Redesigning the Dragon

Financial Reform in the Peoples Republic of China

Duncan Marsh dmarsh@indiana.edu
Anna Pawul apawul@indiana.edu
Dmitri Maslitchenko dmitri@mailroom.com
V550, Government Finance in the Transitional Economies
21 November, 1996

In 1978, the People’s Republic of China (PRC) embarked on the enormous undertaking of opening its doors to the outside world. Until this point in time, the PRC had relied on a centralized economic system much like that of the former Soviet Union[1]. However, the PRC’s situation differed with the former Soviet Union in three substantial ways[2] 1) although reforms followed the Cultural Revolution (which did exact its toll on the Chinese economy) there was an absence of severe macroeconomic crises when reforms were begun 2) agricultural infrastructure was good, although the incentives were poor and 3) China had a strong presence of overseas Chinese and Hong Kong that influence its economic development and over the years supplied capital and human resources.

The industrialization strategy adopted by the PRC has been characterized by gradualism and experimentation. Its focus has been to introduce market forces, reduce mandatory planning, decentralize, and open the economy to foreign investment and trade[3]. This strategy had three main stages. The first (1979-1983) established four “Special Economic
Zones” (areas awarded special freedoms to conduct business relatively free of the authorities intervention) in Guangdong and Fujian provinces, the second (1984-1987) added 14 port cities creating the “Economic Development
Zones”, and finally the third stage (1988-present) which opened most of the country to foreign trade and created “tariff free zones”[4]. In the rural areas, land reforms spearheaded further reforms and also the establishment of Township and Village Enterprises (TVEs). These enterprises were able to capitalize on the abundant cheap labor in rural areas and to operate without the burden of providing social spending. They also provided a training ground for the learning of market skills and concepts. Today, production of manufactured goods by rural and township enterprise is estimated to account for more than 40% of the GDP.

In many respects, China’s process of economic reform has been highly successful.

Since its inception, the average GDP growth has been a world-leading
9.3% year, the poverty rate has declined 60%, and 170 million Chinese living in absolute poverty have seen their standard of living raised above the minimum poverty level. Export growth was 7.8% in 1993, 29% in 1994 and
34.7% in 1995.[5] Government measures to control inflation, which had threatened to overheat the economy in the early 1990s, seem to have taken effect: inflation was under 15% in 1995. (See Tables 1 and 2.)

Table 1.

Source: EIU Country Report, China/Mongolia, 3rd Quarter 1996. The Economist
Intelligence Unit.
Table 2.

Source: EIU Country Report, China/Mongolia, 3rd Quarter 1996. The Economist
Intelligence Unit.

Chinese economic reform has one other characteristic that sets it apart from that of the former Soviet Union, the absence of democratic reforms. The current transition is being carried out within the “socialist framework” and for the most part is centrally controlled. Much of the world waited to see whether the economic transition would derail after the
Tiananmen incident in 1989; it did not. However China did seem to be looking for a way of separating itself from reforms and democratic upheaval that were happening in the former Soviet Union[6]. In 1992, Deng Xiao Ping toured the southern economic zones - a journey significant for its highly symbolic approval of the reform and investment efforts he witnessed - and coined the phrase “socialist market economy”. Deng emphasized that this transition must promote the development of productivity, strengthen the national power and improve people’s standard of living, stating that,
“..with all these achievements secure, our socialist foundation is greatly strengthened..”[7].

Within this backdrop, we will take a closer look at the system of reforms currently underway in the People’s Republic of China. This year marks the beginning of the Ninth Five-Year Plan (1996-2000). Examining the individual parts (the budget process, public expenditure, taxes, banking, the interaction between central and provincial governments, and the emerging need to transform the social safety net) will present a clearer picture of what has been accomplished by the macroeconomic reforms put in place in 1976 as well as what still needs to be done.

Revenue, Expenditure and the Budget

One problem of major proportion facing the Chinese government is that central government revenues are growing at a much slower rate than the overall economy, and a growing budget deficit has resulted (see Table 3 in
Appendix, page 20).[8] This is especially debilitating in the face of increasing demands from the surging economy for investment in infrastructure and with the need for investment in a reformed social insurance system that will come with economic disruptions caused by continuing liberalization. Expenditures have also been falling as a percentage of GDP, but are growing faster than revenue.

Several factors have been identified in the shrinking revenue-to- expenditures ratio problem:
Revenue
Tax arrears on the industrial and commercial tax (CICT) from enterprises, which are growing as state-owned enterprises (SOEs) become more unprofitable in the face of increasing competition. At the end of 1994, these arrears amounted to 8.2 billion yuan (Ґ), and just seven months later, the figure had grown to Ґ17.9 bn.[9]
Tax exemptions granted by local governments to state-owned and private enterprises.
Expenditures
Subsidies to the loss-making SOEs, in the form of loans or direct subsidies
(see Table 4). China’s 1995 budget deficit was around a mere 1.5% of GDP.
If policy lending by centrally controlled banks - most of which is, effectively, transfers to SOEs which can never afford to pay back these loans - is taken into account, the central government’s true deficit is 6% of GDP or higher.[10]
Price subsidies. (Most of these were for urban food, and adjustments made in 1992 have reduced this drain on the budget.)
Higher than expected increases in expenditures (in 1995, these were 18% higher than planned on the central level, with local government expenditures over 30% higher than in 1994.)[11]
A drop of 10.7% in customs revenue from 1994 to 1995.
Inflation-indexed interest subsidies on bank deposits and treasury bonds, which have been kept high by high inflation rates.
Table 4.

Source: Wong, Christine P.W., Christopher Heady, and Wing T. Woo. Fiscal
Management and Economic Reform in the People’s Republic of China. Oxford
University Press. Hong Kong: 1995.

For a country controlled by a Communist party, the government’s proportion of economic activity has been remarkably small, even before implementation of reform. In 1995, official government spending was just
11.6% of GDP. Off-the-books revenue raising schemes by local governments may mean the state’s total revenue is two times the official level.

The extra-budgetary revenue investment was dispersed, uncoordinated and did not fulfill the central government’s investment priorities. The central government faced growing infrastructure demands, but with shrinking
(in proportionate terms) assets available, has been forced to reduce capital construction spending substantially. Also, expenditures on administration, culture, education, and welfare increased over the reform period, and reduced the government’s ability to spend on infrastructure.[12] (See Table 5 in Appendix, page 22.) The increases in administration spending are particularly troubling, because of government policies to reduce control of the economy and shrink some government bureaus.

One of the stated goals of the Ninth Five-Year Plan is to eliminate the budget deficit by year 2000. But this goal is highly unlikely to be achieved due to other conflicting goals, like spurring employment, which may mean increasing subsidies to unprofitable SOEs; reducing regional income disparities; and strengthening agriculture, which is seen as a key to controlling inflation.

Christine Wong, an expert on the Chinese financial system, identifies three necessary changes to restore the health of the budget: First, the tax administration must be strengthened. Second, the tax structure must be reformed so that it is neutral across products and sectors. Third, the revenue-sharing system between local, provincial and national levels of government must be revamped, with clearer tax assignments in line with each levels set of responsibilities. The central government’s control over the tax system and share of total revenues will likely have to be increased.
The next two sections will address these proposed changes.[13]
Taxation
The Pre-Reform Tax System

Prior to economic reforms, China’s tax structure was based on the
Soviet model. Enterprises remitted their profit to the government, retaining only what was necessary to pay expenses. Revenues were collected by local governments, and a certain amount was filtered up to the central government. In 1984, this was replaced by a system of enterprise income taxation reform, in which companies were taxed on their profits, as the government tried to respond to economic imbalances created by the emerging private sector. The turnover tax (the Consolidated Industrial and
Commercial Tax, or CICT), which had been the largest contributor to the government’s annual revenue, was replaced with a business tax, a product tax, and a value-added tax (VAT). These featured highly differentiated tax rates across sectors, types of good and service, and form of firm ownership. Most private firms paid a base tax rate of 33%, while most state- owned enterprises (SOEs) were nominally taxed at 55%.[14] In practice, however, taxes paid were governed by a contract responsibility system
(CRS), in which enterprises negotiated individually with local government units. This system created conflict of interest because often the local government was both tax collector and enterprise owner. Not only were there differentiated rates which distort economic activity, there was little incentive for full tax remittance back to the central government under this system. (See Table 6 in Appendix, page 23, for a description of the tax structure from 1985-1991.)
1994 Reforms

In 1994, the Chinese government began to respond to these problems by enacting a series of reforms. The CICT was abolished and the following taxes were created or modified:
Enterprise Income Tax. This unified corporation tax taxes companies at a single 33% rate. Foreign enterprises and joint ventures are still enjoying lighter tax burdens, because of the fierce competition between regions to attract foreign investment, but these privileges are to be gradually eliminated.
Personal Income Tax. Operates on a sliding scale, with a maximum of 45%.
Not yet comprehensively-implemented.
Value-Added Tax (VAT). Replaces the product tax of the CICT. Most goods taxed at 17%, but agricultural and food products will be taxed at 13%, and small-scale businesses will pay flat rate of 6%.
Consumption (Excise). Focuses narrowly on “luxury goods:” tobacco, alcohol, gasoline, and a few others.
Business tax for services. Service industries will face a business tax of
3% to 20% on sales in place of the VAT. This tax also will apply to transfer of intangible assets and the sale of real estate.[15]
Capital Gains. A capital gains tax was to be introduced in 1994, but its implementation was postponed because of concern over its adverse impact on
China’s fledgling stock markets.

1996 Reforms

In 1996, China announced plans to reduce its import tariff rate from
35.9% to 23%, while abolishing preferences for certain goods and, importantly, eliminating exemptions from import tariffs (currently, over
80% of imports are exempt from import duties for various reasons). [16]
This step alone should help to reduce the recent losses in customs revenue.
The Ninth Five-Year Plan also includes provisions to introduce taxes on interest earnings and inheritances, policies designed to reduce income disparity.

Revision of Tax Collection Structure

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