The System of Equalization Transfers in China

In 1994 in its push toward the establishment of a market economy, China introduced a fundamental reform of its tax and intergovernmental fiscal relations systems, which became known as the "tax-sharing system" or TSS reform. The fundamental goal of the TSS reform was to improve the behavior of the "two ratios" ----the central government share in total revenues of the public sector, and the share of public revenue in GDP. After more hesitation, the 1994 TSS reform has been successful in achieving those goals. All in all, the TSS can also be credited with facilitating the rapid rate of economic growth the Chinese economy has experienced over the last decade. However, not all the consequences of rapid growth have been positive ones. One of the consequences of the rapid growth of the economy has been i ncreasing regional fiscal disparities, especially between the coastal provinces and the inland provinces. How to achieve a better balance in the territorial distribution of fiscal resources has become a first policy priority for the Chinese government. The 1994 TSS reform concentrated in reforming China's tax sharing system, but it also introduced an equalization transfer system. The focus of this paper is to describe the many components of the equalization system and analyze its strengths and weaknesses. We ask several fundamental questions: Is the current system of equalization transfer adequate for reducing current horizontal fiscal disparities? Does the system yield the correct incentives for revenue mobilization and expenditure efficiency of sub-national governments ? Even if the equalization system worked adequately across provinces, what is to be done by the central government to ensure equalization at the sub-provincial level? The paper is organized as follows. The first section reviews the current framework for tax sharing. Revenue sharing, after all, is nothing else than a particular form of transfers in practically every country, but in China the links between the tax sharing system and the system of transfers is particularly strong. Section two of the paper describes the current system of equalization transfers. Section three assesses the current system of transfers in light of first principles and international best practices. Section four offers several conclusions and recommendations.