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China’s local government finances are a mess. Regional authorities have become overly dependent on income associated with the sale of land to developers, and are struggling under the heavy burden of debt that they built up during the state-led investment boom in 2009-10. As land sales have dropped off in 2012, some have resorted to unorthodox measures to raise extra revenue. An upturn in the property market in 2013 may provide a breathing space, but structural reforms to the system of local government financing remain an urgent priority.At first glance, China’s fiscal picture does not look alarming. The Economist Intelligence Unit estimates central government debt at the equivalent of around 16% of GDP in 2012, with the budget deficit for the year likely to come in at a modest 2.3% of GDP. Even taking into account the fact that the government has many liabilities that are not fully reflected in official data, public debt is still far below the levels prevailing in most Western economies, while the Chinese state has a vast array of assets that it could sell if necessary to pay its debts. Total fiscal revenue rose by 11.2% year on year in the first 10 months of 2012, a rate of growth that many countries would envy.
However, when one looks more closely at the data it becomes obvious that the economic slowdown of 2012 has placed new strains on the public finances. Although revenue rose strongly in January-October, the rate of increase was significantly slower than in the previous two years: government revenue expanded by 21.3% in 2010 and 24.9% in 2011. In addition, public spending, which in the past has tended to rise at a similar pace to revenue, jumped by 19.6% year on year in the first 10 months of 2012, far exceeding the rate of growth in income.
Although the expansion in local government fiscal revenue in the first 10 months of 2012, at 15.6% year on year, outpaced the overall average increase in fiscal revenue of 11.2% in the period, this is something of a statistical mirage. In recent years, regional authorities have come to rely increasingly heavily on sources that do not appear in headline fiscal revenue numbers. During the 2009-10 stimulus spending splurge, vast amounts of public investment were funded by the state-owned banking system.
In addition, earnings from land sales to developers have become a vital part of the local government financing system. According to the Ministry of Finance, local authorities’ earnings from sales of land-use rights amounted to Rmb2trn (US$320bn) in the first 10 months of 2012, equivalent to roughly one-fifth of total local and central government revenue in the official budget. However, inflows have plunged recently, falling by 21.7% year on year in January-October, in line with a decline in property investment (particularly during the first half of 2012) that left fewer developers needing to acquire land.
The fiscal crunch among local authorities has led some to resort to unorthodox strategies to shore up their finances and thus sustain their public investment-led economic growth models. In August there was a widespread shutdown by retailers in the city of Shenyang, in Liaoning province. Reports suggested that this represented an unofficial protest against what was perceived as a harsh campaign of inspections of privately owned stores and restaurants by municipal officials who were targeting hygiene breaches and counterfeit goods and imposing heavy fines on violators. The city government denied that any such campaign was under way, but it does seem that many regions have toughened their enforcement regimes: local government income from fines, although still modest, was up by 20.2% year on year in October. Anecdotal reports have also suggested that some local authorities, including a number in Zhejiang and Jiangsu provinces, are asking taxpayers to pay their tax for 2013 in advance; it is unclear whether such revenue is being inappropriately recorded as part of fiscal income for 2012.
Troubled local governments should get some breathing space in 2013. The property sector is edging out of a two-year downturn, and this should lift demand for land from developers. Meanwhile, stronger economic growth should buoy revenue more generally (although the recovery is itself partly the result of an up-tick in public investment spending). The problems experienced in 2012 will nonetheless serve as a wake-up call, and the relief provided in 2013 will soon dissipate. Rates of property development still look worryingly high, and land sales cannot serve as a perpetual source of fiscal income. The central government’s proposal to implement a sharp rise in compensation for those whose land is appropriated for development shows that it is already trying to wean local authorities off dependence on such income (although even if it is enacted, enforcement of the regulation may prove problematic). As China’s economy makes the transition to a slower rate of economic growth in the longer term, tax inflows are likely to slow in parallel but upward pressure on spending may well remain strong, particularly as public-sector wages rise.
Reforms are still at the pilot stage
The central government is well aware of the financial challenges facing local governments. Several initiatives have been launched in the past few years that aim to provide long-term solutions, although none is yet contributing substantial amounts of revenue. The measures have included allowing some regional authorities to issue debt, and also experimenting with property taxes (currently in Shanghai and Chongqing, although other cities may soon join the pilot programme). A more fundamental realignment of the system may have to await a new budget law, but this could be on the way soon, as a draft proposal for a revised budget law was issued earlier in 2012.
Although the policies announced so far point the way to possible reforms of the local government tax system, completely restructuring it would be likely to prove extremely difficult, as this would alter the balance of power between China’s regional and central authorities. The need for these problems to be tackled is nevertheless acute. Investment by local governments has been useful in terms of driving economic growth in the past, but its potential to do so in the future is limited. The 2009-10 stimulus effort left local governments with debts of at least Rmb10.7trn (US$1.7trn) at end-2010, equivalent to roughly 21% of China’s GDP in that year. They will be paying for that spending binge for many years to come.
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