Public Finance Reforms Crucial for Sustainable Growth in People's Republic of China

News Release | 23 March 2014

BEIJING, PEOPLE’S REPUBLIC OF CHINA – Reforming public finance is essential to the sustainable and inclusive development of the People’s Republic of China (PRC), Asian Development Bank (ADB) President Takehiko Nakao highlighted today at the China Development Forum, a two-day annual event on the country’s economic development.

Commending the comprehensiveness and clarity of the reform plan as adopted at the Third Plenum of the 18th Communist Party of China Central Committee last November, Mr. Nakao pointed out that the decision to give the market a decisive role in resource allocation will not mean a smaller role for the government. 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.

“The PRC needs to proceed with public finance reforms for its sustainable and inclusive development,” said Mr. Nakao. “Transition to higher income status through innovation-driven growth requires more investment in human capital. Rapid population aging, rural-urban integration and remaining poverty require the increase of expenditures to strengthen social safety nets. To finance these increasing expenditures, the tax system should be reformed.”

Mr. Nakao noted that the tax revenue in the PRC is only 22% of GDP as compared to 34% in OECD countries, and recommended six principles for tax reforms: (i) sufficiency, to ensure adequate revenues; (ii) equity, to ensure fair distribution of income and wealth; (iii) simplicity, to facilitate compliance and collection; (iv) neutrality, to avoid distortion to economic activities; (v) incentives, to adjust externalities and promote needed action; and (vi) be forward-looking, to anticipate socioeconomic challenges such as demographic change and slower growth.

Mr. Nakao also highlighted the need to address challenges related to local government finance. Local governments are now responsible for 85% of total expenditure but their share of total revenues is less than 50%. It is important to reconsider the assignment of expenditure responsibilities between the central and local government so that they are not overburdened. He discussed some ideas to increase local government revenues: the enhancement of local government-specific taxes such as taxes on natural resources and property; provision of larger transfers from the central government; and introduction of municipal bonds to give local governments more flexibility to borrow.

The public-private partnerships (PPP) model could help the local governments in the PRC make the transition to becoming buyers of services on a competitive basis rather than suppliers, Mr. Nakao said. However, he cautioned against using PPPs 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 PPPs have 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 (SOEs) is critical to allow the market a greater role in the economy but it is also deeply related to the reform of public finance, Mr. Nakao noted. In many developing countries, inefficient SOEs are the reasons for the loose fiscal expenditure to subsidize them and for the loss of potential revenues to the government. Mr. Nakao took note of the Third Plenum’s decision to transfer an increased share of SOE’s dividends to public spending such as education and health, and to the social security fund.

In concluding his address, Mr. Nakao reiterated the importance of starting the implementation of the reforms as soon as possible. He also promised ADB’s continued willingness to provide strong support to the government in its endeavors.