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LOCAL PUBLIC FINANCE MANAGEMENT IN THE PEOPLE’S REPUBLIC OF CHINACHALLENGES AND OPPORTUNITIES

Local Public Finance Management in the People’s Republic of ChinaChallenges and Opportunities

PRC is a highly decentralized unitary state with local governments having a dominant share of public service delivery responsibility. Local governance is critically linked to a local public finance system that creates incentives and accountability mechanisms. To ensure the policy response, this project focused on the three interrelated areas in local public finance management, i.e., local budgeting, local debt management and local taxation, and produced policy options in the short, medium and long terms. The overall purpose of the reforms is to improve local accountability and transparency, strengthen local fiscal capacity, and institutionalize formal frameworks for local public debt management.

About the Asian Development Bank

ADB’s vision is an Asia and Pacific region free of poverty. Its mission is to help its developing member countries reduce poverty and improve the quality of life of their people. Despite the region’s many successes, it remains home to approximately two-thirds of the world’s poor: 1.6 billion people who live on less than $2 a day, with 733 million struggling on less than $1.25 a day. ADB is committed to reducing poverty through inclusive economic growth, environmentally sustainable growth, and regional integration.

Based in Manila, ADB is owned by 67 members, including 48 from the region. Its main instruments for helping its developing member countries are policy dialogue, loans, equity investments, guarantees, grants, and technical assistance.



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Asian Development Bank. Local public finance management in the People’s Republic of China: Challenges and opportunities.Mandaluyong City, Philippines: Asian Development Bank, 2014.

1. Fiscal administration. 2. Tax reforms. 3. Public finance. 4. Local finance. I. Asian Development Bank.

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iii

Contents

Tables, Figures, and Boxes iv

Foreword (Ayumi Konishi) vi

Foreword (Li Kouqing) vii

Acknowledgments viii

Abbreviations ix

Executive Summary x

1 Introduction 1 1.1 Overview of Local Public Management 3 1.2 Issues in Local Public Finance Management 7

2 Reforming Local Budgeting and Budgetary Institutions 9 2.1 Local Budget Management 9 2.2 Local Debt Management 20

3 Local Tax Reforms 34 3.1 Residential Property Tax 35 3.2 Environmental Taxes 40

4 Conclusion 44

Appendixes 45

References 55

iv

Tables, Figures, and Boxes

Tables1 Expenditure Assignment in the PRC 42 Tax Assignment in the People’s Republic of China (%) 63 Features of Alternate Budget Formats 134 Performance Budget Payoffs 135 Spectrum of Performance Budgeting Reforms 136 Vertical Fiscal Gap in the PRC—2011 227 Subnational Revenues by Source, 2010 (%) 228 Sources of Subnational Capital Financing (%) 229 Revenues of Prefecture-Level Cities, 2010 (%) 2310 Comprehensiveness of Local Budget Using Data

from Jiangyin Muncipality, 2009 2311 The PRC’s Local Budgetary Revenues and Land Leasing Income 2312 Local Government Debt, Sources of Finance and Disposition

of Borrowed Funds, 2010 (CNY billion) 2513 Local Bond Financing, 2005–2013 (CNY billion) 2614 Sources of Capital Financing by Type of Investment and Fiscal Capacity

of Local Government 2915 Fiscal Risk Matrix, Local Government Exposures 3116 Real Property Tax in an International Context 3817 Approaches to Property Valuation 3918 Decision Criteria Regarding the Choice of Public Policy Instrument

for Environmental Protection 4219 Energy Subsidies in the People’s Republic of China, 2011 42A1 Basic Elements of Public Finance Management Framework 45A2 Debt Affordability in the United States, by State 49A3 Moody’s Rating Criteria for Credit Worthiness 50A4 Ex ante Regulation of Subnational Debt—A Worldwide Perspective 51A5 Costs and Benefits of Carbon Taxes for Selected Countries, 1987 54

Tables, Figures, and Boxes v

Figures1 Share of Revenue Collection and Direct Spending by Level

of Government, 2011 52 Relative Importance of Subprovincial Governments as Measured by Local

Government Expenditure Share 53 Reversal of Fortunes of Local Governments in the PRC—1978–2011 214 Local Debt by Order of Local Government, 2010 24A1 Structure of Government of the People’s Republic of China, 2011 46A2 The Unified Budget System of the People’s Republic of China 47A3 Local Budget Process in the People’s Republic of China 48

Boxes1 The Medium-Term Budget Framework Process in Hebei Province 112 Project Evaluation and Budget Review Framework Piloted

by Yunnan Province, 2012 143 Zhejiang Province‘s Requirements for Budget Plans, 2012 154 Questionnaire Used in the Executive Review in Canada 185 Diversity of Views on the Objectives and Design of a Future Residential

Property Tax in the People’s Republic of China 37A1 Early Warning Systems of Fiscal Stress 53

vi

Foreword

T he People’s Republic of China (PRC) has a long history of recognizing good local governance as a catalyst for economic growth and to improve local economies and social outcomes. Local governments in PRC have had a stellar record of

delivering growth and reducing poverty. These achievements, however, came at the lack of attention to fiscal transparency in budgeting; fiscal responsibility in borrowing; and underprovision of public goods such as environmental protection, orderly urban growth, and social inclusion.

This report grew out of an Asian Development Bank (ADB)-financed technical assistance project to ensure an adequate policy response to local public finance management and to achieve medium-term fiscal reforms in PRC. It analyzes the bottlenecks in local public finance management by focusing on local budgeting, debt management and taxation, and suggestions for policy options.

Local budgeting, debt management, and taxation have important bearings on local public finance management. Linking local budgeting with fiscal planning and medium-term priorities is key for accountability, whereas comprehensiveness in budgeting and its execution is vital for transparency. Strengthening local fiscal capacity is also necessary to balance spending powers with expenditure responsibility. To meet local investment needs with fiscal discipline, local borrowing needs to be formalized by institutionalizing ex-ante and ex-post regulatory frameworks.

ADB will continue to support the government’s initiatives since it believes that the adaption of the policy options proposed will ensure effective local public finance management for the continued inclusive growth of PRC, overcoming fiscal risks. Also, ADB is pleased to have contributed to PRC’s efforts in strengthening the fiscal management capacity of its local governments. Through this report, ADB hopes to contribute to a better understanding of the current reform status and an agenda for future reform options in local public finance management and their impacts on the economy.

Ayumi KonishiDirector GeneralEast Asia DepartmentAsian Development Bank

vii

Foreword

T he reform of fiscal and taxation systems is one of the key priorities in the People’s Republic of China (PRC). Over the past 30 years, the PRC has taken incremental reform in fiscal and taxation systems to adapt to its economic development. It has significantly contributed to the economic growth and accumulated valuable

experience for the subsequent reform in fiscal and taxation systems in the PRC.

After 30 years of rapid economic growth, the PRC now faces challenges in economic transformation and sustainable development. To address the challenge, the PRC needs to make continued efforts to further improve its fiscal and taxation systems, while drawing upon international experience and building on its own successful practice in the past. The fiscal and taxation systems need to better serve the needs for economic development and construction of a socialist market economy with Chinese characteristics. Such reform will also contribute to sustainable and harmonious development of the Chinese economy and society.

The objectives and major aspects of fiscal and taxation systems’ reform was laid out by the Twelfth Five-Year Plan for National Economic and Social Development released in 2011, together with the Decision on Some Major Issues Concerning Comprehensively Deepening the Reform of the Third Plenary Session of the 18th Communist Party of China Central Committee in 2013. This demonstrates the government’s determination to improve the fiscal and taxation systems and to build a harmonious and prosperous society in the PRC.

With this background, in December 2012, the Asian Development Bank (ADB) and the Asia-Pacific Finance and Development Center (AFDC) jointly launched a study on “Local Public Finance Management in the People’s Republic of China: Challenges and Opportunities”, under an ADB technical assistance on Strengthening Fiscal Policy and Public Finance Reform over the Medium-Term. The study carried out a comprehensive analysis of major issues in local public finance management in the PRC from broad perspectives through concerted efforts of national and international experts. Policy recommendations suitable for follow-up reform in the PRC were then proposed on the basis of the findings from the research and workshops targeting finance officials both at national and subnational levels while drawing upon international experience.

The joint research is another achievement of knowledge cooperation between ADB and AFDC, with the support of the Ministry of Finance (MOF) of the PRC. In addition to experts from ADB and AFDC, this study was greatly supported by the International Department and other relevant departments of the MOF, Finance Departments (Bureaus) at provincial level, Research Institute for Fiscal Sciences of the MOF, Shanghai National Accounting Institute, Fudan University, Central University of Finance and Economics, and Jiangxi University of Finance and Economics. This publication is the product of hard work and collective wisdom of the team of national and international experts. We truly believe that this book will deepen understanding of ongoing reforms of fiscal and taxation systems in the PRC.

Li KouqingDirector GeneralAsia-Pacific Finance and Development CenterMinistry of Finance, PRC

viii

Acknowledgments

T his report presents a synthesis of findings of technical reports completed under a technical assistance project, Strengthening Fiscal Policy and Public Finance Reform over the Medium-Term. It was prepared by Anwar Shah under the direction

of the Asian Pacific Finance Development Center (AFDC), the implementing agency, and Hiroko Uchimura-Shiroishi, Asian Development Bank (ADB) task manager. It draws upon inputs by Gou Yannan, and Ma Haitao on budget management; Yan Yan and Kuang Xiaoping on taxation; and Yin Xingman and Liu Junmin on local public debt management. Special thanks go to Yesim Elhan-Kayalar and Tariq Niazi, peer reviewers, for their valuable comments. This report has also benefited from inputs and guidance received from senior officials and scholars at Beihai, Beijing, and Shanghai workshops, especially from Xie Xuan, Ministry of Finance, the PRC; Peng Ruzhong, AFDC; Zhao Min, AFDC; Yolanda Fernandez Lommen, ADB; and Ying Qian, ADB.

ix

Abbreviations

ADB – Asian Development BankGDP – gross domestic productMTEF – medium-term expenditure frameworkNAO – National Audit OfficeNPC – National People’s CongressOECD – Organisation for Economic Co-operation and DevelopmentPRC – People’s Republic of ChinaUDIC – urban development investment corporationVAT – value-added tax

x

Executive Summary

T he People’s Republic of China (PRC) is a unitary state with a unified and integrated budget system and a centralized tax system, but in the interest of efficiency, most of the public service delivery responsibilities are decentralized to subprovinical

governments. Generally, the central government has legislative, policy making, and financing responsibility, while provincial and local governments enjoy significant budgetary discretion provided that they deliver on their growth and citizen satisfaction mandates. However, local own-source revenues are inadequate, and central transfers lack predictability and time consistency. To fulfill their mandates, local governments must strengthen their economic base through innovative means, which often creates a culture of competition between local governments. This culture has brought substantial prosperity and growth, but also lack of attention to macro fiscal risks, fiscal responsibility, environmental protection, food security, urban sprawl, and social inclusion. This technical assistance project, Strengthening Fiscal Policy and Public Finance Reform over the Medium-Term, is concerned with addressing these challenges to sustain the PRC growth path.

To ensure an adequate policy response to fiscal and economic challenges at the local level and to achieve the medium-term public finance reform objectives, this project implemented a three-prong approach to achieve these objectives. First, a research program developed policy papers on (i) budgeting and budget execution, (ii) local debt management, focusing on the current status of reforms and an agenda for future reform, and (iii) newer tax handles for local governments. These analyses were supplemented by lessons from international experiences. Second, these policy papers served as the basis of consultations, policy dialogue, training, and capacity development workshops for more than 100 provincial officials conducted in Shanghai and Beihai, Guangxi Province. Based upon the feedback received from these workshops, the policy papers were revised, and another report was created to summarize the reform issues and options. Finally, the report served as a source document for a discussion of the same issues with central government officials and other stakeholders in Beijing in June 2013. The final version of this report, presented here, incorporated the feedback received at the Beijing workshop. The following paragraphs highlight the project rationale, key findings, and lessons in selected areas of local public finance management addressed by this project.

Executive Summary xi

Rationale for Selected Areas of Focus

PRC realizes that good local governance is critically linked to a fiscal system that creates incentives and accountability mechanisms to ensure that local governments serve the public interest with trust and integrity. A good local public finance management system establishes institutional arrangements, processes, and methods to motivate local governments to conduct their fiscal operations with due regard for fiscal risks, allocate resources consistently with people’s preferences, deliver services in the most cost-effective manner, allow fair access to the poor, and be accountable to local residents and higher-level governments for management failures. The local capacity of budgeting and fiscal planning is a basis to evaluate local investment needs and affordability. Moreover, the balance between local fiscal capacity and expenditure responsibility is fundamental. Local budgeting, local debt management, and local taxation are keys for local government performance accountability. Based on these considerations, this project focused on these three critical areas in strengthening local public finance management in PRC.

Strengthening Local Budgeting and Budget Execution

Issues in local budget formulation and execution. PRC has a unified budget system intended to provide a unique window to all government operations in a single document. A lack of comprehensiveness in local budgeting, however, diminishes the usefulness of this document. Local budgets, besides being incomplete, also provide only an annual perspective on budgeting and fail to establish a link between planning and budgeting. Local budgets are line-item budgets with cash accounting, providing useful data on current (i.e., operating) revenues and expenditures. However, they do not fully account for capital finances and capital expenditures and provide no information on service delivery. Thus, they serve as an imperfect guide to local government operations for citizen-based or higher-level government accountability for performance.

Local budget and approval processes are well defined but lack a few critical elements such as opportunities for the local people’s congress to provide pre-budget feedback on budget priorities and the business plan of the government, specific guidance on the overall fiscal framework, and the level of central transfers in budget preparation and planning.

In terms of local budget execution, there have been significant improvements in recent years associated with the introduction of the Treasury Single Account and strengthening of external and internal controls. The issues that still remain are integration of subprovincial governments in the Treasury Single Account, slow disbursal of funds from the center to the provinces, and further delays in central pass-through transfers by the provinces. In addition, results-based internal evaluations, external performance audits, and periodic government-wide reviews are not yet practiced.

Recent reform initiatives in local budget formulation and execution. An important initiative in this area is to connect budget formulation to budget execution. The Ministry of Finance in recent years has encouraged local governments to have comprehensive

xii Executive Summary

budgets and to explore a multiyear perspective in budgeting. For example, Hebei Province has already implemented a pilot of medium-term expenditure framework.

More recently, in May 2012, the Ministry of Finance provided comprehensive guidance to local governments to establish, within the next 3 years, a well-articulated budget performance management system with explicitly stated objectives and verifiable indicators of performance for budget formulation and appropriate external and internal controls on budget execution. It has further advised local governments to use performance evaluation findings as well as evaluation studies by experts and think tanks to inform future planning and budgeting decisions. Guangdong, Hebei, Sichuan, Yunnan, Zhejiang, and several other provinces now require project evaluation results to inform budgeting decisions. Early results of these pilots appear promising in improving effectiveness of existing programs and developing better projects for future budgets. Such actions, however, should be accompanied by performance management evaluation systems that use formal evaluation techniques to determine the effectiveness and impact of executed projects as well as ex-ante evaluation of projects being proposed.

The Ministry of Finance’s approach is to be commended for building a better foundation for local budgeting and evaluation systems. With the implementation of these guidelines, local governments will have created modern systems of budgeting and evaluation.

The following are short- to medium-term reform options to strengthen local budgeting and budget execution.

• Improve coverage and present integrated capital and operating budgets.

• Evaluate pilot projects on the introduction of medium-term expenditure frameworks.

• Introduce requirements for commercially audited financial statements on an annual basis.

• Announce a macro fiscal framework for budget planning at least 3 months before the fiscal year begins.

• Introduce penalties for delays in disbursement by provinces for pass-through transfers to the local governments.

• Eliminate provincial discretion to withhold local funding unless it is mandated by law (e.g., an intercept for debt default).

• Introduce pilot projects for including performance information in the budgets for a selected few local public services with direct delivery to residents.

The following are long-term reform options to strengthen local budgeting and budget execution.

• Integrate subprovincial governments into the Treasury Single Account.

• Introduce a medium-term expenditure framework if pilot projects prove successful.

• Expand coverage of the budget by including tax expenditures (i.e., revenues foregone to advance certain policy objectives).

• Expand performance budgeting to include more local services with local capacity development if pilot projects prove successful.

• Introduce results-based internal evaluations.

Executive Summary xiii

• Introduce external performance audits on a stratified random sampling basis with necessary local capacity building.

Improving Local Debt Management

Issues in local debt management. The prohibition on direct capital market access by local governments, accompanied by a framework of accountability that placed a premium on local economic development, resulted in pressure on local governments to exploit innovative financing vehicles that created a large overhang of hidden debt and liabilities. These financing vehicles led to (i) lack of transparency in capital finance, (ii) fragmentation of local budgets, (iii) greater dependence on unstable sources of local revenues, (iv) greater finance sector and macro fiscal risks, and (v) missed opportunities in learning and building capacity for managing sustainable debt finance.

Recent reform initiatives. The central government recognizes these concerns and has restrained local government access to these financing vehicles. It issued guidelines prohibiting the use of public assets as collateral for debt finance by local governments and their entities, brought urban development investment corporations under a strict regulatory framework, opened new channels for providing proactive assistance in issuing provincial bonds, and allowed a few wealthier municipalities direct access to capital markets under central government supervision. It is also providing technical assistance to local governments to improve their capital budget planning process and linking it with planning.

The following short- and medium-term options may be considered for strengthening local debt management.

• Provide a legislative and regulatory framework for ensuring that local governments follow due process in evaluating the affordability of debt and for local debt monitoring and management.

• Institute a program to monitor the fiscal health of local governments and an early-warning system for local fiscal stress.

• Institute a capital grant program to noncreditworthy local governments to establish national minimum standards in physical and social infrastructure across the country.

• Provide technical assistance for creditworthy local governments to access capital market finance.

• Expand existing programs of central assistance in issuing provincial bonds and provincial direct access to capital markets.

The following long-term options may be considered for strengthening local debt management.

• Lift prohibitions on borrowing, and replace these with a framework for responsible credit market access.

• Provide a foundation grant to establish an independent, nonprofit, single-purpose credit-rating agency.

xiv Executive Summary

• Establish a legal framework to deal with local governments under fiscal distress, and establish a control board and insolvency mechanisms.

Local Tax Reforms to Improve Revenue Adequacy and to Preserve the Local Environment: Residential Property Tax and Environmental Taxes

Residential property tax. A residential property tax is a new tax, and there is no consensus regarding its design and objectives in PRC. There are also significant institutional hurdles to its introduction on a countrywide basis. Some view it as a redistributive tax rather than as a benefit charge for local services. Pilot projects in Chongqing and Shanghai view it in this light and impose a small tax on a narrow base, primarily to tax the wealthy. Such a perspective will not result in a tax that will improve local revenue adequacy or serve as a tool for better land use in urban areas. Further, there is also a lack of knowledge on the design and implementation of such a tax.

Organisation for Economic Co-operation and Development countries have centuries of experience in administering such taxes and see them as a benefit charge for services to residences and use a broad tax base to serve as a stable source of local revenue. A residential property tax in PRC can be a promising source of additional revenue for local governments if the tax is also viewed as a benefit charge for property-related public services and to provide incentives for local economic development by taxing land at a higher rate than improvements. It can also deal with urban sprawl and resulting food security issues if the land at the periphery is taxed higher than at the center to encourage compact urban development.

Property tax assessment, however, is a difficult and arduous task as it requires information systems that capture market value and rental transactions with all hedonistic characteristics. In PRC, capacity development is required prior to the introduction of such a tax.

The following short- and medium-term options may be considered for instituting a residential property tax.

• Conduct an education campaign targeted to policy makers, academia, and the general public on a mature residential property tax system that can be adopted in PRC in the long term.

• Conduct specialized training on property assessment techniques and property taxation for central Ministry of Finance and provincial finance bureau officials.

• Initiate pilot projects using broad-based property taxes with appropriate relief measures for the poor, elderly, and the disadvantaged as well as appropriate exemptions.

• Provide a foundation grant to establish an independent agency that tracks sales prices and hedonic characteristics of all properties transacted on the market.

• Establish a local cadaster of properties.

Executive Summary xv

The following long-term options may be considered for instituting a residential property tax.

• Establish enabling legislation for countrywide imposition of such taxes by local governments, which establishes the tax base, methods of assessment, and appeal mechanisms.

• Clarify the roles of central and local governments in tax base determination, tax rate determination, and tax collection and administration.

Local environmental taxes. In PRC, energy is heavily subsidized, and there are no substantial environmental taxes. In the past, faster local economic development has been pursued to almost neglect of environmental consequences. Recently, the central government has been more concerned with the degradation of environmental quality and is encouraging exploration of policy options to deal with environmental protection. It has already announced implementation of a CNY10 carbon tax on fossil fuels starting in 2014.

Local governments can also do more, as environmental taxes serve to protect the environment as well as raise additional local revenue. Such taxes can also serve tax reform objectives by reducing economic distortions created by the tax system, if introduced as equal yield replacement for more distortionary enterprise and personal income taxes. A menu of policy options involve (i) correcting energy prices by eliminating energy subsidies, (ii) introducing a combination of market-based incentives and standards for reducing local pollution, and (iii) promoting a carbon tax.

Eliminating energy subsidies could save the national exchequer much money. In addition, removing subsidies will lead to a reduction in greenhouse gas emissions. Not all subsidies can be easily removed, however, especially those that directly impact the rural poor, but this is an area requiring careful examination for further reform.

Policy tools to design market-based incentives will be indirect taxes on inputs and outputs, effluent and emission charges, and hazardous or nonbiodegradable waste disposal charges. The first tool adds an externality charge on existing input taxes or output taxes on polluting firms or environmental charges on consumer products. This tool would be a good option but may not provide incentives for cost-efficient abatement equipment. The second tool entails effluent charges per unit discharged into water or air, which are efficient instruments but pose significant challenges in terms of technology for measuring and monitoring. Thus, it would require significant upfront costs. Hazardous or nonbiodegradable waste disposal charges are differentiated by type of waste and their potential for environmental damage, which are easier to administer. Carbon taxes reduce greenhouse gas emissions, and they may strengthen the fiscal position of governments. In terms of tax reform, carbon taxes may increase economic efficiency and contribute to favorable distributional consequences.

The following short- and medium-term options may be considered for instituting environmental taxes.

• Seek elimination of energy subsidies gradually.

• Seek local piggyback rates on the national carbon tax base.

• Introduce congestion tolls in major urban areas.

xvi Executive Summary

The following long-term options may be considered for instituting environmental taxes.

• Introduce pollution taxes, effluent charges, and subsidies for abatement technology.

• Introduce standards for reducing emissions and effluents.

These are the broad contours of an ambitious reform agenda that requires consideration by policy makers in PRC. While this path may be best with major difficulties in reaching a consensus on the design and implementation, PRC has already taken important first steps in moving this agenda forward. A combination of market-based incentives and standards for reducing local pollution could be the next priority. Also, what is needed is to sustain this momentum of reform over the intermediate and long terms.

1

1 Introduction

Since initiating economic liberalization in 1978, the People’s Republic of China (PRC) has had a remarkable record of economic growth. Today, PRC is the second-largest economy behind the United States, and the largest exporter and manufacturer in

the world. While many other Organisation for Economic Co-operation and Development (OECD) countries are languishing under mounting public debt burdens with unsustainable public finances, PRC has emerged largely unscathed from the recent global financial crisis, enjoying a rising positive net worth with large reserves to deal with any budding fiscal calamity.

As PRC is one of the most decentralized countries in the world in terms of fiscal expenditures, its success is inexorably linked to the capabilities, incentives, and accountability of its local governments. Indeed, local governments in PRC have played a catalytic role in bringing about the country’s historic economic transformation, as they have assumed a dominant role in service delivery and local economic development. However, at the local level, there has also been a lack of attention to fiscal transparency in budgeting; fiscal responsibility in borrowing; and underprovision of public goods such as environmental protection, food security, orderly urban growth, and social inclusion.

Since 1978, a series of radical as well as incremental fiscal system reforms has been conducted in the PRC. Faced with declining transfer of revenues from the provinces, the central government in 1988 introduced fiscal contracts with the provinces by which the provinces were to provide the central government lump-sum transfers and retain the remainder of revenues for own use. This solution still could not provide the central government with enough financing and as a result radical fiscal reforms were introduced in 1994 to recentralize the tax system, and its administration, and initiate a new system of central-local tax sharing and transfers. Under these reforms, the provinces only retain 25% of the value-added tax (VAT), 40% of income tax, and 50% of security and exchange transactions tax. In addition, the central government introduced prohibitions on local government access to private market capital financing to protect against macro fiscal risks.

Over the past decades, it has also introduced incremental reforms in central-provincial transfers, budget transparency and comprehensiveness. More recently in 2012 introduced a new framework for raising and reporting local debt. These reforms have had positive impact on local public finance management yet many areas of concern remain. These include: (i) local governments having inadequate access to tax and bond finance; (ii) unconditional transfers have limited equalization impacts, and conditional transfers are not focused on setting national minimum standards for public services and creating incentives for results based accountability; (iii) provincial-local transfers lack transparency

2 Local Public Finance Management in the People’s Republic of China

and predictability; (iv) local budgets remain segmented and nontransparent; and (v) new borrowing framework is welcome but not yet available to most local jurisdiction.

Meanwhile, local governments face strong incentives for local economic development. This is because political and bureaucratic careers are directly linked to growth in local GDP. The 1994 reforms significantly curtailed opportunities for local tax financing and the situation was further aggravated by prohibitions on access to capital finance. Local government motivated by their commitment for uplift of local economy sought imaginative solutions, some with questionable legal basis, to overcome these centrally imposed constraints. They were helped in these efforts by having antiquated cash based segmented budgeting systems. Many local governments set up commercial enterprises, known as urban development investment corporations (UDICs), and public service units, and borrowed from these enterprises with no oversight by the central government or the financial market. They also followed aggressive land-grab policies from adjoining rural areas to support their expansion, and provided off-the-books guarantees to attract private businesses.1 In the process, according to the National Audit Office (NAO), they accumulated CNY10.7 trillion of debt obligations by December 2010. These debt obligations are estimated to have grown by 12.9% in 36 sample local jurisdictions based upon an audit report released by NAO in June 2013 (Shuli 2013). By applying the same growth rate, the aggregate local debt would have risen to CNY12.08 trillion by 31 December 2012 (Liu unpublished).

The pace of rapid growth and urbanization has also brought forth newer challenges in dealing with regional inequalities; services to migrants, the elderly, and the rural poor; environmental preservation; and higher expectations regarding quality and quantity of public services and social safety nets. However, local governments’ fiscal limitations, especially their mounting debt obligations, constrain effective responses. Fiscal system reforms are thus necessary to provide local governments with more fiscal space while enabling the central government to have better oversight over their fiscal health. To ensure adequate policy response to the reform needs, a key is to improve local budgeting and execution, local public debt management and local taxation. These are interrelated and underlying issues in local public finance management. The Asian Development Bank (ADB) has developed a technical assistance project on these three issues, reviewing their current status supplemented by lessons from international experiences. 2 This technical assistance served as the basis for policy dialogue and training of local government officials at workshops and for final consultations with central government officials in Beijing in June 2013. This report draws upon the policy research informed by the feedback from these policy dialogues. It is intended to inform policy makers in developing policy options and building consensus for achieving medium-term local public finance management reform objectives.

1 According to a report by the Ministry of Land and Resources, Bulletin of Land and Resources of China 2012, the approved land being used for construction increased from 0.418 million hectares in 2008 to 0.615 million hectares.

2 ADB. 2010. Technical Assistance to the People’s Republic of China for Strengthening Fiscal Policy and Public Finance Reform over the Medium-Term. Manila.

3Introduction

1.1 Overview of Local Public Finance Management

PRC is a unitary state with one government administratively organized into a hierarchical five-tier governance structure (Figure A1, Appendixes). Below the central government, there are 23 provinces, 4 province-level municipalities (i.e., Beijing, Chongqing, Shanghai, and Tianjin) and 5 autonomous regions (i.e., Guangxi, Inner Mongolia, Ningxia, Tibet, and Xinjiang), and 2 special administrative regions. Provinces and autonomous regions are then divided in prefectures, counties, autonomous counties, and cities. Several provinces directly manage the counties. Counties and autonomous counties are divided into townships, nationality townships, and towns. As of December 2012, there were 333 prefecture-level governments, 2,852 county-level, and 40,446 township-level governments.

All government levels have executive branches separate from legislative branches. Executive branch staff members at the local level are appointed by higher-level governments, whereas local people’s congress members are directly elected by local residents. The central government exercises some control over the number of total staff positions and wages and benefits at the local level, and does appoint staff members to top positions. However, local governments have discretion in personnel management and hiring and firing of personnel. In addition, in each government level, the Communist Party has party committees providing oversight. Local governments also use contracting and other innovative methods in delivering public services.

The central government has exclusive responsibility for currency, banking, foreign affairs, defense, and communications. The National People’s Congress (NPC), the national legislature, also has overriding legislative powers in all areas. Local governments, however, have responsibility over all people-oriented services, such as social and welfare services including pensions and unemployment insurance.3 Local governments also have exclusive responsibilities for property-oriented services, such as urban construction and water supply. Most responsibilities are shared between the central and local governments if they involve policy making, standards setting, and financing of shared services (Table 1).

Local governments account for nearly 85% of total state expenditures (Figure 1). Thus, in expenditure decentralization, PRC ranks among the top quintile of countries globally. Even on the basis of subprovincial governments including provinces and below provincial governments, PRC ranks favorably with most OECD countries in terms of importance of local governments (Figure 2).

As previously stated, since 1994, tax legislation has been centralized for all revenue sources. Local governments have no ability to vary the base or rate of any tax without central approval. Moreover, productive tax bases, such as the VAT, enterprise tax, and personal income tax, are centralized, creating greater fiscal space for the central government to support regional development and economic integration of lagging regions. More recent reforms also integrate local business taxes with the VAT, further enlarging the fiscal space for the central government. Table 2 provides an overview of the current tax assignment

3 In many OECD countries, the central government oversees social security and unemployment insurance.


Table 1 Expenditure Assignment in the PRC

Expenditure Items Central Provincial Prefecture County Township

Shared responsibilities between the central and local government

Government administration X X X X X

Capital construction X X X X X

Research and development and state-owned enterprise promotion

X X X X X

Education X X X X X

Health care X X X X X

Culture development X X X X X

Policy reimbursement X X X X X

Agricultural development and production

X X X X X

Armed police troops X X X X X

Social welfare X X X X X

Exclusive responsibilities of the central or local governments

National defense X

Diplomacy and foreign aids X

Geological prospecting X

Principle and interest payment for national debt

X

Urban maintenance and construction

X X X X

Environmental protection X X X X

City water supply X X X

Community services X X

Source: Qiao and Shah (2006).

in PRC. Major local revenue in relative order of importance is land-leasing revenue, the urban maintenance tax, contract tax, and vehicle purchase and use taxes. Overall, local governments collect about 50% of national revenues.

Central–local transfers (including tax rebates) finance about 40% of local expenditures. These transfers flow through the governance structure, as provinces receive these transfers from the central government and pass them down to local governments either using the same criteria utilized by the central government or modified to suit local circumstances.4 Two-thirds of fiscal transfers are provided as general-purpose transfers, that is, without conditions. General-purpose transfers include (i) revenue sharing from the VAT, enterprise tax, and personal income tax; (ii) VAT rebates equaling previous-year rebates inflated by 30% of the growth in VAT and consumption tax revenues in local jurisdictions to compensate for the 1994 centralization of VAT and excise taxes and to provide incentives for growth in productive activity and consumption; and (iii) equalization

4 In some instances, the transfers are incomplete or delayed (World Bank and DRC 2012).

5Introduction

Share of Revenue Collection Share of Direct Spending

Central LevelProvincial Level

Prefectural LevelCounty Level

18.9%36.3%

15.1%

29.7%

49.4%

11.3%

22.1%

17.2%

Figure 1 Share of Revenue Collection and Direct Spending by Level of Government, 2011

Sources: National Bureau of Statistics. 2012. China Statistical Yearbook (2012) (Zhongguo Tongji Nianjian-2012). Beijing: China Statistics Press. Table 8-2 and Table of 8-3. http://www.stats.gov.cn/tjsj/ndsj/2012/indexch.htm; National Bureau of Statistics. 2012. China Statistical Yearbook for Regional Economy (2012) (Zhongguo Quyujingji Tongji Nianjian-2012). Beijing: China Statistics Press. Table 3-6, Table 3-7, and Table 4-1. Central government-level data are from Tables of 8-2 and of 8-3 of the China Statistical Yearbook (2012); other data are calculated from Tables of 3-6, 3-7, and 4-1 of the China Statistical Yearbook for Regional Economy (2012).

Figure 2 Relative Importance of Subprovincial Governments as Measured by Local Government Expenditure Share

Sources: Ivanyna and Shah (2012).

0

10

20

30

40

50

60

70

Local government exp share

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People

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Denm

ark

Viet N

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and

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Table 2 Tax Assignment in the People’s Republic of China (%)

Revenue Instrument Central Share

Provincial Share

Subprovincial Share Total

Customs 100 0 0 100

Excise 100 0 0 100

Enterprise incomes and profits of central enterprises, banking, insurance, and transport

100 0 0 100

Securities trading tax 97 3 0 100

Vehicle purchase tax 100 0 0 100

Enterprise income and profit taxes, others

60 20 20 100

Individual income tax 60 16 24 100

Consumption tax 100 0 0 100

VAT on imports 100 0 0 100

VAT on domestic production 75 6 19 100

Business tax (currently being integrated with domestic VAT)

3 27 70 100

Business taxes on transportation and banking

100 0 0 100

Resource taxation—offshore resources

100 0 0 100

Resource taxation—inland resources 0 100 0 100

Urban maintenance and construction tax on banking, insurance , and transportation

100 0 0 100

Urban maintenance and construction tax

0 0 100 100

Property tax 0 0 100 100

Residential property tax (to be introduced in future)

0 0 100 100

Urban and township land use tax 0 0 100 100

Farmland occupation tax 0 0 100 100

Land lease revenue 0 0 100 100

Land appreciation tax 0 0 100 100

Vehicle and vessel use tax 0 0 100 100

Contract tax 0 0 100 100

Tax on special agricultural products 0 0 100 100

Fixed asset investment tax 0 0 100 100

Slaughter tax 0 0 100 100

Banquet tax 0 0 100 100

All Revenues (2011) 49 11 40 100

VAT = value-added tax.

Source: Updated and adapted from Qiao and Shah (2006).

7Introduction

transfers using complex, need-based criteria. Specific-purpose transfers include (i) wage grants, (ii) grants for rural tax reform, (iii) financing of rural education and health, (iv) grants to minority regions and local subsidies that were grandfathered by the 1994 reform, and (v) earmarked grants by various central line agencies.

PRC follows an integrated, countrywide budget system, resulting from both top-down and bottom-up interactions. Local governments have significant budgetary discretion within the overall envelope established at the center. Local budgeting is annual and input- and cash-accounting based. It is segmented, with about 9.5% of the local expenditures currently off-budget (Wong 2013). External and internal controls are in place, but effectiveness varies across local governments. Processes for both internal and external audits are in place.

Local governments also have complete discretion in design and delivery of public services and often use contracting and other innovating methods in delivering public services at the local level.

1.2 Issues in Local Public Finance Management

The assignment of social services and social welfare to local governments has resulted in issues relating to social exclusion of migrant workers and inadequate access to services by rural residents. Social protection e.g. old age security could become a problem for local governments with relatively higher proportion of population over 60years. Services to rural residents are an ongoing concern. Conceptually a strong case can be made for central provision of unemployment insurance and old age pensions. However, the same objectives can be achieved if these services are financed fully by the central government through output-based transfers that set minimum uniform national standards of these services to all citizens regardless of their place of residence or registration. Such financing regime could overcome the problems with decentralized provision.

At present, local government revenue means are inconsistent with their expenditure needs, creating a vertical fiscal gap in the operating budget that is mostly overcome through central fiscal transfers. Yet more can be done to facilitate greater revenue adequacy and revenue autonomy at the local level. For example, replacing the current revenue-sharing system with a tax base-sharing system that allows local piggybacking onto central tax bases by levying supplementary local rates for a comprehensive consumption-based VAT, personal income tax, and national carbon tax would serve these objectives. In addition, local governments could be encouraged to explore other tax instruments such as environmental taxes, charges on pollution and congestion, and residential property taxes.

Central fiscal transfers also require major reforms. The current system is complex and opaque and creates budgetary uncertainty for local governments as they are unable to estimate expected central transfers until the central budget is executed. A piecemeal approach is used to fill gaps, undermining local government accountability to local residents, as they receive the majority of transfers as general purpose. The equalization


program is too complex in design and does not achieve equalization to a defined standard. Moreover, for most specific-purpose transfers, there is a lack of consistency in design and objectives, emphasizing input controls with less accountability for results.

Lack of access to capital market finance while judging local governments on local GDP growth creates incentives for local governments to explore off-budget borrowing opportunities leading to a lack of transparency and accountability. Further it encourages them to do land grab from adjoining rural areas converting productive agricultural land to commercial use and creating potential risks for food security.

Local budgeting and finance management are in their infancy throughout PRC. Local budgets are incremental, segmented, and do not provide a good overview of government operations. External and internal controls are not yet well developed, and the local people’s congresses do not have the means to exercise effective oversight. A system of local debt management is not in place in most local jurisdictions, since there is no systemic monitoring and oversight on local debt, and there are no formal mechanisms to deal with local governments in fiscal distress.

9

2 Reforming Local Budgeting and Budgetary Institutions

Budgeting and budgetary institutions include the budget process, legislative framework for budgeting, budget methods, and the framework for debt monitoring and management. These institutions create incentives and accountability

mechanisms that impact the fiscal health of local governments as well as efficiency, equity, and responsiveness in local service provision. The following subsections deal separately with local budget management and debt management issues in the PRC. For each of these major areas, current practices and ongoing reforms are presented followed by next steps in the reform agenda.

2.1 Local Budget Management

2.1.1 Budgetary Methods and Practices

PRC has a unified state budget providing an annual overview of operating and capital expenditures by all levels of government (Figure A2, Appendixes). Thus, the state budget offers a unique window to all government operations and can be a useful tool for internal management and control and external citizen-based accountability.5 In view of this unique nature of the state budget in the PRC, transparency of the budget, quality, format and comprehensiveness of the information assumes added significance. In order to analyze the comprehensiveness of the budget, the information contained in local budgets is important, which is reported in summary form in the state budget. The following paragraphs examine the coverage, time perspective, budget format and budget methods used in local budgeting in the PRC.

Comprehensiveness in coverage of local budgets. Over the past few decades, incremental reform has made local budgets more comprehensive by incorporating some off-budget expenditures. However, local budgets still provide only a segmented view of local government operations, as a significant percentage of local expenditures remain off-budget (Wong 2013). Partially or fully excluded expenditures include tax expenditures (i.e., revenues for special tax incentives), local public enterprises, earmarked funds, external assistance, contingent and noncontingent liabilities, and other extrabudgetary and off-budget expenditures by special funds and public services units. Clearly, this segmented budget limits (i) the integrity and fiscal discipline of local budgets, (ii) examining allocative

5 This contrasts with large federal countries, such as the United States and India, where budgets of various levels of government are not integrated.


and technical efficiency of various operations, and (iii) building the population’s confidence and trust in government. Recognizing the usefulness of a comprehensive budget, the Ministry of Finance in 2012 issued instructions to local governments to have all-inclusive comprehensive budgets by 2015. It is expected that in future local budgets will incorporate this comprehensive view.

Annual versus medium term perspective in the budget. In PRC, local government budgets simply present annual budgets, as opposed to a medium-term expenditure framework (MTEF). MTEFs are useful in linking annual budgets with medium-term priorities as specified in planning documents. Baseline and forward estimates for the next 3 years can serve as an important management tool for a review of government operations. MTEFs not only provide more certainty in planning and budgeting but also assist in detecting emerging fiscal issues, restrain public spending as political favors, foster fiscal discipline, and support dialogue on government priorities. However, for MTEFs, local governments must closely examine their fiscal capacity and needs, and such an exercise is costly if no framework for fiscal discipline exists and if it is used as a resistance tool to block needed changes in the budget in the event of a major economic shock or natural catastrophe. Moreover, MTEFs require sophisticated capacities with long-term training in local governments.

Hebei Province is currently piloting an experiment with an MTEF. The province initiated an MTEF with a 3-year rolling view of its capital budget (i.e., development fund) only (Box 1). The results of this experiment will assist other provinces in determining the suitability of this framework. It will also highlight additional resources and the time frame needed to train staff, develop and implement an MTEF, and demonstrate any gains in aggregate fiscal discipline and allocative efficiency and equity achieved with the use of an MTEF. An evaluation of the overall costs and benefits of this reform will inform reform options for other provinces.

Budget Format. Local governments traditionally present their budgets either by objects of expenditure (e.g., wages, employee benefits, travel, office supplies, other material costs, and utilities and equipment), useful for internal management and compliance control, or by organization (i.e., by administrative and institutional units, required for accountability, legal appropriations, fiscal control and management, and oversight of budget execution). Effective 1 January 2007, local budgets are also presented using functional classifications (e.g., education, health, or transport) as well as economic classification (e.g., transfers to individuals, grants to other levels of government, or subsidies to firms) (Gou Unpublished). This helps in policy analysis and benchmarking local government performance against relevant comparators. Local budget formats in PRC have already achieved a degree of comparability with OECD countries.

Budget Methods: Line item budgeting. Local governments also use line-item budgets, which present revenue and expenditure details typically on a cash-accounting basis. This type of budgeting is useful for ensuring compliance with appropriations and when strict controls on inputs are desired. Under this budgeting method, local government officials have no discretion in reallocating expenditures across various categories, and managers are held accountable for what, how, and when they spend inputs. A line-item budget is less useful for accountability for service delivery performance or for benchmarking.

11Reforming Local Budgeting and Budgetary Institutions

Programing budgeting. Program budgeting offers some improvement over line-item budgeting in performance accountability by clustering line items by each program of expenditure. This method affords public managers flexibility in intraprogram allocations. Managerial accountability remains top-down and input-based, but program objectives, expected results, and impact enter public discourse. Pioneered by local governments in the United States, it offers a comprehensive view of budget operation, presents the purpose and objectives for which funds are required and the costs of programs proposed for achieving those objectives, and specifies outputs to be produced or services to be rendered under each program. It also details expected outcomes and the long-term impact of various programs.

Performance budgeting. Performance budgeting has been implemented for more than a decade worldwide, but the results vary across countries and by government level (Hawkesworth and Klepsvik 2013). On the positive side, performance budgets are seen as useful tools for exposing government performance. Policy makers feel better informed about government operations, while citizens have easier, less costly access to information on government performance. Performance budgeting also has resulted in benchmarking local government performance with a positive impact on local government performance. However, the impact on central government performance, with a few important exceptions

Box 1 The Medium-Term Budget Framework Process in Hebei Province

The government of Hebei Province created a medium-term budget framework for its capital budget in 2012. It entails the following three stages:

(i) Preparation. In the first quarter of every year, the Provincial Department of Finance requests all provincial departments to prepare 3-year budget rollover plans on development expenditures. In April and May, according to the medium- and long-term development plans, all departments decide their 3-year plans annually and overall arrangements on the 3-year budget rollover. After receiving feedback from the Department of Finance, these departments report to the provincial government for review and approval.

(ii) Presentation. All departments present detailed budget projects as well as plan budget advice. In June and July, all departments screen the 3-year development expenditure programs, including the budget for the next year. Then, departments add 3-year budgeting projects to the project library. After the Department of Finance’s examination and approval, approved projects are added to the financial projects library. In August and September, all departments choose development projects from the financial projects library when planning the next year’s budget. They prepare a 3-year budget rollover on development expenditure and report it to the Department of Finance.

(iii) Review and approval. In October, the Provincial Department of Finance examines all 3-year budget rollovers on development expenditure reported by these departments. Then, the Department of Finance provides feedback and advice on the first year’s development expenditure quota and on the next 2 years’ development budget.

Source: Gou (2013).


such as New Zealand and Singapore, has generally been modest in most countries. In the United States, such budgeting at the federal level has resulted in a costly information overload with uncertain benefits. At the local level, however, performance budgeting is widely practiced on a voluntary basis with great success in achieving transparency and building taxpayers’ trust in local government operations.

A performance budget can be a useful tool in ensuring that mangers are accountable for what they achieve in meeting service delivery targets, provided there is an accompanying human resources management framework that affords managers flexibility in program design and implementation but holds them accountable for achieving agreed results. Information requirements of such budgeting are enormous, although the payoffs are great with successful implementation (Table 4). Therefore, considerable preparatory work and accompanying complementary reforms are needed prior to introduction of such budgeting. Also, substantial capacity development at the subnational level is required prior to introduction of performance budgeting.

For a performance budget to serve as a citizen-based accountability tool, it would also be useful to adopt a budget format that conforms closely to services delivered. It should be noted that performance budgeting is more useful for programs with direct service delivery objectives, mostly local functions. It is less useful for central policy, planning, and coordination functions and therefore may not be adopted for the Ministry of Finance and planning, advisory, and research and development departments and tasks.

Table 3 presents a comparative perspective on the three alternative budget formats. Table 4 presents main payoffs of performance budgeting, and Table 5 presents an overview of international practices in performance budgeting reforms.

Performance budgeting in PRCPRC has studied performance budgeting over the past few years but seems to, generally, have opted against its adoption. Instead, focus has been on initiating pilot projects with a view to improving budget performance through budget performance management innovations, that is, improving efficiency and quality of public service provision through process and management reforms. A central government directive issued by the Ministry of Finance, on 21 September 2012, encouraged local governments to improve budget methods, budget formulation, budget execution, and evaluation processes and techniques and to strengthen the roles of external experts and think tanks in budget formulation and evaluation processes. It further encouraged provinces to implement project and program performance management by objectives so that provinces monitor results achieved against original objectives of the project or program and make periodic adjustments.

Guangdong, Sichuan, Yunnan, Zhejiang, and several other provinces require project evaluation results to inform budgeting decisions. In 2011, Yunnan Province conducted an evaluation of all major provincial projects using a standardized evaluation, and the results of this evaluation informed budgetary decisions for the following year (Box 2). Zhejiang Province requires that all projects have clearly specified goals and verifiable quantitative and qualitative performance indicators (Box 3). These provinces have found


Table 3 Features of Alternate Budget Formats

Feature Line Item Program Performance

Contents Expenditure by objects (e.g., wages, travel, utilities, vehicles, or organization) or by function

Expenditure by cluster of activities (e.g., enforcement or investigations)

Results-based chain

Format Operating and capital expenditures

Expenditure by major programs

Inputs, outputs, outcomes, impact, reach

Orientation Input controls Input controls Focus on results

Management Paradigm

Top-down, rules driven Top-down but flexibility within a program

Managerial flexibility but accountability for results

Source: Authors’ compilation.

Table 4 Performance Budget Payoffs

Budget as a source of performance information

• Cost: Inputs/resources used to produce outputs

• Output: Quantity and quality of goods and services produced

• Outcome: Progress in achieving program objectives

• Impact: Program goals

• Reach: People who benefit or bear most of the tax burden of financing a program

• Quality: Measure of service such as timeliness, accessibility, courtesy, accuracy

• Productivity: Output by work hour

• Efficiency: Cost per unit of output

• Satisfaction: Rating of services by users


Table 5 Spectrum of Performance Budgeting Reforms

Type of Performance Budget Where practiced

• Performance-reported budgeting. Performance information presented as part of the budget documentation but infrequently used by budgetary actors in allocations

• Performance-informed budgeting. Performance information actively used to inform budget decisions, along with other information but may not significantly affect budgetary decision making

• Performance-based budgeting. Performance information very important in the decision-making process but does not necessarily determine the amount of resources allocated

• Performance-linked or -determined budgeting. Also known as the performance budgeting ideal, allocation of resources directly and explicitly linked to units of performance

• Denmark, Indonesia (local governments), South Africa, United Kingdom, United States (federal government)

• Australia, Canada (local governments), Chile, Finland, France, Malaysia, Poland, Singapore, Sweden, Uganda, and United States (local governments)

• Netherlands, New Zealand

• Nowhere. Not feasible in practice.

Sources: Shah and Shen (2007); De Jong, Beek, and Posthumus (2013).


Box 2 Project Evaluation and Budget Review Framework Piloted by Yunnan Province, 2012

Yunnan Province adheres to the following framework in evaluating project and budgetary proposals:

Appropriate targeting (20% weight)

• Is the project rationale clear and convincing?

• Does the project specify its objectives early and lay out measurable and verifiable targets?

Well-designed plan (60% weight)

• Does the project have a realistic and feasible implementation plan?

• Is the project design consistent with the achievement of its objectives?

• Are the specified capital requirements reasonable and well-articulated?

Management framework (20% weight)

• Do we have assurance that project will be well managed?

• Does the project have in place appropriate external and internal controls to ensure integrity of financial management?

Source: Authors’ compilation based on the information of Professor Gou Yannan.

such evaluations to be helpful in improving the effectiveness of programs and developing better projects for future budgets.

Concluding observations on budget methods and practicesThe coverage of local government operations in local budgets remains incomplete in the PRC. Also the budgets currently provide only an annual perspective although efforts are underway for gradual phase in of a medium term perspective. Medium term perspective is helpful in linking planning with budgeting. Budget format conforms to OECD standards. Line item budget are in vogue using with cash accounting. Phased introduction of a variant of performance budgeting is being tested in a handful of provinces.

The PRC has adopted a gradual and cautious approach to the implementation of performance budgeting at the local level that emphasizes learning by doing. Considering that implementing performance budgeting highly demands relevant and quality performance information and capacity at the local level, that is a welcome approach as fast track implementation without adequate preparation poses significant risks.

Transparency and presentation of local budgets in citizen friendly formats providing information on important services and costs still remain an unmet goal in PRC. Such presentation will help benchmark local government performance, enhance accountability of local governments to local residents, and serve as an important tool in monitoring local government performance. Performance information plays important roles in long-term development strategic directions and in holding local governments to be accountable. A gradual approach to performance budgeting, targeting relatively sophisticated provinces and starting with a few basic services, such as garbage collection, water and sewerage,


Box 3 Zhejiang Province’s Requirements for Budget Plans, 2012

T he Zhejiang Provincial Department of Finance requires clarity of goals and verifiable indicators of performance for budget plans. The following is an example of performance

goals required of the project on school internet access improvement.

Overall Description of GoalsTo interlink network connections among all school campuses; to form internal connections between campuses through one computer network. To ensure users’ right to enter the internet; to eliminate all illegal actions.To increase the safety of the internet; to achieve united management in long distance.To create an online learning platform for learning at any time and at any place; to satisfy the self-learning needs of students; to offer support service on online study.

Quantitative Index and Standards(1) Load bearing for internet users(2) The proportion of users verified through charging system(3) The increasing number of information point(4) The accumulating time of abnormal interrupting time(5) The students’ satisfaction

Qualitative Index and Standards(1) The sharing of data and information: safe, convenient, and credible.(2) Network connections between school campuses: the function of the network remains the

same on each campus.(3) To complete the initial building of network unification among campuses: complete the

building of primary frame; stable and extendible.(4) The goal of systematic function: accurate and integrate.(5) The improvement of teaching outcome: tutoring of exams, pinpointing of content, accuracy

of knowledge points.

Source: Gou (2013).

education, and health, should be evaluated. If the result of the evaluation is positive, it may be extended to other services over time with sufficient local capacity development.

2.1.2 Local Budgeting Framework: Ex ante regulations

Ex-ante regulations for fiscal responsibility and discipline can be helpful to the executive as well as the legislative branch for government oversight. Many countries have legislation that embodies fiscal rules on budgetary operations, and others, such as Brazil, have more comprehensive fiscal responsibility legislation that covers a broad range of government operations and outlines sanctions for noncompliance.

PRC adopted subnational fiscal rules as part of its 1994 Budget Law.6 The law, which guides the preparation and execution of provincial and local budgets, requires that all budgets be balanced annually and that local governments be prohibited from borrowing

6 The Budget Law was promulgated in 1994 and effective in 1995.


unless the State Council grants an exception. The law forbids provinces and local governments to divert for their own use the funds intended for other government levels. Provinces and local governments also must set aside 1%–3% of revenues as reserves to deal with natural disasters and other calamities (Gou Unpublished). Further, the annual increase in provincial spending on agricultural and technological development must be higher than the increase in revenues. Total provincial–local spending on education must be at least 4% of gross domestic product (GDP).

Although the 1994 Budget Law provides helpful guidance, as mentioned previously, provinces and local governments have discovered ways to circumvent some of the budget rules. As local budgets are segmented, balanced budget requirements are difficult to enforce. Local governments also have found ways to “borrow” through their specialized UDICs without being in technical violation of the law. These actions could pose potential macro fiscal risks for the nation, especially given that such hidden debt is difficult to uncover and monitor and contributes to a lack of transparency in local budgeting.

Most developed and developing countries require local government operating budgets to be balanced and that borrowing can only be used to finance capital projects. PRC has stricter requirements, as it obliges all budgets to be balanced. Yet prohibitions on borrowing and capital budget balance requirements, if effective, can constrain capital financing and limit possibilities to overcome infrastructure deficiencies. In view of these considerations, PRC may consider reforming the law to remove these constraints and provide for prudent regulations of capital financing.

2.1.3 Local Budget Formulation and Approval Process

PRC’s unified state budget begins 1 January. Local government budgets are prepared by the local executive, and approved by the people’s congress at the local level. They are also subject to review by the State Council and the NPC. At the provincial level, budget formulation involves the following steps.7

(i) April–May. After consulting with the Ministry of Finance, the provincial finance bureaus issue budget circulars inviting provincial departments to submit funding requests for the next year as well as revised estimates of current-year spending and actual amounts of the previous year’s spending. The circulars also ask local governments to follow a similar process and to prepare local budgets for approval by the people’s congresses at the local level with final submission to the provincial finance bureaus. Department and local governments are expected to carry out an evaluation of their current programs using evaluation by objectives in deciding on continuation. They are also expected to follow a zero-based budgeting (i.e., a budgeting system where every item of expenditure has to be justified every year) approach in determining allocation priorities for the next year.

(ii) June–July. Departments submit their wish lists and estimates to the provincial finance bureaus.

7 The two cycle process is illustrated in Figure A3, Appendixes.


(iii) August–September. The provincial finance bureaus review departmental proposals and provide feedback on departmental spending caps as well as individual programs. They also advise local governments on the availability of higher-level financing for the next year.

(iv) October–November. Provincial departments submit their final requests to the provincial finance bureaus along with current spending estimates and actual expenditures over the previous year. Local governments also submit their approved budgets to the provincial finance bureaus for information.

(v) November. The provincial finance bureaus collate local government budgets, departmental spending proposals, revenue forecasts, current-year revenue estimates, and actual revenues of the previous year into a budget document for review and approval by the provincial councils. The provincial councils solicit advice from the standing committees in the provincial people’s congresses on budget priorities.

(vi) December. The final budgets approved by the provincial councils are submitted for review by the provincial people’s congresses. They are reviewed by the standing committees and voted upon by the provincial people’s congresses. Upon approval by the provincial people’s congresses, the budgets are submitted to the Ministry of Finance for inclusion in the central budget.

To meet unforeseen budgetary demands in the medium term, departments initiate virement (i.e., the process of transferring amounts from one account to another) requests for shifting funds from some activities to others within the departmental limits to the provincial finance bureau, which, in turn, initiates a process of executive review for approval and for information to the provincial people’s congress at the same level. If, on the other hand, budgetary limits are to be exceeded, the bureau prepares supplementary estimates for executive review and provincial people’s congress submission and approval. Upon provincial people’s congress approval, the amended appropriations are reported to higher levels.

Concluding observations on budget formulation and approvalThe current budget formulation process serves PRC well, but a few further improvements are needed. First, the budget formulation process offers very little opportunity for provincial people’s congresses to provide upfront pre-budget feedback on government business plans and budget priorities. Yet local governments could be required to submit to the provincial people’s congresses their business plans and budget priorities for the next year in February and to receive provincial people’s congress feedback by March. This will extend the budget cycle only by 2 months and provide an effective voice to the local people’s congresses in the budget process.

Second, zero-based budgeting is impractical given that public sector wages and benefits command a significant share of local expenditures and that most local public services require long-term continuity. Under such circumstances zero-based budgeting would be a futile exercise.

Third, it would be helpful if, at the beginning of the second cycle, the Ministry of Finance provides a fiscal framework detailing the government’s short- and medium-term policy


objectives as well its resource envelope, spending priorities, and borrowing stance to guide local budget deliberations.

Fourth, project review using evaluation by objectives is also a flawed methodology as it creates incentives for project goals to be understated and then to overachieve these goals. A project manager that sets ambitious goals and then underachieves would be subject to sanctions, although he or she may have outperformed in terms of desired impact on service delivery. Projects must be evaluated for their impact on service delivery relative to their resource use. For example, road-paving programs can be compared for cost per lane-kilometer paved. Project reviews are helpful, but it is more important to conduct periodic, with a 5-year interval, program reviews at department levels using a few simple questions about each program (Box 4). In addition, periodic government-wide program reviews conducted at provincial and local levels could be helpful in discontinuing ineffective programs and replacing these with more effective interventions to achieve stated public service delivery objectives.

2.1.4 Budget Execution: Executive Oversight

The budget departments of the finance bureaus at the provincial and local levels issue budget execution guidelines based upon the guidance provided by the Ministry of Finance. These guidelines detail compliance requirements to ensure that budget execution is consistent with appropriations and that it is done efficiently and effectively.

In a wave of recent reforms, the Treasury Department of the Ministry of Finance introduced the Treasury Single Account (TSA), comprising a set of interlinked accounts through which central and provincial governments transact all payments and cash balances at the central Ministry of Finance level. Central departments and agencies and provincial governments have bank accounts controlled by the TSA, which are zero-balance accounts receiving funds when approved payments are made. The accounts are “swept” daily for consolidation into the TSA, aiding in cash management, supervision of all government bank accounts, cash planning, borrowing forecasts, and management of debt and financial assets.

Box 4 Questionnaire Used in the Executive Review in Canada

• Does the program serve the public interest?

• Is there an appropriate role for the government?

• Could this be done better by another level of government?

• Could this be left to the private sector or volunteer sector or done in partnership with them?

• If it is to be done in-house by the government, could it be delivered more efficiently using business principles?

• If the answers to all of the above questions are affirmative, is it affordable given the government’s resource envelope?

Source: Shah (2005).


Although local governments are not yet part of this system, provinces and local governments also have introduced several types of budget execution controls. Precommitment financial controls were introduced to ensure funds availability, correct category of expenditure, and fulfillment of authorization process requirements. Prepayment accounting controls ensure valid commitment, certification of goods and services, and correct invoice and payment requests and identification of payees. Postpayment audit controls have also been introduced as a further check on internal controls and to ensure accuracy of final accounts. Similar controls are placed on revenues collected by various departments and by the finance bureaus.

Additionally, the Treasury Department has introduced elaborate procedures for preparing final accounts. It issues a directive in November of each year directing all local governments and their agencies to prepare final accounts in the format provided. These drafts are scrutinized for accuracy of detail on revenues, expenditures, assets, liabilities, receivables, and cash reserves by the audit section of finance departments in December. Upon completion of this review final account statements are issued and submitted to the next higher level for review and integration, and the process moves upward to the Ministry of Finance for review and submission to the State Council in January. The State Council review culminates in a submission of the final accounts to the NPC, which ultimately passes these to the Budget Committee of the NPC Standing Committee. The Budget Committee, in turn, submits these to the Standing Committee of the NPC for approval.

In PRC, local audit bureaus conduct periodic financial audits of local governments for the NPC and the executive branch. PRC has recently introduced new formal procedures for executive review of executed budgets at local levels, including project evaluations by objectives, which utilize standard questions relating to program objectives, relevance, design, financial management, and results to rate individual programs.8

Local people’s congresses exercise oversight on local budget execution. These committees oversee departments of investigations, which conduct special audits and investigations of any corrupt practices. The focus of these audits is examining compliance with law and following money trails, with very little emphasis on performance audits. Nevertheless, local people’s congresses actively monitor people’s dissatisfaction with local government operations. Thus, while the local people’s congresses’ role in budget formulation is constrained, it is more active in monitoring local government performance.

Concluding observations on budget executionRecent budgetary reforms in the PRC have overcome many of the problems noted by an earlier review (Shen and Shah, Unpublished). Shah and Shen noted that budget execution in the PRC lacked a single treasury account i.e. daily cash balance clearing mechanism, had a greater focus on local autonomy and a lesser focus on internal and external controls and congressional accountability. These issues have been remedied to a large extent. The issues that still remain are integration of below province local government in the TSA, slow disbursal of funds from the center to the provinces and further delays in central

8 A methodology used by the World Bank’s Independent Evaluation Group in its evaluations of World Bank project performance, and Program Assessment Ratings Tools patterned after a similar tool used by the Office of Budget and Management, Government of the United States.


pass through transfers by the provinces. Canada provides a simple, least cost yet very effective approach to such reviews as illustrated in Box 4. The most important missing element in budgetary oversight in the PRC is the lack of any tool to benchmark local government performance against self and against other local governments. A proper incentive structure for local governments is equally important. Further reforms in budget exeution is condusive to providing necessarly public services and enhance orderly urban growth and social inclusion.

2.2 Local Debt Management

2.2.1 Needsfordebtfinancing

Urbanization has proceeded at an astounding pace, and the urban population has doubled over the past decade, in PRC. To cope with the growing demand for urban services, local governments must expand economic and social infrastructure. For rural local governments, the need to provide goods and services to the urban economy calls for upgrading the local infrastructure. For poorer jurisdictions, there is a need integrate with the broader national economy and be part of the internal common market’s path to growth and prosperity. All local governments must attract capital and labor for local economic development, but a local jurisdiction that has major infrastructure deficiencies would not be in a position to compete.

Overall investment in long-lived economic and social assets is critical for improving economic and social outcomes for residents. As these assets are long-lived, a case can be made for debt financing to have equitable burden and benefit sharing over several generations. But debt financing was prohibited under article 28 of the Budget Law, 1994 which required that local budgets must be in balance and local governments must not borrow from banks or issue bonds unless otherwise prescribed by law or specifically authorized by the State Council. The 1994 reforms centralized productive tax bases but maintained expenditure responsibilities with local governments. This led to creation of large vertical fiscal gaps as reported in Figure 3.

Table 6 shows local governments’ fiscal surpluses to serious gaps in financing needs, based upon 2011 data.9 The table shows that the fiscal gap is largest for county and township governments. These gaps in operating expenditures are largely met by central transfers, but this only fills a small fraction of local government capital spending. Local governments are instead left to their own devices to seek innovative financing for capital spending and other off-budget expenditures. Land-leasing income is a major source of such financing (Tables 7–10).

2.2.2 Sources of Local Government Capital Financing Prior to 2009

Central government on-lending. The central government provides capital finance to local governments in several ways (Liu and Qiao 2013). First, the NPC passed the Road

9 These data understate vertical fiscal gaps, as they include tax rebates into local own-source revenues.


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Figure 3 Reversal of Fortunes of Local Governments in the PRC—1978–2012

Source: Yin (2013).

Act of 1998 under which subnational governments were allowed to borrow for roads and transport infrastructure. Second, from 1998 to 2004, to mitigate the consequences of the 1997/98 Asian crisis, the central government issued treasury bonds (about CNY2.7 trillion) and onlent these funds for financing local capital projects.

Land based financing. Ownership of all land vests with the government in the PRC. Local governments found land ownership to be an important source of local finance by leasing land-use rights for 40 or 70 years. They charge additional fees for more intensive use of land, for example, for high-rise commercial and residential buildings. These revenues accrue upfront as a single charge when such leasing rights are granted by local governments. In view of rising land prices, this continues to be the most dominant, lucrative, and buoyant source of local revenue, financing more than two-thirds of local budgets in 2010 (Table 11). This source, according to the NAO 2013 report, however, is


Table 7 Subnational Revenues by Source, 2010 (%)

Source Percent of total

Budgetary revenues 37

Gross transfers including tax rebates 10

Land revenues 32

Social security fund 17

Other Government special funds 4

All sources 100

Source: Wong (2013).

Table 8 Sources of Subnational Capital Financing (%)

Source Percent of total

Budget 5.1

Self off-budget financing 77.4

Domestic credit 15.7

Foreign credit 1.8

All sources 100.0


Table 6 Vertical Fiscal Gap in the PRC—2011

Order of GovernmentNumber of

JurisdictionsAverage 2011

Population

Share of Revenue

Collection

Share of Direct

Expenditures

Fiscal Gap Surplus or Deficiency

Center 1 1.35 billion 49.4 15.1 34.3

Provinces 23 52 million

11.3 18.9 (7.6)Municipalities 4 22 million

Autonomous regions 5 21 million

Special administrative regions 2 4 million

Prefectures 382 4 million 22.1 29.7 (7.6)

Counties 2,853 470,00017.2 36.3 (19.1)

Townships 40,466 33,000

Total 100.0 100.0 0.0

( ) = negative.

Source: National Bureau of Statistics. 2012. China Statistical Yearbook (2012) (Zhongguo Tongji Nianjian-2012). Beijing: China Statistics Press. http://www.stats.gov.cn/tjsj/ndsj/2012/indexch.htm; National Bureau of Statistics.

insufficient to repay principal and interest due, as repayments will exceed the land-leasing income by 1.25 or more in coming years (Liu unpublished).

Local government financing institutions. Another innovative response was to create new financing institutions starting in 1990s. Local governments established autonomous investment corporations, construction investment corporations, and utility investment corporations, commonly referred to as UDICs. The most prominent of these was the


Table 9 Revenues of Prefecture-Level Cities, 2010 (%)

Revenue Source Percent of total

Ordinary budget revenues 29.9

Gross transfers including tax rebates 11.6

Land revenues 34.9

Government funds (excluding land) 4.0

Social Security Fund 19.5

All Revenues—Comprehensive Budget 100.0


Table 10 Comprehensiveness of Local Budget Using Data from Jiangyin Municipality, 2009

Expenditure Percent of total

Budgetary expenditures 65.1

Extra-budgetary expenditures 6.0

Social Security Fund expenditures 10.3

Government Fund expenditures 18.6

Total 100.0


Shanghai Urban Investment Corporation established in July 1992. Soon, local governments in the coastal regions followed suit; then, they emerged all over the country. Their growth was approved by the State Council in 2004 by granting them access to a wider set of financing channels and instruments. By December 2010, there were 6,576 UDICs, with

Table 11 The PRC’s Local Budgetary Revenues and Land Leasing Income

YearLocal Budget

CNY. billion Growth (%)Land Leasing Income

CNY. billion Growth (%)LLI/Local BudgetPercentage (%)

2002 851.50 9.12 241.7 86.50 28.39

2003 985.00 15.68 542.1 124.29 55.04

2004 1,189.34 20.75 589.4 8.73 49.56

2005 1,510.08 26.97 550.5 (6.60) 36.46

2006 1,830.36 21.21 767.6 39.44 41.94

2007 2,356.50 28.75 1,194.8 55.65 50.70

2008 2,864.49 21.56 1,037.5 86.83 36.22

2009 3,258.07 13.74 1,591.0 53.35 48.83

2010 4,060.98 24.64 2,911.0 82.97 71.68

2011 … … 3,150.0 8.21 …

2012 … … 2,701.1 (14.25) …

… = data not available, ( ) = negative.

Sources: Yin (2013) drawing upon data from The PRC Statistical Yearbook, various issues; Ministry of Finance; 21st Century Report, 4 March 2013


165 at the provincial level, 1,648 at the municipal level, and 4,763 at the county level (Liu unpublished). These were set up to borrow from various sources to finance local investment projects.

UDICs finance infrastructure projects by bank loans, bond floatation, private equity investments, and participation of local governments providing land as a collateral and guarantees for private equity participation. Subnational bond issuance by UDICs rose from $10 billion in 2002 to about $60 billion in 2009 (Liu and Qiao 2013). Bond issuance by UDICs received further support from a fiscal stimulus program initiated by the government in 2008. All bonds issued by UDICs are general obligation bonds that are backed by the full faith and credit of the local government concerned.

2.2.3 Local Government Indebtedness

The extent of local government indebtedness is difficult to ascertain in view of the financing instruments used by local governments and because no systematic central oversight of this debt was carried out up to 2009. Fitch Ratings estimated that the local debt had risen to CNY12.85 trillion by the end of 2012 or about 25.1% of GDP. On 9 April 2013, it downgraded PRC’s credit rating from A+ to AA– with a stable outlook. Moody’s opined that the 2011 audit report may have underestimated the total subnational debt by CNY3.5 trillion and that the level of such debt poses serious macroeconomic risks. Thus, on 16 April 2013, Moody’s lowered the PRC economic outlook from positive to stable by noting that PRC has not made the expected progress in reducing the risks associated with local debt and in addressing credit expansion problems. Moody’s warned that the outlook could turn negative if the local debt situation was not properly addressed (Yin unpublished). The IMF Fiscal Monitor, April 2013, echoed similar concerns regarding potential risks with unregulated borrowing for infrastructure finance in PRC.

Figure 4 Local Debt by Order of Local Government, 2010

Source: Liu (2013).

Provinces30%

Municipalities43%

Counties27%


Of the total debt of about CNY12 trillion at the end of 2012, about 30% of this debt is held by the provinces, 43% by municipalities, and 27% by county governments (Liu unpublished). About 63% of this debt is from bank borrowing, 22% from local government and enterprise bonds, and 15% from revenue guarantees (Yin unpublished). UDICs raised 46% of this debt, an additional 23% was raised by local government departments and agencies, 16% by public utilities, and the rest by other public entities. In terms of regional indebtedness, 50% is owed by the eastern provinces, 23% by the central provinces, and 27% by the western provinces.

Table 12 provides details on sources of capital financing and the disposition of borrowed funds. Most of the borrowing is in very short-term bank borrowing. The dominant disposition of funds is for urban commercial and residential buildings and roads, transport, and telecommunications. These are typically high-return projects thereby minimizing risks for default. Table 13 updates the data on bond financing.

2.2.4 Principal Issues Arising from the Legal Framework for Borrowing Prior to 2009

The prohibition on direct capital market access by local governments resulted in the use of inventive financing vehicles, such as UDICs, which lead to hidden debt and liabilities.

Table 12 Local Government Debt, Sources of Finance and Disposition of Borrowed Funds, 2010 (CNY billion)

Sources of Finance Disposition of Funds

Source Amount % Capital spending Amount %

Bank loans 8,468.0 79.01 Urban construction 3,530.1 36.72

From upper-level government

447.8 4.18 Communication and transportation

2,392.4 24.89

Bonds floatation 756.7 7.06 Land acquisition and storage

1,020. 9 10.62

Borrowing from other entities

1,045.0 9.75 Education, science, culture, health and sports, low-income housing

916.9 9.54

Water conservancy facility 458.4 4.77

Ecological construction and environmental protection

273.3 2.84

Defusing financial risks of local governments

111.0 1.15

Industries development and promotion

128.3 1.33

Energy development 24.1 0.25

Others 757.6 7.89

Sub-total 9,613.0 100.00

Unspent balance 1,104.4

Total 1,0717.5 100.00 Total 10,717.5 100.00

Sources: National Audit Office. 2011. Announcement of Audit Findings. 104 (35), and Liu (Unpublished).


The principal issues that emerged with the use of these financing arrangements are the following.

(i) Lack of transparency. As local governments made bilateral deals with the commercial and banking sectors, the nature of risks associated with these deals remained unknown to local residents and to higher-level governments. Such lack of transparency often breeds corruption, selecting projects that may not be in the best interest of the public. Even ignoring the enhanced opportunities for malfeasance, information on fiscal risks imposed by the off-budget debt and liabilities assumed by UDICs cannot be ascertained. Since PRC has a unitary system of governance, ultimately, the central government would need to bear the consequences of any default.

(ii) Fragmentation of local budgets. The system has also worked against development of a comprehensive budget at the local level. For most local governments, only one-third or more of expenditures were accounted for. Such a high degree of fragmentation of the budget may undermine fiscal discipline, allocative and technical efficiency, and integrity and trust in governance. Budgeting system reforms introduced since 2005 have aimed to improve the comprehensiveness of local budgets.

(iii) Higher finance sector risks. The finance sector is mostly state-owned in PRC, so local governments cannot make arm’s-length transactions, which may pose risks to both the banking sector as well as the local governments. Under such circumstances, local bank borrowing is not guided by sound economic and financial criteria, and banks may be forced to lend to noncreditworthy local governments or for projects with no assured returns on investment. The booming economy limits such risks but does not eliminate them.

(iv) Instability in revenues. Reliance of local governments on land-leasing income financing is subject to risks associated with property price bubbles or economic cycles. Since local governments typically own construction and development companies, these risks are accentuated for the local economy. These risks have

Table 13 Local Bond Financing, 2005–2013 (CNY billion)

YearLocal Government Bonds

(New Issues)Local Enterprise Bonds

(New Issues)Total New Bond

Financing

2005 5.0 5.0

2006 34.3 34.3

2007 51.5 51.5

2008 68.4 68.4

2009 200.0 205.7 405.7

2010 200.0 197.7 397.7

2011 200.0 226.7 426.7

2012 250.0 530.2 780.2

2013a 350.0 232.9 782.9a As of April 2013, CNY232.9 billion of local enterprise bonds were issued, and CNY350.0 billion of local

government bonds were planned to be issued in 2013.

Source: AFDC’s compilation based on data from China Central Depository and Clearing.


not materialized in the past due to a long period of sustained growth and rising land prices, but they have to be recognized in developing a mature system of capital finance.

(v) Higher overall fiscal risks. Risks associated with contingent and noncontingent liabilities assumed as part of bilateral agreements or local government guarantees are often not evaluated by UDICs while reaching partnership agreements. In exceptional cases, these risks may pose a danger for solvency of local finances.

(vi) Missed opportunities in learning and building capacity for managing sustainable debt finance. The legal framework also limits local government opportunities for direct relationships with capital markets and building in-house capabilities for raising and managing debt finance.

While the aggregate hidden debt may not pose significant risks for the nation as a whole, a smaller number of local governments may face significant hardships in repayment of debt, and national assistance may be needed in the future to bail them out. Of greater concern, however, is the lack of transparency and fragmentation of local budgets incentivized by the prohibition regime.

2.2.5 Review of Recent Reforms to Local Government Capital Market Access

The central government is cognizant of the above difficulties and taken important steps in reforming local government access to capital finance.

Central government proactive assistance in issuing provincial bonds. Starting in 2009, the central government—rather than issuing own bonds and onlending funds to provincial governments—started issuing bonds on behalf of the provincial governments. CNY200 billion in provincial bonds were issued from 2009 to 2011, each year. This was increased to CNY250 billion in 2012, and another CNY350 billion bonds were scheduled to be issued in 2013. In deciding upon provincial bond quotas, the Ministry of Finance developed criteria that includes the need for capital finance based upon infrastructure deficiencies, fiscal capacity of each jurisdiction, its existing revenue–debt ratio, estimated growth of own-source revenues, and availability of matching funds (Liu and Qiao 2013). These issues were deemed provincial debt, and provincial budgets provided provisions for matching funds and repayment of principal and interest. In addition, the central government provided for the intercept of central transfers to provinces in the event a province ran into default of its arrears.10 This approach has helped provinces lower their costs of financing due to the higher credit rating of the central government while developing the local capacity to evaluate debt affordability and manage debt on a sustainable basis.

Allowing direct access to capital markets to richer urban jurisdictions. In addition to supervised access to credit markets, on 20 October 2011, the Ministry of Finance announced the launch of 2011 Pilot Measures for Local Self-Issued Bonds to give

10 The approach mimics the approach to municipal finance in Canada where provincial finance corporations pool local debt and issue local bonds using the higher credit rating of the province.


selected local governments permission to issue their own bonds.11 Following this, the State Council, in October 2011, authorized four major cities to directly issue municipal bonds. Guangdong, Shanghai, Shenzhen, and Zhejiang, by the end of 2012, issued medium (i.e., 3–5-year) project-specific revenue obligation bonds totaling CNY25.1 billion. Debt servicing for these bonds will be done by the Ministry of Finance, while charging the costs to the issuing city through the intercept of central transfers.

Recent regulatory reforms. The Ministry of Finance, National Development and Reform Commission, People’s Bank of China, and the China Banking Regulatory Commission jointly issued the directive, Notice to Stop Local Government Behavior of Illegal Financing (MOF Document No. 463, 31 December 2012). It provides the following guidance on local borrowing: (i) local governments and enterprises are prohibited from borrowing, including those for build and transfer public–private partnership projects unless specifically authorized by the State Council; (ii) local governments are prohibited from using public assets such as government buildings, schools, and hospitals as collateral for raising finance for local investment corporations; (iii) local governments cannot use future land sales or leasing income as a source of debt repayments to qualify for new debt; (iv) local public welfare projects in the future cannot be financed by raising funds from finance or nonfinance sector entities or individuals; and (v) local governments and their subordinate entities cannot provide any guarantee directly or indirectly, and they shall not use government assets as collateral for enterprise financing or for financing public–private partnerships.

The State Council in 2010 also issued guidelines for regulating the activities of UDICs, including separation of management from ownership of companies, requirements regarding the reporting of debt, credit risk analysis requirements for bank borrowing and local government guarantees, and audit requirements. The China Banking Regulatory Commission further issued a directive on 27 March 2013, Notice to Standardize Investment Financing Services of Commercial Banks, placing restrictions on the use of special financial products such as derivatives, and shadow banking such as off-balance sheet lending (Liu unpublished).

Complementary institutional reforms. In OECD countries, capital budget planning precedes and binds borrowing decisions and debt management. In PRC, the central government, through the Ministry of Finance, is helping provinces implement capital budget planning and evaluation processes. Also, as previously mentioned, through broader budgetary reforms, it is advising local governments to link planning with budgeting through an MTEF. The Ministry of Finance is also emphasizing the comprehensiveness of local budgets and bringing off-budget expenditures into the budget. Thus as recognized by the government, debt management is critically linked to capital budgeting and finance decisions. The PRC is undertaking both types of reforms simultaneously.

11 Self-issuance still requires authorization by the Ministry of Finance. Local governments are simply given autonomy in choosing bond underwriters and term and yield options.


2.2.6 Next Steps in Local Debt Management

Since 2009, PRC has come a long way in developing a long-term framework for local borrowing, yet much work is still needed. In the following paragraphs, additional steps worthy of consideration are highlighted based upon lessons from OECD country experiences.

Assessing debt affordability. The fiscal capacity of local governments and the type of investment are important criteria in deciding on the type of financing that may be desirable (Table 14). For fiscally poor local governments, bond finance would not, in general, be feasible. Instead, they should rely on grants for social infrastructure investments and, in addition, on loan finance for revenue-producing investments. Richer local jurisdictions would have access to a wider array of financing instruments, including bond finance.

To assess the fiscal capacity and debt affordability of local governments beyond in-house analysis, a higher-level government perspective, as well as a capital market perspective on debt affordability, is needed.12 For example, state governments in the United States issue guidelines for local government debt affordability using a wide range of criteria (Table A2, Appendixes). One of the most frequently used criterion is debt service as a percent of the general fund and special revenues. A capital market perspective is provided by credit-rating agencies, such as Standard and Poor’s, Moody’s, and Fitch Ratings (Table A3, Appendixes). PRC has already three such agencies, with two of these in partnership with Moody’s and Fitch Ratings. The Ministry of Finance has also been working on developing such assessment criteria.

The experience in the United States shows that while the ratings provided by these agencies are well regarded by the market and greatly influence the cost of capital, such ratings have not been without controversy. The difficulties arise from the criteria itself and the governance environment of these agencies. The criteria used by these agencies are highly subjective and backward-looking. They overemphasize the broader, subjective environment to the determinant of a more objective assessment of local government fiscal capacity. These ratings often are a poor guide to the future, as highly rated entities are often downgraded when performance does not match expectations. Second, the rating agencies have a conflict of interest. They rate governments for a fee and then provide assistance for bond issuance. Therefore, they have a built-in incentive for over optimism.

12 The Debt Management and Financial Analysis System, developed by the United Nations Conference on Trade and Development, may provide a tool to develop the information infrastructure, related data management, and a creditworthiness assessment.

Table 14 Sources of Capital Financing by Type of Investment and Fiscal Capacity of Local Government

Type of capital investmentFiscally Poor

Local GovernmentFiscally Rich

Local Government

Revenue producing investment Loans and grants Loans and bonds

Social investment Grants only Loans and grants

Source: Peterson and Valdez (2004).


Form of local debt. PRC has, so far, largely focused on general obligation bonds with short- to medium-term maturity. OECD countries, on the other hand, use a variety of instruments. Local governments use notes for short-term temporary borrowing of less than 1 year. They issue long-term bonds, usually 10–30-year, in the form of general obligation bonds but mostly as revenue bonds. They also try to lower the cost of bond finance by credit enhancement, such as pooling through bond banks in the United States and municipal finance corporations in Canada and higher government-level guarantees as in Canada. In PRC, revenue bonds and access to higher-level credit enhancement are recent developments. In OECD countries, there is much experience with issuance of debt, mostly through competitive sales but also through negotiated sales or private placement. PRC has made an important start in this regard by allowing four cities to issue their own revenue bonds through competitive sales.

On managing existing debt. Most OECD countries have well-established frameworks to ensure that local debt is managed well. Frameworks include requirements of fiscal transparency and full information disclosure, operating budgets in balance and reserves for contingencies, commercially audited quarterly and annual financial statements using Generally Agreed Accounting Principles, monitoring of debt and debt service and data made publicly available, debt term consistent with the economic life of assets, and a strategy for retiring more expensive debt and a framework to anticipate financial emergencies and take corrective actions. In this regard, PRC has a long way to go on fiscal transparency and open fiscal management.

2.2.7 Central Government Oversight on Local Debt

OECD countries also have elaborate arrangements for higher-level government and market oversight of local debt. These include:

(i) Ex-ante regulations through fiscal rules and finance sector regulations. These include the golden rule, which states that borrowing can only be for long-term capital spending and that the annual operating budget must be balanced. There are also limits imposed on key fiscal indicators such as overall debt–local GDP, debt service–revenues, debt–revenues, and guarantees–revenues (Table A4, Appendixes). There are often prohibitions on providing higher-level explicit or implicit guarantees for lower-level debt and no bailouts in the event of default. Arm’s-length relationships with the finance sector with no government ownership of finance institutions are an important requirement for capital market access. The overall intent of this framework is to ensure that both local governments and the market assess fiscal and financial risks and rewards realistically. This is an area requiring further reform attention in PRC.

(ii) Monitoring and early-warning systems. Monitoring of local debt and establishing early-warning systems by higher-level governments are essential in ensuring fiscal prudence. This is frequently done in both developed countries and in developing countries, including transition economies (Box A1, Appendixes). However, this is still an area where there is a significant potential for improvement in OECD countries and in PRC. The work of Brixi (2005) on measuring fiscal risks provides a framework, which can be refined and adapted to suit PRC circumstances (Table 15).


Table 15 Fiscal Risk Matrix, Local Government Exposures

Sources of risk Direct obligation in any event

Contingent obligation only if a particular event occurs

Explicit

Government liability as recognized by a law or contract

Local government debt (loans contracted and securities issued by the local government)

Arrears in wage and benefits payments (if legal responsibility of the local government)

Nondiscretionary budgetary spending

Expenditures legally biding in the long term (e.g., civil service salaries and pensions)

Local government guarantees for debt and other obligations of public sector entities

Local government guarantees for debt and other obligations of nonpublic sector entities

Local government guarantees on private investments (e.g., infrastructure)

Local government insurance (e.g., crop insurance)

Implicit

A moral obligation of the government that reflects public and interest group pressures

Remaining capital and future recurrent costs of public investment projects

Cost of future benefits under the local social security schemes

Future spending on public health and disease control and on goods and services that the local government is expected to deliver

Claims related to local government letters of comfort

Claims to failing finance institutions

Claims by various entities to assist on their nonguaranteed debt and their own guarantees, arrears, letters of comfort, and other possible obligations

Claims related to enterprise restructuring and privatization

Claims by beneficiaries of failed local pension funds, employment funds, or social security funds beyond any guaranteed limits

Claims related to local crisis management (e.g., public health, environment, or disaster relief)

Source: Brixi (2005).

(iii) Sanctions for noncompliance. Most OECD countries typically treat noncompliance on a case-by-case basis, but developing countries, especially in Latin America, have instituted punitive actions for noncompliance with a fiscal prudence framework. Most noteworthy is Brazil’s 2000 Fiscal Responsibility Law, which imposes monetary sanctions and prison terms of up to 4 years and impeachment for official and future noneligibility for elected officials if they do not comply with fiscal rules on debt and deficit and ceilings on wage expenditures.13

(iv) Ex-post insolvency mechanisms. Most OECD countries provide legal frameworks for local governments, including receivership and insolvency

13 Ecuador imposes personal sanctions as well as suspension of central transfers. Argentina and Mexico provide for the intercept of central fiscal transfers and denial or limits on new guarantees and loans in the event of a debt service default by a local government. Colombia imposes personal sanctions, prohibits new debt, and imposes workouts to achieve compliance. Peru suspends central transfers.


mechanisms in the event of default or repudiation. A local government is deemed to be in default if it fails to meet a scheduled payment of principal or interest on a debt issue. It is considered in repudiation if it announces that it no longer recognizes an existing debt as a liability and will terminate payment of principal and interest. Under these circumstances, a higher-level government or a court may place a local government under receivership and appoint a third-party manager or control board to bring it to fiscal health.

In the United States, a local government has the option to voluntarily petition a federal court for bankruptcy protection under Chapter 9 of the Federal Bankruptcy Code. Such a protection ensures that essential services are maintained while the court works out solutions in dealing with local government default. Under the code, creditors cannot initiate court proceedings against local governments, and public assets are protected. Such protection, however, is not available to local governments in South Africa and Hungary, where creditors could initiate court proceedings against local government default. Insolvency mechanisms are intended to protect the general public from serious adverse consequences of default by a local government while, at the same time, ensuring that moral hazards associated with possibility of bailouts is avoided.

Presently, PRC does not have any formal legal mechanisms for such eventualities other than through administrative action on a case-by-case basis. While such an approach is helpful, it does not overcome the moral hazard of a central bailout. A formal bankruptcy code will help strengthen the incentive regime for prudent local fiscal management. Such a code could be embedded into existing budgetary legislation.

An argument often advanced against insolvency mechanisms in a unitary state is that local governments are simply agents of the central government and therefore must be bailed out by the center in the event of a local default. Most OECD unitary countries, however, do not accept this argument and treat local governments as public corporate entities subject to legal consequences of default as specified under law. In PRC, in view of the unitary government, there would be presumption on the part of capital markets for a higher-level government bailout in the event of local default. Local government bankruptcy legislation would dispel this belief and thereby reduce the moral hazard associated with such borrowing as well as hold assurances that delivery of essential public services will not be affected in the event of local default.

Concluding observations on local debt managementResponsible access to credit for creditworthy local governments is critical for overcoming local infrastructure deficiencies. Ironically, in OECD countries where infrastructure deficiencies are small, central governments proactively facilitate such access, whereas developing countries with higher infrastructure deficiencies block local government access to credit markets. There is a need for further technical assistance in PRC to facilitate such access and to create a regulatory framework to ensure that the access is responsible and that potential fiscal risks are minimized.

Since local public finance management closely relates to debt management, developing multiyear perspective of investment and expenditure planning is a basis for a debt


management strategy. Moreover, ex ante regulations and early warning systems help in mitigating fiscal risks. For local governments under fiscal distress formal mechanisms for workout and insolvency procedures are helpful in ensuring continuity of essential public services while bringing them back to fiscal health.

During the past a few years, the PRC has made important strides in better monitoring of local debt and improving the transparency and comprehensiveness of local budgets. It has also initiated reforms to institute formal processes for capital budgeting and linking it with planning. It has also implemented regulatory reforms for proper oversight of local debt issued through UDICs and for improved governance of the UDICs. It has also moved proactively to assist local government access to credit by acting as an issuing agent for such debt as well as authorizing direct capital market access to richer urban jurisdictions. The measures already taken have minimized fiscal and financial sector risks associated with hidden local debt overhang.

The agenda for such reform is unfinished yet as it requires establishing a legal framework to ensure that local governments follow due process in evaluating the affordability of such debt. They take due diligence in deciding upon the type of debt and how to raise in and that they have instituted appropriate framework of accountability in managing debt and retiring costlier debt.

Further work is also needed at the center to help create independent and unbiased rating assessment of local government, a framework for monitoring local government fiscal health and any warning systems for emerging issues and formal mechanisms for dealing with local fiscal distress and insolvency. Furthermore, the balance between local fiscal capacity and expenditure responsibility is fundamental to local public finance management.

34

3 Local Tax Reforms

T ax policy and administration is centralized and most of the productive taxes are administered by the Central Government. Centralization of taxes is desirable on the efficiency of tax administration considerations. Local governments have autonomy

for a few relatively unproductive tax bases. These include: urban and township land use taxes, residential property tax, vehicle and vessel utilization, land appreciation tax, farmland occupation tax, stamp tax, agriculture and animal husbandry tax, fixed assets investment taxes, gifts and bequest taxes, local public enterprise profit tax, pollution and resources taxes, and slaughter house taxes. These taxes are collected by provincial finance bureaus on behalf of the province and local governments and returned by origin to below province local governments.

Provincial finance bureaus typically follow a revenue task model that sets revenue targets at county and township levels. Once these targets have been met, officials have an incentive to delay collection to the next fiscal year, and if the targets are not met, then refunds may be delayed to the next fiscal year.

Overall revenue adequacy remains a concern at the local level as own-source revenues and central transfers are inadequate to meet local expenditure needs, especially dealing with infrastructure deficiencies. Accountability of local governments for local economic development accentuates revenue adequacy concerns and local governments explore innovative ways of financing capital investment. This quest for growth is exacting a high price in terms of heightened fiscal and food security risks, urban sprawl and environmental degradation. This should not be case as more sustainable and nondistortionary public finances can stimulate growth while protecting the environment.

The central government recognizes these concerns and is encouraging local governments to examine local tax reform options that would facilitate better urban planning and address food security and environmental concerns while improving local finances. Two new area of taxation under examination include a residential property tax and environmental taxes and charges.

Residential property tax is a new tax for the PRC and there is not yet sufficient consensus on its objectives, knowledge about international practices and experience in its design and implementation especially on property value assessments. Environmental taxation is another new area of taxation for local governments. In view of this, this project focused on the design and administration of these taxes, and aims to develop a better understanding of the full potential of these taxes if properly administered by highlighting steps needed to achieve full revenue potential of these sources

35Local Tax Reforms

3.1 Residential Property Tax

The most recent incarnation of the real property tax dates back to a September 1986 regulation by the State Council, Provisional Regulation of the People’s Republic of China on a Real Estate Tax (National Order No. 90). Foreign corporations and individuals were brought under the domain of this tax by State Council Decree No. 546 dated 31 December 2008. Currently, the base of this tax covers all business and nonbusiness property other than owner-occupied housing. This tax, on average, accounted for only 1.2% of municipal revenues nationwide and for 2.15% of municipal revenues in Shanghai in 2011.

With a view to dealing with an overheated housing market, on 27 January 2011, the State Council authorized lifting the tax-free exemption—on new purchases only—of individual owner-occupied housing (with the exception of detached houses in Chongqing) for pilot projects initiated by Chongqing and Shanghai municipalities, the two fastest-growing cities (National Order No. 136). The results of these pilots may affect the future course of action regarding the implementation of the expanded residential property tax system nationwide (Yan unpublished). The central government has recently shown interest in expanding these projects to three to five additional cities, but no decision on implementation has been announced as of 21 July 2013. Most prominent potential candidates include Hangzhou, Shenzhen, Guangzhou, Beijing, Wuhan and Kunming.

3.1.1 Pilots in Chongqing and Shanghai

Chongqing levied a tax on new purchases effective January 2011 of large, single-family homes (0.5%) and luxury flats (1.2%), which numbered only 8,500 in 2011, raising about CNY110 million in 2011, accounting for 0.2% of municipal revenues. Chongqing exempts farmhouses and residences of 180 square meters or less if the property was purchased prior to 2011, and 100 square meters and less for post-2011 purchases by a legal resident of the city. The owner of multiple units has a choice to declare a principal residence exempt for tax purposes. Property tax exemption is not available to nonresidents and immigrant owners of properties.

The property tax rate is tied to the purchase price of the house, with a tax rate of 0.5% for properties with a per square meter market value four times or more lower than new commercial housing. The tax rate is 1.2% if the purchase price is four times or higher than the new housing price. For all other properties, a tax rate of 1% of the purchase price applies. Note that the median house value was CNY5,720 (about $950) per square meter in July 2010 (Xu 2011). This value declined in 2011 by about 10.5% but subsequently has shown an upward trend, rising 6.8% in June 2013 over June 2012 values (Fung 2013). In 2011, Chongqing raised about CNY100 million from this source, amounting to about 0.3% of local tax revenue.

Shanghai grants property tax exemption to farmhouses and principal residences of any size. Additional new purchases of residential properties are taxed but receive tax relief of 60 square meters per person for all family members including adult children. A second house purchased by parents to accommodate an adult child’s family is also exempted. The normal tax rate is 0.6% of the purchase price with a reduced rate of 0.4% if the purchase price of the property is less than half of the median purchase price of new


commercial housing. Note that the median price for new residential properties in Shanghai in July 2011 was CNY13,448 (about $2,137) per square meter, representing a decrease of 5.4% over the previous year (Wang, Zhang, and Li 2012). More recent data reported by the National Bureau of Statistics suggest that Shanghai’s average home prices rose 11.9% in June 2013 compared with 1 year earlier (Fung 2013).

In Shanghai, principal residence exemption is also available to “highly talented” immigrant workers holding work permits for 3 or more years. Assessed values are placed at 70% of the purchase price for tax purposes. Shanghai collected CNY6.3 billion in the first half of 2013 from this tax, indicating an annual uptake of about CNY13 billion or about 0.5% of total local tax revenue.

Wang, Zhang, and Li (2012) summarized the evidence published by market research institutions from the two pilot projects in Chongqing and Shanghai. They reported that the projects are highly constrained in scope, as most properties are not covered (i.e., in Chongqing, 90% of the properties are excluded). Moreover, tax revenue collection has been insubstantial. They also reported that the tax and related measures had a negative impact on transaction volume, especially those of high-value residential units. It also may have contributed to dampening the speculative trades by raising the holding costs of these properties. Also the market may be capitalizing on the future increases in tax costs of residential property tax investments.

In any case, dealing with a housing bubble rather than raising additional revenues was the goal of these projects. From 2010 to 2011, housing prices declined by 10.5% and 5.4%, respectively, in Chongqing and Shanghai, but this decline may be attributable to a multitude of factors that include property purchase limits imposed by Shanghai and rising borrowing costs in both cities—in addition to the introduction of a residential property tax. From 2011 to 2013, both cities experienced a surge in property values, demonstrating that the property tax, which is low and covers few properties, does not restrain property prices. This is to be expected given that the taxes are too low and cover only a small fraction of total properties. As mentioned, there is no consensus yet regarding the design and objectoves of the residential property tax in PRC. Box 5 summarizes the diversified views on this tax in PRC.

The two pilot projects, while helpful, are limited in drawing up lessons for implementation of a countrywide residential property tax. The use of the purchase price as a basis for assessment may create incentives for understating the price in the legal contract to save on taxes. Further, most residential properties are exempted. Third, the tax is seen simply as an economic stabilization tool rather than as a predictable and stable source of local revenues, and the tax reform is not integrated with a broader reform of property taxes. This is especially true in the area of land taxation. Currently, local governments charge fees for land leases to developers, and developers shift these forward to homeowners. Therefore, homeowners pay an implicit indirect tax on land that forms part of their property. A full-fledged property tax would then appear to impose a double tax burden on homeowners as well as on renters (Weng, Zhang, and Li 2012). Finally, in view of the valuation method chosen, the project is not creating the institutional edifice needed for a full-fledged property tax in the long run.

37Local Tax Reforms

Box 5 Diversity of Views on the Objectives and Design of a Future Residential Property Tax in the People’s Republic of China

D iscussions on the design and scope of a future residential property tax in several work-shops conducted in Beihai (Guangxi Province), Beijing, and Shanghai invited passionate,

diverse opinions from various stakeholders. Such diversity of views is also observed from a survey of the literature published on this subject in the People’s Republic of China (PRC). These range from using this tax as a tool to tax the wealthy only at one extreme, to a benefit charge for local services imposed on all properties but with appropriate accommodation of equity concerns at the other extreme.

Some academics (e.g., Yan unpublished) who advocate that the proposed tax should be a tool to tax the wealthy argue that the tax should be on a narrow base covering high-value invest-ment properties and that all residences, including detached houses and apartments, should be exempt. They argue that homeownership is a fundamental right enshrined in local culture and that there is already a significant tax burden on residential properties through land-leasing fees. They argue that homeownership should not be taxed, but a residential property tax is an appropriate tool for redistribution and social justice by taxing returns accruing to the wealthy from real estate investments. They reject the notion that a residential property tax could be an appropriate tool for paying for local services or land-use planning. They assert that property-oriented services should be financed by a value-added tax and income tax or specific fees and charges.

There is also widespread opposition to the tax from local governments, property developers, and middle-income citizens. Local governments prefer massive revenues from land sales and also see real estate construction as a source of growth. Developers see this tax as reducing their profits, and middle-income citizens see this tax reducing the value of their main saving asset essential for retirement income (Fung 2013).

Other scholars (e.g., Xu 2011) do not share this view and advocate adoption of a broad-based residential property tax but with appropriate exemptions to recognize ability to pay. They see a residential property tax as a benefit charge for local services provided to residences, for ex-ample, for water, sewerage, street lighting, roads, and garbage collection, as well as a tool to affect land-use planning. They further argue that such a tax would increase the cost of holding property and reduce asset prices and incentives for speculative purchases. This view is also grounded in Organisation for Economic Co-operation and Development countries.

A middle-of-the-road point of view was expressed by a PRC government official. He argued that in the short term, a residential property tax could be introduced as a tax on the wealthy to gain wider acceptance of the tax as well as to build an institutional edifice for a broad-based benefit tax to be introduced in the long run once sufficient experience has been gained.


3.1.2 Next Steps in Improving Residential Property Tax

A residential property tax has the potential to raise about 1%–3% of GDP when introduced countrywide (Table 16). It can be an important instrument to finance property-related local services such as roads, lighting, water, and sewerage; create incentives for better land use; dampen speculative purchases in the housing market; and enhance accountability of local governments to local residences. It can be an equitable tax, as its design is able


Table 16 Real Property Tax in an International Context

Organisation for Economic Co-operation and Development Developing Countries

1%–3% percent of GDP 0.5% of GDP

50%–90% of local government revenues 40%–80% of local government revenues

2%–4% of consolidated public sector revenues

2% of consolidated public sector revenues

GDP = gross domestic product.

Source: Kelley (2005).

to accommodate ability to pay. However, the introduction of property tax would be a long term agenda for the PRC as it currently does not have the institutional edifice to support implementation of such tax.

Institutional role. PRC must make choices regarding the different roles that various government levels must play in property tax administration. The central government may have to assume the legislative role, creating a framework through the NPC and regulations through the Ministry of Finance on behalf of the State Council. The central government may also decide the education mill rate, a supplementary tax rate to support additional financing of education.

Provincial governments could be responsible for property assessments by setting up autonomous property assessment authorities entrusted with classification and valuation of properties. Financed by the provinces with contributions from local governments based upon a share of local property values as a percent of provincial aggregates, it could take the form of an autonomous nonprofit corporation with provincially appointed boards of directors. Alternately, provinces could ensure uniformity of assessments by setting up an oversight board on equalization of assessments if local governments have the authority to carry out the assessments. The tax rate should be at the sole discretion of local governments. Local governments with more than 1 million population may also be responsible for their own tax collection. For smaller urban municipalities and rural governments, it may be desirable to have taxes collected by an independent agency or by a provincial government agency.

Tax base. National legislation should specify the tax base for this property tax. In OECD countries, residential property taxes are broad-based, and include land and improvements with exceptions for religious, educational, and health institutions; government properties; and foreign embassies and consulates. Government properties still pay a grant-in-lieu tax (equivalent to property tax payables). In PRC, urban land ownership is vested with the government, and state-owned enterprises lease land for a period of 30–40 years for commercial and 70 years for residential developments. Rural land, on the other hand, is collectively owned by farmers’ cooperatives. Therefore, grants in lieu of taxes assume added significance in urban property tax design.

Valuation and data requirements. For detached single-family homes and condominiums, recent sales of comparable properties is the most widely used method in determining assessed values in most OECD countries (Table 17). However, residences in PRC are

39Local Tax Reforms

Table 17 Approaches to Property Valuation

Approach Determination of Current Value Property Type

Sales comparisons Comparison of sales prices of comparable properties

Single residences, condominiums, small commercial

Cost approach Current value of land plus cost of improvements minus depreciation

Manufacturing plants

Income approach Income potential (capitalization of income minus expenses)

Hotels, apartments, office buildings

Souce: Authors’ compilation.

predominantly apartments and condominiums with only a small percentage that are detached single-family homes. For apartments, rental income is the best approach to assess value. Annual net rental income divided by an appropriate discount rate gives the assessed value of the property. For valuation of properties, prior to introduction of a residential property tax regime, a comprehensive database on market transactions must be developed, along the lines of multiple listing services and a cadaster of assessed values. Developing a credible cadaster, including relevant land characteristics, is key to practically expand this tax to other regions in PRC. For this purpose, substantial technical support and capacity development need to be provided to the local governments.

Assessment. Instead of using the purchase price as in the pilot projects, the assessed value should be the market-based capital value, which is the value based upon current use plus the development potential of the property. Capital value can also be derived from rental values by applying an appropriate discount rate. PRC also needs to make a determination on valuation cycle (usually 5 years in most OECD countries) and on the phasing in of newly assessed values. In most countries, annual increases in value are limited by 5%, and taxes by 10%. Also, the balance between central and local roles in setting tax rates will be critical.

Mitigation. The two pilots provide mitigation for principal residence and farm houses and housing for adult children. In OECD countries, instead mandatory tax credits/rebates are common for low income, old age, disabled persons, vacant buildings and charities. Occasionally additional rebates are also provided for nonprofits, heritage and brown-field properties.

Tax relief option. Tax deferrals are used to encourage inward direct investment. Tax credits or rebates are used to provide full or partial tax relief based on need. Differential tax rates can be used to give preference to one type of housing. Exemptions or tax base reductions can be used to exclude certain types of properties from the tax net, such as for community centers, educational institutions, and hospitals. To keep the tax base as broad as possible, exemptions must be used only in exceptional cases and with great care. Tax credits present a more desirable policy option, as these help maintain a comprehensive tax base but achieve equity objectives in a more objective, and transparent fashion.

Concluding observations on residential property taxA residential property tax is a promising source of additional revenue for local governments if the tax base is broad and the exemption is limited. Charging for property-related


public services can provide incentives for local economic development by taxing land at a higher rate than improvements. Property tax assessments, however, are difficult and arduous tasks, as they require information systems that capture market value and rental transactions. In PRC, a great deal of new institutional and information edifice is required prior to the introduction of such a tax. PRC has taken the first step on this road but much further thought is required on the road map to introduce of residential property taxation nationwide.

3.2 Environmental Taxes

PRC currently accounts for 7% of global GDP but consumes 19% of global energy, representing twice the world average per unit of GDP (Xiaoping 2013). About 68% of energy consumption is coal-based, a highly pollutant source of energy, pushing the air quality in major cities to unsafe levels. In recent years, PRC has taken important steps to improve energy efficiency as well as to protect the environment. In doing so, it has largely relied upon a command- and control-based regulatory approach, which has not yielded the desired results. Recognizing this, the government, responding to the severity of industrial pollution, proposed environmental tax reforms in the 12th Five-Year Plan, 2011–2015.

The State Council issued guidelines in October 2011 to pursue research and reform options to replace existing sewage charges with taxes on emissions and effluents. In this context, the Ministry of Finance has been examining options for local environmental protection as well as to deal with global climate change. A carbon tax of CNY10 per ton of carbon content of fossil fuels is under consideration for introduction in 2014. In further guidelines issued in late 2012, the State Council affirmed that the government will place a higher priority on environmental protection in the next annual budget (Li, Leung, and Xie 2012).

To achieve the environmental protection, one has to first agree on basic principles of environmental taxation and then look at the feasibility of a range of taxing options that create market based incentives in protecting environment as well as raising revenues in less distortionary manner.

3.2.1 Basic Principles of Environmental Taxation

Many activities and products cause damage to the environment. Some of these such as discharge of effluents are rarely taxed, whereas others such as fuels are either under-taxed or subsidized. Corrective taxes on activities or substances with negative externalities (e.g., effluents, pollution, noise, and congestion) can expand the tax base and at the same time restrict such activities. If the taxes succeed in inducing environment friendly practices among producers and consumers, they will not generate much revenue but will be efficient in protecting the environment. If, however, producers and consumers continue to follow environmentally damaging practices, the taxes will generate revenue that can be used either to lower other distortionary taxes or to fund cleanup programs or

41Local Tax Reforms

abatement technologies (World Bank 1991). Keeping these considerations in mind, the following are the basic principles that environmental tax design should follow:

(i) Simplicity in design. Taxes should be easily understood and low-cost to comply with associated legislation and so that the government can ensure compliance.

(ii) Efficiency criteria. Taxes should be neutral as to business choices regarding various inputs and assets and type of business organization when the environmental externality is the same.

(iii) Revenue neutrality. Environmental taxes should be introduced as a replacement for existing distortionary taxes in a revenue-neutral manner so that the efficiency of tax system is enhanced without creating an additional tax burden on businesses and individuals.

(iv) Equity. The tax burden on inputs, effluents, and outputs should be equal for an equal level of environmental externality or marginal environmental and health costs. Interpersonal equity is best addressed through public spending and progressive income taxes.

(v) Patience. Adequate time should be allowed to build consensus for reform prior to introduction of legislation for nationwide implementation. The legislation must allow sufficient phase-in time for new taxes for information dissemination, preparation, associated changes in tax administration, and for businesses and individuals to understand the legislation and gear up with its compliance requirements.

(vi) Gradual phase-in. To avoid costly mistakes, a gradual phase-in structure should be created, starting with major urban centers and ultimately covering the entire country.

3.2.2 Taxing Choices for Environmental Protection

Table 18 characterizes public policy instruments by the degree of flexibility in adaptation by the polluter and the degree of control available to a government regulator. According to Deloitte (2013), currently, no substantial environmental taxes are levied in PRC, although a large number of existing taxes and subsidies have environmental consequences (Xiaoping unpublished).

Eliminating energy subsidies. According to the International Monetary Fund (2013), PRC is the second-largest subsidizer of energy, providing nearly $279 billion in energy subsidies in 2011 and accounting for 15% of world energy subsidies.14 Table 19 highlights the incidence of energy subsidies by source.

Table 19 indicates that the removal of coal subsidies alone could save the national exchequer about 14% in foregone revenues, enough revenues to finance the subnational provision of education and health services. In addition, removal of these subsidies will lead to a reduction in greenhouse gas emissions of about 11% (Larsen and Shah 1992).

14 The United States is first, with $502 billion in energy subsidies, accounting for 26% of world energy subsidies.


Table 19 Energy Subsidies in the People’s Republic of China, 2011

Source Percent of Central Government Revenues

Petroleum products 0.88

Electricity 1.34

Natural gas 0.42

Coal 14.27

Total ($279 billion) 16.91

Source: IMF (2013).

Table 18 Decision Criteria Regarding the Choice of Public Policy Instrument for Environmental Protection

Government

Polluter

High Flexibility Medium Flexibility Low Flexibility

Market-based incentives with focus on price

Market-based incentives with focus on quantity control

Regulatory approaches with focus on quantity controls

High Control Emissions and effluent charges

Marketable quotas and permits

Abatement technology standards, emission or abatement standards

Low Control Indirect taxes and content taxes, subsidy removal

Abatement subsidies


Of course, not all of these subsidies can be easily removed, especially those that directly impact the rural poor, but this is an area requiring careful examination for further reform.

Indirect taxes on inputs and outputs. This option includes adding an externality charge on existing input taxes or introducing excise taxes consistent with the level of externality on offending inputs. This option leads to easier monitoring of inputs and their effects on environmental quality. It is, however, too blunt an instrument, as some uses of an input may be less harmful than others, for example, use of coal for heating in urban areas versus at farms. Output taxes on polluting firms or environmental charges on consumer products that are nonbiodegradable, such as plastic bags and containers, offer a second alternative but may not provide for incentives for cost-efficient abatement. Therefore, such taxes would have to be supplemented by subsidies for abatement equipment.

Effluent and emissions charges. This would entail an effluent charge per unit discharged into water or the air. These are efficient instruments but pose significant challenges in terms of technology for measuring and monitoring and further require significant upfront costs for utilization. Commonly imposed taxes that fall into this category include sulfur dioxide emission taxes, nitrogen dioxide emission taxes, and effluent charges on sewerage and industrial liquid waste.

43Local Tax Reforms

Hazardous or nonbiodegradable waste disposal charges. Hazardous or nonbiodegradable waste disposal charges, differentiated by type of waste and their potential for environmental damage, are easier to administer.

Carbon taxes. Carbon taxes are imposed on the carbon content of fossil fuels, with the intent of reducing greenhouse gas emissions. As a by-product, such a tax also reduces sulfur dioxide and nitrogen dioxide emissions. Higher pollutants are taxes more heavily; for example, a $5 per ton carbon tax translates into a 13% tax on coal (0.605 tons of carbon per ton of coal) and a 5% tax on natural gas (0.027 tons of carbon in same volume as a ton of coal). Low-carbon taxes yield quadruple dividends. They (i) combat climate change; (ii) strengthen the fiscal position of governments (e.g., a $5 per ton carbon tax could raise about 1% of GDP); (iii) incite tax reform by increasing economic efficiency if introduced in an equal yield manner as a partial replacement of personal income and corporate income taxes, and distributional consequences are favorable if significant foreign direct investment with foreign tax credits are present; and (iv) reduce local pollution.15

Concluding observations on environmental taxationIn PRC, energy is heavily subsidized, and, at present, there are no significant environmental taxes. The first priority could be to fix energy prices by eliminating energy subsidies. Second, a combination of market-based incentives (e.g., pollution taxes and subsidies for abatement technology) and standards for reducing local pollution could be instituted. Then, small (i.e., a low tax rate) carbon taxes could be introduced in a revenue-neutral manner as an equal yield replacement for corporate income taxes. Such carbon taxes levied at the national level could be piggybacked by local governments by levying supplementary rates at the national tax base. Thus such taxes would enhance revenue adequacy at the local level while preserving local environment.

15 Table A5, Appendixes illustrates impact of a $10 per ton carbon tax in selected countries. The overall cost–benefit ratio in reducing local pollutants is greater than 1 under most scenarios.

44

4 Conclusion

PRC is a highly decentralized unitary state with local governments having a dominant share of public service delivery responsibility. Local governments enjoy significant budgetary discretion, and they have had a stellar record of success in delivering

on their growth and local economic development mandates. These achievements nevertheless came at relative lack of attention to fiscal transparency in budgeting; fiscal responsibility in borrowing; and underprovision of public goods such as environmental protection, food security, orderly urban growth, and social inclusion. This technical assistance has attempted to analyze the latter issues with a view to developing a long-term strategy for keeping the growth momentum alive while overcoming some of the overlooked fiscal and environmental risks at the local level. The government already placed these issues at high priority and, during the past several years, has undertaken an ambitious reform program to address these concerns.

Local budgeting, local debt management, and local taxation are interrelated, and the overall purpose of the reforms is to strengthen local public finance management by improving local accountability and transparency, strengthening local fiscal capacity, and institutionalizing formal frameworks for local public debt management. Linking local budgeting with fiscal planning and medium-term priorities is key to improve accountability, while comprehensiveness in local budget and execution is necessary for the transparency. Strengthening local fiscal capacity is necessary to balance local expenditure responsibilities with its revenues. Intergovernment alignment, both in revenue and expenditure, needs to be reassigned. To fill the investment needs at the local level under fiscal discipline, local borrowing needs to be formalized by the institutionalization of ex-ante and ex-post regulatory frameworks.

The project studies confirm the success of recent reform initiatives in improving transparency of budgeting, regulated access to capital finance, and strengthening local finances at the local level. To maintain the momentum of these reforms, this report provides suggestions for additional policy options in the three areas of local public finance management, i.e., local budgeting, local debt management and local taxation, which may be considered by the policymakers in the short, intermediate and long terms.

45

Appendixes

Table A1 Basic Elements of Public Finance Management Framework

Aggregate Fiscal Discipline

• Aggregate budget envelope established in advance of spending decisions and sustainable over the medium and long term

• Local revenue means consistent with local expenditure needs

• Fiscal gap minimized by exploring additional own-source revenues

• Operating budget financed by current revenues and capital budget from borrowing and reserves

• Budgeting linked with planning through medium-term expenditure framework

• Debt management framework formalized

• External and internal controls in place

• Ex-ante fiscal rules regarding deficit and debt and sanctions for noncompliance

Allocative Efficiency • Expenditure priorities based upon the most effective programs consistent with citizens’ preferences for public services

• Businesses taxed for services to businesses, residents taxed for services to residents, and no cross-subsidization

• Spending limits established for various services, and departments encouraged to reallocate funds within this envelope depending upon evaluation findings of program effectiveness

• Departmental managers acquire and disseminate information on the resources used and results achieved.

Operational Efficiency • Local public services provided in a least-cost manner based upon best value for the taxpayers’ money

• Local managers held accountable for output targets and given flexibility in the used of resources and the modes of service delivery.

• Local provisions subjected to competitive pressures from alternate service providers, and residents have voices and exit options.

• Local government performance on individual services benchmarked against comparator local jurisdictions.

Equity • Local governments strive to ensure fairness in service delivery and social inclusion

• Redistributive programs financed by higher-level governments so that local economic development objectives are not compromised.

Accountability to Residents and Higher-Level Governments

• Local governments accountable to local residents and higher-level governments

• Full disclosure of all information on local government operations to residents and higher-level governments

• Comprehensive, transparent, and output-based budgeting, presented in a user friendly format and disseminated in timely fashion


46 Appendixes

Figure A1 Structure of Government of the People’s Republic of China, 2011

Source: Government of the People’s Republic of China, Ministry of Civil Affairs. 2012. Handbook on Administrative Divisions of the People’s Republic of China (Zhonghua Renmin Gongheguo Xingzhengquhua Jiance). Beijing: China Society Press.

Central Government(Total population: 1.4 billion)

23 Provinces 4 Municipalities5 Autonomous Regions

2 Special Administrative

Regions (average population:

4 million; range, 0.5–7 million)

(average population: 52 million; range,

6–105 million)


3–47 million)


14–29 million)

332 prefecture-level units

2,853 country-level units

40,466 township-level units(average population: 33,000)

(average population: 470,000; range, 10,000–2,690,000)

(average population: 4 million; range, 0.08–11.89 million)

Appendixes 47

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48 Appendixes

Source: Shen and Shah (2007).

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Figure A3 Local Budget Process in the People’s Republic of China

Appendixes 49

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ia

Dire

ct d

ebt a

s % of assessed

value of taxable

prop

erty

1X

Dire

ct d

ebt p

er

capi

ta7

XX

XX

XX

X

Dire

ct d

ebt a

s % of personal

inco

me

(als

o pe

r ca

pita

)

9X

XX

XX

XX

XX

GO debt as % of

market value of

taxa

ble

prop

erty

1X

Deb

t ser

vice

as

a % of general

fund and special

reve

nues

12X

XX

XX

XX

XX

XX

X

Bud

get r

even

ues

as % of general

reve

nues

1X

% of net debt paid

in 1

0 ye

ars

2X

X

New

deb

t authorization

not g

reat

er th

an

rede

mpt

ions

1X

Est

imat

ed m

arke

t ca

paci

ty1

X

Source: Ma

(unp

ublis

hed)

.

50 Appendixes

Table A3 Moody’s Rating Criteria for Credit Worthiness

Aggregate Indicators and Subindicators (with weights) Weights

Operating environment

GDP per capita (50%)

GDP volatility (25%)

Government effectiveness index (25%)

60%

Institutional framework on powers and responsibilities

Predictability, stability, and responsiveness (50%)

Fiscal flexibility (33.4%)

Fiscal adequacy (16.6%)

10%

Financial position and performance

Interest payments–operating revenues (25%)

Cash surplus–total revenues (25%)

Gross operating balance–operating revenues (25%)

Net working capital–total expenditures (25%)

7.5%

Debt profile

Net direct and indirect debt–operating revenues (50%)

Short-term direct debt–direct debt (25%)

Four-year trend in net direct and indirect debt–operating revenues (25%)

7.5%

Governance and management practices

Fiscal management (40%)

Investment and debt management (20%)

Transparency and disclosure, financial statement disclosure (15%)

Transparency and disclosure, audit (15%)

Institutional capacity (10%)

7.5%

Economic fundamentals

GDP per capita

7.5%

GDP = gross domestic product.

Source: Qiao et al. (2012).

Appendixes 51

Table A4 Ex ante Regulation of Subnational Debt—A Worldwide Perspective

Market Dsiciplines

Rules-Based Control

Administrative Control Prior

Approval

Prohibition

Limit on Debit

Limit on Debit

ServiceSpecific Purpose Domestic Abroad

Industrial Countries

Austria X X

Belgium X

Canada X X (local) X (local)

Denmark X X (local)

Finland X

France X (local)

Germany X X

Greece X (local)

Ireland X (local)

Italy X X X X

Japan X

Norway X (local) X

Portugal X (local)

Spain X X X

Sweden X

Switzerland X

United Kingdom

X (local) X (local)

United States X

Developing Countries

Argentina X X

Bahamas X X

Bolivia X X X X

Brazil X X X

Chile X X

Colombia X X X

Costa Rica X X

Equador X X X X

El Salvador X X

Ethiopa X X

Guatemala X X

Guyana X X

Honduras X X

India X X X

continued on next page

52 Appendixes

Market Dsiciplines

Rules-Based Control

Administrative Control Prior

Approval

Prohibition

Limit on Debit

Limit on Debit

ServiceSpecific Purpose Domestic Abroad

Jamaica X

Korea, Rep. of X X

Mexico X X (local)

Panama X X

Paraguay X X

Peru X X X X

Suriname X X

Thailand X X

Trinidad and Tobago X X

Turkey X (local)

Transition Countries

Albania X X

Armenia X X

Azerbaijan X X

Belarus X

Bosnia X X

Bulgaria X

People’s Republic of China

X

Croatia X X

Czech Republic X

Estonia X X X

Georgia X X

Hungary X X (local)

Kazakhstan X X X X

Kyrgyz Republic X X

Latvia X X

Lithuania X X

Poland X X

Romania X

Russian Federation X X X X

Slovakia X

Slovenia X X

Tajikistan X X

Ukraine X X

Uzbekistan X XSource: Crivelli and Shah (2009).

Table A4 continued

Appendixes 53

Box A1 Early Warning Systems of Fiscal Stress

Indicators Used by Several Countries

• Debt–revenues (Russian Federation, <30% for oblasts and <15% for rayons)

• Debt service–revenues (<25% Italy, Spain; <20% Japan; <15% Russian Federation)

• Deficit–revenue

• Contingent liabilities adjusted for risk as a ratio of total revenues

• Liquid assets–spending needs

• Borrowing requirements–revenues

• Short-term debt–total debt

• Guarantees–revenue

• Debt dependency ratio: debt income–total expenditure

• Debt burden ratio: debt–GDP

State of Michigan: 10-Point Fiscal Stress Indicators for Local Governments

• Population growth (2 years)

• Real taxable value growth (2 years)

• Large decrease in real taxable value

• General fund expenditures as a percent of taxable value

• General fund operating deficit

• Prior general fund operating deficits

• General fund operating balances as percentage of general fund revenues

• Current year deficit in a major fund

• Previous year deficit in a major fund

• General long-term debt as a percent of real taxable value

State of Ohio, Fiscal Watch Program

• Fiscal watch. Local government placed under fiscal watch if deficit exceeds 8.3% of revenue. Requires state auditor to suggest a workout.

• Fiscal emergency. More than 30 days default on debt obligation and/or payment of salaries or deficit or overdue amounts exceed one-sixth of the previous year revenues. Local government placed under a state-appointed control board (planning and supervisory commission).

Colombia’s Traffic Light System for Local Debt

Indicator Green light Yellow Light Red light

Interest payments–savings (liquidity indicator) <40% 40%–60% >60%

Debt–current income (solvency indicator) <80% >80%

Source: Ma (2002), Qiao (2010).

54 Appendixes

Table A5 Costs and Benefits of Carbon Taxes for Selected Countries, 1987

Pakistan Indonesia India United States Japan

Fossil fuel consumption (million US $)

3,345 5,330 17,266 246,502 126,100

Carbon (C) emissions (million tons)

13.2 26.6 148.2 1,246.1 237.1

Price of carbon ($ per ton) 253 200 117 198 538

Energy Taxes ($/ton C) 65.13 0.0 10.69 26.64 104.80

Carbon Tax ($/ton) 10 10 10 10 10

Elasticity of energy demand

Price increase (from carbon tax):

–0.64 –0.60 –0.651 –0.60 –0.55

coal 37.58% 17.5% 26.2% 18.3% 8.7%

petroleum products 3.2% 5.8% 2.3% 3.4% 0.15%

natural gas 2.6% 4.4% 3.0% 4.3% 1.4%

Efficiency costs of a $10/ton carbon tax as percent of carbon tax revenues

Case A. Revenue neutral reductions in personal income taxes

–17.5 –1.5 –8.7 –8.4 –11.4

Case B. Revenue neutral reductions in corporate income taxes

+9.0 +8.7 +16.9 –6.2 +9.0

Case C. Lump sum redistribution of carbon taxes

–17.7 –1.5 –8.8 –10.2 –12.3

Case D. Lump sum redistribution of carbon taxes and accounting for energy subsidies in Indonesia and India

+0.4 0.0

Benefit-cost ratio*

High (SO2+NOx+PM) 1.8 17.9 9.5 11.2 1.3

Medium (SO2+NOx+PM) 1.6 12.9 7.5 8.7 1.0

Low (SO2+NOx+PM) 0.5 2.2 1.9 2.1 0.2

* “High” is based on Glomsrod et al (1990); “Medium” is based on Bernow and Marron (1990); “Light” is based on EPA/Energy and Resource Consultamts, Inc. referenced in Repetto (1990).

Source: Shah and Larsen (1992).

55

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Local Public Finance Management in the People’s Republic of ChinaChallenges and Opportunities

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