Speech by ADB Vice-President Stephen P. Groff on 24 March 2013 at the China Development Forum 2013, Session III: Promoting the Reform on Fiscal Taxation Systems to Allow for Inclusive Growth.
Your Excellencies, distinguished participants and fellow presenters, ladies and gentlemen; it is an honor for me to participate in this prestigious Forum.
The China Development Forum convenes this year against the backdrop of a once-in-a-decade leadership transition.
China's new leaders have indicated their intention to focus on the quality, efficiency and sustainability of economic growth. This is a welcome approach. Not only will it help to rebalance the sources of growth in the economy, it will also reduce the gap between high and low income groups. The leaders have announced that efforts to restructure the economy will evolve around three major areas of reform:
First, financial market reform to liberalize interest rates and accelerate bond market development;
Second, fiscal reform to support economic rebalancing and narrow the income gap;
And third, greater deregulation to foster private sector participation in the economy.
I am delighted to have the opportunity to share my views on key policy-making challenges in China.
Key Policy Challenges
I would like to focus today on the role that fiscal policy can play in supporting inclusive growth, balancing income distribution and improving living standards – particularly here in China, the world's second largest economy. In my view, failure to overhaul taxation and fiscal transfers to balance income distribution could pose a major risk to the sustainability of the country's growth.
International experience shows that fiscal policy is instrumental in reducing income inequality. In the OECD countries, for example, a broad tax base, progressive taxation and increased government transfers reduced inequality by one third between 1985 and 2005.
China's reform agenda, set out in the Twelfth Five-Year Plan, also acknowledges the importance of fiscal policy. China has undergone significant fiscal reforms in recent years that have helped to build a solid fiscal position. Fiscal revenues have increased from less than 10% of GDP, in the mid nineties, to 20% of GDP today.
However, greater efforts are needed to address major constraints. 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.
While social spending has increased rapidly in recent years, it too remains relatively low. About 35% of government revenue is spent on social security, education and healthcare, compared with an average of 52% in other middle-income countries. Moreover, recent reforms have focused on expanding the coverage of benefits rather than restructuring the benefits themselves.
The government is piloting some important initiatives, such as the introduction of a property tax on luxury housing in Shanghai and Chongqing. These taxes are 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. The pilot program to introduce a value-added tax, or VAT, on services in selected cities and sub-sectors has proved highly successful, but the scope of the pilot is restricted to 12 cities and municipalities.
More broadly, reforms are needed to ensure that the fiscal system will support inclusive growth and the rebalancing of the economy. This is a complex task, requiring comprehensive and mutually supportive policy actions. Let me touch on four initiatives that I believe could move the country further toward these goals.
First, the tax base should be broadened. Recent reforms have reduced the number of personal income tax payers to less than 3% of the population. Tax evasion is high, and collection and enforcement are low. More importantly, the narrow base leaves policy-makers with no powerful income distribution tool. Last year, the share of personal income tax in China's total fiscal revenues reached less than 6%, far below the OECD average of 24%. The income tax base can be broadened through measures to curtail tax evasion, reduce the informal sector in the economy, and strengthen tax administration.
Second, the progressivity of taxation should be increased. Currently the VAT is China's single largest source of tax revenue. 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 to balance income distribution.
Third, social expenditure should be increased. Improved tax collection would allow for higher social expenditure. International experience indicates that increased public spending on health care 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 to balance income distribution.
The authorities in China could consider gradually increasing fiscal spending on education and health, which combined amounts to 5.6% of GDP, to levels closer to OECD averages at about 12.5% of GDP.
Fourth, it is essential to overhaul the tax revenue sharing system between the central and local governments. Universal coverage and equal access to social benefits in urban and rural areas requires increased budget support, and reform of the income distribution and equalizing mechanisms in the central government's transfers to poorer provinces. One approach would be to increase existing transfers of fiscal resources from the central government and the share of the value added tax revenue accruing to local governments to ensure sufficient funds for an adequate provision of social services at the local level. Without such reforms, large disparities in public social spending per person will emerge, and perpetuate inequality.
As fiscal reforms are implemented, how can China ensure fiscal sustainability? Improved tax collection, further liberalization of energy and resource prices, introduction of environmental taxes, and the transfer of state-owned enterprises' dividends into social expenditure would allow increased social spending without straining public finances.
Ladies and gentlemen, fiscal reform is a complex undertaking, but the benefits are clear. Through tax reform and increased spending on health, education, and pensions, the government can reduce pressure on low-income household budgets. The reforms will encourage households to consume, providing the country with social stability and the economy with an important buffer against external shocks.
ADB has worked closely with governments across Asia and the Pacific on key reforms. As 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.