prerequisite to improving fiscal and a range of policy outcomes

23. Sequencing of reforms reflects current worries Problem was too much decentralization and loss of control – over the macro economy, over resource allocation Phase 1 is critically important: improve public financial management to strengthen accountability – a prerequisite to decentralized control over resources Rein in extra-budgetary resources and regain comprehensive oversight of fiscal resources Giving local governments legal power to borrow while stopping back-door borrowing

24. PFM systems need to be strengthened both at central and local gov’t levels Improve budget practice – introduce medium term expenditure framework and accrual acc’ting Harmonize and upgrade government accounting standards Intensive reporting and monitoring Limits not only for debt and deficit, but perhaps also for PPPs, investment, expenditure growth More active review of budget and medium-term expenditure framework by people’s congresses as well as higher levels of government

25. What are the prospects for intergovernmental reform under Xi Jinping?

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