fter several rounds of tax reform in the past couple of years, the central government finally unveiled on June 15 plans to merge the national and local taxation offices. China’s current dual taxation system will be unified.
While the authorities said the new tax system would be jointly led by the State Administration of Taxation (SAT) and China’s provincial-level governments, experts believe that the SAT will inevitably have more say than provincial authorities, with the central government gaining considerable power to collect and distribute tax revenue.
According to Liu Jianwen, director of the China Association for Fiscal and Tax Law under the China Law Society, the significance of the reform will stretch far beyond the field of taxation. “It is about a fundamental problem with the distribution of power between the central and provincial governments under China’s constitutional framework,” Liu told NewsChina.
Liu said that the rationale and the significance of recent tax reforms can only be fully understood in their historical context. China’s taxation system, as a reflection of the power relationship between central and provincial governments, has experienced a couple of major overhauls since the establishment of the People’s Republic of China in 1949.
Prior to China’s reform and opening-up policy launched in the late 1970s, China had a highly centralized political system which included a highly centralized tax system. During this period, the central government had total control under its doctrine of the planned economy, and provincial governments had very little power over taxation and were largely funded by the central government.
From the 1970s China began to decentralize political power as a means to encourage provincial- and local-level governance innovation and to encourage entrepreneurship and spur economic development.
From 1979 to 1993, the national government handed much of its taxation power to provincial governments. A variety of arrangements were made. In some cases, the central government and provincial governments would agree on a benchmark figure of tax revenue to be collected in the provinces. Provincial governments were allowed to keep any revenue under this figure, and were only required to hand over a certain percentage of tax revenue that exceeded the figure. In other cases, the provincial governments were required to submit a benchmark tax revenue to the central government and were allowed to keep most of the revenue over the benchmark of figure for themselves.
While the decentralization jump-started China’s reform-era economic growth, it soon led to a revenue crisis at the central level, as the provincial governments were more concerned with their own interests than with propping up Beijing. As they started to compete to attract investment, tax incentives became a major tool, and central interests were often sacrificed during the process.
In cases where provincial governments were allowed to keep a benchmark tax revenue, they would relax efforts to collect tax beyond that threshold to minimize the amount of money they had to hand over to the central government. In cases where they were required to submit a benchmark revenue, the central government was unable to benefit from the expansion of tax revenue resulting from the economic growth.
The central government witnessed a steady decline in revenue in terms of its share of total government revenue. According to data released by the National Bureau of Statistics, in 1985, central government revenue accounted for 38.4 percent of all government revenue, which declined to 22 percent in 1993. In absolute terms, the central government’s revenue in 1993 (76.96 billion yuan) was slightly lower than the 1985 figure (75.75 billion yuan). By comparison, China’s GDP almost quadrupled over the period, with total government revenue more than doubling.
Experts also argued that the revenue crisis at the central level and a weakened central government sparked multiple additional economic problems. “The problem went beyond a revenue crisis of the central government,” said Jia Chaohua, an economist who directs the Tax Education Institute of the Central University of Finance and Economics. According to Jia, a weakened central government led to a lack of central coordination, unbalanced cross-regional economic development, excessive investment in certain sectors and a distorted economic structure.
In the early 1990s, the central government started to explore ways to take back its taxation power. Peng Sen, former vice-director of the powerful National Development and Reform Commission (NDRC), China’s top economic planner, recalled that the central government’s efforts were met with strong resistance at local levels, and the then Premier Zhu Rongji had to go to at least 13 provinces to negotiate with provincial leaders.
The negotiation between the central and provincial governments eventually led to the creation of a dual taxation system. This divided taxes into national taxes, provincial taxes and shared taxes. Take business tax, value-added tax and consumption tax, which together
account for about 70 to 80 percent of China’s total tax revenue and a half of the total government revenue, for example. While business tax was categorized as a local tax, entering the coffers of provincial governments, the consumption tax was categorized as a national tax. The value-added tax become a “shared” tax, with its revenue split between the central and provincial governments.
The reform was effective in solving the central government’s revenue crisis. “The  tax reform managed to provide reliable sources for the central government and strong incentives for provincial governments to implement effective tax codes, especially on local taxes,” said Shi Zhengwen, a professor of tax law at China University of Political Science and Law. In contrast, the share of revenue of provincial and local governments declined steadily compared to that of the central government.
The share of central government revenue as a percentage of total government revenue rapidly increased from 22 percent in 1993 to 55.7 percent in 1994 after the reform. This marked the start of a long-term trend toward centralizing China’s tax system. In the following years, the central government gradually carved off more territory from provincial governments. For example, in 2002, the enterprise income tax, previously a revenue of the provincial governments, was converted to a shared tax.
But many experts say a major problem with the dual taxation system is that the 1994 reforms and gradual centralization were not accompanied by formal reform of the legal framework that delineates the boundaries of political and administrative power between the central and provincial governments. In other words, provincial government revenue does not reflect provincial administrative responsibilities.
According to Jia Chaohua, currently, on average, provincial governments are responsible for 85 percent of administrative affairs in their localities, while having access to only 55 percent of locally-generated tax revenue. Provincial governments rely on the central government to finance 30 percent of their budgets through a mechanism called “transfer payments.”
Because the central government has its own budget and agenda – which often run contrary to those of provincial governments – the latter have had to find alternative financial sources, which have resulted in local abuses of taxation power.
It is widely held that China’s runaway house prices have been largely caused by the thirst for government revenue at the provincial and local levels, where strong incentives existed to increase the land grant fee, an administrative fee under the authority of the provincial and local governments, which is charged on real estate developers and ultimately transferred to homebuyers.
In many cities, proceeds from the fee account for 30 to 50 percent of local government revenue. The runaway property prices along with ever-growing land grant fees have further emboldened many local governments in their fiscal governance, leading to a high debt level among local governments, which now rely on the central government to bail them out. The dual problems – high property prices and high debt – have become major financial hurdles that pose a serious threat to China’s economy.
It appears that the current taxation reform aims to address these problems. For example, according to the reform plan, provincial and local governments are required not only to hand over their taxation powers to national taxation authorities, but also hand over their power over levying and collecting 12 items of “non-tax” revenues, which include the land grant fee.
But according to experts, as the detailed reform plans are yet to be released, many questions remain unanswered. Fan Ziying, a Professor at Shanghai University of Finance & Economics, told NewsChina that a major issue faced by provincial governments following the tax system reform is how to make and implement their annual budgets.
Fan said that with the merging of the central and provincial tax systems, provincial governments will face great uncertainty regarding their annual revenue, which will create problems with budget making down the line.
So far, the reform plans remain vague on that issue. As the new taxation system will be jointly led by the State Administration of Taxation and province-level governments, the lower authorities may still have a considerable say.
But most experts who talked to NewsChina argued that it was time to fundamentally address the issue regarding the central-provincial financial relationship. Liu Jianwen, for example, said that the core question of the taxation system reform would have to be the distribution of power and finance between central and provincial governments.
Liu warned that centralization of taxation powers without reforming and delineating the boundary of financial and administrative powers between the central and provincial governments would only exacerbate the problem of the mismatch between the financial and administrative responsibilities.
Liu told NewsChina that academic circles had long called for legislating the financial relationship between the central and provincial governments to fundamentally and legally address the problem.
“There should be a law to clearly define the financial power boundary between the central and provincial governments,” said Liu. But so far, the legislation of such a law is still at the research and recommendation stage,” Liu told NewsChina.
Given the complexity of the issue and stakes of reform, Liu said that the central leadership may take a step-by-step approach. “We can expect that the central leadership will release further documents to address the central-provincial relationship,” Liu said. “It will be a long process.”