China and fiscal governance

Building clearer relations
OECD Observer

“The hills are high and the emperor is far away” is an old Chinese dictum that rapid growth is now putting to a severe test. Some consequences of rapid expansion, such as spending imbalances and regional lags, are probably inevitable in a country as large and varied as China, with its 1.3 billion people, multiple spoken languages and dialects, a score of provinces and five autonomous regions. But if they are not addressed, these problems could worsen, to the detriment of the economy.

A new OECD report, Governance in China, sets out the issues clearly. In constitutional terms, China may be a unitary state, but its system of governance has quite disjointed features that are, ironically, a legacy of central planning, with its successive waves of decentralisation and recentralisation. When it comes to fiscal and regional issues, the current institutional set-up no longer seems to suit the heavy demands placed on the government of a large dynamic economy.

Central government has long had difficulty exerting fiscal control over local authorities. Beijing knows this–its tax reforms in 1994 made it a priority to reorganise fiscal transfers across levels of government and to redefine their functional responsibilities. But problems of enforcement and funding persist, hampered by local habits and priorities. Broadly speaking, Beijing transfers funds to the provinces, which then share these funds out among their counties, mostly via the prefectures. But the exact way in which these and other locally generated funds are distributed is a little ad hoc. The process is inevitably subject to powerful lobbies, with many counties slipping through the cracks. This leads to strains and distortions in local budgets, undermining spending on vital areas like health and education. These can only be corrected by forging stronger, more clearly defined, fiscal relations across all levels of government, the new report argues.

The challenge of creating more coherence in government is repeated throughout Governance in China, which examines public sector reform, finance and the role of the market (see references). The concern is that unless coherent institutions and frameworks for government to transmit its decisions and policies to the regions and beyond to local municipalities are enhanced, China will find it hard to harness its strong growth of recent years and move to the next stage of development. Growth may surge in some regions, but strains will deepen between provinces as some populations are left behind.

How can greater coherence be achieved? The answer is to improve fiscal relations by exercising more control over expenditure, though this time by reforming institutions and building better multilevel government to manage this large country. Under the old command system, higher-level authorities would set spending guidelines, and then leave local authorities leeway to meet them. Frequent gaps between expenditure responsibilities and available resources led to illicit tax collection–from farmers and firms for instance–off-budget spending, and the accumulation of illegal local government debt, features which persist today. The price of this has been disparities in public spending per capita within and between regions, and under-funding of some services.

China’s overall public spending is not that low, at nearly 21% of GDP in 2002, compared with an OECD average of 44%. And with extra budgetary funds controlled by local governments and outlays on social security, China’s total outlays rise to some 32% of GDP, which is comparable with some OECD countries.

How that spending is allocated demands attention; while it appears that the share of spending on investment is high by international standards, reflecting expanding infrastructure, for instance, an all too low proportion is spent on education and training, science and technology, and social welfare. In fact, China’s public spending on education is not just lower than OECD countries, but low compared with many developing countries too. While the authorities are aware of the need to address this area, increasing expenditure on these items heightens the need to improve fiscal relations across the country. Only then will it be able to direct spending policy priorities towards areas like education.

China’s hotchpotch of provinces and counties for the most part derive their autonomy from a mix of historical isolation and central planning neglect, rather than from any formally devolved model. A more federal-type structure of multilevel government would restore structure and coherence by involving regions in decision making from the start. Nor would central government transfers continue to benefit better-off regions as they do now. Despite reforms in the 1990s, actual spending per capita in some provinces, particularly in the central and western regions, is far lower than national spending figures would suggest. The central provinces, such as Hunan, Jiangxi and Anhui, have been left behind in a drive to invest in the west and north-east of the country.

To help redress this, the report recommends an increase in central government transfers of some 3% of GDP, or 12% of government spending. However, the report reasserts that simply raising spending would not be enough. Improving fiscal relations via a more standardised province/county revenue sharing and fiscal transfer agreement will be needed, if only to give lower level authorities the revenue they need to carry out the tasks assigned to them from higher authorities. This would reduce the pressure, not least at the county level, to raise taxes illegally and engage in off-budget spending that leads to illegal debt. The report also notes that a large share of spending is channelled to administration. Here, there is ample scope to improve efficiency, the report says, by merging some localities and by abolishing the township level and where possible, the prefecture level as separate budgetary units. That would free up funds for education and health.

In short, improving fiscal relations would be about tightening central control while improving transparency and accountability throughout the government system, the report says. Without a multilevel administration to transfer and manage wealth for the entire country, well-meaning government-led campaigns to bring investment into the provinces, like Go West, will not resolve regional disparities in the longer run. Regulatory reform, on the other hand, by delivering better governance, will help ensure that rapid growth spreads to the benefit of all. Seen from the provinces, Beijing might no longer feel so far away. RJC

References

OECD (2005), Governance in China, Paris. This 574-page review, complete with graphs and tables, comes in three parts: Public sector management, which covers civil service reform, the fight against corruption and e-governance; Public finance, which examines taxation and budgets; and the Institutional framework for market forces, which examines labour, competition, banking and property rights. For a full list of contents, see www.sourceoecd.org. See also www.oecd.org/gov.

For more information on the study Governance in China, contact Irene.Hors@oecd.org.

For more on fiscal relations issues, contact Margit.Molnar@oecd.org.

©OECD Observer No 251, September 2005




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