1 Overview of China’s Fiscal Policy: 1949–1992

1. Background before the Establishment of Market Economy

2. Fiscal Policy before the Establishment of Market Economy

3. Analysis of the Evolution of Fiscal Policy before the Establishment of Market Economy

After the founding of the People’s Republic of China (PRC) in 1949, China had a short period of national economic recovery and socialist transformation featuring the coexistence of both planned and market economic mechanisms. The country made its way to a planned economy in 1957 when the government employed administrative commands for the allocation of economic resources such as funds and materials according to plans. After the central government launched reforms and opening-up in 1978, China was in transition from a planned to a market-oriented economy for ten years. Initially, the mainstay of the planned economic system was supplemented by market-oriented regulations. With the gradual economic restructuring and deepened understanding of market economy, a planned market economy was adopted in 1984. This economic system is the integration of economic planning and market mechanisms, with gradual strengthening of the market system as the main objective of economic reforms.

During the planned economy period, the Chinese government largely depended on administrative measures in exercising macro control for a general equilibrium. In this context, China’s fiscal operations were subject to mandatory planning. For this reason, fiscal instruments and functions were constrained by the planning system, although the importance of fiscal policies could not be denied. During the transitional period from a planned to market economy, the importance of various fiscal policy tools in resource allocation was emphasized over time, and their application was explored and improved.

1. Background before the Establishment of Market Economy

China’s economic reform and development from 1949 to 1992, when the decision was made to establish a socialist market economy system, can be divided into two stages according to the relations between functions of government and market. The first is a planned economy before opening-up and reform were launched in 1978; the second is a planned market economy during the initial period of reform and opening-up. The fiscal operation mechanism is an important integrated component of economic development. Different models of economic operation apply to different development stages, giving rise to different patterns of fiscal operation and fiscal policy practices. For a better understanding and grasp of the trajectory of China’s fiscal policy practices, we need to examine and analyze the operations and institutional evolution of China’s economy during this period.

1.1 Economic Operation in the Planned Economy

Since the late 1950s, China instituted a planned economy after a short period of economic recovery and socialist transformation. Mainly through administrative means, the country quickly accumulated funds needed for economic development, and gradually established an independent and comprehensive industrial system and a national economic system. The main features of China’s economic development under the planned economy are detailed below.

1.1.1 Government planning as the main instrument in economic operation

First, in terms of resource allocation, an overwhelming portion of materials and funds were controlled by the government that allocated production factors, procured and sold products, collected and channeled the profits to the Treasury, and examined and disbursed enterprise expenditures. In addition, workers were recruited and assigned exclusively by the government, and foreign trade was solely under government’s control. Second, in terms of the impetus for economic development, the government exerted pressure on or directly commanded enterprise management through administrative organs at various levels. Material benefits and other incentives were hardly utilized. Third, socioeconomic activities were mainly incorporated into the national plans with a top-down transmission of planning commands. Enterprise operations were basically immune to market signals, and principles of market supply and demand were seldom at work. Fourth, in terms of the distribution of wealth, income, expenditure, profits, and losses of enterprises were all under unified state control. Both enterprises and employees were covered by the egalitarian principle of “everybody eating from the same big pot.” Fifth, in the rural economy sector, agricultural collectivization was adopted, production means were collectively owned, and the procurement and sale of agricultural products were under the monopoly of the state. To sum up, almost all economic activities were subject to government planning, making it impossible for the market to play a fundamental role in resource allocation.

1.1.2 Public sector as the mainstay of the national economy

In the early 1950s, China gradually increased the share of the public sector in the economy after the confiscation of bureaucratic capital and monopolistic capital in financial, industrial, and commercial sectors. A fundamental change took place in the ownership structure of the economy especially after 1952, as the Chinese government transformed agriculture, handicraft industry, and capitalist industries into socialist ones. The proportion of the socialist public sector, which comprised state and collective ownership, rapidly went beyond 70% in 1957 and topped 90% soon afterwards. As a result, an ownership structure dominated by a single form of public ownership came into being in China. The state possessed and controlled most fixed assets and economic resources as well as all enterprises and industries except agriculture. During this period, the Chinese government made minor adjustments in the ownership structure based on changes in economic and social development; nevertheless, the proportion of the state sector maintained a level of around 70% with slight variations. The proportion of collective economy, a quasi state-owned sector, also rose, while the proportion of the private sector fell drastically (Exhibit 1.1).

1.1.3 Economic growth amidst booms and fluctuations

During the period of planned economy, China’s economic growth followed a wave-like pattern because of the government’s lack of experience in managing and controlling the economy and the limitations of a planned economy in allocating resources. Cyclical economic booms and recessions caused drastic fluctuations in economic output as a result of the expansion and contraction in capital stocks. However, these fluctuations were not reflected in employment and prices, which were under government control. Specifically, during the First Five-Year Plan period (1953–1957), the Chinese government concentrated on 156 key projects, which quickly filled up the blanks in the national economy, and enhanced the productivity of the vulnerable economic sectors. The period also saw an average annual gross domestic product (GDP) growth of 9.2%, and an average annual rise of 4.5% in per capita consumption. From 1958 to 1960, due to the reckless “Great Leap Forward” movement and a series of natural disasters, the economy was severely out of equilibrium, with a sharp drop in agricultural production against an excessively high growth in industrial sectors, especially in heavy industry, as well as an excessive accumulation rate. To reverse the abnormal trend, the Chinese government began a five-year economic adjustment, reform, consolidation, and improvement in 1961, bringing agriculture, and light and heavy industries back on the track of coordinated development. During the ten-year Cultural Revolution, China’s economy plunged again into extreme volatility. Industrial and agricultural production was in shambles and industrial structure in chaos. The central government attempted to resume the economic order in 1976–1977, but no visible improvement was achieved.

Despite the turmoil, China made achievements in economic development under the planned economy, and maintained a relatively rapid growth. From 1952 to 1978, its GDP grew 3.7-fold,¹ at an annual rate of 6.1%; fiscal revenue grew 5.5-fold, at an annual rate of 7.5%; and per capita consumption went up 0.78-fold, with an annual growth rate of 2.3% (Exhibits 1.2 and 1.3).

1.1.4 An independent national economic system in place

After 1949, the Chinese government aimed for rapid recovery and economic development, and devised a “catch-up” economic development strategy. For that, the government vigorously adjusted

¹ The GDP growth here is calculated at comparable prices.

the economic structure by prioritizing the development of heavy industry and raising its proportion in the gross industrial output and gross industrial and agricultural output. The continuous expansion of production and development investments had increased the percentage of heavy industry in gross industrial outputs from 26.4% in the early 1950s to 56.9% in 1978. Consequently, the share of agricultural output in gross industrial outputs dropped from 70% in the early years after 1949 to 24.8% in 1978. The rapid development of heavy industry augmented production capacity, improved the distribution of productivity, enhanced the technical and equipment capability of various economic sectors, and boosted the development of the national defence industry and cutting-edge science and technology. A relatively independent industrial and national economic system was established. Data showed that income generated by agriculture, industry, construction, transportation and commerce grew by 0.75, 16, 4.74, 4.46, and 1.97 times, respectively, on the basis of comparable prices (Exhibits 1.4 and 1.5).

1.2 Economic Operations Progressed during the Period of Planned Commodity Economy

In 1978, based on lessons learnt and experience gained during the nearly 20 years of economic restructuring and development since 1949, the Chinese government began to adjust its economic development strategy by initiating the policy of reform and opening-up and embarking on market-oriented economic reform. In the start-up period (end of 1978–October 1984), successful rural reform became a breakthrough, and pilot reforms to expand enterprise autonomy were underway in the urban areas. In the initial expanding period (October 1984–September 1988), the priority shifted from rural to urban areas, focusing on invigorating state-owned enterprises (SOEs). Meanwhile, the reform expanded gradually from micro to macro level, covering politics, science and technology as well as education systems. From September 1988 to 1992, the goal to establish a socialist market economy was set. China pushed ahead with its market-oriented reforms, improved the economic environment, and straightened out the economic order. During these 14 years, China’s production progressed, market expanded, market players gradually came into being, and market mechanisms began to play a fundamental role. Unprecedented achievements were made mainly in the following areas.

1.2.1 Increasing role of market in resource allocation

The market-oriented reforms launched in 1978 changed the means of resource allocation by introducing market mechanism and highlighting its role. The household contract responsibility system in the rural areas linked returns with outputs. Under this system, rural households began to possess land-use rights and surplus products, and became the grass-root entities of agricultural production. The rapid enhancement of agricultural production and farmers’ rising income enabled rural collectives and households to accumulate wealth, and in turn, promoted the development of township and village enterprises (TVEs). In urban areas, the SOEs reform granted decision-making authority to enterprises, and allowed them to retain more profits. With the implementation of the contracting and shareholding systems, enterprises obtained greater autonomy, and the development of the non-public sectors of the economy was promoted. Consequently, market transactions gradually recovered. As autonomous market players came into being and increased in number, market price and competition mechanisms took effect. Meanwhile, the market-oriented reforms gradually expanded from micro to macro level, and from some to all economic institutions. That is, reforms were carried out sequentially in trade, materials management, employment, credit management, and foreign exchange administration. The pricing mechanism also changed gradually from that of a planned administration to a market mechanism. Market started to play an increasingly important role in resource allocation.

1.2.2 A new economic framework taking shape with public ownership supplmented by diversified ownerships

The ownership structure of the economy changed dramatically after reform and opening-up started in 1978. With rural and urban reforms, the non-public sector expanded as it was viewed as a necessary supplement to the public sector. The non-public sector, composed mainly of self-employed and private enterprises, became a major constituent of the ownership structure. Guided by the opening-up strategy, the Chinese government actively supported the utilization of foreign investment, leading to rapid rise of equity joint ventures, cooperative joint ventures, as well as foreign-owned enterprises. Enterprises with mixed ownerships, including various forms of shareholding and joint-stock cooperative enterprises, flourished. Meanwhile, the public sector also developed continuously with the state sector still dominating the major industries and key sectors. The policy of reform and opening-up led to an economic structure of diversified ownerships with public ownership as the mainstay (Exhibit 1.6).

1.2.3 National economy growing amidst adjustment and reform

After 1978, the operation mechanism of the planned economy was done away with gradually and a new stage was set for a market economy. Subsequently, China’s economy underwent dramatic adjustments and reforms and faced challenges as shown in the three evident economic fluctuations in 1979–1981, 1985–1986, and 1988–1989.

At the start-up stage of China’s economic reforms (1979–1981), economic overheating emerged, such as excessively high growth rates, swelling investment and accumulation ratios, as well as a large trade deficit. For this, under the guiding principle of “a planned economy supplemented by a market economy,” the Chinese government implemented forceful macroeconomic control using mainly administrative measures. These measures included reducing infrastructure scales (stopping, delaying projects or ceasing the approval of new projects), tightening price control, banning unauthorized price increases, and broadening decision-making power to enterprises. Economic overheating was brought under control within a short period. After 1984, however, macroeconomy experienced another overheating with the implementation of overall economic restructuring. In order to avoid an all-out overheating and curb rapid price increases, the Chinese government adopted a series of measures, such as controlling the scale of fixed asset investments and bank credit, and cracking down on unauthorized price increases from 1985 to 1986. In early 1987, the overheated economy somewhat cooled but rebounded soon, resulting in a more serious overheating than that in the past as well as severe inflation. In 1988 and 1989, the Chinese government once again implemented a new round of macro control, focusing on “improving the economic environment and strengthening the economic order.” Because the government mainly relied on administrative and one-fit-all measures, the economic growth rate plummeted despite the repression of severe inflation. This led to a “hard landing” in early 1990. It was not until 1992, when the goal to establish a socialist market economy was put forward, that the economy started to recover and embrace a new growth cycle (Exhibit 1.7).

1.2.4 Achievements of economic restructuring

From 1978 to 1992, China’s economy was gradually freed from the shackles of a planned economy. Productivity improved tremendously and economic restructuring brought forth significant institutional benefits. On the one hand, economic growth picked up and economic strength was enhanced. During this period, China’s GDP increased from 362.41 billion yuan to 2,663.81 billion yuan, at an annual growth rate of 9.5%; industrial value added grew from 160.7 billion yuan to 1,028.45 billion yuan, at an annual growth rate of 11.2%; fiscal revenue was up by 9.7% per year from 113.23 billion yuan to 348.34 billion yuan; and residents’ consumption increased from 18.4 billion yuan to 107 billion yuan, yielding an annual growth rate of 7.1%. On the other hand, economic restructuring not only unleashed the potential of economic development, but also exposed some deeply rooted impediments of the planned economy. The main impediment was the use of administrative measures to manage the economy, resulting in frequent fluctuations and inflation. China had to make new breakthroughs and strategic choices in economic restructuring and developing.

From 1949 to 1992 when the goal of socialist market economy was set, China’s economy underwent a transition from a planned to a market economy, and major changes took place in economic operations, ownership structure, and economic development. In the early 1950s, the Chinese government aimed to boost economic recovery and accelerate the socialist transformation, and refrained from frequently using the planning tools unless those were essential for stabilizing economic and social order. The market mechanism still played its role to some extent. At the planned economy stage, mandatory plans became the main tool for resource allocation. Power was excessively centralized, making it hard for the market to play its role. The central government had been adjusting and reforming the planned economic system, targeting the obvious drawbacks of planning tools. Nevertheless, all of these adjustments and reforms were conducted within the framework of planned economy, with the plan as the main means of resource allocation. As such, China’s economy ran in a cycle of “deregulation-inflation-regulation-depression” to some extent, despite major achievements.

After over 20 years of reform, the Chinese government came to realize that the crux of the problem was that the pattern of resource allocation under the planned economy did not suit economic development. Consequently, market-oriented reforms were initiated in the late 1970s. In contrast to the earlier adjustments and reforms, these market-oriented reforms started with operating mechanism on a micro level, but touched the very core of the planned economy at the beginning by abandoning mandatory plans and allowing the market a role to play in allocating resources. With the deepening of reforms and with lessons learnt from experience since 1949, the Chinese government further realized that a socialist market economy needed to be in place through deepened economic restructuring for a better economy. Hence, the government announced the tasks and objectives of establishing a socialist market economy in 1992.

2. Fiscal Policy before the Establishment of Market Economy

After 1949, along with economic recovery and gradual rehabilitation of fiscal conditions, fiscal management in China changed from wartime to peace-time mode, from rural-focused and decentralized to urban-focused and centralized, and from supply-oriented to development-oriented. In 1978, China started shifting from a planned to a planned commodity economic system. To support this transition, the Chinese government reformed its fiscal institution through fiscal policy instrument innovation, and operational mechanism improvement. Furthermore, the fiscal functions and management methods were geared in the direction of a market economy.

2.1 Fiscal Policy and its Implementation during the Planned Economy Period

Under the planned economy, public finance was the key instrument for materializing government plans. The government collected revenues from taxation and enterprise profits and other sources, and arranged for fiscal expenditures. Revenue collection and expenditure arrangements were made to attain the planned ratio between accumulation and consumption, develop prioritized sectors and projects, and meet economic development targets.

2.1.1 Giving top priority to economic development

Boosting and strengthening the economy is an urgent task for the Chinese government after several years of economic recovery and socialist transformation. According to plans, the government actively collected revenues, and adjusted the scale and structure of fiscal investment to increase production and promote high-tech and other industries. All of these measures targeted establishing an economy composed of a variety of sectors and promoting China’s development.

First, accelerating industrialization. Promoting the industrial sector, particularly heavy industry, was the top priority for the Chinese government given China’s weak industrial base. Under the First Five-Year Plan (1953–1957), budgetary investment reached 50.64 billion yuan, accounting for 86.1% of the total capital construction investment. At the same time, public funds were channeled into industrial production in tandem with fiscal funds. The capital construction investment in industry reached 25.03 billion yuan or 42.6% of the total capital construction investment, of which 21.28 billion yuan or 36.2% of the total was invested in heavy industry.

Second, supporting agriculture. On the one hand, fiscal policies had been adjusted and improved to support institutional development in the agricultural sector. For example, during the economic recovery period after 1949, a disproportionate agricultural tax was adjusted in connection with the land reform policy to

rationalize the tax and ease the burden on farmers. Agricultural taxes were further reduced in 1961, which promoted agricultural production and development. On the other hand, funds were collected from multiple channels at different levels to support agricultural development. From 1950 to 1978, fiscal expenditures on supporting agricultural production reached 186.36 billion yuan.

Third, using treasury bonds, taxation, and other policy instruments on a trial basis to support economic development. For example, the “People’s Victory discount bond” issued in 1950 played an active role in offsetting the fiscal deficit, withdrawing currency from circulation, adjusting money supply, and stabilizing prices. In the same year, a deposit interest income tax and other new tax categories were introduced to control prices, stabilize the economy, and tighten the money supply. During the period of socialist transformation, grain production was promoted by stabilizing the agriculture tax, and agricultural cooperatization was promoted by amending the means of collecting agricultural tax. Meanwhile, tax and fiscal credit policies were adopted to accelerate the socialist transformation of the handicraft industry and capitalist industry and commerce.

2.1.2 Coping with economic fluctuations mainly through fiscal investment and expenditure

The government’s planning was the main means for allocating resources under the planned economy. Correspondingly, fiscal investment became an important source of funds for economic development. The aggregate and structure of fiscal expenditure determined, to a large degree, the scale and structure of supply and demand. Thus, it became an important function of fiscal policy to regulate economic operation by increasing or reducing fiscal expenditure for production and construction during the period of planned economy. For example, the capital construction expenditure expanded to an accumulated 58.85 billion yuan between 1953 and 1957, representing 37.6% of the total fiscal expenditure. This supported China’s rapid economic development in the short term. When overheating or disequilibrium occurred, the government actively applied fiscal expenditures to adjust economic operation. During the period of economic adjustment between 1961 and 1964, for instance, the fiscal budget for capital construction was drastically slashed from 35.4 billion yuan in 1960 to 11 billion yuan in 1961, and down further to 5.6 billion yuan in 1962, in order to cool down the overheated economy. The proportion of the fiscal budget appropriated for capital construction was reduced from the annual average of 54.8% between 1958 and 1960 to 18.2% in 1962. It can be seen that fiscal expenditure for investment was used as the most important instrument to address economic overheating, and it indeed played an important role in achieving economic stability and growth (Exhibit 1.9).

2.1.3 Achieving an economic general equilibrium through a “balanced budget”

Fiscal balance was the key for the general equilibrium of public finance, credit, materials, and foreign exchange under the planned economy for three reasons. First, fiscal imbalance would lead to unbalanced currency and credit. This is because any fiscal deficit could only be offset by the surplus from the previous year’s budget or an overdraft from the central bank. However, the surplus from the previous year would become credit funds in commercial banks, participating in the fund circulation of social reproduction. So, using the previous year’s surplus to offset a fiscal deficit would affect the banks’ credit balance. An overdraft from the central bank would compel the bank to issue more currency, which would in turn lead to a price increase and currency depreciation. Second, fiscal imbalance would lead to a material imbalance. Almost half of the fiscal expenditure was being used for production under the planned economy. If the government expanded fiscal investment by increasing the fiscal deficit, which means that the distribution and expenditure exceeded the national income in the fiscal year, the total social demand would exceed the total supply of materials, upsetting the material balance. The economic overheating and imbalance of the economic structure induced by the over-investment in 1950s was a case in point. Third, fiscal imbalance would also have an impact on foreign trade, affecting the balance of foreign exchange revenue and spending. Therefore, the Chinese government had always adhered to a balanced budget under the planned economy, and rarely used budget deficit policy in economic operation.

2.1.4 Implementing a relatively centralized fiscal management system

In order to straighten out the economic order and maximize the role of fiscal funds in stimulating economic growth, a highly-centralized fiscal management system, featuring unified collection and allocation of fiscal funds, was adopted in the early years of the P.R.C. when the financial resources of local governments were comparatively limited. The central government reformed the fiscal management system after entering the period of planned economy in 1957, and put in place a system characterized by “consolidated guidance, decentralized management.” Under this system, the central government would examine and determine the local revenue and expenditure, and the total revenue would be divided into two parts—fixed revenue for governments at various levels, and revenue distributed among governments of different levels according to specific proportions. The local governments had to turn over revenue increments to the central government if their revenues exceeded their expenditures. Otherwise, the central government would grant subsidies to those local governments if their revenues were less than their expenditures. The central budget also set aside special appropriations, which was subject to the control by the central government.

The Chinese government continued to adjust its fiscal management system several times thereafter, through defining the scope and limits of fiscal revenue and expenditure authority between the central and local governments. However, generally speaking, the fiscal management system during this period featured “centralization” in compliance with the planned economic system.

2.1.5 Forming a single tax system through simplification and consolidation

Under the planned economy, economic operation was subject to direct management of fiscal instruments and other administrative measures, such as government plans, and the regulatory role of taxation was thus weakened. China’s tax system was simplified and consolidated three times to meet the requirements of the planned economy and government administration. A single tax system that fitted in the framework of planned economy was gradually formed. The Chinese government first reformed its tax system in 1953. The main measures included levying commodity circulation tax, amending goods tax and business tax, and cancelling or suspending transaction taxes other than the livestock transaction tax. Taxes were simplified and consolidated into 14 categories, while the overall tax burden remained unchanged.

In 1958, based on the principle of “basically keeping the current tax burden, while properly simplifying the tax system,” the Chinese government simplified and consolidated the tax system again. The main measures included consolidating tax categories, revising tax payment stages, adjusting the tax rate of a small number of products, while keeping the original tax burden, and consolidating the agriculture tax system. This reform fundamentally changed the former tax system featuring multiple tax categories and multiple collection periods, and established the turnover tax as the mainstay of the tax system. Taxes were consolidated, and the tax categories were reduced from 14 to 9.

In 1973, the Chinese government further simplified and consolidated its tax system. The main measures adopted this time included further consolidation of tax categories, simplification of tax items, adjustment of tax rates, and relegation of part of tax administrative power to local governments. According to the simplified industrial and commercial tax system, only one tax was levied on SOEs, and two taxes (industrial and commercial tax, and industrial and commercial income tax) on collective-owned enterprises (COEs). Urban real estate tax, vehicle and vessel usage license plate tax, and livestock slaughtering tax were levied only on individuals.

2.2. Fiscal Policy during the Period of Planned Commodity Economy

The Chinese government began its economic and social reforms in 1978. As the main instrument of the government for allocating resources and fulfilling national economic development plans, public finance became the starting point for reform and opening-up. As a major economic policy, China’s fiscal policy was constantly adjusted and improved in the course of reform and opening-up, forming a unique functional mechanism on fiscal policy during the transition period.

2.2.1 Supporting and promoting reform

China’s economic operation mechanism changed significantly after reform and opening-up were initiated in 1978. The country’s fiscal policy was committed all along to supporting and promoting reform and opening-up, with its orientations and operation mechanisms adjusted from time to time. These trends could be seen in the following aspects:

First, promoting the SOE reform by firstly adjusting and regulating the relations in distribution between the state and enterprises. On the one hand, the government changed its fiscal management system and the SOE management system through various measures, including substituting tax payment for profit delivery,¹ implementing the contracted managerial responsibility system, separating taxes and profits, standardizing the enterprise financial accounting system, and promoting SOE reform. All these measures were aimed at adjusting the distribution relations between the state and enterprises, and expanding the latter’s decision-making powers. Meanwhile, the government refrained from intervening in routine operation of enterprises, and focused instead on invigorating them through technological upgrading and economic restructuring. On the other hand, the government enhanced its policy and financial support for enterprise reform. The disposable income of state-owned industrial and transport enterprises increased to 420 billion yuan through tax deduction and profit surrender from 1981 to 1990. In 1992, other preferential measures were taken to support the

¹ In April 1983, the State Council decided to implement a pilot reform on substituting tax payment for profit delivery at the proposal of the Ministry of Finance. All profit-making SOEs paid enterprise income tax at the rate of 55%; for the post-tax profits, a specific amount was delivered to the State while the rest was retained by the enterprises. From June 1, 1983 on, this reform was conducted in all SOEs.

development of large and medium-sized state-owned industrial and transport enterprises, including accelerating depreciation, increasing research and development (R&D) spending, supplementing working funds, relieving the depreciation fund of “two funds” (the energy and transportation construction fund and the national budgetary adjustment fund), and reducing the enterprise income tax rate for specific enterprises. These measures helped increase the disposable income of these enterprises by 15.5 billion yuan that fiscal year.

Second, shoring up price reforms. Price was the most fundamental signal in the market economy. One of the important tasks of China’s economic restructuring was to form a rational price system. A large sum of subsidies was granted to promote the reform designed to establish a dual-track price system. In 1979, 7.8 billion yuan-worth of subsidies was granted to the commercial sector to offset the loss incurred by the price hike of agricultural products and byproducts. The amount of subsidies given for this purpose rose to 16.8 billion yuan in 1980. Various price subsidies given out in 1981 exceeded 32 billion yuan. Price subsidies on non-staple foodstuffs were also provided to employees of SOEs apart from the policy subsidies.

Third, establishing a sound foreign-related tax system. The Chinese government promulgated Income Tax Law of the People’s Republic of China for Chinese-Foreign Equity Joint Ventures, Individual Income Tax Law of the People’s Republic of China, and Income Tax Law of the People’s Republic of China for Foreign Enterprises in 1980 and 1981, putting in place an initial foreign-related tax system. Since then, this system has been amended regularly to allow for more preferential policies. The system played a positive role in attracting foreign investment, introducing advanced technologies, and expanding foreign trade and economic relations.

Fourth, boosting the reform of the wage system. The reform played an important part in straightening out the relations in primary distribution of national income and establishing a sound distribution mechanism. After the reform and opening-up program was launched, a significant amount of funds was allocated to increase wages in support of the reform, even though the revenue could not meet the expenditure. Meanwhile, the Ministry of Finance (MOF) worked closely with other departments to plan the wage reform in administrative units, public institutions, and enterprises. Great efforts were made to bring into play the role of public finance in properly managing the increase in wages and bonuses.

2.2.2 Exploring the regulation of economic operations with fiscal policy instruments

Investment in production and construction has remained a key instrument by which China’s fiscal policy regulated the economy, as shown by all macroeconomic adjustments since 1978. In 1981, the Chinese government implemented a contractionary economic policy, and a major measure adopted was tightening fiscal investment spending. The budgetary capital construction investment was reduced from 41.86 billion yuan in 1980 to 34.9 billion yuan in 1981. The government also took two successful macro control moves during 1987–1988 and 1988–1990. A shared measure adopted was curbing mounting investments by slashing total fixed asset investments, which proved both powerful and effective.

It should be noted that the Chinese government was continually experimenting with taxation, subsidies, treasury bonds, and other market instruments in regulating economic operations as market-oriented reform continued. First, tax policies were more frequently used. To encourage the export of industrial products and expand the effective aggregate demand, export taxes were refunded or exempted on clocks, watches, and 16 other products including their parts, while import tax was imposed on foreign products in 1983. In 1988, the government applied tax policies to regulate the economy, levying a special consumption tax and other new taxes; these played an important part in curbing overinflated demand and preventing economic overheating. Second, the treasury bond policy was resumed for economic regulation. In 1981, the issuance of treasury bonds was resumed, and the bond instrument was once again included in the framework of China’s fiscal policy. The government achieved its target of regulating economic operations through revising policies on the issuance, encashment, and circulation of treasury bonds.

2.2.3 A Compound tax system taking shape

Along with the ongoing economic restructuring and changing economic environment, the Chinese government revamped its tax system several times between 1978 and 1992, and a compound tax system was gradually introduced to regulate the economy through multiple tax categories, stages and levels. With a strengthened role of economic regulation, the system also helped standardize distribution relations between the state and enterprises.

In early 1980, in order to expand foreign economic activities, the Chinese government formulated its tax policies on enterprise income and individual income, targeting Chinese-foreign equity joint ventures and foreign enterprises in China. In 1983, the Chinese government started the first round of tax-for-profit reform, which was designed to convert part of SOEs’ profits into the enterprise income tax revenue; accordingly, economic relations between the state and enterprises were initially standardized. In 1984, the government took the second round of tax-for-profit reform as an occasion to initiate a full-scale reform of the industrial and commercial tax system. Industrial and commercial taxes were divided into product tax, value-added tax (VAT), business tax, salt tax, resource tax, and a regulatory tax on large and medium-sized SOEs were introduced. After two rounds of tax-for-profit reform, a compound tax system was put into place, primarily composed of turnover tax and income tax. Meanwhile, the Chinese government also took gradual steps to restructure the agriculture tax system by establishing a threshold of agriculture tax, and standardizing the methods of tax reduction, exemption, payment, and collection. A specialty tax on agriculture and forests, and a farmland occupation tax were levied on a full scale, and the deed tax was adjusted and improved. Thereafter, the government continued to restructure the industrial and commercial tax system, introducing a series of supporting policies, levying new taxes, improving collection methods, and adjusting the scope of collection and rate of some taxes.

2.2.4 Implementing a fiscal management system of “eating in separate kitchens”

China carried on its reform of the fiscal management system between 1978 and 1992. Beginning with relegating powers to the local governments and surrendering part of the profit to enterprises, the central government introduced the management system of “eating in separate kitchens.” Based on fiscal contracts, this system considerably increased the withholding percentages of local governments with regard to added or over-quota revenues, while keeping the distributing proportions for the total revenue.

In 1980, except for a few provinces still practicing the unified revenue and expenditure system, most provinces began to implement the new fiscal system, dividing revenue and expenditure responsibilities among governments at all levels. Four methods were employed by these provinces to distribute their revenues between the central and local governments. In 1985, the central government changed the original revenue distribution pattern to one based on tax categories, specifically, the revenues were distributed between the central and local governments on the basis of tax categories. The revenue proportion for the local governments, their turnover to the central government, and the transfer payments granted by the central government were defined on the basis of the general revenue and expenditure condition of each province, and would remain unchanged for five years. Basing revenue distribution on tax categories, this system discontinued the traditional practice of taking the jurisdiction of enterprises and public institutions as the criterion for distributing revenues, marking a big step forward for China’s reform of its fiscal management system, and heralding the taxsharing reform. In 1988, the government conducted another round of reform of China’s fiscal management system, and six methods were adopted to implement revenue responsibility measures in various provinces and cities specially designated in the state plan, and local governments were appropriately granted more fiscal power. These reform initiatives carried out in the fiscal and tax systems from 1978 through 1992 laid solid groundwork for the tax-sharing reform launched in 1994, which represented a milestone in the history of China’s fiscal and tax policies.

2.2.5 Coordinating the fiscal and monetary policies

Since 1978, thanks to the constantly increasing bank deposits, the capital market has developed gradually. The financing channels became more diversified, and the autonomy of the central bank was also enhanced. As a market-oriented financial system was taking shape, the avenue for monetary policies to regulate the economy was opened, and their functional range expanded continually. All these required the Chinese government to coordinate the relations between fiscal and monetary policies.

In 1981, in the face of an overheated economy, the central government tightened fiscal expenditure to prevent a general overheating. The direct state investment in capital construction was reduced by 28%, and the total fiscal expenditure also experienced a decline of 7.4%. At the same time, to keep a certain level of economic growth, the central government appropriately loosened its monetary policies in the light of changing economic conditions. Instead of depressing the scale of enterprise loans indiscriminately, the government supported the purchase of farm products and the development of the textile and other light industries through prudent credit investment. Industrial loans increased by 7.98 billion yuan or 10.8% in 1981 over the previous year; commercial loans rose by 22.3 billion yuan or 15.5%. This combination of a contractionary fiscal policy and an expansionary monetary policy proved fairly effective. The national industrial and agricultural production registered all-round growth, leading to a GDP increase of 9.1%.

In 1985, to dampen economic overheating, the Chinese government reduced fiscal investment spending. The growth rate of capital construction investment decreased from 43.5% in the first half of the year to 30.8% in the fourth quarter, and a fiscal surplus appeared for the first time since 1978. The government also reduced the money supply by 36.6 billion yuan that year. A coordinated implementation of contractionary fiscal and monetary policies effectively restrained the overheated economy, facilitating a fall of the industrial growth to 10.2% from 23.1% in the first half of the year.

Between 1989 and 1991, the Chinese government again adopted the contractionary fiscal and monetary policies. Money supply stood at 21 billion yuan in 1989 and 30.04 billion yuan in 1990, a huge drop from 67.95 billion yuan in 1988. The government’s tightened fiscal expenditure on capital construction resulted in an 11% decrease of fixed asset investment for two straight years. The targets of macro control were basically attained.

3. Analysis of the Evolution of Fiscal Policy before the Establishment of Market Economy

In the 40 years between 1949 and the establishment of the socialist market economy, China’s public finance underwent profound changes in terms of its operating mode, functions, policy instruments, tax system, and management system, along with the transition from a planned economy to a planned commodity economy and then to a market economy.

3.1 Fiscal Functions Becoming more Market-oriented

Public finance is an important basis and institutional guarantee for a government to realize its adjustment targets. Fiscal functions are the epitome of government functions. The fiscal functions of China’s public finance began to assume market characteristics as a result of the changed government functions during the transition from a planned economy to a market economy.

Under the planned economy, public finance was the major tool for realizing the national plan. It achieved the targets of economic development through direct resource allocation in the primary distribution and redistribution of social reproduction. China’s public finance was meant to serve economic development during this period, restricting the fundamental role of the market in resource allocation. On the one hand, the governments, rather than the enterprises, became the main investors. More than 80% of the total capital construction investment was arranged through fiscal appropriations. Fiscal investment had a decisive impact on the ratio of consumption and accumulation, and on the operation of the national economy. On the other hand, a special revenue mechanism was established. Profits and taxes paid by enterprises became the two dominant sources of fiscal revenue. Such fiscal functions under the planned economy stimulated economic development and guaranteed the realization of the national plan. However, it also led to excessive and rigid governmental control and deprived enterprises of their necessary autonomy in business operations, which somewhat devitalized the economy.

After China initiated reform and opening-up, the original fiscal functions under the planned economy began to weaken, as economic reform went on and economic conditions changed. The scale and scope of direct resource allocation by the government was gradually reduced. The reform measures, such as relegating powers, surrendering profits to SOEs, turning fiscal appropriations into loans, separating tax revenues from profits turned over by the enterprises, and contracting management, enabled enterprises to gain greater autonomy. The extent of direct intervention by government finance in an enterprise’s micro operations was also noticeably reduced. At the same time, non-public economic sectors, such as self-employed businesses and privately-owned businesses, kept on developing with their profits and wage distribution out of control of public finance.

New fiscal functions began to emerge in line with the market orientation. First, attention was paid to the allocation of public goods. As market-oriented reform went further, public finance exited from the production field gradually, and focused instead on offsetting market failure and providing public goods. Between 1978 and 1992, fiscal expenditure on education, science and technology, culture, and public health increased from 11.27 billion yuan to 79.30 billion yuan, with an annual growth rate of 15%. In contrast, the fiscal spending on capital construction rose from 45.19 billion yuan to 76.48 billion yuan at a mere annual growth rate of 3.8%. Second, the use of redistribution was emphasized for regulating income gaps. SOEs gradually became independent market players, enjoying greater autonomy and less intervention by public finance in operation, as reform and opening-up proceeded. In addition, the government adjusted income distribution to realize social equity through indirect measures such as strengthening and improving the individual income tax system, and increasing the transfer payments and expenditure on social security. Third, fiscal policy was reoriented from direct economic management to indirect regulation. In the process of market-oriented reform, it was hard to avoid economic fluctuations, large or small, owing to the market’s inherent defects and instability incurred by the transition. As one of the two major government tools for economic regulation, fiscal policy also changed its roles, gradually assuming the function of regulating, developing, and stabilizing the economy.

3.2 From Centralization to Moderate Decentralization

Based on repeated exploration and practice, China’s fiscal management system went through an evolution from a highly centralized pattern to a moderately decentralized one, from unified expenditure and revenue in the early years of the P.R.C. to relatively centralized administration during the period of a planned economy, and then to the system of “eating in separate kitchens” during the phase of a planned commodity economy.

In retrospect, three trends can be discerned during this evolution. The first was power relegation. Under the highly centralized fiscal system of united revenue and expenditure, fiscal management lay mainly with the central government, while the fiscal authority of local governments was extremely limited. During the period of planned economy, the Chinese government adopted a centralized fiscal management system to make sure that resources were distributed and allocated in accordance with national plans. Under this system, the central government determined revenue and expenditure, which were revised on a yearly basis. It is true that the central government had relegated certain fiscal power to local governments in some years, but the fiscal power was generally held by the central government. The tiered contracting responsibility system for revenue and expenditure was introduced after reform and opening-up were launched. The revenue and expenditure of local governments were still controlled by the central government, but the base figures were negotiable between the central and local governments, and would remain unchanged for five years in principle, leaving a fairly large leeway for the local governments. As per some specific contracting methods, a large proportion of the revenue in excess of the base figures would be left to the local governments, and more and more fiscal authority and revenue were granted by the central government to local ones. The second trend was institutionalization. In the period of planned economy, China’s fiscal management system was adjusted frequently, and the base figures of revenue and expenditure had to be revised, sometimes once a year. The subjective factors of the central government also contributed to those volatile base figures. Under the planned commodity economic system, however, the defined base figures remained unadjusted for five consecutive years. This was a sign of China’s fiscal management system moving toward stability and institutionalization. The third trend refers to the evolution of the fiscal management system into a tiered one. All efforts made since 1949 to adjust and reform the fiscal management system had a common goal: granting greater fiscal authority to the local governments and moving toward a tiered fiscal system. A multi-level budget was adopted in 1951; the local governments were allowed to retain a chunk of the incremental revenue in 1954; local taxes were introduced in 1958; some taxes were redefined as revenue sources to the central or local governments in 1980; and more than ten other taxes were reclassified as revenue sources to the central and local governments in 1985.

These trends toward decentralization, institutionalization, and multi-tiered fiscal management were still influenced and determined by the planned economy and corresponding fiscal operation mechanisms. Under the planned economy, the central government could not distribute and allocate resources according to mandatory state plans to the highest possible extent unless a unified revenue and expenditure system was practiced. Consequently, centralization remained a defining feature of China’s fiscal management system. After China initiated the reform and opening-up programs, public finance no longer functioned as the main determinant of the distribution of social products and national income. The delivery of basic public services and national public goods gradually became its main function. The fact that there was still a large quantity of local public goods called for more fiscal authority to be given gradually to the local governments, leading eventually to the formation of a multi-tiered fiscal system. In the initial period of reform and opening-up, all adjustments made in the fiscal management system were transitional, since economic restructuring was not yet in full swing. Nevertheless, all these efforts offered abundant experience for later reforms, and pointed out the correct direction and general trend of moderate decentralization.

3.3 From a Single to a Compound Tax System

Shortly after the P.R.C was founded, the Chinese government consolidated taxes but retained the compound tax system, in light of the actual conditions during the period of economic recovery. China gradually phased in the planned economy after 1957, and a single tax system was established after rounds of simplification and consolidation. Along with the reform and opening-up, China’s tax system went through timely adjustments and improvements before a compound tax system was put in place, in line with the requirements of the market economy. The tax system evolved over the years with the government’s shifting positioning and the changing relations in distribution between the state and enterprises, as determined by the different economic systems.

Under the planned economy, resources were allocated mainly through mandatory plans. The government guaranteed economic stability and income distribution through more direct and convenient administrative commands and plans, while the indirect regulatory role of taxation as an economic lever was discounted and reduced to the collection of fiscal revenue. Also, during the planned economy period, the public sector of the economy was the mainstay and the enterprises were owned by the state. The state could collect revenue from the enterprises in the form of profits, which further weakened the function of taxation. That is also why the tax system was simplified several times in this period. The compound tax system that existed in the early years of the P.R.C gave way gradually to a single tax system with only the agriculture tax system as an exception.

A compound tax system was established in China that consisted of multiple tax categories, stages and levels, after the country started reform and opened up to the outside world. This was attributed to the changed mechanisms of economic operation. First, the relations in distribution between the state and enterprises had to be standardized due to the reform, aiming to relegate power and share profits. Through two stages of tax-for-profit reform and the subsequent policy of separating profits from taxes, the relations in distribution between the state and the enterprises were basically rationalized. This expedited the SOE reform and defined more clearly the forms of fiscal revenue. Second, the fiscal revenue needed to be collected effectively. Individual businesses, privately-owned businesses, foreign-invested businesses, and other non-public sectors had developed quickly since 1978. The original tax system featuring limited tax categories and a narrow scope of taxation could not ensure an effective collection of fiscal revenue, and even resulted in an unfair tax burdens among enterprises of different ownerships. Third, the role of taxation for economic regulation needed to be given more room. With China’s transition from planned to market economy completed, resources were no longer directly allocated by the government, and the command-based economic management was phased out. A brand-new tax system was needed, which would work as a lever for effective economic regulation.

3.4 Fiscal Regulation Shifted from Relying on Administrative Instruments to Economic Means

In the transition from a planned economy to a planned commodity economy, and as the market-oriented reform advanced, the Chinese government shifted its method of economic regulation from administrative instruments to economic means.

Under the planned economy, the Chinese government gradually developed its fiscal policy instruments and their functional mechanisms. A major functional mechanism of fiscal policy was determining the production and development investment through administrative plans. By comparison, the role of economic tools, such as taxation and treasury bonds, were relatively weak. Fiscal investment in production and development became an important policy instrument that had a bearing on aggregate demand and supply. When the economy was overheated, the government would achieve a balance between aggregate supply and demand through curbing and slowing down fiscal investment. In addition, the finance of SOEs was an important part of national public finance under the system of a planned economy. The government could exercise its influence on the economy from the micro perspective, through formulating and adjusting the SOEs’ financial management system, covering such aspects as cost, spending, profit distribution, and wages. This constituted another important method for fiscal policy to regulate the economy.

The market-oriented reform initiatives launched since 1978 created an environment necessary for enriching fiscal policy instruments. As a result, the role of administrative instruments under the planned economy waned, while the role of economic instruments was increasingly enhanced. As the market-oriented reform accelerated, the proportion of production and development investment in the total fiscal expenditure experienced a decline. Fiscal investment was withdrawn gradually from the production and development field and channeled instead into infrastructure development such as energy and transportation. Meanwhile, the government began to explore new fiscal policy instruments in order to meet the new requirements of economic regulation. Treasury bonds, taxation, subsidies, transfer payments, and other instruments were employed for fiscal regulation, playing an increasingly important role. However, as the market economic system had yet to be fully implemented and the economic instruments for fiscal regulation were not adequate, their functional mechanisms remained ill-defined. Nevertheless, the fiscal policy explorations carried out in this period boosted the gradual shift of fiscal regulation from administrative instruments to economic tools, and paved the way for the establishment of a market-oriented functional mechanism for fiscal policy.