-30- 1

Lecture 6Fiscal Reforms

-30- 2

Pure market economy without a government

Households Firms

Output Market

Input Market

-30- 3

Market failures Micro level

1. Incomplete competition. 2. Externality. 3. Insufficient public goods and merit goods. 4. Incomplete information and high transaction cost. 5. Risk and uncertainty.

Macro level 1. Unequal income distribution. 2. Economic fluctuation. 3. International trade deficits.

-30- 4

Circular Flow in a Mixed Economy

GovernmentHouseholds Firms

Output Market

Input Market

-30- 5

Government failures

Politicians and bureaucrats are self-interested and they may not act in the interest of the society. Political business cycle is one example of artificially made fluctuation. Bureaucratic empire building: absence of bottom line.

Public and private sector share some common problems. Incomplete information, transaction cost, problematic performance

measurement and incentive systems, and risk and uncertainty. Governmental institutions and political arrangements may not make the

government responsive to the solution of the market failures. For example, the log-rolling process may lead to budget expansion. Divided government reduces the efficiency of decision making.

Decision making may be controlled by organized interest groups without reflecting median voter preferences.

-30- 6

Basics of Public Finance

The general economic goals of a government 1. Economic growth; 2. Stable price; 3. Balance in international trade; 4.

Full employment.

The major economic instruments of the government 1. Financial instruments: interest rates, deposit reserve ratio, credit

provision, etc. 2. Fiscal instruments: taxation, debts, redistribution, spending 3. Other: industrial policies, regulatory policies, etc.

Public finance serves purposes beyond efficient resource allocation 1. Providing public goods to overcome market failure 2. Balance different regions and social groups 3. Intra- and inter-governmental check and balance

-30- 7

Sovereign credit ratingby Standard & Poor's Foreign Rating in March 2013

Three major credit rating agencies: Standard & Poor’s, Fitch, and Moody’s. Dagong, a Chinese rating agency in Beijing.

-30- 8

How can fiscal policies be used to stimulate economic growth?

1. Mobilize local initiatives. 2. Facilitate incentives of investment.

Enterprise income tax Laffer Curve

3. Facilitate capital cumulation Structural inclination of taxation

4. Facilitate infrastructure construction 5. Stimulate innovation and export

-30- 9

Pros and cons of centralized fiscal system Merits

1) Central fiscal management internalizes the cross-jurisdiction externality effects

2) Intergovernmental transfer redistributes wealth. 3) Restrain excessive local fiscal competition. 4) Central government grants/transfer payment empower its political

control. Demerits

1) Federal grants may lead to overly reliance on federal finance. 2) The separation of revenue and expenditure creates fiscal illusion and

offsets the policy purpose of the federal government. 3) Correspondingly, it gets more difficult to motivate local jurisdictions

to match its revenues with local expenditure preferences. 4) Such system may encourage rent-seeking behavior.

-30- 10

Pros and cons of a decentralized fiscal system

Merits 1) Exit model: Tiebout’s model argues that local residents vote by feet

according to their preferences and the local revenue-expenditure patterns. Decentralized system more directly links the local performances to the

capacity of local officials who are driven by the pressure of local competition.

When assets are mobile, local governments are reluctant to impose heavy taxes. This may result in a small government in general.

2) Voice model: local democratic process can help match the financial arrangements and local preferences.

The demerits of a decentralized system is just the absence of the merits derived from a centralized system. Reduction of public goods supply to the bottom Externality problem is not well solved if high transaction cost exists Inequality

-30- 11

The evolution of intergovernmental fiscal arrangement in China 1. Fiscal arrangement under planned economy

United revenue and expenditure system Local governments didn’t have fiscal power. They were the agents of

central government, collecting revenues and retaining some for local expenditures according to central plans.

A heavy reliance on enterprise profits of SOEs rather than on tax In 1978, Shanghai had 1.1% of China’s population, but contributed

7.5% of national GDP and 15% of national fiscal revenues. It collected RMB 16.9 billion revenues, and kept RMB 2.6 Billion. The

contribution rate is 85%. In 1985, SOE’s profit remittance was replaced by income taxation

Major expenditures were on industry investment and infrastructure construction In 1978, expenditures on administration and services were only 11.6%

of the fiscal expenditures.

-30- 12

Fiscal revenue Structure of China: 1970-1993 (100 Million)

Year Total Revenue Tax revenue Enterprise income revenue Subsidies to SOEs

1970 662.9 281 378

1973 783.94 348 427

1975 815 402 400

1976 776 407 338

1977 874 468 402

1978 1132 519 571

1979 1146 537 495

1980 1159 571 435

1981 1175 629 353

1982 1212 700 296

1983 1366 775 240

1984 1642 947 276

1985 2004 2040 43 (income tax began ， 595 this year) -507

1986 2122 2090 42 -324

1987 2199 2140 42 -376

1988 2357 2390 51 -446

1989 2664 2727 63 -598

1990 2937 2821 78 -578

1991 3149 2990 74 -510

1992 3483 3296 59 -444

1993 4348 4255 49 (582 tax submission this year) -411

-30- 13

2. 1978 ~ 1994: discretion-based fiscal contracting and revenue sharing system Since 1978, decentralized fiscal management was gradually

introduced.

Fiscal contracts were signed between central and local governments There were 6 types of revenue-sharing arrangements

Basically, local governments could retain a big portion or even 100% of the surplus revenues after they submitted the quota set by the contract.

This essentially removed central government’s responsibility to provide local services.

This drove local governments to maximize local revenues: LSC

The emergence of a prosperous economy and a weak state

-30- 14

3. 1994 ~ Present: rule-based revenue sharing system (A return to centralization)

A reclassification of taxes and taxing authorities Fixed Central Revenues: Customs Duties; VAT and Consumption Tax

collected by the Customs; Domestic Consumption Tax, Income Tax of Central Enterprises; Income Tax of Local Banks and Nonbank Financial Institutions; Revenues remitted by Railway Department, Headquarters of State-owned Banks and Insurance Companies; Profits remitted by Central Enterprises.

Fixed Local Revenues: Business Tax; Income Tax of Local Enterprises; Profits remitted by Local Enterprises; Individual Income Tax; City and Township Land Use Tax; Fixed Assets Investment Orientation Regulation Tax; City Maintenance and Construction Tax; House Property Tax; Urban Real Estate Tax; Vehicle and Vessel Usage Tax; Stamp Tax; Slaughter Tax; Agriculture Tax; Animal Husbandry Tax; Farmland Occupation Tax; Deed Tax; Inheritance and Donation Tax; Land Appreciation Tax.

Shared Revenues: a. Domestic VAT (17%): 75% for central government and 25% for local

governments; b. Resource Tax: the part for the central government is the tax paid by offshore oil

enterprises, and the rest is for local governments; c. Security Transaction Tax: Split by half between central and local governments d. In 2002, individual income tax was changed to be shared half by half, in 2003 the

central government began to share 60% percent.

-30- 15

Restructure the tax administration system

Removal of local discretion in making tax breaks

The banking sector reform in 1998 Building 9 branches of the Central Bank

-30- 16

Improved extractive capacity

0%10%

20%30%40%

50%60%

Revenue Share of Central Gov Expendi ture Share of Central GovTotal Revenue Share i n GDP

-30- 17

The two ratios of China’s fiscal revenues 1978-2007

Year GDP(RMB billion)

Ratio 1 Ratio 2 Year GDP(RMB billion)

Ratio 1 Ratio 2

1978 364.52 0.31 0.16 1993 3533.4 0.12 0.22

1979 406.26 0.28 0.20 1994 4819.79 0.11 0.56

1980 454.56 0.26 0.25 1995 6079.37 0.10 0.52

1981 489.16 0.24 0.26 1996 7117.66 0.10 0.49

1982 532.36 0.23 0.29 1997 7897.3 0.11 0.49

1983 596.27 0.23 0.36 1998 8440.23 0.12 0.50

1984 720.81 0.23 0.41 1999 8967.71 0.13 0.51

1985 901.6 0.22 0.38 2000 9921.46 0.14 0.52

1986 1027.52 0.21 0.37 2001 10965.52 0.15 0.52

1987 1205.86 0.18 0.33 2002 12033.27 0.16 0.55

1988 1504.28 0.16 0.33 2003 13582.28 0.16 0.55

1989 1699.23 0.16 0.31 2004 15987.83 0.17 0.55

1990 1866.78 0.16 0.34 2005 18386.79 0.17 0.52

1991 2178.15 0.14 0.30 2006 21087.1 0.18 0.53

19922692.35

0.13 0.28 2007

249530 0.21 0.54

-30- 18

Tax revenue structure 1978-2008

Domestic

Value-addedTax

DomesticConsumption

Tax

BusinessTax

CorporateIncome

Tax

Individual Income

Tax

Tariffs

1978 519.28 28.76

1980 571.70 33.53

1985 2040.79 147.70 211.07 696.06 205.21

1990 2821.86 400.00 515.75 716.00 159.01

1991 2990.17 406.36 564.00 731.13 187.28

1992 3296.91 705.93 658.67 720.78 212.75

1993 4255.30 1081.48 966.09 678.60 256.47

1994 5126.88 2308.34 487.40 670.02 708.49 272.68

1995 6038.04 2602.33 541.48 865.56 878.44 291.83

1996 6909.82 2962.81 620.23 1052.57 968.48 301.84

1997 8234.04 3283.92 678.70 1324.27 963.18 319.49

1998 9262.80 3628.46 814.93 1575.08 925.54 313.04

1999 10682.58 3881.87 820.66 1668.56 811.41 413.66 562.23

2000 12581.51 4553.17 858.29 1868.78 999.63 659.64 750.48

2001 15301.38 5357.13 929.99 2064.09 2630.87 995.26 840.52

2002 17636.45 6178.39 1046.32 2450.33 3082.79 1211.78 704.27

2003 20017.31 7236.54 1182.26 2844.45 2919.51 1418.03 923.13

2004 24165.68 9017.94 1501.90 3581.97 3957.33 1737.06 1043.77

2005 28778.54 10792.11 1633.81 4232.46 5343.92 2094.91 1066.17

2006 34804.35 12784.81 1885.69 5128.71 7039.60 2453.71 1141.78

2007 45621.97 15470.23 2206.83 6582.17 8779.25 3185.58 1432.57

2008 54223.79 17996.94 2568.27 7626.39 11175.63 3722.31 1769.95

2009 59521.59 18481.22 4761.22 9013.98 11536.84 3949.35 1483.81

2010 73210.79 21093.48 6071.55 11157.91 12843.54 4837.27 2027.83

-30- 19

National Government Revenue and Expenditure

Revenue

(100 million yuan)Expenditure

(100 million yuan)Revenue growth (%)

Yearly balance (100 million yuan)

1978 1132.26 1122.09 29.5% 10.2 1980 1159.93 1228.83 1.2% -68.9 1985 2004.82 2004.25 22.0% 0.6 1990 2937.10 3083.59 10.2% -146.5 1991 3149.48 3386.62 7.2% -237.1 1992 3483.37 3742.20 10.6% -258.8 1993 4348.95 4642.30 24.8% -293.4 1994 5218.10 5792.62 20.0% -574.5 1995 6242.20 6823.72 19.6% -581.5 1996 7407.99 7937.55 18.7% -529.6 1997 8651.14 9233.56 16.8% -582.4 1998 9875.95 10798.18 14.2% -922.2 1999 11444.08 13187.67 15.9% -1743.6 2000 13395.23 15886.50 17.0% -2491.3 2001 16386.04 18902.58 22.3% -2516.5 2002 18903.64 22053.15 15.4% -3149.5 2003 21715.25 24649.95 14.9% -2934.7 2004 26396.47 28486.89 21.6% -2090.4 2005 31649.29 33930.28 19.9% -2281.0 2006 38760.20 40422.73 22.5% -1662.5 2007 51321.78 49781.35 32.4% 1540.4 2008 61330.35 62592.66 19.5% -1262.3 2009 68518.30 76299.93 11.7% -7781.6 2010 83101.51 89874.16 21.3% -6772.7

-30- 20

Individual income tax

Taxable income = income – pension deduction – medical insurance deduction – unemployment fee – housing accumulation fund

Tax = (Taxable income-3500) * tax rate – fixed deduction

Taxable income Tax rate Fixed deduction

1 0-4500 5 0

2 4500-7500 10 75

3 7500-12000 20 525

4 12000-38000 25 975

5 38000-58000 30 2725

6 58000-83000 35 5475

7 >83000 45 13475

-30- 21

Outstanding Debts of Central Government (100 million yuan)

YearTotal

Domestic

DebtsExternal

Debts

2005 32614.21 31848.59 765.52

2006 35015.28 34380.24 635.02

2007 52074.65 51467.39 607.26

2008 53271.54 52799.32 472.22

2009 60237.68 59736.95 500.73

2010 67548.11 66987.97 560.14

Local debts? It is reported that in 2010 local governments had 11 trillion debts. Shanghai by Jun 2013 had debts RMB 845 billion, including 519 direct debts, 52 debt guarantee, and 273 with some obligation to rescue.

-30- 22

In 2009, SOE made a profit of RMB 1339.22 billion, with an annual increase by 9.8 ％ .

Central SOEs made a profit of RMB 944.54 billion, with an increase by 10.3 ％ ; local SOEs made a profit of RMB 394.68 billion, with an increase of 8.4 ％

Since 1994 tax-assignment reform, SOEs were in general not required to submit profits to the government.

Now major SOEs only submit less than 10% of their profits to the state.

SOEs and their profits

-30- 23

China’s giant companies

In 2008, 35 Chinese (Mainland) companies got into Fortune 500, according to revenues.

These firms are many SOEs or stated controlled stock company.

These firms are mainly in oil, gas, banking, electricity, railway, airline industries.

Profits were concentrated to few super-large enterprises.

-30- 24

In 2011, Mainland China had 61 companies on the list

Three were among the top 10.

-30- 25

Are they making or losing money?

A report by Unirule Institute of Economics Between 2001 and 2008, compared to private companies,

SOEs were waived interests of RMB 2.85 trillion, land rents of RMB 3.09 trillion, resource rent of RMB 0.5 trillion, and got RMB 0.12 trillion subsidies from governments.

These lead to a cost saving of RMB 6.48 trillion. In the same period, SOEs made a profit of RMB 4.92

trillion.

-30- 26

Fiscal control and efficiency Adjustment of the revenue structures.

Extra-budgetary spending decreased from about half of the overall spending, to 32.6% in 1996, and 14.4 percent in 2003

Land sales revenues are still not incorporated into the budgetary system

Budgetary reforms Increase the engagement of NPC in making and monitoring the budget The growing role of the Auditing Office Centralize the budgetary function of MOF Harden the making and implementation of budgets

Strengthening the taxation system Modernize and enhance taxation institutions Increase the tax base but focus on taxation capacity Lower the taxation cost Cultivate the notion of tax-payer

-30- 27

Use of public money is still weakly monitored.

-30- 28

Spending management

Change of spending focus: from efficiency to justice and social equality Introduction of governmental procurement Introduction of program performance management Clear definition of spending responsibilities The emphasis on the equalization in basic public services

-30- 29

More active use of fiscal policies

Anti-crisis fiscal expansion policy

Since late 2008, the central government made a huge investment plan to stimulate domestic demands.

The total investment plan reaches RMB 4000 billion, and is to be administered up to the end of 2010.

Central government directly covers RMB 1180 billion, leaving the rest to the local governments.

Many investments are earmarked, for example, for educational projects, central and local governments will invest with a 2:1 ratio. For building of low-rent housing, central and local government offer subsidy of RMB 300 and 400 for every squared meter.

These investments suppose to create a big leverage/multiplier effect, although that may not be easy…(infrastructure, SOEs…)

-30- 30

Areas of investmentPlanned Expenditures(RMB billion)

Urban livelihoods projectssecurity-oriented housing like low-rent housing, renovation of old houses

4000

Rural livelihoods projectswater, electricity, road, gas, housing

3700

Infrastructurerailroad, highway, airport, irrigation, etc

15000

Public serviceseducation, health, culture, birth control, etc

1500

Energy preservation and anti-pollution 2100

Adjustment of industrial structure and technical upgrading 3700

Reconstruction of earthquake area in Sichuan 10000

Total 40000