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China economy: fiscal and tax reform since the third plenum

Research and analysis – China economy: fiscal and tax reform since the third plenum
Published by FCO on 15 September 2014
0.1 Summary

The Third Plenum last November prioritised fiscal and tax reform. Since then, relatively rapid progress has been achieved, most recently with the passing of the new Budget Law at the end of August, following over 10 years of amendments and debate. Successful reform would deliver significant long-term benefits, particularly to the sustainability of China’s public finances. But given the scope and sensitivity of many fiscal reforms, implementation is likely to take some time.
Recent developments on fiscal reform in China

The Communist Party’s Third Plenum last November put unprecedented emphasis on fiscal and tax reforms. For the first time, the issue was raised to the status of ‘national governance’. The Decisions document, published after the 3rd Plenum, set the targets and principles for budget management, tax reform and central vs. local government revenue and obligations. On June 30th this year, China’s Politburo is reported to have approved a detailed fiscal and tax reform plan (but this plan is not yet publicly available).

Finance Minister Lou Jiwei has stated that the immediate priority is budget reform. This will be followed by tax reform. Central and local relations will be tackled later. The Plan also set a timetable: to finish the priorities of the reform by 2016 and to basically finish the reform by 2020.

The objective is to build a modern fiscal system. Budget management aims at establishing a more comprehensive, efficient and transparent system. Tax reform focuses on six taxes: value-added tax (VAT), consumption tax, resource tax, environment tax, property tax, and income tax. Some tax reform has been underway, such as the replacement of the business tax on services companies with VAT. The obligations and expenditure of central government will be increased.

Important landmarks in recent months:

In May this year, the Chinese Ministry of Finance announced that local authorities in ten areas were permitted to issue their own debt.
On 31 August, China’s National People’s Congress Standing Committee approved the amendment of the budget law, which will come into effect on 1 January 2015. The revised budget law sets strict control on local governments’ debt, reduces scope for special transfer payment, increases budget information transparency, enhances NPC supervision and restores central bank’s role as manager of Treasury department.
On 3 September, the State Council Executive Meeting decided to improve budget management and transparency by cancelling private coffers, unnecessary fees, and regulating tax collection, non-tax incomes and local government debt. Current system

China’s current fiscal and tax system was established in 1994. The preceding reforms had simplified the tax structure, introduced tax sharing system and established a multiple budget system. Through this tax sharing system, the central government increased its share in tax revenue. In addition to a smaller share of tax revenues, local government also received tax refunds and transfer payments from central government.

The tax sharing system introduced in 1994 stabilized central government’s revenue growth. The central government got greater fiscal power as it had more revenue. This made local government more dependent on central government for transfer payments.

Fiscal power was shifted to central government but local governments still had more obligations: central government received around 48 percent of total revenues but were responsible for less than 20 percent of total expenditure. This imbalance became even more prominent at the lowest levels of Chinese administration (China has five tiers of government). Local government, especially the governments at bottom, do not have any direct sources of tax revenue, making them wholly dependent on either transfer payments or finding alternative sources of revenue.

To bridge the gap between their (high) expenditure resources but (low) revenue transfers, local governments turned to alternative sources of revenue. Land sales have been a popular option, increasing the volatility of China’s property market.

Taking on additional borrowing was also popular, especially through local government financing vehicles: a national debt audit published at the end of 2013 showed that local government debt (including contingent liabilities) had increased by 67 percent between the end of 2010 and the summer of 2013. More positively, however, the audit showed that local government debt represented only 35 percent of GDP, less than many people had feared.

The Plenum Decision stated that the fiscal system is the foundation and important pillar of national governance – this is significant upgrading of the importance of the fiscal system.’. Finance Minister Lou Jiwei subsequently said that the new reforms themselves represented far-reaching institutional innovations and the restructuring of China’s administrative system.

By using fiscal reform as a starting point to improve national governance, the government shows strong determination in pushing forward reform. Fiscal reform is a bottleneck in China’s reform. The key of fiscal reform is to deal with two relations: the relation between the government and the market, and the relation between central and local government. Both are essential in China’s overall reform.

As ever, implementing the reforms will be difficult, not least because the key terms have not yet been clearly defined, for example ‘national governance’ or ‘modern fiscal system’.

One of the objectives of budget reform is to cut down the number of budgets for special purpose while increasing budget for general purposes. This means to shift the power of different government departments to the finance department.

The revision process of Budget Law, finally completed last month, is an indication of how long implementation is likely to take.. Proposals to revise the budget law were first announced by the National People’s Congress in 2004. It took over 10 years to debate the proposed changes before the revised law was finally passed in the Congress on 31 August this year.
0.2 Disclaimer

The purpose of the FCO Country Update(s) for Business (”the Report”) prepared by UK Trade & Investment (UKTI) is to provide information and related comment to help recipients form their own judgments about making business decisions as to whether to invest or operate in a particular country. The Report’s contents were believed (at the time that the Report was prepared) to be reliable, but no representations or warranties, express or implied, are made or given by UKTI or its parent Departments (the Foreign and Commonwealth Office (FCO) and the Department for Business, Innovation and Skills (BIS)) as to the accuracy of the Report, its completeness or its suitability for any purpose. In particular, none of the Report’s contents should be construed as advice or solicitation to purchase or sell securities, commodities or any other form of financial instrument. No liability is accepted by UKTI, the FCO or BIS for any loss or damage (whether consequential or otherwise) which may arise out of or in connection with the Report.

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