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Redesigning the Dragon Financial Reform in the Peoples Republic of China

Redesigning the Dragon Financial Reform in the Peoples Republic of China

Redesigning the Dragon

Financial Reform in the Peoples Republic of China

Duncan Marsh dmarsh@indiana.edu

Anna Pawul apawul@indiana.edu

Dmitri Maslitchenko dmitri@mailroom.com

V550, Government Finance in the Transitional Economies

21 November, 1996

In 1978, the People’s Republic of China (PRC) embarked on the

enormous undertaking of opening its doors to the outside world. Until this

point in time, the PRC had relied on a centralized economic system much

like that of the former Soviet Union[1]. However, the PRC’s situation

differed with the former Soviet Union in three substantial ways[2] 1)

although reforms followed the Cultural Revolution (which did exact its

toll on the Chinese economy) there was an absence of severe macroeconomic

crises when reforms were begun 2) agricultural infrastructure was good,

although the incentives were poor and 3) China had a strong presence of

overseas Chinese and Hong Kong that influence its economic development and

over the years supplied capital and human resources.

The industrialization strategy adopted by the PRC has been

characterized by gradualism and experimentation. Its focus has been to

introduce market forces, reduce mandatory planning, decentralize, and open

the economy to foreign investment and trade[3]. This strategy had three

main stages. The first (1979-1983) established four “Special Economic

Zones” (areas awarded special freedoms to conduct business relatively free

of the authorities intervention) in Guangdong and Fujian provinces, the

second (1984-1987) added 14 port cities creating the “Economic Development

Zones”, and finally the third stage (1988-present) which opened most of the

country to foreign trade and created “tariff free zones”[4]. In the rural

areas, land reforms spearheaded further reforms and also the establishment

of Township and Village Enterprises (TVEs). These enterprises were able to

capitalize on the abundant cheap labor in rural areas and to operate

without the burden of providing social spending. They also provided a

training ground for the learning of market skills and concepts. Today,

production of manufactured goods by rural and township enterprise is

estimated to account for more than 40% of the GDP.

In many respects, China’s process of economic reform has been highly


Since its inception, the average GDP growth has been a world-leading

9.3% year, the poverty rate has declined 60%, and 170 million Chinese

living in absolute poverty have seen their standard of living raised above

the minimum poverty level. Export growth was 7.8% in 1993, 29% in 1994 and

34.7% in 1995.[5] Government measures to control inflation, which had

threatened to overheat the economy in the early 1990s, seem to have taken

effect: inflation was under 15% in 1995. (See Tables 1 and 2.)

Table 1.

Source: EIU Country Report, China/Mongolia, 3rd Quarter 1996. The Economist

Intelligence Unit.

Table 2.

Source: EIU Country Report, China/Mongolia, 3rd Quarter 1996. The Economist

Intelligence Unit.

Chinese economic reform has one other characteristic that sets it

apart from that of the former Soviet Union, the absence of democratic

reforms. The current transition is being carried out within the “socialist

framework” and for the most part is centrally controlled. Much of the

world waited to see whether the economic transition would derail after the

Tiananmen incident in 1989; it did not. However China did seem to be

looking for a way of separating itself from reforms and democratic upheaval

that were happening in the former Soviet Union[6]. In 1992, Deng Xiao Ping

toured the southern economic zones - a journey significant for its highly

symbolic approval of the reform and investment efforts he witnessed - and

coined the phrase “socialist market economy”. Deng emphasized that this

transition must promote the development of productivity, strengthen the

national power and improve people’s standard of living, stating that,

“..with all these achievements secure, our socialist foundation is greatly


Within this backdrop, we will take a closer look at the system of

reforms currently underway in the People’s Republic of China. This year

marks the beginning of the Ninth Five-Year Plan (1996-2000). Examining the

individual parts (the budget process, public expenditure, taxes, banking,

the interaction between central and provincial governments, and the

emerging need to transform the social safety net) will present a clearer

picture of what has been accomplished by the macroeconomic reforms put in

place in 1976 as well as what still needs to be done.

Revenue, Expenditure and the Budget

One problem of major proportion facing the Chinese government is that

central government revenues are growing at a much slower rate than the

overall economy, and a growing budget deficit has resulted (see Table 3 in

Appendix, page 20).[8] This is especially debilitating in the face of

increasing demands from the surging economy for investment in

infrastructure and with the need for investment in a reformed social

insurance system that will come with economic disruptions caused by

continuing liberalization. Expenditures have also been falling as a

percentage of GDP, but are growing faster than revenue.

Several factors have been identified in the shrinking revenue-to-

expenditures ratio problem:


Tax arrears on the industrial and commercial tax (CICT) from enterprises,

which are growing as state-owned enterprises (SOEs) become more

unprofitable in the face of increasing competition. At the end of 1994,

these arrears amounted to 8.2 billion yuan (Ґ), and just seven months

later, the figure had grown to Ґ17.9 bn.[9]

Tax exemptions granted by local governments to state-owned and private



Subsidies to the loss-making SOEs, in the form of loans or direct subsidies

(see Table 4). China’s 1995 budget deficit was around a mere 1.5% of GDP.

If policy lending by centrally controlled banks - most of which is,

effectively, transfers to SOEs which can never afford to pay back these

loans - is taken into account, the central government’s true deficit is 6%

of GDP or higher.[10]

Price subsidies. (Most of these were for urban food, and adjustments made

in 1992 have reduced this drain on the budget.)

Higher than expected increases in expenditures (in 1995, these were 18%

higher than planned on the central level, with local government

expenditures over 30% higher than in 1994.)[11]

A drop of 10.7% in customs revenue from 1994 to 1995.

Inflation-indexed interest subsidies on bank deposits and treasury bonds,

which have been kept high by high inflation rates.

Table 4.

Source: Wong, Christine P.W., Christopher Heady, and Wing T. Woo. Fiscal

Management and Economic Reform in the People’s Republic of China. Oxford

University Press. Hong Kong: 1995.

For a country controlled by a Communist party, the government’s

proportion of economic activity has been remarkably small, even before

implementation of reform. In 1995, official government spending was just

11.6% of GDP. Off-the-books revenue raising schemes by local governments

may mean the state’s total revenue is two times the official level.

The extra-budgetary revenue investment was dispersed, uncoordinated

and did not fulfill the central government’s investment priorities. The

central government faced growing infrastructure demands, but with shrinking

(in proportionate terms) assets available, has been forced to reduce

capital construction spending substantially. Also, expenditures on

administration, culture, education, and welfare increased over the reform

period, and reduced the government’s ability to spend on

infrastructure.[12] (See Table 5 in Appendix, page 22.) The increases in

administration spending are particularly troubling, because of government

policies to reduce control of the economy and shrink some government


One of the stated goals of the Ninth Five-Year Plan is to eliminate

the budget deficit by year 2000. But this goal is highly unlikely to be

achieved due to other conflicting goals, like spurring employment, which

may mean increasing subsidies to unprofitable SOEs; reducing regional

income disparities; and strengthening agriculture, which is seen as a key

to controlling inflation.

Christine Wong, an expert on the Chinese financial system, identifies

three necessary changes to restore the health of the budget: First, the

tax administration must be strengthened. Second, the tax structure must be

reformed so that it is neutral across products and sectors. Third, the

revenue-sharing system between local, provincial and national levels of

government must be revamped, with clearer tax assignments in line with each

levels set of responsibilities. The central government’s control over the

tax system and share of total revenues will likely have to be increased.

The next two sections will address these proposed changes.[13]


The Pre-Reform Tax System

Prior to economic reforms, China’s tax structure was based on the

Soviet model. Enterprises remitted their profit to the government,

retaining only what was necessary to pay expenses. Revenues were collected

by local governments, and a certain amount was filtered up to the central

government. In 1984, this was replaced by a system of enterprise income

taxation reform, in which companies were taxed on their profits, as the

government tried to respond to economic imbalances created by the emerging

private sector. The turnover tax (the Consolidated Industrial and

Commercial Tax, or CICT), which had been the largest contributor to the

government’s annual revenue, was replaced with a business tax, a product

tax, and a value-added tax (VAT). These featured highly differentiated tax

rates across sectors, types of good and service, and form of firm

ownership. Most private firms paid a base tax rate of 33%, while most state-

owned enterprises (SOEs) were nominally taxed at 55%.[14] In practice,

however, taxes paid were governed by a contract responsibility system

(CRS), in which enterprises negotiated individually with local government

units. This system created conflict of interest because often the local

government was both tax collector and enterprise owner. Not only were

there differentiated rates which distort economic activity, there was

little incentive for full tax remittance back to the central government

under this system. (See Table 6 in Appendix, page 23, for a description of

the tax structure from 1985-1991.)

1994 Reforms

In 1994, the Chinese government began to respond to these problems by

enacting a series of reforms. The CICT was abolished and the following

taxes were created or modified:

Enterprise Income Tax. This unified corporation tax taxes companies at a

single 33% rate. Foreign enterprises and joint ventures are still enjoying

lighter tax burdens, because of the fierce competition between regions to

attract foreign investment, but these privileges are to be gradually


Personal Income Tax. Operates on a sliding scale, with a maximum of 45%.

Not yet comprehensively-implemented.

Value-Added Tax (VAT). Replaces the product tax of the CICT. Most goods

taxed at 17%, but agricultural and food products will be taxed at 13%, and

small-scale businesses will pay flat rate of 6%.

Consumption (Excise). Focuses narrowly on “luxury goods:” tobacco,

alcohol, gasoline, and a few others.

Business tax for services. Service industries will face a business tax of

3% to 20% on sales in place of the VAT. This tax also will apply to

transfer of intangible assets and the sale of real estate.[15]

Capital Gains. A capital gains tax was to be introduced in 1994, but its

implementation was postponed because of concern over its adverse impact on

China’s fledgling stock markets.

1996 Reforms

In 1996, China announced plans to reduce its import tariff rate from

35.9% to 23%, while abolishing preferences for certain goods and,

importantly, eliminating exemptions from import tariffs (currently, over

80% of imports are exempt from import duties for various reasons). [16]

This step alone should help to reduce the recent losses in customs revenue.

The Ninth Five-Year Plan also includes provisions to introduce taxes on

interest earnings and inheritances, policies designed to reduce income


Revision of Tax Collection Structure

In order to make the above tax policy changes effective, the tax

collection system must be revamped and greatly improved. The current

structure is based on a system of revenue contracts between enterprise and

government unit, and between local and central governments. One of the

necessary reforms involves tax exemptions, which local governments often

have the authority to grant to enterprises who for one reason or another

are unable to pay their taxes. This is a fundamental weakness in the

Chinese fiscal system: local government has decision-making authority to

grant exemptions on a tax the proceeds of which may in large part be

assigned to governments above. Numerous conflicts of interest can appear

to reduce incentives to enforce the tax at the local level.[17]

To address these changes, China in 1994 initiated the setting up of a

centrally-managed National Tax Service. This would replace the contract

system with a national “tax system,” based on uniform rules of tax

assignment and tax sharing. Certain assignments will be assigned to local

governments, and others to central government; others will be shared

according to predetermined formulas. Interestingly, in 1995, a special

police unit was set up to protect tax collectors under this new


A potential obstacle to tax reform comes from local governments.

Local governments have traditionally supported reforms. But this is

because the reforms have usually given them greater autonomy. The tax

system reforms need to restore some control over investment and spending

back to the central government, which could encounter local opposition.

Allowing local governments some discretion over local tax rates can give

them some of the autonomy they desire, and provide greater incentive for

intergovernmental cooperation.

Few reports exist at present on the implementation of these reforms.

Certainly, the spirit and scope of the reforms has been well-received by

analysts, though more changes are advocated. But it will take several more

years to determine the success of the reform of tax collection structures

at the local level.

Intergovernmental Fiscal Relationships

A product of economic reforms in transitional economies is often a

shift in intergovernmental fiscal relationships. In the transition from

centralized economy to market economy it is often from a relationship where

the local or provincial government is the receiver of the “plan” to the

local or provincial government proceeds with a greater autonomy. The

evolution of this relationship in the PRC has been very similar. However,

the provincial or local governments were at an advantage over many other

transitional economies because the Chinese system had the following

characteristics 1)local implementation capacity was already established in

the rural areas 2)China in most areas has a high ethnic homogeneity and 3)

there was much to gain by inter-province trading[19]

The very nature of Chinese economic reforms, gradual and incremental,

allowed “scaffolding” of behavior. Partial reforms provided the environment

to learn behaviors that could then be applied to the next level of reform.

Chinese economic reform was also structured on the idea of

decentralization. The establishment of Special Economic Zones (SEZs)

encouraged the local areas to develop their own strategies to attract

business and allowed them the freedom to implement the strategies. The

very earliest reforms, breaking up of farm communes, were also carried out

at the local level.

Many of the SEZs are doing very well and people living in these areas

are enjoying a higher standard of living than they had previously enjoyed.

However, tax collection still remains a difficult endeavor with compliance

at only 70%. In order to improve the poorest areas in China, policies and

programs that are able to move this revenue to the poorer areas will be

needed. This can take the form of a better accounting system to ensure that

all taxes due the central government for infrastructure development

actually arrive there.

Banking Reforms, State Owned Enterprises and the Social Safety Net

In order to put current economic reforms in perspective, understand

the recommendations made by the international economic community, and fully

address the quagmire of State Owned Enterprises (SOEs), a more in depth

look at the interconnectedness of the SOEs and the banking system must be

taken. We will attempt to do just that using the context of bank

development in the PRC, monetary policy, and ongoing reforms to SOEs.

Reform of the banking system in the PRC has taken on similar

characteristics to reform in other areas: i.e., gradual and experimental.

At the beginning of reforms the financial sector in the PRC could hardly be

called a financial sector[20]. Financial sector development and

implementation is a complex undertaking which should include the

development of institutions, instruments and markets[21]. Currently in the

PRC, banking reform lags behind other areas of reform[22]. This is due to

a complex array of policy decisions. No discussion of banking reform in the

PRC would be complete without an examination of the current state of SOEs

restructuring. Many macroeconomic initiatives are being put on hold in

order to bolster a failing state sector and postpone the social upheavals

that may be associated with the needed reforms of this sector.


The Central Bank was established in 1984. In 1987 two additional

universal banks were formed and non-bank financial institutions were

started. In 1988 new capital markets were formed and the secondary trade of

government bonds was allowed. In 1990 the Shanghai and Shenzhen stock

exchanges were opened. In 1992 all treasury bonds were issued through

underwriters[23]. At the end of 1994, the PRC had a total of 13 banks (of

which 3 were specialized banks and 3 were comprehensive banks). The new

“financial system” contained 20 insurance companies, 391 trust and

investment companies and greater than 60,000 credit cooperatives that

operate in local areas[24].

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