Reform of tax distribution system needed to overcome local governments' dependency on land sales and loans

The year 2012 is crucial for China to solve its local government debt problem. Because it directly relates to the division of taxation between local and central governments and concerns the financial balance of governments, reforming the current finance and tax system is the only solution.

Statistics indicate that about 43 percent of the 10 trillion yuan ($1.57 trillion) government debt, around 4.6 trillion yuan, matures between 2011 and 2012. So a large financial gap may appear this year.

Because most local government debt exists in the form of collateral loans or local financing platforms, mostly for large-scale infrastructure construction, it is difficult for local governments to profit from their investments in the short term.

Meanwhile, the revenues from land transfers for 130 cities declined by 13 percent year-on-year in 2011. The central government is determined to continue its strict controls on real estate, so with reduced income from their main source of revenue, it will be a big test for local governments to repay their debts.

However, the root cause of this test lies in the mismatch of revenue division between local governments and the central government.

The reform of the tax distribution system in 1994 established a basic framework for revenue distribution between local and central governments that still functions today. It was an important step toward a market economy back then. Yet, under this tax distribution system, local governments' revenues today cannot pay for their expenditures. So they struggle to get transfer payments from the central government, which is an important form of assistance to local governments. However, these transfer payments entitle the central government to decide how the money is spent.

As local governments are the main public service providers and the main sponsors of infrastructure construction, they thus have to rely on loans and lucrative land sales to finance them.

The revenues from land transfers amounted to 910 billion yuan from 2001 to 2003, accounting for about 35 percent of local government revenue during those three years. In 2009, the revenue from land transfers had risen to 1.59 trillion yuan, 46 percent of local government revenue.

Although the budget laws and regulations in China strictly prohibit local governments from raising debt, many governments, at various levels, run high deficits.

The real estate bubble not only puts the banks' loans in a very dangerous position, it forces all macro-control measures to accommodate the troubles of indebted local governments.

Local governments now seem ready to unlock the real estate market to pay their debts. But if the market overheats again the economy will be caught in another vicious circle and all previous efforts will be wasted.

The only way to avoid this is to reform the framework designed in 1994 and increase the tax revenues of local governments.

China can learn from the United States in the field of tax distribution. The US has an effective three-layer finance and tax distribution system, comprising the federal government, state governments and local governments at various levels.

There is a clear division of labor among the three layers of government, accompanied by corresponding revenue share and taxing powers. Although different levels of governments levy their own taxes, the proportion of different taxes varies from state to state according to respective economic development conditions. So local governments have more financial space than their Chinese counterparts.

China urgently needs to build up its local tax system now to better match local governments' financial revenue with their obligations. Otherwise, it will be difficult to change local governments' addiction to land revenues.

Establishing a modern finance and tax distribution system between the central and local governments is also necessary to transform the economic structure and improve public services nationwide.

The author is an economics researcher with the State Information Center.