China's local governments have long been criticized for their precarious financial situation, which is largely reflected in their mounting debts and heavy dependence on land transfer fees for revenue.
With the nation's economic growth slowing, the calls for local governments to address these problems are becoming louder. However, unless China reforms its tax system, local governments will not ease back on their unsustainable reliance on borrowing or land sales.
Since 1994, China's tax system has categorized tax revenues into central taxes, regional taxes and taxes shared by the central and local governments. For historical reasons, the system favors the central government in accessing tax revenue. Also, most of the largest tax categories, such as consumption tax and value-added tax, go to the central government. This system has left local governments with little room to expand their revenues through taxes.
Yet, local governments are mainly responsible for urban construction and many of the services which improve the lives of residents in their areas, such as education and health care. Though local governments are entitled to bailouts from Beijing when they are short of money, most are still burdened with financial difficulties since the central authorities decide how much money to give them in times of trouble.
The imbalance between local governments' fiscal power and administrative authority has led these governments to lean on the two reliable sources of revenue they have at their disposal - bank credit and land leasing fees. Over the past few years, land use fees have accounted for a growing chunk of local government revenues.
When land transaction volume declined in the wake of purchasing restrictions meant to cool the property market, local governments turned to debt financing for funding. According to the National Audit Office, local government debts amounted to 10.7 trillion yuan ($1.69 trillion) at the end of June, and it is estimated that 43 percent of this debt has fallen, or will fall, due in 2011 and 2012, leaving a large financing gap looming for many local governments this year.
To rectify this situation, China needs to rebuild its tax system to ensure that local governments have the financial means to perform their functions. I would recommend shifting all business tax into local government revenue. Also, Beijing should extend the trial property tax program to more cities, as property taxes have the potential to become a major source of revenue for local governments.
