Chapter 2: Finance, Taxation and Government Action

To understand government actions, must understand finance & taxation, because everything costs money. But you also have to understand the government's intent, look at flows and amounts, not just read documents.
The reality is that local governments have a very large disconnect between revenues and expenditures. In recent years local govt expenditures are about 85% of total expenditures but only 50-55% of revenues. The gap has to be filled by the central government. Below we see the local % of revenue in dotted lines (~50%) and % of expenditures in black (~85%).

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Tax Reform

Lots of reforms, but we'll begin with 1985. From 1985-93, as in chart above, revenues and expenditures were largely in line with each other. But it also created a lot of problems.
The 80s were characterized by the collective contracting 承包 reforms, and this extended to the tax system. Specifics differed wildly but one characteristic example is Beijing in 1988: sets 1987 as base, and adds a 4% set increase. Revenues above 4% are exclusively Beijing's, below that it is divided 50/50 between Beijing and central government. Guangdong's was even more favorable to the local government, just 13% of revenues in 1988, but Shanghai's was 65%.
But central government share of taxes grew lower and lower as % of total (dotted line) mainly because local economies grew so fast ...
but the national budget as % of GDP (black line) dropped as well, because local governments were not incentivized to increase their budgets, since they renegotiated with the central government every few years and the better they did, the more they'd had to give up. Thus they tended to help companies evade taxes. A bankrupt (or poor) central government is not helpful nor desirable.

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1994 tax reform divided taxes into 3 types: central (such as customs), local (such as business taxes), and shared taxes (such as VAT). Two systems — national tax and local tax authorities, separated from local finance department, and provincial level and below tax authorities are vertically managed. This is to decrease local government influence over tax collection and ensure central government gets their share, but the con is also very obvious — two sets of personnel is very expensive. So in 2018, this was merged together again.
- Before reform, VAT was local and 1/4 of total national revenue, after reform, it became 75% central, 25% local. Central put in some refunds to slow the decrease in funding. (Black line is VAT and dotted is business taxes.)
It was very difficult to convince provinces to go along with reform. Premier Zhu had to go personally. This is difficult to understand for the youth of today, but that's because the central government was a lot weaker in those days. Also, the provinces would try to play with the numbers each time a reform was put in.
Business taxes are the second largest category and accounted for 23% of revenue in 2018. Before reforms of 2002, local enterprises paid taxes to local governments, central enterprises to central. This led to a lot of protectionism in the provinces. After 2002 this was changed to 60/40 in favor of central (except for central SOEs who still pay to central).
Nowadays, central govt has about 55% share of total national budget (up from 22%), and as % of GDP it is about 20% (vs 11% before).

Land Finance

Because business tax post-reform was collected by the government where the business was established, local governments were hugely incentivized to get businesses to come.
Since a lot of taxes are collected during manufacturing, local governments emphasized this versus consumption. They also didn't care where the consumers are, just where the manufacturing was. This led to overcapacity. During 2007-2014, about half of taxes came from industries with overcapacity.
90% of taxes came from businesses, but also most other things like land use rights transfers and income from state-owned capital operations were also from businesses. So local governments spent most of time recruiting businesses vs. spending money on citizens. But central shifted strategy in 2002. However, since local expenditures suffer from economies of scale & complex information problem, it went up to 85% of total expenditures (see first graph).
Local government revenue decreased over the years —
- Shifted from economic expenditures 40% vs social 26% in the 90s to 40% for social expenditures in 2018
- In addition, a lot of fees, sponsorships, etc. that were collected from businesses were removed
- In the reform of 2001 (as mentioned above), central government now takes 60% of the tax revenue
- Thus, local governments had to come up with this "land finance"