Reforming Public Finance to Sustain Inclusive Growth

Speech by ADB President Takehiko Nakao At the China Development Forum 2014, "China: To Comprehensively Deepen Reform", Session III: Reform of Financial and Taxation System and Transformation of Growth Model on 23 March 2014 in Beijing, PRC

(as drafted)

Your Excellencies, distinguished participants and fellow presenters, ladies and gentlemen. I am honored to participate in the China Development Forum.

I. Introduction

I welcome the opportunity to discuss policy developments at a critical moment in the economic transformation of China. I acknowledge the importance of the successful Third Plenum last November and its Decisions. The Decisions were endorsed by the National People’s Congress (NPC) this month.

Since the introduction of reform and opening-up in 1978, effective economic policies have sustained growth in China at an unprecedented pace. However, rapid double-digit growth cannot continue forever. As the economy matures, the advantages of technological catching-up and labor surpluses in rural areas diminish. Rapid growth also comes at a cost. The excessive reliance on investment, exports, and industrial development has created structural constraints and social and environmental issues that require a new model of growth.

The Decisions adopted at the Third Plenum clearly recognize these challenges. By emphasizing a shift from the quantity to the quality of growth, the Decisions capture the government’s strategic vision to build a “moderately prosperous society” by 2020.

I am impressed by the comprehensiveness and clarity of the Decisions regarding reforms. They bode well for China that the country’s leadership has committed to improve modern market systems, accelerate the transformation of government functions, deepen public finance reform, develop mechanisms for closing the urban-rural divide, liberalize the financial sector, and protect the environment.

The leadership pledged to assign a “decisive role to the market” in the allocation of resources. China’s new vision will unleash the dynamism of the private sector to facilitate the country’s transition to higher income status. Indeed, the NPC has already endorsed non-state capital to take part in areas that were previously occupied by the public sector, such as banking, electricity, railway, telecommunications, resource development and public utilities.

I would like to emphasize that the greater role of the market will not weaken the role of 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 including externalities.

The task ahead is challenging. It is easy to talk about the need for structural reforms but it is more difficult to carry them out. In that regard, I am pleased that, in a TV interview earlier this year, President Xi Jinping remarked that “Reform is 10% design and 90% implementation.” The Decisions already incorporated an institutional framework for implementing the reforms and established the Small Group for Comprehensive Deepening of Reforms. This framework has been emulated at provincial level and many of the ministers are engaged in top-level initiative to implement reforms. More recently, Premier Li Keqiang outlined solid steps to start implementing the reforms in the Government Work report presented to the NPC.

Today, I will focus on the importance of reforming public finance for the sustainable and inclusive development of China. More specifically, I would like to speak about taxation, local government finance, public-private partnerships, and reform of state-owned enterprises.

II. Public Finance Reform

First, about reform of government functions in general, and reform of public finance, including taxation.

The Decisions highlight the importance of reforming government functions to support a greater role for the market. The role of the government as a provider of good public service and promoter of a market-friendly environment will become increasingly important.

The Decisions call for increasing social expenditure to address the growing needs of a maturing economy. Transition to higher income status through innovation-driven growth requires more investment in human capital. As the NPC noted, rapid population aging, rural-urban integration and remaining poverty require the increase of expenditures to strengthen social safety nets, including the provision of universal health care and pensions.

To finance these increasing expenditures, the tax system should be reformed. China has already undergone significant tax reform, and is currently piloting important initiatives, such as the expansion of the value-added tax (VAT) into the services sector, and the introduction of property taxation in local governments.

However, more is needed. I would like to suggest that tax reform be guided by the following six principles:

(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 actions; and
(vi) Forward-looking, to anticipate socioeconomic challenges such as demographic change and slower growth.

Based on these principles, I want to propose four concrete reforms for taxation while I acknowledge that the Government is already aiming at these reforms.

First, it is essential to increase tax revenue as a share of GDP. At 22% of GDP, fiscal revenue in China is still relatively low compared to an average of 34% in OECD countries. 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% 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 would also provide a reliable and fair source of revenue for financing the increasing cost of social welfare when society is aging and the workers’ share of population is decreasing. It is worth noting that the NPC has endorsed the Government’s plans to extend VAT to the railway, post and telecom services.

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, such as petrochemical products. This could serve as a precursor to the future adoption of an emissions tax.

III. Local Government Finance

To address China’s public finance issues in totality, local government finance deserves special attention.

At present, local governments are responsible for 85% of total expenditure although their share of the country’s total revenues is less than 50%. When local governments cannot close the financing gap by transfers from the central government, they have often turned to off-budget resources, thereby accumulating debt. Local government debt has increased by 67% since 2010.

While the amount of total local government debt is still manageable at 30% of GDP, its rapid expansion is worrisome. Moreover, approximately 40% of this debt has been incurred by non-transparent local government financing vehicles (LGFVs), 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 for the CNY 4 trillion 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. But what is more important is to reconsider the assignment of expenditure responsibilities between the central and local governments so that the latter are not over-burdened. It is also crucial to ensure sufficient revenues for local governments.

There are several ways to increase fiscal revenue at the local level.

First, strengthening 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. I am glad to see that the potential of these taxes is discussed in the Decisions.

Second, regarding the provision of social services such as education, health and pensions, the central government should play greater role in these expenditures. In addition, larger transfers from the central government to local governments could be considered.

Third, 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.

Separately, reforms should also contemplate developing more effective inter-provincial compensation mechanisms from richer to poorer provinces. This mechanism, however, has to be carefully designed to avoid moral hazard or inappropriate incentives that result in overspending at the local level.

IV. Public-Private Partnerships (PPP)

In connection with public finance reform, I would like to touch upon the role of public-private partnerships (PPPs).

A PPP is a long-term contract between a public sector agency and a private partner to provide public services. China has solid experience with over 1,000 PPPs in place since the early 1990s. They have invested CNY 9 trillion on transport, energy and water management. Recently, use of PPPs has been encouraged in the delivery of municipal services.

PPPs leverage private sector resources and can reduce the cost to government of delivering public services. PPPs have the potential to enhance the efficiency of public service provision. PPPs may improve the preparation, procurement, and implementation of public projects. The PPP model could help local governments in China make the transition to becoming buyers of services on a competitive basis rather than suppliers.

However, PPPs do bring risks and contingent fiscal costs on local governments. When a government provides a revenue stream to a private partner under a PPP, it forgoes that revenue. In addition, PPPs usually entail contingent liabilities in the form of implicit or explicit government guarantees. There are numerous examples of failures in adopting PPPs in both advanced and developing economies. Problems are caused by mismatches between technical specifications and commercial viability, poor risk allocation, and inadequate project preparation, among other factors.

Hence, let me emphasize that PPPs are not a panacea. They should be designed and implemented well. They should not be used as a tool to transfer expenditure to less transparent off-budget funding. Essentially, they need to be viewed as a way of improving the efficiency of public service delivery.

V. State-owned Enterprises Reform

Reforming state-owned enterprises (SOEs) is critical to allow the market a greater role in the economy and eliminate market distortions. But it is also deeply related to the reform of public finance. In many developing countries, inefficient SOEs were reasons for the loose fiscal expenditure to subsidize them and for the loss of potential revenues to the government.

The Third Plenum recognized the important role played by SOEs in China’s modernization process, and the 2014 Government Work Report pledges to further deepen SOE reforms.

As public ownership remains a pillar of the Chinese economic model, the challenge is how to increase the efficiency of the SOEs.

The private sector in China already produces 60% of GDP and creates 80% of the new jobs. Yet, SOEs dominate key sectors in the economy, crowd-out private investment, and get a dominant share of financial resources as major banks remain state-owned.

One option for reform would be to further separate management from ownership in SOEs. This model has proven successful in some countries. SOEs could be corporatized, and managerial teams selected strictly on merits and evaluated on performance.

More importantly, the private sector should be allowed to compete with SOEs on an equal basis. This is particularly relevant in terms of access to finance. While China has achieved significant progress in financial sector liberalization, financial resources remain biased toward large SOEs. Limited access to finance by small- and medium-sized enterprises has resulted in the rapid proliferation of shadow banking, another source of concern for the Chinese economy.

Reforming SOEs is also vital to increase fiscal revenue. For example, the Decisions mentioned transferring an increasing share of SOEs' dividends to public spending such as education and health, and to the social security fund. More generally, stronger and reformed SOEs will pay more tax.

VI. Conclusion

In closing my address, I am pleased to mention that the Asian Development Bank is a long-standing partner of China. Since 1986, ADB has provided China with $30 billion in loans and $426 million in technical assistant grants in various sectors. We are proud to be supporting ongoing government initiatives to develop a public finance strategy. Moreover, we are assisting the National Development and Reform Commission in the preparation of the 13th Five-Year Development Plan, which will start in 2016 and implement longer term structural reforms.

While numerous challenges await China, China can enjoy an important comparative advantage, which is the opportunity to benefit from both successful and failed international experiences. ADB can help China to learn important lessons from reforms in other countries.

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 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.

Thank you.