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Intergovernmental fiscal reforms, expenditure assignment, and governance 
 
David Dollar and Bert Hofman
1
World Bank Office Beijing 
 
Paper Presented at the Roundtable Conference on  
 
Public Finance for a Harmonious Society 
 
Session on  
 
Expenditure Assignments within a Framework of Decentralization 
 
Beijing, June 28-27, 2006 
 
Introduction 
 
The Tax Sharing System (TSS) Reform of 1994 brought China’s intergovernmental fiscal 
system much closer to international practice.  It also moved China out of the precarious 
fiscal situation of the mid-1990s, and general government revenues as a share of GDP as 
well as the center’s share has increased rapidly.  At the same time, the fiscal disparities in 
the system that prevailed at the time of introduction of the TSS, which were supposed to 
be gradually reduced by expansion of the equalizing “Transitory Systems Transfer,” has 
persisted until now.  This paper argues that the unequal distribution of resources is a 
major impediment to achievement of the goals of a Harmonious Society.  However, a 
more equal distribution of resources alone is not enough, and should go hand in hand 
with better specification of expenditure responsibilities of the various levels of 
government, and stronger mechanisms for holding local governments accountable for 
those responsibilities. 
 
China’s fiscal system 
 
China’s fiscal situation has vastly improved over the last decade, and signs are that with 
the current tax structure revenues will continue to increase, provided tax administration 
keeps pace with the changing economy.  General government revenues went up from 
below 10 percent of GDP (new GDP numbers) in the mid-1990s to almost 18 percent of 
GDP now.  Some 2-2.5 percent of GDP social security contributions, which are included 
in government revenues in other countries, could be added to that, as well as 
extrabudgetary revenues of some 3 percent officially, and considerably more unofficially.  
1
This paper relies in part on the forthcoming World Bank (2006) report 
Reforming Subnational Finance:  
Lessons from Northeast China 
 authored by Dana Weist, Roy Bahl, Ines Kudo, Magnus Lindelow, Mei 
Wang and Christine Wong. 
 
56759 
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Together with a sustainable deficit of some 2-3 percent of GDP, this would provide 
China with a fiscal envelope of some 25 percent of GDP, comparable to the lower income 
OECD countries, and higher than most East Asian countries, including East Asian Newly 
Industrialized Economies (NICs).  Indeed, excluding redistributive functions through 
social security and non-contributory transfers that take up more than half of government 
spending in advanced OECD countries, China’s government size is already comparable 
in terms of share in GDP with those advanced OECD countries.
2
China is much more decentralized than OECD countries and middle income countries, 
particularly on the spending side (Table 1).  In part, the sheer size of the country explains 
this degree of decentralization, but the structure of government and some unusual 
expenditure assignments also give rise to this pattern of spending.  Functions such as 
social security, justice, and even the production of national statistics are largely 
decentralized in China, whereas they are central functions in most other countries.   
 
Table 1: Share of Subnational Governments in Total Government 
 
Developing 
Countries 
OECD 
Countries 
Transition 
Countries China 
Sub-national share of 
Government Tax Revenues 
9.27 19.13 16.59 40 
Sub-national share of 
Government Expenditure 
13.78 
32.41 
26.12 
73 
Among the sub-national levels of government, sub-provincial levels spend more than 50 
percent of overall government expenditures (Table 2).   
 
2
China’s Flow of Fund accounts 1996-2002 show that Taxes net of non-contributory transfers—the 
amount available for government consumption and investment was some 18 percent of GDP in 2002. This 
is comparable to Germany (18.6), France (18.3), the United States (17.9), and Japan (17.5).  Thanks to 
Francois Bourguignon for the OECD data, which were taken from the OECD National Accounts for 1994. 
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Table 2.  Changing Shares of Revenues and Expenditures:  
Percent Distributions by Level of Government 
Revenues 
1993 1999 2003 
1993 1999 2003 
Central Government 
22% 
51% 
55% 
Provinces 13% 
10% 
12% 
 
35%
61% 66% 
Prefectures/Municipalities 34% 17% 16% 
Counties + Townships 
32% 
21% 
17% 
 
66%
39% 34% 
Expenditures 
 
Central Government 
28% 
31% 
30% 
Provinces 17% 
19% 
19% 
 
45%
51% 49% 
Prefectures/Municipalities 23% 21% 21% 
Counties + Townships 
31% 
28% 
30% 
 
54%
49% 51% 
Source:  World Bank (2006) 
 
Fiscal disparities among subnational governments are larger in China than in most OECD 
countries.  These disparities have emerged alongside a growing disparity in economic 
strength among the provinces.  From 1990 to 2003, the ratio of per capita GDP of the 
richest to poorest province grew from 7.3 to 13. In China, the richest province has more 
than 8 times the per capita spending than the poorest province.  In the US, the poorest 
state has about 65 percent of the revenues of the average state, and in Germany, any state 
falling below 95 percent of the average level gets subsidized through the 
“
Finanzausgleich
”
(and any receiving more than 110 percent gets taxed).  In Brazil, the 
richest state has 2.3 times the revenues per capita of the poorest state (World Bank, 
2002).  Some countries for which data exist have higher fiscal disparities than China, 
though.  In Russia, disparities are larger: the richest of the 89 regions has revenues per 
capita some 40 times higher than the poorest (Martinez-Vazquez et al, 1998).  After 
transfers the richest province in the Philippines has 28 times more revenues per capita 
than the poorest one, while the same numbers for Indonesia and Viet Nam are 10, and 22 
respectively.
3
Inequalities in spending are much larger at the sub-provincial level.  The richest county, 
the level that is most important for service delivery, has about 48 times the level of per 
capita spending than the poorest county (World Bank 2006).  In Indonesia, the richest 
district government has thirty times the expenditure per capita of the poorest one 
(Hofman and Cordeiro, 2005).   These disparities in aggregate spending levels also show 
up in functional categories such as health and education where variation among counties 
and among provinces is large (Figure 1) 
3
It should be noted that these countries’ regions are much smaller than the average province in China and 
indications are that the smaller the sub-national entity in a country, the larger the measured inequality. 
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Figure 1: Within Province Disparities in Per Capita County Expenditure 
a. Education (constant 2000 RMB) 
2003
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The large vertical and horizontal fiscal imbalances put much demands on the transfer 
system, which should not only provide adequate resources to the various levels of 
government, but should also reduce the large disparities.  The current transfer system is 
dominated by the “Tax Rebates” that can best be understood as a form of revenue 
sharing, and numerous earmarked grants, which together make up over 60 percent of total 
grants.  The general equalization grant (the “transitional systems transfer”) has been 
growing in recent years, but still makes up only 10 percent of all transfers to the regions   
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Vertical imbalances in China are, as noted, large, but by itself that does not imply that on 
aggregate, insufficient resources are transferred to subnational levels.  Indeed, without a 
better specification of the role and functions of various levels of government, it is hard to 
determine whether subnational governments receive sufficient resources for their 
functions (see below).  At the same time, there are signs that the budgetary resources 
available to local governments are insufficient to cover their perceived functions.  For 
one, there is growing subnational government indebtedness.  Even though local 
governments are formally only allowed to borrow with State Council approval, this can 
be, and is, easily circumvented, and many local governments are thought to be in arrears 
on their debt.  On aggregate, local government debt is estimated to be as high as 
14percent of GDP.
4
This local government debt is one sign that the allocated budgetary 
resources are not sufficient to discharge local government responsibilities.   
 
Another sign of this is the considerable amounts of extrabudgetary resources, which have 
become critical to the finances of public service units.  Although consolidation has taken 
place since the mid-1990s when extrabudgetary funds peaked, budgetary units throughout 
the government system still generate considerable non-tax revenues, which are by and 
large used for service provision.
5
The disparities in expenditure per capita cited above already suggest that the transfer 
system has limited impact on the horizontal imbalances.  Indeed, the transfer system as a 
whole is not equalizing in the sense that per capita transfers to the provinces continue to 
show a positive correlation with per capita income (World Bank 2006).  Even if the tax 
return transfers are taken out, the remaining discretionary transfers show a similar 
positive correlation with per capita income (Persson and Erikson, 2006), which suggests 
that other considerations than equalization dominate the transfer system.  
 
Intergovernmental Fiscal Reforms for a Harmonious Society  
 
The Chinese intergovernmental fiscal system is clearly evolving.  The Tax Sharing 
System Reform of 1994 has been very successful in reversing the downward trend in 
government revenues and the central share in government revenues.  As a result, the size 
of the public sector has grown, but so has the fiscal imbalance among the central, 
provincial and local governments.  Expenditure assignments to sub-provincial 
governments are inappropriate in some cases and expenditure responsibility is unclear.  
Disparities between rich and poor places are large, and the present system of transfers 
does not sufficiently equalize these disparities.   
 
Ongoing reforms such as completing the Tax Sharing System reform below provincial 
levels, the rural tax reform, changes in expenditure assignment, the “three rewards and 
one subsidy” program, budget management and treasury reform are introducing 
P
Half of that is owed to the center, and the 14 percent of GDP should therefore not all be seen as additional 
general government debt 
5
It is largely because of the extrabudgetary funds that the government sector in the National Accounts is 
some 5 percentage point larger than in the fiscal accounts.   
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fundamental changes that affect virtually all aspects of the intergovernmental fiscal 
system.  However, because these reforms are implemented in piece-meal ways, they often 
introduce complications that have had unintended effects.  For example, policy calls for 
addressing the fiscal problems of the county and township levels, but reform measures 
such as the rural fee reform and the abolition of the agricultural tax reduce revenues, and 
policies such as the teacher salary increases push up cost burdens to those levels of local 
government.  Compensatory transfers from central government only partially cover the 
lost revenue or increased costs.  Other levels of government are meant to contribute to 
this compensation as well, but implementation is often only partial.   
 
A
rebalancing of the fiscal system is essential.  This can be accomplished through some 
combination of expenditure reassignments, productivity improvements, new independent 
sources of revenue for local governments, a restructuring of intergovernmental transfers, 
and establishing a framework for responsible borrowing.  Correcting the 
dysfunctionalities in the existing intergovernmental fiscal system will likely also have a 
positive effect on the financing and delivery of local education and health services.  
 
The key challenge for China’s fiscal system in supporting the Harmonious Society 
remains the high fiscal inequality.  This fiscal inequality is a problem for China as a 
whole, not just the poor regions: from the perspective of the central government, the 
fiscal system should provide for a minimum standard of public goods for all Chinese, but 
the highly unequal distribution of resources means that China as a whole can only afford 
very low standards that are increasingly out of line with the country’s status on the 
international scene.  The rich regions have arguably 
excess
 revenues, which they are free 
to spend on pet projects like Olympics and World Exhibitions, but from a national point 
of view such spending means that Gansu is not capable of sending kids to school for 9 
years of basic education.   
 
To illustrate, on current policies, the poorest region on a per capita basis (Henan 
province) only spent RMB900 per capita for consolidated provincial government in 2004.  
The richest (Shanghai) spent RMB 8000.  If China would seek minimum standards of 
public service for the country as a whole, this can only cost as much as the poorest region 
can afford (Figure 2, the bottom line), so RMB900.  If more equalization were to take 
place, those minimum standards could be raised.  With perfect equalization on a per 
capita basis,
6
i.e. all provincial resources are pooled, and allocated on a per capita basis to 
the provinces, the average per capita spending level could be almost RMB1600, and so 
the national minimum standard could be almost twice as high. 
6
Note that such an extent of equalization may not be desirable from the perspective of incentives for 
revenue mobilization, nor may an equal per capita amount necessarily equalize expenditure needs. 
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Figure 2: Provincial expenditures and central minimum standards. 
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National Minimum Standard 
with Current Distribution
Feasible Minimum Standard 
with Perfect Equalization
Provincial expenditures per capita, 2003
Source:
 China Statistical Yearbook 2005 and staff estimates 
Thus, achieve the Harmonious Society for 
all,
 a
major reallocation of fiscal resources 
will need to take place.  This is politically very difficult, as well as technically 
challenging, but in the end it will be necessary.   
 
First, China would need to devote an increasing amount of resources to equalizing 
grants
—in exchange for higher performance standards for the receiving regions (see 
below).  A better definition of fiscal needs in the regions, including a much more detailed 
assignment of obligatory functions across all levels of government, and over time 
establishment of affordable minimum standards will be required for this.  In addition, a 
better definition of revenue capacity, including extrabudgetary funds, would be needed to 
better define the grants system.   
 
Second, China should consider options for devolving more revenue sources that benefit 
poor regions.  An excellent opportunity here is natural resource taxation, which in China 
are assigned to the regional governments.
7
Many of China’s scarce resources (water, 
energy, land) are located in the poor regions, whereas most of the consumers of the 
resources are located in the rich regions.  Taxing these scarce resources more by means of 
7
This by itself could be problematic, although many countries around the world have similar arrangements.  
See Hofman and Manuelyan, 1994, for a comparison of China’s and international practice.   
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higher resource taxes would therefore not only be good for a more efficient use of those 
resources, but also help in reducing some of the current fiscal disparities.   
 
Third, China could consider cutting transfers to the rich regions in tandem with 
increasing 
the tax base for subnational governments.  This is good for reasons of 
accountability, and would free up fiscal resources for more transfers to the poorer 
regions.  A well-designed property tax to replace the existing real estate and land taxes 
(and the many extrabudgetary fees and charges put on land transactions) would be an 
excellent source of revenue for urban areas, and one that could promote more efficient 
land use at the same time.  Other options for local tax bases include motor vehicle taxes 
and a surcharge on the personal income tax. 
 
Fourth, central government should get involved in sub-provincial distribution of 
resources.  As noted, sub-provincial inequalities are even larger than inter-provincial 
inequalities, and the center could, as a minimum, set limits on the disparities among sub-
provincial governments.  China could go further, and consider defining revenue 
assignments for each level of governments, and expanding the central treasury system 
such that the transfer system can target the county level directly, and thereby making 
equalization a truly central task. 
 
Expenditure Assignment and Accountability. 
 
Since reforms in the intergovernmental fiscal system started in 1980, the emphasis has 
been on the revenue side and the transfer system.  Indeed, the budget law, which is the 
basis for the current intergovernmental fiscal arrangements, only provides a broad 
division of labor between central and local governments, and does not touch upon sub-
provincial responsibilities, which is left to provincial governments, and considerable 
variation exists.  Sector laws often give only token attention to the issue of functional 
assignment and its fiscal consequences.  In contrast, other decentralized countries define 
the responsibilities in much more detail, either in the constitution (South Africa, 
Germany), in a special law on local government (Philippines, Indonesia) or in sectoral 
laws.   
 
The absence of a clear assignment of responsibility is problematic in a number of ways: 
·
It could lead to overlapping responsibilities, to unfunded mandates on local 
government, or to the underprovision of essential public services 
·
It leaves expenditure needs of the various levels of governments undefined.  
Without it, it is hard to define an effective intergovernmental fiscal system, as it is 
unclear as to what level of spending a local government is to undertake to 
implement national policies. 
·
It undermines accountability of local governments, as neither their constituents, 
nor supervising governments are in the clear what to expect in terms of service 
delivery from that level of government. 
 
The international literature emphasizes that clarity of function is more important than 
exactly which level does what.  The economic literature prescribes that a function should 
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be assigned to that level of government that best matches benefits and costs of that 
function, whereas the “subsidiarity principle” would lead to assignment of a function to 
the lowest possible level.  These considerations, however, still leave much scope for 
interpretation, and in practice there is considerable variety in the assignment of functions 
among countries.   
 
For some functions, China’s assignment of functions is out of line with what theory 
would prescribe and with what other countries practice. Thus, China could consider 
centralizing
 some of the responsibilities for government services, or at least of 
centralizing the financing of those services, for equity reasons as well as efficiency as 
well.  In particular, income-maintenance responsibility (pensions, disability, and 
unemployment insurance) would seem an inappropriate assignment for sub-provincial 
governments.  In most countries, this is a central government responsibility.  In a large 
country like China, it may be reasonable to assign this function to the provinces, but 
prefectural and county responsibility for this function, as is presently the case, is likely 
not viable in the long run.  The reassignment of these functions should be accompanied 
by a reassignment of revenues.   
 
For most functions it is more important to clarify rather than to reassign.  In that context, 
first order of business for China is to establish more clearly the nature of local 
government.  While China is a unitary country, and local governments are in principle an 
agent of the central government, de facto there is a high degree of autonomy for 
subnational governments.  This may well be desirable in a large country such as China, 
but at the same time, determining the boundaries of autonomy would from a fiscal 
perspective be desirable.  In particular, the continued role of many sub-national 
governments in the production of basically private, tradable goods remains an issue.  In 
many unitary countries, the central government determines by law what type of activities 
local governments can be engaged in through a 
positive list 
of
functions (“an “ultra vires” 
definition of local governments).  But even if local government is granted a wide range of 
autonomy (“general competence”), central government could consider specifying at least 
those functions that a local government 
must
 perform, 
obligatory functions
,
lest fiscal 
resources be used for tasks that are not considered national priorities. 
 
Detailed empirical evaluation of the fiscal implications of expenditure assignment and 
reassignment is needed.  In doing this analysis, it will be necessary to work out the fiscal 
implications (and necessary
 
remedial policies)
 
for the next five to ten years if no 
restructuring takes place.  This is a bigger issue than just expenditure assignment.  The 
financing of this shift in responsibility would likely include a reassignment of some 
revenue sources and reallocation of transfers as well.   
 
The gradual expansion of the experiment to establish three levels of (budgetary) 
government rather than the current five offers an important opportunity to clarify 
expenditure responsibility.  Functions will need to be reassigned from either the township 
level or the prefectural level to county/municipal level or province level, which is a 
massive task, and one fraught with considerable risk to service delivery as well as budget 
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discipline, if not done together with a careful mapping of responsibilities and expenditure 
needs. 
 
Enforcing accountability
 
Even if responsibility over functions is clarified, China still faces considerable challenges 
with enforcing accountability.   This is of considerable concern, because without 
accountability there are limits to what the intergovernmental fiscal system can achieve in 
terms of efficiency and redistribution.  Specifically, if there is limited accountability for 
results, more equalization of spending to poorer provinces could well lead to higher waste 
of resources rather than better service delivery for the poorer part of the population, and 
achieving the goals of the Harmonious Society may be only partial. 
 
Given the high degree of decentralization in China, a key issue is accountability of local 
governments to central government.  Key in this accountability is the evaluation criteria 
for local officials.  Up until recently, evaluation criteria for local officials were heavily 
focused on achieving investment and growth.  These are not that hard to measure, and the 
accountability system has evidently worked reasonably well.  But the shift in focus to a 
“harmonious society” reflects the fact that China has reached a stage of development in 
which the people and the central government are putting more weight on non-growth 
outcomes, such as health status of the population, educational attainment, energy 
efficiency, and quality of the natural environment.  It is inevitably going to be harder for 
the central government to know if the local government is doing a good job meeting these 
multiple objectives and to use that information in staffing and financing decisions.   
 
There are complementary directions in which China can try to improve accountability of 
local officials to the center.  First, China has quite a few transfers ear-marked to specific 
issues: for example, transfers for rural education.  In many countries some or all of the 
transfer would be conditional on meeting certain performance criteria.  The criteria could 
be as simple as number of students who complete the school year; or they could be a 
more sophisticated measure of what the government really wants to support: for example, 
having a certain percentage of exiting students pass a standardized exam.  There are a 
number of areas of public policy where performance-based grants can be an effective tool 
of redistribution and accountability.  A system of broad categorical block grants for the 
main functions in which the center takes an interest (health, education, rural 
infrastructure) with equalizing properties, and conditional on performance could also be a 
good intermediate steps—better than the multitude of ad-hoc earmarked grants with 
conflicting objectives in place today, but short of a single unconditional equalizing grant 
that requires a better specified system of expenditure responsibilities. 
 
A
second and complementary approach is a more general benchmarking of the quality of 
government in different locations.  The World Bank is involved in an interesting example 
of this right now.  We have worked with the National Statistical Bureau to carry out an 
investment climate survey covering 12,400 firms in 120 Chinese cities.  Many of the 
questions get at the issue of local governance and how it affects the climate for 
investment: for example, how much time firms have to spend dealing with the 
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government bureaucracy, whether they have to pay bribes to get loans from the state-
owned banks, how long it takes to clear goods through customs.  In general, cities in 
China vary enormously in these areas, and cities with better local government receive 
more foreign investment, more local private investment, and more growth.   
 
An innovation in this round of investment climate surveys is that we also collected data at 
the city level on social issues such as the unemployment rate, education expenditure per 
capita, and medical insurance coverage, as well as on environmental issues such as clean 
air days per year, percent of water treated, and green space per capita.  We find a very 
clear pattern in which cities with better investment climate also tend to have better social 
and environmental conditions (Figure 3).  To some extent these measures provide a 
scorecard on local governance.  I do not think that there is a unique, scientific way to 
create such a scorecard.  But efforts to measure and publicize the quality of governance in 
different cities stimulate a healthy debate and puts competitive pressure on cities to 
provide better services.  Indeed, such benchmarks are likely to influence investors in their 
choice of location, which in turn would stimulate cities to improve their investment 
climate.  For the central government, looking at these kinds of benchmarks can help 
identify locations where governance is quite poor and which need specific reform 
measures before any large increase in transfers are likely to bear fruit.   
 
Figure 3: Investment Climate and Harmonious Society 
Harmonious society and investment climate
-1.5
-1
-0.5
0
0.5
1
1.5
-3
-2
-1
0
1
2
3
Investment climate index
H
a
r
m
o
n
i
o
u
s
s
o
c
i
e
t
y
i
n
d
e
x
Source: Author’s estimate based on 120 cities investment climate survey 2005 
A
similar benchmarking exercise is under way for public services.  The World Bank, 
together with the DRC and Tsinghua University is sponsoring a pilot household survey in 
5
cities to 
determine people’s perception of public services in their city, a variation of the 
“citizen’s scorecards” that has gained popularity in countries such as India, Indonesia, 
and the Philippines.  Although people are less mobile than capital in China, and 
perception based surveys need careful interpretation, the central government could decide 
to take these and similar indications of household satisfaction with their public services 
into account in allocation decisions and/or promotion of local officials. 
 
Page  12
12
A
third option for better accountability is citizens
’
participation in decision making on 
budgets.  China has already started several experiments in this regard citizen’s budgets 
and community driven development.  The China Development Foundation is 
experimenting with participation in budget processes in several local governments in 
China, whereas the Leading group for Poverty Reduction has just started an experiment 
in community driven development in 60 villages across the country in which villagers 
themselves rather than the government decide on how to use village grants funded from 
the county and central budget. 
 
Finally, more fiscal transparency at all levels of government would improve 
accountability over service delivery as well.  More information as to how the budget is 
spent would allow People’s Congresses at all levels to better discharge their oversight 
function.  More information in the public domain would allow better policy analysis and 
evaluation by the rich field of research institutes and universities that China possesses.  
The upcoming revision of the budget law is in this respect an opportunity t anchor more 
transparency in fiscal and intergovernmental fiscal matters in law. 
 
Conclusion
 
China has in principle sufficient fiscal resources to afford the level and type of spending 
that would be commensurate with a Harmonious Society.  But to achieve this spending a 
major redistribution of resources will be needed, not just among provinces, but also 
below the province.  This reallocation of resources can only be done gradually, and 
would need to go hand in hand with a better specification of roles and functions of the 
various levels of government, and stronger mechanisms for accountability to ensure that 
poorer local governments use their higher level of resources well.  
 
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13
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