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February 05, 2008

New Challenges for Public Finance Reform in China

Posted by Holger van Eden

China Last week the World Bank presented here in Washington a new book titled "Public Finance in China - Reform and Growth for a Harmonious Society". The book has been edited by the ex-deputy Finance Minister, Mr. Lou Jiwei -- one of China's most influential reformers and currently chairman of the China Investment Corporation, China's new sovereign wealth fund -- and World Bank senior economist Mr. Wang Shuilin. A panel of experts including Mr. Lou and Fiscal Affairs Department (FAD) Director, Mrs. Teresa Ter-Minassian noted a number of challenges facing China in the public finance field, ranging from intergovernmental fiscal reform, tax policy modernization, further development of public financial management to various sectoral reform agendas. Health, education, and pension reforms stand out according to the book's many prominent authors as the major policy challenges given the aspiration of the Chinese government to limit growing regional and other income disparities and to manage the aging of the population.

Mr. Lou recalled the major reforms that had transformed the Chinese society in the past decades. On the public finance front, the taxation reforms initiated in 1994 were very important in raising government revenue as share of GDP and in lifting the share of central government in overall revenues. China's public spending is still relatively low as percentage of GDP, and with state enterprises no longer providing public services as in the past, this has created challenges for public service delivery. Expenditure assignments between center and local government have, moreover, not followed the centralization of revenues. Most education, health and social security expenditures are still the responsibility of lower levels of government. The imbalances in China's spectacular GDP growth, both regionally and between the poorer and richer parts of society, have exacerbated the discrepancies between tax and expenditure assignments. Lou indicated that China' central government has to urgently develop policy instruments to improve service delivery and ensure a level of equity between regions and income groups. This can be done through targeted grants or  equalization transfers from the center. If no action is taken, however, there are definite risks for the "harmonious" development of society that China has embraced.

Mrs. Ter-Minassian noted that the reforms in China in budget planning and treasury management, and in tax policy and administration have really been remarkable given the size of the country and its complex public sector. Nevertheless, many challenges remain. On fiscal policy, she stressed the importance of rebalancing China’s growth towards domestic consumption and of helping to reduce global imbalances by tackling the reasons for very high precautionary household savings, through reform of social expenditure programs. On the structural side, Ter-Minassian stressed that improving tax policy and tax administration are also important priorities . The VAT does not cover the growing services sector, and does not provide credit for capital goods. Personal and corporate income tax still need to incorporate elements of international best practice to reap their full potential. Both the IMF and World Bank are assisting the Chinese authorities in their ambitious program of modernization of the Chinese state tax administration; this reform will be essential for maintaining the remarkable growth of revenue of recent years. [Download china_fiscal_policy_book_remarks_of_ms_terminassian.pdf]

An interesting question from the audience during this book presentation was whether the Chinese reforms of the public sector should be seen as unique. Did foreign experience play a role in directing reform, and could the Chinese experience provide lessons for other developing countries? The panel members expressed the view that while of course China and every other country is unique in its needs and its reform path, there is ample scope in institutional reforms for learning from each other's experience. Public sector reforms were seen as successful due to the Chinese willingness to experiment with new models - in public financial management this has often taken place at the provincial level - and to accept that which works well.

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