Rebalancing and modernization: What to expect from China's new round of fiscal reforms

Central-local fiscal restructuring and taxation adjustments are on the horizon.

Finance is the foundation and a key pillar of state governance. The Chinese government has, on many occasions, pledged to deepen fiscal and tax system reforms to support the country's modernization agenda.

Of the 300-strong reform measures announced at the tone-setting Communist Party of China's plenary session in July, a significant portion focused on fiscal policies and taxation, which are going to redefine how fiscal resources are managed, distributed and utilized across the nation.

In this newsletter, Peking Ensight would like to unpack the scope and impact of the proposed adjustments, delve into some of the major policy changes, and explore the details as well as broader implications of these much-expected moves to understand how these reforms will shape China's economic future.

Fixing central-local fiscal imbalance

While China's fiscal institutional framework has been basically established through years of reform to meet development needs, some contradictions and issues remain to be solved.

One of the major but toughest fiscal challenges lies in rebalancing the relationship between central and local governments.

According to the July plenum, the Chinese leadership wants to foster a central-local fiscal relationship that "features well-defined powers and responsibilities and the appropriate allocation of resources, with an optimum balance between regions."

The notion aims directly at the thorny imbalance in China's fiscal architecture, which has been amplified in recent years as economic shifts, like adjustments in the property market and an aging population, added financial pressure on local governments.

The foundations for China's central-local fiscal structure were laid in 1994, when a tax-sharing system was introduced to determine the delineation of administrative and fiscal powers as well as tax revenue distribution between central and local authorities.

The system, despite providing a forceful underpinning to China's economic and social developments over the past decades, spawned growing burdens on local governments as they often needed to spend much more than they collected.

According to Gao Peiyong, an economist with the Chinese Academy of Social Sciences, local governments in China nowadays shoulder as high as 85 percent of the country's fiscal spending responsibility, but their revenue only accounts for over half of the national total. More than 40 percent of the local spending is covered by transfer payments from central finance.

Such a high amount of transfer payments has led to unstable fiscal resources for local governments, thus reducing spending efficiency and local revenue, Gao wrote in a research article.

The central-local imbalance in expenditure, according to Lou Jiwei, China's former finance minister, "mainly arises from the unreasonable division of responsibilities."

In mature market economies, he said, central expenditure often accounts for over 50 percent of the total, and for countries of the Organisation for Economic Cooperation and Development (OECD), the average portion stood at 61 percent.

Today, China's central fiscal responsibilities mostly focus on areas like national defense, foreign affairs and strategic reserves, while for basic public services, such as social security and education, the primary spending responsibility still lies with local governments.

"Driven by local interests, allocating responsibilities relevant to a unified national market to local governments often results in lax management," Lou said in a public speech in July.

"While some would suggest allocating more financial resources to the local level...the new round of fiscal and tax system reforms should address long-term structural issues and overall mechanism problems," he said.

Fully aware of the imbalance, Chinese policymakers, in their latest reform pledge, said they plan to "let the central government hold more fiscal powers as appropriate and raise the proportion of central government expenditure accordingly."

For transfer payments, China said it would overhaul special transfer payments and increase the scale of general transfer payments, therefore helping ensure that the fiscal resources of prefecture- and county-level governments are commensurate with their powers.

Han Wenxiu, executive deputy director of China's Office of the Central Committee for Financial and Economic Affairs, has noted the need to "enhance the central government's ability to coordinate, direct and manage economic and social development" in the fiscal and taxation reform.

Meanwhile, local governments should enjoy more fiscal autonomy, so that they could pursue high-quality economic and social development tailored to local conditions, he wrote in an article explaining the fiscal reform.

Increasing local government revenue

Notable changes are also expected in taxation as Chinese authorities strive to improve local governments' balance sheets.

More fiscal resources shall be placed at the disposal of local governments, according to the July plenum, which also promised to expand sources of tax revenue at the local level, grant greater authority for tax management to local governments as appropriate, and optimize the ratio for taxes shared between the central and local governments.

For instance, the meeting said China would consider rolling several surcharges into one local surtax, allowing local governments to set the rate for this tax within a predetermined range.

Another highly-anticipated adjustment is about excise tax collection, which would be moved down the production-to-consumption chain, and the power of collection would be passed steadily to local governments, according to the reform package.

"This will be done with careful consideration of factors like central-local revenue distribution as well as tax collection and management capabilities, and will be implemented in stages and by category," Vice Minister of Finance Wang Dongwei told a press conference in July.

Excise tax, or consumption tax, is among China's four largest sources of tax revenue. In 2023, China collected over 1.6 trillion yuan (228 billion U.S. dollars) of excise tax, accounting for about 8.9 percent of the total annual tax revenue.

Currently, only 15 items are subject to excise tax, the bulk of which comes from tobacco, alcohol, oil products and automobiles. It is collected from producers, and most of the revenue goes to the central government.

Besides allowing local collection, experts also expect more high-end products and services, like luxury goods and cruise trips, would be added to the taxable items, further contributing to local revenue.

Furthermore, a research note by Galaxy Securities in June pointed out that moving excise tax collection down the production-to-consumption chain, which means collecting from wholesalers or retailers rather than producers, would push local governments to pay more attention to boosting consumption, a priority in the country's macroeconomic regulation.

In the past, it noted, local taxes in China were largely collected by governments in the regions where goods were produced. While this helped accelerate manufacturing development, it also led local authorities to prioritize production over consumption.

The excise tax reform could help tilt the focus toward consumption, and encourage local governments to invest more in consumer infrastructure and boost household consumption, thus creating a positive cycle of investment and consumption, said Galaxy Securities.

Facilitating modernization goals

Beyond tackling immediate challenges, the upcoming fiscal reform is also setting its sights on broader, long-term objectives.

Luo Zhiheng, chief economist of Yuekai Securities, said the reform's mid-to-long-term goal is to modernize the fiscal system, thereby supporting the modernization of national governance. 

More importantly, it aims to serve major national strategies like advancing Chinese modernization, promoting high-quality development, building a unified national market, and achieving common prosperity, Luo told a forum in June this year.

Han Wenxiu, in his article, said China will look into approaches that would better adapt the taxation systems to new forms of businesses, and support and regulate China's digital and green development.

To fuel green and low-carbon development, China will move to replace water resource fees with taxes, reform the environmental protection tax, and improve relevant policy frameworks of value-added tax, excise tax and corporate income tax, he said.

The existing fiscal and tax system faces new challenges from China's rapidly developing digital economy, according to Luo. How should the value generated by data be taxed? How should the tax sources and bases be determined? More issues await.

Jia Kang, chief of the China Academy of New Supply-side Economics, also noted that direct tax reform, with improving the individual income tax as a priority for the next period, will be a crucial task in China's pursuit of common prosperity.

China will regulate taxation policies on incomes generated from business operations, capital, and property, and unify tax rates for incomes earned through work, according to the resolution adopted at the July meeting.

Jia said non-wage income could be included in the "comprehensive income," which is subject to individual income taxation, in the next round of individual income reform.

According to Luo Zhiheng, pending issues also include clarifying the boundary between the government and the market, and building a local tax system.

"The core of fiscal difficulties lies in the relationship between limited financial resources and unlimited responsibilities on expenditure," he said.

Han's explanatory article has, likewise, stressed the importance of properly handling the relationship between the government and the market, an imperative part of China's push to build a high-standard socialist market economy.

Tax reform, Han said, should avoid excessive tax burdens that could deplete fiscal resources, while also preventing excessively low taxation that could weaken government regulation and public service provision.

The goal is to "maintain an appropriate fiscal capacity as well as government revenue and expenditure scale, ensuring that fiscal and economic development remains on a positive and sustainable trajectory," he wrote.