4 Prudent Fiscal Policy

1. Background

2. The Decision-making on Prudent Fiscal Policy

3. Measures of Prudent Fiscal Policy

In 2005, THE CHINESE government decided to implement a prudent fiscal policy, or rather, the neutral fiscal policy in economics. This was the third major shift in fiscal policy for macro control since China decided to establish a socialist market system. It is not only an important decision by the central government in response to the changes in economic operations, but also a concrete example of implementing the scientific approach to development.

1. Background

Following several years of implementing a proactive fiscal policy, China’s economy gradually emerged out of the shadow of deflation and stepped into the upswing phase of a new economic cycle. All the macroeconomic indicators looked good. The three major types of demand—investment, consumption, and export—recovered simultaneously. The robust demand in investment and export spurred economic growth and kept the general price level stable. Foreign trade grew steadily and rapidly, keeping the balance of payments in surplus. Pressure was eased on employment.

The regulatory role of market mechanisms was greatly enhanced, bringing about a mechanism of self-sustained economic growth. However, in the second half of 2003, despite the rapid development of the national economy, problems began to appear in some areas, such as over-investment and increasing inflation pressure. In short, China’s economy was confronted with a different situation from that in 1998, when the government decided to carry out a proactive fiscal policy. In 2003, the internal and external environment was conducive to economic development. Deflation was basically curbed and demand increased, bringing about a general equilibrium. However, structural and institutional issues became prominent (Exhibit 4.1).

1.1 Positive Conditions for Economic Growth

The role of market mechanisms was enhanced. As a result of its long-term market-oriented reform, China basically established a market economy. Almost 90% of the prices for its goods and services were

determined by market forces. The private sector became an important driver of the country’s economy. Non-governmental investments were active. Production factors were compensated. The mechanisms of supply and demand, pricing, and competition played an increasingly important role in resource allocation.

The pattern of supply and demand changed markedly. With the continued adoption of a proactive fiscal policy as a means of macro control, social demand grew and transformed the aggregate supply and demand landscape, which saw an important transition from insufficient demand and deflation to a basic equilibrium.

Heavy industrialization and urbanization stood out. China’s per capita GDP exceeded US$1,000 in 2001, and reached US$1,486 in 2004. In this developmental phase, the focus of China’s consumption shifted from foodstuff, clothing, and household articles to housing, transportation, and travel. This transformation accelerated the development of heavy and chemical industries, enabling the value added of the heavy industry to increase faster than that of light industry and boosting the urbanization by 1.4 percentage points annually and bringing it to 41.8% in 2004.

1.2 Economy at the Upswing Stage

An analysis of the economic climate showed that China’s economy entered a rising phase in the economic growth cycle in 2003, as shown by the upward trend of four major macroeconomic indicators. First, economic growth was approaching the potential output level. Since the second half of 2002, China’s economy had been growing steadily and rapidly. GDP grew 10% and 10.1% in 2003 and 2004 respectively. However, due to rapid economic growth, bottlenecks or resource constraints, such as insufficient grain production and short supply of coal, electricity, petroleum, and transportation, surfaced. All these were signs of GDP growth coming near the potential output level. Second, prices were on the upward trend. In 2003, the CPI went up 1.2% and the retail price index (RPI) fell 0.1%. However, in 2004, these two indicators increased 3.9% and 2.8% respectively. Leading price indicators accelerated. The ex-factory price index of industrial products and the purchase price index of raw materials, fuel, and power, went up 2.3% and 4.8% in 2003, and 6.1% and 11.4% in 2004 respectively. Third, the unemployment rate slowed down. In 2003, a total of 8.59 million new jobs were created in urban areas, keeping the urban registered unemployment rate at 4.3%. The year 2004 saw 9.8 million new jobs created in urban areas and the urban registered unemployment rate dropped to 4.2%. Fourth, China’s balance of payments continued to enjoy a surplus. The foreign trade surplus reached US$25.5 billion in 2003 and US$32.1 billion in 2004. The foreign exchange reserves amounted to US$403.3 billion in 2003 and US$609.9 billion in 2004 (Exhibits 4.2 and 4.3).

1.3 Deep-seated Economic Problems

Firstly, structural problems stood out. On the one hand, industries, such as real estate, aluminum, and iron and steel, were over-invested. On the other hand, underdeveloped sectors, such as agriculture,

environment, education, and social security, were under-invested. Structural imbalances became prominent between economic and social development, between urban and rural areas, among eastern, central, and western regions, and between man and nature. All these showed that putting the scientific approach to development in place was a tough task and that economic structural adjusting and optimizing would become the primary target of fiscal policy thenceforward.

Secondly, the mode of economic growth stood in an increasingly sharp conflict with the constraints in resources and environment. China’s per capita reserves of such important mineral resources as oil, natural gas, coal, iron ore, copper, and aluminum, were just 11%, 4.5%, 79%, 42%, 18% and 7.3% respectively of the world’s averages. In 2004, China’s GDP was only 4.7% of the world’s total, but it consumed disproportionately large shares of the world’s energy and resources: 8.2% of oil, 34.4% of coal, 30.8% of iron ore, 27.7% of steel, 20.4% of aluminum, and 44.6% of cement. All these pointed to the fact that the mode of China’s economic growth was still extensive, and promoting the transformation of the mode of economic growth had become an imperative task for macro control.

Thirdly, slow-paced institutional reforms hindered the implementation of the scientific approach to development. Among other things, the pricing mechanism for production factors market was still in its infancy, resulting in highly underestimated investment costs; the lagging SOE reform led to ineffective budget control and distorted business operations. Therefore, the fiscal policy had to prioritize the efforts to promote reform and remove institutional obstacles (Exhibit 4.4).

1.4 Global Economy Grew Stably

The global economy started to recover in the second half of 2003 after a three-year downturn. Its real growth rate reached 5.1% in 2004, the highest in the past 30 years. The global economy entered a new period of stable growth after a correction in late 2004 due to surging oil price.

Firstly, driven by the cyclical economic recovery, especially the increasing individual income and corporate profits, the major economies grew stably. The U.S. economy grew at a relatively fast rate, laying a solid foundation for the stability of the global economy. The Asian economies, in general, maintained their growing trend despite the shock of tsunami. The European economies were expected to speed up its recovery. Secondly, the world economy enjoyed a relatively stable environment and its risk resilience strengthened dramatically. After several years of reform and adjustment, the global financial system became more flexible and risk-resistant; market indicators, such as interest rates, exchange rates, and labor costs, were stabilized; the pressure of cost-push inflation was manageable, and prudent regulatory measures were the common choice by various governments.

And thirdly, short-term risks existed in the world economy. For instance, the fluctuation of oil prices, the shrinkage of financial markets, and the high reliance of the world economy on the United States and Asia would probably extend a national risk into an international risk. However, the short-term risks described above and their impacts were limited, posing no immediate threat to the growth momentum of the world economy. These risks could be controlled through coordinated, rational regulation among countries. The trend of steady global growth would not encounter any drastic reversals. The sound global economic climate would help China attract foreign capital and expand exports, creating an enabling environment for the central government to shift its fiscal policy from proactive to prudent.

In view of the new economic situation, the government began to reorient its fiscal policy in 2004.

Firstly, the rural tax-for-fee reform was accelerated to shore up agriculture and grain production. More fiscal support was given to boost agricultural development. Apart from abolishing all taxes on agricultural specialties (excluding tobacco) in 2004, the central government intensified its efforts to cut or exempt agricultural taxes. A total of 11.6 billion yuan in subsidies benefited the grain producers in 29 provinces including autonomous regions and municipalities under the central government; 2.85 billion yuan was appropriated to subsidize the farmers in 13 major grain-producing provinces for purchasing improved crop seeds. Agricultural investments were also increased. These measures effectively raised grain output and farmers’ per capita net income by 38.8 billion kilograms and 6.8% respectively that year.

Secondly, the size, structure, and schedule of government investments were adjusted timely and appropriately. The central government reduced the budget for treasury-bond-financed projects from 140 billion yuan in 2003 to 110 billion yuan in 2004, with priority given to the projects in agriculture, forestry, water conservancy, education, science, culture, public health, energy, and ecological conservation. Through properly scheduling the disbursements of treasury-bond-financed projects and capital construction expenditures, around 50 billion yuan of budget funds earmarked for treasury-bond-financed projects in 2004 was saved

and carried forward to 2005, and capital construction expenditures were reduced by 0.3% in 2004. These measures effectively slowed the overheated fixed asset investment, which increased by 26.6% in 2004 or 1.1 percentage points lower than that in 2003.

Thirdly, more inputs were channeled into social sectors. In response to the slow-paced social developments, the government considerably expanded its expenditures on education, science, culture, public health, and social security. The reemployment subsides, in particular, enjoyed an increase of 76.6% in the central government budget. These measures had effectively coordinated economic and social development and contributed to social stability.

Fourthly, the fiscal authorities actively supported various kinds of economic institutional reforms. On the one hand, they pushed further the fiscal reforms with a view to improving departmental budgets, centralized treasury revenue and payment, and government procurement; de-linking departments’ revenues from expenditures; steadily optimizing the mechanism for export tax rebates; and actively accelerating the pilot reform in VAT. On the other hand, they vigorously promoted the SOE reform, the restructuring of the Bank of China, China Construction Bank, and Bank of Communications for IPO, and the pilot reform of rural credit cooperatives. All these measures considerably improved the efficiency of fiscal operation and boosted other reform efforts.

Fifthly, the revenue over budget was appropriately used to address such longstanding problems as accumulated export tax rebates in arrears. In 2004, national fiscal revenue increased by 595.6 billion yuan (including 127.5 billion yuan earmarked for paying off accumulated export tax rebates in arrears), 27.4% over the previous year, a record high in terms of both amount and growth rate. The revenue over budget was not used to increase recurrent expenditures, but used to pay off longstanding arrears, such as accumulated export tax rebates, and to balance social and economic development. In practice, using the revenue over budget to pay off longstanding arrears meant a reduction of implicit fiscal deficit, which is conducive to the sustainable growth in national economy and public finance.

The above policy measures show that the reorientation of fiscal policy by the Chinese government in 2004 was prompt and correct as it had effectively promoted sustainable, rapid, and healthy socioeconomic development. At the same time, it can be argued that China’s fiscal policy tended toward prudence in 2004, paving the way for a smooth shift from proactive to prudent fiscal policy.

2. The Decision-making on Prudent Fiscal Policy

Prudent fiscal policy is also known as neutral fiscal policy in economics. In the face of the new economic situation, MOF initiated the study on fiscal policy adjustment in early 2004. For this purpose, it held a series of seminars to solicit opinions and suggestions from domestic and international experts and to examine the lessons and experience of other countries in implementing the neutral fiscal policy. Based on these preparatory activities, MOF proposed a shift in fiscal policy to the central government, which, after careful assessment, approved it and made a resolute decision to implement a prudent fiscal policy in 2005. Clearly the prudent fiscal policy was born out of a scientific and democratic decision-making process.

2.1 Acknowledging International Experience

2.1.1 International understanding of neutral fiscal policy

Discussion of neutral fiscal policy abounds in Western economic literature, involving important concepts such as neutral fiscal policy, neutral fiscal stand, fiscal neutrality, and neutral budget. All these concepts mean almost the same thing, that is, a relatively steady state where the central government does not expand or contract aggregate demand.

A neutral budget refers to a budget prepared by the government that neither contracts nor expands. In terms of public finance, fiscal neutrality occurs when tax revenue and government expenditure do not stimulate or contain demand and the net effect is neutral. In general, by implementing a neutral fiscal policy in the context of a general equilibrium, relatively stable prices, and steady economic performance, the government’s direct intervention will be curbed, making it possible to bring into full play the role of market mechanisms.

Of course, neutrality does not require a complete balance between fiscal revenue and expenditure. Fiscal neutrality can be achieved in the case of a general equilibrium between fiscal revenue and expenditure, an incremental balance, or growth of fiscal revenue and expenditure based on certain rules. Many international experts and scholars have defined neutral fiscal policy from different perspectives. These definitions are based on six situations where:

• A government breaks even, with little or no influence on economic activities.
• Fiscal expenditure (exclusive of interest) rises in tandem with potential GDP growth and expected inflation, while tax revenue is the function of real GDP.
• A basic balance is maintained in public finance, together with managed government debts, despite a certain potential output gap.
• The average tax ratio (the proportion of fiscal revenue in GDP) and the proportion of fiscal expenditure (exclusive of interest) in potential GDP remain constant.
• The proportion of non-cyclical fiscal expenditure in potential GDP is kept constant.
• A balance is kept between the structural parts of fiscal revenue and expenditure, after excluding the influence of a business cycle.

2.1.2 Countries implementing neutral fiscal policy

Neutral fiscal policy is nothing new. Indeed, many countries have already implemented it. The European Commission (EC) considers it important to keep a neutral fiscal status in the European Union (EU). For the EC, it is necessary to reduce fiscal deficit and keep fiscal neutrality, if the Euro-zone seeks to maintain economic growth under lower inflation. According to Juergen von Hagen, the EU’s fiscal policy was expansionary in 1998 and 2000, and neutral in 1999 and 2001. In particular, Germany, France, Spain, Italy, and Portugal shifted their fiscal policies from expansionary in 2000 to neutral in 2001. Most European countries have turned to neutral fiscal policy since 2001. France and Spain’s policies in 2003 were basically neutral.

In a report on the Euro-zone monetary and exchange rate policies released after the fourth round of consultation with Euro-zone member countries, the International Monetary Fund (IMF) pointed out that most Euro countries were implementing neutral fiscal policies. According to the economic policy analysis report issued after the fourth round of consultation between IMF and Austria in 2001, Austria was also believed to be adopting a neutral fiscal policy from 1999. Analysis also reveals that Denmark’s fiscal policy was neutral in 2001 and 2005; Norway’s was mainly neutral in 1998, 2000, 2001, 2003, and 2004; Finland’s was expansionary from 1990 to 1991, contractionary from 1992 through 1995, and neutral from 1996 through 1999; the United Kingdom’s was neutral from 1974 through 1979, and neutral in 2004; Thailand’s was neutral from 1992 through 1997; Korea’s was neutral from 1994 through 1997. In its research on Japan’s economy in 2002, the OECD suggested that Japan should adopt a neutral fiscal policy instead of short-term incentive measures.

The UN Global Economic Prospect Report 2004 points out that fiscal policy varies from one country to another. Among developed countries, the United States practices the most expansionary fiscal policy, most western European countries adopt properly expansionary or neutral ones, and Japan’s is contractionary. Most developing countries in Asia follow expansionary policies; the majority of Latin American countries implement contractionary ones. Other developing countries and economies in transition do not follow any fixed pattern, and their policies can be expansionary, neutral, or contractionary. Generally speaking, in periods of steady economic growth and price stability, neutral fiscal policies are implemented by these governments to control the size of fiscal deficit, and keep aggregate demand in a state of non-expansion and non-contraction. Its essence lies in an enhanced role of market mechanisms and a heightened efficiency of resource allocation, which helps attain the target of macroeconomic control.

All in all, neutral fiscal policy has been adopted by many countries as another choice besides expansionary and contractionary options. Theoretically, a typical neutral fiscal policy is able to:

• Maintain a balance between fiscal revenue and expenditure, and call for a neutral tax policy.
• Keep the net effect of fiscal revenue and expenditure on aggregate demand at one, being neither expansionary nor contractionary.
• Bring into full play the role of market mechanisms without distorting the activities of microeconomic agents.

Certainly, what these features portray is merely a purely theoretical state of neutral fiscal policy. They represent only a policy orientation, and cannot be fully realized.

2.2 Decision Making

In view of China’s new economic environment in 2003 and the international and domestic experience of using fiscal policy to regulate macro economy, the country was in great need of an important transformation of its fiscal policy. On May 27, 2004, at the closing of the Global Conference on Scaling Up Poverty Reduction in Shanghai, it was revealed for the first time in a press release that China would shift from expansionary to relatively neutral fiscal policy, in order to ensure sound economic growth. Moderate regulation would be implemented to support underdeveloped sectors, and to curb overheating industries. This message soon became the focus of attention: the policy shift became a hot topic in the media, triggering heated discussions in various quarters of society, especially in the financial academia. MOF also conducted further research in due time.

In late July 2004, the ministry held a symposium, consulting with economists on the orientation of China’s fiscal policy. Participants included economists from the People’s Bank of China, the State Administration of Taxation, the National Bureau of Statistics, the Development Research Center under the State Council, the Chinese Academy of Social Sciences, the Research Institute for Fiscal Science of the Ministry of Finance, universities and colleges, and nongovernmental research institutes. It was generally agreed that China’s macroeconomic environment had changed and that a new growth cycle had started. The six-year-old proactive fiscal policy was no longer effective and valid. It was time to adopt a neutral one, in view of the changes in policy targets and the prevailing environment. However, opinions were divided on the naming of such a pro-neutral policy. Different names were proposed, such as “neutral fiscal policy,” “prudent fiscal policy,” “coordinated fiscal policy,” and “structural fiscal policy.”

In early August 2004, MOF held another symposium on the orientation of fiscal policy in the next stage. Present at the

symposium were experts from the Policy Research Office of the CCCPC, the Chinese Academy of Social Sciences, Renmin University, and the Research Institute for Fiscal Science of the Ministry of Finance. It was agreed that the proactive fiscal policy, which had fulfilled its historical mission, had to be phased out to accommodate the new economic environment. A neutral fiscal policy would take its place to focus on aggregate control and economic restructuring. The name of “neutral fiscal policy” was also widely accepted by the majority of the participants.

Apart from the above symposia, MOF also convened meetings with local financial officials in Hangzhou, Hohhot, and Guiyang, from July to August 2004, to deliberate the shift of China’s fiscal policy. While believing that China’s fiscal policy should be adjusted, participants were of the view that fiscal deficit should be maintained at the existing level without further expansion or contraction, to produce a neutral effect on current aggregate demand, and keep the economy developing in a rapid and sound manner.

While echoing my proposal on fiscal policy adjustment, the participants also put forward their suggestions on the content, intensity, and naming of the new policy, which could be called “neutral fiscal policy,” “prudent fiscal policy,” “coordinated and development-oriented fiscal policy,” or “coordinated and balanced fiscal policy.” Even so, all of them agreed that it was more important to define the specific content of the new policy than to name it.

To get a clearer understanding of the macroeconomic situation and reorient the fiscal policy more accurately, MOF held an international seminar in late November 2004. Among the participants were chief representatives and economists from the World Bank (Beijing Mission), the IMF (Beijing Mission), the Asian Development Bank (Beijing Mission), the Asia-Pacific Regional Branch of Deutsch Bank, and the Asia-Pacific Regional Branch of Credit Suisse First Boston. They suggested that China should abandon its proactive fiscal policy for a neutral one in 2005, and refrain from increasing its fiscal deficit in absolute terms unless major, unexpected, or uncontrollable factors occur in the coming years. Thus, the proportion of fiscal deficit in GDP would be reduced with rapid GDP growth.

All these consulting and studying efforts were made under the guidance of the Chinese government, reflecting the government’s extraordinary capability for strengthening and improving macroeconomic regulation, and steering the socialist market economy. Following intensive study, research, and deliberation, it was decided at the central conference on economic work on December 3, 2004, that China would begin to adopt a prudent fiscal policy in 2005. It was pointed out at the conference that China had implemented a proactive fiscal policy for seven years to cope with the Asian financial crisis by expanding domestic demand, and remarkable progress had been made to that end.

With the dramatic changes in the economic situation, the focus of proactive fiscal policy gradually shifted from boosting domestic demand and fueling economic growth to strengthening weak links, and adjusting the economic structure. It was therefore appropriate and necessary to reorient toward a prudent fiscal policy.

The conference also emphasized that the fiscal policy reorientation sought to moderately reduce the sizes of fiscal deficit and long-term construction treasury bonds, and to appropriately increase allocation from the central budget for investment in regular development projects. In addition, sustained financial support was to be expanded for agriculture, rural areas, farmers, social development, underdeveloped regions, and other soft spots in the economy.

In the Report on the Work of the Government delivered on March 5, 2005 at the Third Session of the Tenth National People’s Congress on behalf of the State Council, Premier Wen Jiabao stressed that China should make persistent efforts to strengthen and improve macro control, and implement a prudent fiscal policy. Specifics of the policy were also represented in the draft budget and other documents submitted to the session for examination and approval. This ushered in a full implementation of the prudent fiscal policy.

A historical review of the research and decision-making on the prudent fiscal policy indicates clearly that the decision was necessary, timely, and also scientific and democratic.

3. Measures of Prudent Fiscal Policy

Prudent fiscal policy is not only a name change, but also a shift of fiscal policy’s nature and orientation. It can play a better role in balancing social and economic development. In brief, the prudent (neutral) fiscal policy can be recapitulated in four aspects: controlling deficits, adjusting structure, advancing reforms, and increasing revenue while curbing expenditure.

3.1 Controlling Deficits

The control of deficits is to reduce the central government’s deficits appropriately rather than considerably. It sends out a signal on the orientation of macro control: preventing the escalation of inflation and the recurrence of deflation. The purpose is to strengthen and improve macro control on the basis of what has been achieved, and balance the increments of fiscal revenue and expenditure. To be specific, it required a gradual reduction of central deficit by 19.2 billion yuan from 319.2 billion yuan in 2004 to 300 billion yuan in 2005. As GDP grew constantly, the percentage of fiscal deficits in GDP gradually decreased (the actual percentage was 2.4% in 2003, 2% in 2004, and 1.6% in 2005).

In the light of current and future economic and social developments, China should keep its scale of fiscal deficit at a stable level. This also explains why the central government’s deficit should not be reduced by a large margin. First, the policy should maintain its consistency. Bond-financed projects take a long time. The projects under construction demand follow-up financial input. According to data provided by related government agencies, the total input in bond-financed projects amounted to 850 billion yuan as of the end of 2004. Suspending these projects would cause extremely high sunk costs. Second, in past years, the investment in bond-financed projects promoted GDP growth. Immediately terminating such investments would have a negative impact on economic growth. Third, more investments are required to develop the western region, rejuvenate Northeast China and other old industrial bases, and promote the development of the central region. Fourth, the government has to bear the cost of improving the socialist market economy and promoting economic and social reforms. Fifth, implementing the scientific approach to development and promoting a harmonious socialist society require a solid material base. It also calls for government spending to be expanded, in order to improve public services, and to provide more and better public goods. Sixth, there are still some uncertain and destabilizing factors on both domestic and international economic arenas, such as changing geopolitical politics and volatile oil prices. By maintaining a certain level of fiscal deficit and keeping macro control in hand, the central government will be better positioned to deal with complicated situations both at home and abroad. Therefore, a modest fiscal policy, which advocates a gradual scale-down of the deficit and seeks fiscal neutrality, conforms to China’s reality, and will contribute to its stable and coordinated social and economic progress.

3.2 Adjusting Structure

On the basis of making no drastic changes in total fiscal expenditure, and in light of the scientific approach to development and the requirements of public finance, effort should be made to adjust the structure of fiscal expenditure and the orientation of investments in bond-financed projects, increasing inputs in some sectors while reducing expenditures in others. Investment should be withdrawn from or reduced in overheating sectors or general competitive fields. To meet the requirements of the “five balances”¹ and economic restructuring, more public funds should be invested in the underinvested public sectors, including agriculture, reemployment, social security, environment, eco-conservation, public health, education, and technology.

¹ A concept advanced during the Third Plenum of the Sixteenth CPC Central Committee in 2003. Specifically, the concept requires that effort should be made to balance rural and urban development, regional development, social and economic development, the relationship between human development and nature, and domestic development and opening-up.

With the sustained, stable, and rapid economic development, and the continual improvement of fiscal and tax systems, China’s total fiscal revenue grew 9.1 times, from 348.3 billion yuan in 1992 to 3,162.8 billion yuan in 2005. Fiscal expenditure grew from 374.2 billion yuan in 1992 to 3,370.8 billion yuan in 2005. In recent years, the fiscal authorities have been committed to adjusting and optimizing the expenditure structure for an efficient use of the fiscal resources, which is an arduous task. The adjustment and optimization should cover both the increment and the stock of fiscal expenditure. That is another reason why the authorities called for efficient utilization of the stock of grain risk fund, and that of long-term construction treasury bonds.

3.2.1 Adjusting the approach on the use of the grain risk fund

Previously, MOF allocated over 70 billion yuan annually as grain subsidies, including 30.2 billion yuan for the grain risk fund. However,

these subsidies were mainly used in the distribution segment, with grain producers benefiting very little from it. It is therefore necessary to adjust the current subsidy approach by giving subsidies directly to farmers, and it was implemented by the ministry in 2004. This significant reform has not only promoted the efficient use of the stock of subsidies, but also increased the farmers’ income directly, facilitating a market-oriented reform of grain distribution. The ministry will continue to improve the direct grain subsidy system.

3.2.2 Adjusting the orientation and structure of bond-financed project investment

The prudent fiscal policy requires the adjustment of investment in bond-financed projects in orientation and structure. On the one hand, bond investment was used mainly in infrastructure construction, with noticeable achievements in the past few years. As completed and ongoing projects are basically able to meet the needs of national economic development, proper adjustment is required for the orientation of bond investment in the next stage. On the other hand, China’s current economic development is in the rising phase of a growth cycle, calling for both deflation and inflation to be prevented. To maintain the momentum of economic growth, it is necessary to reduce bond investment and spare some funds to support the reform of the tax system and other efforts at institutional innovation, which will help tackle bottlenecks restricting economic and social development and pave the way for long-term economic and social development in a coordinated way. While bringing into full play market mechanisms, the bond investment and budgetary fund for construction should be consolidated. In the light of the “five balances” strategy, more effort will be made to reorient and restructure fiscal resources by gradually reducing direct investment in general commercial and competitive fields, and increasing capital input in public services and public goods, with a view to promoting the coordinated development of economy, society, and the people.

3.3 Advancing Reforms

Effort must be made to promote the reform of the fiscal system and support reforms in income distribution, social security, and public health, creating a sound and fair policy environment for market players and economic development, and establishing a long-term mechanism conducive to sound, self-sustained growth. All this is done to optimize the mode of economic growth.

3.3.1 Transforming production-based VAT into consumption-based VAT

The production-based value-added tax (VAT) does not deduct the newly purchased fixed assets, causing double taxation. When China started its tax reform in 1994, its economy was on the verge of inflation. The production-based VAT fitted in with the financial and economic situation at that time and helped control investment. However, it could also dampen the enthusiasm of enterprises for technological innovation and impede economic growth. In view of the changing international and domestic economic environment, it is necessary to replace the production-based VAT with the consumption-based VAT. This will make enterprises vital and competitive, boost social demand, and enhance China’s capacity for self-sustained economic growth. Based on the results of pilot VAT reforms in Northeast China, the central government will fine-tune the relevant measures, and extend the reform gradually to the whole country.

3.3.2 Accelerating the preparation for unifying the two laws on domestic and foreign corporate income taxes

Currently, China levies two different corporate income taxes on domestic and foreign-invested enterprises. Although the nominal income tax rates for foreign-invested enterprises is the same as that for domestic enterprises, the actual income tax rate for the foreign enterprises is about 10% lower than that for domestic corporations. This is because the foreign-invested enterprises enjoy more tax incentives. In other words, domestic enterprises are treated unfairly while their foreign-invested competitors enjoy a super-national treatment, resulting in unfair competition among different types of enterprises. At the early stage of China’s reform and opening-up, tax preferences for foreign investors, though unfair, helped attract foreign capital. Currently, China has entered a new stage with a more opened market, especially after the accession to the WTO. Adopting different income tax rates for domestic and foreign enterprises will undermine fair competition and contravene the WTO rules. It is, therefore, necessary to speed up corporate income tax legislation by unifying the two separate corporate income taxes. The tax rates will be adjusted appropriately and a new unified tax system will be introduced, creating a favorable tax environment for fair competition. On top of this, tax collection and management need to be strengthened to make the real rate closer to the nominal one. The government will take some transitional measures toward foreign enterprises before the unification is fulfilled. After the new corporate income tax law is promulgated, tax incentives for specified industries will replace the present ones, and more incentives will be given for some areas. Therefore, a unified corporate income tax will not increase significantly the burden on foreign enterprises or have a huge impact on China’s efforts to attract foreign investment.

3.3.3 Deepening the rural tax-for-fee reform

In March 2004, the Chinese government declared that agricultural taxes should be phased out within five years. In 2005, agricultural taxes were cut significantly or exempted across the country: The counties prioritized by the national poverty alleviation and development program were exempted from agricultural taxes; the provinces, which lowered agricultural tax rate by one percentage point in 2004, further reduced it by four more percentage points; the provinces, which lowered agricultural tax rate by three percentage points in 2004, further reduced it by two more percentage points; and the animal husbandry tax was eliminated throughout China. Twenty provinces abolished agricultural taxes in 2005. Plus the eight provinces that had eliminated agricultural taxes in 2004, twenty-eight provinces eradicated agricultural taxes ahead of schedule, benefiting around 700 million rural residents. By 2006, China has completely abolished agricultural taxes countrywide and the central government allocated special transfer payments for this purpose. As a result, the target of rescinding agricultural taxes within five years was achieved two years ahead of schedule.

At the same time, to establish a long-term mechanism for preventing the burden on farmers from rebounding, and to consolidate the achievements of the rural tax-for-fee reform, the government vigorously pushed forward a comprehensive rural reform aimed to restructure governments at the township and town level, promote compulsory education in rural areas, and improve fiscal management at county and township levels.

3.3.4 Improving the mechanism of export tax rebates

Export tax rebate, an international common practice, was first introduced in China in 1985. After the reform of fiscal and tax systems in 1994, China continued to practice its export tax rebate policy, with all rebates reimbursed by the central government. This policy played an important role in enhancing the international competitiveness of China’s exports, promoting the reform of the foreign trade system, expanding export volume, stimulating the development of relevant industries, and maintaining the sustained, fast, and sound development of the national economy. Nevertheless, export rebates have been defaulted for years because of the insufficient funding. This has impacted China’s foreign trade and its social and economic development.

In view of this, MOF formulated a reform proposal after rounds of consultation with ministries, local governments, and enterprises. In October 2003, the central government decided to reform the export tax rebate system, based on the principle of “precluding new arrears, paying off old arrears, improving mechanism, dividing up the financial burden, accelerating reform, and intensifying development.” To be specific, the central government took the responsibility of settling up the export tax rebates in arrears accumulated over the past years, and, at the same time, rationalized export rebate rates. A new mechanism for sharing the financial burden between central and local governments was established to prevent new arrears. To promote sound and sustained foreign trade development, efforts were made to reform foreign trade system, optimize export structure, and enhance export efficiency. The reform was kicked off on January 1, 2004. Over the past two-plus years, apart from timely reimbursing the export tax rebates and exemptions and preventing new arrears, the central government also paid off all the export tax rebates owed to enterprises and local governments that accumulated over the past years, through appropriately utilizing revenue over budget and the accumulated deposits in the treasury resulting from the centralized treasury system reform.

The new export tax rebate mechanism operated smoothly on the whole although there were still discrepancies between export tax collection and rebates, with some coastal and eastern cities bearing much of the resulting burden. Aware of the importance of this issue, the central government adopted corresponding measures to improve relevant policies. Based on the progress of reimbursing export tax rebates in the first half of 2005, the government came up with a method for improving the mechanism of export tax rebates, i.e., appropriately increasing the share of the central government for the part of export tax rebates above the base. This method was designed to promote coordinated regional development, ensure stable funding for export rebates while tackling the problem of uneven financial burden amongst regions, properly concentrate fiscal resources while promoting rapid development in foreign trade, promulgate measures to improve the export tax rebate mechanism while stabilizing the tax-sharing system, properly increase the central government’s proportion of rebates over the base figure, and further straighten out the relations in fiscal distribution between the central and local governments. The government will continue to monitor the export tax rebate mechanism in operation and improve relevant policies and measures, so as to attain reform targets.

3.3.5 Further improving the systems of income distribution, social security, education, and public health

To implement the scientific approach to development and expand domestic demand, it is imperative to improve the systems of income distribution, social security, education, and public health. Investment, as a type of productive consumption, is a demand derived from consumption. Without the support from end consumption, investment driven economic growth are unsustainable in the long term although it might be possible in the short run. Overinvestment also causes a large amount of resources to be accumulated in the production process, creating serious economic structural problems. As the final stage and actualization of social reproduction, consumption demand is the fundamental and decisive driver of long-term economic growth with more direct, effective, stable, and persistent impact.

The four reforms described above are essential to China’s “five balances” strategy. The reform in income distribution is designed to straighten out the order and adjust the pattern of national income distribution in an attempt to gradually address the increasing income disparity. To increase the income of lower-income groups and enlarge the proportion of middle-income groups, efforts must be made to regulate the income of monopolized industries, promote the reform of income distribution system in the public institutions, appropriately raise minimum wages, improve the protection of labor rights, strengthen the role of taxation in adjusting high incomes, and expand transfer payments.

With regard to social security, it is necessary to accelerate the establishment of a system that fits in with China’s economic and social development. Moreover, the government needs to adopt various preferential policies for reemployment, such as improving pension fund management, ensuring a basic living standard for workers laid off from SOEs, and a subsistence allowance for the urban poor. Such preferential policies will also create a closer link between social security and employment to safeguard the livelihood of the needy. Meanwhile, the government will continue to improve the social security system by expanding the coverage of basic pension, medical and unemployment insurance in urban areas, and to initiate the pension insurance pilot scheme for farmers. Rural minimum living standards will also be set up in areas where conditions permit.

In terms of education, the government will increase its investments and strengthen compulsory education, especially in rural areas. For this, a mechanism will be established to ensure funding for compulsory education, and increase financial subsides for the financially-challenged students in colleges and middle schools.

Moreover, the government will guide and encourage private investments in education through fiscal and taxation incentives so as to stimulate educational consumption.

As far as public health is concerned, the government will increase its support for building rural and urban public healthcare systems. Pilot schemes will be launched to promote urban medical system reform and new rural cooperative medical reform. In addition, efforts will be made to put in place and improve urban and rural medical assistance systems.

3.3.6 Supporting the reforms of SOEs and the financial system

To maintain a sustainable, rapid, and sound economic development, put in place a modern corporate system, and remove the institutional constraints to economic development, it is essential to promote reforms of SOEs and the financial system. This is also one of the chief targets set for fiscal policy. Thus, continued efforts must be made to reform SOEs and state assets management, promote a strategic adjustment in the state sector of the economy, improve the system of equity investors, establish a budgetary system for the state capital management, and support the transformation and restructuring of SOEs. In the process, enterprises will be relieved from the burden of providing social services. Furthermore, large and medium-sized SOEs are encouraged to separate their secondary business from their core business, spin off their secondary business, reassign redundant personnel, and steadily promote policy-based closures and bankruptcies of SOEs.

Reform should be deepened in the monopolized industries, such as railways, electricity, telecommunications, and civil aviation. Reform in the postal services and urban public utilities should be accelerated. Moreover, market-oriented reform of the distribution system for major commodities including cotton, fertilizers, and sugar will be promoted. There are improvements in the monitoring and managing of state assets in government agencies. The regulatory system of non-profit state assets will be strengthened.

Reform in the financial sector will be accelerated with a view to establishing a modern banking system in line with the mechanisms of a market economy. In addition, the regulatory systems of banking, securities, and insurance must be improved, so as to effectively prevent financial risks. Favorable fiscal and tax policies should be formulated to promote the development of rural finance and rural credit cooperatives. Accounting oversight needs to be tightened over all financial institutions for sound financial operation.

3.4 Increasing Revenue and Curbing Expenditure

Fiscal revenue should be fully collected in accordance with regulations to ensure its stable growth. Expenditure must be strictly controlled in line with budgetary plans so that fiscal resources are efficiently utilized. Although these are the primary and regular tasks for fiscal authorities at all levels, “increasing revenue and curbing expenditure” also serves as a policy signal in view of the current macroeconomic environment. It will be able to help prevent such issues as under collecting, over spending, and blind expansion. Therefore, it plays a role of macro control.

3.4.1 Reinforcing revenue collection and management to increase fiscal revenue

Increasing fiscal revenue is fundamental to China’s stable socioeconomic development, the central government’s effective performance of its functions and duties, and the sustainable development of public finance. The task of increasing revenue is enormously tough, given the foreseeable negative factors, such as the upcoming nationwide VAT reform, the unification of two different corporate income tax systems, tariff adjustment, and the full reimbursement of export tax rebates. Therefore, it is necessary to adopt proactive measures to stabilize the growth of fiscal revenue.

First, effective fiscal and taxation policies should be in place to support economic development, foster and enlarge financial resources, and enhance a stable and rapid increase of fiscal revenue.

Second, it is imperative to strengthen revenue collection and management, and standardize tax incentive schemes. Tax collection should be resumed when tax incentives expire. Unauthorized or disguised tax reduction and exemption must be forbidden.

Third, the management of non-tax revenue should be enhanced. While continuing to straighten out administrative charges and government funds, and rectify and punish unauthorized charges, the government will also enhance the examination and approval of these charges and funds, improve the methods on the management of state asset proceeds, licensing earnings, and other non-tax revenue, expand the scale of lottery issuance, and tap the potential of non-tax incomes. These will serve as a basic financial safeguard for effectively implementing various fiscal policy measures.

3.4.2 Improving the standardization, safety, and effectiveness of fiscal fund utilization to curb fiscal expenditure

It is an important part of fiscal policy implementation to maintain the seriousness and authority of a budget. To this end, the central government needs to make full use of modern management methods, tighten oversight, reduce losses and waste, and straighten out the financial and economic order. It is important to promote the reform of logistical services in the public sectors, define scientifically the scope of daily expenses for government-supported nonprofit institutions, and optimize fiscal expenditure structure. The government will deepen the reform of the budgetary management system, accelerate the establishment of a scientific and standardized classification system for government revenue and expenditure, strengthen the overall supervision of budgetary enforcement, and establish and improve the system for evaluating budgeting performance. The government will also enlarge the reform scope of basic expenditure budget, practice a rationing system for appropriations to administrative bodies, manage the budgets for projects on a rolling basis, and promote the evaluation of expenditure performance by putting in place a performance-based evaluation system for fiscal resources. The reform aimed to disconnect the management of revenue and expenditure should be deepened through incorporating suitable administrative charges and other non-tax revenues into the budget. More government institutions will be included in the pilot programs for preparing comprehensive budgets.

Furthermore, efforts will be made to carry out the reforms designed to centralize treasury payments that involve central and local governments. Pilot programs will be conducted to implement direct payment of special appropriations from central to local governments. Lastly, the government procurement system will be further reformed through expanding the scope and size of the procurement.