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Fiscal Contracts

To tackle the problems in the old system the government implemented a series of changes throughout the 1980s and early 1990s. These changes were structured around an arrangement known as the fiscal contract system (caizheng chengbao tizhi). A fiscal contract was an agreement between a lower-level government and a higher-level government with regard to the fiscal rights and responsibilities of the two parties for a certain period of time (mostly two or more years). Its formulation typically involved three steps: (1) to assess, based on recent fiscal data and near-term projections, the spending needs and the revenue-generating capacity of the lower-level government; (2) to set the targets for revenue and spending during the contract period; and (3) to determine the share or amount of remittance to the higher-level authority or, in the event of projected local revenue being insufficient for covering projected spending, the amount of subsidies from the latter.

The first fiscal contract was adopted in the province of Jiangsu in 1977. Based on the information about past fiscal flows, a fixed percentage (42% vs. 58%) was set for dividing the revenue extracted by the province with the central government. The contract covered a period of four years. It set a precedent for subsequent experimentation of similar measures in other provincial entities and at sub-provincial levels. In 1980 the State Council introduced sweeping changes that made fiscal contract the basic mechanism governing central-provincial fiscal relations. The new practice was characterized in Chinese economic literature as “dining in separate kitchens” (fenzao chifan), which drew a metaphorical contrast with the old doctrine of “unified revenue and spending.”

The actual form of fiscal contract varied by province and experienced adjustments over time during 1980- 1 993 (Jia Kang and Zhao Quanhou 2008).[1] A most widely used arrangement was known as “dividing revenue and expenditure and assigning full contractual responsibility to each level of administration” (huafen shouzhi fenji baogan). It defined the scope of central and provincial responsibilities for covering different spending needs in the pertinent province, and divided revenues into local and central categories benchmarked to the fiscal structure in a baseline year (oftentimes the year preceding the contract). When local revenue was projected to be greater than local spending, the extra amount would be shared with the central government according to a fixed percentage. When local revenue was projected to fall short of local spending, the central government would subsidize the deficit. Once the baseline figures on projected revenue and spending were set, they would hold for certain years. Any increase above the baseline figure on local revenue or in excess of certain growth rate would either be retained by the province concerned or shared with the central government according to a preset percentage, whereas any shortfall below the baseline revenue would have to be absorbed by the pertinent province through spending cuts. Similar and variant arrangements of this contractual form were also widely adopted between provincial and lower-level governments (Jia Kang and Zhao Quanhou 2008).

Parallel to the implementation of fiscal contracts was a restructuring of the tax system. In 1980 the Ministry of Finance began pilot programs in some six hundred SOEs to replace SOE profit remittance with an enterprise income tax. That experiment, known as the “tax for profit” (li gai shut) reform, was intended to provide SOEs with greater incentives by allowing them to retain part of their profits after paying income tax. Introduced to all SOEs during 1983, it was coupled with a reform (also known as “phase 2 of the tax-for- profit reform”) in 1984 that decomposed and expanded the all-encompassing industrial and commercial tax into several taxes targeting different economic organizations and activities.[2] In the meantime, several concurrent or sequential steps were taken to expand tax categories ( Jia Kang and Zhao Quanhou 2008), and to gradually free SOEs and other public enterprises from central planning and turn them into market players (Naughton 1995). As a result of these changes, taxes became the predominant source of budget revenue, as can be seen from the statistics in table 3.1.

A major feature of the restructured tax system is that the total revenue generated through income taxes (all but one of which—the collective enterprise income tax—were created in the 1980s) fell far short of the magnitude that SOE profit remittance had commanded. In contrast, the bulk of tax revenues

Table 3.1 Selected statistics of public finance, 1978-2010

Year

Fiscal revenue as % of GDP

Budget deficit (billions of yuan)

Central share in revenue and spending

% in total budget revenue

Enterprise profit remittance

Taxes

Other

(SOE

share)

1978

31.1

0

l6

47

51

46

3

(87)

1980

25.5

6.9

25

54

38

49

3

(85)

1985

22.2

5.8

38

40

2

88

10

(72)

i99°

15.7

14.7

34

33

<1

96

4

(45)

1995

10.3

58.2

52

29

0

97

3

(43)

2000

13.5

249.1

52

35

0

94

6

(41*)

2005

17.1

228.0

52

26

0

91

9

(37)

2010

22.5

677.3

51

18

0

88

12

(32)

Note: The “other” category consists mainly of various fees and surcharges. The figure with “*” is for 2001. SOE shares after 2000 do not include contributions from financial SOEs.

Sources: CSY2012; FYC1992,1999, 2006,2011.

after 1984 came from indirect taxes that were collected from or through the sale of products and services. Figure 3.1 illustrates the importance of these taxes both before and after the restructuring in 1984. Particularly noteworthy is the period from 1985 to the late 1990s, when the share of these taxes rose significantly and remained at very high levels and when public enterprises first experienced considerable expansion but then (after 1995) began to decline.

Also important to note is the fact that “regional property rights” continued to matter in the fiscal relations between different levels of government, as the boundaries between central and provincial fiscal rights and responsibilities (and those involving lower administrative levels as well) were still defined in connection with the “affiliation relationships” (lishu guanxi) of the economic organizations located in a province. That is, the central government retained all the fiscal revenues from centrally owned enterprises in the province, whereas the size of the fiscal revenues from local enterprises relative to local spending projections was a key determinant of the extent to which the province would be required to upload extra revenues to the center or receive subsidies from it. But there were two differences with the prereform system.

First, the profits of SOEs “owned” by different levels of government no longer made up the mainstay of budget revenue after 1984. Instead, it was the taxes paid or generated by these enterprises, along with those by other types

The Evolving Structure of Public Finance 89

Major components (%) of tax revenue, 1978-2010

FIGURE 3.1 Major components (%) of tax revenue, 1978-2010

Sources: FYC1992,1999, 2011.

of economic organizations (including collective enterprises, foreign-invested entities, and private entities), that served as the benchmarks for setting the baseline figures on revenue and spending in fiscal contracts.

Second, the so-called affiliation relationships of revenue providers (enterprises) were no longer synonymous with “ownership” by different levels of government. Instead, they encompassed both public enterprises and some other types of economic organizations (i.e., shareholding companies, Chinese-foreign joint ventures) over which different levels of government held fiscal rights and responsibilities. Indeed the vast majority of those in the latter group were licensed by the governments of the cities or counties where they operated, and the fiscal extractions from them (including those without clearly defined “affiliation relationship” labels) combined to form “local” revenue.

Still another development under the fiscal contract system was the expansion of extrabudget funds, which lay outside the fiscal contracts between different levels of government. In 1978 they were equivalent to 31% of budget revenue; in 1992 the figure went up to 111% (FYC2011, 472). The growth rate of extrabudget revenue was far higher than that of budget revenue. During 1979-1992 the average annual growth rate of extrabudget revenue was 19.1%, whereas budget revenue grew at an average rate of 8.6% (FYC2011, 472). This expansion was in part the result of a multiplication of various fees charged by government agencies, over which centralized control became increasingly

Extrabudget revenue and SOE-related funds (100 million yuan), 1978-1992 Sources

FIGURE 3.2 Extrabudget revenue and SOE-related funds (100 million yuan), 1978-1992 Sources: FYC1992,2011.

ineffective.[3] But the main driver came from SOE-related funds, which continued to be the mainstay (70%-8o%) of extrabudget revenue, as shown in figure 3.2. These funds grew with the progression of SOE reforms.

Starting from 1978, SOEs were allowed to retain part of their profits to finance production, fringe benefits, and bonus schemes. During 1983-1984 the “tax for profit” reform further broadened the scope of profit retention after income tax payment. Yet not all the authorized retention was kept and used by SOEs. As indicated by the curve closest to the horizontal axis in figure 3.2, from 1978 to 1992 only about 20%-30% of the SOE-related funds in extrabudget revenue were booked to the accounts of SOEs, whereas some 70%-8o% were held by various supervising agencies (FYC 1993, 684-685, 688, 691). The latter included depreciation charges, profits withheld from SOEs, proceeds from SOEs formed outside the state budget, and unspecified revenue categories. With the exception of depreciation charges, a major source of the growth of these funds was the diversion of fiscal resources from budgetary to extrabudgetary categories (Jia Kang and Zhao Quanhou 2008). A commonly used method for such diversion was to grant tax breaks to enterprises “owned” by local governments.

Under the fiscal contract system, revenue targets were mostly set as lumpsum figures. Although the target figures were derived by estimating the revenues from regular fiscal sources, such as profit remittance (before 1985), taxes, and fees, there was considerable maneuvering room for local governments. Given that above-target revenues were subject to sharing with higher- level authorities, local governments had the incentive to negotiate down the baseline target and not to overfulfill the contract greatly. During 1988-1993 (when pertinent data are available), for example, the average level of fiscal contract fulfillment by provincial governments was iii%.7 Since all taxes were collected by the local tax authority and then divided with higher-level government, local governments could give tax reductions and exemptions to the enterprises they “owned” to any extent that would not affect the fulfillment of the fiscal contract. The tax breaks were then subject to “recall” for discretionary use by the local government concerned (Ma et al. 1994). From 1985 to 1993, for example, large and medium-sized SOEs were subject to an enterprise income tax at the rate of 55%, whereas small SOEs (and urban and rural collective enterprises) were faced with a progressive income tax rate ranging from 10% (for income under 1,000 yuan) to 55% (for income above 200,000 yuan). In reality, these tax rates were rarely applied.[4] [5] In fact, figure 3.3 shows that the effective tax rate for industrial SOE profits trended down from over 55% in 1985 to less than 13% in 1993.[6] The uncollected tax revenue ended up in the pool of off-budget funds controlled by the supervising bodies of SOEs.[7]

SOEs were not alone. Township and village enterprises (TVEs) “owned” by rural authorities (see chapter 4) were also given substantial tax breaks as a way to divert funds away from the budgetary process. Table 3.2, based on published statistics, reveals a significant gap between “taxes due” (according to the prevailing tax rates) and “taxes paid” by TVEs during 1987-1992 (the

Enterprise income tax paid as percentage of gross profit of industrial SOEs, 1985-1997

FIGURE 3.3 Enterprise income tax paid as percentage of gross profit of industrial SOEs, 1985-1997

Source: FYC1998.

Table 3.2 Taxes due and paid by township and village enterprises (RMB billions)

Year

All taxes

Income tax

Indirect taxes

Due

Paid

Due

Paid

Due

Paid

1987

16.9

13.1

1988

23.7

17.7

6

3.8

17.7

13.8

1989

26

19.6

6.1

3.8

19.9

15.7

1990

27

20.3

5.7

3.6

21.3

16.7

1991

33.4

24.2

6.8

4

26.6

17.3

1992.

41.7

33.6

9.6

5.4

32.1

27.9

Sources: CTEY 1988,1989,1990,1991,1992,1993.

period for which sufficiently detailed information is available). The tax breaks not only concerned income tax on enterprise profits but encompassed indirect (transaction) taxes that constituted the mainstay of budgetary revenue. Part of the unpaid taxes was parked in the accounts of TVEs for use by their supervising authorities; part became “self-raised funds” under township governments, which were not included in the statistics on extrabudgetary revenue until 1996 (Jia Kang and Zhao Quanhou 2008).

The outgrowth of extrabudget funds throughout the 1980s and early 1990s took place at the expense of budget revenue. As shown in table 3.1, the share of budget revenue in GDP steadily declined from 25.5% in 1980 to 15.7% in 1990 and further to 10.3% in 1995.

A concurrent problem under the fiscal contract system was the erosion of the central government’s fiscal power. After an initial rise in the early years of reform, the share of the central government in budget revenue began to trend down after reaching an interim high of 40.5% in 1984. In 1993 it dropped to 22%. On the other hand, during most of the years under the fiscal contract system the responsibilities of the central government in total fiscal spending remained above the revenue it could dispose of, adding to the pressure to increase budget deficit (which indeed trended up, as shown in table 3.1). In 1993, for example, the central government was responsible for covering 28.3% of total spending but had only a 22% share in total revenue (FYC 2011, 459-463).

Governance costs also posed a problem. Although the fiscal contracts between the central government and provincial governments were set for multiple years, renegotiations for ex post adjustments after the start of a contract were commonplace, making contract enforcement and monitoring a formidable administrative task. Still another problem is that under the fiscal contracts local governments tended to promote sectors with high tax rates and/ or large profit margins (e.g., tobacco and alcoholic products) and sought to protect their parochial revenue bases by creating trade barriers (e.g., through bans on the sale of locally produced raw materials and inputs to other, especially competing regions), resulting in overcapacity and segmentation of markets (Tao et al. 2009).

  • [1] There were three major rounds of fiscal contracts: 1980-1984, 1985-1987, and 1988-1993. The firstround largely centered on the division of fiscal rights and responsibilities benchmarked to the revenuesfrom basic extraction channels in the existing system—i.e., SOE profit remittance and industrial andcommercial tax. The second round incorporated changes in the composition of revenues under therestructured tax system (see the discussion below) for ascertaining and determining central and localshares in fiscal flows. The third round featured greater emphasis on benchmarking these shares to thegrowth rate rather than the size of the revenues generated by local governments, so as to keep the centralgovernment from being blocked out of the above-target portions of revenue growth.
  • [2] These taxes include value-added tax (on twelve categories of industrial products), product tax (onindustrial products and select agricultural products), business tax (on service activities and construction), salt tax, (large and medium) SOE profit adjustment tax, resource tax, motor vehicle and vessellicense tax, and SOE bonus tax.
  • [3] See Lin 2001 for a discussion of the central governments largely unsuccessful efforts during the 1990sto curb the outgrowth of “three arbitrary charges” (.sanluan) by government agencies—fees, fines, andad hoc levies known as tanpai.
  • [4] This figure is estimated by taking the ratio of “actually collected revenue” to “projected revenue” ofdifferent provincial entities, reported in the internally circulated material Fiscal Statistics of Prefectures,Cities and Counties for 1988-1993 (Ministry of Finance).
  • [5] In 1994 enterprise income tax rate was reset at a unified level of 33% for all economic organizations.It was further lowered to 25% in 2008.
  • [6] These rates are estimated by dividing the total enterprise income tax paid with the total amount ofgross profits earned by industrial SOEs. The income tax here includes the SOE income adjustmenttax, which was levied as a (firm-specific) percentage of the net profits (after income tax) of large andmedium SOEs.
  • [7] Under the new accounting system adopted in 1993, SOE-related funds previously defined as extrabudget revenue were reclassified as part of enterprise equity and therefore ceased to be categorized asextrabudget revenue. The removal of these funds from fiscal statistics, however, did not necessarily stopsupervising authorities of SOEs from continuing their influence over the use of these funds. Moreover,remaining elements in the extrabudget revenue category continued to grow throughout the 1990s andinto the new millennium (Jia Kang and Zhao Quanhou 2008).
 
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