Redesigning the Dragon Financial Reform in the Peoples Republic of China
Redesigning the Dragon
Financial Reform in the Peoples Republic of China
Anna Pawul email@example.com
V550, Government Finance
in the Transitional Economies
21 November, 1996
In 1978, the People’s Republic of China (PRC)
embarked on the enormous undertaking of opening its doors to the outside world.
Until this point in time, the PRC had relied on a centralized economic system
much like that of the former Soviet Union.
However, the PRC’s situation differed with the former Soviet Union in three
1) although reforms followed the Cultural Revolution (which did exact its toll
on the Chinese economy) there was an absence of severe macroeconomic crises
when reforms were begun 2) agricultural infrastructure was good, although the
incentives were poor and 3) China had a strong presence of overseas Chinese
and Hong Kong that influence its economic development and over the years
supplied capital and human resources.
The industrialization strategy adopted by the
PRC has been characterized by gradualism and experimentation. Its focus has
been to introduce market forces, reduce mandatory planning, decentralize, and
open the economy to foreign investment and trade.
This strategy had three main stages. The first (1979-1983) established four
“Special Economic Zones” (areas awarded special freedoms to conduct business
relatively free of the authorities intervention) in Guangdong and Fujian
provinces, the second (1984-1987) added 14 port cities creating the “Economic
Development Zones”, and finally the third stage (1988-present) which opened
most of the country to foreign trade and created “tariff free zones”.
In the rural areas, land reforms spearheaded further reforms and also the
establishment of Township and Village Enterprises (TVEs). These enterprises
were able to capitalize on the abundant cheap labor in rural areas and to
operate without the burden of providing social spending. They also provided a
training ground for the learning of market skills and concepts. Today,
production of manufactured goods by rural and township enterprise is estimated
to account for more than 40% of the GDP.
In many respects, China’s process of economic
reform has been highly successful.
Since its inception, the average GDP
growth has been a world-leading 9.3% year, the poverty rate has declined 60%,
and 170 million Chinese living in absolute poverty have seen their standard of
living raised above the minimum poverty level. Export growth was 7.8% in 1993,
29% in 1994 and 34.7% in 1995.
Government measures to control inflation, which had threatened to overheat the
economy in the early 1990s, seem to have taken effect: inflation was under 15%
in 1995. (See Tables 1 and 2.)
Source: EIU Country Report, China/Mongolia, 3rd Quarter
1996. The Economist Intelligence Unit.
Source: EIU Country Report, China/Mongolia, 3rd Quarter
1996. The Economist Intelligence Unit.
Chinese economic reform has one other
characteristic that sets it apart from that of the former Soviet Union, the
absence of democratic reforms. The current transition is being carried out
within the “socialist framework” and for the most part is centrally
controlled. Much of the world waited to see whether the economic transition
would derail after the Tiananmen incident in 1989; it did not. However China
did seem to be looking for a way of separating itself from reforms and
democratic upheaval that were happening in the former Soviet Union.
In 1992, Deng Xiao Ping toured the southern economic zones - a journey
significant for its highly symbolic approval of the reform and investment
efforts he witnessed - and coined the phrase “socialist market economy”. Deng
emphasized that this transition must promote the development of productivity,
strengthen the national power and improve people’s standard of living, stating
that, “..with all these achievements secure, our socialist foundation is
Within this backdrop, we will take a closer look
at the system of reforms currently underway in the People’s Republic of China.
This year marks the beginning of the Ninth Five-Year Plan (1996-2000).
Examining the individual parts (the budget process, public expenditure, taxes,
banking, the interaction between central and provincial governments, and the
emerging need to transform the social safety net) will present a clearer
picture of what has been accomplished by the macroeconomic reforms put in place
in 1976 as well as what still needs to be done.
Revenue, Expenditure and the Budget
One problem of major proportion facing the
Chinese government is that central government revenues are growing at a much
slower rate than the overall economy, and a growing budget deficit has resulted
(see Table 3 in Appendix, page 20).
This is especially debilitating in the face of increasing demands from the
surging economy for investment in infrastructure and with the need for
investment in a reformed social insurance system that will come with economic
disruptions caused by continuing liberalization. Expenditures have also been
falling as a percentage of GDP, but are growing faster than revenue.
Several factors have been identified in the
shrinking revenue-to-expenditures ratio problem:
Tax arrears on
the industrial and commercial tax (CICT) from enterprises, which are growing as
state-owned enterprises (SOEs) become more unprofitable in the face of
increasing competition. At the end of 1994, these arrears amounted to 8.2
billion yuan (¥), and just seven months later, the figure had grown to
granted by local governments to state-owned and private enterprises.
Subsidies to the
loss-making SOEs, in the form of loans or direct subsidies (see Table 4).
China’s 1995 budget deficit was around a mere 1.5% of GDP. If policy lending
by centrally controlled banks - most of which is, effectively, transfers to
SOEs which can never afford to pay back these loans - is taken into account, the
central government’s true deficit is 6% of GDP or higher.
(Most of these were for urban food, and adjustments made in 1992 have reduced
this drain on the budget.)
expected increases in expenditures (in 1995, these were 18% higher than planned
on the central level, with local government expenditures over 30% higher than
A drop of 10.7%
in customs revenue from 1994 to 1995.
interest subsidies on bank deposits and treasury bonds, which have been kept
high by high inflation rates.
Source: Wong, Christine
P.W., Christopher Heady, and Wing T. Woo. Fiscal Management and Economic
Reform in the People’s Republic of China. Oxford University Press. Hong
For a country controlled by a Communist party,
the government’s proportion of economic activity has been remarkably small,
even before implementation of reform. In 1995, official government spending
was just 11.6% of GDP. Off-the-books revenue raising schemes by local governments
may mean the state’s total revenue is two times the official level.
The extra-budgetary revenue investment was
dispersed, uncoordinated and did not fulfill the central government’s
investment priorities. The central government faced growing infrastructure
demands, but with shrinking (in proportionate terms) assets available, has been
forced to reduce capital construction spending substantially. Also,
expenditures on administration, culture, education, and welfare increased over
the reform period, and reduced the government’s ability to spend on
(See Table 5 in Appendix, page 22.) The increases in administration spending
are particularly troubling, because of government policies to reduce control of
the economy and shrink some government bureaus.
One of the stated goals of the Ninth Five-Year
Plan is to eliminate the budget deficit by year 2000. But this goal is highly
unlikely to be achieved due to other conflicting goals, like spurring
employment, which may mean increasing subsidies to unprofitable SOEs; reducing
regional income disparities; and strengthening agriculture, which is seen as a
key to controlling inflation.
Christine Wong, an expert on the Chinese
financial system, identifies three necessary changes to restore the health of
the budget: First, the tax administration must be strengthened. Second, the
tax structure must be reformed so that it is neutral across products and
sectors. Third, the revenue-sharing system between local, provincial and
national levels of government must be revamped, with clearer tax assignments in
line with each levels set of responsibilities. The central government’s
control over the tax system and share of total revenues will likely have to be
increased. The next two sections will address these proposed changes.
The Pre-Reform Tax System
Prior to economic reforms, China’s tax structure
was based on the Soviet model. Enterprises remitted their profit to the
government, retaining only what was necessary to pay expenses. Revenues were
collected by local governments, and a certain amount was filtered up to the
central government. In 1984, this was replaced by a system of enterprise
income taxation reform, in which companies were taxed on their profits, as the
government tried to respond to economic imbalances created by the emerging
private sector. The turnover tax (the Consolidated Industrial and Commercial
Tax, or CICT), which had been the largest contributor to the government’s
annual revenue, was replaced with a business tax, a product tax, and a
value-added tax (VAT). These featured highly differentiated tax rates across
sectors, types of good and service, and form of firm ownership. Most private
firms paid a base tax rate of 33%, while most state-owned enterprises (SOEs)
were nominally taxed at 55%.
In practice, however, taxes paid were governed by a contract responsibility
system (CRS), in which enterprises negotiated individually with local
government units. This system created conflict of interest because often the
local government was both tax collector and enterprise owner. Not only were
there differentiated rates which distort economic activity, there was little
incentive for full tax remittance back to the central government under this
system. (See Table 6 in Appendix, page 23, for a description of the tax
structure from 1985-1991.)
In 1994, the Chinese government began to respond
to these problems by enacting a series of reforms. The CICT was abolished and
the following taxes were created or modified:
Enterprise Income Tax. This unified corporation tax taxes companies at a
single 33% rate. Foreign enterprises and joint ventures are still enjoying
lighter tax burdens, because of the fierce competition between regions to
attract foreign investment, but these privileges are to be gradually
Personal Income Tax. Operates on a sliding scale, with a maximum of 45%. Not yet
Value-Added Tax (VAT). Replaces the product tax of the CICT. Most goods
taxed at 17%, but agricultural and food products will be taxed at 13%, and
small-scale businesses will pay flat rate of 6%.
Consumption (Excise). Focuses narrowly on “luxury goods:” tobacco, alcohol,
gasoline, and a few others.
Business tax for services. Service industries will face a business tax of 3% to
20% on sales in place of the VAT. This tax also will apply to transfer of
intangible assets and the sale of real estate.
Capital Gains. A capital gains tax was to be introduced in 1994, but its
implementation was postponed because of concern over its adverse impact on
China’s fledgling stock markets.
In 1996, China announced plans to reduce its
import tariff rate from 35.9% to 23%, while abolishing preferences for certain
goods and, importantly, eliminating exemptions from import tariffs (currently,
over 80% of imports are exempt from import duties for various reasons). 
This step alone should help to reduce the recent losses in customs revenue. The
Ninth Five-Year Plan also includes provisions to introduce taxes on interest
earnings and inheritances, policies designed to reduce income disparity.
Revision of Tax Collection Structure
In order to make the above tax policy changes
effective, the tax collection system must be revamped and greatly improved.
The current structure is based on a system of revenue contracts between
enterprise and government unit, and between local and central governments. One
of the necessary reforms involves tax exemptions, which local governments often
have the authority to grant to enterprises who for one reason or another are
unable to pay their taxes. This is a fundamental weakness in the Chinese
fiscal system: local government has decision-making authority to grant
exemptions on a tax the proceeds of which may in large part be assigned to
governments above. Numerous conflicts of interest can appear to reduce
incentives to enforce the tax at the local level.
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