The reason fiscal policy is interesting is that it is the concrete expression of a country’s political priorities: how governments spend money tells you how they work and what their priorities are. By the same token, it is impossible to really interpret fiscal policy without some understanding of the political structure in which the government operates. There are a lot of major differences in political structure–to put it mildly–between the country I grew up in, the US, and the country I have spent my professional life in, China. One of the ones whose importance took me a while to figure out is that China is a unitary state while the US is a federal state.

This issue springs to mind every time I read assertions like this about China: “The ratio of central government debt or sovereign debt to GDP is a mere 21 percent, the lowest among the world’s major economies.” (I’m quoting from the most recent example to have arrived in my inbox, but this argument is so widespread that I don’t need to pick on anyone in particular.) It is indeed true that, if you look at statistics on government debt in China, the majority of it is assigned to local governments rather than central governments (see chart). Many people therefore contend that while local governments have strained balance sheets and limited capacity to borrow further, the central government does not.

Such a distinction would make sense if China were a federal state: if the central and local governments were independent entities with clearly defined constitutional and legal roles and separate finances. But China is not a federal state, and local governments are not separate from the central government. There is only one government throughout China; local governments are merely the authorized agents of this state. There is no constitutional or legal support for the idea that China’s local governments have any independent fiscal power and could ever be considered as having balance sheets that are separate from the central government.

It’s true that China’s government is often deliberately obscure about its true organization and structure. But some things are out in the open. Let’s turn to the Constitution of the People’s Republic of China:

Article 105. Local people’s governments at various levels are the executive bodies of local organs of State power at various levels and are the local organs of State administration at the various levels.

Article 110. Local people’s governments at various levels throughout the country are all organs of State administration under the unified leadership of the State Council and are all subordinate to the State Council.

That’s pretty clear. There is only one government in China, and the State Council, meaning essentially the executive, controls that government. As a matter of constitutional theory, local governments have power and authority only because the State Council gives it to them. The fiscal implications of the unitary state are also clearly spelled out in the Law on the Administration of Tax Collection:

Article 5. The competent department for taxation under the State Council shall be in charge of the administration of tax collection throughout the country. The national tax bureaus and the local tax bureaus in various places shall administer tax collection respectively within the limits set by the State Council. 

The local people’s governments at various levels shall strengthen their leadership over or coordination of the administration of tax collection within their respective administrative regions, and support the tax authorities in performing out their duties in accordance with law, calculating the amounts of taxes to be paid according to the statutory tax rates and collecting taxes in accordance with law. 

This is also quite clear. The authority to raise tax revenue lies solely with the central government. Again as a matter of constitutional theory, local governments’ job is to help implement the tax policies decided by the central government. They do not have any authority to raise taxes on their own, and have no independent sources of revenue.

If you look at local government budgets in China, there are two sources of funds: revenue “at the local government level,” historically 55-60% of total revenue, and transfers from the central government, historically 40-45% of the total. In reality, though, these are the same thing: money from the central government. The central government allows local governments to retain a share of the taxes that are collected at the local level. The remainder that is handed over to the central government, and the taxes collected at the central level, are then redistributed back to local governments as transfers. Ultimately all tax revenue is controlled by the central government, which decides how much money local governments get.

What’s surprising is that, in a unitary state, there could even be such a thing as local government debt. And indeed before 2010 there was not. The local government bonds that have been sold since then are a curious thing: the central government approves their issuance, so the local governments do not have any independent borrowing authority. And the central government controls how much revenue local governments have, so whether local governments can repay the debt still ultimately depends on the central government. This is a weird arrangement. The central government could just issue the same amount of money in treasury bonds and redistribute it to local governments. But for internal political reasons that I honestly struggle to understand, it is considered desirable that some of this debt be “in the name” of local governments. Even though local governments do not have any authority to raise revenues to repay the debt!

Because of this unitary structure, it makes no sense to split either the income statement or the balance sheet of China’s government between central and local entities. There is only one state in China and its finances are unified. I should point out that an excellent recent quantitative overview of China’s government balance sheet by the IMF, “Fiscal Policy and the Government Balance Sheet in China,” does not fall victim to the fallacy I criticize; the authors follow best practices by presenting their assessment on a “general government” basis, i.e. the combination of central and local governments. That’s the right way!

What all this means is that you cannot wave away the debts of local governments by saying they are local, and it’s only central government debt that matters. The central and local governments are part of a single unitary state, and the central government is in charge of figuring out how to repay all of its debt. This is precisely why it has been such a disaster for the central government to allow local governments to engage in all that uncontrolled off-balance-sheet borrowing. If China was a federal state, local fiscal incontinence wouldn’t matter too much ultimately. When local authorities borrowed beyond their means, they eventually wouldn’t pay it back, and it would just be an issue between them and their creditors without national implications. But because China is a unitary state, every time local authorities abused their power by creating unauthorized liabilities, they worsened the fiscal situation for the entire state.

Moral of the story: a unitary state needs to act like one, not pretend to be a federal state. A combination of centralized revenue-raising authority and decentralized liability-creating authority is the worst of both worlds, and the sooner China gets away from it the better.

P.S. My thanks to the excellent NPC Observer website for making it easy to track down the relevant laws.