The 1994 Tax Reform and the Emergence of Land-Based Local Financing

Key Insight

The reform-era fiscal system saw a major division in 1994, following a period of rapid decentralization. During the planned economy era and early reforms, government revenues, primarily from state-owned enterprise (SOE) surpluses, plummeted from over 30% of GDP in 1978 to less than 11% by 1994. The central government's proportion of revenue also sharply declined from a peak of 41% in 1984 to just 22% in 1993. This decline sparked concerns in Beijing that the central government lacked sufficient revenue to fund its activities and adequate leverage to control localities and enforce national policies, especially when compared to developing countries typically collecting at least 20% of GDP and rich countries over 30%.

The 1994 tax reform aimed to resolve these issues by increasing total government revenues and ensuring the central government controlled at least half. Under the new system, central and local governments received fixed shares of each tax; for the crucial Value-Added Tax (VAT), the central share was 75% and the local share 25%, while localities retained all revenue from the 'business tax' and corporate income tax from locally controlled firms. This reform had an immediate and permanent impact, with the central share of revenues leaping from 22% in 1993 to 56% in 1994, remaining above 50% until 2010. Total government revenue collection, though slower to emerge, also significantly improved, rising from just over 10% of GDP in 1996 to 23% in 2013.

Despite strengthening central power, the 1994 reform structurally burdened local governments with operating deficits, as they were assigned a minority of revenues but a majority of expenditures, initially around 70%. Although central government transfers were intended to balance local budgets, the system functioned poorly, compelling localities to seek alternative revenue. This pressure intensified as their pre-transfer deficits grew from about 3% of GDP in the mid-1990s to nearly 9% by 2013. Faced with 'unfunded mandates' and ballooning responsibilities, including funding social services post-SOE reform and urban infrastructure (local expenditure share rising from 69% in 2000 to 85% in 2011, or 1 trillion to 9.3 trillion RMB), localities turned to land. Starting in the early 2000s, cities created 'local government financing vehicles' (LGFVs) to borrow against urban land as collateral, with repayment financed by land sales or leases. This model, exemplified by Tianjin financing a 170 billion RMB project and raising 95 billion RMB from land sales in six years, led to land sales and leases accounting for about 20% of local government revenues by 2010. However, after 2008, especially following the 4 trillion RMB stimulus, it spiraled out of control, resulting in nearly 18 trillion RMB in local government liabilities by mid-2013.