Major Issues and Policies in China's Financial Reform 9781623201111, 9781623201104

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Published by Enrich Professional Publishing, Inc. Suite 208 Davies Pacific Center 841 Bishop Street Honolulu, HI, 96813 Website: www.enrichprofessional.com A Member of Enrich Culture Group Limited Hong Kong Head Office: 11/F, Benson Tower, 74 Hung To Road, Kwun Tong, Kowloon, Hong Kong, China China Office: Rm 309, Building A, Central Valley, 16 Haidian Middle Street, Haidian District, Beijing, China Singapore Office: 16L, Enterprise Road, Singapore 627660 Chinese original edition © 2013 China Renmin University Press Editors in chief: Chen Yulu and Guo Qingwang Deputy editors: Zhang Jie, Wang Changyun, and Qu Qiang English edition © 2017 by Enrich Professional Publishing, Inc. With the title Major Issues and Policies in China’s Financial Reform Volume 4 Translated by Barbara Cao Edited by Barbara Cao All rights reserved. This book, or parts thereof, may not be reproduced in any form or by any means, electronic or mechanical, including photocopying, recording or any information storage and retrieval system now known or to be invented, without written permission from the Publisher. 978-1-62320-110-4 ISBN (Hardback) ISBN (pdf) 978-1-62320-111-1 This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is sold with the understanding that the publisher is not engaged in rendering legal, accounting, or other professional service. If legal advice or other expert assistance is required, the services of a competent professional person should be sought. Enrich Professional Publishing is an independent globally-minded publisher focusing on the economic and financial developments that have revolutionized New China. We aim to serve the needs of advanced degree students, researchers, and business professionals who are looking for authoritative, accurate, and engaging information on China.

Contents Chapter 22 Tax Sharing Reform ......................................................................... 1

Jia Junxue

Chapter 23 “Two Guarantees” Policy ............................................................... 27 Zhu Qing Chapter 24 Proactive Fiscal Policy ..................................................................... 43



Guo Qingwang

Chapter 25 Reform of Three Budgetary Systems ............................................. 79

Wang Xiuzhi

Chapter 26 Debt-for-Equity Swap ...................................................................... 111

Xu Rong

Chapter 27 Split Share Reform ........................................................................... 131

Qu Qiang

Chapter 28 Consolidation of Enterprise Income Tax Laws ............................ 153

Zhu Qing

Notes

............................................................................................................. 167

Bibliography ............................................................................................................. 179 Index

............................................................................................................. 193

22

Chapter

Tax Sharing Reform

MAJOR ISSUES AND POLICIES IN CHINA’S FINANCIAL REFORM VOL. 4

Term Definition Tax sharing system is a scheme of defining taxation responsibilities and dividing fiscal revenues between central and local governments, and it often comes in four forms:

1. Amount sharing. Taxes will be collected uniformly across the country and the total amount will be distributed between central and local governments according to a certain ratio. 2. Independent scheme. Two independent taxation structures and corresponding management systems will be set up for central and local governments, both of whom enjoy relevant tax legislation and adjustment powers. 3. Differential tax rate. Differential tax rates will be imposed on different items. This usually happens in two ways: First, governments of different levels impose different tax rates on the same tax base; second, apart from collecting their own tax, governments of higher levels charge the same tax on the behalf of lower governments according to the tax rate set by the latter and then transfer the tax revenues to the latter. This tax is also known as a piggyback tax, and it is a surtax created on the existing higher-level government tax. 4. Tax type division. Under the premise of centralized taxation power, taxes are divided between central and local governments to form central taxes, local taxes and shared taxes.1 In 1994, the Chinese government announced a tax sharing reform, laying the foundation China’s current fiscal management scheme. Following the principle of “maintaining stocks, adjusting increments, gradually improving the central government’s ability of macroeconomic control, and building a reasonable fiscal distribution mechanism,” the reform introduced major adjustments to fiscal revenue increments on the premise of keeping local delivery and central subsidization confirmed in the fiscal contracting system unchanged and local vested interests unaffected.2 By doing so, the government aimed to achieve an overall reform target of “strengthening central fiscal power while not impairing local vested interests to stimulate the reasonable growth of state revenues under the premise of mobilizing both central and local governments.” To this end, the guiding ideology of “rationalizing the distribution relationship between central and local governments, properly adjusting the allocation of financial resources among different regions, and combining unified leadership with decentralized management, and overall planning with step-by-step implementation” was 2

Tax Sharing Reform

formulated on the basis of examining national conditions and learning from international experience. In accordance with the above guiding ideology, the tax sharing reform of 1994 divided the taxes into central taxes, local taxed and centrallocal shared taxes, set up two sets of tax collection and management institutions, i.e., state administration of taxation and local taxation bureaus, and also developed the system of inter-government transfer payment centering around tax returning, financial transfer payment, and special transfer payment, under the prerequisite of properly dividing administrative powers between central and local governments. The tax sharing reform in 1994 is an innovation in China’s fiscal management since New China was founded. It provided an institutional basis for managing the fiscal relationship between central and local governments in a scientific, standardized and reasonable way, and has had profound impacts on government behaviors and thereby the Chinese economy.

Background As the largest and most radical and influential reform to the fiscal system since the founding of New China, the tax sharing reform has its realistic bases.

Constant decline in two proportions Since the mid-1980s, the proportions of fiscal revenues in GDP and of central revenues in total fiscal revenues had been consciously falling, from 22.9% and 40.5% in 1984 to 13.1% and 28.1% in 1992 (see Fig. 22.1). Government finances, especially central finances, were in serious crisis and were on the verge of “bankruptcy.” The central government was in an unprecedentedly disadvantageous position. Fig. 22.1 % 50 40 30 20 10 0

24.5

Changes of the two proportions, 1980–1992

26.5 28.6

35.8

40.5 38.4 36.7 33.5 32.9 30.9 33.8 29.8 28.1

25.7 24.2 22.9 23.0 22.9 22.4 20.8 18.4 15.8 15.8 15.8 14.6 13.1 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1950 1991 1992

Year

Central revenues/total revenues Fiscal revenues/GDP

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MAJOR ISSUES AND POLICIES IN CHINA’S FINANCIAL REFORM VOL. 4

The fiscal contracting system instituted after the mid-1980s confirmed the leading position of local governments in the entire fiscal distribution, and the central government counted on local governments to turn in revenues. The sharp decline in fiscal revenues impeded the central government’s ability to perform its normal functions, and therefore the central government often had to raise the delivery proportion of or require extra contributions from local governments. From 1981 to 1989, the central government borrowed from local governments a cumulative total of CNY42.22 billion, making up 6.1% of central fiscal expenditures. Table 22.1 Central borrowings from local governments, 1981–1989 (Unit: CNY1 billion) 1981

1982

1983

1984

1985

1986

1987

1988

1989

Borrowing

6.84

4.02

3.62

3.84

4.30

4.52

4.83

5.02

5.24

Central spending

62.57

65.18

75.96

89.33

79.53

83.64

84.56

84.50

88.88

Borrowing as % of central spending (%)

10.9

6.2

4.8

4.3

5.4

5.4

5.7

5.9

5.9

Source: Li ping, A Brief Illustrated Guide to the Fiscal System.

In 1991, economic sluggishness inflicted severe financial difficulties on local finances. This, coupled with natural disaster in Guizhou Province, necessitated urgent financial support from the central government. However, with merely CNY99.24 billion of incomes collected in 1990, central finances faced a huge financial deficit. The Ministry of Finance thus demanded some affluent provinces or cities, such as Guangdong Province, to make extra contributions by turning in CNY10 million to CNY100 million apart from their usual duties, but this demand was turned down by those provinces. The difficult and disadvantageous position of central finances were fully revealed. In 1992, national fiscal revenues recorded CNY348.3 billion, among which CNY97.95 billion was central finances, and central expenditures in the same year was CNY117.04 billion, creating a fiscal gap of CNY19.1 billion. In the absence of support from local finances, the Ministry of Finance had to resort to bank borrowings to fill the financial gap, which was also declined by central authorities.3 In 1993, fueled by Deng Xiaoping’s southern tour speech, China’s economy showed a vigorous growth momentum, but fiscal revenues remained down trended: National fiscal revenues dropped by 2.2% year-on-year in the first quarter, and were basically flat even if calculated in comparable terms; among the

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Tax Sharing Reform

total, CNY140 billion was tax revenues, up 12% year-on-year and 1.4% if allowing for export rebates. To make matters worse, fiscal spending grew substantially, further expanding the fiscal gap and putting many major construction projects at a stagnation stage. Central finances had to rely on bank loans to pay wages and were on the brink of “bankruptcy.” Fiscal hardships, especially central fiscal difficulties, attracted great attentions from the central authorities. As the Vice Finance Minister Xiang Huaicheng recalled, Zhu Rongji, Vice Premier of the State Council, noted at the National Work Conference of Finance and Taxation on July 23, 1993 that “Under the current system, the central finance is having a very hard time, and it cannot get along if without a reform and will break down at any time before 2000. Generally speaking, in advanced market economies, central fiscal revenues usually account for no less than 60% of total revenues, and the ratio between central and local spending is often at 4 : 6. However, things are the opposite in China and the conflict between income and spending is eminent. This situation runs against the development of market economy and therefore must be reversed!”4 Consequently, a large-scale and influential fiscal reform was at hand.

Unsustainable fiscal contracting system The fiscal contracting system initiated in the 1980s was widely considered as the root cause of the constant decline of the “two proportions” and the “bankruptcy” of the central finances. In October 1984, Decisions on Reforming the Economic Structure was passed at the 3rd Plenary Session of the 12th CPC Central Committee. To implement these decisions, the State Council promoted a fiscal scheme of “separate categories of taxes, designated scope of revenues and expenditures, and responsibility contracts at various levels” in 1985 upon the expiration of the fiveyear arrangement of “division of revenues and expenditures between central and local governments and responsibility contracts at different levels.” Specifically, the new scheme had multiple variations in different areas, including revenueprogressive increase contract (shouru dizeng baogan 收入遞增包乾), dividing total revenues (zong’e fencheng 總額分成), dividing the total plus dividing the increase (zong’e fencheng jia zengzhang fencheng 總額分成加增長分成), remittanceprogressive increase contract (shangjie e dizeng baogan 上解額遞增包乾), fixedamount remittance (ding’e shangjie 定額上解), and fixed-amount subsidy (ding’e buzhu 定額補助) (see Table 22.2). In addition to that, a pilot reform of tax sharing on a 50/50 basis was also carried out. This situation was vividly described as a fiscal system of “one rate one province.”

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MAJOR ISSUES AND POLICIES IN CHINA’S FINANCIAL REFORM VOL. 4

Table 22.2 Fiscal system variations in different regions in 1988 Contracting method Region RevenueRegion, retained proportion, prescribed progressive revenue progressive increase increase rate contract Beijing, 50%, 4%; Hebei Province, 70%, 4.5%; Liaoning Province (excluding Shenyang City and Dalian City), 58.25%, 3.5%; Shenyang City, 30.29%, 4%; Harbin City, 45%, 5%; Jiangsu Province, 41%, 5%; Zhejiang Province (excluding Ningbo City), 61.47%, 6.5%; Ningbo City, 27.93%, 5.3%; Henan Province, 80%, 5%; Chongqing City, 33.5%, 4% Dividing total revenues

Region, retained proportion Tianjin City, 46.5%; Shanxi Province, 87.55%; Anhui Province, 77.5%

Dividing the total plus dividing the increase

Region, retained proportion, contribution proportion of increased revenue Dalian City, 27.74%, 27.26%; Qingdao City, 16%, 34%; Wuhan City, 17%, 25%

RemittanceRegion, remittance base, progressive remittance increase rate progressive increase Guangdong Province, CNY1.41 billion, 9%; Hunan Province, contract CNY0.8 billion, 7% Fixed-amount remittance

Region, remittance amount Shanghai, CNY10.5 billion; Shandong Province (excluding Qingdao City), CNY289 million; Heilongjiang Province (excluding Harbin City), CNY299 million

Fixed-amount subsidy

Region, subsidy amount Jilin Province, CNY125 million; Jiangxi Province, CNY45 million; Fujian Province (started in 1989), CNY50 million; Shaanxi Province, CNY120 million; Gansu Province, CNY125 million; Hainan Province, CNY138 million; Inner Mongolia Autonomous Region, CNY1.84 billion; Guangxi Zhuang Autonomous Region, CNY608 million; Guizhou Province, CNY742 million; Yunnan Province, CNY673 million; Tibet Autonomous Region, CNY898 million; Qinghai Province, CNY656 million; Ningxia Hui Autonomous Region, CNY533 million; Xinjiang Uyghur Autonomous Region, CNY1.53 billion; Hubei Province (excluding Wuhan City), 4.78% of the final account revenue of Wuhan City in the current year; Sichuan Province (excluding Chongqing City), 10.7% of the final account revenue of Chongqing City in the current year

Source: Li Ping, A Brief Illustrated Guide to the Fiscal System.

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Tax Sharing Reform

The fiscal contracting system consolidated the local governments’ status as the “possessor of remnants” by directing surplus fiscal increments to local finances, greatly arousing the enthusiasm of local governments. Over time, however, the defects of this system gradually revealed themselves, becoming the source of the unstable fiscal distribution relationship between central and local governments. Under this system, the central finance department was clearly at an disadvantaged position with no guaranteed income, which impelled it to raise the remittances proportion of local governments. This act provoked strong discontent among local authorities and their deep distrust towards the central government. In response, various tax rebates or reliefs were introduced by local governments to “store the wealth among the people” (cangfu yumin 藏富於民), and in such a way, real local fiscal income was concealed to reduce revenue remittance to the central government. Liu made an in-depth analysis on such a situation in Beijing and Shanghai.5 At that time, Beijing implemented a system of revenue-progressive increase contract: A progressive revenue increase rate was determined based on the final-account revenue of 1987, revenue increments fell within the prescribed increase rate would be turned in to the central government apart from the established remittance amount whereas the rest could be retained by the local government. The progressive revenue increase rate agreed between the central government and Beijing municipal government was 4% (see Table 22.2), and to avoid a further raise of this rate and the remittance proportion, Beijing concealed up to CNY9.8 billion of fiscal income in five years to keep the increase rate stable around 4%. Similarly, in Shanghai, a fixed-amount remittance method was carried out, where a fixed amount of CNY10 billion out of the stipulated revenue target of CNY16.5 billion should be remitted to the central government and on this basis, for every increase of CNY100 million, CNY50 million would also be contributed to the central treasury. However, during the five-year implementation of fiscal contracting, the annual fiscal revenues of Shanghai averaged at CNY16.5 billion, barely above the stipulated lower limit. In fact, such a practice was common across the country and without effective correction measures, the central government had no choice but to watch the constant decline of local remittance amount. This shows that the fiscal contracting system firmly trapped the central government by cutting off its channels of incremental revenue, which perfectly explains the state’s financial predicament. To get rid of the financial difficulties, the central government had to frequently raise the local remittance proportion, further aggravating the discontent among local governments and thus making central income even less. As a result, the state finance fell into a vicious cycle of “central revenues decreasing → fiscal system being changed → local governments concealing real income → central revenues

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MAJOR ISSUES AND POLICIES IN CHINA’S FINANCIAL REFORM VOL. 4

further declining.” In view of this situation, Finance Minister Xiang Huaicheng, key figure of the 1994 tax sharing reform, gave a succinct and insightful comment, “the finance and taxation system of a market economy should be a distribution system which is stable and standardized, more aligned with the principles of a market economy, and fair and transparent. The frequently changed finance and taxation system of China has caused the distrust of local governments towards the central government and their mutual suspicion, because local governments have no idea how the system will be reformed and what to expect.”6 Once the budgetary income cannot meet the state’s financial demand, the central government had to resort to fees: The fund for national key construction projects of energy and communications set up in 1982 and the national budget adjustment fund established in 1989 were best examples. Meanwhile, to lower the contribution to the central government, local governments tried every means to suppress budgetary income growth, while enlarging extra-budgetary or even extra-institutional income by imposing all kinds of apportionments and fees to increase their disposable income. As a result, the practices of “three arbitraries” (arbitrary fee collection, arbitrary cost apportionment, and arbitrary fund-raising) ran rampant, incurring heavy economic losses on the society, disturbing the normal order of fiscal distribution and the market economy, as well as the healthy and orderly development of the economy and society. Moreover, the division of financial sources and powers based on administrative hierarchy in the fiscal contracting system largely induced local authorities to tamper with the market and commodity circulation, encouraging local protectionism and inhibiting the formation of an unified national market. The resulting low-level, redundant construction and investment inflation have exerted negative impacts on the continuous and smooth operation of the Chinese economy.7 Hence, it is clear that both central and local governments were dissatisfied with the fiscal contracting system: The central government was displeased with the continuous decline of revenue whereas local governments were not happy about frequent system changes. Besides, the negative impacts of the system on the economy became more and more salient, and the system became increasingly inadaptable to the development demand of China’s socialist market economy. China was desperately in need of a radical and all-round fiscal reform. Consequently, in November 1993, Decisions on Issues with Establishing a Socialist Market Economy passed at the 3rd Plenary Session of the 14th CPC Central Committee officially put forward the tasks of the tax sharing reform. It signaled the beginning of the most large-scale, radical, and influential reform in the finance and taxation system since the founding of New China.

8

Tax Sharing Reform

Institutional Innovations in the Game of Interests The major task of the tax sharing reform in 1994 was to reverse the continuous decrease of the “two proportions,” and confirmed the leading position of the central government in fiscal distribution. It featured the centralization of fiscal powers, which was contrary to the interests of local governments. For this reason, the game of interests between central and local governments was running through the whole process of the reform, from the initial plan design, reform implementation, and gradual reform deepening. In this sense, the tax sharing reform can be regarded as an institutional innovation amid the game of interests in China’s fiscal history.

Determination of the basic reform plan in the game of interests The content of the tax sharing reform in 1994 was very broad, including not only the division of administrative and financial powers and the establishment of a tax returning system, but also a series of complementary measures, such as the profit distribution system of state-owned enterprises (SOEs) and the development of the tax management system. In terms of administrative power division, the central finance department was responsible for providing funding in 14 areas, such as national security, foreign affairs, operation of state organs and undertakings within their jurisdiction, economic structural adjustment and macroeconomic regulation and control; local finance authorities bore the expenses in 13 aspects, such as the operation of local administrative organs and expenditures for the development of the economy and public undertakings. In respect of the division of financial power, 8 kinds of taxes that relate to the safeguard of the national interests and macroeconomic control, such as tariff and consumption tax, were categorized as central taxes; 18 taxes that pertain to local administration, such as business tax, individual income tax, and tax on real estate, were classified as local taxes; 3 other taxes that are closely linked to economic development, such as value added tax were labeled as central-local shared taxes (see Table 22.3). Among them, the centrallocal sharing ratios of value added tax and securities transactions tax were 75 : 25 and 50 : 50, respectively, and all taxes on resources belonged to local governments with an exception of the tax on offshore oil resources that is levied by the central government. As for tax refund, the returning schemes of value added tax and consumption tax were established: taking the net revenue remittance amount in 1993 (consumption tax + 75% of value added tax – central allocated revenue in 1993) as the base, all the base amount will be returned to local finances; the returning amount thereafter will grow at a certain rate, proportionate to the average growth rate of the two taxes at a ratio of 1 : 0.3.

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MAJOR ISSUES AND POLICIES IN CHINA’S FINANCIAL REFORM VOL. 4

Table 22.3 Arrangements for fiscal revenue and expenditure responsibilities among central and local governments in the tax sharing reform Fiscal revenue responsibility Central taxes: taxes pertaining to safeguarding national interests, and implementing macroeconomic regulation and control; Local taxes: taxes matter to the administration of local authorities; Shared taxes: taxes relevant to economic development Domestic consumption tax, Central fiscal Expenditure on national defense, outlay customs duties, import expenditure for armed police forces, expenditure value added tax and (central taxes) for foreign affairs and aid, central-level administrative expenses, centrally managed consumption tax, vehicle purchase tax, and vehicle capital construction investment, technical and vessel tonnage tax innovation and trial production of new products in enterprises directly under the central government, geographical prospecting expenditure, expenditure for supporting agriculture arranged by the central government, expenditure on payment for the principal and interest of foreign and domestic debts, and expenditure for public security organs, procuratorial organs, and people’s courts at the central level, and for social undertakings in the fields of culture, education, public health, and science Local fiscal Local administrative expenses, expenditure Tax on the use of urban land, tax on the occupancy for public security organs, procuratorial expenditure of cultivated land, value organs, and people’s courts at local levels, (local taxes) added tax of the land, tax part of the outlay for armed police forces, on real estate, urban real expenses of people’s militia, locally estate tax, vehicle and managed capital construction investment, vessel use tax, vehicle and technical innovation and trial production vessel license plate tax, and of new products in local enterprises, contract tax expenditure for supporting agriculture arranged by local governments, expenses of city maintenance and construction, local expenditure for culture, education, and public health, expenditure on price subsidies and other expenditures Division principle

10

Fiscal expenditure responsibility Central finances: National security, foreign affairs, operation of state organs, economic structural adjustment, regional development coordination, macroeconomic regulation and control, and undertakings under central direct administration; Local finances: operation of local administrative organs, and development of the local economy and public undertakings

Tax Sharing Reform

(Cont’d) Central-local shared taxes

Fiscal expenditure responsibility —

Fiscal revenue responsibility Domestic value added tax (central, 75%) Business tax: the part paid by the Ministry of Railways, head offices of all banks, and head offices of all insurance companies (central, 100%); the rest (local, 100%) Enterprise income tax: the part paid by the Ministry of Railways, head offices of all banks, and offshore oil enterprises (central, 100%); the rest (local, 100%) Individual income tax: tax revenues from savings deposit interests (central 100%); the rest (central 60%) Resource tax: the part paid by offshore oil enterprises (central 100%); the rest (local, 100%) City maintenance and construction tax: the part paid by the Ministry of Railways, head offices of all banks, and head offices of all insurance companies (central, 100%); the rest (local, 100%) Stamp tax: tax revenues from securities transactions (central, 94%); other stamp tax revenues (local, 100%)

Sources: 1. Xie, 30 Years of China’s Fiscal Reform;

2. Guo and Zhao, Public Economics.

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MAJOR ISSUES AND POLICIES IN CHINA’S FINANCIAL REFORM VOL. 4

The key of the reform content lies in the division of revenue powers and the scheme of tax returning, which are the main points of conflict of interests between central and local governments, and among them, the biggest difficulty is the reform of value added tax. Valued added tax was the largest tax of the turnover tax system after the last tax system reform, and it accounted for around 40% of total tax revenues. Thus, it is understandable that the reform of value added tax would affect the entire taxation system and was naturally the focus of the game of interests between central and local governments. In the reform plan design, value added tax was soon confirmed as the shared tax, but the determination of the actual sharing ratio and tax returning methods met with a lot of troubles. At the first, the central government proposed three sharing ratios of 2 : 8, 3 : 7, and 4 : 6 between local and central governments, but after careful calculation and consideration, a ratio of 75 : 25 between central and local governments was finally confirmed. As for tax returning, the Ministry of Finance learned from the “contracting at different levels” in 1980 and the fiscal contracting system in 1985 to come up with a plan of “base plus growth”: Base amount will be fully returned to local government and increments will be returned according a certain percentage. The core of this plan lied in the determination of the base amount, base period, and percentage of growth. The Ministry of Finance first suggested deciding the percentage of growth based on the inflation rate, but this idea was rejected by the central government after rounds of discussion and replaced by the decision that the growth percentage will be 0.3% of the average growth rate of value added tax, that is the ratio of the average growth rate of valued added tax to the returning growth percentage is 1 : 0.3. For the base amount and period, they were not clearly stated in the plan and took the experience in the past years as a reference. Although the above plan had given much consideration to local vested interests, it still stirred a great disturbance throughout the country upon its release. Apart from a few places, most provinces raised an objection against the plan, especially Guangdong Province. For this reason, the central government sent many times representatives to Guangdong Province to give detailed explanation of the plan. As an important witness of this event, Vice Finance Minister Xiang Huaicheng repeatedly said that the toughest battle in the tax sharing reform of 1994 was in Guangdong Province, where the persuasion work was most difficult and met with a series of frustrations.8 At the start, Guangdong government wrote to the central government to express its objection against the reform plan and requested continuous independent implementation of the fiscal contrasting system. Then, in a meeting between the Party Committee of Guangdong Province and Vice Premier Zhu Rongji who was delegated by the Party Central Committee and State Council to promote the reform plan, Guangdong Province further explained

12

Tax Sharing Reform

its reason that over CNY100 billion more revenues would be taken away by the central government in a decade after the tax sharing reform, directly delaying the pace of the province to catch up with the “four Asian tigers.” To eliminated all its worries, Vice Premier Zhu immediately asked the accompanying officials from the Ministry of Finance to estimate the tax revenues of Guangdong Province in the next 10 years under the two taxation systems. According to the result, under the tax sharing system, around CNY70 billion of tax revenues will be turned in to the central government in the next 10 years, but this system will contribute to a much larger growth of local finances, and therefore the overall impact on local finances will be small. Seeing the estimation, Guangdong government agreed to carry out the tax sharing system but with the condition that the final account revenue of 1993 should be used as the base (originally, 1992 was confirmed as the base year). As Xiang recalled, the Ministry of Finance strongly disagreed with that, arguing that local governments could artificially pushed up the fiscal revenues of 1993 to create a high returning base and obtain higher tax returns, considering the fact that it was in September 1993 and the final account of fiscal revenues of 1993 could not be out until the first half of 1994. Vice Premier Zhu, however, accepted the condition against all dissenting views to win the support from Guangdong Province, and the reform plan of value added tax was finally confirmed.9 In addition, according to the original idea of the central government, additional support will be given to economically backward provinces through transfer payment. But western provinces, such as Guizhou, Yunnan, and Guangxi, did not appreciate it and complained that to classify consumption tax as central tax would greatly harm local interests. To remove their concerns, the central government decided to return consumption tax by referring to the returning scheme of value added tax. By then, an agreement between central and local governments in key areas of interest conflicts was finally reached, paving the road for the later smooth implementation of the tax sharing reform. After rounds of negotiation, a tax sharing plan with Chinese characteristics, acceptable to both central and local governments and full of wisdom, finally came out.

Progressive reform deepening in the game of interests The taxing sharing reform of 1994 is a significant innovation in the finance and taxation system since the founding of New China and the scale and complexity of the reform are unprecedented. Because of this, many problems, especially the reactions of local governments, were hard to predict. Even for the problems that had been foreseen by the central government, many roundabout means were adopted to avert radical responses from local governments. As a result, many important

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MAJOR ISSUES AND POLICIES IN CHINA’S FINANCIAL REFORM VOL. 4

problems were left unsolved in the initial plan of the tax sharing reform. However, the central government always kept a close eye on the development of the reform and made constant adjustments to the reform plan to facilitate the deepening of the reform. Subsequent reform measures were introduced mainly in the following aspects.

Perfection of the tax returning scheme In the second half of 1993, a returning method of giving tax rebates on the basis of the real fiscal revenues of 1993 was confirmed. To maximize their vested interests, local governments intensified their efforts to collect taxes and introduced unconventional measures, such as “refunding after collection” and “collecting a year ahead,” to fake a larger base. As a result, fiscal revenue in the second half of 1993 surged: It increased by 60% year on year in September, 80% in October, 90% in November, and 120% in December. Fiscal revenue was up by 39.9%, or CNY90 billion, from the previous year. The central government immediately realized that local governments were cheating at the result and a large part of the total number was exaggerated, but the national inspection group organized by the central government did not find any obvious fault, as constrained by realities. Since a large proportion of the newly increased fiscal revenue will be returned to local governments, a fund gap of CNY30 billion will be created in the fiscal budget plan of 1994 if the refunding plan continued to be implemented. How to effectively resolve the fund gap became the first challenge for the central government. At first, the Ministry of Finance intended to close the gap by diminishing the local rebate base, but this idea was strongly opposed by local governments, believing that this judgement lacked objective evidence and will undermine the seriousness of institutional arrangement. Finally, after intense discussion and prudent consideration, the central government approved the base of 1993, but modified the tax rebate system by adding a reward and punishment mechanism. To be specific, 1/3 (16%) of the local growth rate of the “two taxes” in 1993 was made the growth target of the taxes for each region; for those who cannot meet the target, a corresponding part of local fiscal revenues will be withdrawn as compensation; for those who cannot even fulfill the base amount, a reduction will be made to their base; for those who have completed the growth target, the rebate rate will be raised in proportion to the local growth rate of the “two taxes” (value added tax and consumption tax) at a ratio of 0.3 : 1; for those who have overfulfiled the growth target, the excess part will be refunded at a higher ratio of 0.6 : 1 as a reward. The rebate rate of growth was no longer linked up to the national average growth rate of the “two taxes” but to the local average growth rate. Compared

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Tax Sharing Reform

with the initial rebate plan, the new plan was more conducive to motivating and restraining local tax collection behaviors by introducing a mechanism of reward and punishment, and it has laid a sound institutional basis for the future continuous and rapid growth of fiscal revenues. So far, China’s economy stepped into a period of steady and fast growth of fiscal revenues and central fiscal revenues: From 1994 to 2002, China’s fiscal revenues increased by 17.5% on an annual basis; the share of fiscal revenues in GDP climbed from 12.6% in 1993 to 18.5% in 2002; in 2002, central fiscal revenues took up 55% of total national fiscal revenues, up 33 percentage points from 1993 when the reform was not implemented.

Reform of income tax sharing When the tax sharing was first carried out in 1994, the central government did not promote the income tax reform on a large scale in view of strong local resistance. Individual income tax was classified as local tax while enterprise income was collected according to their respective administrative relations, namely income tax of centrally owned enterprises will be considered as central fiscal revenue and that of local enterprises will be counted as local fiscal revenue. However, as the reform of economic system, especially the enterprise reform, was gradually deepened, the drawbacks of this tax division method became increasingly salient: 1. It contributed to the government intervention and enterprises’ administrative dependence on local governments, impeding the building of a modern corporate system, intensifying the vicious competition among enterprises and local protectionism, and disrupting normal economic order; 2. With the development of modern enterprises, the administrative relation of enterprises became increasingly hard to define, leaving a large loophole for abuse, and thus making a mess in tax collection and causing a great loss in central tax revenue: According to the statistics of the Ministry of Finance, a total of CNY1 billion central revenue was wrongly collected in local treasuries in 2000, as indicated by its survey of 239 state administration of taxation bureaus at municipal or county levels;10 3. It further widened the financial gap between different regions, hindering the free and efficient flow of production factors, and interrupting the coordinated development of the national economy. To effectively solve the above problems, the central government decided to introduce an income tax sharing reform effective from January 1, 2002, and income tax would be divided between central and local governments according to a certain

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ratio rather than based on the administrative relation. The income tax sharing reform was the largest reform of taxation power division since 1994, and its main contents included: 1. Apart from several special industries or enterprises, such as railway transportation and state-owned banks, income tax from other enterprises and individuals will be shared between central and local governments at a certain ratio, 50 : 50 in 2002, and 60 : 40 in 2003; 2. Growth in income tax will be shared with the real local tax revenue of 2001 as the base, and the corresponding calculation formula was: local income tax rebate in 2003 = real local income tax revenue in 2002 * 60% – real central income tax revenue in 2002 * 40%; 3. Central revenue growth resulting from income tax sharing will be diverted to central and western regions through transfer payment; 4. Income tax paid by transregional operations will be distributed among different regions where their branch offices or subsidiaries were based, in accordance with the weights of three different factors — operating income, number of employees, and total assets — which were 0.35, 0.35, and 0.3, respectively. Overall, the income tax sharing reform of 2002 has achieved satisfactory results. For one thing, this reform completely broke the administrative relation between governments and enterprises and the administrative dependence of enterprises on governments, and therefore facilitated the deepening of enterprise reform, prevented government intervention on business management, redressed local protectionism and redundant construction, and promoted the formation of a national unified market and the healthy and orderly development of the Chinese economy. For another, this reform not only addressed the disorder in income tax collection, but also established a mechanism for the steady growth of general transfer payment funds from the central government — CNY112.1 billion in 2005, an increase of nearly CNY100 billion from 2001 — and this played an important role in relieving the financial difficulties in central and western regions and promoting the regional coordinated development.11

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Fig. 22.2

General transfer payments from the central government, 1995–2005

CNY1 billion

112.1

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Building of an inter-government transfer payment system To reverse the unfavorable position of central finance in the fiscal distribution system, the tax sharing reform centralized the fiscal power, which caused severe vertical fiscal imbalance in localities. At the same time, due to the difference in resource endowments, economic development was imbalanced among different regions, leading to serious horizontal fiscal imbalance. In view of this situation, the central government established a system of inter-government transfer payment in 1994 to better promote fiscal balance and realize equalized basic local public service. In addition to tax rebate, inter-government transfer payment in China mainly included the following two kinds: 1. General transfer payment (originally known as financial purpose transfer payment). It aims to relieve local financial stress and promote the equalization of public service capacity among local governments. It can be subcategorized into transfer payment for equalizing access to basic public services (originally termed as general transfer payment), transfer payment to ethnic minority areas, transfer payment for awards and subsidies for implementing the mechanism for ensuring basic funding for county-level governments, transfer payment for adjusting wages, transfer payment for rural tax and fee reform, transfer payment for compulsory education, and transfer payment for fixed-amount subsidies (originally institutional subsidies); 2. Special transfer payment. This fund was earmarked for specified purposes only to fulfill particular central policy targets, such as special budgetary allocation and treasury subsidies, especialy used for developing public services in the fields of education, health care, social security, agriculture, etc.

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After 1994, especially after 2002, as the central government’s financial power was constantly increased, central transfer payment also showed momentum of continuous and rapid growth, and it went up by 9.62 times from CNY238.9 billion in 1994 to CNY2,299.1 billion in 2008, with the accumulated amount reaching CNY12,028.5 billion, an annual growth rate of 17.55% (see Fig. 22.3). Among this, the proportions of general and special transfer payment in total transfer payments were low at the beginning of the reform to have been stable at 30% (see Fig. 22.4). After that, the proportions were constantly rising as the income equalization function was reinforced while institutional functions were weakened. The proportion of special transfer payment was stabilized at 35% after 1999 and that of general transfer payment was continuously growing, with the two accounting for a total of 80%. So it was evident that central transfer payment has made remarkable progress since 1994 and the transfer payment system has taken shape with its structure being constantly optimized. In the meantime, capital allocation methods of inter-government transfer payment were also improved to be more fair and scientific. Take transfer payment for equalizing access to public services (originally known as general transfer payment) as an example. In 1995, the equalization transfer payment system was established, and it was then called a “transfer payment for the transitional period.” At first, the respective transfer payment amounts for each region were calculated following an unified formula, taking into account objective factors such as the difference between standard fiscal revenue and expenditure and available transfer payment funds, and in accordance with the principles of justice and equity. Here, standard fiscal revenue refers to fiscal revenue capacity, measured by tax bases and tax rates of different taxes; standard fiscal expenditure describes local fiscal spending Fig. 22.3

Changes of China’s fiscal transfer payments, 1994–2008

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%

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Fig. 22.4 Changes in the proportions of different kinds of transfer payment, 1994–2008 %

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demand, mainly determined by local government scale, average expenditure, and the difference coefficient of relevant costs. The difference coefficient of expenditure costs is mainly affected by geographical conditions, population size and structure, and other objective factors. The more difficult local finances are, the higher central subsidies. In 2002, the distribution formula of equalization-purpose transfer payment was refined. In 2008, the central government further upgraded the calculation method of central transfer payments and announced the Methods of General Transfer Payments from the Central Government to Local Governments, in line with the requirements of scientific, delicate, and standard management, under the guidance of scientific outlook on development and the idea of “putting people first.” In 2009, general transfer payment was renamed into transfer payment for equalizing access to basic public services. The new methods made adjustments to the calculation of standard fiscal expenditure in response to the changes of local governments’ functions and general transfer payment’s targets. In the Methods of General Transfer Payment of 2002, the main targets were to alleviate outstanding contradictions in the fiscal operation of financially distressed places and guarantee basic pubic expenditures, such as payroll expenses and expenditures for normal operation of government departments and public institutions, and therefore, the standard scale of fiscal dependents and personnel expense standard were the main variables in calculating local general transfer payments. In contrast, the new Methods were set against the backdrop of the transition of local governments towards service-oriented, and a switch in the target of general transfer payment to realizing equalized access to public services. Accordingly, when calculating standard fiscal expenditure, expenditures for public service were the main concern,

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and specifically, general transfer payments were calculated, by using a standard formula, on objective factors affecting fiscal revenues and expenditures, with due regard to cost variances in relation to population size, population density, elevation, and ethnic minorities, while taking into consideration local fiscal realities.

Innovation of fiscal system at lower-provincial level The tax sharing reform of 1994 has standardized the fiscal relationship between central and local governments but did not stipulate the fiscal management system at lower-provincial level. Governments below provincial level carried out a tax sharing management system by learning from the institutional framework of the fiscal relationship between central and local governments with a wide variation in the arrangement of fiscal revenue and expenditure responsibilities. In general, they adopted the methods of dividing tax types and total revenues between higher and lower governments, but the division varied greatly in form. As for expenditure responsibilities, a number of basic principles were laid down according to local realities, and similarly, a significant difference was present in actual practice through lack of a clear and practical legal basis. Overall, the arrangement of fiscal revenue and expenditure responsibilities at lower-provincial level shared one common feature: Fiscal power to revenues was centralized upwards to higher level governments whereas expenditure responsibilities were devolved downwards to lower level governments. Under this structure, governments at county level generally assumed more responsibilities of public expenditures but were assigned limited financial sources. This can be observed from the kernel density plot of fiscal decentralization in county-level governments (see Fig. 22.5).12 From 1997 to 2001, the decentralization level dropped noticeably, reflected in the left shift of the peak in 2001 compared to 1997, and this was consistent with the national trend of expenditure centralization since the tax sharing reform of 1994.13 However, expenditure responsibilities of county-level governments markedly increased after 2002 and the expenditure decentralization level rebounded back to the level of 1997 in 2005. In stark contrast, the revenue decentralization of county-level governments was continuously falling between 1997 and 2005, which was especially evident between 1997 and 2001. Hence, this showed that financial and administrative powers were imbalanced in China’s county-level governments between 1997 and 2005. In fact, these governments undertook 35.1% of national public expenditures but received 18.2% of total fiscal revenues, with a correlation coefficient between fiscal revenue and expenditure decentralization of merely 0.545.

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Tax Sharing Reform

Fig. 22.5 Kernel density of fiscal revenue and expenditure decentralization in China’s county-level governments

0.05 0.04 0.03 0.02 0.01 0

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Because of the serious imbalance between financial power and responsibilities, governments at county level suffered from acute financial difficulties. To reverse this situation, China has made some innovative exploration on fiscal management system reform centering around enlarging fiscal administrative authority in hopes of resolving the financial difficulties of governments at county and township level and enhancing their ability of independent development. One of the best example is the reform of “direct provincial supervision of county finance” (sheng zhi guan xian 省直管縣). China implements a five-tier government structure, namely central, provincial, municipal, county-level, and township-level, and countylevel governments are within the jurisdiction of municipal governments. For this reason, at first, county finance was managed by the municipal government at a higher level: Fiscal revenue and expenditure responsibilities, transfer payments at lower provincial level, and the transfer of budgetary funds were passed down from provincial governments to municipal governments and then to county-level governments. In 2005, all counties of 9 provinces including Zhejiang, Anhui, Hubei, Heilongjiang, Fujian, Hainan, Ningxia, Jilin, and Guangxi, and 72 counties, including Xinji, Hejin, Xinguo, and Dengzhou, in Hebei, Shanxi, Jiangxi, and Henan provinces implemented the fiscal management system of “direct provincial supervision of county finance.” At present, this system was practiced in more than 10 provinces, autonomous regions and municipalities across the country. Judging from current institutional operation, the new fiscal management system is advantageous in multiple ways: It can lower administrative costs, avoid improper concentration of county finances by municipal governments, give full play to the role of provincial governments in adjusting financial disparity, enlarge the administrative authority of county governments, enhance the independent

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development ability of counties and cities, promote the coordinated development of the economy and society at county level, and get county and township governments out of financial hardship.14

Overall Evaluation Compared to the fiscal contracting system which contains many unstable factors, such as administrative orders and bargaining, the tax sharing system has brought about dramatic changes to both the fiscal adjustment idea and fiscal operation mode. Conforming to the requirements of standardization and stabilization of the market economy, it ushered in a new era in the history of China’s fiscal development and has exerted profound influences on the Chinese economy.15 In this part, an in-depth meta-analysis will be given on the economic influences of the tax sharing reform of 1994 in order to explore an optimum choice for China’s fiscal decentralization and offer reform suggestions for building a fiscal and taxation system favorable to sustainable economic development.

A meta-analysis framework The primary objectives of the tax sharing reform of 1994 was to optimize the functions of local governments and encourage better and faster development of the local economy through clearly defining the responsibilities, power and rights between central and local governments. The success of these objectives hinged on the incentive and restraint mechanism brought about by the reform and associated influence on local governments’ behaviors. In existing literature, the prime focus was given to the significance of a fiscal competition mechanism,16 and advocated the use of “Pigouvian” transfer payments to correct negative impacts of fiscal competition.17 But due to cost externality and information asymmetry, corrective transfer payment polices should take into consideration the incentive problems of moral hazard and adverse selection of local governments.18 In addition, the administrative management structure and the government organizational structure, as important external institutional environments, will also deeply influence the behaviors of local governments.19 Therefore, a meta-analysis framework was established to comprehensively tease out and anatomize the economic impacts of the tax sharing reform of 1994 and the logic mechanism behind it, by taking behaviors of local governments as the core, fiscal decentralization, fiscal competition, and economic development as the main line, and the inter-government transfer payment system and the governance structure of local governments as institutional environments.

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Fig. 22.6 The meta-analysis framework for the economic impacts of the tax sharing reform Inter-government transfer payment system

Institutional restraints

Fiscal incentives Tax sharing Fiscal incentives reform

Fiscal competition

Local government governance structure

Political promotion incentive

Local government behaviors

Economic development

The tax sharing reform of 1994 altered the fiscal distribution pattern between central and local finance formed under the fiscal contracting system by replacing “one-on-one” negotiations with unified division of fiscal and administrative powers in dealing with the central and local fiscal relationship. Through establishing a long-term, stable incentive and restraint mechanism, the reform has played a positive role in regulating the behaviors of local governments and then economic development. 1. By assigning independent taxes and corresponding taxation power to local governments and establishing a tax rebate system with clear reward and punishment measures, the reform provided massive fiscal incentives to local governments, aroused their enthusiasm for taxation, and urged them to change their competition strategy of a low tax rate. This not only turned around the situation of excessive regional competition and contributed to regional economic growth,20 but also accelerated the continuous and rapid development of national fiscal revenues, providing a financial basis for China’s long-term sustainable economic growth.21 2. It introduced the practice of dividing central and local revenues based on tax type, and in particular, the income tax sharing reform of 2002 changed the division of income tax revenues based on an enterprise’s administrative relation, thus breaking the interest connection between local governments and enterprises and greatly undermining local governments’ profit motive through supporting the development of local enterprises with vicious competition means, such as local protectionism, economic blockade, and market segmentation. It has well contained and corrected the vicious competition and low-level, redundant construction brought about by the fiscal contracting system, and facilitated the formation of a nationally

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unified market and the healthy and orderly development of the economy. 3. The gradual perfection of the inter-government transfers payment system and the corresponding distribution methods, especially the continuous expansion of the equalization-oriented transfer payments, helped to give full play to the function of transfer payment policies in redistributing interests among local governments, effectively alleviated the financial difficulties of less developed areas, motivated local governments to undertake functional transformation, and promoted balanced development of local basic public services. In addition, the simplification of fiscal hierarchy and the reform to local governance structure, such as “merging townships into towns” (che xiang bing zhen 撤鄉并鎮) also greatly improved the efficiency of fiscal fund use and eased the financial burden of local governments,22 thus bringing the positive effects of the decentralization reform into full play. On the other hand, the practice of “centralizing financial power while decentralizing administrative power” adopted by the tax sharing reform of 1994 led to the mismatch between financial and administrative powers among local governments, especially among gross-roots governments, and therefore created eminent adverse impacts on local governments’ behaviors and then economic development. 1. In want of stable financial sources, local governments started to seek some extra-budgetary or even extra-institutional income, as epitomized by the so-called “land finance,” namely, profiting from the transfer of land use right. In some developed provinces, the income from land transfer equal to local budgetary income, pushing up China’s housing prices. This not only adversely impacted the healthy and stable operation of the Chinese economy, but also brought about a series of social consequences. 2. The mismatch between financial and administrative powers resulting from the tax sharing reform sent local governments, especially gross-roots governments in central and western regions, into severe financial distress, posing a threat to the regime and social stability and accounting for the low level of basic public services, such as elementary education and health care, in China and especially in the central and western regions. Despite the achievements in bailing county- and village-level governments out of their financial difficulties, the problem was still acute. 3. Since the tax sharing reform of 1994, the central government developed a strategy of offsetting the adverse impact from fiscal decentralization by transfer payment. Due to a lack of overall planning, transfer payments were

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fragmented and short-term, unfavorable for the formation of a long-term, stable incentive and restraint mechanism. Besides that, this also induced the ever-growing dependence of local governments on transfer payments and provoked irrational government behaviors, thereby bring about all sorts of moral hazards, diminishing the effectiveness of transfer payment policies and creating massive losses of financial resources. 4. The vertical administrative structure and the overemphasis on GDP in the political promotion mechanism further magnified the adverse impacts of the tax sharing reform of 1994. Moreover, the central government overlooked the restraints of the local governance structure in the countermeasures, contributing to the undesirable results of many reform measures.23

Optimal option for fiscal decentralization According to the modern fiscal decentralization theory, the mismatch between financial and administrative powers will easily ends up with a common pool effect, which will undermine the restraints of fiscal decentralization on the behaviors of local governments and lead to low fiscal expenditure efficiency. For this reason, advocates of this theory suggest that financial power should suit administrative power.24 This, however, is hardly the case in most countries. Through the tax sharing reform of 1994, China was moving from an extreme to another in terms of fiscal decentralization mode, and as time went by, this trend was increasingly evident. Before 1994, China adopted an overly decentralized mode through the fiscal contracting system, determining the dominance of local finance in income distribution, and the central government had to rely on the “reversed transfer payments” from local governments to obtain necessary fiscal revenues. Therefore, it is considered an extreme and abnormal decentralization mode, and such a mode is unsustainable and will inevitably impinge on economic and social development, political stability, and national unity, no matter from the perspective of pure economic or political economics. The tax sharing reform of 1994 completely abandoned this mode and replaced it with a mode of centralizing financial power, decentralizing administrative power, and correcting fiscal imbalance with transfer payments. Under this new decentralization mode, the leading role of central finance in financial distribution was established, and the financial and political control of central government over local governments and of upper local governments over lower local governments was reinforced, which was favorable for political stability and national unity. However, the mismatch between financial and administrative power has brought about a series of critical problems and the total reliance on

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transfer payments to calibrate the fiscal imbalance implied great moral hazards due to information asymmetry and fiscal externality, in addition to the challenge of seeking to be compatible with China’s government organizational structure in objective and incentive. Therefore, the key to the acute conflicts in China’s economy and society is whether an optimal decentralization mode can be established in the next fiscal system reform. Obviously, this is a complex question, entailing not only social and economic factors but also cultural and political factors. The direction of reform, however, is clear: to properly decentralize financial power, centralize administrative power, and reduce the scale of transfer payments, in order to form a more balanced fiscal decentralization mode between financial and administrative power.

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Chapter

“Two Guarantees” Policy

MAJOR ISSUES AND POLICIES IN CHINA’S FINANCIAL REFORM VOL. 4

Introduction In June 9, 1988, the Central Committee of the Communist Party of China (CPC) and the State Council put forward a “two guarantees” policy in the Notice on Guaranteeing the Basic Living and Reemployment of the Laid-Offs from State-Owned Enterprises, which stipulated: “To guarantee the basic livelihood and job creation for laid-off workers from state-owned enterprises (SOEs) is the main task of the central government for the current and future periods, with guaranteeing their basic living as the priority, in accordance with the general plan of SOE reform and taking into consideration the social bearing capacity.” It also pointed out, “While doing a good job on guaranteeing a basic living standard of the laid-offs, the government should also further the reform of pension system for retirees by speeding up legislation; the government needs to guarantee the timely and full payment of basic pension benefits to the retirees of enterprises to secure their basic living, and new pension arrears should be avoided while past arrears must be gradually paid out.” Simply put, the “two guarantees” policy can be summarized as: to guarantee the basic living of the laid-offs from the SOEs and to guarantee the timely and full payment of basic pension benefits to the retirees of enterprises.

Historical Background China’s Economic Reform started in 1978. Being market-oriented, this reform boosted the country’s overall economic efficiency within just one to two decades: By the early 21st century, China grew its GDP to CNY9,593.3 billion with the per capita GDP quadrupling between 1980 and 2000, and ranked sixth around the world in economic aggregate. Despite notable achievements in economic efficiency, the Economic Reform generated a few side effects on social equality, conspicuously manifested in the ever growing income gap and poor social security for vulnerable groups, including the elderly, sick, handicapped and unemployed. When it goes to the middle-to-late 1990s, social members who have more difficulty feeding themselves can be categorized into two types. First, laid-off workers. After the Economic Reform, especially after the 1990s, China’s economic structure underwent fundamental changes. The adjustment of the industrial structure made traditional high energy-consuming, labor-intensive industries and industries with outdated technologies increasingly incompatible with economic development, forcing many companies to close down, shift to other line of production, or cut back production. Others, even if with marketable products, had to seek ways to lower costs and increase efficiency against fierce

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market competition. Things got worse, especially after the Economic Reform when SOEs generally recorded losses, and naturally, to turn losses into gains topped the agenda of the reform. At the 15th National Congress of the CPC and the 1st Planetary Session of the 15th CPC Central Committee convened in September 1997, it was proposed that within about three years, the majority of large and middle-sized SOEs should be extricated from their predicament through reform, reorganization, upgrading and improved management, and a modern corporate system should have been set up in most of backbone SOEs by the end of 2000. Under such a situation, how to absorb a large population of surplus labor created from downsizing for efficiency was the problem that SOEs must solve. Since to simply push the laid-offs out to society was politically and socially unacceptable at that time, some SOEs opted to lay off those who were less competent in either health or skills while still maintaining employment relations with them. This solution not only solved the problem of superfluous staff in SOEs, but also was easily acceptable by workers. Despite the continued employment relations, the laidoffs were no longer entitled to their past wages and benefits, and lived on a basic living allowance from their employers before the establishment of relevant social security systems for laid-off workers. However, these SOEs generally performed poorly, thus unable to take out enough funds to give out the allowances, landing many laid-off workers in hot water. Second, retired workers. Due to the policy of “high employment, low wage” in the period of planned economy, workers found it hard to build up substantial personal savings and had to live on the state or company pension after retirement. China’s basic old-age insurance system, however, was unsound at the beginning of the Economic Reform, and many problems emerged during the transition from “business insurance” to “social insurance,” hindering timely and full payment of pensions and exposing the lives of some retirees to hardship. Worse still, the population control policy announced in the 1970s activated China’s population aging and in October 1999, China entered an aging society — that is to say, more than 10% of its population were above age 60. It was estimated that the number of retired workers under the basic old-age insurance plan rose dramatically between 1989 and 1998 from 8.93 million to 27.27 billion, with the state’s spending on oldage insurance growing from CNY11.89 billion to CNY151.16 billion.1 The emergence of large numbers of needy groups not only was incompatible with the requirements of China’s socialist system and the ultimate goal of the Reform and Opening Up policy, but also exerted negative impacts on social stability. According to statistics, there were 36,300 reported cases of robberies in 1988, but this figure climbed up to 175,100 cases in 1998.2 To address the problems in the economy, the report delivered at the 15th National Congress of CPC in

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September 1997 pointed out that “Raising the standard of living of the people is the fundamental goal of the Reform and Opening Up and economic development. We should enable the people to enjoy a fairly comfortable life on the basis of economic growth and then move on toward higher standards…. We shall adopt a policy that will ensure the basic standard of living for urban residents in difficulty.”3 The “two guarantees” policy was brought forward under such social and economic situations.

Guarantee the Basic Living of Laid-Off Workers Creation of the laid-off system Laid-off workers are a new phenomenon as well as a new issue surfaced as China’s SOE reform was developed at a certain stage. Under the traditional planned economy, employment in SOEs was equal to having an “iron rice bowl,” namely, guaranteed job security as well as steady income and benefits. Crowned as an advantage of socialism, this lifelong employment system ensured full employment, but it also brought about overstaffing to SOEs and impaired the economic efficiency. In response to this, to invigorate SOEs and improve their economic efficiency was set as one of the targets of the Reform and Opening Up policy. At the 3rd Plenary Session of the 12th CPC Central Committee in October 1984, Decisions on the Economic System Reform stated that China practiced a planned commodity economy and this economic system required the separation between government administration and corporate operation to allow more business autonomy. At the 13th National Congress of the CPC in October 1987, the instruction of “invigorating enterprises owned by the whole people by separating ownership from managerial authority” was declared in the report. Although the state intended to hand the management right over to enterprise owners and allowed them to “make their own management decisions and take full responsibility for their own profits and losses,” it also emphasized the importance of “integrat[ing] the authority of managers with the role played by the workers and staff as masters of their enterprises,” making it politically unacceptable to install a laid-off system in SOEs. At the beginning of 1992, Deng Xiaoping delivered a series of important speeches, urging the government to expedite the economic system reform. At the 14th National Congress of the CPC in October 1992, the target of economic system reform was set as building a socialist market economy. Decisions on Problems with Establishing a Socialist Market Economy passed at the 3rd Plenary Session of the 14th CPC Central Committee stipulated that to establish a socialist market

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“Two Guarantees” Policy

economy, it is imperative transform the operational mechanism of SOEs and build a modern enterprise system whose essential feature is to organize production according to market demand free from direct government intervention with raising labor productivity and economic efficiency as the operation goal. The above groundbreaking thinking paved the way for the later implementation of the laidoff system. Although laid-off workers emerged before the 15th National Congress of the CPC in September 1997, it was by then that the arrangements for laid-off workers from SOEs were for the first time put forward. The report of the meeting said that during the reform of SOEs, “We should encourage merger of enterprises, standardize bankruptcy procedures, divert laid-off workers, increase efficiency by downsizing staff and encourage reemployment projects so as to form a competitive mechanism selecting the superior and eliminating the inferior. With the deepening of enterprise reforms, technological progress and readjustment of the economic structure, it would be hard to avoid the flow of personnel and lay-offs. It will cause temporary difficulties to some of the workers. But, fundamentally speaking, it is conducive to economic development, thus conforming to the long-term interests of the working class. The Party and the government will take measures and rely on all quarters of society to show concern for laid-off workers, help them with their welfare, organize job training, and open up new avenues of employment and promote the reemployment project.”4 The practice of laying off workers peaked in the period between 1998 and 2003 when more than 24 million workers were laid off by SOEs. In addition to that, a large group of employees were laid off by collectively-owned enterprises, especially the large ones that were akin to SOEs and put under centralized management of specialized departments. In general, laid-off workers from SOEs could account for 70% of the total laid-offs, thus forming a new social group of China.

Living security for laid-off workers According to the Chinese government, to be “laid off” in this context means that one leaves his post of duty but is still in an employment relationship with his employer. Different from the unemployed, which will become a burden to society, the laidoffs will be taken over by reemployment service centers opened by their employers. This was specified in the Notice on Guaranteeing the Basic Living and Reemployment of the Laid-Offs from State-Owned Enterprises announced in June 1998, which required that SOEs with laid-off workers had to set up a reemployment service center, whose functions are to give out basic living allowances to laid-off workers, pay social insurances including pension, medical, unemployment insurance, on behalf of the employees, and organize vocational guidance and reemployment trainings to help

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the laid-offs to find new jobs. Laid-off workers can get a certain amount of basic living allowances from the reemployment service center for at most three years while receiving reemployment training and job guidance to prepare themselves for new employment opportunities. It was reported that from 1998 to 2003, a total of 19 million laid-off workers from SOEs found new jobs. As early as in September 1997, the Labor Department (now Ministry of Human Resources and Social Security of the People’s Republic of China), the State Planning Commission (now National Development and Reform Commission of the People’s Republic of China), and other eight ministries jointly issued Opinions on Further Establish and Improve the Work of Helping Distressed Workers to Tide Over Difficulties (Labor Department Document No. 269[1997]), ordering that relief funds should be raised from four sources: 1. Local financial resources, such as to extract a certain proportion of individual income tax revenue based on the need of relief work and financial capacity; 2. Funds collected by enterprises and their competent departments; 3. Social donations; 4. Other financing channels endorsed by local governments. The Notice on Guaranteeing the Basic Living and Reemployment of the LaidOffs from State-Owned Enterprises released by the CPC Central Committee and the State Council further confirmed the proportions of each source: Budgetary funds, enterprise fundraising, and social donations (including money transferred from unemployment insurance funds) each contributed one third, with minor variations depending on local conditions; as for fiscal contributions, central enterprises will be financed by the central government while local enterprises will be subsidized by local governments. Additional central support was given to central and western regions and old industrial bases where difficulties were more prevalent. From 1998 to 2003, a sum of CNY109 billion of basic living allowances were granted to SOE laid-off workers in China.5 Judging from local experience, fiscal budget general bore over 70% of the financial need of reemployment centers. From 1998 to 2003, fiscal spending on basic living allowances for the laid-offs jumped from CNY9.28 billion to CNY17.27 billion, with the number hitting CNY22.54 billion in 2001; among the accumulated total of CNY102.9 billion fiscal spending made during this period, central finances took up over 60%, with the highest percentage reaching 83.5% in 2004.6 The financial assistance from government finances especially central finances has played a vital role in guaranteeing the basic living of SOE laid-off workers. It was reported that in 1998, among 6.04 million laid-off workers in reemployment service centers, 93.2% received living allowances; in 2000, 6.14 million people were accepted in reemployment service centers with 97.3% granted basic allowances; in 2001–2003, nearly all laid-offs in reemployment service centers were provided with the allowances; after 2004, subsistence allowances were paid on time and in full to all the laid-offs in reemployment service centers.7

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Unification of laid-off and unemployment systems The laid-off system of SOE workers is an interim arrangement for a particular period, and being laid off and being unemployed are essentially the same with the only difference being that in the former case, the labor relation between laidoff workers and enterprises remains valid for a time, while the latter immediately severs the contractual relationship between the two and push the unemployed out to society. Reemployment service centers generally provide job services and financial assistance for at most three years, and after that, the laid-offs who still have not find a new job will be included in the unemployment insurance plan organized by local social security agencies. In this sense, it can be said that being laid off is just the “prelude” to unemployment, or a special form of unemployment. Even so, as being laid off only means the departure from one’s post but not the company, it is emotionally more acceptable for workers. Considering the particular historical contexts, it is both necessary and reasonable to create the laid-off system to digest superfluous staff during China’s SOE reform, but the system also brought about two side effects. First, finance departments, acting as the major payer in the system, found themselves facing increased burdens. Second, the laid-off system was like a “dam” holding up the flood of unemployment in urban areas, building up the unemployment insurance funds. According to the data from the Labor Department and the National Bureau of Statistics of China, from 1993 to 1996, the recorded urban unemployment rate was 2.6%, 2.8%, 2.9%, and 3.0%, respectively, and this rate stayed around 3.1% between 1997 and 2000. Meanwhile, the balance of unemployment insurance funds was more than doubled from CNY12.87 billion in 1998 to CNY31.38 billion in 2002.8 The surplus, according to the management regulations of social insurance funds, can only be used to buy government bonds or to be deposited in banks with a low or even negative return on investment. Consequently, the burden on government finances to provide laid-off allowances grew larger and larger while the surplus of unemployment insurance funds continued piling up with the risk of depreciation. Moreover, according to local regulations, the standard of basic living allowances for the laid-offs is usually higher than that of the unemployment relief. For instance, in Beijing, workers who were laid off before July 1, 2001 can receive CNY296 per month, whereas the standards of unemployment relief varied with the successive length of service, and even if a worker retired after 15 years of service, he can get at best CNY272 per month in the first year and CNY224 in the second year. The relatively high standard of laid-off allowances engendered negative reactions from laid-off workers who just passively relied on government grants for a living rather than actively seeking reemployment opportunities, and even if they got a chance, they were reluctant

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to accept jobs with hard working conditions, or felt disinclined to end the labor relation with their old employers. In view of the above issue, the central government decided to integrate the laid-off system into the unemployment system in around three years. In December 2000, the State Council promulgated the Pilot Scheme on Perfecting the Urban Social Security System, in which the reform goal of “integrating the subsistence allowances for laid-off workers into the unemployment insurance system” was brought forward. According to this scheme, “from January 1, 2001 onwards, SOEs will not in principle open new unemployment service centers, workers that are to be laid off due to company downsizing will no longer enter the unemployment service centers, and their labor contracts will be terminated by the employers in accordance with law; these workers may enjoy unemployment benefits on the condition that their employers have registered with the unemployment insurance program and paid contributions in full. Local governments must give specific instructions to different enterprises based on their particular situations and complete the unification of the laid-off system and the unemployment system step by step in around three years.” In addition to that, the scheme also required that “As of 2001, budgetary funds earmarked for giving basic living allowances to laid-off workers by government finances at different levels, apart from the original purpose, should also be diverted to replenish unemployment insurance funds and urban minimum subsistence funds.” As a result of the policy, the scale of laid-off workers from SOEs trended down and from 2001 to 2005, the actual figure was 5.15 million, 4.10 million, 2.60 million, 1.53 million, and 0.61 million, respectively, after hitting a peak of 6.57 million in 2000. By the end of 2006, the unification work had basically been completed. By then, the laid-off system finally stepped down from the stage of history. After the laid-off system fade away, China’s system of three social security programs has been transformed into two programs, namely, unemployment insurance and subsistence allowances for the urban poor. Once the labor contract is terminated between urban enterprises and public institutions and their employees, the unemployed workers can collect unemployment insurance benefits at local social security agencies as long as they have, along with their work units, fulfilled insurance fee payments for at least one year, their employment has been terminated not on their own wishes, and they have conducted unemployment registration and wish to seek another job. The duration for receiving unemployment insurance benefits is related to the aggregate fee-paying time by the former work units and the unemployed persons, with the maximum duration for receiving unemployment allowances of 24 months. If after the maximum duration, the unemployed persons still have not find a new job and their household income is below a certain amount,

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they can receive the benefits for guaranteeing the minimum livelihood of urban residents. The minimum livelihood security scheme do not require fee payment by the insured and is fully sponsored by government finances. It has no stated maximum duration and benefits from this scheme can be received as long as the household income is below the local poverty line (for example, in March 2010, the poverty line was CNY430 in Tianjin and CNY170 in Guizhou). For this reason, the minimum livelihood security scheme is also reckoned as the last “safety net” for guaranteeing people’s basic living.

Guarantee the Payment of Pension to Retirees On Time and In Full Development of China’s basic old-age insurance system China’s basic old-age insurance (also known as social pension insurance) was set up following the issuance of Labor Insurance Regulations by the Government Administration Council (now the State Council) in 1951. By 1958, the pension scheme had been installed in SOEs of all trades and a large portion of collective enterprises. According to the regulations, enterprises would extract 3% payroll for labor insurance funds to be managed by the companies’ labor unions; 70% of the labor insurance funds would be left to the labor unions for paying all kinds of labor insurance benefits and 30% would be deposited into the account of the AllChina Federation of Trade Unions for redistributing across the country. However, labor unions were revoked when the Great Cultural Revolution started, leaving labor insurance funds unmanaged. Under such a situation, the Ministry of Finance announced in February 1969 the Opinions on the Reform of Several Regulations on the Financial Work of State-Owned Enterprises (Draft), stopping the withdrawal of social insurance funds by SOEs and enterprises’ spending on social insurance benefits such as retirement benefits should be list as non-business expenditure with reimbursement linked to actual expenses. In this way, the old-age insurance system was deprived of its functions of coordination and redistribution and transformed from social insurance to business insurance. This change had not exerted huge impacts on business operation under unified state control over income and expenditure of SOEs until the central government introduced a two-step “tax for profits” reform in 1983 and 1984 to invigorate SOEs. After the reform, a portion of enterprises’ realized profits must be turned over to the central finances in the form of income tax and income adjustment tax with the remaining kept by the enterprises as production development funds, employee welfare funds, and bonus funds, thus

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linking production development and workers’ welfare to the enterprises’ retained profits. In this case, to finance retirement funds by non-business expenditure led to the imbalance in profitability between new and long-established enterprises: New enterprises, exempt from the burden of retirement expenses, can generally make more profits than the old ones who have a great many retirees to feed despite good economic performance. In short, the old-age insurance system seriously impeded the fair competition between enterprises, posing obstacles to the SOE reform. To address the above problem, the Chinese government introduced a reform to the old-age insurance system in the mid-1980s, that is to raise pension funds on the level of counties or cities: Local governments should determine local enterprises’ contribution proportion of retirement funds based on the principle of “deciding revenue by expenditure with a small surplus,” and enterprises must withdraw the retirement funds at this rate and turned them over to local social insurance agencies as old-age insurance funds; the pensions that should be paid by enterprises will be distributed by social insurance agencies. This practice, in fact, converted the oldage insurance back into social insurance. Compared with situations before the Great Cultural Revolution, basic old-age insurance system after the reform displayed the following three features: 1. Retirement funds were raised on the level of counties or cities instead of on the national level. By the end of 1995, SOEs across the country had all participated in social pension fund pooling at or above the county or city level. But, only 13 provinces implemented provincial level social pooling, major through setting up redistribution funds rather than unified collection and allocation of funds. 2. Employees themselves should also share a portion of pension insurance premium. In June 1991, the State Council promulgated Decisions on the Reform of the Pension System for Enterprise Employees, which decided to change the state- and enterprise-sponsored pension system and split the responsibilities of pension insurance premium among the state, the enterprise, and the employee; the employee’s share should be no more than 3% of his wages at the beginning and can gradually increase with economic growth and pay rises. In July 1997, the State Council further elevated the individual contribution rate to no less than 4% and required that from 1998 onwards, the rate should increase by 1% every two years to eventually reach 8% in the Decisions to Establish a Unified Basic Old-Age Insurance System (State Council Document No. 26[1997]). 3. Old-age insurance funds are comprised of two parts: social pooling and individual contribution. In November 1993, the 3rd Plenary Session of 14th

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CPC Central Committee passed the Decisions on Problems With Establishing a Socialist Market Economy, which clearly stated that “Urban employees’ old-age and medical insurances should be paid by employees and their working units under two accounts of social pooling and individual contribution.” To carry out this instruction, the State Council released, in March 1995, the Circular on Deepening the Reform of the Old-Age System for Enterprise Workers (State Council Document No.6[1995]), ordering enterprises to pay no more than 20% of the total payroll (including the part transferred into the individual account), and to deposit funds equivalent to 11% of an employee’s average monthly wage to the individual account from individual contributions supplemented with employers’ payments.

Institutional reasons for pension defaults At the early stage, social pooling of the old-age insurance system followed the practice of “difference payment and allocation.” Specifically, an enterprise only pays the part of required contributions to social insurance premiums (calculated based on company payroll and the local enterprise contribution rate) in excess of the actual pension payments of the enterprise to its employees in the current period; local social security agencies only allocate the amount of the actual pension payments of an enterprise in excess of its required premium contributions. Under such an arrangement, the main pension payment responsibilities still hinged on enterprises, who were the primary payers. Some enterprises, however, could not afford their due amount because of their low profitability and even diverted pension funds to other uses or refused to pay their contributions. Worse still, there was still a number of enterprises, although with little pension burden, reluctant to pay their part out of their own interests, leading to huge deficits in local social security agencies. In brief, the “difference payment and allocation” system, enterprises’ low corporate profits and their intentional defaults on pension payment were the main reasons for the arrears of pension to employees. Besides that, enterprises’ low contribution rate made it even impossible to finance pension expenditure, especially in areas where local retirement burden was heavy. This was another reason for pension payment arrears. According to the provisions made by the State Council, the contribution rate of local enterprises should be controlled within 20%. However, China’s population was aging rapidly, and the number of retired workers surged after the 1990s, boosting the scale of retirement costs. It was estimated that the number of retirees in China was 16.82 million in 1992, but increased by over 10 million to reach 27.27 million in 1998.9 Correspondingly, the national pension expenditure was CNY33.88 billion in 1992,

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and soared to CNY170.85 billion in 1998.10 In the face of this “retirement tide,” companies’ pension contributions in many areas were just a drop in the bucket, let alone there were still due but unpaid contributions. In fact, according to the institutional design of China’s basic pension system, social pooling funds were used for current period pension payment whereas individual account funds were for future payment; social pooling funds adopted a pay-as-you-go system while individual account funds were based on an accumulating fund system. In many regions, however, social pooling funds were inadequate to cover current pension payment, so funds from the individual account were also withdrawn to balance the pension budget, leaving individual accounts “empty.” Being “empty,” individual accounts only performed bookkeeping and stop accumulating individual pension savings. According to the estimate made by the then Ministry of Labor and Social Security, by 2004, there was a deficit of nearly CNY600 billion in individual pension accounts.11 Worse still, even though funds from individual accounts were drawn on, the basic pension scheme in many areas still cannot make the ends meet due to the high percentage of aging population and enterprises’ defaults on pension contributions. It was reported that in 1998, 21 provinces recorded a deficit in the basic pension insurance system with a funding gap of CNY7 billion; in 1999, the number of deficit provinces grew to 25, with the funding gap further widening.

State measures to guarantee pensions for retirees paid on time and in full To make sure that pension benefits are paid on time and in full, the State Council announced on August 6, 1988, Notice on Relevant Issues Concerning the Transfer of Provincial and Industrial Management of Basic Pension Insurance for Enterprise Employees to Local Governments. It explicitly stated, “From September 1, 1998 onwards, the pension fund settlement method in areas which were practicing the “difference payment and allocation” system should be changed to full collection of basic pension insurance premiums from enterprises and individuals and full payment of basic pensions to retired workers. Each province, region, and city must create conditions to facilitate the delivery of basic pensions by social service institutions and promote the socialized management of pension funds.” Since then, social pooling funds of China’s basic pension insurance system shifted from “difference payment and allocation” to “full payment and allocation,” and eventually headed towards socialized delivery. After 1999, the central government started to promote the delivery of basic pensions by social service institutions such as banks and post offices. In June 2003, General Office of the CPC Central Committee and

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General Office of the State Council transmitted Opinions Concerning Promoting the Socialized Management Services for Enterprise Retirees issued by the Ministry of Labor and Social Security. According to the document, “Socialized management services for enterprise retirees mean that after employees complete the formalities of retirement, their management services will be separated from their companies: Pension delivery will be performed by social service institutions, and management services for individuals will be provided by local sub-district offices or community service organizations.” It also pointed out that, “Considering the rich content and wide scope of retiree services, local authorities were ordered to mobilize relevant social forces to do a good job under the unified leadership of party committees and people’s governments.” It was reported that after 2003, the proportion of basic pensions granted through social channels remained above 99%. Apart from reforming the management mode of social pooling, increased financial support to the basic pension insurance plan from finance departments, especially the central treasury, was another important means to solve pension defaults. In accordance with the requirements of “to guarantee the timely and full payment of basic pension benefits to the retirees of enterprises to secure their basic living, and new pension arrears should be avoided while past arrears must be gradually paid out,” made by the State Council in Notice on Guaranteeing the Basic Living and Reemployment of the Laid-Offs from State-Owned Enterprises, the central treasury allocated over CNY7 billion to local governments to clear off historical pension arrears. By the end of 1999, 98% of pensions was paid on time and in full, and CNY13.3 billion of pension arrears was paid off.12 At the same time, the central treasury was also increasing its financial support to basic pension insurance plan to avoid new arrears. It was estimated that government subsidies to the basic pension insurance plan was CNY2.16 billion in 1998, but escalated to CNY88.9 billion in 2006, with an annual increase of 59%; among this, subsidy expenditures by the central treasury (including expenditures at the central level and for subsidizing local governments) accounted for around 90%.13 Thus, finance departments, especially the central treasury, have played a vital role in guaranteeing the timely and full payment of pensions to retired workers.

Historical Significance and Far-Reaching Impacts of “Two Guarantees” “Two guarantees” were put forward against the backdrop of dramatic changes taking place in social and economic environments at a certain stage of China’s market-oriented reform. This policy not only showed the concern and help from

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the CPC and the central government to the social vulnerable groups whose lives were impacted by the Economic Reform, but also reflected a new vision of the Chinese leaders towards the development of social security. At the early stage of the Economic Reform, the reform of the social security system was widely deemed as a complementary measure to the Economic Reform, but after 1998, social instability triggered by a large number of laid-off workers and retirees compelled the government to rethink the question. At the Working Conference of Guaranteeing the Basic Living and Reemployment of SOE Laid-Off Workers convened by the State Council in May 1998, Premier Zhu Rongji pointed out that “It is both important and urgent to do a good job of guaranteeing the basic living and reemployment of SOE laid-off workers, and it has a direct bearing on the immediate interest of workers, decides the success of the SOE reform, and affects the balance among reform, development and stability.” In October 2000, Suggestions on Formulating the Tenth Five-Year Plan for Economic and Social Development passed at the 5th Plenary Session of the 15th CPC Central Committee restated that “A complete and perfect social security system is an important pillar for a socialist market economy, and will also have an overall impact on reform, development and stability.” In November 2002, the report of 16th CPC National Congress explicitly put that “Establishing and improving a social security system compatible with the level of economic development constitutes an important guarantee for social stability and long-term peace and order in the country.”14 The “two guarantees” policy has also exerted profound influences in the fiscal and taxation fields. First, it accelerated the adjustment of China’s fiscal expenditure structure. The structure of fiscal expenditures explains the categories of government spending and the proportion of each category in total spending. Prior to the Economic Reform, China’s fiscal expenditure structure was evidently economy-prone: The proportion of fiscal spending on economic construction remained above 50% for a long time, while the expenditure for developing social undertakings such as culture, education, science, and health took up less than 15% of total expenditure. This so-called “production-oriented finance” suited to government-led social production under the planned economy and the economic development idea of “production first, livelihood second.” After the Economic Reform was introduced, the structure of China’s fiscal expenditures was changing as well, and more spending was channeled to the fields of education, social security, and health care. Especially after the “two guarantees” were proposed, governments at all levels increased their subsidies to the basic living allowance scheme for laidoff workers and to the basic pension insurance plan. “Two guarantees” turned fiscal spending on social security into a “rigid expenditure,” eventually driving up the share of social security expenditure in total fiscal expenditures. For example,

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from 1998 to 2006, China’s fiscal spending grew by 17% every year while social security expenditure increased at an annual rate of 28.3%. Among this, subsidy expenditures for social security15 recorded an annual growth rate of 39.3%, fastest of all social security expenditure items. In the time span of eight years, the growth of social security expenditures outran that of total fiscal expenditures for six years. After eight-year rapid growth, the proportion of social security expenditures in total fiscal expenditures escalated to 10.8% in 2006 from 5.2% in 1998, and it even approached to 12% in 2002. Second, the “two guarantees” policy helped transfer social insurance premium collection from the Ministry of Labor and Social Security to the State Administration of Taxation, facilitating the future levy of social security tax. Before 1998, social insurance premiums were collected by labor and social security agencies, but due to a lack of strict laws and regulations and effective levying means, defaults on premium payment were common in many places. After the “two guarantees” were announced, fiscal subsidy expenditures for social security became rigid spending, and more premium arrears meant heavier pressure on subsidy expenditures for social security. In view of such a situation, many areas started to entrust premium collection of social insurance, especially that of pension insurance, to tax authorities. In January 1999, the State Council released Interim Regulation on the Collection and Payment of Social Insurance Premiums, which stipulated, “The people’s governments of provinces, autonomous regions, and municipalities directly under the central government shall prescribe the premium collecting agencies. Premiums may be collected by taxation departments, or by social insurance agencies established by the administrative department of labor security according to the provisions of the State Council.”16 Currently, social insurance premiums were collected by taxation authorities in 22 provinces (municipalities and autonomous regions). However, the collection of social insurance premiums by taxation authorities was merely on a proxy basis. To be specific, the labor security department remained the main responsible organ for social insurance premium collection in law and it also responsible for the verification of the premium collection base (gross payroll) of social insurance; taxation departments only collected premiums at enterprises on the behalf of the labor security department. Under the principal-agent relationship, social insurance premiums were not a tax in that they were less mandatory and guaranteed than taxes. For instance, if an enterprise refuses to pay social insurance premiums, taxation authorities cannot take coercive measures to enforce premium collection in accordance with the Law on the Administration of Tax Collection. In light of this, it is widely believed that social security tax should be levied to ensure the timely and full collection of social insurance premiums. In April 2010, Xie Xuren, Minister of Finance of China, also wrote in Quishi magazine that “To perfect

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the financing form of social security must go hand in hand with the upgrading of the management level of pension funds, and the levy of social security tax should be studied.” Over the decade-long practice, China’s tax departments have accumulated extensive experience in collecting social insurance premiums, which will lay a sound basis for future levy of social security tax.

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Chapter

Proactive Fiscal Policy

MAJOR ISSUES AND POLICIES IN CHINA’S FINANCIAL REFORM VOL. 4

Proactive fiscal policy is an expansionary fiscal policy launched in 1998 in China and tried again in 2008. Generally speaking, it denotes the government’s active use of discretionary factors of fiscal policy.

Origin of Proactive Fiscal Policy According to the theory of macroeconomic policy, in times of economic setbacks and inflation, the government needs to follow a counter-cyclical, expansionary fiscal policy. In 1998, when China announced such a policy, it was not termed as expansionary but proactive fiscal policy, which sparked off a dispute over the name of the policy among the academia.1

Explanation for the name Opponents of the name argue that the modifier “proactive” cannot clarify the precise meaning of the policy, and therefore it is an ambiguous expression. Also, the degree of “proactive” is hard to quantify, which entails endless explanation in response to changing situations. Proactive fiscal policy was at first just a provisional name, and it described more a moderate adjustment to the original policy than an independent category of policies introducing a turning point in policy orientation. Later, as economic situations at home and abroad underwent some profound changes, macroeconomic policy called for a revolutionary adjustment. As a result, new contents were constantly added in while the name remained unchanged as a way to show the consistency and smooth transition in policy, and after that this term took on the nature of expansionary policy and became an independent category. Although the practice which “maintains the original policy name, while enriching it with new contents” ensured the smooth transition and consistency in policy, the ambiguity in term expression may easily lead to obscure policy direction and undecided government behaviors.2 Proponents of the name of “proactive fiscal policy” claim various possible explanations for “proactive” on the basis of agreeing to this term. In the following, we will list several typical statements to help enhance the understanding of this term. Proactive fiscal policy was proposed against the backdrop of the ever weakening role of fiscal policy since the start of the Reform and Opening Up, and it meant to fully activate all sorts of fiscal instruments and through the coordination of various fiscal instruments, give full play to the due role of government finance under the market economy, namely, to rationally allocate resources, adjust income

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distribution, and stabilize and develop the economy. For this reason, proactive fiscal policy cannot be simply interpreted as a single expansionary policy or a single fiscal means of issuing national debts.3 Then, why was not it named an expansionary policy and how did proactive fiscal policy differ from expansionary fiscal policy? These are related to the historical situations back then. Prior to the implementation of this policy, China had been practicing a moderately tight fiscal policy, and to move from a moderately tight to an expansionary policy would imply a sharp shift in policy direction. To obscure such a drastic change in expression, the Chinese authorities opted for a relatively vague term, namely proactive fiscal policy. By using “proactive,” it did not suggest a fixed opposite: Even if this policy did not work out, there was no such logical opposite like “inactive” policy. “That is to say, proactive fiscal policy is a kind of expansionary policy launched after 1998 for counter-cyclical regulation at the macroeconomic level. In my opinion, it can be better phrased by adding one more modifier as expansionary fiscal policy with Chinese characteristics.”4 Expansionary fiscal policy is named relative to contractionary fiscal policy and although it is internationally used, the word “expansionary” can be understood both way, either positive or negative. It not only involves expanding fiscal expenditures, spurring economic growth and achieving desirable results, but also contains blindly expanding fiscal expenditures and ultimately causing inflation. To avoid the misunderstanding, “proactive” is a better choice to emphasize the positive side of fiscal policy.5 Before activating proactive fiscal policy, the government needs to regulate the economy mainly by means of monetary policy supplemented with fiscal policy. Between 1993 and 1995, moderately tight fiscal and monetary policy were carried out to curb inflation. Following the successful economic soft landing, banks announced several rounds of interest cuts from 1996 to early 1998, and the monetary policy was in fact changed from “moderately tight” to “moderately loose” whereas the fiscal policy was still “moderately tight” and characterized by cutting the fiscal deficit. Despite continuous interest reduction, the Chinese economy, hit by the Asian Financial Crisis, remained mired in a downward trend, and there was a determined voice that the “moderately tight” fiscal policy must be changed. More importantly, struck by the Asian Financial Crisis, China’s banking industry received much attention for its non-performing assets, with the main tasks of guarding against the financial crisis and resolving financial risks, monetary policy cannot play its role of offering an anchor for economic growth as its effects were restricted by the unhealthy state of the financial industry and external shocks from the financial crisis, and therefore, fiscal policy had to assume the role of maintaining stable economic growth. In this sense, proactive policy suggests a

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more active action and the primary function of regulating economic growth.6 The above explanations for the origin of the term were at best guesses given by different scholars. It is better to hear how the policymaker said — the then Finance Minister Xiang Huaicheng. Below is an excerpt of an interview between the Finance Minister and the host in a TV talk show named “Economic Half-Hour.”7 Host: First, thanks to Minister Xiang for giving us the honor to do an exclusive interview… many people feel confused about the word “proactive” in proactive fiscal policy, and what does it mean? Xiang: In fact, economists of many countries also can’t understand this term. Because for macroeconomic policy, there are basically two categories: One is contractionary fiscal policy, the other is expansionary fiscal policy. Host: Expansionary is corresponding to proactive, and why it changes into “proactive” in China. Xiang: I think in China, it is hard for ordinary people to fully accept an expansionary policy. Because generally speaking, economic jargons are sometimes misleading. A neutral and familiar word is more acceptable for people. Host: To leave the impression that this is a good policy. Xiang: Yes, a good policy. But if we use “expansionary,” people would think things are getting terrible. Host: So, did you coin this name? Xiang: This name was decided by the central government. Because “expansionary” implies to expand the deficit and increase national debts, and it is part of the nation’s mentality to be afraid of a larger deficit and fast growing debts. These are pretty good concerns. Under this situation, if we say we will expand our deficit, it will be contradictory to the spirit of the 15th National Congress of the Communist Party of China (CPC). According to the decisions reached at the 15th National Congress, we have to cut CNY10 billion of fiscal deficit every year. How much did we cut in 1997? Over CNY56 billion. In 1998, as I remember, the deficit was CNY46 billion, less 10 billion. After I took over the position of Finance Minister, my predecessor Liu Zhongli told me to reduce CNY10 billion annually in order to basically eliminate the deficit by 2003. At that time, we practiced a moderately tight fiscal policy. To issue CNY100 billion national debts will inevitably expand the deficit.

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Definition of proactive fiscal policy Then, what is indeed proactive fiscal policy? At that time, the academic circle had done much analysis on the contents of proactive fiscal policy with little mention to the definition. Some scholars pointed out that in Samuelson’s Economics, there is a definition for “proactive fiscal policy.”8 Proactive fiscal policy decides the ways of government taxation and spending in order to help: 1. weaken the fluctuations of business cycle; 2. maintain a full-employment economic system free from excessive growth of inflation and deflation. Chinese scholars also have given diverse definitions for proactive fiscal policy: 1. Proactive fiscal policy refers to the situation where the government keeps a close eye on economic trends and predict future economic development in order to adopt effective measures in taxation and government spending to achieve the policy goals of macroeconomic regulation.9 2. Proactive fiscal policy is the expansionary fiscal measures that are carried out by the government, in times of economic recession, to stimulate economic growth, encourage investment and consumption, and expand aggregate demand; or the contractionary fiscal measures that adopted, in times of economic overheating, to slow down economic growth, discourage investment and consumption, and adjust production, investment and consumption structures.10 3. Proactive fiscal policy describes the scenario where the central government issues a large number of public debts to expand government investment while practicing a loose monetary policy and a loose export policy to stimulate aggregate demand.11 4. Proactive fiscal policy is the macroeconomic measures adopted by the central government at a specific period for designated purposes, that is to prevent an economic downturn and drive economic growth through increasing government spending and expanding social aggregate demand.12 The first two definitions cover a wide range of contents, and basically reflect the essence of the policy. But the problem is, they fail to tell the difference between this policy and the commonly referred fiscal policy. The latter two define proactive fiscal policy based on the fiscal policies that China has adopted in recent years. As these two definitions only depict the recent major practices of the Chinese government, they are considered too narrow. In this chapter, proactive fiscal policy refers to the active use of the discretionary factors in fiscal policy. To correctly understand this concept, one has to first bear in

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mind the following three points:13 1. Proactive fiscal policy is a kind of discretionary fiscal policy. In macroeconomics, there are two types of fiscal policy, discretionary and automatic, considering the difference in functioning mechanism. Automatic fiscal policy can automatically offset fluctuations in output without explicit policy changes. Inherent in the fiscal framework and inclined to automatically dampen economic cycle fluctuations with no need for external help, this fiscal policy can change with the social and economic situations and automatically play its role of economic adjustment. Discretionary fiscal policy, in contrast, depends on government intervention to ease output fluctuations. This means that this policy either has no effect of automatic stabilization, or the effect is not large enough to iron out economic fluctuations in time and thus requires external assistance. In most cases, discretionary policy involves conscious government intervention in economic operation by using of different fiscal instruments to fill the inflationary or deflationary gap. Apparently, proactive fiscal policy is a type of more active or powerful discretionary fiscal policy. 2. Proactive fiscal policy may be expansionary or contractionary fiscal policy. Based on the role in regulating economic aggregates, fiscal policy can be divided into expansionary and contractionary policy. Expansionary fiscal policy involves government attempts to increase and stimulate aggregate demand through fiscal means. Contractionary fiscal policy is to reduce and suppress aggregate demand by means of fiscal tools. Therefore, whether the proactive fiscal policy is expansionary or contractionary is decided by the economic situations and expected goals faced by the government when choosing a fiscal policy. If the economy shows a sign of severe recession, the proactive policy is apparently expansionary; if the economy faces a strong pressure of inflation, the proactive policy is definitely contractionary. 3. Proactive fiscal policy is a short-term policy. From the perspective of macroeconomic operation, discretionary fiscal policy is a kind of shortterm stabilization policy, in theory or practice. Here, it is a question of how to understand “short term” and “long term.” In economic terms, both short term and long term are abstract concepts of time. According to the supply theory in microeconomics, short term refers to the time that elapses for adjusting the output through changing the quantity of variable inputs (such as raw materials and labor force) since other factors of production (such as the plant and equipment) are fixed; long term refers to the time that takes for all inputs to change under the current technology conditions

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and production methods. So, short term and long term are distinguished by whether fixed inputs have been changed, and if no changes of fixed inputs are involved, even three to five years are considered a short term. For instance, in the petrochemical industry, it will take five or more years to build a plant and put it into operation. During this interval, the increase of output can only be realized through upgrading the production capacity of existing plant and equipment. In contrast, the garment industry may complete equipment purchase and installation within a couple of weeks, and for industries like this, short term means a month or less. If understood within the framework of economic stabilization at the macroeconomic level, the two terms are divided by the duration of economic prosperity or economic recession. If it takes five years for economic operation to go from recession to recovery, the expansionary proactive fiscal policy will still be considered a short-term policy. Therefore, proactive fiscal policy cannot be a long-term policy, and its implementation period should be decided based on the length of business cycle.

Implementation Background of Proactive Fiscal Policy The introduction of a new economic measure is undoubtedly linked to the current economic performance and the corresponding economic policy. The proactive fiscal policy of 1998 was proposed and implemented in response to the economic recession and deflation in macroeconomic operation and the moderately tight fiscal policy practiced over the past few years. In this section, discussions on the reasons for the implementation of proactive fiscal policy will be conducted at two levels: first, macroeconomic operation; second, macroeconomic policies.

Macroeconomic operation According to the principle of demand management policy, proactive fiscal policy will be carried out if macroeconomic operation suffers from insufficient effective demand, economic slowdown, growing unemployment, and continuous price falls. Then, when China introduced the proactive fiscal policy in 1998, had all these phenomena occurred? The answer is yes. It just so happens that in almost all research on the implementation backgrounds of proactive fiscal policy, the Asian Financial Crisis was considered a trigger for China’s deteriorating economic situations. In view of this, the analysis on macroeconomic background will be further split into an analysis of international economic background and domestic economic background.

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Macroeconomic background in 1997 and the first half of 1998 China experienced an overheated economy between 1993 and 1995, with an annual economic growth rate and the consumer price index (CPI) of as high as 12.2% and 15.6%, respectively. In response to the economic overheating and inflation, in June 1993, the CPC Central Committee and the State Council jointly issued Opinions on Current Economic Situations and the Strengthening of Macroeconomic Regulation, announcing the start of an economic soft landing. Policies of soft landing were mainly comprised of two parts: First, to carry out a moderately tight monetary policy; second, to intensify the reform of all kinds of regulatory systems, such as the fiscal and taxation system reform, the financial system reform, the reform of foreign trade and foreign exchange systems, the planning system reform, the reform of pricing and circulation systems, and the reform of state-owned enterprises (SOEs). By 1996, the Chinese economy finished its soft landing: The economy continued rapid growth (the economic growth rate of that year was 9.6%, only 0.9 percentage point lower from a year earlier), and the price level plummeted (the CPI rose by 8.3%, falling by more than half from 17.1% of the previous year), presenting a desired situation of “high growth and low inflation.” However, after entering 1997, especially after the outbreak of the Asian Financial Crisis, China’s economy shifted from overheating to cooling down, and even headed towards deflation and a recession. This can be discerned from the five aspects below. Continuous fall of commodity prices As early as June 1996, prices of industrial goods in China began to slide. In October 1997, the retail prices index (RPI) dipped below zero growth and then continued a negative growth for nine consecutive months, from –0.4 to –3% in June 1998. At the same time, the CPI also turned negative since March 1998. As a result, price levels throughout the year of 1997 dropped by a large margin: The rise in CPI, RPI, and producer price index (PPI) slowed by 5.5, 5.3, and 3.2 percentage points, respectively, from in 1996. Worse still, in 1998, the changes in all three indices were negative and this situation continued until 1999. It should be said that since the fourth quarter of 1997, China’s economy has been already in deflation. Economic slowdown Judging from the situations of 1997, the growth rate of GDP fell by 0.8 percentage

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Proactive Fiscal Policy

point from 9.6% in 1996 to 8.8%. And in early 1998, the first-quarter GDP rose by 7.2% year-on-year, 2.2 percentage points lower than the growth rate in the same period of last year.14 Insufficient domestic investment and consumption demand Total investment in fixed assets and total retail sales of consumer goods are used to indicate the situations of domestic investment and consumption demand. In 1997, The growth in fixed-asset investment continued to further plunge to 8.8% following three consecutive years of declines, and the trend was also discovered for retail sales of consumer goods, whose growth rate was only half that of the previous year. In early 1998, China’s domestic demand grew more slowly. In the first quarter of 1998, fixed-asset investment rose by 10.8%, down 3.6 percentage points compared to the same period last year, and retail sales of consumer goods went up by 6.9%, 12.9 percentage points lower than the same period last year.15 Slower household income growth Economic slowdown was also manifested in the growth of household income. After entering the 1990s, China’s net household income escalated rapidly: Between 1991 and 1996, rural per capita net income rose by 19.2% annually while urban per capita net income grew at an annual rate of 21.7%. In 1997, however, the growth rate of rural per capital net income was less than half of the average level of previous years, and that of urban per capital net income was smaller than 1/3 of the average level. Higher unemployment pressure As a result of the soft-landing policies and the intensified reforms in the economic system, especially the reform of SOEs, introduced in previous years, many problems popped up at the microeconomic level, one of which was the large number of laidoff workers. It was estimated that starting in 1997, there were more than 10 million of workers that got laid off every year.16 How to create job opportunities to solve unemployment has become a serious concern for decisionmarkers and the society. As indicated above, China’s economy has been going down since the second half of 1997. Apparently, this situation was a combined result of two factors: It was impacted first by increasing external shocks from the world economy, and more importantly, by the domestic economic imbalance and sluggish domestic demand.

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To be more precise, the Asian Financial Crisis acted just as a trigger of China’s economic recession, but the real cause was that China’s business cycle was moving towards a recession phase.

International background: The Southeast Asian Financial Crisis was the trigger In July 1997, Thai baht collapsed, and the currency declines soon spread to other Southeast Asian countries — including Malaysia, Indonesia and the Philippines, which also saw slumping currencies. Investors began to panic and withdraw funds from Asia altogether, including South Korea, Hong Kong and Taiwan, and by then, the devaluation crisis was rapidly upscaled into a financial crisis throughout Asia. Shortly afterwards, the Asian Financial Crisis broke the geographic boundaries to throw the global financial market into turmoil. At early October 1997, European major stock markets plummeted and financial markets in Japan, Australia, Latin America were also affected to some extent. The crisis soon caused the demand in international market to slacken and then escalated into a global economic recession, leading to worldwide overcapacity and deflation. As China’s economy is increasingly linked to the world economy, fluctuations of the world economy will definitely impact China’s macroeconomic operation. This impact is especially large when Asian countries are the largest trade partners of China. Between 1994 and 1997, for example, imports and exports from and to Asian countries accounted for, on average, over 60% of China’s total imports and exports. Thus, understandably, the Asian Financial Crisis had have severe impacts on China’s economic operation. A steep fall in China’s export growth After the Reform and Opening Up policy was announced, China’s imports and exports kept growing, and this trend was even more pronounced especially after the mid-1990s when the share of total exports in GDP exceeded 20% in most years, contributing a lot to the growth of aggregate demand.17 Between 1986 and 1990, China’s exports recorded an average growth of 18%, and continued to maintain a growth of around 17% between 1991 and 1997. However, in 1998, this rate dipped to 0.5%. This was closely related to the sharp decline of exports to Asian economies: In just the first half of 1998, China’s exports to South Korea dropped by 30%, ASEAN countries by 12.9%, and Japan by 4.5%.18 The steep fall in export growth undoubtedly aggravated the deficiency of aggregate demand in China.

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A significant decline in import prices The fall in import prices inhibited the rebound of China’s commodity prices as most of China’s imports were from the Southeast Asian region and industrialized countries. The steep devaluation of currencies of East Asian countries (at a rate of 20%–80%) and the deflation in Japan brought down the prices of 60% of China’s imports. Moreover, the majority of China’s imports from industrialized countries was machinery, electronic products and high-tech products, whose most prominent feature was the decline of the price-performance ratio over time. These two factors together exacerbated the downward trend of China’s price level starting in 1998. A massive reduction in foreign direct investment (FDI) In terms of the situation before the mid-1990s, China’s FDI soared at an average rate of 72.2% between 1991 and 1995, and this was probably related to the small base. However, after the foreign investment in actual use exceeded USD40 billion in 1996, it never reached USD50 billion until 2002. In fact, the amount hardly made any increase in 1998 and even recorded a negative growth in 1999. Clearly, this situation had some bearing on the Asian Financial Crisis. Judging from the accumulative FDI to China in the past 20 years, 81% of the investment companies, 80% of the contracted investment, and 77% of the actual investment came from Asia. A 30% drop in China’s FDI from Asian countries in the first half of 1998 cut down the absolute value of foreign investment in actual use in China.

In short, the Asian Financial Crisis and the sluggish demand from the international market led to the weakness in China’s export. This coupled with the fierce competition in the world market greatly undermined the role of exports in driving economic growth.19 It was estimated that due to the impact of the Asian Financial Crisis on China’s exports, the growth of industrial output value decreased by 2 percentage points, and that of GDP by 1 percentage points.20 Thus it is clear that external shocks including the Asian Financial Crisis have accelerated China’s economic recession.

Domestic economic background: Economic cyclical fluctuations were the root cause If the Asian Financial Crisis was the trigger of China’s proactive fiscal policy, then economic cyclical movements were the root cause.

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China’s business cycle can be generally divided into two phases with the announcement of Reform and Opening Up policy as the watershed. After the People’s Republic of China was established in 1949, a large-scale economic construction was introduced in 1953 following three years of recovery and regulation. In the same year, the First Five-Year Plan was launched, marking the start of the economic cyclical fluctuations of New China. Fig. 24.1 depicts the basic trajectory of economic cyclical swings in China from 1953 to 2000. It is clear that China’s economy has obvious fluctuations on an evident cyclical basis. Fig. 24.1 tells the following three facts. First, China’s economy has always shown cyclical movements throughout the economic construction, whether it was a planned or a market system. Second, before the Reform and Opening Up policy was announced, China’s economic fluctuations were characterized by “violent ups and downs,” that is, large amplitudes, high peaks, deep troughs, low waves, and a short expansion length.21 In contrast, after the implementation of the Reform and Opening Up policy, China’s economic fluctuations have been trending upwards gradually towards stability, that is, smaller amplitudes, lower peaks, higher troughs, higher waves, and a longer expansion. Third, during the ninth economic cycle starting in 1991, China was undergoing an economic transition with profound changes to the economic system and the macroeconomic and microeconomic operational mechanisms. This economic cycle showed a different feature from the previous cycles: longer duration, especially of the contraction phase. To be specific, after the GDP growth rate hit the peak at 14.2% in 1992, it kept sliding down until arriving at 7.1% in 1999, and although rebounding slightly to 8% in 2000, the rate once again fell to 7.3% in 2001. Fig. 24.1

China’s cyclical economic fluctuations

0.3 0.2 0.1

2001

1997

1993

1989

1985

1981

1977

1973

1969

1965

– 0.2

1961

1953

– 0.1

1957

0

– 0.3

According to theoretical basis of government macroeconomic control — Keynesian demand management policy, if there is a recession in economic operation and this recession is caused by inadequate demand, then the government must immediately announce a policy to stabilize the macroeconomy. Here, two

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questions must be answered first: One is in this economic cycle, when the economy moved into a recession; the other is what the real causes for the recession are and what kind of stabilization policy should be adopted. From Fig. 24.1, it can be seen that after the GDP growth rate rose to the peak in 1992, it started to fall and reached a single digit number in 1996. This fact alone, however, was not enough to prove an economic recession, and the changes in the price level should also be considered. In 1996, the growth rates of CPI, RPI, and PPI declined to 8.3%, 6.1%, and –0.3%, from 17.1%, 14.8%, and 14.9% in 1995, respectively; in 1997, the growth rates further dropped to 2.8%, 0.8% and –0.3%. In view of this situation, it is justified to implement a stabilization policy. Next, as a stabilization policy can be either a demand management policy or a supply management policy, what type of policy should be chosen considering the current economic situation. The decision rests upon the main causes of economic recession. Heated debate has been going on in China’s academic community on the causes of the economic recession and the long-term stagnation in the trough, and the viewpoints can be categorized into six groups: consumption demand deficiency, social investment deficiency, consumption structural fault, effective demand deficiency, effective supply deficiency, and institutional contraction effect.22 The first four reasons can be further grouped as insufficient aggregate social demand, which is more widely recognized and close to the reality. Therefore, to combat this economic recession, a stabilization policy centering on demand management should be adopted.

Macroeconomic policy With expanding aggregate social demand as the entry point to counter recession, there are theoretically two policy tools available for the government to manipulate, according to the principles of macroeconomic policy. They are monetary and fiscal policy. The Chinese government first activated the monetary policy: After the Chinese economy’s soft landing in 1996, the government began monetary loosening with a cut in lending and deposit interest rates for financial institutions in May 1996, and after that, China’s monetary policy shifted its target from fighting inflation to beating recession, as it moved from being moderately tight to moderately loose and then to prudent. Major policy measures involved here included: continuous interest cuts, lifting the loan cap, lowering the reserve ratio, resuming open market operations, and adjusting credit policies.23 To issue monetary policy in such a frequent and intense manner could be said to have “gone all out” on the part of the government.24 Frankly, the above measures did play a positive role in lowering business costs, encouraging investment, stimulating household consumption, and increasing the money in circulation.

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However, as the Chinese economy had already entered a liquidity trap, any monetary policy would turn out ineffective. With a low interest rate, the demand curve for money was infinitely elastic. Under such a condition, any attempt to stimulate more investment through interest cuts was in vain, only resulting in more currency holdings. It was because of such constraints from the economic environment that financial institutions were caught in a dilemma: Given the generally poor economic performance of enterprises, an increase in business loans will step up banks’ credit exposure; if banks do not expand their lending to enterprises, the fast-growing household savings cannot be effectively transformed into investment, which not only is detrimental to economic growth, but also will build up the operating cost for banks. Consequently, two results emerged during the implementation of a moderately loose monetary policy in 1997 and the first half of 1998: For one thing, banks were prudent with lending to guard against financial risks; for another, enterprises were low in borrowing demand considering the sluggish market and little business opportunities. The two situations together contributed to the weak effects of the monetary policy practiced during this period.25 First, the monetary policy failed to achieve the expected intermediate targets. Despite continuous interest cuts, the removal of the credit ceiling for wholly stateowned banks and the lowering of the reserve ratio, the growth rate of money supply did not rebound. With regard to M2, its growth rate was 25.3% in 1996 and fell to 14.8% in 1998, a decline of nearly 10 percentage points. Although the growth rate of monetary supply was not low compared to the economic growth rate in 1997 and 1998, these policy measures did not attain the goal of increasing the money supply and even failed to meet the growth target set in 1996.26 Second, it also failed to increase aggregate social demand. Although the central bank released a series of monetary policy measures in 1997 and especially in the first half of 1998, investment and consumption growth rates remained low and the price level kept going downwards, thus contributing to the continuous economic slowdown.27 In view of the limited effects of monetary policy, the government had to resort to another stabilization tool — fiscal policy — to curb economic downturn and ensure the growth target of 1998. In this way, fiscal policy naturally and inevitably assumed the role of stabilizing economic growth. Moreover, Keynes has long pointed out that in the midst of a stagnant economy with a liquidity trap, the only way to stimulate investment is to increase government spending or reduce tax revenues in order to drive up aggregate demand and bolster companies’ confidence to make investments.

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Major Measures of Proactive Fiscal Policy In June 16, 1998, People’s Daily published an article named “Fiscal Macro-Regulation and Igniting Economic Growth” authored by Finance Minister Xiang Huaicheng. It proposed changing the moderately tight fiscal policy, expanding the scale of fiscal debts and expenditure, increasing investment, consumption, and exports, and promoting economic growth through reforming the restrictive factors affecting effective demand in systems and policies. In July 1998, the State Council transmitted the Economic Operation in the First Half of This Year and Work Suggestions for the Second Half of the Year drafted by the State Development Planning Commission (SDPC), which finally launched the proactive fiscal policy aiming to expand demand. It was not until 2005, after the Central Economic Working Conference convened on December 3, 2004 had decided to practice a prudent fiscal policy, that the proactive fiscal policy retreated from the stage of history. Then, during the seven years of implementation, what measures had the proactive fiscal policy adopted? In textbooks, common fiscal policy tools can be categorized into four groups: budgetary policy, taxation policy, expenditure policy, and debt policy. The policy tools having been used since 1998 also fell into the above four categories. With regard to budgetary policy, China’s fiscal deficit increased substantially after 1998 and the ratio of fiscal deficit to GDP rose from 0.74% in 1997 to 1.1% in 1998 and continued to ascend in 1999 and 2000 to reach 19.94% and 2.51%, respectively, before hitting the peak of 2.62% in 2002. In the following two years, although declining year by year, this ratio remained high, at 2.16% and 1.31%. Obviously, a fiscal deficit policy was practiced in these years. Debt policy centered around issuing long-term treasury bonds for construction. As soon as the proactive fiscal policy was launched in 1998, the government issued CNY100 billion of long-term treasury bonds for construction. Between 1998 and 2004, a total of CNY910 billion of new bonds was issued to offer financial support for the proactive fiscal policy. In the next section, a more in-depth analysis on expenditure and tax revenue policies will be conducted.

Expenditure policy measures Increasing infrastructure investment In August 1998, a fiscal adjustment plan was approved at the 4th Meeting of the

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Standing Committee of the 9th National People’s Congress. According to the plan, the central bank sold CNY100 billion worth of long-term government bonds to the big four state-owned banks, for the purpose of investing in infrastructure construction projects listed in the central budget.28 Among the listed projects, investments mainly went to those related to agriculture, forestry, water conservancy, environmental protection, transportation and communication construction, urban infrastructure construction, upgrades of urban and rural power grids, and construction of central grain reserve depots and affordable housing. In the following years until 2004, funds raised from issuing long-term construction bonds were also chiefly spent on infrastructure projects, with the investment priorities and scales varied slightly from year to year. By the end of 2004, a cumulative total of CNY864.3 billion of funds from government bonds had been invested in infrastructural projects (see Table 24.1). Table 24.1 Investment distribution of government debts, 1998–2004 Project Agriculture, forestry, water conservancy, and ecological construction Transportation and communication infrastructure construction Urban infrastructure construction Technical advance and industrial upgrade

Amount (CNY1 billion)

Percentage (%)

259.6

30.0

171.1

19.8

131.7

15.2

68.8

8.0

Rural power grids upgrade Education, culture, public health, tourism infrastructure construction Central grain reserve depots construction Environmental protection Construction of facilities of public security organs, prosecuting bodies, courts, and other judicial bodies Source: Jin, Theory and Practice of China’s Fiscal Policy.

77.5

9.0

43.3

5.0

35.2 31.2

4.1 3.6

18.0

2.1

Raising the income and social security levels of low- and mediumincome families The wage level of administrative and public institutions was substantially improved. Basic wages of employees from government departments and public institutions had been raised four times in a row since 1999, and in addition to that, schemes of a year-end lump-sum bonus and allowances for working in remote and border areas were also introduced. By the end of 203, the average wage (including bonuses) of these institutions reached CNY877 per month, more than doubled

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from 1998.29 Moreover, spending on social security was also increased. In 1998, a basic living allowance system was introduced for laid-off workers from SOEs, and in the following year, Regulations on Unemployment Insurance and Regulations on Guaranteeing Minimum Subsistence for City Residents were successively promulgated. Hence, a relatively complete social security system was established. Starting from July 1, 1999, the standards of the “three guarantees” for laid-off workers were raised by 30%.30 In 2000, the government accelerated the construction of the social security system to strengthen the social security for laid-off workers and the urban poor: It formulated the Pilot Scheme for Improving the Social Security System in Urban and Rural Areas, promoted the reforms in the medical insurance system for urban workers, the healthcare system, and the drug circulation system, and adjusted the fiscal expenditure structure. From 1998 to 2004, government expenditures on subsidies to enterprises’ pension insurance funds, basic living allowances for laid-offs from SOEs, and minimal subsistence allowances for urban residents grew from CNY12.3 billion to CNY103.5 billion, an annual increase of 42.6%, reaching a cumulative total of CNY446.4 billion.31

Revenue policy measures Structural tax reduction In the implementation of proactive fiscal policy, China did not apply overall tax cuts but chose the so-called “structural tax cuts,” that is to grant tax breaks to specific taxpayers or economic activities. For example, consumption tax on skincare and haircare products except soaps was lowered to 8% from 17%, and business tax, contract tax, and land appreciation tax involved in real estate were all reduced to a certain extent in 1999; starting from 2001, business tax for banking and insurance industries was down by 1 percentage point on an annual basis until reaching 5% in 2003; stamp tax on securities trading was cut to 4‰ on June 15, 1998, and was further adjusted to 2‰ in October 2001. Moreover, the focus of tax cuts was enlarged in an orderly way, from stimulating exports and attracting foreign investments in 1998 to encouraging investments and promoting technological progress, then to supporting industrial development in the western region, and finally to supporting the development of high and new technology industries. For instance, while the overall level of customs duties dropped from 17% at the end of 1997 to 10.4% in 2004, equipment imports of investment projects encouraged by the state were exempt from customs duty and importrelated taxes within the prescribed scope starting in 1998. Export VAT rebates were

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adjusted up in eight times, with the average rate going up from 8.3% in 1998 to 15% in 2002. Fixed asset investment regulation tax was halved in the second half of 1999 and completely cancelled in 2000. In 1999, the government increased its inputs to support the technical transformation and industrial upgrading of enterprises with CNY15.3 billion spent in interest subsidies to enterprises’ technical transformation projects, and by the end of 2001, there was a total 781 projects launched on T-bond interest discounts. In 2000, a series of preferential tax policies for the software industry, integrated circuit industry and other high and new technology industries was formulated, covering VAT, corporate income tax, and import tax. In 2001, CNY150 billion worth of long-term construction bonds was issued, among which CNY50 billion of special bonds was used to support China Western Development for infrastructure construction projects like Qinghai–Tibet Railway, West–East Gas Pipeline, West-East Electricity Transmission, South-to-North Water Diversion, and ecological construction.

Abolishment of numerous fees While giving out tax incentives, the Chinese government also conducted a tax and fee reform to abolish a large number of illegal and unjustified fees. Between 1998 and 2004, a total of 1,913 chargeable items was removed and the charge standards of 469 items were lowered, thus alleviating social burdens of CNY149 billion (see Table 24.2).32 Table 24.2 Fee abolishment and the reduction of charging rates, 1998–2004 Year

Chargeable items abolished

Items with a lowered charging rate

Reduction in total fee amount (CNY1 billion)

1998

727

—

37.7

2000

238

—

14.5

1999

2001

408

469

69

—

2002

298

2004

108

2003 Total

65

1,913

— — —

469

24.5 30.0 21.0 14.0 7.3

149.0

In conclusion, concrete measures of proactive fiscal policy can be summarized as follows: First, they focused on increasing fiscal expenditures and chose structural tax cuts over comprehensive tax cuts;33 second, while enlarging fiscal spending, they improved the structure of government expenditure, and more importantly,

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largely raised infrastructure investments with the money financed from issuing long-term construction bonds;34 third, under the premise of an increase in tax revenues, structural tax cuts were introduced to lower taxes that have a direct bearing on investment, and abolish a lot of chargeable items through the tax and fee reform.

Evaluation of Proactive Fiscal Policy Characteristics evaluation Although the name of proactive fiscal policy has triggered widespread controversies, it accurately reflected the complexity in the formulation and implementation of China’s macroeconomic policies. It was right because of this that this proactive fiscal policy had many distinct characteristics and unique measures.

An active fiscal policy An important indicator of fiscal policy is fiscal deficits. For simplicity, changes in fiscal deficits since the launch of the Reform and Opening Up policy were used to describe the difference in fiscal policy before and after 1998. From Fig. 24.2, it can be seen that fiscal deficits were present from 1979 throughout 2004, except 1985. This seems to indicate that China has been practicing a policy of deficit financing for over 20 years. Fig. 24.2

Deficit ratio, 1979–2004

% 4

3.5 3

2.5 2

1.5 1

0 – 0.5

1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004

0.5

Note: Starting from 2000, fiscal expenditures also included the interest payments for foreign and domestic debts.

Source: National Bureau of Statistics of China, China Statistical Yearbook 2009.

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Although fiscal deficits persisted throughout the years, they were created passively in most years before 1998 whereas deliberately expanded through enlarging government spending in 1998 and beyond. So, the fiscal policy implemented after 1998 was called an active or proactive fiscal policy. Then, why were fiscal deficits before 1998 said to be a passive result? In general cases, the premise of a fiscal deficit is a recession in economic operation and the government uses the fiscal deficit to expand aggregate social demand to curb economic slowdown. However, during the 19 years from 1978 to 1996, China’s economy experienced three rounds of cyclical fluctuations with 10 years having an economic growth of more than 10%, which should not have a deficit.35 Here, it is clear that fiscal deficits before 1998 existed, to a large extent, not for ironing out economic fluctuations. Given that the scale of fiscal expenditures was subject to the scale of fiscal revenues, China’s deficits were mainly caused by the decline in fiscal revenues prior to 1998. From 1978 to 1996, the ratio of budget revenue to GDP shrank from 31.2% to 10.9%, which also affected the ratio of budget spending to GDP, down from 30.9% to 11.7%. The reason for the drop in the budget revenue ratio was not the active choice of the government to combat the recession, but a passive result of the reform in the economic system and the changes in the national economic structure. First, one of the essential part of China’s economic system reform was the SOE reform, and the key of this reform was to transform fiscal and taxation systems, that is to streamline administration and delegate more power to lower-level governments, and reduce taxes on enterprises and allow them to retain more profits through replacing profit delivery with taxes, which directly led to the sharp decline in fiscal revenue. Since 1978, the distribution relationship between the state and SOEs has experienced four major changes: 1. 1978–1982: An enterprise fund system and profit retention in SOEs; 2. 1983–1986: A two-step tax-for-profit reform in SOEs, changing 100% profit delivery to 55% of profits paid as corporate income tax; 3. 1987–1993: A contracted management responsibility system, and a trial run of the separation of tax delivery from profit remittance; 4. After 1994: A comprehensive reform to the profit distribution system of SOEs, unifying the corporate income tax rate at 33% Therefore, considering the fact that the measures of tax reduction and profit retention changed 100% profit delivery to 55% corporate income tax on profits and then to 33% corporate income tax, it is understandable that the fiscal revenue plunged.

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Second, the changes in the economic landscape aggravated the downward trend of fiscal revenue. Given the constraint of data availability, the impacts of economic structural changes on fiscal revenue will be explained by comparing the proportions of different economic sectors in gross industrial output value and the ownership composition of fiscal revenue. From 1985 to 1995, the share of the output value of state-owned economy in gross industrial output value declined from 64.9% to 33.9%, and the share of the fiscal revenue from state-owned economy in total fiscal avenue fell from 77.7% to 71.1%; on the contrary, the collective economy saw a rise in its output value proportion, from 32.1% to 36.6%, but its contribution to total fiscal revenue dropped from 19.3% to 17.3%; the individual economy experienced an increase in both proportions, from 1.9% to 12.9% and from 19% to 6.1%, respectively; similarly, other economic ownerships also took up a larger part in both gross industrial output value and aggregate fiscal revenue, ascending from 1.2% to 16.6% and 0.9% to 5.5%.36 As in China’s economic system reform, the priority of development was given to economic ownerships other than the state-owned economy and the fact that a large number of enterprises of the collective and individual economy were small in size raised the difficulty of tax collection, the faster the development of non-state-owned economic ownerships and the higher their proportions in gross industrial output value, the slower the growth of fiscal revenue.

A counter-cyclical fiscal policy A counter-cyclical fiscal policy adjusts the economy opposing the trend of a business cycle: practicing a contractionary fiscal policy and reduce or even eliminate a deficit when the economy is expanding; adopting an expansionary fiscal policy and running a deficit through overspending when the economy is contracting. It is the opposite of a procyclical fiscal policy which accelerates the growth of fiscal revenue and increases a fiscal deficit during an economic boom but slows down the growth of fiscal revenue and narrows a fiscal deficit during a recession. From the perspective of stabilizing economic operation, a counter-cyclical fiscal policy was what the Chinese economy needed. That is because a procyclical policy will aggravate economic cyclical fluctuations whereas counter-cyclical policy will resist such movements. The proactive fiscal policy proposed in 1998 as well as the corresponding measures was clearly a counter-cyclical policy that conform to the theory of modern macroeconomic policy. However, fiscal policies implemented before 1998 or even dating back to the founding of New China were all procyclical policies (see Fig. 24.3).37

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Fig. 24.3 Fluctuations in the growth rates of fiscal revenue and expenditure and GDP % 60 40

Fiscal revenue growth rate

Fiscal expenditure growth rate

2007

2004

2001

1998

1995

1992

1989

1986

1983

1980

1977

1974

1971

1968

1965

1962

1959

– 40 – 60

1956

0

– 20

1953

20

GDP growth rate

As shown in Fig. 24.3, the movements of fiscal revenue and expenditure growth rates corresponded to that of GDP growth rate; that is to say, fiscal revenue and expenditure slowed down when GDP grew at a slow pace, and vice versa. This proves that China’s fiscal policies were procyclical before 1998. What can be also learned from this graph is that fiscal revenue and fiscal expenditure moved in the same direction too, with the only difference that fiscal expenditure fluctuated more violently.38 However, there was a shift in direction of fiscal policies implemented after 1998. During the fourth business cycle after the start of the Reform and Opening Up policy, fiscal policies formulated between 1991 and 1997 were still procyclical — that is, fiscal revenue and expenditure grew rapidly when GDP growth sped up; fiscal revenue and expenditure slackened off when GDP growth slowed down. But things were different after 1998: Although GDP grew at a slower pace, the growth of fiscal revenue and expenditure accelerated, especially the fiscal expenditure growth, which undoubtedly helped resist the economic downturn and stabilize the economy. It should be noted that the growth of fiscal revenue was different from the past. In the past, with a procyclical fiscal policy, the growth rate of fiscal revenue declined if GDP growth slowed down; but after 1998, the growth rate of fiscal revenue escalated despite a fall in the GDP growth rate, and it was just lower than that of fiscal expenditure. This situation also showed a counter-cyclical fiscal policy but only appeared during an economic recession.

An expansionary fiscal policy with an increase in fiscal revenue During the implementation of fiscal policy after 1998, the fiscal revenue growth rate moved up. Did this mean the fiscal policy was contractionary? The answer is negative.

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First, in theory, there are multiple combinations of measures under an expansionary fiscal policy. If considering from the perspective of growth rate, there will be four possibilities: 1. The growth rate of fiscal expenditure rises while that of fiscal revenue declines; 2. The growth rate of fiscal expenditure rises while that of fiscal revenue remains the same; 3. The growth rate of fiscal expenditure stays unchanged while that of fiscal revenue falls; 4. The growth rates of fiscal expenditure and revenue both increase, but fiscal expenditure grows faster than fiscal revenue. Generally speaking, the first scenario applies to a serious economic recession, the second and third are suitable for a mild recession, and the last one is most appropriate for when there is just a sign of economic recession. Obviously, the first three measure mixes belonged to expansionary fiscal policy and judging from the theory of the function mechanism of fiscal policy, the fourth combination also has an expansionary effect on the economy. The fiscal policy launched after 1998 was of the fourth kind, hence an expansionary fiscal policy. Besides that, to decide whether a fiscal policy is expansionary or contractionary, it also needs to compare between fiscal revenue and expenditure, which can be indicated by the fiscal deficit. In Fig. 24.2, the ratio of fiscal deficit to GDP was the highest between 1998 and 2004 since the implementation of the Reform and Opening Up policy, and the ratio in any year during this period was far above that in any year between 1980 and 1997.39 A high fiscal deficit is the direct outcome of an expansionary fiscal policy.

A fiscal policy combining aggregate adjustment and structural adjustment According to the traditional Keynesian macroeconomic stabilization policy, economic recession and inflation are mainly caused by the deficiency in aggregate social demand. When social investment and consumption demand are low, the government has to increase spending and lower taxes through an expansionary policy to close the gap between social demand and supply and eventually stabilize the economy. However, factors leading to China’s macroeconomic difficulties were various and complicated, including both the short-term imbalance between aggregate

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demand and supply and accumulated long-term institutional and structural factors. In other words, the problem in China’s macroeconomy was neither a simple conflict between supply and demand nor an absolute “surplus economy,” but a relative surplus economy, reflected in a structural contradiction where surplus and deficiency coexist. For this reason, in the policy design after 1998, the policy makers had to make sure that the fiscal policies were not only expansionary in terms of the aggregate (budgetary policy) but also favorable to the adjustment of industrial, regional and urban-rural structures in expenditure and revenue policies. To some extent, the fiscal policy formulated after 1998 integrated the demand management policy of short-term aggregate adjustment with the supply management policy of long-term structural adjustment to become a policy of aggregate adjustment on the basis of structural adjustment and optimization. Taken together, the fiscal policy practiced after 1998 was a proactive policy but with unique characteristics. It was nothing like the passive policy and procyclical policy that had been adopted before, but an expansionary policy accompanying an increase in fiscal revenue and combining aggregate and structural adjustment.

Measures evaluation In the theory of traditional macroeconomic stabilization policy, during an economic slump, the government should take an expansionary fiscal policy which means to increase government spending while reducing taxes. However, from the section of “Major Measures of Proactive Fiscal Policy” in this chapter, it can be seen that first, the proactive fiscal policy adopted after 1998 focused on encouraging more government spending but did not take measures to cut taxes; second, the increase in fiscal spending mainly went to infrastructure or public construction projects. Therefore, someone may ask why there was no sweeping tax cuts and why more money was spent on public investments.

To not introduce all-round tax cuts was a wise choice As mentioned earlier, the economic recession after 1998 was predominately caused by demand constraints, which provided the economic environment for a tax cut policy. In theory, to increase fiscal expenditure while reducing taxes will greatly magnify the effect of an expansionary policy. But there was a conflict between the actual need and reality: Although the economic environment was suitable for giving tax breaks, other necessary conditions were missing.

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Unfavorable social economic background Based on the macroeconomic stabilization theory, the purpose of tax reductions is to increase disposable income, expand effective demand, and boost consumption. Although it is important and necessary to stimulate consumption demand, the effect of tax relief will be small considering China’s social economic situations at that time. That is because during a period of economic downturn, household income is not expected to grow significantly from the low level, and the purchasing power of low-income earners whose marginal propensity to consume was insufficient. Next, the low expectation towards future economic operation added to people’s cautiousness in spending. Finally, as the reform of housing, education, health care, pension systems was sped up, people’s expectation for future expenditure rose, which explained why household savings surged while household income was slowing down. Given the above, it is apparently that to significantly increase real household consumption demand in a short term, especially during an economic recession, is impossible to achieve through tax cuts. And even if household income rises, whether consumption will also go up, it rests with the nature of the income. In economics, the consumption function can be written as: C = a + cYd where C represents household consumption expenditure, Yd disposable income, and c marginal propensity to consume. It is generally agreed by economists that consumption hinges on (disposable) income, but there is no consensus on how to define income, and whether it is current-period or permanent income.40 Permanent income refers to the household expected future income flow (namely, regular household income or long-term income). If a certain change in household income is believed to be temporary and only has an negligible effect on permanent income, then its impact on consumption will also be small. Certainly, in the real world, people will not splash out because of a temporary increase in income. In this way, when the Chinese government carried out tax cuts in 1998, people undoubtedly realized that it was a temporary means to save the economy and thus unlikely to expand their spending. In addition, tax cuts do not necessarily mean a boost in enterprise investment. Here, several issues needs to be further discussed. 1. Have tax burdens been lessened? A view is expressed that China’s macro tax (fee) burden ratio (dividing tax revenue by GDP) has already exceeded

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25% (some even suggest over 30%), far higher than the average level of developing countries which is 16%–20%. According to the research done by Forbes in 2002, China ranked the third in terms of tax burden ratio, only second to France and Belgium.41 This estimation clearly included fees. If fees are excluded from tax revenues, the ratio was only 11.8%, which is pretty low. So, even if the proactive fiscal policy did not directly reduce taxes, the abolishment of ungrounded fees in fact lowered the tax burden. 2. Yet another view held that from international comparisons, corporate income tax and VAT are high in China, placing a heavy tax burden on enterprises. The statutory rate of corporate income tax was 33% in China, whereas the rate was 25% in Germany, 8% in Australia, and 30% in the UK, Japan and India. Although the maximum marginal tax rate was 33% in the US, but the top three tax brackets were just 15%, 18%, and 22%, lower than in China. As for the statutory rate of VAT, it was 17% in China if calculated based on production, but 23% if translated into the consumption-type one. This is still a high rate compared with below 20% in most western countries. It has to be admitted that these two taxes paid by Chinese enterprises were relatively high. However, if considering from the relationship between fiscal revenue and expenditure, to boost business investments, significant reductions in these two taxes are needed, which will further exacerbate the fiscal deficit. That is because the two taxes act as the pillars of China’s tax revenue, accounting for 45%–50% of gross tax revenue, and the reduction in the two rates must be compensated by an increase in other tax rates. As individual income tax cannot be raised dramatically, the gap in tax revenue must be made up by a rise in business tax and consumption tax, which will equally add to the tax burden of enterprises. 3. Even if enterprises’ tax burden is eased, their investments may not necessarily grow. Enterprises’ contribution to domestic demand is mainly manifested through an increase in investment, but such an increase has to meet a certain requirement of scale. In other words, a company make new investment unless the money for additional investment reaches a certain amount, even if the company has some money at hand. In this case, a dollar reduction in tax will not necessarily bring a dollar increase in investment. So, even though a tax cut is large in scale nationally, it will still be inadequate for an enterprise to increase investment. Moreover, whether a company decides to make additional investment also rests upon the prospects and future returns of the project. Companies will not invest even if they have money during an economic downturn, or in the face of economic uncertainty. This has been proved by the fact that with bank lending as the primary financing

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method, business investment was not as active as expected in recent years even if banks’ lending rate was repeatedly lowered. The multiplier effect of tax cuts was little for income tax was not the principal tax in China In theory, tax cuts mainly aim to reduce income tax, especially personal income tax. Because an effective way to increase household consumption demand is to raise people’s disposable income and a reduction in individual income tax is a direct way to boost disposable income. As learned from the tax multiplier formula, the tax cut multiplier depends critically on marginal propensity to consume. The marginal propensity to consume measures the proportion of an aggregate raise in disposable income that is spent on consumption, and disposable income is an after-tax income. So, the effect of tax cuts is subject to two factors: First, whether the tax system is individual income tax–based; second, whether changes in individual income tax will impact disposable income. In China, the tax system centers on indirect taxes and the proportion of individual income tax is very low. In 1998, the proportion of individual income tax in total tax revenue was only 3.7%, equivalent to 1/10 of the average level of developed countries, and even after the rapid growth of individual income tax, the share remained low at 7% in 2002, 1/5 of the average level of developed countries. Under this circumstance, the multiplier effect of tax cuts will be weak. Moreover, if indirect taxes are lowered, there will be many uncertainties: First, whether such a tax reduction can boost consumption demand will, to a certain extent, depend on whether enterprises will correspondingly cut the retail prices of commodities and services; second, it will also be influenced by whether enterprises are willing to make investment after getting extra profits without cutting prices down. So, as analyzed above, the reduction in indirect taxes will have an impact on the supply side rather than the demand side. Moreover, individual income tax is not a common tax in China, and therefore it has little impact on the disposable income of the vast majority. First, the number of taxpayers of individual income tax is really small, as a result of whether tax evasion or the low level of income, so the changes in this tax cannot affect the disposable income of most people; second, as far as the taxpayers of individual income tax are concerned, most of the taxpayers are from the working class whose income is generally low, so the tax they paid is rather small, unable to form the consumption demand that could drive the recovery of the entire economy. As for high-income taxpayers, their consumption has reached saturation, and tax cuts will only add to the number in their savings accounts.

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There was little room for further tax cuts given years of a low tax ratio in China Prior to 1998, China’s total tax revenue was low, lagging far behind the economic growth. Consequently, the tax-to-GDP ratio fell year after year, making it difficult for the government to even fulfill its basic functions, let alone perform macroeconomic regulation. From a static point of view, the tax-to-GDP ratio was 11.8% in 1998, and it only rose to 15.8% in 2001 after constant improvements, which remained low whether compared to that in other countries or considering the actual needs. China’s tax ratio was 15–30 percentage points lower than that in developed countries, and around 10 percentage points lower than that in other developing countries. Moreover, the fact that China’s economy was at the initial stage of an economic takeoff created a huge demand for social and economic infrastructure. However, there were many bottleneck sectors standing in the way of economic development. For example, transportation, energy, and telecommunications sectors fell behind of economic development, and primary and secondary education had to run with the help of the “Project Hope” launched by an non-governmental organization. All these indicate that the scale of tax revenue was disproportionate to the needs of economic development. China’s fiscal situation was not suitable for a tax cut In general, fiscal balance is considered a measure of a country’s fiscal performance. But as the fiscal deficit was present in most years across the world, deficit dependence becomes the major indicator of the fiscal situation in a country. Deficit dependence is the ratio of fiscal deficits to central government spending, showing how much fiscal expenditure was made on the basis of fiscal deficits, or in other words, the dependence of total expenditure on deficit spending. It reflects the gap between the need of fiscal spending and the supply capacity of tax revenue. Before 1998, China’s deficit-to-GDP ratio was basically below 1% and even during the recent economic recession, the ratio was slightly up to reach 2.62% in 2002. But even this comparatively high ratio was lower than the average level of industrialized countries (at 3.8%) and newly industrialized Asian countries (at 6%), including South Korea, Indonesia, Malaysia and Thailand, during the critical period of industrialization between 1968 and 1986. Although it was much smaller than the mean level (at 6%) of the developing countries with a comparatively high ratio, it was still large than the average level of the other developing countries. This shows that China’s deficit ratio was moderate.42 However, China’s deficit dependence was high, making its fiscal situation worrisome. From 1990 to 1995, the deficit dependence ratio of the most developed

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industrialized countries averaged 11%, up 57% from 7% in the mid-to late-1980s, the average ratio of the developing countries with a comparatively large deficit was 23%, down 23% from 30% in the mid to late 1980s, and it closed to 23% in China.43 By comparison, China’s deficit dependence was apparently higher than both that of industrialized countries and that of the newly industrialized Asian countries in the process of industrialization (17%), and was roughly the same as that of the developing countries with a high deficit dependence. Clearly, deficit spending occupied too large a share in China’s fiscal expenditure, which resulted in a disadvantageous fiscal situation, unfavorable to the implementation of fiscal policy. It is reasonable that the expansionary fiscal policy adopted by the government during an economic downturn will lead to a fiscal deficit. But, why was that the deficit dependence ratio in developed countries was smaller than half of that in China while their deficit-to-GDP ratio was nearly doubled than that in China? The answer to it is the serious deficiency in the supply capacity of China’s tax revenue. Under this circumstance, China’s fiscal operation cannot be sustained if there is a cut in taxes. To conclude, while China’s economy remained at the bottom and the call for stimulating consumption demand was increasingly strong, a tax cut was plausible in theory but not in practice, for it lacked both channels and the capacity to play its role.

To prioritize public investment was a correct thing From the section of “Major Measures of Proactive Fiscal Policy,” it can be known that the proactive fiscal policy announced in 1998 focused on the increase of fiscal spending, especially public investments. What are the reasons? From the Roosevelt’s New Deal by which public works projects were introduced for the first time to achieve an economic recovery to the Keynesian theory of “hole-digging,”44 it can be concluded that the policy measure of boosting public investment in the face of China’s economic depression in the 1990s was a right initiative.45 There are three main reasons: 1. While total social demand is constantly lower than total supply, a sharp increase in public investment will directly raise total demand, easing the conflict between supply and demand. This is what commonly known as the “demand effect” (short-term effect) — public investment can multiply the increase in income (multiplier effect), hereby adding to total demand. Meanwhile, public investment will have a supply effect (long-term effect)

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through building up the capital stock in the economy and improving the production potential of the economy. 2. In the process of China’s economic development, agriculture, transportation and urban infrastructure have always been the “bottleneck” sectors hindering economic growth. To take these sectors as the focuses of public investment will not only propel economic structural adjustment but also lay a basis for future sustainable economic growth. Furthermore, public investment, through public works projects in the underdeveloped West China,46 has driven investment growth, improved the investment environment, and boosted economic growth in the western region, thus creating conditions for future coordinated development of regional economy. 3. An increase in public investment can ameliorate the structure of public expenditure. This is because budgetary investment only took a small portion in total investment in fixed assets and this percentage was constantly declining and eventually hit the bottom at 2.7% in 1996, only up slightly in 1997 at 2.8%. It was not until 1998 that a substansive growth in public investment rapidly pushed up the share of fiscal investment to 4.2%, and by 2001, this proportion further went up to 6.7%, but still below the level of the 1990s. According to the experience of many other countries, public investment usually accounted for a high proportion in the early stage of economic growth. In the next session of an overall evaluation on the proactive fiscal policy, it can be clearly seen that public investment did play a notable role in expanding domestic demand, driving economic growth, and improving the economic structure. In addition to that, it also needs to be noted that public investment has a strong effect on employment — it can directly or indirectly increase job opportunities. This is crucially important for China who has a huge labor force reserve. In the short run, public investment can create new jobs: first, direct employment, that is jobs from public works projects; second, indirect employment, that is employment opportunities created in the input supply industries for the construction projects; third, induced employment, that is jobs generated from the purchase of goods and services by workers employed directly or indirectly by the public works projects or the input supply industries.47 As mentioned above, it is estimated that an accumulative total of 7.5 million jobs has been created since the implementation of proactive fiscal policy in China. In an economic slump, new job opportunities can play a vital role in easing the employment pressure. As Keynes suggests, “The employment of a given number of men on public works will (on the assumptions

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made) have a much larger effect on aggregate employment at a time when there is severe unemployment, than it will have later on when full employment is approached.”48 Certainly, some people may argue that other counter-cyclical policy tools also have the effect of job creation to combat the unemployment caused by economic recession. It is surely that many fiscal policy tools have been proved to be reliable in increasing jobs, such as reduction in individual income tax, wage subsidy, and investment tax credit, apart from public investment. However, the job creation effect of public investment is direct, whereas that of other tools (except the public employment service) all depends on the response of the private sector. If the private sector is responsive to the policy by increasing investment or expanding the production scale, new employment opportunities will be made; on the contrary, if the private sector shows little or no reaction, there will be no new jobs. Finally, public investment also helps improve income distribution. In general cases, unemployed families are impoverished families. Although the government can lessen income inequity through taxes and one-time transfer expenditure, the effect will be weakened by political and social factors. To increase the income of poor families, the key is to expand employment and improve their pay. To expand employment entails more job opportunities, and to increase work chances for the poor is premised on expanding public investments, because the priority of private investors is investment returns rather than job creation. Public investments, especially those in the economically backward areas, are significant for improving income fairness and social welfare. In short, public investment is a common counter-cyclical fiscal policy tool. To use public investment as the primary tool in China’s economic recession was a right decision, judging by whether theory or recent practice.

Effect evaluation Practice has proven that the proactive fiscal policy has gained remarkable achievements since it was introduced 7 years ago. It not only stimulated shortterm demand and maintained the stable growth of the national economy, but also improved the endogenous growth capacity of the economy and coordinated the relationship among reform, stability and development. This is of both practical and historical significance for the long-term development of China’s economy and the comprehensive construction of a moderately prosperous society.

Driving economic growth

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To maintain moderate growth is extremely important for China’s social and economic development. Then, what is moderate growth? Moderate growth is not measured by an economic growth rate, but a proper economic growth range. In retrospect of China’s economic development since the implementation of the Reform and Opening Up policy, if the GDP growth rate fell below 7%, there would be tremendous pressure on employment and reemployment, revealing the deepseated problems in economic development; if GDP grew at a rate faster than 10%, a high inflation rate should be expected. Therefore, considering the fact that China’s economy is approaching the borderline of economies of scale with growing pressure from population growth and economic aggregates, and the effect of institutional reform launched during the Reform and Opening Up is stepping down, to keep China’s GDP between 7% and 9% is an ideal range in the upcoming period. If 7%–9% is a moderate growth range, then let us review the economic development after the mid-1990s. From 1993 to 1998, the GDP growth rate dropped from 13.5% to 7.8%, down nearly 1 percentage point a year. If it had not been for the government’s initiative to adopt a macroeconomic stabilization policy, the economic growth rate would have continued to decline and finally fallen below the lower limit of the moderate growth range in 1999. However, thanks to the proactive fiscal policy carried out in the middle of 1998, China’s economic growth remained stable at above 7%. The proactive fiscal policy successfully stopped the decline of economic growth through effectively stimulating investment, consumption and exports: It increased investment demand by issuing national debts, expanding government investment, and driving private investment; encouraged private investment and exports by preferential tax policies; and promoted household consumption by fiscal-supported income distribution policy.

Improving the economy’s capacity of endogenous growth Proactive fiscal policy not only curbed the economic recession triggered by temporary conflicts and problems in economic operation through adjusting economic aggregates, but also raised the economy’s endogenous growth capacity by means of structural adjustment centering on infrastructure construction and supplemented by industrial structure optimization, regional economic development and the strategy of rejuvenating the country through science and technology. It can be said that the proactive fiscal policy has basically achieved the targets of boosting effective supply while increasing total demand as well as using effective demand to expand total demand, which paves the way for the continuous coordination between total supply and demand in the future.

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Infrastructure is the prerequisite of private investment and consumption and also the basis of constant economic growth. However, the most prominent problem faced during China’s economic development in the past 30 years was the acute shortage of transport, energy, telecommunication, rural power supply and irrigation facilities, and this continued to be the obstacle in China’s future sustainable economic growth. In view of this situation, the Chinese government decided to place the focus of proactive fiscal policy on infrastructure construction. In the first three years between 1998 and 2000, the government launched 6,620 investment projects with government bonds and issued CNY360 billion of longterm treasury bonds for construction, and if bank loans and local and enterprise self-financed funds were also counted, the investment on infrastructure totaled CNY2,400 billion. By the end of 2000, the cumulative realized investment reached CNY1,510 billion, accounting for 63% of total contracted investment. Moreover, the unreasonable industrial structure has been a chronic problem in China’s economic development. In particular, the share of tertiary industry output value in GDP was relatively low, hovering between 30% and 34% in 1986–1997, and although the share of secondary industry output value was high, the industry was subject to repeated construction and backward technology and equipment. Therefore, the proactive fiscal policy focused on transforming traditional industries and developing high and new technology industries through granting tax credits and fiscal subsidies to hi-tech industries and technical innovation projects. Starting from 1998, the central government had given interest subsidies to 880 technical innovation projects for civilian use, which aroused enterprises’ enthusiasm for technical transformation and bolstered banks’ confidence in financing technical innovation projects. As a result, a large batch of projects of technical upgrading, hi-tech industrialization, and domestic production of equipment was carried out. As of the end of 2000, 68 projects were put into operation. Regarding technical innovation projects, driven by the policy of T-bond interest discounts, the government had made CNY26.54 billion worth of investment and financed 1,218 projects, which accordingly stimulated CNY281 billion of investment and brought 288 projects into operation. During this period, the proportion of tertiary industry output value in GDP rose gradually from 34% in 1997 to 41.2% in 2003.

Balancing between reform, stability, and development A lesson learned from the experience in the 30 years after the launch of the Reform and Opening Up policy is that the relationship between reform, stability and

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development must be balanced. Only with reform, can China build a socialist market economy and sustain rapid economic growth. But as reform will inevitably entail the adjustment of economic interests relationship, to ensure social stability, it is must to increase household income, raise people’s living standard, and create more jobs. While pursuing economic growth, the government should also pay attention to environmental protection and ecological construction and seek for a road of sustainable growth. Only in this way, can people’s livelihood be truly improved. After the mid-1990s, China’s economic reform arrived at a crucial stage. The proactive fiscal policy provided strong support for the reforms of SOEs, financial system, investment and financing system, social security system, rural tax and fee system, and grain distribution system, and at the same time, a series of reforms was also conducted on the fiscal system as a support to the proactive fiscal policy.49 These reforms have offered an institutional guarantee for China’s sustainable and efficient economic growth in the future. Social stability is of upmost importance for China, and a premise for social stability is to guarantee the livelihood of low-income earners. After 1998, while repeatedly raising the wages and pensions for employers and retirees in government departments and public institutions, the government placed its work focus on the establishment of social security system and has basically formed the framework of social security including unemployment, pension, and health care benefits as a social stabilizer with a huge infusion of government funds. The proactive fiscal policy increased the input to sustainable development while keeping a rapid economic growth trend. The projects of erosion and torrent control, ecological and environmental protection, reforestation, and pollution control resulting from the proactive policy not only remedied the overdevelopment of natural resources under the past development model, but also contributed to the future implementation of the strategy of sustainable development.

Through the above analysis, it can be concluded that the proactive fiscal policy not only curbed economic slowdown and prevented inflation, but also laid a solid foundation for China’s economic sustainable development in the future. It cannot be denied that the proactive fiscal policy has also triggered some problems in stabilizing the economy, given the fact that the primary task during China’s past economic operation was to fight inflation mainly through monetary policy.50 For example, some people argued that “policy measures were launched in haste and lacked necessary legal and regulatory bases,” and “the fiscal expenditure structure was not reasonable.” But these have some historical and realistic reasons:

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“Policy measures were rushed out” because there was no experience to follow and to deal with an emergency, haste was unavoidable; “a legal framework for T-bond issuance was not ready” because the need and size of T-bond issuance were subject to economic situations which cannot wait for the legal system to be established in three to five years; “the input into infrastructure took up a large share of government investment whereas that in hi-technology research and development was inadequate” because under limited capital, the priority of proactive fiscal policy should be to expand domestic demand through investing in infrastructure. In conclusion, the implementation of proactive fiscal policy not only stabilized economic operation, but also enriched the Chinese government’s experience of macroeconomic regulation. It is a beneficial attempt to conduct counter-cyclical adjustment through fiscal policy under the market economy, and also a large breakthrough and successful practice of strengthening macroeconomic regulation. This experience will offer valuable lessons for China to formulate macroeconomic policy in the future.

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Chapter

Reform of Three Budgetary Systems

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Since 1998, the Chinese government has introduced several reforms to innovate the budget process from budget preparation to budget enforcement and control, and the most noteworthy three are the reforms in departmental budgeting, centralized treasury collection and payment, and government procurement.

Definition

Definitions of the three systems Departmental budgeting is to list all planned expenditures and forecasted revenues of different nature in an independent budget of a government department to reflect all public resources shared by the department. A departmental budget is compiled by each department and will be submitted to the legislature for approval after being reviewed and collected by the state finance department. Centralized treasury collection and payment is a centralized mechanism for the collection and payment of fiscal funds, and its core is to implement centralized management of cash through a treasury single account, so it is also known as a treasury single account system. This system has three basic features: First, the Ministry of Finance opens a treasury single account in banks; second, all fiscal revenues are directly turned over to the treasury, and major fiscal expenditures are paid to suppliers of goods and services directly by the Ministry of Finance; third, an efficient budget enforcement agency, a scientific information management system and a sophisticated supervision and inspection mechanism are established. Government procurement refers to the procurement of goods, constructions and services by governments at all levels and other public departments mainly with fiscal funds according to the ways and procedure as prescribed by law in domestic and foreign markets in order to meet the demand for public products. Government procurement is different from the activities of other consumers as its capital is derived from revenues collected from taxpayers, so the uses of procurement funds should be for the benefits of taxpayers and insist on the principle of openness, impartiality, and justice.

Relationships between the three systems Reform of the three systems reinforce each other, with departmental budgeting as the basis, and centralized treasury collection and payment and government procurement as the means. A well-prepared departmental budget offers a foundation for centralized treasury payment and government procurement, while well-developed treasury payment and government procurement systems are

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guarantees for budget enforcement and also useful references for budgeting. The coordination between different links in the reform of the three systems and the continuous deepening of the reform will bring out the best use efficiency in fiscal capital. Relationships of the three system reforms are shown in Table 25.1. Table 25.1 Relationships of the three system reforms Name

Status among the three

Stage of fiscal management

Reform target

Departmental Budgeting

Basis

Budget preparation

Unity, integrity and seriousness of budgeting

Centralized treasury Means collection and payment Governmental procurement

Means

Flexibility and Budget enforcement effectiveness of fund allocation

Transparency and Budget enforcement effectiveness of capital use

Reform Background Macroeconomic background From 1978 to 1994, the reform priorities of China’s fiscal work were given to the fiscal system and the government revenue system, with little progress made in the fields of budgeting and treasury management. At the 14th National Congress of the Communist Party of China (CPC), the target of building a socialist market economy was proposed, and accordingly, government functions have been adjusted to focus on economic regulation, market supervision, social administration, and public service, as the market started to play a fundamental role in resource allocation. Since fiscal management is a reflection of government functions, the reform of the economic system and changes in government functions also require a corresponding reform in the fiscal management system, in order to connect fiscal budgeting with the performance of governmental departments and ensure the successful fulfillment of government functions. The tax sharing reform of 1994 marks a shift in government focus from the reform of income distribution to fiscal expenditure control.

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Defects in the old systems Defects in the old budgeting system For a long time, China’s government budget was prepared by the nature of expenditure rather than by government department or unit. A department or unit usually incurs many different types of expenditures, such as administrative expenses, education fees, technology development expenses and capital investment, which will be reported to corresponding divisions under the finance department for fund allocation. More specifically, ministries, commissions and grassroots units under the State Council will claim money from different divisions of the Ministry of Finance through their own channels. The Ministry of Finance had no idea about how much money a certain department had got from the treasury and sometimes, even the department heads themselves did not know the total amount of fiscal appropriations. This system made it hard for the finance department to optimize resource allocation and restricted government departments and units from performing unified management and control over expenditures. Meanwhile, as fiscal funds were allocated through multiple layers of government organizations with each holding a reserve fund, the budget was made arbitrarily. This not only undermined the use efficiency of budget funds, but also obstructed the budget supervision by the legislature and the audit department. Major problems existed in the old budget preparation system were as follows: • The budget content was incomplete, creating inconsistency in budget enforcement and final settlement, and increasing the difficulty in analyzing the quality of budget execution. • The budget plan was prepared roughly, with simple content and lack of specific expenditure items. • Budget preparation work often started late with a short preparation cycle, accounting for the low quality of budget plans. • Budget compilation lacked scientific forecasts, updated compilation methods, and rational budget quotas. • The preparation procedure was not standardized and the finance department was sometimes forced to be engaged in budget preparation.

Defects in the old treasury management system Before 2000, China followed the treasury management scheme established under the planned economy, namely a decentralized treasury collection and payment

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system. Its major defects are as follows: • Repeated and dispersed accounts were set up and a large volume of extrabudgetary funds were excluded from budget management, which was detrimental to effective budget management and supervision. • Feedback on fiscal revenue and expenditure was slow and thus cannot provide timely information for budget compilation and macroeconomic analysis. • The collection and returning of budget revenues were not standardized. • Payments of budget expenditure were made dispersedly and a large number of fiscal funds became idle in the account of budget preparation units. Illegal interception, occupation, and embezzlement of fiscal funds were common, reducing the use efficiency of fiscal capital and easily breeding corruption.

Defects in the traditional government procurement system According to the internationally accepted practice, the procurement scale of a government normally takes up over 10% of its annual GDP or 30%–40% of fiscal expenditure. Given the large scale, government procurement will be an effective system to strengthen fiscal spending management, an important channel for fiscal expenditure to undertake macroeconomic regulation, and a key measure to prevent and inhibit corruption at the source. Since the implementation of the Reform and Opening Up policy, China has established the direction and requirements of building a socialist market economy and thus to promote and institute a government procurement system became a natural choice. Before 1995, government procurement in China was conducted by each budget spending unit in an extensive way, and fiscal expenditures were broken up into pieces, unable to exert the scale effect. Fiscal activities were increasingly breaking away from fiscal supervision and more and more problems emerged as a result. Among the problems were the low use efficiency of fiscal funds, corruption in government procurement, and unfair trading. In November 1995, at the meetings of leaders of the Asia-Pacific Economic Cooperation (APEC), the Osaka Action Agenda (OAA) was passed, in which government procurement was listed in the scope of trade and investment liberalization. Among the 18 existing members, China was the only country that had not established a government procurement system. To narrow the gap with the developed countries of APEC, China’s State Council ordered to speed up the building of a government procurement system, which was put on the government

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agenda as a key part of reforming fiscal expenditure management. In October 2005, the Standing Committee of the 10th National People’s Congress (NPC) decided to join the United Nations Convention against Corruption (UNCAC), in which the 9th Article stipulates “Each State Party shall, in accordance with the fundamental principles of its legal system, take the necessary steps to establish appropriate systems of procurement, based on transparency, competition and objective criteria in decision-making, that are effective, inter alia, in preventing corruption.” Thus, to reform the procurement system became a urgent need for China to observe the UNCAC and adapt to international economic integration.

Main Contents of the Reform of the Three Systems Reform of departmental budgeting The tax sharing reform of 1994 defined the scope of government activities and the financial relationship between central and local governments from the aspect of government revenue to reinforce the ability of macroeconomic regulation of the central government. However, a corresponding reform in government expenditure was not launched simultaneously, giving rise to a series of problems, such as incomplete budgeting, unscientific expenditure procedure, ambiguous expenditure scope, opaque use of spending, and low benefit of spending. In view of the problems in the traditional budget compilation, the Chinese government learned from the internationally accepted practice and incorporated it with its own reform experience to explore a budgeting system that complies with the requirements of a socialist market economy and make necessary preparations for the reform of departmental budgeting, in both theory and practice. In the Audit Report on the Central Budget Implementation and Other Financial Revenues and Expenditures of 1998 prepared by the National Audit Office of China on behalf of the State Council at the 10th Meeting of the Standing Committee of the Ninth NPC in June 1999 and the report of central final accounts and central fiscal audit of 1998, it was put forward that central budget compilation should be improved and standardized to strictly follow the Budget Law and ensure the timely review and approval of budgets, and the Ministry of Finance should make the draft budget delivered to the NPC for approval more detailed to increase its transparency. The Budgetary Affairs Commission of the Standing Committee of the NPC required, in particular, the Ministry of Finance to provide information about the budget of each central department when submitting the central draft budget to

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the NPC. Following the instruction of the NPC, the Ministry of Finance presented a Request for Instructions on the Implementation of the Opinions of the Standing Committee of National People’s Congress Concerning the Improvement and Standardization of Budget Management to the State Council on July 24, 1999, by taking public finance as the guidelines, starting with a reform of budget compilation, and building on intensive study. This document formally put forward the idea of making government budgets more detailed in compilation and introducing departmental budgeting.

Process of departmental budgeting reform Pilot stage (1999–2000) In August 1999, the Ministry of Finance held two central budgetary meetings participated by 11 relevant departments with budgetary allocation power, including the State Development and Planning Commission (SDPC), State Economic and Trade Commission, and Government Offices Administration of the State Council, to collect opinions on the improvement of central budget preparation for 2000. On September 29, 1999, the Opinions on the Improvement of Central Budgetary Compilation for 2000 was released by the Ministry of Finance, marking a start of the departmental budgeting reform. On September 29, 1999, the Ministry of Finance convened a working conference on the budget preparation of central government departments for 2000 to assign the budgeting work to each central department. Main contents of the meeting included:

1. To make the draft budget submitted to the NPC more detailed; 2. To change budget compilation methods by preparing departmental budgets on a trial basis, where each central department was ordered to compile its own budget plan covering all its revenues and expenditures by using an unified and standard form as stipulated by the Ministry of Finance, setting up the basic framework of departmental budgeting; 3. To select the Ministry of Agriculture, Ministry of Education, Ministry of Science and Technology, and Ministry of Labor and Social Security as pilot units for departmental budgeting and submit their budget plans to the NPC together with the central draft budget for 2000; 4. To set a standard time for budget compilation and submission.

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Promotion stage (2001–2003) In 2001, 26 departments under the State Council, apart from the Ministry of National Defense, Ministry of State Security, and People’s Bank of China (PBC), submitted their own budgets for deliberation by the NPC, with some improvements in budget contents and form. Upon drawing lessons from the pilot departmental budgeting for 2000, the Ministry of Finance formulated the Notice on Carrying Out the Pilot Program of Basic Expenditure and Project Expenditure Budgeting in the State Development Planning Commission and Other Nine Departments, which for the first time made a distinction between basic expenditure and project expenditure. Basic expenditure was managed according to the number of staff and the level of administrative expenses, while project expenditure was subject to project review and evaluation, changing the traditional incremental budgeting to zero-based budgeting. In July 2001, further adjustments were made to achieve more detailed budgeting: 12 headings of basic expenditure were expanded to 44, which can be classified into four parts — staff expenses, regular public spending, subsidies to individuals and households, and payment to acquire and overhaul fixed assets. Meanwhile, the Ministry of Finance announced the Tentative Measures for the Budget Management of Basic Expenditures of Central Departments and the Tentative Measures for the Budget Management of Project Expenditures of Central Departments, ordering all central departments to prepare the departmental budget following basic and project expenditures. In December 2001, the reform of comprehensive departmental budgeting was deepened. Extrabudgetary funds were put under budgetary management through strict separation between revenues and expenditures in management: Administrative charges by the Ministry of Public Security and other four ministries were included in budget management with all incomes turned over to the state treasury and expenditures allocated by the Ministry of Finance in budgeting according to their needs for fulfilling duties; extrabudgetary revenues of General Administration of Quality Supervision and Inspection and Quarantine (AQSIQ) and other 27 departments were managed under special accounts and corresponding expenditures were arranged by the Ministry of Finance based on actual needs; the withdrawal of expenditures in proportion to incomes practiced by national tax and customs institutions was replaced by a budgeting system, and expenditures were estimated in line with the unified requirements of departmental budgeting. In June 2002, 44 budget headings were rearranged into 35 and subheadings related to agriculture, education, technology, etc., were modified to adapt to the needs of budget management. Meanwhile, the filling of budget report and related software operation were much improved to meet the demands of the departmental budgeting reform. In July 2002, the Ministry of Finance released the

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Regulation on the Procedure of Budget Preparation of Central Department (Trial), which explicitly stipulated the time arrangement, specific work contents, functions and powers of different competent authorities at the stages of budget compilation, enforcement, and adjustment to further regulate departmental budgeting. In 2003, 127 public institutions were added to the units that were ordered to prepare departmental budgets, besides the central-level administrative units and part of public institutions that follow the management system of civil service. Popularization stage (since 2004) By 2004, over 160 first-class central budgeting units prepared departmental budgets, and the number of department budgets transferred from the State Council to the NPC grew to 34 in 20041 and 35 in 2005.2 Meanwhile, the pilot program of departmental budgeting was under way. In August 1998, Hebei provincial government formulated the Opinions on the Implementation of the Reform of Budget Management to Promote Wealth Management by Law and compiled the provincial budget for 2000 in accordance with the new method in March 1999. Local governments of Tianjin, Shaanxi, and Anhui provinces made innovations to the reform of the budgetary management system based on their own realities. Tianjin City learned from the experience of budget management of market economies to introduce a management system with standard budgeting cycle in 1999. Anhui Province implemented comprehensive fiscal budgeting starting from 1999. Up to 2002, there were 36 provinces, autonomous regions, municipalities directly under the central government and municipalities separately listed under the state plan that had performed departmental budgeting, and the practice was being promoted to governments at city and county levels. All these reform measures have accumulated rich experience for China’s reform of the budget management system.

Contents of departmental budgeting A departmental budget is an estimation of the income and expenses of a specific government department, and it is the basic form of government budget management of a market economy. According to international experience, the departmental budget is a comprehensive fiscal plan of all revenues and expenditures prepared by the grassroots unit of a government department in accordance with relevant state policies and regulations and the needs to fulfill its functions, and reported, reviewed, and consolidated level by level up to the state finance department to be submitted to the legislature for final approval. Departments that are qualified for

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preparing a departmental budget must be first-class budgetary account units that directly receive appropriations from the government finance department. To sum up, the government budget is compiled on a departmental basis by grassroots units, and is implemented and managed by each specific department; a departmental budget is an aggregate of the budgets of all its subordinate units with all fiscal funds used by a department, despite their different nature, placed under the same budget. Dissection of departmental budgeting 1. Budget scope: A departmental budget covers all income and expenses of a department or unit, including not only budgetary funds, but also extrabudgetary funds, and not only general budgetary revenues and expenditures, but also revenues and expenditures of government funds, representing the principle of “aggregate revenues and expenditures,” or “one budget for one department.” 2. Budget expenditure: All funds used by a department or unit, whether they are capital expenditures, operating expenses of governments, or other expenditures, should be compiled by function into the same budget based on the prescribed format and standard to give a whole picture of the purposes and specific application of funds. 3. Budgeting procedure: A departmental budget is an aggregate budget made up of budget proposals prepared by grassroots budgeting units after being examined and consolidated level by level. Specifically, the grassroots budgeting unit prepares its budget based on its work tasks, the departmental development design, and the annual work plan, and then delivers the budget to the next higher level of authority for review and final compilation. 4. Budget categorization: The assembled budget plan reflects not only the total amount of all income and expenditures of a department, but the composition of revenues and expenditures by budgeting unit and project, as well as subcategorization by function. 5. Legitimacy. A departmental budget must conform to relevant state policies and regulations and not exceed the budget control amount verified by the Ministry of Finance, and it must be submitted to upper authorities upon the approval of the department head. The general fiscal budget proposal must first seek approval from the State Council before being passed on to the NPC. Upon the approval of the annual budget by the NPC following legal procedure, the budget will be allocated by the Ministry of Finance to

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each department and then to each grassroots unit. According to the current categorization of budget, department budgets are generally composed of general budget and fund budget, under which are income budget and expenditure budget. General budget income includes fiscal appropriations, extrabudgetary income, and other income; general budget expenditure includes basic expenditures and project expenditures.

Differences between departmental budgeting and traditional budgeting China had been practicing a traditional budgeting system (also known as functional budgeting) for a long time, whose major characteristics are budgeting by income type and expenditure function. In other words, a traditional budget is prepared not based on department but government functions and capital uses. By contrast, a departmental budget first puts together budgets of different budgeting units under a department and then subdivides budget items by expenditure function and economic category. Departmental budgeting and traditional budgeting have both similarities and differences. There are mainly two things that they have in common:

1. Budget compilation and approval procedure (two submissions, and two returns) is the same. A budget proposal formulated by the budgeting department will be submitted to the Ministry of Finance (first submission), then the Ministry of Finance and authorities of macroeconomic regulation with budget allocation power will examine the proposal and set a spending limit for budget control (first return), next the budgeting department will revise its proposal based on the control limit and submit the budget again to the Ministry of Finance which will consolidate all departmental budgets into one and send it to the NPC for approval (second submission), and last the Ministry of Finance will approve and return the budget proposals to each department based on the reply of the NPC (second return). 2. Budget review and control authorities are still the Ministry of Finance, National Development and Reform Commission (NDRC), Ministry of Science and Technology, Commission of Science, Technology and Industry for National Defense, and other similar organizations with budget allocation rights.

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Major differences between departmental and traditional budgeting are as follows:

1. Basis of classification. Traditional budgeting is developed following the classification of government functions, such as economic construction, public services, public security, culture, education, public health, social security, and environmental protection, and based on this, budget expenditures are listed by function and estimated separately in the central budget. Unlike traditional budgeting, departmental budgeting is made on a department or unit basis, where all income and expenditures related to a certain department or unit are compiled in the same budget sorted by function, and the Ministry of Finance will examine and incorporate budgets of all departments into the central budget that is again broken down by function as in a traditional budget. 2. Budget coverage. Traditional budgeting only covers budgetary funds, but leaves out income and expenditures from government funds, extrabudgetary funds, and other funds that are organized in pursuance of state laws. Departmental budgeting counts all income and revenues of a certain department, including not only general budget but also fund budget. The general budget comprises not only budgetary funds but also extrabudgetary and other funds. 3. Management method. Under traditional budgeting, expenses for different functions of a department are managed separately by different units of the Ministry of Finance and within the department itself. A finance unit manages all expenditures of the same function for several departments, and the examination and approval of different expenditures of the same department are subject to several different competent authorities as well as other authorities with the budget allocation power. By contrast, under departmental budgeting, all income and expenditures of a department are managed by the same unit of the Ministry of Finance and within the department. Or conversely, a finance unit is in charge of all the expenditures of a certain department and the associated budget examination and approval is subject to one competent authority. 4. Management focus. Traditional budgeting focuses on the analysis of fiscal revenue and expenditure structures and government macroeconomic control, and it emphasizes budget planning. Departmental budgeting gives an overall picture of fiscal revenues and expenditures of a certain department but with detailed categorization, and it highlights the management of budgets throughout the whole process of the fulfillment of

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government functions, extending budgeting to micro management level. 5. Budget breakdown. Traditional budgeting only makes a distinction by function and does not reflect budgeting units and projects. However, departmental budgeting first lists all kinds of funds by department and then further sorts the funds by function. 6. Budgeting procedure. Traditional budgeting is conducted in a top-down manner, where the Ministry of Finance will first confirm the budget size and the spending structure, then distribute the budget quota by function to different departments, and on this basis, each department will prepare a budget on behalf of its subordinate units to be included in the central fiscal budget. By contrast, departmental budgeting follows a bottomup approach, starting from grassroots units and progressing through successively higher echelons for review until all budgets are consolidated into a central fiscal budget. 7. Compilation time. Traditional budgeting starts around November each year and continues for two to three months. The tight schedule of budget compilation causes subsequent discretional amendments during budget execution, weakening budgetary constraints. Departmental budgeting begins in March every year with sufficient time for compilation and detailed budget contents, adding to the accuracy of budgeting.3

Basic framework and details of departmental budgeting Basic framework According to current budget classification system, a departmental budget is composed of general budget and fund budget, with each part consisting of revenue budget and expenditure budget. General budget revenues comprise fiscal appropriations, extrabudgetary revenues and other revenues; general budget expenditures include basic expenditures and project expenditures. The contents of fund budget are mainly income and expenditures related to government funds. The structure of the department budget is shown below (see Fig. 25.1).

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Fig. 25.1

Framework of departmental budgeting Fund income budget

Departmental fund budget

Departmental budget

Fund expenditure budget

Departmental revenue budget

Fiscal appropriations Extrabudgetary income

Other income

Income from government funds Expenditures from government funds

Revenues from administrative charges Centralized revenues of competent departments Other extrabudgetary revenues Revenues from public institutions Revenues from subordinate units Operating income from public institutions Other revenues

Departmental general budget Basic expenditures Departmental expenditure budget

Project expenditures

Regular public spending Personnel expenditures Expenditures for capital construction projects Expenditures for government administrative projects Expenditures for other projects

Source: Department of Budget of the Ministry of Finance of the People’s Republic of China, Guide to the Budget Preparation of the Central Government (2002).

Details A departmental budget is comprised of revenue budget, basic expenditure budget and special expenditure budget. Revenue budget includes both budgetary revenues and extrabudgetary revenues of a certain department and its subordinate units. It contains: fiscal appropriations, revenues from administrative charges, income from fines and penalties, extrabudgetary funds, revenues from public institutions, operating income from public institutions, income from government funds under budget management, grants from higher authorities, revenues from subordinate units, and

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other income. Basic expenditure refers to personnel and non-personnel expenses incurred by a certain department and its subordinate units, which mainly includes the follows. • Personnel expenses: regular wages, subsidies, bonus pay, subsidies for heating and cooling expenses, welfare allowance, housing provident fund, pension insurance fund, medical benefits fund, pensions for retirees, special allowance for retired veterans, living expenses, allowance for the survivor, compensation for service-connected disability or death, allowance for funeral expenses, relief payment, single children allowance, children care grant, and wages paid to long-term contract workers and contemporary workers. • Daily public expenses: administrative expenses, printing expenses, water and electricity bills, postage, postage and phone/fax expenses, heating bill, transport costs, travel grants, conference expenses, training costs, entertainment expenses, service charge, rental fee, and maintenance expenses. • Special expenditures: expenditures that are assigned for completing specific tasks or fulfilling certain development goals in addition to basic expenditure budget, including expenses for large conferences, renovations, and equipment purchase, and expenditures related to construction and production.

Status of departmental budgeting in the budget system According to relevant laws and regulations, China’s budget system comprises three aspects. First, the central government budget is made up of the budgets of its departments (including units directly under them). Second, the local budget consists of the general budgets of various provinces, autonomous regions and municipalities directly under the Central Government. A local general budget at any level consists of the budget of the government at the corresponding level and the totalized general budget at the next lower level. In the absence of the budget at the next lower level, the general budget means the budget of the government at the corresponding level. The budget of a local government at any level consists of the budgets of the various departments at the corresponding level (including the units directly under them). Third, the budget of a department consists of the budgets of the units subordinate to it. The budget of a unit refers to the budget for revenues and expenditures of a State organ, social organization or any other unit which is listed in the budget of a department.4

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Reform of centralized treasury collection and payment The main contents of the reform of centralization treasury collection and payment include: first, build a single treasury account system; second, standardize the procedure of revenue collection; third, regulate the procedure of expenditure allocation; fourth, implement an inter-bank clearing method of fiscal funds; fifth, establish supporting measures. Fiscal revenues are ordered to be turned over to the treasury by two ways, direct depositing and centralized depositing. Appropriations of fiscal funds are made through either direct payment or authorized payment, depending on the type of expenditure, and direct fiscal payment is used most. In accordance with the basic requirements of the development of the treasury management system, a treasury single account system should be established and all fiscal funds should be placed under the management of the single account. Fiscal revenues should be directly deposited in the treasury of special accounts while fiscal expenditures should be paid directly to suppliers of goods and services or spending units.

Treasury single account system The treasury single account system comprises the following five types of accounts. • A treasury deposit account opened by the Ministry of Finance at the PBC, also known as the treasury single account. It is used for recording, accounting, and reporting fiscal revenues and expenditures brought under budgetary management, and payment clearing with accounts set up by the Ministry of Finance at commercial banks. • Zero-balance accounts of the Ministry of Finance at commercial banks for direct fiscal payment and clearing with the treasury single account. • Zero-balance accounts of budgeting units set up by the Ministry of Finance on behalf of budgeting units at commercial banks for authorized payment and clearing. • Extrabudgetary accounts controlled by the Ministry of Finance at commercial banks for recording, accounting and reporting extrabudgetary revenues and expenditures, and daily clearing for extrabudgetary funds. • Special accounts set up by the Ministry of Finance on behalf of budgeting units for earmarked, transitory activities and clearing with the treasury single account under the approval or authorization of the State Council. The above accounts and special accounts should be consistent with the accounting

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records of the Ministry of Finance and its collection and payment execution institutions, the Treasury Department of the PBC, and budgeting units. The structure of China’s treasury single account is shown in Fig. 25.2. Fig. 25.2

China’s treasury single account structure Treasury State treasury

General (capital) account

Treasury of PBC Indirect supervision

Treasury single account Extrabudgetary accounts

Budgetary revenues Budgetary Expenditures

Treasuries managed by commercial banks on behalf of the PBC

Zero-balance accounts (petty cash) Secondary (accounting) account

Zero-balance accounts (authorized payment) Zero-balance accounts (wages) Zero-balance accounts (procurement) Special accounts

Source: Zhang, Practices and Case Study of Government Budgeting, 175.

Procedure of revenue collection Revenue classification Fiscal revenues can be divided into six kinds according to economic nature, including taxes, social security contributions, non-tax income, transfer and donation revenues, income for the recovery of principal and the disposition of property, and income from debts. Collection methods At present, fiscal revenues are collected in two ways: depositing at the locality and depositing after being centralized. Under direct depositing, paying units or individuals pay their revenues payable directly to the treasury single account

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or extrabudgetary accounts, in accordance with relevant laws and regulations. Revenues collected in this way include taxes, social security contributions, non-tax income, transfer and donation revenues, income for the recovery of principal and the disposition of property, and income from debts. Under centralized depositing, collection institutions (relevant legal units) first centralize the revenues received and then deposit them into the treasury single account or extrabudgetary accounts, in accordance with relevant laws and regulations. Revenues follow this method include small, scattered tax revenues and cash payments of non-tax income. Collection procedure For taxes paid directly into the treasury, a taxpayer or tax agent first files a tax return to the collection organization for verification; then a tax bill will be issued to the taxpayer if the information in the tax return is correct; next, the taxpayer makes a payment into its deposit bank; last, the deposit bank transfers the money into the treasury single account. Other revenues of direct depositing are treated with in the similar manner provided above. For small, scattered taxes, the collection organization will first collect the taxes from individual taxpayers and tax agents, and then formulates a totalized tax bill, with which it deposits the consolidated taxes into the treasury single account through banks. The collection of non-tax cash payments follows the same procedure to be deposited in the treasury single account or extrabudgetary accounts.

Procedure of expenditure allocation Expenditure classification In general, fiscal expenditures comprise government purchases and transfer payments. Based on the needs of payment management, fiscal expenditures can be divided into: expenditures on wages, namely wages of budgeting units; purchase spending, namely spending on goods, services, construction projects made by budgeting units in addition to expenditures on wages and miscellaneous items; miscellaneous expenditures, namely daily small expenditures of government purchases, spending on items not listed in the Classified Catalogue of Government Procurement Items, and spending on items listed in the Classified Catalogue of Government Procurement Items but below the prescribed amount; transfer payments, namely payments made to budgeting units or lower level finance departments for unspecified purposes, including subsidies to enterprises, government funds with unspecified purposes, and general transfer payments from central to local governments.

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Payment methods Two types of payment were applied to different kinds of expenditures based on the type of payer. First, direct payment by the Ministry of Finance. The Ministry of Finance issues a treasury warrant, and then fiscal funds will be paid through the treasury single account to payees (namely, suppliers of goods and services, similarly hereinafter) or the bank accounts of paying units (including lower finance departments and budgeting units, similarly hereinafter). This method is applicable in the following cases. • To payees: expenditures on wages, purchase spending, transfer payments from central to local governments, and appropriations to enterprises for financing large construction projects or purchasing large equipment; • To paying units: transfer payments (excluding those from central to local governments) including tax returns, subsidies under the fiscal contract system, transfer payments in transition period, settlement subsidies, subsidies to enterprises, and government funds with unspecified purposes. Second, authorized payment. Budgeting units, authorized by the Ministry of Finance, issue a treasury warrant, and ask the bank to make payment through the treasury single account to the accounts of payees. Expenditures adopt such a method include purchase spending that is not suitable for direct payment and miscellaneous expenditures. Specific expenditure items under direct and authorized payment were listed in the departmental budget confirmed by or the specific measures of the implementation of a pilot reform formulated by the Ministry of Finance. Payment procedure For direct payment, the budgeting unit will submit a payment application to the payment execution agency of the state treasury according to the approved departmental budget and the capital use plan, then if the application is confirmed upon examination, the payment execution agency will issue a treasury warrant to the agent bank and at the same time notify the Treasury Department of the PBC, and after that, the agent bank will make payment through the national bank clearing system and transfer the fiscal funds from the treasury single account to the accounts of payees.

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Direct payment is mainly realized through bank transfer, but sometimes it also can be made through treasury check. The payment execution agency of the state treasury will write a check based on the requirements of the budgeting unit and ask the budgeting unit to pass the check on to the payee. The payee can cash the check and deposit the money into the bank account through his deposit bank, and then the deposit bank will settle the payment with the agent bank through the treasury single account on a daily basis. Moreover, the staff size, wage standards, and expenditure amount of budgeting units with regard to wage expenditures will be confirmed by the staffing department, personnel department, and finance department, respectively. Expenditures made to budgeting units and lower finance departments will be transferred from the treasury single account to their accounts by the Ministry of Finance in accordance with the progress of budget execution. As for authorized payment, the budgeting unit will apply for the monthly payment quota to the payment execution agency of the state treasury in accordance with the approved departmental budget and the capital use plan; then the payment execution agency informs the agent bank and the budgeting unit about the approved quota and at the same time notify the Treasury Department of the PBC; next, the budgeting unit issues a treasury warrant based on the prescribed monthly quota and instructs the agent bank to complete the payment to payees; last, the agent bank settles the payment with the treasury single account. The above direct and authorized payment procedures are established based on the treasury management and operation system integrating the modern bank payment system and the fiscal information management system. Before these systems were established, treasury warrants issued by the payment execution agency and budgeting units were transferred manually to agent banks, and the agent banks made payment to payees through the current bank clearing system and settled with the treasury single account before reconciling the account every day.

Reform of government procurement system China’s government procurement started in 1996. At that time, the Shanghai Municipal Government got loans from the World Bank, and according to the loan terms, government purchases must be made through open tendering, bringing in the system of government procurement. The Government Procurement Law was drafted by the Drafting Group founded in April 1999 by the Committee of Economics and Finance of the NPC, approved at the 28th Meeting of the Standing Committee of the Ninth NPC on June 29, 2002, and took effect on January 1, 2003. Other laws and regulations related to government procurement include: Law of the

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People’s Republic of China on Tenders and Bids, Contract Law, Law of Small and Mediumsized Enterprises, Budget Law, Administrative Measures for the Government Procurement of Import Products, Administrative Measures for the Government to Initially Purchase and Order Independent Innovation Products, Order No.18, 19, 20 of the Ministry of Finance, and relevant local laws, regulations, and rules. The purpose of practicing a government procurement system was to improve cost efficiencies and strengthen capital management. Later, it was redirected to rooting out corruption and building a public finance framework. Now, government procurement has developed into a necessary means for economic regulation and policy guidance.

Characteristics of the government procurement system Government procurement refers to the purchase of goods, services or constructions in the domestic or international market with fiscal funds by governments at different levels and other public institutions, following legal procedures and in a manner prescribed by law, in order to provide public products. It is different from other purchasing activities conducted by other consumers for its money coming from taxes, and therefore the money should be used to meet the demands of taxpayers and be rationally allocated. Government procurement should insist on the principle of openness, impartiality, and justice. Characteristics of government procurement include:

1. Publicness and non-profitability. The publicness of government procurement is decided by its source of funding, mainly fiscal appropriations and public borrowings, which ultimately come from taxes and public charges. Government procurement is a component of fiscal expenditures and should be listed in the government budget. It aims to meet the needs of the whole society, or more accurately, to satisfy the interests and demands of the public and be responsible for the public. Here, it is clear that government procurement is non-profit, as opposed to commercial activities. Government procurement is not for making a profit and any commercial purposes. Because of this, government procurement activities easily fall victim to capital abuse and corruption, so a corresponding system has been established in each country to strictly manage government behaviors and ensure the transparency and efficiency of the procurement process. 2. Market orientation and competitiveness. Although government procurement is different from commercial activities, it is a commercial

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operation in the market. This is shown in two aspects. First, government procurement is a commercial operation following market rules, and purchasers and suppliers are of equal status in the market and form an equal civil relationship. In the market, governments are, the same as other economic players, participants of market transaction, and therefore they must abide by market rules rather than above the market, which embodies the principle of openness, impartiality, and justice. Second, governments also must follow the principles of efficiency and competition to improve the efficiency of fiscal spending. As the scale of government procurement is usually large, it is a must to mobilize and utilize funds in a prudent manner. The premise of pursuing economies of scale and good quality at an affordable price is to achieve cost effective. 3. Policy orientation. Given the large scale, government procurement is strongly policy driven, and it is an important component of the state’s macroeconomic policies. To begin with, it can ensure the fulfillment of basic government functions and the normal operation of economic and social activities. The process of government procurement is also the process of executing macroeconomic regulation policies, and government procurement should be carried out in line with the approved fiscal budget, which must not be modified or changed by any purchaser without permission. Next, government procurement can minimize fiscal spending, support mediumand small-sized enterprises, encourage innovation, and protect national industries. 4. Legality. Government procurement is different from general purchase activities, and to achieve the established goals, it needs a complete set of legal procurement procedures. Each country has established or seeks to establish a set of sound legal system, including the basic law of procurement and the corresponding implementation rules, to regulate government procurement activities, and bring standards and procedures to the procurement process in a systematic way, so as to practice the principles of openness, impartiality, and justice as well as cost-effectiveness while accept the supervision by the whole society. Management by law is one of the fundamental characteristics of government procurement.

Procurement methods In accordance with the Government Procurement Law, government procurement can be divided into five types: open tendering, invited tendering, competitive negotiation, single-source procurement, and request for quotation.

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Open tendering Open tendering is an invitation to an uncertain number of suppliers, in the form of a tender notice, to apply for tender. During the process, purchasers or purchasing agents (collectively referred to as the tenderee) publish a tender notice on the media designated by the government procurement supervision and management department to attract suppliers (the tenderer) to bid, and the tenderee selects the best tenderer in accordance with the pre-determined procedures and criteria. Open tendering should be the principal method of government procurement. The purchaser must not divide the goods or services to be procured by open bidding into several parts, or avoid procurement under open bidding by any other means. Invited tendering Invited tendering occurs when the procuring entity invites randomly more than three qualified suppliers to tender by invitation for bids according to law. Procurement items that adopt such a method should meet one of the following basic conditions: 1. Procurement items are special in character and can only be procured from a limited range of suppliers; or 2. The cost of open tendering accounts for an excessive proportion of the total value of government procurement items.5 Competitive negotiation Competitive negotiation is a procurement method where a negotiating group negotiates with more than three qualified suppliers for the purchase of goods or services. Competitive negotiation accounts for a large fraction in China’s current procurement activities, and it is characterized by time saving, high efficiency, low cost (due to repeated offers), and detail-oriented. However, this method can be easily affected by subjective factors. Under one of the following conditions, goods or services may be procured through competitive negotiation:

1. After bidding is invited, no supplier submits any tender, or qualified tender is lacking, or re-invitation fails; or 2. It is hard to determine the detailed specifications or specific requirements because of technical complexity or special nature; or

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3. Bid invitation takes so long a time that it is hard to satisfy the urgent needs of the procuring entity; or 4. The total value of the goods or services to be procured cannot be determined in advance.6 Single-source procurement Single-source procurement is defined as one in which the government centralized procurement organ organizes a negotiation between the procuring entity and a single supplier over the procurement price and contract, under given item types, quality standards, and service requirements. This method is relatively rarely adopted considering its specific requirements: 1. Goods or services can be procured from only one supplier; or 2. Goods or services cannot be procured from other suppliers due to an unforeseeable emergency; or 3. Consistency of the items or compatibility of the services procured requires procurement of additional items or services from the same supplier, provided that the total value of the additional procurement does not exceed 10% of the value of the base procurement contract. Request for quotation Request for quotation is a type of procurement solicitation in which the inquiry team of a government project asks more than three qualified suppliers to offer a quote for product or service. This method is applicable to the procured goods whose specifications and standards are uniform, supply is sufficient, and prices fluctuate very little.

Procurement procedure • Determining a procurement demand. The procurement demand should be proposed by the procuring entity and reported to the finance department for examination and approval to be included in the annual procurement plan. When examining the procurement proposals, the finance department should consider not only the budget limit, and the reasonability of procurement demand, but also accompanied risks. • Selecting a procurement method. Each country has detailed provisions on procurement methods and their respective application conditions, and the decision must be made on multiple factors, such as the nature, quantity,

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and time of procurement. A proper procurement method can save the time and cost of procurement activities. • Signing a procurement contract. After the procurement method is decided, the procuring entity should enter into a contract with the successful supplier in accordance with established procedures and requirements. The successful supplier must be qualified. When signing the contract, the supplier must pay a certain amount of deposit as a guarantee for the fulfillment of contract obligations. • Performing the contract. The contract supplier must provide goods, constructions or services, according to the contract; and no party to the procurement contract may unilaterally alter the contract. During the process of the performance of the contract, the procuring entity should inspect and evaluate the fulfillment of the contract at different stages, and invite a inspection team of professionals to issue an inspection report and a certificate of assessment and acceptance, based on which the finance department pays the supplier. • Evaluating the procurement efficiency. Upon the completion of the contract, the procuring entity and relevant administrative and supervisory departments will evaluate the performance of procured goods to see whether the expected target has been met, and assess the decision-making and management abilities of the procuring entity and the supplier’s ability to fulfill the contract, in order to accumulate useful information for further government procurement.

Reform Evaluation Achievements of departmental budgeting reform After a couple of years of hard efforts, the reform of departmental budgeting has made substantive progress in actual budget management. In theory, the implementation of departmental budgeting could be helpful in enhancing the accuracy and scientificity of budget estimates, promoting the integration and centralization of budget plans at different levels, and ensuring the transparency and rule by law of budgeting activities. The supervision and restriction from the NPC and the public on government fiscal activities will help overcome arbitrariness, human factors, and the lack of oversight in fiscal expenditure activities to greatly improve the efficiency of fiscal expenditures. In practice, major achievements of introducing departmental budgeting are as follows:

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1. Unify the budget allocation power and enhance the accuracy and seriousness of budgeting. The introduction of departmental budgeting has changed the traditional practice where budgeting units were established based on the nature of expenditure by placing each department under the management of a specific office of the Ministry of Finance, which avoids the problems of overlapping management and ensuring the normalization and integrity of budget allocation. Moreover, the decentralized fiscal management power has been united in the hands of the finance department, changing the traditional method of segmented capital allocation and increasing the comprehensive regulation ability of fiscal budgeting units. Meanwhile, the amount of funds available at the start of the budget year has been increased, removing the reserves for contingencies at each level of budgeting units and lowering the chance of capital retention at intermediate links, thus improving the transparency of capital use and the accuracy and seriousness of budgeting. 2. Establish a primary framework of departmental budgeting and improve the consistency of government budgeting. Departmental budgeting has remedied the shortcomings of traditional functional budgeting, such as different compilation time, nonstandard budget contents and format, and separate fund arrangements, by incorporating all income and expenditures of a department in one budget in the same format and manner. 3. Adopt a bottom-up compilation procedure and make more detailed presentation of the budget. Departmental budgeting follows a bottom-up approach, generally going through “two submissions and two returns,” from grassroots budgeting units all the way up to the Ministry of Finance, avoiding the arbitrariness of preparing a budget on the behalf of lower units. 4. Extend the budget preparation time. Before 1999, the central budget preparation work normally started in November with a duration of two to three months; in 2000, the preparation work was brought forward to September four months, lasting for four months; in 2001 and 2002, the start date was once again put forward to July, with a preparation period of six months. Meanwhile, departmental budgeting of local governments also has made huge progress in this regard. For example, the standard budgeting cycle system implemented by the Tianjin Municipality Government extended the compilation time to 12 months, the budget reform in Hebei pushed the starting time earlier to March. The extension of compilation time is useful for improving the budgeting quality. 5. Realized the digital management of departmental budgets. Since 2003,

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much efforts have been made in the aspects of budget form filling and software operation, as a response to the requirements of the reform of basic expenditures and project expenditures in the central departmental budget. Computer-based management is extensively promoted and applied to increase the efficiency of budget compilation and approval, laying a basis for promoting more detailed budgeted management and building a budget management information system in the future.

Achievements of centralized treasury collection and payment reform The centralized treasury collection and payment reform has established a treasury single account system and realized centralized, systematic, and standardized management of fiscal funds.

Centralized Centralization is mainly reflected in three aspects: treasury accounts, fiscal collection and payment, and the associated management. In the context of treasury accounts, it refers to the treasury single account system, including the treasury deposit account (treasury single account), zero-balance accounts of the Ministry of Finance, zero-balance accounts of budgeting units, and special accounts. The first four accounts are set up by the Ministry of Finance and the last one are established by budgeting units with the approval from the Ministry of Finance. The treasury single account system is used for the storage, payment, and settlement of fiscal funds, and is controlled by the Ministry of Finance. No unit shall set up, alter or cancel the accounts under the system without permission. For fiscal collection and payment, centralization conveys the idea of direct collection and payment of fiscal funds through the treasury single account. Fiscal revenues will be deposited in the treasury in a direct or centralized manner. Under direct depositing, budgeting units or payers will directly pay into the treasury single account; centralized collection cancels transit accounts, and collecting authorities and statutory collecting units will directly deposit the revenues (scattered taxes and non-tax cash payments) they received from individual payers into the treasury single account. Fiscal expenditures on wages and the procurement of projects, goods and services will be paid directly to payees or paying units by agent banks at the sight of the treasury warrant issued by treasury payment institutions (the payment bureau or payment center); the agent bank will settle with the treasury single account (the PBC) on the same day. Miscellaneous spending on a single good, service or project less than CNY100,000 will be paid by agent banks based

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on the monthly authorized payment warrant from the Ministry of Finance and the agent banks will later settle with the treasury single account. Before the reform, treasury accounts were set and managed according to department and unit, including accounts of revenues to be reported and transferred, the general budge accounts, and department/unit accounts. Fiscal accounts were extremely complicated considered the fact that accounts of revenues to be reported and transferred and general budget accounts were set by administrative hierarchy while department/unit accounts were set by industry or management attribute and can be opened repeatedly under the same name. After the treasury single account system was introduced, fiscal funds are mainly recorded in the treasury single account, zero-balance accounts, extrabudgetary accounts and special accounts, and the opening of multiple accounts under the same department or unit was cancelled.

Systematic The systematic aspect of the state treasury reform is embodied in the parallel structures of treasury. As shown in Fig. 25.2, China’s treasury system was transformed from a system of a single PBC treasury plus general budget accounting to a system of parallel structures of state and PBC treasuries, indicating a larger role of the finance department in treasury management. The parallel structures are reflected in the following aspects: • Accounting and fund collection and payment. The state treasury is in charge of the verification of the records of payments to and appropriations from the state treasury to ensure the accounts of governmental departments and units consistent with the documents, statements and books of the finance departments. The PBC treasury is responsible for the clearing and settlement between the treasury single account and individual wage accounts or the accounts of suppliers. • Public management and financial management. The state treasury strengthens the management over the fiscal funds of departments and units through the single account system. The PBC treasury reinforces the controlling power of the central bank over monetary base and monetary policy by acting as an agent of the treasury single account (capital account), and enhances credit guidance and financial supervision towards commercial banks through conducting capital clearing with them.

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The complexity of fiscal collection and payment decides that the state treasury management should be systematic apart from being centralized. • Systematic accounts. The general account (single account) is a capital account, directly controlled by the state treasury and operated by the PBC as an agent. Secondary accounts (zero-balance accounts) are accounting accounts, set up by the Ministry of Finance for budgeting departments and units and managed by commercial banks as agents. • Systematic management. The state treasury has to not only satisfy government macroeconomic functions to execute the collection and payment of fiscal funds, but also fulfill departmental functions to monitor the financial activities of governmental departments and units. The PBC treasury must both ensure the implementation of monetary policy and financial regulation, and strengthen the supervision of commercial banks.

Standardized The state treasury reform made use of the networking technology to conduct centralized management on fiscal accounts and fiscal activities, and established an open, transparent and relatively strict capital management approach. This method is useful in combating the phenomena of imposing arbitrary charges and excessive fees, setting up local little coffers, incurring unwarranted expenditures, conducting black-box operation, unilaterally approving fiscal expenditures, and even accumulating funds for rent-seeking by some departments and units through the repeated opening of fiscal accounts and decentralized collection and payment of fiscal funds, thus laying an institutional basis for regulating the economic order and constructing a clean and honest administration.

Achievements of government procurement reform Opinions are divided as to the achievements of the government procurement reform. Comments from the Chinese Finance Minister Xie Xuren are perhaps a more authoritative version. The following is an interview with the Finance Minister by the China Government Procurement News about the positive significance and achievements of the government procurement reform, published in its first issue on May 7, 2010.7 China Government Procurement News: Dear Minister, as we know the government procurement system is an important part and key link of deepening fiscal budget

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management, could you share with us the significance and achievements of the government procurement reform? Xie: The government procurement system is an important system for deepening the fiscal reform and strengthening fiscal expenditure management, an effective channel for preventing and controlling corruption, improving the party’s work style and establishing clean government, and a useful tool for creating a sound market environment and realizing macroeconomic regulation under the market economy. In the seven years after the implementation of the Government Procurement Law, local governments and government departments had been constantly reinforcing institutional construction and regulating procurement activities under the leadership of the party’s Central Committee and the State Council, and the government has made great progress in raising the use efficiency of fiscal funds, protecting national interests and social benefits, preventing corruption, supporting energy conservation and environmental protection, and promoting indigenous innovation.

Expanded scope and scale of government procurement and rising economic and social benefits The scope of government procurement was expanded from just goods to include projects and services and the proportion of projects showed an rising trend. More importantly, items that are closely related to public benefits and people’s livelihood were also incorporated into the government procurement list, and they became the highlight of procurement expansion. The source of procurement funds grew from budgetary funds to all sorts of fiscal funds including extrabudgetary funds and self-raised funds. The total value of government procurement increased rapidly from CNY10.10 billion to over CNY70 billion between 2002 and 2009, with over CNY30 billion of fiscal funds saved due to the reform.

Establishment of a legal framework and separation of purchase and management After the Government Procurement Law was carried out, more than 40 supporting regulations and regulatory policies were successively launched, forming a legal framework of government procurement headed by the Government Procurement Law, providing an institutional guarantee for government procurement activities. According to the requirement of the Government Procurement Law, the management function should be separated from operation, and therefore, the division of labor in government procurement management agencies, procurement units,

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and centralized procurement institutions has been adjusted to be increasingly reasonable, and the working mechanism of “separating between management and purchase, between supervisory institutions and operating institutions, and between government administration and public service, and ensuring mutual restriction of the two parts” has basically taken shape. A procurement management system of keeping centralized procurement agencies and procurement units under the centralized supervision of the Ministry of Finance has been basically formed.

Exertion of the policy effect of government procurement The policy effect of government procurement was brought into full play, and government procurement has become an important government policy tool for regulating the economy and promoting economic and social development. In recent years, a number of government procurement policies related to energy conservation and environmental protection and the development of related industries were rolled out to support the growth of those industries.

Procuring by law The degree of procuring by law has been comprehensively improved, centralized procurement has been increasingly enhanced, and a procurement pattern centering on centralized procurement with an open, transparent operating mechanism has been gradually formed. Since the promulgation of the Government Procurement Law, the awareness of managing and procuring by law has been generally heightened, procurement activities have been continuously standardized, and the quality of procurement work has been increasingly improved, during which process the leading position of open tendering in government procurement has been confirmed.

Strengthened procurement supervision Finance department at all levels took seriously their supervisory obligations by actively improving and innovating supervision methods and carrying out more detailed inspection and tougher punishment, which effectively maintained the market order and made breakthroughs in building a multi-layer, multi-link dynamic supervision mechanism and promoting clean government. Institutions of centralized procurement also paid attention to improving their own restriction mechanism, perfecting the internal job responsibility system, and standardizing internal management. Departments of discipline inspection and supervision and auditing did a good job in monitoring the procurement activities of governments,

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and played a key role in punishing and correcting wrongdoings. All these efforts were helpful in containing and preventing corruption and building a beneficial interaction mechanism between government procurement and anti-corruption.

Increased foreign exchanges and improved ability to cope with international procurement As China’s external exchanges and cooperation in finance and economics continued to develop, government procurement was increasingly connected to the international market, which was reinforced by China’s GPA (Agreement on Government Procurement) accession negotiation started at the end of 2007. Through increased international exchanges and cooperation in government procurement, the Chinese government actively advertised its achievements in the government procurement reform, learned about the international government procurement system and reform trends on a selective basis, and participated in the formulation of relevant international rules.

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Chapter

Debt-for-Equity Swap

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Debt-for-equity swaps were used in China in 1999 when financial asset management companies (FAMCs) were set up in April to deal with the high nonperforming loans (NPLs) in the four major state-owned commercial banks. The Ministry of Finance first capitalized each FAMC with CNY10 billion and then the central bank also lent money to the FAMCs for buying out the NPLs in the stateowned commercial banks. The FAMCs swapped the debts brought at face value into equity in the debtor companies, and exited from the companies and repaid the central bank loans by equity selling or other means.

Background of Debt-for-Equity Swap Historical background of debt-for-equity swap In the 1990s, the problem of an outrageous debt-asset ratio in state-owned enterprises (SOEs) was prominent. It was estimated that by 1996, the total debts of 30.12 million SOEs which had completed asset and capital verification reached CNY5.17 trillion, with a debt-asset ratio of 71% given the total assets of CNY7.28 trillion.1 A large number of enterprises even recorded a debt ratio of over 100% after deducting asset losses and potential losses. According to a report from China’s State Economic and Trade Commission (SETC) in 1997, by the end of 1996, the total assets of state-owned industrial companies amounted to CNY5.28 trillion, and the total debts stood at CNY3.44 trillion, with a debt ratio of 65.1%.2 Meanwhile, high NPLs were also an obstacle to the development of stateowned banks. Due to the difference in statistical standards and the constraint in information disclosure, the estimates of NPL ratio varied a lot. According to the data from the central bank, the loan balance of China’s state-owned commercial banks was CNY5.3 trillion; and among this, around CNY1.2 trillion was NPLs based on a report from Bank for International Settlements (BIS). In the early 1998, Dai Xianglong, Governor of China’s central bank, pointed out that NPLs including overdue, doubtful, and bad loans, accounted for 25% of all loans in China’s banks by the end of 1997, and these loans mainly came from the backbones of the Chinese economy — SOEs.3 Lardy argues that if calculated based on the international standard, the NPLs in the mid-1990s would turn the net worth into negative territory.4 Despite the difference in estimation, they all indicated a stubbornly high NPL ratio of China’s banks. To address the high debts and NPLs is of paramount importance for steady economic growth. The origin of NPLs can be traced back to complex reasons, and it has a close connection to the behaviors of various participants around the debts (see Fig. 26.1).

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Fig. 26.1

Causes of banks’ NPLs

Government-directed loans and loans of fiscal appropriation contributed to the low quality of loans

The credit management mechanism was unsound for lack of an internal risk control system

SOEs were suffered from unclear ownership and poor performance, and lacked a restraint mechanism for capital demand and use

Causes for NPLs

The central fiscal funds for replenishing the owned capital of banks were insufficient

After the founding of policy banks, commercial banks did not completely strip policy businesses off commercial businesses

Whether the root cause of SOE debts is the high debt ratio or the low yield rate, this is the preliminary question for studying SOEs’ debt issue and the related “debt-for-equity swap” policy and also the direction for solving the problem of SOE debts.5 According some scholars, the high debt ratio should account for the losses and poor economic performance of SOEs.6 Debts, surplus staff, and social duties comprise the three historical burdens to enterprises’ development and reform. On the basis of this view, the solution will be to relieve the burdens of enterprises, lower the debt-asset ratio, and improve economic performance through debt-forequity swaps to finally turn a profit. But it will be meaningless if the debt ratio is considered alone with no regard of the surrounding environment and specific features of an enterprise. “Moderate leverage” in the finance theory thoroughly reveals the humanized (enterpriserelated) and irrational aspects of the criteria of the debt ratio.7 Many scholars suggest the fundamental cause of SOEs’ debt crisis is the inherent defect in the enterprise governance structure, resulting to the low efficiency of business management and capital operation.8

Theoretical discussion on debt-for-equity swap Debt restructuring is quite special in China. Liu and Qian point out that under the same nominal owner (the state), there are three sectors that have a major stake in enterprises’ debts: SOEs (represented by the SETC), state-owned banks, and the Ministry of Finance. SOEs expect to write off and waive more debts; state-owned

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banks are prone to oppose such an idea unless they can get enough compensation; the Ministry of Finance also does not want to recapitalize the enterprises with fiscal revenue for fear of creating a deficit. So the key to a debt restructuring plan is to make sure that the interests of all three parties have been guaranteed without sacrificing the nation’s overall interests. The government also has to ensure that the write-offs will not induce unreasonable expectations and irregularities of enterprises and banks. In early 1994, the People’s Bank of China (PBC), SETC, State Commission for Restructuring the Economic System, and State Development Planning Commission, Ministry of Finance, and China Securities Regulatory Commission jointly established a research group for “debts restructuring of SOEs and Banks,” to conduct a special research on NPLs and propose a basic framework of debtfor-equity swap. In 1995, while presiding over the national key project of “overall design for the reform of China’s economic system,” Chinese economist Wu Jinglian put forward a plan for debt restructuring in Chinese SOEs and banks.9 As for the specific model of debt-for-equity swap, Wu, Zhou, and Liu and Qian in the mid-1990s offered three different choices.10 Yin and Xue gave a thorough analysis and explanation on the three models.11

Model 1: Direct conversion of enterprises’ debts into shares held by banks This is one of the earliest proposals of debt-for-equity swap, which emphasizes the role of banks in debt restructuring and calls for a main bank system.12 The basic idea of this model is that: The state allocates a certain number of subscription warrants to banks who will use the warrants to buy stocks of enterprises. This is conducted in three steps: First, the debts (including sunk loans for fixedassets and a certain proportion of loans for liquid assets) of enterprises within the debt restructuring program will be transferred into the equity of banks; second, specialized banks will be reorganized into commercial banking and investment banking, and investment banks will handle direct investment businesses and use the income from bond issue to purchase enterprises’ stakes whereas commercial banks only hold the bonds of investment banks but not enterprises’ stocks; third, the state injects capital into banks through allocating stock warrants with which the banks will purchase the stocks of enterprises with good performance. After this process, investment banks raise the grade of equity portfolio through purchasing stocks of financially better-off companies with stock warrants, and by doing so, the credit rating of investment banks’ bonds will rise accordingly. Meanwhile, the bonds held by commercial banks will also see a rise in the grade, thereby upgrading the quality of whole assets while lowering the risk exposure. Xue

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claims that policy markers attach great importance to the balance among enterprise system, banking system and fiscal system during the economic transition, and strive to find a reform route that will not increase fiscal spending but can relieve enterprises’ burdens and guarantee the asset quality of banks.13 But the problem is that complementary measures of banking and enterprise reforms are demanding. China’s banks are in nature state-owned companies, and to make them to care about the quality of holdings and business operation, a commercialization reform of banks will be inevitable. Moreover, after the debt write-offs, it is hard for banks to meet requirements of capital adequacy and asset quality stipulated in the Basel Accord I.

Model 2: Debt swap through intermediaries Model 2 centers around intermediaries, to which the bad debts of enterprises will be transferred, and through this process, companies’ debts will be eased while the quality of banks’ assets will be raised. The Research Group of State Commission for Restructuring the Economic System explains that intermediaries will raise funds via various channels from domestic and foreign investors to purchase the debts of SOEs in specialized banks and then exchange the debts for equity in these companies in order to conduct business restructuring and receive dividends; reasonable returns will also be given to ultimate investors. Zhang suggests the founding of a National State Assets Supervision Commission and discriminating between “old debts” and “new debts.” Following his idea, “old debts” of enterprises to banks will be transformed into “new debts” of custodian institutions to banks, and the custodian banks will own the stocks of enterprises.14 The most detailed model description is done by Liu and Qian, who propose a “reconstruction fund for enterprises and banks.”15 This fund has two main functions: first, as an intermediary to issue bonds to banks to offset the losses from bad debts; second, as a substitute of policy loans to subsidize loss-making enterprises through a special agency in order to ensure capital flows. The purpose of the reconstruction fund is to transfer out policy loans from banks, and the banks operate following the principles of business and give subsidies to enterprises in a transparent way. In such a manner, the reconstruction fund links bank reengineering with enterprise restructuring. According to this idea, the reconstruction fund is a government trust fund instead of banks’ and the operation of the fund is completely transparent. As a new institution, the construction fund is probably most capable of making the government to disclose the real information with regard to the debt restructuring

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and promise to end policy loans and finally subsidies. Meanwhile, this model specifies the order of restructuring — banks first, enterprises second, and pays attention to technical issues, thus highly operable. However, this model also has a problem: The smooth operation of intermediaries demands a comparatively developed capital market, and various constraints on stock transfer and market listing in China decide that this model cannot be applied on a large scale.

Model 3: Debt restructuring among the government, enterprises, and banks Designers of this model think that the solution to the debts of SOEs has a strong constraint, that is the proportion of state-owned economy cannot be lowered, and therefore the debts of SOEs to specialized banks should be transformed into the debts of the government to the central bank.16 Under this model, debts are split into fiscal debts and excessive debts. Fiscal debts are a result of price control, excessive burden of social welfare, poor business management, and changes in macroeconomic policies, and will be shouldered by government finances. Debt restructuring only covers excessive debts, which are bad claims on the balance sheet of banks. In actual practice, SOEs will first adjust capital stocks and optimize business structure, and debt restructuring will be conducted in enterprises whose assetliability structure and business operation are neither too good nor too poor. The state can sell a portion of stakes in the enterprises to concentrate the capital into the businesses affected national well-being and people’s livelihood and leave medium and small companies in competitive industries to society. Next, the government will borrow from the central bank and allocate the money to enterprises in the form of special purpose checks, and the enterprises will repay their loans with the money to specialized banks which will in turn repay central bank’s lending. Through this process, enterprises’ debts are converted into the debts of the central government without expanding the total volume of credit. The Ministry of Finance and other investors will entrust a “state-owned asset management company” to devise the operational mechanism of enterprises and reinforce the assessment and supervision of business performance. Last, the asset management company will work with banks to perform an analysis on enterprises’ assets, liabilities and performance, and decide on the list of enterprises that needs a debt restructuring; for those require a capital injection, their balance sheet will be differentiated into old and new accounts, and this is also true for banks, which allows enterprises and banks to operate in the new account while stopping charging interest and

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levying taxes in the old account. After ascertaining the nature of the old account of enterprises, a certain portion of debts will be approved to be offset by earnings in the new account and the rest will be written off based on the shares held by each business owner. The prime risk of this method is that it will encourage the indifference of SOEs towards debt repayment, and after a new balance sheet is created, these companies will not seek to improve business operation, but pin their hope on the next debt restructuring. In view of this, necessary measures must be adopted to ensure that a reliable signal will be sent out after the debt restructuring to make enterprises understand that this is the “last meal” of the “big rice bowl” system under the planned economy and prevent the policy loans from becoming the stock of bad debts. At the same time, it is difficult to differentiate between fiscal debts and excessive debts, especially in the cases of deliberate loan defaults and operational losses of SOEs.

Policy development for debt-for-equity swap The introduction of the debt-for-equity swap policy In the 1990s, the debt restructuring plan including debt-for-equity swaps was put forward and put into practice. In November 1997, at the National Conference on Finance Work held by the Central Committee of the Communist Party of China (CPC) and the State Council, it was proposed to minimize the risk of China’s banking industry in about three years. At the Central Economic Working Conference in 1998, it was decided to establish a financial asset management company (FAMC) to deal with the long-term accumulative NPLs in the big four wholly state-owned commercial banks, by learning from foreign experience. In March 1999, the Report on the Work of Government passed at the Fourth Session of the 9th National People’s Congress of China pointed out, “to gradually build a FAMC responsible for handling the NPLs in banks while practicing a strict accountability system of newly-created loans.”17 In September of the same year, at the Fourth Plenary Session of the 15th Central Committee of CPC, it was put forward that “on the basis of the reform of NPLs in state-owned banks, debtfor-equity swaps should be carried out in SOEs whose products have a market and prospects are promising but which are mired in overindebtedness, through establishing a FAMC and other means, in order to lower the excessively high debt ratio. Enterprises undergoing debt-for-equity swaps must shift their operational mechanism to put in place a standard company system, which should be subject to the independent assessment of a FAMC. This must be carried out according to the

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principles and relevant regulations of the market economy to prevent enterprises from rushing into action and state-owned assets from draining away.”18 On April 4, 1999, General Office of the State Council transmitted the Opinions on Setting Up China Cinda Asset Management Corporation issued by the PBC, Ministry of Finance, and China Securities Regulatory Commission, addressing the significance of the formation of a FAMC on the sound development of China’s banking industry and the coordination between banks and enterprises, but lacking concreate measures.19 On April 20, 1999, China Cinda Asset Management Corporation was incorporated, followed by the founding of Huarong, Great Wall, and Orient asset manage companies (see Table 26.1), and the four FAMCs offered almost all financial services, except for deposit taking, thereby nicknamed “financial department stores.”20 Table 26.1

Comparison of the four FAMCs

Name

Incorporation Registered capital date

China Cinda Asset Management Corporation

Apr. 20, 1999

CNY10 billion

China Orient Asset Management Corporation

Oct. 15, 1999

China Great Wall Asset Management Corporation

CNY10 billion (CNY6 billion and USD0.5 billion)

Oct. 18, 1999

CNY10 billion

China Huarong Asset Management Corporation

Oct. 19, 1999

CNY10 billion

Paired-up banks China Construction Bank; China Development Bank Bank of China Agricultural Bank of China Industrial and Commercial Bank of China

After the founding of the four FAMCs, the large amount of NPLs was disposed of via various means, including debt-for-equity swaps and asset securitization (see Table 26.2), among these tools, debt-for-equity swaps, characterized by little social repercussions, easy to operate, and promising quick results, were used most by the FAMCs.21 On September 2, 1999, China Cinda signed a contract with Beijing Building Materials Group on debt-for-equity swap, and Beijing Cement Plant thus became the first pilot enterprise of debt-for-equity swap. In June 2000, the debtfor-equity swap was expanded to 580 companies that had been recommended by the SETC and confirmed by relevant commercial banks, China Development Bank, and FAMCs.

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Table 26.2 Disposal method

Comparison of the disposal methods of NPLs Content

Target asset

Expected result

Necessary market means

Assist in operating projects with market demand through asset restructuring

Combine market means and administrative means

Debt-forequity swap

Covert companies’ debts into equity

“Five ranges” and “five conditions”

Bundle sale

Sell a particular type of assets to institutions or individuals

Equity market, especially Regional or Liquidate assets secondary industrial assets market of loans

Individual sale

May offer buyer financing

Secondary market of A specific target Realize the asset loans and bond asset market

Pool assets with expected income Securitization into a package and market and sell it as a security

Loans mainly related to the real estate industry

Enhance asset liquidity

Secondary market of loans and bond market

Auction

Public or sealedMainly tangible bid auctions, with loans sold in assets whole or in part

Fund management

Initiate, organize and manage investment funds

Assets with development potential

Raise funds

Securities market

Mergers and acquisitions

Reshuffle enterprises with unrealized or underestimated market value

Assets with market value

Activate assets through restructuring

Capital market

Capital custody

Entrust nonperforming assets to active Mainly tangible specialized assets institutions that are experienced in asset management

Draw on all kinds of social resources

Supervision methods including legal tools to prevent moral hazard

Liquidate assets Auction market

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(Cont’d) Disposal method

Content

Target asset

Write-off

Inject capita to offset bad debts

Assets with no Completely realistic prospect wipe off of recovery

Expected result

Necessary market means Administrative means

Notes: 1. “Five ranges” include a. industrial enterprises that had been financed by bank loans (including foreign currency loans) during the 7th and 8th Five-Year Plan

periods and the first two years of the 9th Five-Year Plan period, and became overindebted and loss making due to a lack of required capital and exchange rate movement, but can turn into profit through debt-for-equity swap;

b. industrial enterprises among the 521 key enterprises confirmed by the state, which recorded a loss because of business restructuring and expansion, but can be turned around through optimizing the structure of assets and liabilities;

c. the eligible enterprises must at the same time had its bad debts formed resulting from loans borrowed from commercial banks in 1995 or before; for enterprises which have a crucial role in the national economy or have heavy financial burdens, the time limit could be extended to 1996, 1997 and 1998;

d. industrial enterprises approved for debt-for-equity swaps must be independent legal entities;

e. some commercial and trade enterprises were also selected for a pilot run.

2. “Five conditions” refers to a. manufactured products should be marketable and competitive;

b. techniques and equipment have reached domestic and international advanced levels and production complies with the requirements of environmental protection;

c. the management skills of enterprises should be high, business liabilities are clear, and financial behaviors are regulated in accordance with the Accounting Standards for Enterprises and General Rules on Enterprise Finance;

 d. enterprise management should be competent and Chairmen and General Managers are skilled at business administration;

 e. the plan for transforming operational mechanism should conform to the requirements of modern corporate system with effective reform measures where downsizing for efficiency and reallocation of laid-off works were carried out and confirmed by local governments.

Source: Website of Hexun, http://bank.hexun.com/2008/amc/.

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Relevant policies Currently, major policies related to debt-for-equity swap include: Opinions on Several Issues Concerning the Implementation of Debt-for-Equity Swaps, published by the SETC and PBC on July 30, 1999; Regulations on the Approval of Debt-for-Equity Swap Plans, by the SETC, Ministry of Finance, and PBC on November 23, 1999; Notice on Standardizing Operation and Strengthening Management in Enterprises of Debt-for-Equity Swap, by the SETC on November 6, 2000; Regulations on Financial Asset Management Companies,22 by the State Council on November 10, 2000. The Opinions on Several Issues Concerning the Implementation of Debt-for-Equity Swaps mainly provided the goals and principles of debt-for-equity swaps, the range, criteria, and procedure of enterprise selection, and the relationship between FAMCs and enterprises.23 The Regulations on the Approval of Debt-for-Equity Swap Plans focused on the principles, scope, contents and procedure for approving a debt-for-equity scheme.24 The Notice on Standardizing Operation and Strengthening Management in Enterprises of Debt-for-Equity Swap proposed standardizing the operation of enterprises of debt-for-equity swap, accelerating the swap process, expediting the transformation towards a modern corporate system, and reinforcing financial control and audit work.25

Implementation of Debt-for-Equity Swap and International Comparison Mode of operation A debt-for-equity swap is in fact the triangular transfer of claims and liabilities between banks, FAMCs and enterprises.26 FAMCs were capitalized by government finances and received loans from the central bank. They were entrusted by banks to manage NPLs which would later be converted into stocks held by FAMCs in debtor enterprises. From the perspective of relations of capital, FAMCs and banks are independent entitles, but are connected through cooperation and interests in business.27 The policy of debt-for-equity swap was proposed in response to the objective of extricating SOEs from financial difficulty within three years, the policy targets were distinctly different from those in the conventional theory.28 In the selection of debts, not all debts of SOEs can be swapped into stocks and only the overdue and doubtful debts issued before 1996 are qualified. Eligible enterprises must meet ten requirements (“five ranges” and “five conditions”). Bei and Feng explain that the

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ten rules were made to narrow the scope to enterprises that still have a hope to revive and the policy only apply to the NPLs of the four state-owned commercial banks while other commercial banks and financial institutions were still exposed to default risk; it can only solve part of overdue and doubtful debts and the risk of bad assets formed inside banks still existed; only the over-indebtedness of some large and medium-sized backbone SOEs can be addressed but not all problems of SOE reform.29 Zhu and Huang point that under the pressure of financial distress, the society has placed high hopes on debt-for-equity swaps in terms of scale and speed, which in fact left FAMCs in a dilemma.30 The swap targets were expanded to include not only heavily distressed companies, but also highly competitive ones.31 In practice, debt-for-equity swaps were conducted in three steps: First, banks transfer their NPLs to respective FAMCs at book value; then, FAMCs negotiate with enterprises according to the list of recommended enterprises for debt-for-equity swap by the SETC to confirm the swap plan and restructuring plan; at last, a formal contract will be executed between the two parties. Yang argues that during the three steps, government opinions superseded the negotiations between enterprises and banks on which enterprises should be selected and how many debts should be swapped and the government became the leading force in the process.32 The government first set an overall scale and size of debt-for-equity swap and then banks and enterprises confirmed the amount of swap within the prescribed scale. Wang believe that the inability of the SETC to pay for the final losses of debtfor-equity swap of enterprises or the losses incurred by the swaps to FAMCs is a reflection of the mismatch between rights and liabilities in the Chinese economy.33 Apart from the big four state-owned commercial banks, China Development Bank also joined in the debt-for-equity swap as an independent entity. Prior to the incorporation of FAMCs, debt-for-equity swaps had been already in motion, and in many cases, banks directly negotiated with enterprises before transferring the debts to FAMCs for management. When the debt-for-equity swap of a company involved more than one banks, a Cooperation Agreement On Debt-For-Equity Swap Between Multiple Creditors would be signed to specify the debt-for-equity swap amount based on the share of their respective debts. After the debt-for-equity swap, rather than participating in direct operation, FAMCs mainly engaged in companies’ decision making, such as the dismissal of senior leaders of a company and the dispatch of financial staff to participate in the company’s financial management. Moreover, FAMCs can also hire industrial management companies and professionals to perform management on their behalf. The purpose of FAMCs was not to impose excessive restraints on enterprises but to safeguard the stakeholders’ interests of FAMCs through effective monitoring on the equity derived from debts.34

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The intended duration of FAMCs was 10 years, which means that the debt-forequity swap and final exit should be completed within 10 years. FAMCs aim to break the restraints on the management framework of separate operation in the financial sector and promote enterprises to extricate themselves from financial difficulties and transform the financial assets from bad to good through business reform or restructuring.

International comparison of debt-for-equity swap Li, Zhu, and Huang make a summary on international experience of debt-forequity swap.35 The operation of debt-for-equity swap can be dated back to the guarantor mortgage system in the Middle Ages, and that in a capitalist enterprise can be traced back to the business takeover system during the bourgeois revolution in Netherlands in the 16th century. In the relief plan for banks, FAMCs as intermediaries are responsible for managing the bad assets of banks, which help boost public confidence in banks. After the 1980s, FAMCs became widely popular with the frequent outbreak of financial crises. In developed countries, there were Resolution Trust Corporation (RTC) of the United States, Custodian Bank of Germany, Bridge Bank of Japan, Caisse des Depots (CDC) of France, and Asset Management Company (AMC) of Sweden, etc; in transitional economies such as Hungary, Poland, and Czech Republic, similar institutions were set up to handle the bad debts of banks resulted from institutional transition; in emerging market economy countries, FAMCs were also incorporated in Mexico, and South Korea, Thailand, Malaysia, and Philippines after the Asian Financial Crisis. Each country was especially cautious about choosing debt-for-equity swap targets, and strove to limit this practice to a certain scale. Most countries gave their priority to irrecoverable debts, especially those categorized as the worst type. For instance, Bulgaria tended to convert the debts of the central bank into equity; Croatia allowed NPLs equivalent to 2.5% of banks’ total assets to be swapped for equity; in Poland, banks and enterprises entered into a negotiation on the concrete plan of debt restructuring and they agreed that enterprises’ debts to banks can either be exchanged for long-term bonds through asset securitization or for stocks of enterprises which could be traded in the secondary market, but on the premise that the swapped debts cannot exceed 25% of banks’ capital as stipulated by the Polish government.36 However, international experience cannot be directly applied to China, and as pointed out by the Macroeconomic Study Group of China Center for Economic Research of Peking University, the restructuring of banks and enterprises in China

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bore little resemblance to the case of the RTC in the United States, but China can learn from transitional economies, like Hungary and Poland.37 At the same time, it should also be noted that in Hungarian and Polish cases, the key to the success of restructuring was privatization, and the purpose of restructuring was not to revitalize SOEs and sustain state-owned banks, but to create conditions for privatization. Because of privatization, capital injections into banks truly became the “last supper,” thus reducing the possibility of moral hazard. As privatization has no role to play in China’s debt-for-equity swap, the Hungarian or Polish model cannot be followed indiscriminately. In fact, debt-for-equity swap is not a common tool of restructuring in mature market economies, and there were certain restrictions even if it was just occasionally used.38 That said, China can still learn from foreign countries, for example, Hungarian experience showed that to use government finances to solve the debts of SOEs could easily make people tend to think that similar actions would be taken again in the future, thus resulting in repeated occurrences of bad debts; experience of FAMCs in Poland and Italy suggested that the bureaucratic style of work of administrative machinery will adversely impact the efficiency of FAMCs.39

Discussion and Evaluation Posterior to the Implementation of the Debt-for-Equity Policy Discussion on debt-for-equity swap goals In the formation of debt-for-equity goal, there is a contradiction between long-term and short-term goals and financial relief and institutional relief are not completely consistent, so a choice must be made on the priority. The difference in priority will naturally result in different policy outcomes. Huang explains that the long-term goal of debt-for-equity is to help SOEs to adapt to the market mechanism and achieve sustainable development, which requires strict regulation and the bailout of barely satisfactory and promising enterprises; on the contrary, the short-term goal is to turn around loss-making enterprises as soon as possible, which requires the relaxation of regulation and the saving of financially troubled enterprise with little hope to revive.40 Hu further points out that after debt-for-equity swaps, the problems in governance structure of enterprises may be worsened and the policy only has a weak effect on the improvement of governance structure and operational

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mechanism. If no supplementary measures adopted to transform the internal operation mechanism of enterprises while the debt-for-equity swap is being carried out, the policy would only turn out to be transient “relief” in the account book.41 Bei and Feng, and Wu and Zhao add that if enterprises only laid their focus on the preferential policies after the debt-for-equity swap and made no efforts on the deep-level reform, then the debt-for-equity swap would turn into a numbers game in the account book and would not in any way alter the ineffective operation in enterprises. If the operational mechanism, business pattern, and management level of enterprises could not be improved, the building of a modern corporate system would become nothing but empty talk.42 Some scholars even suggest that debt-for-equity swaps do not bear a connection to the debt relief of enterprises. Zhou argues that the interest burden from enterprises’ debt financing is closely related to the economic and policy cycle, but the debt-for-equity swap is clearly not an anti-cyclical tool; and from a medium to long-term perspective, the rate of return from equity financing is in fact higher than that of debt financing. So, apart from certain cyclical “phase-related” reasons, there is no direct link between debt-for-equity swaps and enterprises’ burdens.43

Potential moral hazard from the debt-for-equity swap policy Moral hazard of banks As the debt-for-equity swap is conducted based on book value, commercial banks will transfer as many as possible NPLs to FAMCs in order to lower the proportion of bad assets and secure a higher new loan quota.44 Banks should have played a leading role in dealing with the bad assets, but local governments, enterprises and component state departments could intervene with the excuse of “preventing inflation and supporting enterprises’ debt relief,” placing banks at a passive position. With weak restrictions on equity ownership, banks may give up their efforts to protect the assets. Since whether a loan can be recovered or not is greatly related to the effort level of banks, if banks become frustrated under huge pressure, then the amount of bad assets will shoot up. Moreover, banks tend to think that the more bad debts they have, the safer they are, because the government will act as the last savior and the losses will be ultimately compensated with public resources. Apparently, this moral hazard will bring about devastative damages to the current financial sector and credit system.

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Moral hazard of enterprises When defining bad assets, enterprises may create moral hazard. During debt-forequity swaps, the nature (what can be categorized as bad assets), amount (how many bad assets can be swapped) and time (when the bad loans were lent out) of bad assets must be clearly stated. Otherwise, SOEs will probably dump all their bad assets on FAMCs.45 The debt-for-equity swap may also encourage enterprises to form the expectation of debt forgiveness and tighten soft constraints. If business owners cannot perform substantial intervention or restructuring on enterprises, the debt-for-equity swap will be nothing else but a “debt amnesty,” further weakening the restraining role of debts. As Bei and Feng note, if FAMCs were treated by enterprises only as a tool to implement debt relief, then the debt-forequity swap may be the debt resolving plan with the largest risk of losses.46 Wu and Zhao and Qian claim that although the problem of soft constraints of debts in SOEs was very acute, the debts of enterprises to banks would be transformed into shares of enterprises held by FAMCs after the debt-for-equity swap; in this way, the creditors would lose their right of recourse to the principal and interest of bad loans, and the shareholders would have to bear the risk of immoral business, corporate insolvency and bankruptcy. Therefore, for business owners, debts are usually a harder constraint than equity.47 Meanwhile, the debt-for-equity swap may play a reversed exemplary role for good companies.48 Debt forgiveness is a punishment to good businesses (who repay capital and interest on time) and a heavy blow to the ethic of repaying one’s owed debts. In profit-making companies, leaders and staff worked hard to improve operation and reinforce management, make economies in project construction, and take the initiative to repay capital and interest, but their accumulative assets after loan repayment were owned by the state. As a result, some good enterprises created “conditions” to be qualified for a debt-for-equity swap by lowering the effort level and reducing economic efficiency to turn good debts into bad ones, leading to wide-spread outstanding debts. Furthermore, moral hazard may take place during an exit. At the end of the stock holding by FAMCs, SOEs may use all sorts of excuses to not repurchase their stocks, thereby exposing FAMCs to moral hazard.49

Moral hazard of FAMCs The features of China’s secondary market of loans and unsecured loans decide that an accurate estimate on incurred losses cannot be obtained, and therefore the

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evaluation on the performance of FAMCs and the formulation of an incentive and restraint mechanism will be impossible.50 Li points out that the determination of purchase price is subject to moral hazard. The acquisition of NPLs by FAMCs is generally performed through three ways: buy at market price, at a fixed discount, or at par value. During this process, asset evaluation agencies may conspire with FAMCs to bid up the price of bad assets.51 Macroeconomic Study Group of China Center for Economic Research of Peking University argues that FAMCs are mainly funded through fiscal and commercial banking capital injections, central bank lending, and fiscal secured bonds. This means that the losses of FAMCs will be ultimately paid with public resources or by levying inflation tax and increasing tax revenues. For this reason, FAMCs are inadequately incentivized by the pressure of risks.52

Moral hazard of local governments and administrative departments of different industries Zhou mentions that the debt-for-equity swap is virtually the redistribution of investment resources transformed from debt resources, implying the reduction in the aggregate repayment burden of a region or a sector.53 Therefore, local governments will compete to secure a large swap quota. Due to information asymmetry and the high investigation cost, local governments are inclined to draw up a huge list of debt-for-equity swap companies, and even build a connection in the central government to try to gain more benefits from debt-for-equity swap. As a result, the quality of debt assets between banks and enterprises may deteriorate and the banking sector will be subject to a larger financial risk. Moreover, local governments will probably initiate rent-setting and rent-seeking while fighting for debt-for-equity swaps.54 Furthermore, under the pressure of extricating financially distressed SOEs from difficulties within three years, local governments and administrative departments of different industries may endeavor to win over more debt-for-equity swap quota to meet the target. Naturally, the debt-for-equity swap policy becomes merely a means of financial buyout and loses its intended role of improving enterprise efficiency and resolving financial risks.

Exit strategies A premise for the participation of FAMCs is that stocks are held on a stage basis. This fact, coupled with FAMCs’ characteristics of poor corporate management

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skills and non-viability, decides that they must exit at an early date. There are mainly three ways of exit: go listed, repurchase, and transfer. However, the commonly chosen exit channel is rather “tight,” that is, to rely on the accumulative profits made after the debt-for-equity swap to buy back stocks. Zhou explains that the stock transfer after the debt-for-equity swap and temporary shareholding of FAMCs will probably pave the way for a shareholding reform and the diversification of ownership.55 To be specific, first, wholly state-owned enterprises will be transformed into joint-stock companies through debt-for-equity swap, then the operational mechanism of companies will be improved through strengthening and restructuring the corporate governance structure, and last, the stocks of companies will be transferred to other domestic or foreign investors, including institutional investors to achieve diversified ownership. During this process, FAMCs complete the task of revitalizing bad assets. However, in practice, the exit process was not as smooth as expected. As analyzed by Bei and Feng, a developed capital market, especially a stock market, in both depth and width, is needed for perfecting the exit mechanism.56 No matter which exit method is chosen, it is generally agreed among scholars that the stocks held by FAMCs will have market value, only if SOEs change their operational mechanism, improve the corporate governance structure, and build a modern corporate system. This is the fundamental guarantee for the successful withdrawal of FAMCs.57

Microeconomic case study In the actual practice of debt-for-equity swap, whether a company is qualitied for the swap has not been fully verified. From the perspective of corporate regime, the debt swap is the redistribution of equity within a certain period of time, and its success hinges on the bargaining position of each stakeholder in the game between different sectors and the degree of maturity of corresponding technical arrangements. The Research Group of Xin’gan County of People’s Bank of China found through an investigation on Jiangxi Nuclear Industry Ruifeng Biochemical Company that strictly speaking, the company did not meet the requirements of a debt-for-equity swap judging from its assets and liabilities and operating performance, but as a branch company, it was unable to offset the huge losses in other branch companies in view of the overall heavy losses of the group company. To relieve the debt burden of the group, Ruifeng company was forced to undertake the debt-for-equity swap. Although this was not a common case, to strip off superior assets will easily lead to a great loss in bank interest income.58

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Moreover, a shift from a loss to profit on the book after the debt-for-equity swap does not indicate an improvement in corporate management performance. Take the first debt-for-equity swap company, Beijing Cement Plant, as an example. During 1992 and 1994, it borrowed CNY509 million bank loans and by 1998, the total amount of principal and interest reached CNY968 million. It was estimated that after the debt-for-equity swap contract was signed in September 1999, the company could make a profit by the end of the same year, and could realize a annual profit of over CNY20 million from 2000, with the debt-asset ratio down from 80.1% to 32.4%.59 In 2000, there were a total of 17 SOEs entered into a debt-forequity swap contract with FAMCs, and the average debt-asset ratio fell from 77.3% to 38% with most companies generating a profit due to a significant reduction in interest expense. Hu notes that after the implementation of the debt-for-equity swap policy, the interest expenses of SOEs are transformed into dividend expenditure of profit distribution, and naturally, a reduction in interest expense will lead, other things equal, to an increase in profit, thereby turning loss to gain. But if measured by economic value added (EVA), the debt-for-equity swap probably even fails to meet the goal of financial rescue, let alone bring in a profit.60 Qiao further points out that since the risk of equity investment is larger than that of debt investment, if the FAMC demands a higher return on investment than the interest payment on debts, Beijing Cement Plant will face the question of whether it can afford such a cost.61 From the perspective of corporate governance, Zhang et al. put forward that a FAMC as a new shareholder will be included in the company’s ownership structure, the debt-for-equity swap company must be transformed into a joint-stock company and involve staff from the FAMC in the board of directors. Although the final say is still in the hand of the original management, all major decisions will be made after the approval of the board of director, during which process the FAMC can exert an influence on the final decision.62 Hunan Wood-Based Panel Plant was transformed into Hunan Wood-Based Panel (Group) Limited after the debtfor-equity swap. Among its total equity of CNY493.97 million, Great Wall Asset Management Corporation held CNY281.81, and a new board of directors was set up in accordance with the diversified equity structure. The newly formed board of directors of Xinjiang Tianlun Chemical Fibre Plant were comprised of 7 members with 2 from Great Wall Asset Management Corporation, 2 from Cinda Asset Management Corporation, 2 from the plant itself, and 1 from Xinjiang Production and Construction Corps. It also should be noted that in actual operation, the risk of equity investment may be overlooked. Qiao claims, after analyzing the first debt-for-equity swap case, that China Cinda Asset Management Corporation did not directly participate

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in the business operation but let the original management to continue handling daily business affairs. That is because the bad assets managed by a FAMC are usually huge (for example, Cinda alone has received a total of over CNY200 billion bad loans), and cover a wide spectrum of industries, so it is hard for the FAMC as a shareholder to participate in the management of every company, thus increasing the risk of equity operation.

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Chapter

Split Share Reform

MAJOR ISSUES AND POLICIES IN CHINA’S FINANCIAL REFORM VOL. 4

Definition In a normal stock market, stocks of listed firms are all tradable. However, this was not the case in China’s stock market at its initial stage between 1990 and 2005. In the A-shares markets of Shanghai and Shenzhen stock exchanges, the shares of listed companies can be generally divided into two kinds: tradeable and nontradable shares. Tradeable shares are also known as public shares whereas nontradeable shares are state-owned or legal person shares. These two kinds of shares are different in stock nature, pricing mechanism, and circulation right, but contain the same voting and dividend rights. The special market system and ownership structure are the so-called a “split share system.”1 The split share system is a special, compromising institutional arrangement under the ideology and legal environment of the early 1990s. The problems of this system were not prominent at the pilot stage of China’s stock market. However, as the stock market was expanding and the volume of non-tradeable shares grew larger and larger, the split share system became one of the major reasons for the long-term slump and the increased risk of a crisis in the stock market, and also an important institutional obstacle to the development of China’s capital market. The split share system greatly undermined the foundation of the sustainable development of China’s capital market and impaired the internal impetus of the development of listed companies and the capital market. Hence, the split share reform initiated in May 2005 was a profound institutional renovation in the history of China’s capital market.

Causes and Harm of the Split Share System Causes In retrospect of the changes in the pattern of international politics and domestic political atmosphere in the later 1980s and early 1990s, there was a heated debate on the ideology of economic reform, and in the field of stock market, the debate mainly centered on whether the stock market is capitalist or socialist in nature.2 Under this background, even the most radical reform can only be introduced to the stock market on a trial basis. So, China’s stock market at the initial stage showed three distinctive features: 1. Pilot public offerings were usually conducted in small businesses and the stockholding system was at first carried out to solve the problems faced by medium and small businesses;3 2. Public-owned shares (including stateowned and legal person shares) took up a very large proportion to ensure the

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socialist nature of stock market; 3. The stock market was largely a regional market, only located in Shanghai and Shenzhen, and most listed companies, investors, and securities institutions were from the two cities.4 At the Seminar on Stock Market Development Policy held by the People’s Bank of China, Research Office of the State Council, the People’s Government of Shenzhen Municipality, and the Securities Association of China in Shen Zhen between 21 and 23 October, 1991, it proposed several principles that must be insisted on in developing the stock market, and one of them was to ensure that public ownership will be the mainstay with multiple forms of ownership developing side by side. Specifically, “the experiment on stockholding system should be carried out actively yet prudently and guards against the threat to the dominance of public ownership posed by privatization. For this reason, it is necessary to maintain the control of public-owned shares in pilot enterprises while allowing the investment of other economic sectors. In this way, China’s stock market will be not like that in Western countries developed on private ownership, but based on public ownership and supplemented by other forms of economic ownership.” Judging from the organizers of this seminar, it can be concluded that this was a high-level meeting and the principles stated at the seminar can be seen as the keynote of China’s stock market development. Therefore, the fact that public-owned shares were non-tradeable was a logical result. If the principle of sticking to the leading position of public ownership in listed companies is said to sow the seed of split share system, then the government’s support, development, and expanding of SOEs through the capital market further grew the “seed” into a huge institutional conundrum within just a decade. In the early 1990s, after careful trials, the government’s attitude towards the stock market became more and more positive, and Party and state leaders frequently inspected the stock exchanges and began to realize that the stock market is an important financing channel for public enterprises. Since then, the stock market has been more and more closely linked to public ownership in China. In December 1996, China Securities Regulatory Commission (CSRC) announced the Notice on the Regulations of Stock Issuance, which stated that “Local governments and government departments should give priority to 1,000 key enterprises (300 in particular) confirmed by the State, and 100 pilot enterprises and 56 pilot business groups of the modern corporate system in carrying out the initial public offering (IPO) plan of 1996.” In September 1997, CSRC further released the Notice on Doing a Good Job on the Stock Issuance of 1997, reiterating the above requirement of stock listing: “To promote the reform and development of SOEs via the stock market, the focus of stock issuance in 1997 should be given to large- to mediumsized SOEs which relate to the lifeline of the national economy, have economies of

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scale, and hold a leading position in the industry. The companies recommended by relevant departments of or head companies directly under the State Council must be their subordinate or holding companies.” These two documents showed that the Chinese government had made the capital market an important financial channel for the reform of large- to medium-sized SOEs in both practice and policy. Under the leading position of public ownership, the combination of stock market and SOEs will inevitably lead to the dominance of public-owned shares in listed companies, which will in turn intensify the split share structure in China’s stock market.5 If seen in the historical context, the appearance of the split share system is inevitable and is also a price that must be paid for the development of China’s stock market.

Evolution of the split share system Policies and regulations concerning equity classification The first policy that classified stocks by owners is the Interim Measures on the Management of the Issuing and Trading of Stocks announced by the People’s Government of Shenzhen Municipality on May 15, 1991. It divided stocks into state shares, legal person shares, individual shares, and special shares. This policy also stipulated that state shares should be strictly demarcated from individual shares, and the two shares must not be mixed together unless with the permission from the state-owned assets management department. In November 1994, the State-Owned Assets Administration Bureau and State Commission for Restructuring the Economic System jointly published the Interim Measures on the Management of State-Owned Shares of Joint Stock Limited Companies, which gave a detailed definition of state shares and categorized stocks into “state shares” and “state-owned legal person shares” according to investor and equity management agency. Here, state shares refer to those obtained by the institutions or departments which are entitled to represent the state to invest, either through capital contribution to joint-stock companies or in accordance with other legal procedures. These shares will be registered in the names of the institutions or departments. State-owned legal person shares refer to the shares obtained by the SOEs, public institutions and other institutions that have legal personality through contributing investment in joint-stock companies with the legal person assets occupied by themselves in accordance with the law, or obtained by them in accordance with other legal procedures. These shares will be registered in the names of the SOEs, public institutions, and legal entities. Compared with the Interim Regulations on the

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Management of State-Owned Assets of Pilot Joint-Stock Enterprises released in 1992, this document expanded the scale of investors and stockholders of state-owned legal person shares from enterprises owned by the whole people to SOEs, public institutions, and other institutions with legal personality. In addition, this document also distinguished between state shares and state-owned legal person shares in the newly founded joint-stock companies or those restructured from SOEs.6

Regulations on stock circulation The circulation of stocks covers two aspects: First, over-the-counter (OCT) transfer of non-tradeable shares; second, exchange trading. In history, to ensure the dominance of state-owned shares, the Chinese government made special regulations for the transfer of state-owned shares. The Interim Measures on the Management of State-Owned Shares of Joint Stock Limited Companies issued in 1994 stated that “state-owned shares can be transferred in accordance with the law and must conform to the following provisions:7 1. To adjust the investment structure should be confirmed as the primary goal; 2. The transfer of state-owned shares must comply with the relevant regulations and the stockholders must submit an application to explain the transfer purpose, amount, method, conditions, price, time, transferee, investment destination of transfer income, and other specific arrangements; 3. The transfer application must be submit to the State-Owned Assets Administration Bureau and state-owned assets management departments of provincial governments; for overseas transfer (including the transfer of rights offer), the application should be sent to the State-Owned Assets Administration Bureau for approval; in cases of a large transfer amount or the change in absolute control or relative control, the application is subject to the approval of the State-Owned Assets Administration Bureau and State Commission for Restructuring the Economic System; 4. Transferors which are not held by state-owned assets management departments must report the amount, investment plan and investment result of transfer income, after the transfer of state-owned shares. Now, the ultimate approval right is in the hands of State-Owned Assets Supervision and Administration Commission of the State Council. As for the transfer of state-owned legal person shares, it was stipulated in Interim Regulations on the Management of State-Owned Assets of Pilot Joint-Stock Enterprises issued in October 1992 by the State-Owned Assets Administration Bureau that the transfer

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of state-owned legal person shares could be decided by the shareholding legal entities. But if the transfer is made in the pilot joint-stock companies that must be held by the state and such a transfer will affect the holding position of state-owned shares in the enterprises, it must be reported to the state-owned assets management departments and the government for approval. In addition to that, the Interim Provisions on the Management of the Issuing and Trading of Stocks released in 1993 required that “the transfer of state-owned shares must get approval from relevant government departments.”8 The Company Law of People’s Republic of China also requested that “For a company formed by way of promotion, equity warrants shall be transferred between legal persons; for a company formed by way of directional stock floatation, equity warrants may be transferred between legal persons or between the company’s employees based on the identities of original holders…. State shares and foreign capital shares shall be transferred according to relevant state provisions.”9 In conclusion, the above regulations and policies can be summarized as follows: First, state shares and legal person shares can be circulated only through OTC trading rather than exchange trading; second, state shares can be transferred to domestic and overseas legal persons or natural persons; third, the management of state-owned share is distinguished between state shares and state-owned legal person shares, and the circulation of state shares must get approval from government agencies such as state-owned assets management departments whereas the transfer of state-owned legal person shares can be decided by the legal entities themselves, but the results of the transfer of both kinds of shares must be reported to the government’s state-owned assets management department.

Market structure under the split share system By the end of June 2005, the market value of stocks in circulation in China’s stock market amounted to CNY100.04 billion, and if calculated based on the closing price of tradeable shares at the end of June, the total market value of China’s listed companies could reach CNY315.90 billion. There were 1,391 domestically listed companies (A, B shares), and 114 companies listed on overseas stock markets, with 7.27 million of stock account holders in Shenzhen and Shanghai stock exchanges.

Shareholding structure of China’s listed companies Table 27.1 and Fig. 27.1 showed the distribution of shares in China’s listed companies up to the end of December 2003. Fig. 27.2 represented the changes in the shareholding structure of the listed companies between 1990 and 2003.

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Table 27.1 Distribution of shares in China’s listed companies Shares in circulation Total Shares not yet in circulation shares Legal (billion Subtotal State person Employee Others Subtotal A share B share H share share share share shares) 642.85 100%

415.73 302.96 109.56 64.67% 47.13% 17.04%

1.10 0.17%

2.11 0.33%

226.99 35.31%

172.70 17.54 26.71% 2.73%

37.76 5.87%

Notes: 1. The data is collected up to the end of 2003.

2. Rights offering, share offering to funds, offering to strategic investors are included



3. Add-ups may not be equal to total due to rounding.

in “Others.”

Source: China Securities Regulatory Commission, China Securities and Futures Statistical Yearbook 2004.

Fig. 27.1 Shareholding structure of China’s listed companies by the end of 2003 27%

3%

6%

47%

State share 47%

Legal person share 17%

Employee share and others 0% A share 27% 0%

B share 3% 17%

H share 6%

Source: China Securities Regulatory Commission, China Securities and Futures Statistical Yearbook 2004.

Fig. 27.2 Changes in the shareholding structure of China’s listed companies (Unit: 1 billon shares) 700

H share

600

B share

500

A share

400

others

300

Employee share

200

Legal person share

100 0

State share 1990 1992 1994 1996 1998 2000 2002

Source: China Securities Regulatory Commission, China Securities and Futures Statistical Yearbook 2004.

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Share splitting in China’s listed companies Table 27.2 and Fig. 27.3 depicted the situation of share splitting in China’s listed companies up to the end of June 2005. Table 27.2

Share splitting in China’s listed companies

Total share Unit Total Billion 751.00 shares % 100

Non-tradeable share Subtotal

Subtotal

Tradeable share A share B share

477.51

273.49

211.06

21.11

41.32

63.58

36.42

28.10

2.81

5.5

H share

Notes: 1. The data is collected up to June 2005.

2. Add-ups may not be equal to total due to rounding.

Source: Website of China Securities Regulatory Commission.

Fig. 27.3 28%

Share splitting in China’s listed companies, June 2005 3%

6%

63%

Non-marketable share A share B share

H share Note: The data is collected up to June 2005.

Source: Website of China Securities Regulatory Commission.

It can be seen from Table 27.1 that in the share structure of listed companies, state share took the lion’s share, averaging 47.13%, and it accounted for 72.8% of all nontradeable shares and is the largest shareholder in China’s capital market.

Risks of the split share structure There have been intense discussions on the risks or problems of share splitting. For example, Liu analyzed this issue from the angles of capital market pricing, internationalization, and business capital operation;10 Qu studied the negative impact of the split share structure on corporate governance in China.11 In the face of the applause and appeal for a split share reform, Financial and Security Research Institute of Renmin University of China conducted massive systematic

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research in this regard and specially dedicated the Annual Conference of China’s Capital Market of 2004 to the research by naming the meeting “China’s Capital Market: The Spilt Share Structure and Its Reform” for scholars, business leaders and government policymakers to exchange their ideas. When preparing the report of the annual meeting, Director of the institute Wu Xiaoqiu gave an comprehensive and systematic review on this issue in the introduction part, by saying that “the split share structure has posed eight risks to China’s capital market, seriously impairing the matching mechanism between market risks and benefits and causing the inequity between holders of tradeable shares and those of non-tradeable shares. To ensure a solid and equal institutional basis and a flourishing future for China’s capital market, a reform of the split share system to form a share structure with equitable benefits to different shareholders is the only way out.”12 The risks of share splitting are summarized as follows.

Disturbing the benefit mechanism of listed companies It first will undermine the benefit mechanism of listed companies and result in imbalanced or even opposite interests between holders of non-tradeable shares (majority shareholders) and holders of tradeable shares (minority shareholders). The split share structure separates the asset appreciation mechanism between tradeable share holders and non-tradeable share holders. Tradeable shares rely on the rise in stock prices through the increase in earnings per share and the improvement in corporate competitiveness to realize asset appreciation, whereas non-tradeable shares are unaffected by the market trend and stock prices, but appreciate through the high premium of stock financing. So the wealth functions of tradeable share holders and non-tradeable share holders are totally different.

Insider trading The widespread insider trading is another risk of share splitting. As the returns on assets of controlling shareholders are not decided by business performance, performance improvement will not bring any benefits to the holders of nontradeable shares. Impelled by the strong feeling of unfairness, they will collude with the holders of tradeable shares to manipulate the market. This is more a result of institutional defect than moral hazard or credit crisis.

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Market information distortion The third risk of share splitting is the distortion of market information. Under the split share structure, the offering price of new shares virtually does not equal to the agreed price of investors for all the shares of the issuing company. To equate the price of tradeable stocks with that of non-tradeable shares in calculating the total market capitalization overlooks the difference between the two share prices resulting from the heterogeneity of assets. Therefore, the calculation of “market capitalization” is a typical reflection of market information distortion. This is, in some sense, the theoretical basis for the reduction of state-owned shares at the market price in June 2001. In a stock market where the liquidity of stocks is heterogeneous, the principle of “shares of the same class having the same rights and benefits” becomes impractical. Moreover, the calculation of price-earnings ratio (P/E ratio) is also a typical representative of market information distortion in China’s stock market. In recent years, the P/E ratio has been frequently used to determine the investment value of market in China. However, the P/E ratio of China’s stock market stands for merely that of tradeable shares rather than that of the entire market, for it takes into consideration liquidity premium.

Special strategic behaviours of controlling shareholders Share splitting will inevitably lead to special strategic behaviours of controlling shareholders or actual controllers of listed companies. Under the split share structure, the strategic behaviours of listed companies is highly consistent with the interests of the controlling shareholders. Generally, it is reflected in at least three aspects: First, pursuing exogenous expansion; second, pursuing diversified development; third, undertaking frequent and large-scale connected transactions. Among these, exogenous expansion and connected transactions bear a certain logical connection, which forces the listed company to be the “shadow” of its parent company, i.e., the controlling shareholder, and finally turns the list company into a “cash machine” of its controlling shareholder.

Special financing behaviours of listed companies Share splitting is highly correlated with the special financing behaviours of China’s listed companies. Existing research results show that the financing behaviours of China’s public companies are almost entirely contradictory to the pecking order theory of capital structure. China’s companies are characterized by seeking

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exogenous equity financing at all costs, reflected in the long waiting list of new listings in China. There are three reasons for this. 1. Tradeable shares are issued at a high premium on the basis of the split share structure. This practice is prevalent not only in IPO but also seasoned offering. This can be also seen in the transfer price and conversion ratio of convertible bonds; 2. By means of issuing stocks at a premium, holders of non-tradeable shares, especially controlling shareholders, can quickly get high returns on capital investment, namely can rapidly increase the net worth per share; 3. Through frequent, connected transactions, controlling shareholders will be able to maximize their benefits. In recent years, as the restrictions of seasoned offering became more and more strict, investors increasingly lost their interests towards seasoned offerings, so listed companies and their actual controllers switched to issuing convertible bonds to realize refinancing.

Inequity in dividend distribution The split share structure will cause unfair dividend distribution and distort the benefit distribution mechanism. Under the split share structure, holders of tradeable shares and non-tradeable shares show different preferences in dividend payment. Holders of non-floating shares desire cash bonus whereas those of floating shares like bonus shares better.

Speculation in business mergers In China’s capital market, due to the split share structure, a company can hardly realize investment returns from the stock market through acquisition. Even if the acquired company improves its performance and becomes more competitive, the returns on investment from acquisition cannot be reflected in price rises of stocks. In addition to that, the cash dividend payout ratio of Chinese companies is low, so the total capital gains will be low. But as all mergers and acquisitions are profitdriven, if the acquiring company cannot profit from stock price rises, how does it achieve its benefits? Research results show that there are mainly three ways for it to profit. 1. The acquiring company can inject high-quality assets or pretend to undertake business transformation to make the acquired company

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qualified for refinancing and then acquires control over the raised funds from seasoned offering; 2. Although non-tradeable shares cannot bring profits through spread arbitrage trading in the secondary market, the acquiring companies will usually perform insider trading in the secondary market and independently or jointly manipulate the stock price to gain illegal profits; 3. The acquiring company can obtain low-cost assets through the abuse of resources of the acquired company, such as using as a guarantee. Apparently, the above three profit motives are far removed from the targets of mergers and acquisitions, that is to realize industrial consolidation and raise industrial competitiveness. These speculative activities will lead to violent ups and downs in stock prices, severely damage the interests of holders of tradeable shares, undermine the role of secondary market in industrial consolidation, and create a market confidence crisis.

Difference in financial costs The split share structure will cause a decline in business performance and stock price while an increase in the assets of holders of non-tradeable shares. Statistical analysis indicates that over the past decade of China’s capital market development, the split share structure has generated a huge gap in financial costs between holders of non-tradeable shares and those of tradeable shares. For the former, the original holding cost was CNY0.68 per share, and it was around CNY6 per share for the latter; by the mid-November 2003, the net worth per share rose to CNY2.8 per for the former whereas the weighted average value per share for the latter was below CNY7. In fact, considering transaction costs, from a static perspective, tradeable shares have barely appreciated passing from the primary to the secondary market. Then, why holders of non-tradeable shares could obtain about 300% return on capital investment while the value of tradeable shares barely increased and the earnings per share barely grew? The immediate cause was that the high premium issuance of tradeable shares brought about huge wealth to holders of non-tradeable shares, and the split share structure was a key institutional reason for the high premium. Therefore, one important conclusion can be drawn: The split share structure has placed holders of tradeable shares and those of non-tradeable shares at unequal status. Holders of tradeable shares have to bear risks far larger than the returns they could receive whereas holders of non-tradeable shares can expect much

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higher earnings than risks. The net risks of tradeable share holders and the net returns of non-tradeable share holders were at a position of risk hedging. Due to the heterogeneity of the liquidity of the two types of ownership rights, it was impossible for the market to automatically create a balancing mechanism between risks and returns, thus the imbalance between tradeable and non-tradeable shares was solidified, leaving holders of tradeable shares to bear all the risks from unfavorable factors in the capital market while holders of non-tradeable shares were just bystanders. This is a natural result of the split share structure. Given the above analysis, Professor Wu Xiaoqiu further summarized the hazards of share splitting into three aspects:13 1. The split share structure placed shareholders at the two opposing ends of interests. It caused the conflict of interests between holders of tradeable shares and those of non-tradeable shares and divided a list company into two forces with different motives and targets; 2. The split share structure impaired the pricing function of capital market. Due to the lack of asset pricing function, the capital market under the system of share splitting was merely a place for speculation, and this was also true for even business mergers and acquisitions; 3. The split share structure made it impossible for China’s capital market to develop scientific assessment standards and an effective incentive mechanism.

Process of Split Share Reform In a broad sense, China’s split share reform can be divided into three stages: trial and error stage; debating and seeking consensus stage; operating stage.

Trial and error stage In fact, the question of the circulation of state-owned shares had been put forward at the birth of China’s stock market, and in 1992, Shanghai Stock Exchange made an experiment on the circulation of non-tradeable shares, in particular, legal person shares.14 On February 19, 1992, the State Council approved the Main Points of the Economic System Reform in 1992 drafted by the State Commission for Restructuring the Economic System. This document explicitly proposed “selecting a number of qualified share-holding companies and business groups that are undergoing a pilot joint-stock reform to experiment on the internal circulation of legal person shares

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in specified stock markets.” In July, the Securities Trading Automated Quotations System (STAQ system) was designated as legal circulation market for legal personal shares.15 But this did not last long, and on May 22, 1993, the Securities Commission of the State Council decided to overhaul the STAQ system and the National Exchange and Trading System (NET), during which process no new legal person shares could be traded in the market. So, the reduction of state-owned shares, in a real sense, refers to the two failed trials in 1999 and 2001.

Pilot reform to decrease state stocks in 1999 Although the CSRC ordered to not float state and legal person shares for the moment in 1994, the debate continued in the theoretical and practical circles. Due to the limited knowledge about the significance of capital market among most people, the discussions centered around the circulation right of state-owned shares and the reform of SOEs, and a consensus was achieved on the rightfulness of state share circulation with various circulation schemes being put forward. At the Fourth Plenary Session of the 15th CPC Central Committee in 1999, the Decisions on Major Issues Concerning the Reform and Development of State-Owned Enterprises was approved, and it put forward the SOEs reform principles of “developing what should be developed, withdrawing what should be withdrawn, doing what should be done while leaving others alone” and proposed adjusting strategically the layout of state-owned economy and the structure of SOEs and “moderately reducing state-holding shares while maintaining the state control of the SOEs.”16 This decision has cleared much resistance faced by the circulation of state-owned shares in theory, and also directly facilitated the process of its practice. On October 26, 1999, the CSRC announced that the reduction of state-owned shares will be realized through share allotment. Specifically, pilot companies will first allot a portion of their state shares to the pre-existing holders of tradeable shares, and the remnants will be allotted to securities investment funds; the share price will be somewhere between net assets value and 10 times of P/E ratio; shares allocated to the pre-existing holders of tradeable shares can be immediately floated in the market, while those to securities investment funds will be traded within two years. On November 29, the CSRC released a list of 10 pilot listed companies; on December 2, the pilot allocation of state-owned shares was officially started; on December 14, the boards of directors of China Jialing Industrial Co. and Guizhou Tyre Co. announced respectively their specific plans for selling off state stakes, but as the plans were in favor of the original holders of state-owned shares, holders of tradeable shares and securities investment funds subscribed less than the offering,

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which marked a failure of the pilot scheme.

Reduction of state-owned shares to replenish social security fund in 2001 On June 12, 2001, the State Council published the Temporary Administration Measures on the Reduction of State Owned Shares for the Raising of Social Security Capital, auguring a new round of reduction of state shares. The Measures explicated three core issues about the state share reduction.

• Capital use: The income from state stock selling will be directed to replenish the social security fund; • Reduction method: “The held State shares shall be reduced by stock issuance. Any of the joint stock limited companies (including companies listed outside the territory of China) with its shares owned by the State shall, when issuing shares to the public investors for the first time or increasing the quantity of shares issued to the public investors, sell the State shares at 10% of the financing amount; where a joint stock limited company has been established for less than 3 years, its State shares planned to be sold shall be allotted to be held by National Social Security Foundation Council, which shall entrust the said company to sell the State shares in a lump sum or by installments at the time of public share offer.” • Share pricing: Article 6 stipulated that “In principle, state shares should be sold at market price.”17 After the Measures was put into practice, the market began to fall sharply and the composite index slid from the highest level of 2,245 to 1,520 points within just four months, down by 32.3%.18 At the night of October 22, 2001, the CSRC announced that considering that further study was needed for revising the specific practice methods, it decided to rescind the provision of “joint stock limited companies with its shares owned by the State shall, when issuing shares to the public investors for the first time or increasing the quantity of shares issued to the public investors, sell the State shares at 10% of the financing amount” in the Measures, which declared a failure of the trial.

Debating and seeking consensus stage The key to the failure of the two times of trial reduction lied in the high market

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price of state shares formed when they were not tradeable. If state shares are sold or transferred at this price, the interests of holders of common stocks will be greatly impaired and the stock price will slump, which will finally lead to the sharp decline in the expected returns of state shares, ending up in a “lose-lose” situation. If this problem cannot be properly addressed, the persistence of negative market expectation will constantly drag down the stock prices. At the same time, the government officials also realized the defect in the reform plans. In fact, the termination of the second trial reduction of state shares was the first time that a central policy was rejected by the market in the history of China’s securities market. On November 14, 2001, the CSRC solicited public opinions on the concrete plans for implementing state stock reduction, opening a national debate on this issue. With the deepening of the debate, greater common ground has been established. An increasing number of people come to realize that the split share structure is a complicated problem of interest game that has been formed in history, and the key to this problem is not the reduction or transfer of state stocks but the protection of public shareholders’ benefits. The fact that state stocks cannot be traded in the market contributed to the high premium of public stocks and public shareholders transferred a good deal of asset ownership and associated right to returns to holders of state stocks in exchange for circulation right. Logically, to float state stocks, it is must to ask holders of state shares to compensate the premium, and protect the benefits of public shareholders, which should be the principle and orientation for further reform. In practice, on January 31, 2004, the State Council promulgated Some Opinions on Promoting the Reform, Opening and Steady Growth of the Capital Market, which required “actively and properly solving the problem of non-tradeable shares”; in July, in accordance with the instruction of the State Council, a Working Group for Solving the Problem of Split Share Structure was formed by the CSRC, Stateowned Assets Supervision and Administration Commission (SASAC), Ministry of Finance, and People’s Bank of China, to be responsible for proposing feasible reform plans to policy makers; in March 2005, when answering questions from the press, Premier Wen Jiabao expressed that, “We should properly solve historical legacies accumulated in the process of developing a securities market,” a commitment by the Chinese leadership to solve the split share structure; on April 29, 2005, the Notice on Piloting the Split share Reform of Listed Companies was published, signifying the official start of the split share reform. During the implementation of the reform, each parties followed three basic principles:

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1. Centralized organization and market-oriented, differentiated decision making. “Unified organization” means that the CSRC established a standard procedure for reform implementation and formulated unified regulatory requirements, and at the same time, the CSRC also played a frontline role in the supervision, coordination and business instruction of stock exchanges. “Differentiated decision making” ensures holders of different stocks in a listed company to negotiate a reform plan on an equal footing, according to the existing laws, regulations and the requirements in the Notice, to be voted on at the general meeting of stockholders. 2. Diversity. As the decision power of the specific reform plan was given to the stockholders of the company, they developed various ways for the company to obtain the right to trade of previously non-tradeable shares, which can be generally categorized into six kinds: capitalization issue from capital reserves, bonus issue, reduction of shares, tender offer, asset restructuring and minimal price commitment. In most cases, the right to trade was obtained through payment of single consideration; but in others, mixed consideration was applied. 3. Voluntariness of stockholders and classified voting. The voluntary principle was mainly for holders of non-tradeable shares, while the rule of classified voting was predominately applied to holders of tradeable shares and was a principle of procedure. When deciding whether a company should apply for the right to trade, it is important to respect the wish of holders of nontradeable shares. To prevent unfair clauses in the reform plan, classified voting must be carried out. According to current rules, the split share reform plan will be valid, only if more than two-thirds voters of tradeable shares approve. By this, the disadvantaged holders of tradeable shares were given the opportunity to excise their due rights. The two principles fully reflected the core goal of the reform: that is to protect the interests of holders of tradeable shares.

Legal basis and economic interpretation for payment of consideration The core of the split share reform was “consideration,” and the legal origin of “consideration” was connected with contract law. In the prospectuses and listing announcements of nearly 1,400 listed companies, it is agreed that “promoter’s shares are not tradeable.” “To be not tradeable” is a kind of contract and agreement. To alter the agreement, the party who wants to terminate the contract must provide enough proof or sufficient reasons to ensure that such a change will not impair the benefits of its counterpart; otherwise, the former must pay an amount

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of consideration to hedge against the potential risks of a contract change. The payment of consideration can be made in cash or other kinds of financial assets or even legal commitments. In the theory of finance, any right that will bring about earnings can be priced. Whether an asset (right) has a price, it is not decided by its physical form but its ability to generate cash flow. If a right which can generate future earnings is to be securitized, the asset by which such a right is backed up will be a liquid asset. In reality, financial assets become increasingly virtual. The right to trade of an asset is one that may bring earnings to the holders. If holders of non-tradeable stocks want the same right as tradeable share holders, the holders of non-tradeable shares must pay a corresponding price. The reason why holders of non-tradeable shares want to apply for such a right is because the right could bring new potential benefits to them. The new benefits at least include three parts: 1. Improved risk aversion ability of assets; 2. Leveraged asset appreciation from the profit growth and increased competitiveness of companies; 3. Capital gains. Given the above, the right to trade can be priced in business, and to obtain the right, holders of non-tradeable shares have to pay the price. Then, who should the money be paid to? Of course, it must be the receiving party of the contract change, namely holders of tradeable shares. Apart from them, no other people, market participants or non-market players are entitled to the income.

Strategic objectives of the split share reform 1. Build a predictable institutional platform for the future development of capital market; 2. Transform listed companies into a community of interests of all shareholders; 3. Establish a market-oriented asset pricing mechanism and promote effective acquisitions and mergers; 4. Lay the foundation for building an effective incentive mechanism for the long-term development of companies; 5. Restore and improve the stock resource allocation function of capital market, enhance the capital market’s ability in consolidating stock resources in order to raise industrial competitiveness. The above five targets are of different importance and will be realized at different stages. It should be noted that to “transform listed companies into a community of interests of all shareholders” is the core objectives of all. The institutional arrangements that undermine the interests of holders of tradeable shares must be

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changed to give an equal status of all shareholders at the institutional level. This should be the core of the split share reform.19

Reform implementation In accordance with the above principles and targets, the central government launched the split share reform in April 2005, and the reform lasted for two years and eight months till the end of 2007. The table below chronicles the major events in the process of the reform.20 Table 27.3

Major events of the split share reform

Date

Event

May 8, 2005

Shanghai and Shenzhen stock exchanges and China Securities

Depository and Clearing Corporation Limited (CSDC) published the Operational Guidelines for the Pilot Reform of the Share-Trading Business

of Listed Companies, and SANY Heavy Industry, Zijiang Enterprise, Jinniu Energy Resources, and Tsinghua Tongfang became first pilot companies of reducing state holdings. June 10, 2005

The reform plan of SANY was overwhelmingly approved and the

June 16, 2005

The CSRC issued the Measures on the Repurchase of Public Shares by

company became the first to complete the share trading reform.

Listed Companies (Trial), providing a favorable market environment of the reform.

June 17, 2005

The SASAC promulgated the Guiding Opinions on Share-Trading

June 19, 2005

The second round of pilot reform was initiated with 42 listed

Aug. 23, 2005

The CSRC, SASAC, Ministry of Finance, People’s Bank of China

Reform of Listed Companies. companies involved.

and Ministry of Commerce jointly issued the Measures for the

Administration of the Share-Trading Reform of Listed Companies, announcing the completion of the pilot phase and the beginning of the nation-wide reform. Sep. 6, 2005

Shanghai and Shenzhen stock exchanges and the CSDC issued the

Guidelines on the Practice and Operation of the Share Reform Proposals of Listed Companies.

Sep. 12, 2005

40 listed companies claimed to enter the share reform, kicking off the all-round implementation of the reform.

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(Cont’d) Date

Event

Nov. 5, 2005

The CSRC and Ministry of Commerce published the Circular

Regarding the Relevant Issues on the Administration of Foreign Investment as Involved in the Share Trading Reform of Listed Companies to regulate the practice of foreign-invested listed companies.

Nov. 22, 2005

50 companies listed in the SME board of Shenzhen Stock Exchange

Feb. 27, 2006

The market value of listed companies that either completed or was

first completed the reform.

undergoing the share trading reform accounted for 53.85% of all A shares, meeting the expected target of the key reform stage.

May 8, 2006

The Administrative Measures for the Issuance of Securities by Listed Companies was put into practice to allow the companies that had completed the reform to conduct secondary offerings.

May 24, 2006

China CAMC Engineering Co., Ltd. released its prospectus and became the first IPO company after the non-tradeable share reform; so far, the financing function of the market was fully recovered.

By the end of 2007

The market value of 1,298 companies that had completed or entered into the share trading reform in Shanghai and Shenzhen stock

exchanges accounted for 98% of the total market capitalization of all scheduled reforming companies, which signified the completion of the share trading reform.

Theoretical Significance and Implication The significance of the split share reform can be understood from multiple angles. From the perspective of stabilizing the market, the market experienced a brief decline resulted from market doubts at the beginning of the share reform in May 2005 (on June 6, 2005, the Shanghai Stock Exchange Composite Index reached a lowest level of 998 points), then returned to 2,000 points by the end of 2006 (on November 20, 2006, the index closed at 2,017 points), and hit a record high of 6,124 points on October 16, 2007. After that, China’s stock market basically maintained a stable development trend despite several rounds of adjustments, and it made notable progress than before the reform in terms of the financing scale, number of investors, market value, and total market turnover. As a result, the stock market has not only become stable, but also achieved prosperity and development. The success of the split share reform was beyond the expectation of most people. The underlying reason was that the sword of Damocles (price uncertainty) having been

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hanging over the head of China’s stock market ever since the trial reform of the reduction of state holdings in 2001 or even the founding of the market was finally dropped. Certainly, the significance of the split share reform was by no means limited to the changes in the stock index if considering from the angle of institutional construction. Right before the split share reform, it was repeatedly stressed that the target of this reform was not to create an exit channel for holders of state shares or any other shares, but to reconstruct the institutional basis for the whole capital market from the basics. Capital market plays a key role in the modern economic system, and its functions go far beyond just capital raising but include information collection, risk spreading, price discovery, facilitating mergers and acquisitions, developing market disciplines, and improving corporate governance. In other words, the focus of the market does not lie in the scale of financing but the efficiency of financing. However, the realization of all these functions is inseparable from the institutional basis, which allows the free flow and trading of shares. Without equity flows, corporate information will be distorted, and so will be the stock price. In this way, business mergers and acquisitions will be more a result of speculation than out of the consideration for better enterprise performance. As long as poor business performance is not punished by the market but continues to be protected by the government, corporate governance will be impossible and the interests of investors will be in peril.21 In this sense, the following official evaluation on the split share reform is pertinent: “The split share reform is an important institutional renovation and unprecedented innovation to the market basis and operating mechanism of China’s capital market, and its significance not only lies in its correction of a historical problem, but also is in its contribution to other reforms and institutional innovations of the capital market by providing valuable experience and creating necessary conditions.”22

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MAJOR ISSUES AND POLICIES IN CHINA’S FINANCIAL REFORM VOL. 4

In March 16, 2007, the Enterprise Income Tax Law of the People’s Republic of China was promulgated to consolidates the two former separate enterprise income tax (EIT) laws for domestic enterprises (DEs) and foreign-invested enterprises (FIEs), the Provisional Regulations on Enterprise Income Tax and the Income Tax Law of Enterprises with Foreign Investment and Foreign Enterprises, into a single one.

Introduction To adapt to economic opening up and attract foreign investment, China introduced two sets of EIT in the early 1980s to give preferential tax treatment to FIEs. This arrangement undoubtedly played a positive role in absorbing foreign capital and was absolutely necessary under the then conditions, but the super-preferential tax policies have harmed the growth and development of DEs. So, there had always been calls for the merger of the two tax laws to create a fair environment for competition between DEs and FIEs. The calls grew increasingly louder especially after China joined the World Trade Organization (WT0) in 2001 when China started to merge into the world economy. Moreover, after over twenty years of development, the investment environment in China has changed dramatically, and main reasons for foreign investors to open businesses in China were no longer the low tax burdens, but the stable social environment, huge domestic market and cheap labor. Under this situation, the cancellation of tax incentives will not cause larger-scale withdrawal of foreign capital. It can be said that the timing for the merger of two tax laws was ready in 2007. Consequently, on March 16, 2007, the Enterprise Income Tax Law of the People’s Republic of China (hereinafter referred to as the New EIT Law) was passed at the Fifth Session of the Tenth National People’s Congress to complete the legal procedure of the law consolidation. The New EIT Law took effect from January 1, 2008. On December 6, 2007, the State Council approved the Regulations on the Implementation of the Income Tax Law. The enactment of the two laws marked an end of the long-term coexistence of two income tax laws and is a milestone in the history of China’s EIT system.

Brief Review of China’s EIT System The New EIT Law has already been practiced for over 60 years. Shortly after the founding of New China, the Government Administration Council issued the National Tax Implementation Rules in 1950 to impose 14 taxes. Among these, the industrial and commercial tax was composed of two parts: business tax and income tax. According to the provisions of the industrial and commercial tax,

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businesses have to pay 1%–3% of operating revenue as business tax and 5%–30% of all taxable income as income tax. The income tax was a progressive tax that has 14 levels of tax rate, and the rate was increased to 21 levels after December 1950. It should be noted that at that time, the income tax was only required to be paid by joint state-private enterprises, collectively-owned enterprise, etc., and state-run enterprises just turned their profits over to the state. The introduction of the industrial and commercial tax indicated that China’s EIT system started to take shape. The EIT, however, was not an independent tax until 1958 when the business tax in the industrial and commercial tax was incorporated into the newly-created industrial and commercial consolidated tax during the tax reform. The income tax was renamed as industrial and commercial income tax, and followed the past collection system in practice. This reform confirmed the independent status of EIT in China’s taxation system and paved the way for the future development of the income tax system. On September 10, 1980, the Income Tax Law for Chinese-Foreign Equity Joint Ventures was passed at the Third Plenary Session of the Fifth National People’s Congress and came into force upon promulgation. On December 14, 1980, the Ministry of Finance released the Rules for the Implementation of the Income Tax Law for Chinese-Foreign Equity Joint Ventures with the approval from the State Council. In December 1981, the Income Tax Law for Foreign Enterprises was adopted at the Fourth Session of the Fifth National People’s Congress, effective from January 1, 1982. On February 21, 1982, the Ministry of Finance, with the approval from the State Council, published the Rules for the Implementation of the Income Tax Law for Foreign Enterprises. So far, the income tax system applicable to FIEs was basically established. After the economic reform of 1978, the traditional idea that state-run enterprises have only to pay profits but not income tax began to waver. In April 1983, the Ministry of Finance published the Interim Provision for the Collection of Income Tax on State-Owned Enterprises, announcing the levying of income tax on state-owned enterprises starting from January 1, 1983.1 This marked the first step of the tax-forprofit reform. In September 1984, the State Council promulgated the Regulations on the Income Tax of State-Owned Enterprises (Draft) and the Measures for the Collection of Regulation tax on State-Owned Enterprises to be implemented on a trial basis as of October 1, 1984. In accordance with the regulations of the State Council, the Ministry of Finance announced the Rules for the Implementation of the Regulations on the Income Tax of State-Owned Enterprises (Draft) in September 1984. The promulgation of the above rules and regulations marked the second step of the tax-for-profit reform. Following that, to adapt to the new situation of allowing the development of diverse forms of ownership, the State Council issued the Provisional Regulations on

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the Income Tax of Collective Enterprises in April 1985 and the Provisional Regulations on the Income Tax of Private Enterprises in June 1988. At this point, China had developed an EIT system by ownership. Later, in view of the problems occurred in the development and practice of economic opening and the need to simplify the tax system, the Income Tax Law for Enterprises with Foreign Investment and Foreign Enterprises (hereinafter referred to as the EIT Law for FIEs) was adopted at the Fourth Plenary Session of the Seventh National People’s Congress, and upon the implementation of the new law on July 1, 1991, the Income Tax Law for Chinese-Foreign Equity Joint Ventures and the Income Tax Law for Foreign Enterprises were annulled. As a result, the EIT laws for companies with foreign investment and foreign companies have been united. At the 14th National Congress of the Communist Party of China (CPC) convened in October 1992, it was stated that the target of China’s economic system reform was to build and improve the socialist market economy system. To promote the fair competition between enterprises, allow enterprises of all kinds of ownership to enjoy the same policy of EIT, and gear the taxation scheme to the socialist market economy system, the State Council promulgated the Interim Regulations on Enterprise Income Tax (effective from January 1, 1994) in December 1993, and at the same time abolished the Regulations on the Income Tax of State-Owned Enterprises (Draft), Measures for the Collection of Regulation tax on State-Owned Enterprises, and Provisional Regulations on the Income Tax of Private Enterprises. Therefore, the EIT regime for DEs was united. However, considering the need to attract foreign investment, this time the new EIT regime did not incorporate the tax regime for FIEs issued in 1991, leading to the long-term coexistence of two EIT regimes after 1994.

Major Differences between the EIT Laws for DEs and FIEs The reason why the tax reform of 1994 did not include the EIT Law for FIEs in the Interim Regulations on Enterprise Income Tax (hereinafter referred to as the EIT Law for DEs) was because the EIT Law for FIEs offered many tax incentives to FIEs and it was considered necessary to retain the preferential policies in order to attract foreign capital. Compared with the EIT Law for DEs, that for FIEs was more advantageous in the following four aspects.

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Region-specified tax remission The EIT rate for FIEs was 30% and plus the 3% local income tax, the total EIT rate was 33%, which was the same as that of DEs stated in the EIT Law of 1994. However, if taking into account the regional tax relief stipulated in the EIT Law for FIEs, the total tax rate will be much lower. In Article 7, it was provided that “The income tax on enterprises with foreign investment established in Special Economic Zones, foreign enterprises which have establishments or places in Special Economic Zones engaged in production or business operations, and enterprises with foreign investment of a production nature in Economic and Technological Development Zones, shall be levied at the reduced rate of fifteen percent.2 The income tax on enterprises with foreign investment of a production nature established in coastal economic open zones or in the old urban districts of cities where the Special Economic Zones or the Economic and Technological Development Zones are located, shall be levied at the reduced rate of twenty-four percent.” That is to say, for eligible foreign-invested companies, the national EIT rate can be reduced to either 15% or 24%. As the covered areas were so wide and the places were where the majority of foreign-invested companies were located, the reduced rates applied to nearly all companies with foreign investment and foreign companies, especially enterprises with foreign investment. In contrast, DEs had to pay the EIT at a rate of 33%, apart from a small number of low-profit enterprises (whose taxable income was less than CNY100,000) which can enjoy a lower rate of 18% or 27% and hi-tech companies which paid at 15%. Although there were also regional tax reductions for DEs (Article 8 in the EIT Law for DEs and Article 37 in the corresponding Rules for the Implementation), the reductions were limited to ethnic autonomous areas and were subject to the approval of provincial governments.

Tax incentives to startups It is an internationally accepted practice to give tax incentives to startups, and the tax incentives for FIEs in China were much more attractive. Productive enterprises with foreign investment were entitled to a five-year tax break period (commonly known as “two-year exemption and three-year half reduction” 兩免三減半), and the period was counted from the year beginning to make a profit. In Article 8, it was stated that “Any enterprise with foreign investment of a production nature scheduled to operate for a period of not less than ten years shall, from the year beginning to make profit, be exempted from income tax in the first and second years

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and allowed a fifty percent reduction in the third to fifth years.” This was markedly different from foreign EIT policies, in which the exemption period begins from the start of enterprise production or operation and thus is much shorter.3 For China’s DEs, the exemption period was only applied to those in the tertiary industry and the period started from the first year of business instead of the first year of profit. For instance, newly incorporated, independently audited enterprises or business operations engaged in consultancy, information and technical services, were exempted from EIT in the first and second years; newly formed, independently audited enterprises of business operations engaged in transportation, post and telecommunications services, were exempted from EIT in the first year and were granted 50% reduction in the second year; newly incorporated, independently audited enterprises or business operations engaged in public utilities, commerce, materials, foreign trade, tourism, warehousing, residential services, catering, education and culture, and public health can enjoy tax exemption or reduction in the first year upon the approval of the taxation authorities. From the above, it is clear that the scope of tax concession for DEs were not as large as that for FIEs.

Tax refund for reinvestment To encourage foreign investors to reinvest their after-tax profits in China, Article 10 in the EIT Law for FIEs stated that “Any foreign investor of an enterprise with foreign investment which reinvests its share of profit obtained from the enterprise directly into that enterprise by increasing its capital, or uses the profit as capital investment to establish other enterprises with foreign investment to operate for a period of not less than five years shall, upon approval by the tax authorities of an application filed by the investor, be refunded forty percent of the income tax already paid on the reinvested amount. Where other preferential provisions are provided by the State Council, such provisions shall apply. If the investor withdraws its reinvestment before the expiration of a period of five years, it shall repay the refunded tax.” However, there was no corresponding provision for DEs.

Pre-tax deduction Given the nominal tax rate, the scope and standards of pre-tax deduction directly decide the size of tax base, thus affecting the real tax burden of an enterprise. Comparatively speaking, FIEs enjoyed a more favorable and loose policy, for example:

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• Wages and salaries. Wages and salaries paid to employees were deductible before EIT. The EIT Law for DEs imposed a limit for such deductions: in 1994, the monthly deductible amount was CNY800 per person, with a maximum 20% fluctuating range for some industries; starting from July 1, 2006, the monthly deduction was adjusted to CNY1,600 per person and the 20% fluctuating range was cancelled. In contrast, FIEs were not subject to such restrictions and all wages and salaries can be deducted before EIT. Moreover, staff welfare expenses, staff education expenditures and labor union dues were also deductible, but for DEs, the deduction was limited to a certain percentage of the deductible wages and salaries whereas for FIEs, the deduction was calculated based on the gross payroll. • Charitable donation. DEs can only have their donations not exceeding 3% of their taxable income to be deducted, while all donations for public welfare and relief purposes made by FIEs can be deducted before EIT. • Entertainment expenses. The deduction of entertainment expenses in connection with production or business operations for DEs was limited to 0.5% of the net sales (or business) revenue if the annual sales is CNY15 million or below; 0.3% of the portion of net sales (or business) revenue above CNY15 million. For FIEs, the deduction is made according to business type. FIEs engaged in the sale of goods shared the same deduction policy with DEs, but for those providing labor services, a higher deduction percentage was granted: not exceeding 1% of the total operating income, if the annual operating income is CNY5 million or below; 0.5% of the portion of operating income above CNY5 million. • Advertising and promotional expenses. The EIT Law for DEs imposed a limit on the deduction of advertising and promotional expenses while there was no such a limit in the EIT Law for FIEs. Advertising expenses of EDs were deductible up to 2% of the sales (or business) revenue for a particular tax year, and the amount in excess of the 2% limit can be carried forward to subsequent years for future claims. A higher percentage of deduction was allowed after 2001 for certain industries, such as pharmacy, food, household necessities, household appliances, communications, software development, integrated circuits, real estate development, sports culture, furniture and building materials, and apparel (after 2006); the deductible limit for pharmaceutical enterprises were raised to 25% after 2005. Promotional expenses (including those not spent on media) were deductible up to 0.5% of the sales (or business) revenue for a particular tax year, and the amount in excess of the limit cannot be carried forward.

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Social and Economic Background of EIT Consolidation and Its Far-Reaching Significance Background Since FIEs enjoyed more preferential treatment concerning EIT than DEs in many aspects, the tax burden of FIEs was much lower than that of DEs. It was estimated that the real EIT rate of EDs was as high as 25% whereas that of FIEs was just around 13%. Therefore, the difference in EIT laws was not only a matter of legal disunity, but caused the inequity in tax burdens between EDs and FIEs, hindering the fair competition between the two. In other words, this uneven EIT pattern seriously impacted the growth and development of DEs. In fact, fair taxation is the basic principle that every country should honor, and the division in China’s EIT law has already drawn wide attention. But many people thought that China was desperately in need of introducing foreign technologies and management skills and the removal of tax concessions would cause the withdrawal of foreign investment. Things have changed in 2001 when China joined the WTO. On December 11, 2001, China officially became WTO’s 143rd member. Upon its entry to the WTO, China has to fulfill its commitments and obligations made in the Protocol on the Accession of the People’s Republic of China, to largely reduce the tariffs on imported goods, remove all non-tariff trade barriers, and apply the principles of non-discrimination (principle of national treatment) to foreign individuals and FIEs. In short, China’s DEs were no longer protected by the tariff and non-tariff trade barriers and was exposed to public competition with the world powers. For a time, there was a general panic among DEs. Under this condition, people started to think about how to make China’s DEs more competitive. In the field of finance and taxation, the first thing came to mind was the merger of EIT laws to abolish the preferential tax policies and super-national treatment given to FIEs and let DEs and FIEs compete on the same ground. Starting form 2001, the finance and tax departments of China sped up the research on the plan for EIT consolidation. At the Third Plenary Session of the 16th Central Committee of CPC convened in October 2003, the Decision on Some Issues Concerning the Improvement of the Socialist Market Economy System was passed, and it underpinned the urgent need to “unify tax systems of all kinds of enterprises.” As the five-year transition period after China’s accession to the WTO was near the end, the debate on the EIT merger became increasingly heated. At the Annual Meeting of the National Institute of Public Finance held in January 2005 in Zhaoqing City of Guangdong Province, Minister of Finance Jin Renqing said, “Unifying EIT rates for DEs and FIEs is our most

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pressing priority and now the time has come and it can’t be delayed any longer.” He added that “There are too few people speak for DEs but too many for FIEs.”4 A report titled “Several Opinions of FIEs on a New EIT Law” pumping through the Internet in the early 2005 lifted the debate to a new height. This report investigated 54 transnational companies in Beijing and Shanghai regarding a new EIT law in the form of questionnaire, and concluded that FIEs generally expected the new EIT law to allow for a five-to-ten year transition period for existing tax preferences.5 Besides FIEs, some relevant government departments and local governments of developed regions also held negative attitude towards the EIT consolidation. In addition to that, in 2004, the growth rate of the utilization of contracted foreign capital declined than in 2003, from 39.03% to 33.38%, and in January 2005, this percentage was further reduced to 27.7%, exacerbating people’s concern for the adverse impact of EIT merger on foreign capital inflow.6 As the date of China’s accession to the WTO was approaching and the competition faced by DEs was increasingly intensified, the calls for EIT consolidation was growing louder in China. Especially after the request for “improving the quality of the utilization of foreign investment” was proposed at the Central Economic Working Conference of 2005, the idea that the cancellation of tax preferences will affect the size of foreign investment was gradually losing ground. Under this circumstance, there was a growing consensus on EIT consolidation among people, and decision-making department also thought that it was time to complete the task. At the 25th Meeting of the 10th Standing Committee of the National People’s Congress held between December 24 and 29, 2006 in Beijing, the Draft New EIT Law was passed by 155 votes and 1 abstention, and the Draft was scheduled to be submitted to the Fifth Session of the Tenth National People’s Congress to be convened in March 2007 for deliberation. This means that EIT consolidation entered into the legislative process. On March 16, 2007, the New EIT Law was passed with simple majority (2,826 to 37 votes with 22 abstentions), and by then the consolidation of EIT laws had been successfully completed. The consolidation of EIT laws unified the income tax regimes for DEs and FIEs and the unification was manifested in many aspects, such as tax rate, pretax deduction, tax preference, and payment deadline. Moreover, to minimize resistance, the New EIT Law also makes special arrangements to guarantee the benefits of FIEs mainly through allowing for a transition period and practicing “old rules for old companies and new rules for new companies.” As stated in the Notice on the Implementation of the Grandfathering Preferential Policies under the Enterprise Income Tax (Decree No.39[2007]), “As from 1st January 2008, the enterprises that have enjoyed preferential tax rates shall be taxed at rates to be

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increased from the current rate to the full rate under the EIT law within a period of 5 years. Among others, the enterprises that have been taxed at 15% currently shall be taxed at 18% in 2008, 20% in 2009, 22% in 2002, 24% in 2011 and 25% in 2012; the enterprises that have been taxed at 24% under the old income tax law shall be taxed at 25% as from 2008. As from 1st January 2008, the enterprises that have been granted ‘two-year exemption plus three-year half reduction’ and ‘five-year exemption plus five-year half reduction’ tax concessions shall continue to enjoy the tax concessions until the expiry day in accordance with the tax preferences under the old income tax law, regulations and relevant provisions. Where the tax preferences have not been granted due to the fact that the enterprises have not made any profits, the tax preferential period shall commence as from 2008. The enterprises, to which the tax preferential policies apply during the transitional period, refer to those enterprises that have obtained the business registrations at the local office of State Administration of Industry and Commerce before 16th March 2007.”7

Significance The consolidation of EIT laws has created an institutional environment for fair competition, and it helps ensure the national treatment regarding EIT for FIEs in China and exclude their chances to enjoy super-national treatment. That is to say, the non-discrimination principle of the WTO not only applies to FIEs but also DEs. The super-national treatment of EIT enjoyed by FIEs under the coexistence of separate EIT laws is actually discrimination against DEs. In fact, what attracts foreign investors to start business in China is not a low tax burden but its investment environment. Investment environment refers to all external conditions that will affect international capital’s fulfillment of its functions, it includes many factors and taxation is just one of them. Other factors include natural resources, quality of labor force, market opportunities, and political stability. Whether or not to make investment in another country, investors will consider the overall investment environment of the destination country rather than just tax burdens and tax preferences. Of course, the level of tax burden is an important factor that will affect the final decision of foreign investors. If a country is politically stable and has rich natural resources, low labor cost, high technological level, and vast domestic market, even though it does not offer tax preferences, as long as there is no discrimination against FIEs, foreign investors will still go and invest in the country. China was among the developing countries that offered the most tax incentives to foreign investors, but according to the survey made by the World Bank and the International Monetary Fund (IMF), what made foreign investors

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to make investment in China were its stable political environment, cheap labor, and huge domestic market. There is a saying in western countries, “Don’t let the tax tail wave the economic dog.” That is to say, companies should not make investment decisions predominantly on tax considerations but their development strategies. In November 1993, Milton Friedman, a famous American economist and Professor at Chicago University, pointed out when visiting China, “Most investors come to China for money, if they can earn profits through effective production and technical cooperation, that is a good thing; but once their wealth is mainly derived from blind tax concessions and a series of preferential policies, China introduces potential risks along with foreign investment, and it is probably a much higher price to pay than the investment it actually attracts. So, when China absorbs foreign capital, it must bear in mind an economic principle, that is a good deal is when both sides win.” In fact, although China unified the EIT regimes and removed foreign investors’ expectation for tax preferences in 2008, the size of foreign direct investment did not change much. For instance, the actual use of foreign capital was USD82.66 billion in 2007, USD92.40 billion in 2008, USD90.03 billion in 2009, and USD105.74 billion in 2010; in May 2007, China’s actual use of foreign capital grew by 9.87% year on year, in May 2008 after the EIT consolidation, it increased by 37.94% from the previous year, in 2009, due to the impact from the international financial crisis, the figure dropped by 2.56%, but in 2010, the year-on-year growth rate rebounded back to 17.44%.8 The above statistics show that the merger of EIT laws did not have an obvious negative impact on China’s introduction of foreign capital. The significance of EIT consolidation is far beyond creating a tax environment for fair competition, but includes strengthening China’s tax administration and anti-tax avoidance. Induced by the larger number of tax incentives offered to FIEs, some domestic investors incorporated companies in a foreign country and then acquired stocks of a DE (holding over 25% shares) or founded a branch in China through these foreign companies. In such way, China’s DEs transformed into FIEs, and people dubbed these companies “fake foreign devils.” As a result, those DEs which should have pay EIT at a rate of 33%, are now entitled to a lower rate and at the same time can enjoy the preferential policy of “two-year exemption and three-year half reduction.” Their tax burdens were markedly lightened. Moreover, domestic investors generally chose to register their offshore companies in “tax heavens” (tax-free or low-tax countries or regions), and earned dividends and bonuses from their acquired or newly opened DEs in China. Under the old EIT law for DEs dividends and bonuses given out by DEs to non-resident enterprises were exempted from withholding income tax. At the same time, tax heaven enterprises which received the dividends and bonuses also did not have to pay

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or pay a little income tax to the local government. In this case, domestic investors made use of the old EIT law for DEs and the advantages of tax heavens to realize tax avoidance. According to statistics, after 2002, the top 10 tax heavens by actual input value of foreign capital in China include Hong Kong, British Virgin Islands (BVI), and Cayman Islands, and BVI always ranks second. The above facts reflect, to some extent, the severity of tax avoidance by domestic investors. The New EIT Law, however, abolished the exclusive tax preferences to FIEs and imposed an 10% withholding tax on DEs which pay dividends and bonuses to non-resident enterprises, reducing the chances for tax avoidance by fake FIEs. Apart from overseas tax avoidance, the coexistence of EIT laws also made it possible for enterprises to minimize their tax liability in China. In the old EIT laws, FIEs established in special economic zones and Shanghai Pudong Development Zone can enjoy a reduced rate of 15%, while the tax rate for DEs was 33%.9 Therefore, DEs incorporated in these areas cannot compete with their foreign counterparts on the same ground. In view of this fact, some regions offered a reduced rate of 15% to DEs in order to balance the tax burden. For example, Shenzhen Municipal Government issued the Rules Regarding Issues on Enterprises Taxation Policies of the Shenzhen Special Economic Zone (People’s Government of Shenzhen Municipality No.232[1988]) on August 1, 1988, which states that “To carry out the principle of ‘fair taxation and equal treatment,’ the following provisions are formulated, in accordance with relevant state provisions on taxation and based on the reality of Shenzhen Special Economic Zone, regarding several issues on tax policies imposed on enterprises incorporated in Shenzhen Special Economic Zone.” Article 6 provides that “A 15% preferential enterprise income tax shall be levied on the income derived from production, business and other sources of any enterprises incorporated in Shenzhen Special Economic Zone.” Therefore, there were regions of different EIT rates for DEs in China: The EIT rate was 33% for enterprises founded in some areas, but 15% for others. This difference in tax rate was used by some enterprises for tax avoidance. They usually set up their headquarters in a low tax region (with an applicable tax rate of 15%) and then founded a branch in a high tax region (with an applicable tax rate of 33%). According to the EIT Law for DEs, if a branch does not perform independent accounting, EIT shall not be paid by at the locality of the branch, but be paid on a consolidated basis by its head office. The definition of “independent accounting” as stated in the Rules for the Implementation of the Interim Regulations on Enterprise Income Tax is that “Enterprises or organizations concurrently meeting the conditions of opening clearance accounts in banks, independently setting up books and records and preparing financial statements, and independently accounting profits and losses.” Given this, in order to avoid tax, an enterprise can make its branch opened in a high tax area not meet

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all three requirements simultaneously, so the branch does not need to pay EIT at its locality. In fact, it is different for tax authorities to know whether a branch conducts independent accounting or not. Due to the above loopholes in the tax regime, to use branch companies to avoid EIT was very common. To address this problem, the State Administration of Taxation issued the Reply on the Determination of Taxpayers of Enterprise Income Tax (Letter No.676[1998]) in November 1998, which provides that “Any enterprises or organizations founded with the approval of relevant national departments and engaged in independent production or operation, that should practice independent accounting according to relevant laws and regulations but not yet, shall be recognized as taxpayers of enterprise income tax, even if they do not meet the three requirements of independent accounting stipulated in the law.” After the announcement of this document, local tax authorities reinforced their management towards the collection of EIT of branches. However, it was not clearly defined as to which companies belonged to the category that “should practice independent accounting according to relevant laws and regulations,” so the actual implementation of the policy met some difficulties and questions. Under the coexistence of the two EIT regimes, many enterprises tried to avoid tax via setting up subsidiaries in low tax areas. According to the EIT Law for DEs, if a parent company in a high tax area receives dividends and bonuses from its subsidiary incorporated in a low tax area, it should pay the difference in EIT rates between the two areas; but if the subsidiary does not distribute profits to the parent company, the payment of the tax difference will be unnecessary. Thus, the parent company will shift its profits to its subsidiary through transfer pricing and ask the subsidiary to not conduct profit distribution, and in this way, the profit of the subsidiary or even part of the profits of the entire corporate group will be taxed at a lower rate. Although the parent company does not take profits from the subsidiary, it can obtain capital from the subsidiary through borrowing. Even if the subsidiary distributes profits to its parent company several years later, the present value of the tax payments will be much lower due to the delay in payments. The coexistence of two EIT laws allowed a large number of corporate groups to reduce their tax obligations through this way. The EIT consolidation blocked, to a large extent, the above paths of tax avoidance through setting up headquarters and branch companies or parent and subsidiary companies. Here, the most remarkable reform to the old EIT laws is the cancellation of tax rate difference between different regions, and enterprises normally pay a 25% EIT.10 In this way, there is basically no room for enterprises to avoid tax by making use of regional tax difference in China. Moreover, according to the New EIT Law and the Interim Measures for the Administration of Collection of Enterprise Income Tax on the Basis of Consolidation of Trans-Regional Business Operations

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(No.28 [2008] of the State Administration of Taxation), headquarters and branch companies should all pay in advance EIT at their localities, but the amounts of their respective payments should be calculated by the headquarters according to a certain formula instead of being determined based on their book profits. As the New EIT Law has basically unified the tax rates of different areas, dividends and bonuses received from subsidiaries by parent companies are considered tax-free income which is exempt from EIT.

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Notes Chapter 22 1. 2. 3.

4. 5. 6. 7.

8. 9. 10. 11. 12.

13. 14. 15. 16. 17.

Guo and Zhao, Public Economics. Chen, Collected Works of Chen Gong; Xie, 30 Years of China’s Fiscal Reform. As the then Finance Minister Liu Zhongli recalled, Vice Premier Zhu Rongji who was in charge of banks, once said to him that “You are really tapped out!” when reviewing the treasury accounting statement. This event has been unforgettable for Liu even long after it has passed and he was still very much saddened when talking about it. Ma, Interviews with Ministers of People’s Republic of China. Liu, “Review of the Fiscal and Taxation Reform in 1994.” Ma, Interviews with Ministers of People’s Republic of China. Zhou, “The Incentive and Cooperation of Government Officials in the Political Tournaments”; Guo and Jia, “Local Government Behaviors, Investment Impulsion, Macroeconomic Stability”; Xie, 30 Years of China’s Fiscal Reform. Ma, Interviews with Ministers of People’s Republic of China. Ibid. Xie, 30 Years of China’s Fiscal Reform. Li, A Brief Illustrated Guide to the Fiscal System; Xie, 30 Years of China’s Fiscal Reform. The data is sourced from Financial Statistics of Cities and Counties, and is based on a sample of 1,938 counties and county-level cities of 30 provinces, autonomous regions, and municipalities. The decentralization level of fiscal revenue and expenditure at county level was measured following the common practice of existing literature with due regard to the difference in the fiscal management system among county-level governments. Under the system of municipal supervision of county finance, the decentralization level of county finance = per capita fiscal revenue (expenditure) at county level / [per capita fiscal revenue (expenditure) at county level + per capita fiscal revenue (expenditure) at central level + per capita fiscal revenue (expenditure) at corresponding provincial level + per capita fiscal revenue (expenditure) at corresponding municipal level]; under the system of direct provincial supervision of county finance, the decentralization level of county finance = Per capita fiscal revenue (expenditure) at county level / [per capita fiscal revenue (expenditure) at county level + per capita fiscal revenue (expenditure) at central level + per capita fiscal revenue (expenditure) at corresponding provincial level]. Jia and Guo, ‘The Effects of Intergovernmental Assignments of Public Revenue and Expenditure Responsibility on the Regional Growth: Empirical Analysis.” Xie, 30 Years of China’s Fiscal Reform; Guo and Jia, “Fiscal Decentralization, Government Structure and Local Governments’ Expenditure Size.” Xie, 30 Years of China’s Fiscal Reform. Brennan and Buchanan, The Power to Tax; Wilson, “A Theory of Interregional Tax Competition.” Zodrow and Mieszkowski, “Pigou, Tiebout, Property Taxation and the Under Provision of Local Public Goods.”

Notes

18. Bordignon et al., “Optimal Regional Redistribution under Asymmetric Information.” 19. Hocman et al., “On the Optimal Structure of Local Governments”; Gilbert and Picard, “Incentives and Optimal Size of Local Jurisdictions”; Jia and Bai, “Overcoming Difficulties in Public Finance at County and Township Level and Innovation in Fiscal System”; Wang, “Alleviation of the Fiscal Difficulty in the County and Township Levels and Governmental Reform: Compatibility and Reform Path”; Guo and Jia, “Fiscal Decentralization, Government Structure and Local Governments’ Expenditure Size.” 20. Guo and Jia, “The Tactical Interaction Among Local Governments, Their Competition in Fiscal Expenditure, and Regional Economic Growth”; Jia and Guo, “The Effects of Intergovernmental Assignments of Public Revenue and Expenditure Responsibility on the Regional Growth: Empirical Analysis.” 21. Moreover, in accordance with the principle of central finance dominance, the tax sharing reform of 1994 classified the taxes which related to the safeguarding of national interests, or were essential for carrying out macroeconomic regulation, or were widely charged, stable, and with ample tax sources, as central taxes or shared taxes, consolidating the leading position of central finance in income distribution. These measures effectively prevented the continuous falling of the “two proportions,” and contributed to the constantly rapid growth of national and central fiscal revenues: In 2008, national fiscal revenues reached CNY6,133.04 billion, among which CNY3,268.06 billion was central fiscal revenues; the proportions of fiscal revenues in GDP and of central fiscal revenues in entire fiscal revenues were 19.5% and 53.5%, respectively, up 7.2 and 21.3 percentage points from 12.3% and 22% in 1993. 22. Jia, Guo, and Ning, “Fiscal Decentralization, Structure of Government Control, and Settlement of County Governments’ Difficulties.” 23. Ibid. 24. Baqir, “Districting and Government Overspending”; Rodden, “Reviving Leviathan: Fiscal Federalism and the Growth of Government.”

Chapter 23 1. 2. 3. 4. 5. 6. 7. 8. 9.

Information Website of the Development Research Center of the State Council, “Situations of National Basic Old-Age Insurance Between 1989 and 2008.” The statistics of 1988 come from the Law Yearbook Of China 1990; statistics of 1998 are from the Almanac of China’s Economy 1999. Jiang, “Hold High the Great Banner of Deng Xiaoping Theory for an All-round Advancement of the Cause of Building Socialism With Chinese Characteristics’ Into the 21st Century.” Ibid. Xin, “Guarantee Basic living, Boost Reemployment, Continue Social Insurances — Policies and Practice of China in Solving Laid-Off Workers from State-Owned Enterprises.” Statistics are sourced from the Ministry of Finance of the People’s Republic of China. Ministry of Human Resources and Social Security of the People’s Republic of China, Statistical Communique of Labor and Social Security in China, various years. Statistics are from the Ministry of Finance of the People’s Republic of China. Department of Population and Employment Statistics of the State Statistics Bureau, and Department of Planning and Finance of the Ministry of Human Resources and Social Security, China Labour Statistical Yearbook, 1993 and 1999.

168

Notes

10. The statistics are sourced from the Website of National Bureau of Statistics of the People’s Republic of China, http://www.stats.gov.cn/tjsj/ndsj/2001c/v2233c.htm. 11. China News Service, “Ministry of Human Resources and Social Security of the People’s Republic of China: The Value of Empty Personal Accounts Reached Nearly CNY6 Trillion.” 12. Lu, “Two Guarantees Remain the Major Task for Labor Security Work in 2000.” 13. The date is from the Ministry of Finance of the People’s Republic of China. 14. English translation is from http://language.chinadaily.com.cn/news/2013-11/26/content_17132209_8. htm (accessed July 20, 2016). 15. Subsidy expenditures for social security mainly include subsidies for social insurance funds, employment subsidies, and subsidies to laid-off workers for maintaining basic living. 16. The English version is from http://www.asianlii.org/cn/legis/cen/laws/irocaposip712/ (accessed July 20, 2016.

Chapter 24 1.

2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13. 14. 15. 16. 17.

Proactive fiscal policy was first introduced in 1998, and relaunched in 2008. As an important historical event, this chapter only talks about the first period because the second is merely a confident imitation of the first. As for a brief contrast of the two, please refer to Guo and Zhao, Public Economics, 327–29. The following section on the debate over the name of “proactive fiscal policy” and our definition on the term was sourced from Guo, Zhao and He, Research on Proactive Fiscal Policy and Its Coordination with Monetary Policy, 7–11. Gong, “Names of Economic Policies Should be Standardized — Opinions on the Expressions of Current Fiscal and Monetary Policies.” Chen, “Analysis on the Effect of Proactive Fiscal Policy.” Jia, “Consideration on the Pro-active Fiscal Policy in China.” Cong, “Discussions on Several Issues Concerning Proactive Fiscal Policy.” Ni, “Interpreting the Proactive Fiscal Policy.” “First Interview with Finance Minister about Proactive Fiscal Policy in Three Years,” accessed October 24, 2016, http://www.china.com.cn/chinese/2000/Dec/13989.htm. Samuelson, Economics. Ye, “Proactive Fiscal Policy: Short-Term Trend and Institutional Basis,” 40. Zhu and Chen, “Proactive Fiscal Policy.” Wu, “Proactive Fiscal Policy and Its Effect Evaluation.” Duan, “On Proactive Fiscal Policy.” Guo, Zhao, and He, Research on Proactive Fiscal Policy and Its Coordination with Monetary Policy, 10–11. Wang, Exploration and Practice: Macroeconomic Operation and Regulation, 126. Ibid. Liu, “Several Questions about Proactive Fiscal Policy (Volume 1&2),” 55. According to the model of national income determination, to calculate the contribution of exports to aggregate demand or GDP, we must first figure out the contribution of net exports or imports minus exports. But since exports alone are discussed here, only the ratio of exports to GDP is considered.

169

Notes

18. Zhang and Li, Theory and Reality of Deflation, 134. 19. Some scholars believe that China’s economic growth is export-oriented. Shen proved, by using the Granger causality test, that China’s economy did have features of an export-oriented economy. 20. Yuan, The Theory of Demand Expansion, 2. 21. Here, the amplitude of a wave is the deviation of economic growth fluctuations from the mean level. The peak measures the economic growth rate in the peak year within each cycle; the trough represents the economic growth rate in the trough year within each cycle. The position of a wave signifies the average growth rate of different years within a cycle. The expansion length is the time span of the expansion phase of each cycle. 22. More details on the six viewpoints please refer to Liu, Business Cycle Fluctuations in Contemporary China and Its Formation Mechanism Research, 209–17. 23. For a comprehensive review on China’s monetary policy measures between 1996 and 1998, please refer to Dai, Proactive Fiscal Policy and Macroeconomic Regulation, 222–28; Dai, “The Theory and Practice of the Monetary Policy of China”; and Research Group of Research Bureau of People’s Bank of China, “Analysis on China’s Monetary Policy.” 24. Jia, “Brief Review and Effect Analysis on China’s Fiscal Policy.” 25. Analysis on the reasons of weak or ineffective monetary policy effects is beyond the scope of this research, and the theoretical community has had intensive discussions in this regard, please refer to Xie, “Challenges to China’s Monetary Policy in the New Century,” 110. 26. In 1996, the central bank made an increase in money supply as the intermediate target of monetary policy, and announced that M2 should grew at an average rate of 23% and M1, 18% during the Ninth Five-Year Plan period. 27. Macroeconomic situations at this period have been analyzed in the previous section “Macroeconomic background in 1997 and the first half of 1998.” 28. The term of the bonds was 10 years with an annual interest rate of 5.5%. Among the CNY100 billion of government bonds, central and local governments each bore a half, all of which were spent in infrastructure construction. Besides, the central government offered CNY270 billion of special government bonds to wholly state-owned banks (with a maturity of 30 years) to replenish bank capital in order to ensure that the capital adequacy ratio of China’s state-owned banks meets the requirement of no lower than 8% required by the Basel II and the Law of Commercial Banks. 29. This was the period when the wage increase was the fastest and largest after the founding of New China. This increase benefited around 49 million people with a cumulative increase of CNY639 billion in government spending, among which CNY371.4 billion was from the central government (Jin, Theory and Practice of China’s Fiscal Policy, 46). 30. The “three guarantees” refers to guaranteed basic livelihood for laid-off workers from SOEs, guaranteed unemployment insurance, and guaranteed minimal living allowances for urban residents. 31. Jin, Theory and Practice of China’s Fiscal Policy, 46. 32. Ibid, 47–48. 33. The reason why the government carried out structural tax cuts rather than a reduction in total tax volume will be explained in the next section.

170

Notes

34. Why the majority of the increase in fiscal spending was directed to fiscal investment will also be discussed later. 35. For more information on China’s business cycle, please refer to cyclical division of economic growth made by Guo, Zhao, and He, Research on Proactive Fiscal Policy and Its Coordination with Monetary Policy, 98. 36. Chen, Public Finance, 147–48. 37. Liu et al. established a regression equation with the monthly data of the 1990s. The estimation result showed that an expansionary fiscal policy in years of economic growth will lead to an increase in fiscal deficit while a contractionary fiscal policy in years of economic recession will contribute to a rise in fiscal surplus (Liu, Cui, and Xie, “Tests on the Stages and Asymmetry of the Fiscal Policy Effect”). 38. Liu studied the relationship between fluctuation coefficients of fiscal revenue and expenditure and that of GDP through a regression approach, and he found that the fluctuation coefficient of fiscal expenditure is larger than that of fiscal revenue, indicating higher instability of fiscal expenditure growth; and the fluctuations of fiscal expenditure have an greater influence on GDP movements than fiscal revenue fluctuations. Here, the coefficient of fluctuation refers to the difference between the growth rate fluctuations of a variable and its long-term trend, and it measures the deviation of cyclical fluctuations from the historical growth trend (Liu, Business Cycle Fluctuations in Contemporary China and Its Formation Mechanism Research, 139–41). 39. So far, the highest fiscal deficit ratio appeared in 1979, at 3.35%. This was a result of the war expenses of the Sino-Vietnamese War and other related abnormal factors. 40. Keynesians hold that consumer spending depends on current-period income whereas economists like Friedman argue that consumption is linked to permanent income, for they doubt the role of tax changes in stabilizing the economy. In their opinion, consumption will change only when tax changes affect people’s evaluation on long-term income. On the contrary, supporters of the former theory believe that tax changes will impact the consumption of the current period, and therefore tax cut policies will play a crucial role in stabilizing the economy in a short term. 41. Policy and Regulations Department of the State Administration of Taxation, Frontier Tax Policy Study in China, 105. 42. Guo and Zhao, Fiscal Theory and Policy — A Discussion on Several Current Key Issues, 288. 43. Ibid, 289. 44. Keynes wrote in his book named The General Theory of Employment, Interest, and Money, “If the Treasury were to fill old bottles with banknotes, bury them at suitable depths in disused coalmines which are then filled up to the surface with town rubbish, and leave it to private enterprise on well-tried principles of laissezfaire to dig the notes up again (the right to do so being obtained, of course, by tendering for leases of the note-bearing territory), there need be no more unemployment and, with the help of the repercussions, the real income of the community, and its capital wealth also, would probably become a good deal greater than it actually is.” This theory of relying on public works to expand demand and solve unemployment was called “hole-digging” theory (Keynes, “The Marginal Propensity to Consume and the Multiplier”). 45. Guo and Zhao, Public Finance, 639–40.

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Notes

46. The private sector is reluctant to invest in West China, probably out of the reasons of the narrow market, the low quality of labor force, the poor natural environment, and the backward technological level; however, the proactive fiscal policy ensured the implementation of regional policies by increasing investments to the western region. 47. Vernez, Public Works as Countercyclical Fiscal Policy. 48. Keynes, “The Marginal Propensity to Consume and the Multiplier.” 49. For example, a fiscal expenditure reform was carried out mainly through establishing a departmental budget system to increase the efficiency of government spending in the form of institution building; and revenue and expenditure were separated in fiscal management with regard to revenues from administrative and institutional fees, fines and confiscations in order to reinforce comprehensive fiscal budget management. For more details, please see Wang, “Analysis on the Background and Highlights of China’s Fiscal Policy.” The above reform measures guaranteed the smooth implementation of proactive fiscal policy, but they did not directly expand domestic demand. 50. For problems and lessons learned during the implementation of proactive fiscal policy, please refer to Guo, Zhao, and He, Research on Proactive Fiscal Policy and Its Coordination With Monetary Policy, 331–42.

Chapter 25 1. 2. 3. 4. 5. 6. 7.

Cong, “To Actively and Steadily Promote the Reform of Fiscal and Tax Systems.” Beijing Daily, March 11, 2005. Department of Budget of the Ministry of Finance of the People’s Republic of China, Guide to the Budget Preparation of the Central Government (2002). The Budget Law of the People’s Republic of China, accessed October 14, 2016, http://www.npc.gov.cn/ englishnpc/Law/2007-12/12/content_1383623.htm. The Government Procurement Law of the People’s Republic of China, accessed October 17, 2016, http:// www.npc.gov.cn/englishnpc/Law/2007-12/06/content_1382108.htm. Ibid. The Website of Ministry of Finance of the People’s Republic of China, “To Further Regulate and Perfect the Government Procurement System — An Exclusive Interview with Finance Minister Xie Xuren by the China Government Procurement News.”

Chapter 26 1. 2. 3. 4. 5. 6. 7.

172

People’s Daily, May 6, 1996. General Department of the State Economic and Trade Commission, “General Situations of State-Owned Industrial Enterprises and State-Owned Large- and Medium-Sized Industrial Enterprises.” Dai, “Speech at the Press Conference Held by the Information Office of the State Council.” Lardy, China’s Unfinished Economic Revolution.. Hu and Lu, “Debt for Equity Swap Policies for State-Owned Enterprises: Functional Defects and Institutional Dependence.” Xu, “The High Debt Ratio Is the Main Reason for the Losses of State-Owned Enterprises.” Hu, “Unveil the Myths of Corporate Finance.”

Notes

8.

9. 10.

11. 12. 13. 14. 15. 16. 17. 18. 19. 20. 21. 22. 23. 24. 25. 26. 27. 28. 29. 30. 31. 32. 33. 34. 35.

Zhou et al., Corporate Reform: Model Selection and Supplementary Arrangements; Zhang, “On the Debt Problem of State-Owned Enterprises”; Li and Li, “A New Idea about the Debt Restructuring of StateOwned Enterprises”; Wu and Zhao, “Debt-to-Equity Swap: A Theoretical and Policy Analysis Based on Corporate Governance.” China Macroeconomic Information Network, “Overview of Debt-for-Equity Swap.” Wu, “China’s State-Owned Enterprises — Thoughts on the Debt Restructuring of Banks”; Zhou, “Several Issues on Debt-for-Equity Swap”; Liu and Qian, “Suggestions on the Reform of China’s Banks and Corporate Finance.” Yin, “Debt Restructuring of Large and Medium-Sized State-Owned Enterprises: Scheme Comparison and Policy Suggestions”; Xue, “Reflections on Corporate Debt Restructuring.” Zhou et al., Corporate Reform: Model Selection and Supplementary Arrangements. Xue, “Reflections on Corporate Debt Restructuring.” Zhang, “On the Debt Problem of State-Owned Enterprises.” Liu and Qian, “Suggestions on the Reform of China’s Banks and Corporate Finance.” Wu and Xie, “China’s State-Owned Enterprises — Thoughts on the Debt Restructuring of Banks.” Report on the Work of Government, passed at the Fourth Session of the 9th National People’s Congress of China, on March 5, 1999. Decisions on Several Major Issues on the Reform and Development of State-Owned Enterprises, passed at the Fourth Plenary Session of the 15th CPC Central Committee, on September 22, 1999. No. 33[1999] Document of General Office of the State Council. Zhu and Huang, “On China’s Asset Management Companies.” Ibid. No.297[2000] Decree of the State Council. No.727[1999] Document of State Economic and Trade Commission, People’s Bank of China, and Department of Industrial Polices of the State Economic and Trade Commission. No.1,130[1999] Document of State Economic and Trade Commission, Ministry of Finance, People’s Bank of China, and Department of Industrial Polices of the State Economic and Trade Commission. No.921[2000] Document of Department of Industrial Polices of the State Economic and Trade Commission. Zhou, “The Transfer Mechanism of Debt-to-Equity Swap Programme and Its Operation Risk.” Zhou, “Several Issues on Debt-for-Equity Swap.” Yang, “Research on Several Issues of Debt for Equity Swap.” Bei and Feng, “Debt for Equity Swap Facing Many Challenges.” Zhu and Huang, “On China’s Asset Management Companies.” Yang, “Research on Several Issues of Debt for Equity Swap.” Ibid. Wang, “Analysis on the Debt for Equity Swap of State-Owned Enterprises.” Zhu and Huang, “On China’s Asset Management Companies.” Li, “On the Debt for Equity Swap of State-Owned Enterprises”; Zhu and Huang, “On China’s Asset Management Companies.”

173

Notes

36. Li, “Ideas and Approaches for Dealing with Non-Performing Assets in China’s Banking Sector.” 37. Macroeconomic Study Group of China Center for Economic Research of Peking University, “Debt for Equity Swap: At the Crossroad of Credit Economy and ‘Repudiation Economy’. ” 38. Zhang et al., “Analysis on the Influence of Debt for Equity Swap on Enterprise Governance Structure and Its Outlook.” 39. Bei and Feng, “Debt for Equity Swap Facing Many Challenges.” 40. Huang, “On the Theories and Policies of Debt for Equity Swap.” 41. Hu, “Evaluating Debt for Equity Swap from the Perspectives of Financing Planning and Accounting.” 42. Bei and Feng, “Debt for Equity Swap Facing Many Challenges”; Wu and Zhao, “Debt-to-Equity Swap: A Theoretical and Policy Analysis Based on Corporate Governance.” 43. Zhou, “Several Issues on Debt-for-Equity Swap.” 44. Wang, “Three Targets, Risks and Measures of the Establishment of Financial Assets Management Companies in China”; Macroeconomic Study Group of the China Center for Economic Research of the Peking University, “Major Problems Faced by the Current Debt for Equity Swap”; Huang, “On the Theories and Policies of Debt for Equity Swap.” 45. Li, “Debt for Equity Swap Is a Double-Edged Sword.” 46. Bei and Feng, “Debt for Equity Swap Facing Many Challenges.” 47. Wu and Zhao, “Debt-to-Equity Swap: A Theoretical and Policy Analysis Based on Corporate Governance”; Qian, “Incentives and Constraints.” 48. Macroeconomic Study Group of the China Center for Economic Research of the Peking University, “Major Problems Faced by the Current Debt for Equity Swap”; Zhou, “The Transfer Mechanism of Debt-to-Equity Swap Programme and Its Operation Risk.” 49. Li, “Debt for Equity Swap Is a Double-Edged Sword.” 50. Wu and Zhao, “Debt-to-Equity Swap: A Theoretical and Policy Analysis Based on Corporate Governance.” 51. Li, “Debt for Equity Swap Is a Double-Edged Sword.” 52. Macroeconomic Study Group of the China Center for Economic Research of the Peking University, “Major Problems Faced by the Current Debt for Equity Swap.” 53. Zhou, “The Transfer Mechanism of Debt-to-Equity Swap Programme and Its Operation Risk.” 54. Wang, “Analysis on the Debt for Equity Swap of State-Owned Enterprises.” 55. Zhou, “Several Issues on Debt-for-Equity Swap.” 56. Bei and Feng, “Debt for Equity Swap Facing Many Challenges.” 57. Hu and Lu, “Debt for Equity Swap Policies for State-Owned Enterprises: Functional Defects and Institutional Dependence.” 58. Research Group of the Xin’gan County Branch of the People’s Bank of China, “The Interest Redistribution in Debt-Share Conversion: A Case Study of Biochemical Co. Ltd.” 59. Pan, “The Birth of China’s First Debt-for-Equity Swap Company.” 60. Hu and Lu, “Debt for Equity Swap Policies for State-Owned Enterprises: Functional Defects and Institutional Dependence.” 61. Qiao, “Empirical Analysis of China’s Debt for Equity Swap — A Case Study of China’s First Debt-for-Equity Swap Enterprise.”

174

Notes

62. Zhang, “Analysis on the Influence of Debt for Equity Swap on Enterprise Governance Structure and Its Outlook.”

Chapter 27 1.

Before 2004, this phenomenon was both referred to as “equity segmentation” and “share split,” and after 2004, the term “share split” was more widely used probably for the sake of more objective analysis. In fact, to classify shares according to the nature of shareholders existed for a long time in the history of Western shareholding system. Throughout this chapter, “circulation” means stock floating in the stock exchanges, and does not include the off-market transfer by agreement. 2. Wei Wenyuan, first President of Shanghai Stock Exchange, made a good statement on the effect of this debate on the share split system, “Based on the knowledge of thinkers and theorist circles on the economic system reform in the 1980s, the development of stock market should not only learn from the experience of capitalist mode of production to raise funds on the stock market, but also insist on the dominance of public ownership to make the state or legal persons with ownership by the whole people or collective ownership hold majority shares. To prevent the erosion of state-owned assets and maintain company control, these shares cannot be traded in the market” (Wei, “Shanghai Stock Exchange in the Start-Up Years”). 3. On March 28, 1987, the State Council issued the Notice on Strengthening the Management of Stocks and Bonds, which made it clear that “at present, stock issuance should be conducted under strict supervision and regulation, and is mainly limited to a small number of enterprises of collective ownership approved by the state. Stock issuance by enterprises owned by the whole people is not permitted.” 4. As the regulatory authority of the banking sector, People’s Bank of China made special provisions on this issue. In Notice of People’s Bank of China on Excising Strict Control over Stock Issuance and Transfer (No.323[1990]) released on December 4, 1990, it was stipulated that public offering and trading of stocks are only limited to Shenzhen and Shanghai on a trial basis; other regions are not allowed to approve the issuance and listing of stocks if without the permission from the head office. 5. Considering the initial conditions of China’s economic reform, the integration of SOEs and stockholding system is also inevitable. By the 1990s, the state-owned economy still maintained its absolute dominance in the national economy, and individual and private economy only took a small portion, inadequate for a standard shareholding reform. 6. The Company Law of People’s Republic of China passed in 1993 established the principle that “shares of the same class must have the same rights and benefits,” but did not specify the ownership structure of jointstock companies. However, the status of state shares and legal person shares as non-tradeable share did not change with the share classification in the Company Law. 7. Article 29 of the Interim Measures on the Management of State-Owned Shares of Joint Stock Limited Companies. 8. Article 36 of the Interim Provisions on the Management of the Issuing and Trading of Stocks. 9. The English Version is from http://www.lawinfochina.com/display.aspx?lib=law&id=6466 (accessed September 1, 2016). 10. Liu, Reform — Sixty Years of China’s Financial System, 254–55. 11. Qu, “Corporate Governance and State-Owned Shares in China Listed Companies.”

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Notes

12. Wu, China’s Stock Market: The Split Share Structure and Its Reform, 205–25. 13. Wu, Conflict and Overcoming: China’s Capital Market After the Split Share Reform. 14. For example, as mentioned by Liu Hongru, Deputy Director of State Commission for Restructuring the Economic System in one of his articles in 1991, “The insistence on the dominance of Socialist public ownership has two forms: statistic insistence and dynamic insistence. Statistic insistence requires a leading share of public economy in the joint-stock economy in absolute terms. Dynamic insistence allows to invest part of state assets in the stock market in order to realize the appreciation of state shares and increase the stock of state assets through share trading, on the premise of maintaining the dominance of public ownership…. When the stock market is on the rise, part of state shares can be unloaded in a planned way in exchange for investment returns that are many times higher than the original input to be used for developing emerging and basic industries. In this way, not only can the total volume of state assets be increased, but also the economic restructuring will be achieved” (Liu, “Actively Try Out the Shareholding System, Develop the Stock Market”). 15. STAQ system was prepared by China’s Securities Market Research and Design Center starting in March 1990, and launched on December 5 of the same year. It was a comprehensive over-the-counter market for security trading on the basis of a computer network. The system center is located in Beijing, connecting active stock markets in 95 large and medium cities and having more than 200 satellite sites. It provides its members with price information and settlement service of securities (including 15 kinds of securities under the four categories of legal person shares, government debts, financial bonds, and enterprise bonds). The STAQ system is managed by the State Commission for Restructuring the Economic System and before the pilot reform, it was mainly used for the transfer of government debts. 16. Before that, most discussions were on the circulation of state-owned shares and until then, the appeal for the reduction of state-owned stocks was heard. 17. The English version is from Interim Measures of the State Council on the Management of Reducing Held State Shares and Raising Social Security Funds, http://www.lawinfochina.com/display. aspx?lib=law&id=1847&CGid= (accessed September 28, 2016). 18. Ironically, at the day when the Temporary Administration Measures on the Reduction of State Owned Shares for the Raising of Social Security Capital was promulgated, Finance Minister Xiang Huaicheng commented that this reform measures will be favorable to the market, and two days later, Chairman of CSRC Zhou Xiaochuan expressed that the reduction of state shares will only have a limited influence on the secondary market (Lu, Restless Hand — The Evolution of China’s Stock Market System,159). 19. Wu, Conflict and Overcoming: China’s Capital Market After the Split Share Reform. 20. China Securities Regulatory Commission, Report of China’s Capital Market Development; Lu, Restless Hand — The Evolution of China’s Stock Market System. 21. Qu and Li, “Break the Split Share Structure, and Rebuild the Market Foundation.” 22. China Securities Regulatory Commission, Report of China’s Capital Market Development,53.

176

Notes

Chapter 28 1.

The tax rate for larger state-owned enterprises was 55% and for small ones, progressive tax rates of eight levels were applied. The after-tax profits of state-owned enterprises, after turned over to the state in various forms, can be retained by the enterprises themselves at a certain proportion. 2. The preferential policy for Special Economic Zones also applies to Shanghai Pudong Development Zone. 3. If a company has operated at a loss since it starts in a certain year, then those years could not be counted into the tax remission period; however, once it begins to make a profit and enters the tax remission period, the period will be calculated continuously and the loss years occurred afterwards must be counted. 4. Xinhuanet, “Unifying Enterprise Income Tax Rates for Domestic Enterprises and Foreign-Invested Enterprises Is Our Most Pressing Priority.” 5. Sina Finance Website, “Last Push for the Merger of Enterprise Income Tax Laws for Domestic and Foreign-Invested Companies.” 6. The statistics are from the Website of Ministry of Commerce of People’s Republic of China. 7. The English translation is from http://forum.hktdc.com/topic/4588/1/en/State-Council’s-Detailedimplementation-of-the-tax-preferential-policies-as-provided-under-the-PRC-Enterprise-Income-Tax.htm (accessed October 6, 2016). 8. The statistics are from the website of Ministry of Commerce of People’s Republic of China. 9. Before 1994, the tax rate for large to medium-sized stated-owned enterprises was as high as 55%. 10. Currently, the New EIT Law only allows a low tax rate in ethical minority areas and the west region.

177

Bibliography Chapter 22 Chinese materials:

Chen Gong 陳共. “Zhongguo fenshuizhi gaige” 中國分稅制改革 [China’s Split Share Reform]. Chen Gong wenji 陳共文集 [Collected Works of Chen Gong]. Beijing: China Renmin University Press, 2007. Guo Qingwang 郭慶旺, and Jia Junxue 賈俊雪. “Difang zhengfu xingwei, touzi chongdong yu hongguan jingji wending” 地方政府行為，投資衝動與 宏觀經濟穩定 [Local Government Behaviors, Investment Impulsion, Macroeconomic Stability]. Management World 管理世界, 5 (5) (2006). ———. “Difang zhengfu jian celue hudong xingwei, caizheng zhichu jingzheng yu diqu jingji zengzhang” 地方政府間策略互動行為、財政支出競爭與地 區經濟增長 [The Tactical Interaction Among Local Governments, Their Competition in Fiscal Expenditure, and Regional Economic Growth]. Management World 管理世界, (10) (2009). ———. “Caizheng fenquan, zhengfu zuzhi jiegou yu difang zhengfu zhichu guimo” 財政分權、政府組織結構與地方政府支出規模 [Fiscal Decentralization, Government Structure and Local Governments’ Expenditure Size]. Economic Research Journal 經濟研究, (11) (2010). Guo Qingwang 郭慶旺, and Zhao Zhigeng 趙志耕. Gonggong jingji xue 公共經濟學 [Public Economics]. Beijing: Higher Education Press, 2006. Jia Junxue 賈俊雪, and Guo Qingwang 郭慶旺. “Zhengfu jian caizheng shouzhi zeren an’pai de diqu jingji zengzhang xiaoying: Shizheng fenxi” 政府間財政收支 責任安排的地區經濟增長效應：實證分析 [The Effects of Intergovernmental Assignments of Public Revenue and Expenditure Responsibility on the Regional Growth: Empirical Analysis]. Economic Research Journal 經濟研究, (8) (2008). Jia Junxue 賈俊雪, Guo Qingwang 郭慶旺, and Liu Xiaolu 劉曉璐. “Ziben xing zhichu fenquan, gonggong ziben touzi goucheng yu jingji zengzhang” 資本性支出分權、公共資本投資構成與經濟增長 [Capital Expenditure Decentralization, Public Capital Investment Composition and Economic Growth]. Economic Research Journal 經濟研究, (12) (2006). Jia Junxue 賈俊雪, Guo Qingwang 郭慶旺, and Ning Jing 寧靜. “Caizheng fenquan, zhengfu zhili jiegou yu xian ji caizheng jiekun” 財政分權、政府治理結構與 縣級財政解困 [Fiscal Decentralization, Structure of Government Control, and Settlement of County Governments’ Difficulties]. Management World 管理世界, (1) (2011). 179

Bibliography

Jia Kang 賈康, and Bai Jingming 白景明. “Xian xiang caizheng jiekun he caizheng tizhi chuangxin“ 縣鄉財政解困和財政體制創新 [Overcoming Difficulties in Public Finance at County and Township Level and Innovation in Fiscal System]. Economic Research Journal 經濟研究, (2) (2002). Li Ping 李萍. Caizheng tizhi jianming tujie 財政體制簡明圖解 [A Brief Illustrated Guide to the Fiscal System]. Beijing: China Financial and Economic Publishing House, 2010. Liu Zhongli 劉仲藜. “1994 nian cai shui tizhi gaige huigu” 1994年財稅體制改革回 顧 [Review of the Fiscal and Taxation Reform in 1994]. Tide of the Century 百 年潮, (4) (2009). Ma Guochuan 馬國川. Gongheguo buzhang fangtan lu 共和國部長訪談錄 [Interviews with Ministers of People’s Republic of China]. Beijing: SDX Joint Publishing Company, 2009. Wang Xiaolong 王小龍. “Xian xiang caizheng jiekun yu zhengfu gaige: Mubiao jianrong yu lujing sheji” 縣鄉財政解困與政府改革：目標兼容與路徑設計 [Alleviation of the Fiscal Difficulty in the County and Township Levels and Governmental Reform: Compatibility and Reform Path]. Finance & Trade Economics 財貿經濟, (7) (2006). Xie Xuren 謝旭人. Zhongguo caizheng gaige sanshi nian 中國財政改革三十年 [30 Years of China’s Fiscal Reform]. Beijing: China Financial and Economic Publishing House, 2008. Zhang Yan 張晏, and Gong Liutang 龔六堂. “Fen shui zhi gaige, caizheng fenquan yu Zhongguo jingji zengzhang” 分稅制改革、財政分權與中國經濟增長 [The Split Share Reform, Fiscal Decentralization and Economic Growth in China]. China Economic Quarterly 經濟學（季刊）, (1) (2005). Zhou Li’an 周黎安. “Jinsheng boyi zhong zhengfu guanyuan de jili he hezuo” 晉升博弈中政府官員的激勵和合作 [The Incentive and Cooperation of Government Officials in the Political Tournaments]. Economic Research Journal 經濟研究, (6) (2004).

English materials:

Baqir, R. “Districting and Government Overspending.” Journal of Political Economy, 110 (2002). Bordignon, M., P. Manasse, and G. Tabellini. “Optimal Regional Redistribution under Asymmetric Information.” American Economic Review, 91 (2001). Brennan, G., and J. Buchanan. The Power to Tax. Cambridge: Cambridge University Press, 1980. Gilbert, G., and P. Picard. “Incentives and Optimal Size of Local Jurisdictions.” European Economic Review, 40 (1996).

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Hocman, O., D. Pines, and J-F. Thisse. “On the Optimal Structure of Local Governments.” American Economic Review, 85 (1995). Rodden, J. “Reviving Leviathan: Fiscal Federalism and the Growth of Government.” International Organization, 57 (2003). Wilson, J. D. “A Theory of Interregional Tax Competition.” Journal of Urban Economics, 19 (1986). Zodrow G. R., and P. Mieszkowski. “Pigou, Tiebout, Property Taxation and the Under Provision of Local Public Goods.” Journal of Urban Economics 19 (1986):356–70.

Chapter 23 Chinese materials:

Chen Gong 陳共. Caizheng xue 財政學 [Public Finance]. Beijing: China Renmin University Press, 2009. Chen Jiagui 陳佳貴. Zhongguo shehui baozhang fazhan baogao 中國社會保障發展報告 [China Social Security System Development Report]. Beijing: China Social Sciences Academic Press, 2001. China News Service. “Laodong he shehui baozhang bu: Yanglao baoxian geren zhanghu kongzhang jin 6 qianyi” 勞動和社會保障部：養老保險個人賬戶空 賬近6千億 [Ministry of Human Resources and Social Security of the People’s Republic of China: The Value of Empty Personal Accounts Reached Nearly CNY6 Trillion]. Sohu.com. September 21, 2004. Accessed October 24, 2016. http://news.sohu.com/20040921/n222153145.shtml. Department of Population and Employment Statistics of the State Statistics Bureau, and Department of Planning and Finance of the Ministry of Human Resources and Social Security. Zhongguo laodong tongji nianjian 中國勞動統 計年鑒 [China Labour Statistical Yearbook]. Beijing: China Statistics Press, 1993 and 1999. Editorial Board of Almanac of China’s Economy. Zhongguo jingji nianjian 1999 中國經 濟年鑒1999 [Almanac of China’s Economy 1999]. Beijing: Press of Almanac of China’s Economy, 1999. Gan Chongdou 甘重斗, ed. Zhongguo falü nianjian 1990 中國法律年鑒1990 [Law Yearbook of China 1990]. Beijing: Press of Law Yearbook of China, 1990. Ge Yanfeng 葛延風, et al. “Zhongguo chengzhen yanglao baoxian zhidu gaige de jianyao huigu” 中國城鎮養老保險制度改革的簡要回顧 [A Brief Review of China’s Urban Pension System Reform]. The Information Website of Development Research Center of the State Council, 2000. Accessed October 4, 2016. http://expert.drcnet.com.cn/Showdoc.aspx?doc_id=123282.

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Information Website of the Development Research Center of the State Council. “1989–2008 nian quanguo jiben yanglao baoxian qingkuang” 1989–2008 年全國基本養老保險情況 [Situations of National Basic Old-Age Insurance Between 1989 and 2008]. Lu Ting 陸婷. “2000 nian laodong baozhang gongzuo shouyao renwu rengran shi liangge quebao” 2000年勞動保障工作首要任務仍然是兩個確保 [Two Guarantees Remain the Major Task for Labor Security Work in 2000,” China Social Security]. China Social Security 中國社會保障, (2) (2000). Ministry of Human Resources and Social Security of the People’s Republic of China. Laodong he shehui baozhang shiye fazhan tongji gongbao 勞動和社會保 障事業發展統計公報 [Statistical Communique of Labor and Social Security in China]. Website of Ministry of Human Resources and Social Security of the People’s Republic of China. Various years. http://www.mohrss.gov. cn/SYrlzyhshbzb/zwgk/szrs/. Xin Changxing 信長星. “Baozhang jiben shenghuo, cujin zai jiuye, jiexu shehui baoxian — Zhongguo chenggong jiejue guoyou qiye xiagang zhigong wenti de zhengce yu shijian” 保障基本生活，促進再就業，接續社會保險——中 國成功解決國有企業下崗職工問題的政策與實踐 [Guarantee Basic living, Boost Reemployment, Continue Social Insurances — Policies and Practice of China in Solving Laid-Off Workers from State-Owned Enterprises]. http://www.cajy.gov.cn/news/%D4%D9%BE%CD%D2%B51.htm. Zhu Qing 朱青. Zhongguo de shehui baozhang zhidu wanshan yu caizheng zhichu jiegou youhua yanjiu 中國的社會保障制度完善與財政支出結構優化研究 [Research on the Perfection of China’s Social Security System and the Optimization of Fiscal Spending Structure]. Beijing: China Renmin University Press, 2010.

English material:

Jiang Zemin. “Hold High the Great Banner of Deng Xiaoping Theory for an Allround Advancement of the Cause of Building Socialism With Chinese Characteristics’ Into the 21st Century.” Report delivered at the 15th National Congress of the Communist Party of China on September 12, 1997. Accessed June 21, 2016. http://www.bjreview.com.cn/document/ txt/2011-03/25/content_363499.htm.

Chapter 24 Chinese materials:

Chen Gong 陳共. “Jiji caizheng zhengce de xiaoying fenxi” 積極財政政策的效應分 析 [Analysis on the Effect of Proactive Fiscal Policy]. Contemporary Finance & Economics 當代財經, (10) (1999).

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———. Caizheng xue 財政學 [Public Finance]. Beijing: China Renmin University Press, 2002. Cong Ming 從明. “Guanyu jiji caizheng zhengce ruogan wenti taolun lunshu” 關於 積極財政政策若干問題討論論述 [Discussions on Several Issues Concerning Proactive Fiscal Policy]. Economic Review 經濟縱橫, (4) (2001). Dai Genyou 戴根有. “Guanyu woguo huobi zhengce de lilun yu shijian wenti” 關於 我國貨幣政策的理論與實踐問題 [The Theory and Practice of the Monetary Policy of China]. Journal of Financial Research 金融研究, (9) (2000). Dai Yuanchen 戴圓晨. Jiji caizheng zhengce yu hongguan jingji tiaokong 積極財政政策 與宏觀經濟調控 [Proactive Fiscal Policy and Macroeconomic Regulation]. Beijing: People’s Publishing House, 2003. Duan Guoxu 段國旭. “Lun jiji de caizheng zhengce” 論積極的財政政策 [On Proactive Fiscal Policy]. China Finance Information 中國財經信息資料, (1) (1999). Gong Xikui 宮希魁. “Jingji zhengce chengwei ying zhunque guifan — Dui dangqian caizheng ji huobi zhengce biaoshu fangshi de kanfa” 經濟政策稱謂應準 確規範——對當前財政及貨幣政策表述方式的看法 [Names of Economic Policies Should be Standardized — Opinions on the Expressions of Current Fiscal and Monetary Policies]. Reform Times 改革時報, Dec. 9, 1999. Guo Qingwang 郭慶旺, and Zhao Zhiyun 趙志耘. Caizheng lilun yu zhengce — Dangqian ruogan zhongda wenti tantao 財政理論與政策 —— 當前若干重大問 題探討 [Fiscal Theory and Policy — A Discussion on Several Current Key Issues]. Beijing: Economic Science Press, 1999. ———. Caizheng xue 財政學 [Public Finance]. Beijing: China Renmin University Press, 2002. ———. Gonggong jingji xue 公共經濟學 [Public Economics]. Beijing: Higher Education Press, 2010. Guo Qingwang 郭慶旺, Zhao Zhiyun 趙志耘, and He Chengcai 何乘才. Jiji caizheng zhengce ji qi yu huobi zhengce peihe yanjiu 積極財政政策及其與貨幣政策配 合研究 [Research on Proactive Fiscal Policy and Its Coordination with Monetary Policy]. Beijing: China Renmin University Press, 2004. Jia Kang 賈康. “Guanyu jiji caizheng zhengce de ruogan renshi” 關於積極財政政策 的若干認識 [Consideration on the Pro-active Fiscal Policy in China]. Journal of Central University of Finance & Economics 中央財經大學學報, (4) (2003a). ———. “Woguo caizheng zhengce de jianyao huigu yu xiaoying pingxi” 我國財政 政策的簡要回顧與效應評析 [Brief Review and Effect Analysis on China’s Fiscal Policy]. Collected Essays on Finance and Economics 財政論叢, (1) (2003b). Jin Renqing 金人慶. Zhongguo caizheng zhengce lilun yu shijian 中國財政政策理論與

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實踐 [Theory and Practice of China’s Fiscal Policy]. Beijing: China Financial and Economic Publishing House, 2005. Liu Heng 劉恆. Dangdai Zhongguo jingji zhouqi bodong ji xingcheng jili yanjiu 當 代中國經濟週期波動及形成機理研究 [Business Cycle Fluctuations in Contemporary China and Its Formation Mechanism Research]. Chengdu: Southwest University of Finance and Economics Publishing House, 2003. Liu Jinquan 劉金泉, Cui Chang 崔暢, and Xie Weidong 謝衛東. “Caizheng zhengce zuoyong de jieduan xing he fei duichen xing jianyan” 財政政策作用的階段 性和非對稱性檢驗 [Tests on the Stages and Asymmetry of the Fiscal Policy Effect]. Finance & Economics 財經科學, (1) (2003). Liu Rongcang 劉溶滄. “Guanyu jiji caizheng zhengce de jige wenti (shang, xia)” 關 於積極財政政策的幾個問題（上、下） [Several Questions about Proactive Fiscal Policy (Volume 1&2)]. Finance & Trade Economics 財貿經濟, (3,4) (2001). Ni Hongri 倪紅日. “Jiexi jiji caizheng zhengce de hanyi” 解析積極財政政策的含義 [Interpreting the Proactive Fiscal Policy]. Public Finance Research 財政研究, (6) (2000). Policy and Regulations Department of the State Administration of Taxation. Zhongguo shuishou zhengce qianyan wenti yanjiu 中國稅收政策前沿問題研究 [Frontier Tax Policy Study in China]. Beijing: China Taxation Publishing House, 2003. Research Group of the Research Bureau of the People’s Bank of China. “Zhongguo huobi zhengce fenxi” 中國貨幣政策分析 [Analysis on China’s Monetary Policy]. Economic Research Journal 經濟研究, (3) (1999). Shen Chengxiang 沈程翔. “Zhongguo chukou daoxiang xing jingji zengzhang de shizheng fenxi: 1977–1998” 中國出口導向型經濟增長的實證分析：1977– 1998 [Empirical Analysis on the Export-Oriented Economic Growth in China: 1977–1998]. The Journal of World Economy 世界經濟, (12) (1999). Wang Bo’an 王保安. “Zhongguo caizheng zhengce de beijing yu yaodian fenxi” 中 國財政政策的背景與要點分析 [Analysis on the Background and Highlights of China’s Fiscal Policy]. Public Finance Research 財政研究, (3) (2002). Wang Chunzheng 王春正. Tansuo shijian: Hongguan jingji yunxing yu tiaokong 探 索 實踐：宏觀經濟運行與調控 [Exploration and Practice: Macroeconomic Operation and Regulation]. Beijing: Economic Science Press, 2003. Wu Junpei 吳俊培. “Jiji caizheng zhengce ji xiaoying pingxi” 積極財政政策及效 應評析 [Proactive Fiscal Policy and Its Effect Evaluation]. Contemporary Finance & Economics 當代財經, (12) (2001). Xie Ping 謝平. “Xin shiji Zhongguo huobi zhengce de tiaozhan” 新世紀中國貨幣 政策的挑戰 [Challenges to China’s Monetary Policy in the New Century].

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Journal of Financial Research 金融研究, (1) (2000). Ye Zhenpeng 葉振鵬, and Jiao Jian’guo 焦建國. “Jiji de caizheng zhengce: Jinqi quxiang yu zhidu jichu” 積極的財政政策：近期取向與制度基礎 [Proactive Fiscal Policy: Short-Term Trend and Institutional Basis]. Economist 經濟學 家, (3) (2002). Yuan Enzhen 袁恩幀. Kuoda xuqiu lilun 擴大需求理論 [The Theory of Demand Expansion]. Shanghai: Shanghai Academy of Social Sciences Press, 2001. Zhang Yongjun 張永軍, and Li Zhenzhong 李振仲. Tonghuo jinsuo de lilun yu xianshi 通貨緊縮的理論與現實 [Theory and Reality of Deflation]. Beijing: China Economic Press, 2000. Zhu Guangjun 朱廣俊, and Chen Jianzhong 陳建中. “Jiji caizheng zhengce” 積極 財政政策 [Proactive Fiscal Policy]. China Taxation News 中國稅務報, August 11, 1999.

Translated Materials:

Keynes, John Maynard. Jiuye, lixi he huobi tonglun 就業、利息和貨幣通論 [The General Theory of Employment, Interest, and Money]. Beijing: The Commercial Press, 1999. Samuelson, Paul A. Jingjixue 經濟學 [Economics]. Trans. Gao Hongye 高鴻業, et al. Tenth Edition. Beijing: The Commercial Press, 1979.

English materials:

James, S. A Dictionary of Taxation. Cheltenham: Edward Elgar, 1998. Keynes, John Maynard. “The Marginal Propensity to Consume and the Multiplier.” Chapter 10 of The Propensity to Consume. Book III of The General Theory of Employment, Interest, and Money. Accessed August 16, 2016. https://www. marxists.org/reference/subject/economics/keynes/general-theory/ch10. htm. Vernez, G. Public Works as Countercyclical Fiscal Policy. Santa Monica, CA: The Rand Corporation, 1977.

Chapter 25 Chinese materials:

Cong Ming 叢明. “Jiji wentuo di tuijin cai shui tizhi gaige” 積極穩妥地推進財稅 體制改革 [To Actively and Steadily Promote the Reform of Fiscal and Tax Systems]. Hebei Economic Information Center. June 22, 2005. Department of Budget of the Ministry of Finance of the People’s Republic of China. Zhongyang bumen yusuan bianzhi zhinan (2002 nian) 中央預算編制指

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南（2002年） [Guide to the Budget Preparation of the Central Government (2002)]. Beijing: China Financial and Economic Publishing House, 2002. Gao Peiyong 高培勇. Zhongguo cai shui tizhi gaige 30 nian yanjiu 中國財稅體制改革 30年研究 [Research on the 30 Years of China’s Fiscal and Taxation System Reform]. Beijing: Economy and Management Publishing House, 2008. Jia Kang 賈康, and Su Ming 蘇明. Bumen yusuan bianzhi wenti yanjiu 部門預算編 制問題研究 [Study on the Problems of Departmental Budgeting]. Beijing: Economic Science Press, 2004. Li Ping 李萍, and Liu Shangxi 劉尚希. Bumen yusuan lilun yu shijian 部門預算理論 與實踐 [Theory and Practice of Departmental Budgeting]. Beijing: China Financial and Economic Publishing House, 2003. Li Yan 李燕. Zhengfu yusuan guanli 政府預算管理 [Government Budget Management]. Beijing: Peking University Press, 2008. Liu Youbao 劉有寶. Zhengfu bumen yusuan guanli 政府部門預算管理 [Government Departmental Budgeting Management]. Beijing: China Financial and Economic Publishing House, 2006. State Treasury Bureau of the Ministry of Finance. Guoku xianjin guanli jichu yu shiwu 國庫現金管理基礎與實務 [Fundamentals and Practice of Treasury Cash Management]. Beijing: Economic Science Press, 2007. Wang Xiuzhi 王秀芝. Bumen yusuan zhidu yanjiu 部門預算制度研究 [Research on the Department Budgeting System]. Beijing: Economic Science Press, 2007. Wang Yongjun 王雍君. Guoku gaige yu zhengfu xianjin guanli 國庫改革與政府現金管 理 [Treasury Reform and Government Cash Management]. Beijing: China Financial and Economic Publishing House, 2006. The Website of Ministry of Finance of the People’s Republic of China. “Jin yi bu guifan he wanshan zhengfu caigou zhidu — Caizheng bu buzhang Xie Xuren jieshou Zhongguo zhengfu caigou bao jizhe zhuanfang” 進一步規範 和完善政府採購制度——財政部部長謝旭人接受《中國政府採購報》記者 專訪 [To Further Regulate and Perfect the Government Procurement System — An Exclusive Interview with Finance Minister Xie Xuren by the China Government Procurement News]. Accessed October 2, 2016. http://www. mof.gov.cn/zhengwuxinxi/caizhengxinwen/201005/t20100510_291263. html. Xie Xuren 謝旭人. Zhongguo caizheng gaige sanshi nian 中國財政改革三十年 [30 Years of China’s Fiscal Reform]. Beijing: China Financial and Economic Publishing House, 2008. Zhang Ming 張明. Zhengfu yusuan shiwu yu anli 政府預算實務與案例 [Practices and Case Study of Government Budgeting]. Beijing: China Financial and Economic Publishing House, 2009.

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Chapter 26 Chinese materials:

Bei Zhengxin 貝政新, and Feng Xun 馮恂. “Mianlin duo fang kaoyan de ‘Zhai zhuan gu’ ” 面臨多方考驗的“債轉股” [Debt for Equity Swap Facing Many Challenges]. Journal of Financial Research 金融研究, (12) (1999). China Macroeconomic Information Network. “Guanyu zhai zhuan gu wenti zongshu” 關於債轉股問題綜述 [Overview of Debt-for-Equity Swap]. April 29, 2001. Dai Xianglong 戴相龍. “Guowuyuan xinwen bangongshi juxing de zhongwai jizhe zhaodaihui” 國務院新聞辦公室舉行的中外記者招待會 [Speech at the Press Conference Held by the Information Office of the State Council]. Global Financial Times 國際金融時報, January 1998. General Department of the State Economic and Trade Commission. “Guoyou gongye qiye ji guoyou da zhong xing gongye qiye jiben qingkuang” 國 有工業企業及國有大中型工業企業基本情況 [General Situations of StateOwned Industrial Enterprises and State-Owned Large- and Medium-Sized Industrial Enterprises]. Economic Work Newsletter 經濟工作通訊, (23) (1997). Hu Yuming 胡玉明. “Cong licai he kuaiji de jiaodu pingxi ‘zhai zhuan gu’ ” 從理財 和會計的角度評析“債轉股” [Evaluating Debt for Equity Swap from the Perspectives of Financing Planning and Accounting]. Guangxi Accounting 廣西會計, (5) (2000). ———. “Jiekai gongsi licai si shi er fei de miansha” 揭開公司理財似是而非的面紗 [Unveil the Myths of Corporate Finance]. Finance and Accounting 財政與會 計, 4 (2002). Hu Yuming 胡玉明, and Lu Haifan 魯海帆. “Guoyou qiye ‘zhai zhuan gu’ zhengce: Gongneng quexian yu zhidu yilai” 國有企業“債轉股”政策：功能缺陷 與制度依賴 [Debt for Equity Swap Policies for State-Owned Enterprises: Functional Defects and Institutional Dependence]. Communication of Finance and Accounting 財會通訊, (5) (2005). Huang Jinlao 黃金老. “Lun zhai zhuan gu de lilun he zhengce wenti” 論債轉股的 理論和政策問題 [On the Theories and Policies of Debt for Equity Swap]. Journal of Financial Research 金融研究, (1) (2000). Li De 李德. “Zhongguo yinhang ye chuzhi buliang zichan de silu he tujing” 中 國銀行業處置不良資產的思路和途徑 [Ideas and Approaches for Dealing with Non-Performing Assets in China’s Banking Sector]. Journal of Financial Research 金融研究, (3) (2004). Li Jiyou 李霽友. “Lun guoyou qiye ‘zhai zhuan gu’ wenti” 論國有企業“債轉股” 問題 [On the Debt for Equity Swap of State-Owned Enterprises]. Collected Essays on Finance and Economics 財經論叢, (6) (1999).

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English material:

Lardy, Nicholas R. China’s Unfinished Economic Revolution. Washington D.C.: Brookings Institution Press, 1998.

Chapter 27 Chinese materials:

China Securities Regulatory Commission. Zhongguo ziben shichang fazhan baogao 中國資本市場發展報告 [Report of China’s Capital Market Development]. Beijing: China Financial Publishing House, 2008. Hu Ruyin 胡汝銀, ed. Zhongguo ziben shichang de fazhan yu bianqian 中國資本市場的 發展與變遷 [The Development and Evolution of China’s Capital Market]. Shanghai: Truth and Wisdom Press, and Shanghai People’s Publishing House, 2008. Liu Hongru 劉鴻儒. “Jiji shixing gufenzhi, fazhan gupiao shichang” 積極試行股份

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制，發展股票市場 [Actively Try Out the Shareholding System, Develop the Stock Market]. In Zhongguo zhengquan shi chang (1991) 中國證券市場（1991 ）[China’s Securities Market 1991]. Eds. Jin Jiandong 金建棟, Xiao Zhuoji 蕭灼基, and Xu Shuxin 許樹信. Beijing: China Financial Publishing House, 1991. Liu Hongru 劉鴻儒. Biange — Zhongguo jinrong tizhi fazhan liushi nian 變革——中國 金融體制發展六十年 [Reform — Sixty Years of China’s Financial System]. Beijing: China Financial Publishing House, 2009. Lu Yi 陸一. Xian bu zhu de shou — Zhongguo gushi tizhi jiyin yanhuashi 閒不住的 手——中國股市體制基因演化史 [Restless Hand — The Evolution of China’s Stock Market System]. Beijing: China CITIC Press, 2008. Qu Qiang 瞿強, and Li Yue 李悅. “Dapo guquan fenlie, chonggou shichang jichu” 打破股權分裂，重構市場基礎 [Break the Split Share Structure, and Rebuild the Market Foundation]. China Securities Journal (Theoretical Edition) 中國證 券報（理論整版）, 2004. Wei Wenyuan 尉文淵. “Shang jiao suo de chuchuang suiyue” 上交所的初創歲月 [Shanghai Stock Exchange in the Start-Up Years]. In Huimou Zhongguo gushi (1984–2000) 回眸中國股市（1984–2000） [Reviewing China’s Stock Market, 1984–2000]. Eds. Fan Yongjin 范永進 and Qiang Jiying 強紀英. Shanghai: Shanghai People’s Publishing House, 2000. Wu Xiaoqiu 吳曉求. Zhongguo ziben shichang: Guquan fenzhi yu liudong xing biange 中國資本市場：股權分置與流動性變革 [China’s Capital Market: The Split Share System and the Liquidity Reform]. Beijing: China Renmin University Press, 2004. ———. Zhongguo zhengquan shichang: Guquan fenlie yu liudong xing biange 中國證 券市場：股權分類與流動性變革 [China’s Stock Market: The Split Share Structure and Its Reform]. Beijing: China Renmin University Press, 2004. ———. Chongtu yu chaoyue: Guquan fenzhi gaige hou de Zhongguo ziben shichang 衝 突與超越：股權分置改革后的中國資本市場 [Conflict and Overcoming: China’s Capital Market After the Split Share Reform]. Beijing: China Renmin University Press, 2006.

English material:

Qu Qiang. “Corporate Governance and State-Owned Shares in China Listed Companies.” Journal of Asian Economics 14 (2003): 771-783.

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Chapter 28 Chinese materials:

Institute of Finance and Trade Economics of Chinese Academy of Social Sciences. Zhongguo: Qidong xin yi lun shuizhi gaige — Li’nian zhuanbian, zhengce fenxi he xiangguan anpai 中國：啟動新一輪稅制改革——理念轉變，政策分析 和相關安排 [China: Initiating A New Round of Tax Reform — Concept Transformation, Policy Analysis, and Relevant Arrangements]. Beijing: China Financial and Economic Publishing House, 2003. Liu Zuo 劉佐. Xin Zhongguo shuizhi 60 nian 新中國稅制60年 [60 Years of China’s Tax System]. Beijing: China Financial and Economic Publishing House, 2009. Qian Guanlin 錢冠林, and Wang Li 王力. Zhongguo shuishou 30 nian 中國稅收30年 [30 Years of China’s Taxation]. Beijing: China Taxation Publishing House, 2009. Sina Finance Website. “Neiwai zi qiye suodeshui hebing zuihou chongci” 內 外資企業所得稅合併最後衝刺 [Last Push for the Merger of Enterprise Income Tax Laws for Domestic and Foreign-Invested Companies]. January 4, 2007. Accessed October 6, 2016. http://finance.sina.com.cn/ roll/20070104/06511134351.shtml. Xinhuanet. “Jin Renqing: ‘Tongyi neiwai zi qiye suodeshui shuilü pozaimeijie’ ” 金人慶：統一內外資所得稅稅率迫在眉睫 [Unifying Enterprise Income Tax Rates for Domestic Enterprises and Foreign-Invested Enterprises Is Our Most Pressing Priority]. June 28, 2005. Accessed October 6, 2016. http:// news.xinhuanet.com/zhengfu/2005-06/28/content_3146788.htm. Zhu Qing 朱青. “Shuishou youhui yu xiyin waizi — Fazhanzhong guojia de jingyan he wenti” 稅收優惠與吸引外資——發展中國家的經驗和問題 [Tax Preferences and the Attraction of Foreign Capital — Experience and Problems of Developing Countries]. International Taxation in China 涉外稅 務, (12) (1998).

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Index accounting, independent 164–65 allowances, laid-off 33 APEC (Asia-Pacific Economic Cooperation) 83 Asian Financial Crisis 45, 49–50, 52–53, 123 assets, bad 122–23, 125–28, 130

CPC Central Committee 5, 8, 29–30, 32, 37, 40, 50, 117, 144, 160 CPI (consumer price index) 50, 55 CSRC (China Securities Regulatory Commission) 114, 118, 133, 137, 144–47, 149–50

banks central 56, 58, 106, 112, 116, 121, 123 specialized 114–16 state-owned 16, 56, 58, 112–13, 117, 124 BVI (British Virgin Islands) 164 budget compilation 80–83, 85–87, 89, 91– 92, 104–5 budget enforcement 80–82 budget management 83, 85–87, 90, 92 budget plans 82, 85, 103 departmental 80, 86–89, 91–92, 97, 104 budgeting departmental 80, 84–93, 103–4 traditional 89–91 budgeting reform, departmental 84–86, 103 business cycle 47, 49, 63–64 business tax 9, 11, 59, 68, 154–55

debt-for-equity swap policy 113, 117, 121, 125, 127, 129 debts bad 115, 117, 120, 123–25 SOEs 113, 115–16, 121, 124 deficit dependence 70 disposable income 8, 67, 69

capital market 116, 119, 128, 132–34, 138– 39, 141–44, 148, 151 corporate system, modern 15, 29, 120–121, 125, 128, 133 corruption 83–84, 99, 108, 110 countries developing 68, 70–71, 162 industrialized 53, 70–71 CPC (Communist Party of China) 28–31, 39, 46, 81, 117, 156

economy individual 63 state-owned 63, 116, 144 transitional 123–24 EIT (enterprise income tax) 11, 154–66 EIT consolidation 160–163, 165 EIT Law 154–57, 159–65 New 154, 161, 164–66 DEs (domestic enterprises) 156, 159, 16365 FIEs (foreign-invested enterprises) 156– 59 expenditure decentralization 20–21 expenditure responsibilities 10, 20–21 FAMCs (financial asset management company) 112, 116–18, 121–30 FAMC China Cinda 118, 130 China Great Wall 118, 129 China Huarong 118 China Orient 118 193

Index

financial crisis 45, 52, 123 fiscal decentralization 20, 22, 24–25 fiscal reform 5, 8, 11, 108 FDI (foreign direct investment) 53, 163 funds budgetary 21, 32, 34, 88, 90, 108 extrabudgetary 86, 88, 90, 92, 94, 108 gap, fiscal 4–5 GDP 3, 15, 25, 28, 50, 52–53, 57, 62, 64–65, 67, 74–75 government central 3–4, 7–10, 12–19, 24–25, 28, 32, 34–35, 38–39, 41, 46–47, 75, 84, 87, 92–93, 116 county-level 17, 20–21 gross-roots 24 municipal 7, 21 provincial 21, 135, 157 government procurement 80, 83, 96, 98– 101, 103, 108–10 Government Procurement Law 98, 100, 108–9 government procurement reform 107–8, 110 government procurement system 80, 83, 98–99, 107–8 income tax 15–16, 23, 35, 69, 154–55, 157– 58, 163 corporate 60, 62, 68 IPO (initial public offering) 133, 141 IMF (International Monetary Fund) 162 index RPI (retail prices index) 50, 55 PPI (producer price index) 50, 55 laid-off system 30–31, 33–34 laid-off workers 28–34, 39–40, 51, 59

194

market, secondary 123, 142 market economy 5, 8, 22, 44, 77, 87, 108, 118 moral hazard 22, 25, 119, 124–27, 139 NDRC (National Development and Reform Commission) 32, 89 old-age insurance funds 36 old-age insurance system 29, 35–39 OAA (Osaka Action Agenda) 83 P/E ratio (price-to-earnings ratio) 140, 144 PBC (People’s Bank of China) 86, 94–95, 97–98, 105, 107, 114, 118, 121 PBC treasury 106–7 policy counter-cyclical 63 procyclical 63, 66 propensity, marginal 67, 69 ratio, deficit dependence 70–71 Reform and Opening Up 29–30, 44, 52, 54, 61, 64–65, 74–75, 83 revenues budgetary 62, 83, 92, 95 extrabudgetary 86,89, 91-92,94 SDPC (State Development Planning Commission) 57, 85–86, 114 SETC (State Economic and Trade Commission) 85, 112–14, 118, 121– 22 shares employee 137 individual 134 legal person 132, 134–36, 143–44 public-owned 132–34 state-owned 134–38, 144–46 tradeable 132, 136, 138–39, 141–44, 147– 48

Index

non-tradeable 132, 135, 138–43, 146–48 single account system 80, 94, 105–6 SOEs (state-owned enterprises) 9, 28–32, 34–36, 39, 50–51, 59, 62, 76, 112–17, 121, 126, 128–29, 133–35, 144, 155– 56 SOE reform 28, 30-31, 33-34, 36, 40, 51, 62, 122, 144 Special Economic Zones 157, 164 tax central 2–3, 9–10, 13 local 2, 9–10, 15 tax areas high 164–65 low 165 tax avoidance 164–65 tax burden 68, 160, 162, 164 tax-for-profit reform 155 tax heavens 163–64 tax incentives 60, 154, 156–57, 163 tendering competitive negotiation 100–101 invited 100–101 open 98, 100–101, 109 request for quotation 100, 102 single-source procurement 100, 102 trading, insider 139, 142 transfer payments 13, 16–21, 24–26, 96–97

195