The 2014-2016 Fiscal Reform Program and its Challenges

Key Insight

The 2014-2016 fiscal reform program, initiated by Xi Jinping's government, directly addresses critical flaws in the post-1994 fiscal system. These problems included local governments' disproportionate expenditure responsibilities compared to their direct revenue resources, which drove reliance on unsustainable sources like land sales, the accumulation of massive, often inappropriately structured debts despite formal borrowing bans, the poor functioning of the central-local transfer system designed to balance local budgets, and a tax structure that fostered excessive investment in capital-intensive industry and infrastructure. The reform aims to rectify these issues, increase central government power, and grant localities more budgetary discretion in exchange for stricter accountability.

The reform package comprises four main elements. First, it involves restructuring local government debt; in 2015, new borrowing by 'local government financing vehicles' (LGFVs) was banned, and 1 trillion RMB of their debt was restructured into long-term bonds, with the eventual goal of converting all infrastructure-related local debt into bonds or public-private partnerships. Second, it adjusts the level and structure of local revenues and expenditures by reassigning some program responsibilities, particularly in education, healthcare, and social welfare, back to the central government. The tax structure will also change to de-emphasize capital-intensive industries in favor of services and consumer spending through a consumption-focused VAT, value-based mining taxes, and stiffer environmental taxes; a property tax, though economically sensible, faces significant political opposition.

Third, the reform seeks to improve the central-local transfer system by moving away from over 200 separate, earmarked transfer programs towards providing localities with more general transfers or block grants, aiming for greater predictability and flexibility. Fourth, budget accountability is being strengthened through a revised Budget Law (passed September 2014) that restricts officials' reliance on off-budget funds and imposes more stringent reporting requirements. While the political and economic aims are to centralize power, increase discipline, and shift local officials' incentives away from land speculation and capital-intensive industry towards public goods and services, a significant challenge remains. The authorities' 'no-default' rule for local government bonds, implying central government or People's Bank of China bailouts, risks undermining market discipline by allowing localities to borrow at uniformly low interest rates, thereby negating incentives for sound fiscal management.