On October 9, China’s central government issued a plan to reform the financial distribution between central and provincial governments aimed at easing local governments’ financial difficulties resulting from the 2 trillion yuan (US$280b) in tax cuts announced in early 2019. The shifting financial relationship between the country’s central and local governments has long been one of major driving forces behind the Chinese economy. Forty years ago when China opened up to the rest of the world and launched its historic reform, it did so by handing much of the central government’s financial power, including taxation and budget-making, to provincial governments, which effectively reinvigorated China’s economy.
Twenty years ago, as China’s economic growth led to rapid increases in tax revenue, most of it going to provincial and local governments which led to a financially weak central government, China conducted another round of realignments, with the central government taking back much of the financial resources from provincial governments. While this policy allowed China to have a strong State sector, it also created serious knock-on effects. Challenged by dwindling revenue sources, provincial and local governments became dependent on the proceeds of selling land to real estate developers.
This model, known as land finance, has been the driving force behind China’s runaway housing prices, and has created serious economic and social problems. In the meantime, as provincial and local governments lacked the financial resources for investment, they relied on bank lending through their financing platforms, which over time has led to mounting debt at local levels that is now posing a serious risk to China’s financial system.
In the past few years, the Chinese government has tried to solve the two problems by launching measures to curb the real estate market and limit the debt level of local governments. Unfortunately, a sustained economic downturn and the ongoing trade war with the US has put great pressure on China’s economy. In response, China has launched a massive 2 trillion yuan (US$280b) tax cut package to boost economic growth.
But the tax cut further exacerbates the financial situation of local governments, which has not only further increased their debt levels, some local governments have also moved back to raising funds through land finance. The new plan to reform the redistribution of tax revenues between the central and local governments appears to be aimed at addressing that.
According to the plan, value-added taxes, the single largest source of tax revenue for governments, will continue to be split 50-50 between the central and provincial governments. But when China launched a tax reform to merge business tax into value-added tax, a temporary 50-50 split arrangement was made for a “transitional period” of two to three years.
According to central authorities, by turning the temporary arrangement into a permanent one, it will stabilize the expectations of local governments. Other than value-added tax, the regime of sales taxes will be reformed so that all sales taxes will be levied, collected and retained by local governments. China’s total revenue from sales taxes in 2018 was 1.06 trillion yuan (US$149.66b), but as sales taxes of different commodities are collected following a dual system, it remains unclear to what extent the new measure will improve local governments’ financial situations.
The reform plan also pledges to adjust the current mechanism for providing tax rebates between central and local authorities. But all things considered, the reform appears to have had a very limited impact on the financial situation of the local governments. It is very unlikely that the plan will have the same significant implications as the previous two rounds of realigning the central-local relationship.
China will have to find new ways to combat the economic downturn and pressure imposed by the trade war with the US, while resisting the temptation to return to the problematic investment-driven and land finance model.
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