China’s struggles to deal with its mounting burden of local government debt continue to make headlines, giving the dry topic of intergovernmental fiscal relations an unusual amount of relevance these days. The proximate cause of all this local government debt is obvious enough: when the world was falling apart in late 2008, the central government wanted to do a big stimulus, but didn’t want to pay for it. So instead it told local governments to spend whatever they needed on infrastructure to get growth going, and told banks to lend the local governments whatever they needed, and turned a blind eye to any irregularities in all this borrowing. But many scholars and analysts argue that the roots of the problem lie even deeper, that they are the result of a system where there is a fundamental mismatch between the huge burden of public services that local governments have to provide, and the scanty revenues the central government permits them to raise. It’s not just in infrastructure that Beijing pushes the burden down on local governments, the argument goes, but in schools and hospitals and so on. Exhibit 1 in this argument is usually some variant of this chart:
The dominant view is that excessive centralization of revenues and decentralization of expenditure responsibilities have precipitated a fiscal crisis in many Chinese counties and townships, with dire consequences to local governance. The ‘gap’ argument emphasizes the relative ratio of central vis-a-vis local revenues and the impact of decentralization of expenditure, and slights the impacts of other parallel fiscal developments, in particular the large flows of central subsidies to local coffers since the 1994 tax sharing reform. As pointed out by the few sceptics, the presence of a large and growing central fiscal subsidy, of a comparable size to the centralized tax revenues, means that logically the latter cannot in itself constitute a sufficient condition for local fiscal difficulties. What then accounts for the difficulties, as localities are not blatantly short of monies?
The answer is that there is not one thing called local government in China: there are multiple levels of local government (at least three). Money does not just have to flow from the central government to local government, but between different levels of local governments. And it is easy to see that this flow might not always be smooth, or that “leakage” may happen along the way as different officials get their hands on the funds. This in fact is the key problem: the central government sends plenty of money to local governments in aggregate, but it does not end up in the right places. The lowest-level governments (counties) are where spending responsibilities are concentrated (see table below), but they are the furthest away from the flow of money from the top. And since responsibility for spending is often assigned without regard to where the revenues come from, mismatches abound.
One of the limitations of the Chinese system is that the need for transfers is assessed mostly based on registered rather than actual population in a province. The problem is that the actual population is generally lower than registered population in low-income provinces, given that migrants remain registered in their home province, regardless of where they live. The government is set to henceforth include 15% of the difference between actual and registered population in the formula for determining transfers. This will partly take into account the cost of migrants to a province.
It’s understandable why the simpler account of a central-local fiscal imbalance dominates the discussion: “the central government has too much money” is a much better slogan than “the fiscal transfer system is suboptimal.” But the first the step in fixing the problem is coming to an accurate diagnosis.