Fiscal reforms adapt to China's condition

It is a welcome step that [People's Republic of] China's new leaders have stated their intention to focus on not just the trajectory but the quality, efficiency and sustainability of economic growth. This is a perspective which will not only help rebalance sources of growth in the economy, but also reduce the gap between high and low-income groups.

Three major areas of reform form the backbone of this plan: financial market reform to liberalize interest rates and accelerate bond market development; fiscal reform to support economic rebalancing and narrow the income gap; and greater deregulation to foster private sector participation in the economy.

These are welcome initiatives, but failure to simultaneously overhaul taxation and fiscal transfers in order to balance income distribution could pose a major risk to the sustainability of the country's growth.

China's fiscal revenues are still relatively low compared to OECD countries, making it difficult to allocate adequate public resources to social development.

This has been particularly noticeable in the limited funding devoted to basic social services, where only about 35 percent of government revenue is spent on social security, education and healthcare, compared with an average of 52 percent in other middle-income countries.

The introduction of measures like a property tax on luxury housing in Shanghai and Chongqing is a step in the right direction, but the ultimate goal must be a genuine property tax based on home values and universally imposed on all urban homes.

Introducing a value-added tax (VAT) on services in selected cities and sub-sectors has also proved highly successful, but should be expanded beyond the current 12 cities and municipalities.

To ensure the fiscal system supports inclusive growth and the rebalancing of the economy, China's tax base must be broadened.

Recent reforms have reduced the number of personal income taxpayers to less than 3 percent of the population. Tax evasion is high, and collection and enforcement are low.

More importantly, the narrow base leaves policymakers with no powerful income distribution tool.

Last year, the share of personal income tax in China's total fiscal revenues was less than 6 percent, far below the OECD average of 24 percent. This income tax base can be broadened through measures to curtail tax evasion, reduce the informal sector in the economy, and strengthen tax administration.

The progressivity of taxation should also be increased. VAT is China's single largest source of tax revenue, but direct taxation is more effective in adjusting income differences, and therefore more equitable. Indirect taxation is more effective in raising revenue, but highly regressive. Taxing capital gains and property, and introducing inheritance and gift taxes would also help balance income distribution.

Revenues from improved tax collection should be earmarked for higher spending on social services. International experience indicates that increased public spending on healthcare directly increases private consumption, which, in turn, supports government efforts to rebalance the sources of growth in the economy.

Similarly, increased spending on education and pensions will reduce life cycle savings, free up household resources for consumption, increase living standards, and help balance income distribution.

As revenue increases, China's authorities could gradually increase public spending on education and health — which currently amounts to 5.6 percent of GDP — to levels closer to OECD averages at about 12.5 percent of GDP.

Finally, it is essential to overhaul the tax revenue sharing system between central and local governments. Increasing existing transfers from the central government and the share of VAT revenue accruing to local governments would help ensure adequate provision of social services at local levels. Without such reforms, large disparities in public social spending per person will emerge, perpetuating inequality.

The Asian Development Bank has worked closely with governments across the Asia-Pacific region on key reforms. As a partner in China's development, we are pleased to offer our support for further reforms with a view to achieving our shared goal of inclusive, sustainable growth and a better standard of living for all.