China’s fiscal time bomb
eijing’s fiscal deficit is a ticking time bomb. The government’s total budget deficit could be up to five times greater than official Ministry of Finance figures indicate, because Beijing counts funds raised by bond issuance as budget revenue rather than as borrowing. An inefficient tax system and the government’s increasing reliance on debt financing for its spending needs also make the repayment and servicing of the public debt a mounting concern.
The fiscal bomb may not explode just yet, as ample household savings will sustain the fiscal deficit in the short term. But the ongoing decline in fiscal revenue from 28 percent of GDP in 1979 to 12 percent in 1998 is a serious concern, because it limits the authorities’ ability to respond to the inevitable need to spend more on social and structural reform. Thorough fiscal reform is needed sooner rather than later to resolve these long-term budgetary woes.
THE TRUE FACE OF THE FISCAL MESS
The culprit for China’s worsening fiscal position is the long-term decline in the central government’s tax revenues. On the surface, the decline has not led to a widening state budget deficit as a percentage of GDP, because of cuts in government spending. But this official deficit figure is misleading because Beijing inflates its budgetary revenues, mainly by including funds raised by bond issuance as revenue. Such bond issues should be treated as borrowing.
Adjusting for this accounting trick, China’s fiscal deficit would have amounted to 5.3 percent of GDP-or 423 billion ($51 billion)-in 1998, instead of the official figure of 1.2 percent, or Y92 billion ($11 billion). This adjusted budgetary gap has been widening, with Beijing financing the deficit by issuing still more bonds to make up for the precipitous fall in tax revenues (see Figure 1).
THE ERODED TAX BASE
According to the International Monetary Fund, the steady decline in China’s tax-toGDP ratio is a result of the combination of a tax policy that gives extensive tax concessions; structural changes that lower the effective tax rate for key economic sectors and erode the tax base; and weak tax administration. Until 1984, Beijing counted all state-owned-enterprise (SOE) profits and depreciation funds as part of central budget revenue, thus imposing an effective 100 percent income-tax rate on SOEs. This public-enterprise revenue was the cornerstone of Beijing’s budget in the early 1980s.
But changes to the tax system have cut SOEs’ tax obligations substantially over time. Especially damaging to tax collection efforts was the contract responsibility system (CRS), under which taxes were paid according to negotiated tax contracts rather than a standardized tax schedule. The 1994 tax reform replaced the CRS with a much lower, uniform rate of 33 percent for all state and non-state enterprises.
More important, structural changes in the economy have eroded the traditional tax base. The key revenue source-the state sector-has dried up, while the rapidly growing non-state sector has not been sufficiently integrated into the tax net. SOEs contributed only 8 percent of total tax revenue and accounted for less than 30 percent of total industrial output in 1998, compared to 29 percent and 65 percent, respectively, in 1985. Meanwhile, the non-state sector, which includes collectives, township and village enterprises, private enterprises, and foreign-funded enterprises, has been taxed relatively lightly-though this may be changing, at least for foreign enterprises (see The CBR, July-August 1999, p.8). The poor finances of the SOEs and the declining share of public-enterprise earnings relative to wages have also contributed to this state-sector revenue loss. About half of SOEs are in the red, and SOE wages have been taxed relatively lightly, further dragging down the overall tax intake.
From a macroeconomic perspective, the declining share of consumption in GDP, from 64 percent in 1979 to 59 percent last year, has also reduced the government’s goods and services tax intake. This is another indication that tax revenues are not growing in step with the economy. Further, the rise in the export sector’s share in GDPfrom about 5 percent in 1979 to 20 percent in recent years-does not help raise tax revenue much, as export production is taxed at lower rates to encourage foreign participation in Chinese export industries. After recent VAT rebate increases, many products are taxed at 5 percent or less.
AND THEN THERE ARE COLLECTION PROBLEMS
The 1994 tax reform has failed to arrest the erosion of the central government’s fiscal control. Fiscal revenue has declined precipitously, from 28 percent of GDP in 1979 to only 12 percent today, one of the lowest percentages among the major economies in the world. The absence of a nationwide tax system is the main administrative culprit. The State Administration of Taxation and local tax authorities define separate tax laws for their own jurisdictions and grant tax exemptions within their authority.
Local governments collect the bulk of taxes and share the revenues with the central government via complex, contract-based, intra-governmental fiscal arrangements. Local tax authorities work with local financial bureaus to formulate and administer local budgets. But these arrangements, coupled with the fact that many SOEs are locally owned, provide an incentive for some local authorities to maximize local revenues at the expense of tax contributions to the central government. These local authorities grant local SOEs generous exemptions from the taxes that are shared with the central government, but preserve their own portion of tax revenues mostly untouched.
The local authorities also wrung a big compromise out of Beijing in the 1994 reform, in the form of a guarantee that the absolute level of local tax revenues would not fall after the reform. Furthermore, Beijing agreed that the post-reform revenue-sharing scheme would only apply to the net future increase in tax revenues. Hence, the reform has failed to improve Beijing’s taxcollection ability, as reflected in the figure for tax revenue as a percentage of GDP
How BIG IS THE BUDGET HOLE?
With tax revenues inadequate, Beijing has been relying on debt financing to fund government spending and, more recently, to boost GDP growth. This has led to a sharp rise in the public debt-to-GDP ratio (see Table).
But China also has a hidden debt. Using Bank for International Settlements (BIS) statistics, HSBC estimates that China’s short-term (less than one year) borrowing from international banks amounted to $34.5 billion, or 53 percent of total borrowing, at the end of 1998. But official PRC statistics only show $17.3 billion-or 11.9 percent of the total-in short-term foreign debt. Even if one accounts for the possibility that official statistics may be inaccurate, the magnitude of the discrepancy between BIS and official data suggests that there might have been significant unauthorized foreign borrowing by Chinese enterprises last year-as much as $17.2 billion. The increasing size of this hidden debt adds to the true debt burden on the economy.
But the official budget deficit does not reflect this rising strain on central-government finances, largely because of Beijing’s inclusion of funds raised by bond issuance in its budgetary revenues, which has effectively deflated the true budget deficit by an average of 2.5 percentage points of GDP in recent years.
Beijing also requires the state banks to increase lending-to a large number of SOEs-by the same amount as the increase in government spending. This has effectively doubled fiscal spending without counting it as expenditure. If bad debts at the state banks, estimated at over $200 billion in total, were included in the budget, the deficit would be significantly bigger.
The government’s reliance on debt financing suggests that the rising cost of servicing the public debt could become worrisome. Indeed, the resources going toward servicing existing government debt have been rising steadily. Debt servicing and repayment accounted for over 70 percent of new government bond issues, which totaled Y331.1 billion ($40 billion) in 1998 (see Figure 2). Thus, the share of fiscal revenue spent on debt servicing and repayment rose to 24 percent of total government fiscal revenue last year, from less than 3 percent in 1989.
If economic growth were strong, Beijing could simply cap spending and enjoy the rise in tax revenues to help ease its fiscal strains. But with the economy struggling through structural reforms, such a cyclical bailout is unlikely.
No IMMINENT CRISIS
Nevertheless, China’s high domestic savings level, estimated at 40 percent of GDP, should provide ample funds for the government in the short term. By selling bonds to the banks, Beijing can tap into the roughly $630 billion in household savings-61 percent of projected 1999 GDP-in the banking system.
China’s rising debt-to-GDP ratio is still low by international standards. Even if the hidden debt is included, China’s total debt is still about 30 percent of GDP, far below the internationally acceptable threshold of 60 percent. All this makes China’s public-sector dissaving much less problematic. Beijing should have little difficulty financing its fiscal spending needs for at least the next two years.
Compared with other countries, China’s debt burden does not appear crushing. The public debt of the United States and Britain in 1946, Europe in the early 1990s, and Japan today has exceeded 100 percent of GDP without disaster striking. Indeed, Beijing’s effort to generate a cyclical economic rebound, if successful, will help to reduce its financial stress by increasing revenues.
MARKETS REMAIN CALM-FOR NOW
In theory, Beijing can live beyond its means as long as it can borrow from the public at reasonable cost. And such an ability to borrow is, in turn, decided by bond investors. If they are worried, they will demand sharply higher interest rates, causing government debt to spiral. But this does not seem likely in China. The yield of the 11.83 percent June 14, 2006 Treasury bond, traded on the Shenzhen Stock Exchange, has continued to fall despite Beijing’s rising demand for funds (see Figure 3).
Several factors suggest that Beijing faces few fundraising difficulties in the near future. The high savings rate and the lack of investment alternatives have ensured a strong local demand for bonds. The government is also selling bonds to distressed domestic banks to help improve their balance sheets. At the same time, demand for funds from the non-state sector is weak, due to low investment levels-a result of the economic slowdown-and the absence of a consumer credit market. As long as the flow of funds to non-state borrowers is weak, the government should face little competition for funds. Finally, most of the government debt is domestic. Unlike foreign creditors, who would pull out at any sign of fiscal stress, domestic investors are usually loyal. And at 15 percent of GDP, foreign-currency debts-the proximate cause of the recent Asian financial crisis-are small.
Current levels of fiscal spending, however, are unsustainable. Without thorough fiscal reform, the government could lose control of its finances entirely. This steady decline in fiscal revenue also limits Beijing’s ability to respond to economic shocks and economic reform’s growing funding needs. Thus, however faithful its bond buyers, Beijing must soon undertake thorough fiscal reform: it must redouble its efforts to mend the tax net; reduce reliance on the state sector for revenues; and collect taxes from the growing non-state sector. Though the recent anti-smuggling campaign has led to an increase in import tax revenue, it will not be enough to improve Beijing’s finances-total imports account for only 15 percent of GDP While a fiscal crisis is not imminent, fiscal reform is.
Copyright U.S.-China Business Council Sep/Oct 1999
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