Redesigning the Dragon Financial Reform in the Peoples Republic of China
Redesigning the Dragon Financial Reform in the Peoples Republic of China
Redesigning the Dragon
Financial Reform in the Peoples Republic of China
Duncan Marsh dmarsh@indiana.edu
Anna Pawul apawul@indiana.edu
Dmitri Maslitchenko dmitri@mailroom.com
V550, Government Finance in the Transitional Economies
21 November, 1996
In 1978, the People’s Republic of China (PRC) embarked on the
enormous undertaking of opening its doors to the outside world. Until this
point in time, the PRC had relied on a centralized economic system much
like that of the former Soviet Union[1]. However, the PRC’s situation
differed with the former Soviet Union in three substantial ways[2] 1)
although reforms followed the Cultural Revolution (which did exact its
toll on the Chinese economy) there was an absence of severe macroeconomic
crises when reforms were begun 2) agricultural infrastructure was good,
although the incentives were poor and 3) China had a strong presence of
overseas Chinese and Hong Kong that influence its economic development and
over the years supplied capital and human resources.
The industrialization strategy adopted by the PRC has been
characterized by gradualism and experimentation. Its focus has been to
introduce market forces, reduce mandatory planning, decentralize, and open
the economy to foreign investment and trade[3]. This strategy had three
main stages. The first (1979-1983) established four “Special Economic
Zones” (areas awarded special freedoms to conduct business relatively free
of the authorities intervention) in Guangdong and Fujian provinces, the
second (1984-1987) added 14 port cities creating the “Economic Development
Zones”, and finally the third stage (1988-present) which opened most of the
country to foreign trade and created “tariff free zones”[4]. In the rural
areas, land reforms spearheaded further reforms and also the establishment
of Township and Village Enterprises (TVEs). These enterprises were able to
capitalize on the abundant cheap labor in rural areas and to operate
without the burden of providing social spending. They also provided a
training ground for the learning of market skills and concepts. Today,
production of manufactured goods by rural and township enterprise is
estimated to account for more than 40% of the GDP.
In many respects, China’s process of economic reform has been highly
successful.
Since its inception, the average GDP growth has been a world-leading
9.3% year, the poverty rate has declined 60%, and 170 million Chinese
living in absolute poverty have seen their standard of living raised above
the minimum poverty level. Export growth was 7.8% in 1993, 29% in 1994 and
34.7% in 1995.[5] Government measures to control inflation, which had
threatened to overheat the economy in the early 1990s, seem to have taken
effect: inflation was under 15% in 1995. (See Tables 1 and 2.)
Table 1.
Source: EIU Country Report, China/Mongolia, 3rd Quarter 1996. The Economist
Intelligence Unit.
Table 2.
Source: EIU Country Report, China/Mongolia, 3rd Quarter 1996. The Economist
Intelligence Unit.
Chinese economic reform has one other characteristic that sets it
apart from that of the former Soviet Union, the absence of democratic
reforms. The current transition is being carried out within the “socialist
framework” and for the most part is centrally controlled. Much of the
world waited to see whether the economic transition would derail after the
Tiananmen incident in 1989; it did not. However China did seem to be
looking for a way of separating itself from reforms and democratic upheaval
that were happening in the former Soviet Union[6]. In 1992, Deng Xiao Ping
toured the southern economic zones - a journey significant for its highly
symbolic approval of the reform and investment efforts he witnessed - and
coined the phrase “socialist market economy”. Deng emphasized that this
transition must promote the development of productivity, strengthen the
national power and improve people’s standard of living, stating that,
“..with all these achievements secure, our socialist foundation is greatly
strengthened..”[7].
Within this backdrop, we will take a closer look at the system of
reforms currently underway in the People’s Republic of China. This year
marks the beginning of the Ninth Five-Year Plan (1996-2000). Examining the
individual parts (the budget process, public expenditure, taxes, banking,
the interaction between central and provincial governments, and the
emerging need to transform the social safety net) will present a clearer
picture of what has been accomplished by the macroeconomic reforms put in
place in 1976 as well as what still needs to be done.
Revenue, Expenditure and the Budget
One problem of major proportion facing the Chinese government is that
central government revenues are growing at a much slower rate than the
overall economy, and a growing budget deficit has resulted (see Table 3 in
Appendix, page 20).[8] This is especially debilitating in the face of
increasing demands from the surging economy for investment in
infrastructure and with the need for investment in a reformed social
insurance system that will come with economic disruptions caused by
continuing liberalization. Expenditures have also been falling as a
percentage of GDP, but are growing faster than revenue.
Several factors have been identified in the shrinking revenue-to-
expenditures ratio problem:
Revenue
Tax arrears on the industrial and commercial tax (CICT) from enterprises,
which are growing as state-owned enterprises (SOEs) become more
unprofitable in the face of increasing competition. At the end of 1994,
these arrears amounted to 8.2 billion yuan (Ґ), and just seven months
later, the figure had grown to Ґ17.9 bn.[9]
Tax exemptions granted by local governments to state-owned and private
enterprises.
Expenditures
Subsidies to the loss-making SOEs, in the form of loans or direct subsidies
(see Table 4). China’s 1995 budget deficit was around a mere 1.5% of GDP.
If policy lending by centrally controlled banks - most of which is,
effectively, transfers to SOEs which can never afford to pay back these
loans - is taken into account, the central government’s true deficit is 6%
of GDP or higher.[10]
Price subsidies. (Most of these were for urban food, and adjustments made
in 1992 have reduced this drain on the budget.)
Higher than expected increases in expenditures (in 1995, these were 18%
higher than planned on the central level, with local government
expenditures over 30% higher than in 1994.)[11]
A drop of 10.7% in customs revenue from 1994 to 1995.
Inflation-indexed interest subsidies on bank deposits and treasury bonds,
which have been kept high by high inflation rates.
Table 4.
Source: Wong, Christine P.W., Christopher Heady, and Wing T. Woo. Fiscal
Management and Economic Reform in the People’s Republic of China. Oxford
University Press. Hong Kong: 1995.
For a country controlled by a Communist party, the government’s
proportion of economic activity has been remarkably small, even before
implementation of reform. In 1995, official government spending was just
11.6% of GDP. Off-the-books revenue raising schemes by local governments
may mean the state’s total revenue is two times the official level.
The extra-budgetary revenue investment was dispersed, uncoordinated
and did not fulfill the central government’s investment priorities. The
central government faced growing infrastructure demands, but with shrinking
(in proportionate terms) assets available, has been forced to reduce
capital construction spending substantially. Also, expenditures on
administration, culture, education, and welfare increased over the reform
period, and reduced the government’s ability to spend on
infrastructure.[12] (See Table 5 in Appendix, page 22.) The increases in
administration spending are particularly troubling, because of government
policies to reduce control of the economy and shrink some government
bureaus.
One of the stated goals of the Ninth Five-Year Plan is to eliminate
the budget deficit by year 2000. But this goal is highly unlikely to be
achieved due to other conflicting goals, like spurring employment, which
may mean increasing subsidies to unprofitable SOEs; reducing regional
income disparities; and strengthening agriculture, which is seen as a key
to controlling inflation.
Christine Wong, an expert on the Chinese financial system, identifies
three necessary changes to restore the health of the budget: First, the
tax administration must be strengthened. Second, the tax structure must be
reformed so that it is neutral across products and sectors. Third, the
revenue-sharing system between local, provincial and national levels of
government must be revamped, with clearer tax assignments in line with each
levels set of responsibilities. The central government’s control over the
tax system and share of total revenues will likely have to be increased.
The next two sections will address these proposed changes.[13]
Taxation
The Pre-Reform Tax System
Prior to economic reforms, China’s tax structure was based on the
Soviet model. Enterprises remitted their profit to the government,
retaining only what was necessary to pay expenses. Revenues were collected
by local governments, and a certain amount was filtered up to the central
government. In 1984, this was replaced by a system of enterprise income
taxation reform, in which companies were taxed on their profits, as the
government tried to respond to economic imbalances created by the emerging
private sector. The turnover tax (the Consolidated Industrial and
Commercial Tax, or CICT), which had been the largest contributor to the
government’s annual revenue, was replaced with a business tax, a product
tax, and a value-added tax (VAT). These featured highly differentiated tax
rates across sectors, types of good and service, and form of firm
ownership. Most private firms paid a base tax rate of 33%, while most state-
owned enterprises (SOEs) were nominally taxed at 55%.[14] In practice,
however, taxes paid were governed by a contract responsibility system
(CRS), in which enterprises negotiated individually with local government
units. This system created conflict of interest because often the local
government was both tax collector and enterprise owner. Not only were
there differentiated rates which distort economic activity, there was
little incentive for full tax remittance back to the central government
under this system. (See Table 6 in Appendix, page 23, for a description of
the tax structure from 1985-1991.)
1994 Reforms
In 1994, the Chinese government began to respond to these problems by
enacting a series of reforms. The CICT was abolished and the following
taxes were created or modified:
Enterprise Income Tax. This unified corporation tax taxes companies at a
single 33% rate. Foreign enterprises and joint ventures are still enjoying
lighter tax burdens, because of the fierce competition between regions to
attract foreign investment, but these privileges are to be gradually
eliminated.
Personal Income Tax. Operates on a sliding scale, with a maximum of 45%.
Not yet comprehensively-implemented.
Value-Added Tax (VAT). Replaces the product tax of the CICT. Most goods
taxed at 17%, but agricultural and food products will be taxed at 13%, and
small-scale businesses will pay flat rate of 6%.
Consumption (Excise). Focuses narrowly on “luxury goods:” tobacco,
alcohol, gasoline, and a few others.
Business tax for services. Service industries will face a business tax of
3% to 20% on sales in place of the VAT. This tax also will apply to
transfer of intangible assets and the sale of real estate.[15]
Capital Gains. A capital gains tax was to be introduced in 1994, but its
implementation was postponed because of concern over its adverse impact on
China’s fledgling stock markets.
1996 Reforms
In 1996, China announced plans to reduce its import tariff rate from
35.9% to 23%, while abolishing preferences for certain goods and,
importantly, eliminating exemptions from import tariffs (currently, over
80% of imports are exempt from import duties for various reasons). [16]
This step alone should help to reduce the recent losses in customs revenue.
The Ninth Five-Year Plan also includes provisions to introduce taxes on
interest earnings and inheritances, policies designed to reduce income
disparity.
Revision of Tax Collection Structure
In order to make the above tax policy changes effective, the tax
collection system must be revamped and greatly improved. The current
structure is based on a system of revenue contracts between enterprise and
government unit, and between local and central governments. One of the
necessary reforms involves tax exemptions, which local governments often
have the authority to grant to enterprises who for one reason or another
are unable to pay their taxes. This is a fundamental weakness in the
Chinese fiscal system: local government has decision-making authority to
grant exemptions on a tax the proceeds of which may in large part be
assigned to governments above. Numerous conflicts of interest can appear
to reduce incentives to enforce the tax at the local level.[17]
To address these changes, China in 1994 initiated the setting up of a
centrally-managed National Tax Service. This would replace the contract
system with a national “tax system,” based on uniform rules of tax
assignment and tax sharing. Certain assignments will be assigned to local
governments, and others to central government; others will be shared
according to predetermined formulas. Interestingly, in 1995, a special
police unit was set up to protect tax collectors under this new
program.[18]
A potential obstacle to tax reform comes from local governments.
Local governments have traditionally supported reforms. But this is
because the reforms have usually given them greater autonomy. The tax
system reforms need to restore some control over investment and spending
back to the central government, which could encounter local opposition.
Allowing local governments some discretion over local tax rates can give
them some of the autonomy they desire, and provide greater incentive for
intergovernmental cooperation.
Few reports exist at present on the implementation of these reforms.
Certainly, the spirit and scope of the reforms has been well-received by
analysts, though more changes are advocated. But it will take several more
years to determine the success of the reform of tax collection structures
at the local level.
Intergovernmental Fiscal Relationships
A product of economic reforms in transitional economies is often a
shift in intergovernmental fiscal relationships. In the transition from
centralized economy to market economy it is often from a relationship where
the local or provincial government is the receiver of the “plan” to the
local or provincial government proceeds with a greater autonomy. The
evolution of this relationship in the PRC has been very similar. However,
the provincial or local governments were at an advantage over many other
transitional economies because the Chinese system had the following
characteristics 1)local implementation capacity was already established in
the rural areas 2)China in most areas has a high ethnic homogeneity and 3)
there was much to gain by inter-province trading[19]
The very nature of Chinese economic reforms, gradual and incremental,
allowed “scaffolding” of behavior. Partial reforms provided the environment
to learn behaviors that could then be applied to the next level of reform.
Chinese economic reform was also structured on the idea of
decentralization. The establishment of Special Economic Zones (SEZs)
encouraged the local areas to develop their own strategies to attract
business and allowed them the freedom to implement the strategies. The
very earliest reforms, breaking up of farm communes, were also carried out
at the local level.
Many of the SEZs are doing very well and people living in these areas
are enjoying a higher standard of living than they had previously enjoyed.
However, tax collection still remains a difficult endeavor with compliance
at only 70%. In order to improve the poorest areas in China, policies and
programs that are able to move this revenue to the poorer areas will be
needed. This can take the form of a better accounting system to ensure that
all taxes due the central government for infrastructure development
actually arrive there.
Banking Reforms, State Owned Enterprises and the Social Safety Net
In order to put current economic reforms in perspective, understand
the recommendations made by the international economic community, and fully
address the quagmire of State Owned Enterprises (SOEs), a more in depth
look at the interconnectedness of the SOEs and the banking system must be
taken. We will attempt to do just that using the context of bank
development in the PRC, monetary policy, and ongoing reforms to SOEs.
Reform of the banking system in the PRC has taken on similar
characteristics to reform in other areas: i.e., gradual and experimental.
At the beginning of reforms the financial sector in the PRC could hardly be
called a financial sector[20]. Financial sector development and
implementation is a complex undertaking which should include the
development of institutions, instruments and markets[21]. Currently in the
PRC, banking reform lags behind other areas of reform[22]. This is due to
a complex array of policy decisions. No discussion of banking reform in the
PRC would be complete without an examination of the current state of SOEs
restructuring. Many macroeconomic initiatives are being put on hold in
order to bolster a failing state sector and postpone the social upheavals
that may be associated with the needed reforms of this sector.
Background
The Central Bank was established in 1984. In 1987 two additional
universal banks were formed and non-bank financial institutions were
started. In 1988 new capital markets were formed and the secondary trade of
government bonds was allowed. In 1990 the Shanghai and Shenzhen stock
exchanges were opened. In 1992 all treasury bonds were issued through
underwriters[23]. At the end of 1994, the PRC had a total of 13 banks (of
which 3 were specialized banks and 3 were comprehensive banks). The new
“financial system” contained 20 insurance companies, 391 trust and
investment companies and greater than 60,000 credit cooperatives that
operate in local areas[24].
During the summer of 1995 the central government announced a series
of new banking laws would be established. These laws were the People’s Bank
of China Law, the Commercial Banking Law, the Negotiable Instruments Law
and the Guarantee Law. Up until this time the roles of each party in the
framework of financial transaction hadn’t been clearly defined. These
laws begin to lay the comprehensive groundwork for financial
transactions[25]. The People’s Bank of China Law which was established in
the summer of 1995 addresses the internal organization of the People’s Bank
of China, its monetary policy, its supervision and tries to establish its
autonomy from provincial and local governments (it is still under the
control of the State Council). This law has provisions in it for setting
the prime lending rate, rediscount window, amount of funds to be lent to
Страницы: 1, 2
|