Cover Story: China Plans Fiscal Overhaul to Fix Crisis in Local Government Finance

China is undergoing a significant overhaul of its fiscal system to address central-local financial relations in light of a sluggish post-pandemic economic recovery and declining local government revenues from land sales due to a real estate downturn. This reform, proposed at the Communist Party’s Third Plenary Session in July, is expected to be completed by 2029, focusing on expanding local governments' financial autonomy, revising tax-sharing mechanisms, and increasing the central government's spending share to relieve financial stress on local governments burdened by spending obligations and diminishing income streams [para. 1][para. 2]. The reform’s urgency is acknowledged, but the details remain uncertain [para. 3]. Unlike past consensus-driven reforms, this initiative is still in development, with extensive deliberations needed [para. 4].

Local governments are experiencing severe financial constraints, evidenced by halted public services and delayed salaries, highlighting structural imbalances between financial responsibilities of Beijing and local entities. Fiscal revenues have decreased, exacerbated by the pandemic and a prolonged real estate slump that traditionally funded local government through land sales, which have dropped for three years, resulting in over 3 trillion yuan in lost revenue [para. 5][para. 6][para. 7]. While the 1994 tax reform increased Beijing’s fiscal revenue share, it left many expenditure responsibilities to local governments, which have risen to 85.7% of total spending by 2024 [para. 8][para. 9]. Efforts to reform central-local fiscal responsibilities, including assigning public service costs and clarifying governmental roles, have been attempted but remain ambiguous [para. 10][para. 11].

Experts emphasize the critical need to tackle the imbalance between spending responsibilities and financial resources for local governments. Suggestions include adjusting revenue distribution and enhancing the transfer payment system. Former Finance Minister Lou Jiwei and other experts argue for a comprehensive strategy, augmented local government autonomy in specific public services, and a clearer division of tasks to improve national economic coordination and efficiency [para. 12][para. 13][para. 14]. Introducing a "matching principle" could align responsibilities with administrative capabilities, reducing inefficiencies caused by current shared responsibilities and shifting more spending to the central government [para. 15][para. 16].

Reforming China’s fiscal system also involves broadening local governments’ fiscal autonomy and reconsidering revenue distribution. Proposals are in place to expand local tax authority and solidify local revenue sources. However, the potential risks of tax competition among regions need careful consideration to maintain market stability [para. 17][para. 18]. Shifts in tax collection responsibilities and the redistribution of corporate and personal income tax revenue could offer local governments more financial resources, although balancing national economic interests remains crucial [para. 19][para. 20]. Despite these challenges, hasty changes could lead to unintended repercussions; thus, policymakers must address the erosion of fiscal discipline and control debt expansion [para. 21][para. 22].

The need for a more robust legal framework is apparent, with calls for a Fiscal Law or Basic Fiscal Law to standardize financial relations between central and local governments [para. 23]. Property market adjustments have intensified fiscal challenges, and some local governments resort to excessive borrowing and revenue generation tactics, including aggressive fines, to mitigate financial shortfalls [para. 24][para. 25]. To ensure fiscal governance is legal, standardized, and transparent, reforms should focus on fostering long-term economic growth instead of short-term financial solutions [para. 26]. Despite these measures, experts caution that without comprehensive fiscal incentives and legal restructuring, local governments may struggle with mounting debt and financial crises [para. 27][para. 28].