Written by Alfred M. Wu.

The Third Plenum of the 18th Chinese Communist Party (CCP) Central Committee has stirred a heated debate about the forthcoming reforms and the country’s future direction. Some argue that the plenum, parallel to that in 1978 is the beginning of the “2.0 version” of “reform and opening up”. Others are cynical of the reforms and claim it is a case of old wine in new bottles. From my point of view on central-local fiscal relations, the top leadership is not committed to fundamental reforms in this area, which will have profound implications in the near future.

Commenting on the Third Plenum, Professor Li Yining, a renowned economist in China, argues that the Chinese government should tackle four important relationships: state and market, the central government and local governments, the urban sector and the rural one, and state-owned enterprises and the private sector. The Third Plenum provided some solutions to the dysfunctional central-local fiscal relationship. However, some fundamental issues have not been mentioned, let alone being addressed.

Public finance is the basis and the pillar of public governance, as noted by The Decision of the CCP Central Committee on Several Important Issues of Comprehensively Deepening Reform released on 15 November 2013. A well-functioning public finance system is an institutional foundation for protecting market unity, safeguarding social justice, and realizing long term stability in China. More intriguingly, the decision claimed that both central and local initiatives should be taken into consideration when making a modern public finance system. In reality, this saying borrows from Chairman Mao Zedong’s earlier argument. At that time, he argued that China should learn intergovernmental management from the USA as the two countries share similar circumstances—a huge territory and a large population.

The current Chinese government seems determined to promote a modern public budgeting system to improve public services and reduce corruption. The decision made by the Third Plenum claimed to build a transparent government budget wherein the review of the budget will focus on expenditure and policy rather than budget balance or deficit. It means that the budget review will be more on substantial level instead of simply making ends meet. More importantly, a multi-year budget framework will be promoted whereby a long-term, forward-looking budgeting plan will be put in place in the future. More familiar to the outside world is that the Chinese government will embrace an accrual basis of budgeting, which may create possibilities of dialogue between the Western world and China on public finance issues. Previously, the Chinese public finance and budget system, borrowed from the former Soviet Union, was not transparent to the general public in China but also to outside observers. It caused great troubles beyond public finance and budgeting.

More intriguing is that the central government makes clear that it will shoulder more responsibility for financing public services in the future. The central state will be responsible for national defense, foreign affairs, homeland security, and the regulation governing a single market in China. Spending on some projects related to social protection and inter-regional infrastructure will be shared by central and local governments. The central government can ask local governments to implement central mandates but the central government will arrange central transfers to compensate local governments.

Why did the central government orchestrate these reforms? Naturally, the fiscal issue is central to governing the state. A well-functioning intergovernmental fiscal system will improve public welfare provision, reduce government debt, and advance income redistribution in China. In the meantime, the dysfunctional fiscal system creates substantial problems at the grassroots level. For example, local governments being short of revenue leads to a widening gap in providing public services in rich and poor areas, large local debts. In addition, as leasing land is a major source of income for local governments, they are eager to lease lands to developers in a bid to save themselves. Otherwise, loans from banks would default, pay arrears in the public sector would occur and public schools might close down. Any of these scenarios could lead to social unrest.

The fundamental problem is that China’s central-local fiscal relations, especially on the revenue side, have become too centralized. A re-centralization of revenue in China since 1994 has led to local governments falling short of sufficient revenues while meeting the ever-increasing demands for public services. Therefore, once local governments have week fiscal capacity, some of them reduce their public services to avoid bigger troubles; on the other hand, local governments promote property market to boost local revenues or incur large local debts without knowing how to pay back.

After 1994, the year the tax-sharing reform took place, the central share of revenue increased substantially. The ratio of central government revenue to the national total revenue was only 15.5 percent in 1978; after several rounds of central-local bargaining, the share increased to 38.4 percent in 1985. After that, it declined further to 22 percent in 1993. Nevertheless, the central government claimed 55.7 percent of the national revenue almost overnight. Since then, the central share of budgetary revenue has stayed at roughly 50 percent until now. Meanwhile, the central share of expenditure declined over the past 15 years. The year 1980 saw a peak. During that time, the central government shouldered 54.3 percent of total spending for public services and others. It hovered roughly 30 percent between 1994 and 2003. After that, it declined substantially over years. In 2011, the central government only spent 15.1 percent of the national total expenditure. The gap between central revenue and central expenditure has enlarged sharply. Therefore, the Chinese central government is super rich as of today. In the meantime, local governments have to cry for handouts from the central government, request for more central transfers while obsessing with land financing to boost local revenue.

The centralization of government revenue has some implications for political and social aspects. Zhou Xueguang, a professor at Stanford University, observed that, “What is distinctive about the Chinese bureaucracy in recent years includes both the growing scope of policy areas and the greater extent of centralization in resources and decision-making authority, as compared with other national governments or the Chinese government in the early years of reform”.[1]

In addition to the change in central-local fiscal relations, the central government has also playing the political game to make the central state more powerful. Some scholars have discussed “soft centralization” in China in recent years.[2] That is, some important government organs, such as those regulating the market, have been directly controlled by provincial governments or the central government in the name of avoiding local protectionism. In reality, becoming more central may not reduce local protectionism and corruption at both the grassroots and central levels.

Noticing the problems inherent in an over centralized system, localization is a continued demand from the intellectuals. The reality is that though some pro-inland policies have been adopted in the past 15 years, substantial differences between provinces still exist, and to some extent have been exacerbated. Decentralized governance has the benefits of aligning revenue and responsibility, thus rendering local governments more prudent in their use of public money. Decentralized governance may also pave the way for democracy as local governments have to listen to taxpayers rather than the central government in Beijing.

Before the Third Plenum, the Development Research Centre of the State Council, China’s top official think tank, released a roadmap for China’s reform in the coming decades, dubbed “3-8-3 plan”. 8 key reform areas have been targeted: the government administrative system, state monopoly sectors, land ownership and administration, financial sector, the fiscal system, management of state assets, business innovation, and further opening-up of the economy. Specifically, in the reform related to public finance, a delineation of responsibilities between central and local governments is highly prioritized in political agenda.

Unfortunately, the blueprint released by the CCP mainly touches on rather technical issues while major issues remain unaddressed. For example, a stable, justifiable source of local revenue has not been discussed. So far, local governments in the coastal area have increasingly relied on land revenues while those in inland China count on central transfers to cover their costs. In some county governments, almost 80 percent of government spending is from the central transfers. Though the central control has been strengthened, the negative impact of this fiscal structure is significant and unignorable. The Chinese government in recent decades has attempted to justify its rule based on social policy-centered approach rather than growth-centered approach. It means that welfare provision rather than GDP generation is more crucial to gain public support. Nevertheless, there are no such institutional arrangements making the transition take root in China.

“Unspecified powers belong to local governments”, some Chinese public intellectuals argue. Professor Li Yining opined recently that if local governments can manage certain public affairs effectively, the central government should be hands-off. Instead of borrowing Chairman Mao’s ambiguous statement on central-local governments, the Chinese government should embark on bold, fundamental reforms to addressing dysfunctional intergovernmental management in China.

Dr. Alfred M. Wu is Lecturer in the Department of Asian and Policy Studies at The Hong Kong Institute of Education. He is the author of the forthcoming book Governing Civil Service Pay in China (NIAS Press, University of Copenhagen, 2014).