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Abstract
Employing the Modern Monetary Theory (MMT), this paper examines the current Chinese fiscal system and highlights its three characteristics. First, fiscal revenues are centralized at the central government while expenditures are decentralized at the local governments; second, fiscal spending focuses on public investment but is insufficient in providing social safety net and public services; and third, indirect tax accounts for a great majority of tax revenues, leading to limited progressivity of the tax system. These limitations have constrained the effectiveness of China’s fiscal policies and generated many perverse impacts. With the understanding that the central government has the monetary sovereignty and does not face financing constrained and that taxes are not to raise revenues for fiscal spending but to serve other purposes, the paper calls for fiscal reforms that realign fiscal resources and spending responsibilities between the central and local governments, increase fiscal spending on social security and public services, as well as broaden personal income tax to improve the distributive effect of taxation.
Disclosure statement
No potential conflict of interest was reported by the author(s).
Notes
1 China is a unitary state with a multi-tiered government structure. Subnational governments are in principle agents of the central government, tasked with carrying out national policy objectives within their own jurisdictions.
2 Local governments can be further divided into provinces, prefectures, counties, and townships. County governments are responsible for the largest expenditure responsibility. Their revenues account for less than 5% of GDP but expenditure takes up 9% of GDP in 2014 (Wingender, Citation2018).
3 There are four budgets for the governments, including the general public budget (GPB), the social security fund, the government fund budget (with 24 government funds, the largest of which is the land lease fund), and the state own enterprise operation fund budget. The four budgets account for 52.6%, 23%, 23.3% and 1.1% of the total government budgets, respectively. Surplus from the government fund budget and the state owned enterprise operation fund budget can be transferred to the general public budget to finance public services, while the financing gap of the social security fund budge can be filled by transfers from the general public budget (See Qiao et al., Citation2022).
4 The majority of the Social Security spending is not part of the general public budget but included in the social security fund budget. What is included in the general public budget are mostly administrative costs of social insurance, employment and labor relations managements, and others.
5 Local governments transfer public assets such as land or shares of public facilities as capital, and use LGFVs to issue bonds or borrow loans from banks or other financial institutions. The funds raised through LGFVs are typically used for infrastructure investments and other fiscal expenditures.
6 One major cause for the rapid expansion of LGFVs borrowing was due to the 4 trillion yuan stimulus package the central government launched in 2008 in response to the Global Financial Crisis. Local governments were responsible for 70% of the spending but without the adequate fiscal resources, they resorted to LGFVs to raise funds for infrastructure spending (see Liang, Citation2016a, Citation2016b).
7 Using US$1 = 7 yuan throughout the paper.
8 Local governments were prohibited from issuing bonds on their own before 2014, except for a five-year pilot program that started in 2009, where the Ministry of Finance issued RMB 200 billion in local government bonds on behalf of local governments. The central government later allowed a small number of provincial governments to issue bonds directly (about 3 billion yuan to 4 billion yuan as of the end of 2014) (Lam, Citation2019).
9 Based on the IMF’s measure of “augmented deficit and debt”, local government debt in China reached 66 trillion yuan ($9.4 trillion) as of 2022. IMF’s estimates include the land sales proceeds as part of the local government debt because it conceives of the reduction in assets as equivalent as an increase in debt. Yu (Citation2023) discredits this computation.
10 Local governments focus on promoting economic growth because their political careers are tied to the economic performance of their jurisdictions. This kind of local government competition tournament on the one hand promotes economic growth but on the other hand, lead to over and repetitive investments in some areas and heighten the local government debt problem, as well as the lack of spending on social programs and public services (see, e.g. Fu & Zhang, Citation2007; Liang & Li, Citation2016).
11 As mentioned above, pension is included in the social security fund budget. In 2020, the central social security fund revenue and expenditure were 858.4 billion yuan ($122.6 billion) and 857.8 billion yuan ($122.5 billion), respectively; the local government social security fund revenue and expenditure were 7928 billion yuan ($1132.6billion) and 8550.5 billion yuan ($1221.5 billion), respectively (Ministry of Finance, Citation2021).
12 For instance, Foxconn facilities in Zhengzhou fill 50% of its workforce with temporary workers in August 2019, violation of the 10% upper limit imposed by the Chinese Labor Law. Many of these temporary workers are not covered by social insurance, including pension. Zhengzhou government has the incentive to look away as Foxconn is a major employer and tax payer for the local economy. Many employers also under report wage levels to reduce pension contributions (OECD 2020).
13 Under China’s hukou (residential registration) system, rural workers can migrate to urban cities for jobs but they are still considered as rural residents and do not enjoy the same social services and benefits (e.g. public education and health care) as their rural counterparts. Migrant workers typically return to their rural residences if they can’t find jobs in the urban cities.
14 Similar to the pension scheme, for medical insurance, a contributory plan is set up for urban employees and the plan consists of social medial insurance and a mandatory individual account. Self-employed individuals could also purchase medical insurance plan. A separate plan would provide basic medical insurance for rural and non-salaried urban residents.
15 Including implicit debt services through the LGFVs, the interest payment could multiply to 20% of the total local government revenues.
16 There are mainly two main counterarguments against the central government involvement. One view holds that central government does not have sufficient fiscal resources to “bail out” local governments. It is clear, from the analysis here, that central government does not have a fiscal/financing constraint. Another view maintains that central government bailout could worsen local governments’ moral hazard. Be that as it may, there are dire consequences if local government debt overhang materializes. To improve local government’s fiscal responsibilities, it is more effective to work on local government officials’ incentives by including debt sustainability as one of the performance evaluation criterions (Zhang, Citation2023).