China: reforming intergovernmental fiscal relations

Since 1979, the Chinese authorities have made a sustained effort at introducing market-oriented reforms and the results have been impressive in terms of growth and poverty reduction. However, reform of fiscal system has lagged behind. In particular, the system of intergovernmental fiscal relations has been unstable, non-transparent, and inequitable. As the economy moves toward greater market orientation, a rule-based system of intergovernmental fiscal relations will be essential. The paper reviews the theory and experience of multilevel fiscal systems in various countries and makes some suggestions for China. Its basic conclusion is that while recognizing the specificities of Chinese conditions, the Chinese authorities cannot but follow some basic principles of multilevel fiscal systems. Among these are the following. First, international experience in countries big and small, federal and unitary, indicates that the Central Government must have effective control over the most important sources of tax revenue, not only in termks of tax law and policy, but also in terms of administration, collection, and allocation of revenue. Second, taxes should not be looked upon mainly as providers of revenue; they must also be seen as tools of policy that, whether intended or not, affect the allocation of resources and their efficient utilization, interregional and interpersonal distribution, and the level of aggregate demand. Third, while for the sake of efficiency and equity most of the major taxes have to be collected centrally, a considerabled egree of decentralization is required on the expenditure side because closeness to the beneficiary helps efficiency. There is thus a need for designing a system for transfer of resources from the center to the localities, but it needs to be done in a way that is transparent and equitable and gives incentives to the localities to maximize their efforts for revenue mobilization. The paper details the practices followed by Japan, India, Canada and Germany as examples on which China can draw in designing its own system of intergovemmental fiscal relations.