The road to public finance reform

Four months ago, the Third Plenum of the 18th Central Committee of the Communist Party of China adopted the decisions on China's reforms in the new stage of its socio economic development. Such vision was endorsed by the National People's Congress earlier this month. I was impressed at the comprehensiveness and clarity of the envisaged reforms.

One of the key directions of the reforms is to assign a "decisive role "to the market in the allocation of resources. On this point, I would like to emphasize that a greater role of the market does not mean that the role of the government will be weakened. On the contrary, a well-functioning market relies on the capacity of the government to ensure social fairness, provide public services, enforce regulations, and address market failures including externalities.

For this reason, public finance reforms are particularly important to ensure that the government can fulfill its responsibilities effectively with adequate provision of financial resources. Given China's changing socioeconomic context, its public finance reforms have to take into consideration factors such as the country's transition to innovation-driven growth which will require more investments in human capital. Rapid aging of Chinese population with reducing share of working population in the total, demands strengthening of social safety nets. Financing these efforts will require adjustments in the tax system to enhance revenue. The tax revenue in China is only 22 percent of GDP as compared to 34 percent in OECD countries.

Under the overall theme of public finance reform, in this commentary, I therefore would like to focus on tax reforms, relationship between central and local governments, public-private partnerships and State-owned enterprise (SOE) reform.

Tax reforms should be guided by the following six principles: sufficiency, to ensure adequate revenues; equity, to ensure fair distribution of income and wealth; simplicity, to facilitate compliance and collection; neutrality, to avoid distortion to economic activities; incentives, to adjust externalities and promote needed actions; and forward-looking, to anticipate socioeconomic challenges such as demographic change and slower growth.

Based on these principles, four concrete reforms for taxation can be considered:

First, it is essential to increase tax revenue as a share of GDP. China could enhance its tax revenue by broadening the base of existing taxes, introducing new taxes, and enhancing tax compliance and enforcement.

Second, to promote equity, there is room in China to strengthen the contribution of progressive individual income tax. Today, individual income tax accounts for only 6 percent of total tax revenue of the central and local governments combined. The base of the individual income tax should be expanded beyond its current exclusive focus on wages. At the same time, taxing capital gains, property, inheritance, and gifts, will help make the taxation system more progressive.

Third, China can further broaden the base of the VAT. This would enhance the neutrality and simplicity of the tax system. It will also provide a reliable and fair source of revenue for financing the increasing cost of social welfare when the society is aging and workers' share of population is decreasing.

Fourth, the tax system should address China's growing environmental challenge. I note ongoing efforts to reform the resource tax by changing taxation on coal from volume-based to value-based. It is also necessary to broaden the coverage of the consumption tax to include goods associated with environmental damage.

Currently, local governments are responsible for 85 percent of total expenditure although its share in total revenues of the country is less than 50 percent. It is important to reconsider the assignment of expenditure responsibilities between the central and local governments so that they are not overburdened.

When local governments cannot close the financing gap by transfers from the central government, they have often turned to off-budget resources, accumulating debt. Local government debt has increased by 67 percent since 2010.

While the amount of total local government debt is still manageable at 30 percent of GDP, its rapid expansion is worrisome. Moreover, approximately 40 percent of it has been incurred by non-transparent local government financing vehicles, which emerged to circumvent the Budget Law's prohibition on local government borrowing. Such financing vehicles have proliferated since 2008 as two-thirds of the financing responsibility of the 4-trillion-yuan ($643 billion) stimulus package rested on local governments.

To address problems arising from local government financing vehicles, China should set in place appropriate monitoring and regulatory frameworks. It is also crucial to ensure sufficient revenues for local governments.

In order to provide more resources to the local governments to meet their needs, strengthening of local government-specific taxes would be a priority. In this regard, international experience suggests that taxes on natural resources and property are an appropriate choice.

Regarding the provision of social services such as education, health and pensions, in addition to possible expansion of the central government's role in the expenditure side, larger transfers from the central government to local governments could be considered.

Local governments need to be provided with more flexibility to borrow by introducing municipal bonds, a practice the government is already piloting in six cities. However, at the same time, there should be effective debt management and monitoring mechanisms to avoid inadvertent over borrowing by local governments.

In public finance reform, public-private partnerships (PPPs) could play a significant role.

The PPP model could help the local governments in China make the transition to becoming buyers of services on a competitive basis rather than suppliers. I would like to however cautioned against using PPP as a tool to transfer expenditure to less-transparent off budget spending. PPPs are not a panacea and they do bring risks and contingent fiscal costs on local governments. While PPP has the potential to enhance public service provision, there are numerous examples of failures in both advanced and developing economies. PPPs need to be designed and implemented carefully.

Reforming State-owned enterprises is critical to allow the market a greater role in the economy but it is also deeply related to the reform of public finance. In many developing countries, inefficient SOEs are the reasons for the loose fiscal expenditure to subsidize them and for the loss of potential revenue to the government. In this context, I note that the Third Plenum's decision to transferring an increased share of SOE's dividends to public spending such as education and health, and to the social security fund.

China needs to embark on implementing reforms earlier than later based on the clearly defined agenda. As the great ancient Chinese philosopher Lao Tzu said, it is important for China to do the difficult things while they are easy, and do the great things while they are small. Indeed, China's challenges will become even more difficult, if not addressed now.