By Liu Yunzhong, Department of Development Strategy and Regional Economy of DRC, & Pan Wenxuan, Research Institute for Science of Ministry of Finance

Research Report No 63, 2010

Different natural conditions and different levels of economic development can cause a fiscal revenue imbalance between different regions. With abundant tax sources, developed regions have a fairly high level of fiscal resources; with scarce tax sources, underdeveloped regions have a relatively low level of fiscal resources. This horizontal imbalance in fiscal resources can lead to a considerable difference in the type, level and quality of public services provided by local governments. Because of weak fiscal resources and insufficient funds, the public services in some poor regions are grossly inadequate. They include compulsory education, public health, social security and infrastructure. This state of affairs not only affects economic efficiency but also runs counter to social equity. It can even cause a host of social contradictions. China is a country noted for a tangible imbalance in regional economic development, a striking horizontal fiscal imbalance and a considerable inter-regional difference in the level of public services. All these are major issues that must be addressed through coordinated regional development.

The inequality in public services due to the difference in regional fiscal resources cannot be solved through market mechanisms. The central-to-regional fiscal transfer payment can redistribute fiscal resources between different regions so that the regions with a relatively low level of economic development and relatively less tax sources can provide local residents with the same basic public services as other regions do. An effective fiscal transfer payment system can serve as a fine mechanism to equalize inter-regional fiscal resources. If fiscal transfer payment can have a stronger effect on the equalization of fiscal resources, basic public services will be more equalized and regional development will be more coordinated.

I. History and Present State of China's Fiscal Transfer Payment System

China's current fiscal transfer payment system was gradually established on the basis of the 1994 tax-sharing reform. In 1995, China began to draw on international experience and introduced for the first time in history a formularized transitional method for transfer payment, with equalization being its basic goal. This method distributed fiscal funds according to the standard revenue and standard expenditure set for various places. It represented a major progress in equity and objectivity, and also a major breakthrough in standardizing the fiscal transfer payment system. By then, China had preliminarily formed a general framework for central-to-regional fiscal transfer payment. The framework consisted of three major parts: tax refund, fiscal transfer payment and special transfer payment. In the central budget, tax refund was an item independent of transfer payment. Transfer payment only included fiscal transfer payment and special transfer payment, excluding tax refund. But in essence, tax refund was also a type of central-to-regional transfer payment. In the economic sense, therefore, this paper shall regard tax refund also as a type of central-to-regional transfer payment and place it in parallel with fiscal transfer payment and special transfer payment. The fiscal transfer payment mainly included the transfer payment for a transitional period, the subsidy under the former system, and the subsidy for final account settlement. Later on, transfer payment for wage adjustment and transfer payment for ethnic regions were added.

In the following decade, the fiscal transfer payment system underwent a series of adjustments to deal with various issues arising from practical operations, while the original system framework was maintained. The major adjustments were as follows. (1) Transfer payment for wage adjustment was introduced in 1999 to offer proper subsidy to old industrial bases as well as to central and western regions. (2) Transfer payment for ethnic regions was introduced in 2000. (3) Transfer payment for rural tax and fee reform was introduced in 2001 to ensure the normal operation of rural grassroots organizations and the issuance of wages for rural primary and secondary school teachers. (4) After the income tax revenue sharing was introduced in 2002, tax refund also included the refund of income tax base. Meanwhile, the increased central revenue arising from reforms was merged with the former transitional transfer payment to form a general transfer payment. The general transfer payment fund was set according to a unified formula and in reference to the inter-regional gap in regional standard fiscal revenue and expenditure and to the amount of the fund that could be used for transfer payment. The more fiscally difficult a region was the more central fiscal subsidy it would receive. (5) In light of the fiscal difficulty at the county and township levels, the central finance established a special transfer payment in 2005 to help ease their fiscal difficulty. (6) In order to narrow the inter-regional gap in fiscal resources, gradually equalize basic public services and ensure the smooth implementation of the national policy on main functional areas, the central finance in 2008 further improved the method to calculate the central-to-regional general transfer payment. (7) The central finance in 2009 turned the former general transfer payment into a balancing transfer payment and the former fiscal transfer payment into a general transfer payment, and included the expenditures on education, social security and employment, public security and general public services, whose subsidies were relatively stable and were formerly included in the special transfer payment, in the general transfer payment.

By 2009, China's central-to-regional fiscal transfer payment consisted of three main items: tax refund, general transfer payment and special transfer payment. Each item had a different fund distribution formula and has somewhat a different impact on the equalization of fiscal resources.

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