Into the Trap of Strengthening State Capacity: China's Tax-Assignment Reform

Author(s): Pak K. Lee

Source: The China Quarterly , Dec., 2000, No. 164 (Dec., 2000), pp. 1007-1024
Published by: Cambridge University Press on behalf of the School of Oriental and
African Studies

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Research Note

Into the Trap of Strengthening State

Capacity: China's Tax-Assignment Reform*
Pak K. Lee

The Third Plenum of the 14th Central Committee of the Chinese Commu-
nist Party (CCP) in November 1993 decided in principle for a compre-
hensive reform of central-provincial fiscal relations. Soon after the
Plenum, the central government announced that the new fiscal system,
known as the tax-assignment system (fenshuizhi), would be implemented
nation-wide in 1994. With the aim of providing adequate revenues for
government, particularly the central government, by revamping central-
provincial revenue-sharing arrangements, the reform is to "[change] the
current fiscal contractual responsibility system of local authorities to a tax
assignment system ..." and to "gradually increase the percentage of fiscal
income in the gross national product (GNP) and rationally determine the
proportion between central and local fiscal income."'
Closely related to fiscal reform is the analysis of the reform policy in
relation to "state capacity." In studying China's previous fiscal reforms
between 1980 and 1993, Wang Shaoguang and Hu An'gang produce a
spectrum of weak to strong states according to the measure of tax receipts
as a proportion of GNP.2 They call for the central government to
strengthen its control over the economy and the regional governments by
increasing its extractive capacity. Although Wang and Hu's policy pro-
posal has won support from the central government, the concept "state
capacity," which lies behind the policy advice, creates more questions
than answers. The questions being addressed here are: is the existing
literature on state capacity, particularly that applied to China, cogent
enough for us to understand the alleged low level of state capacity in
China? If this is not so, what new perspective can be suggested to account
for the problem?
This article focuses on the political factors that shape the capacity of
the central government in implementing the 1994 tax reform. It first
offers a critique of the theory of state extractive capacity, and in its place
presents a normative theory of state capacity. Secondly, it highlights the

* Research for this article was supported in part by a research grant offered by the School
of Arts and Social Sciences at the Open University of Hong Kong.
1. See the "Decision of the CPC Central Committee on some issues concerning the
establishment of a socialist market economic structure," Beijing Review, 22-28 November
1993, p. 20.
2. Wang Shaoguang and Hu An'gang, Jiaqiang zhongyang zhengfu zai shichang jingji
zhuan xing zhong de zhudao zuoyong - guanyu Zhongguo guojia nengli de yanjiu baogao (To
Strengthen the Leading Role of the Central Government in the Transition to a Market
Economy: A Research Report on China's State Capacity), 1993, mimeo. See also Wang
Shaoguang, Fenquan de dixian (The Lower Limit of Decentralization) (Beijing: Zhongguo
jihua chubanshe, 1997), ch. 1.

? The China Quarterly, 2000

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1008 The China Quarterly

politics behind the evolution of the tax-assignment system. It then

assesses the impact of the new system on the extractive capacity of the
central government. Problems in augmenting the central government's
extractive capacity are thoroughly examined.

A Normative Theory of State Capacity

Following the pioneering studies by Almond and Powell and by

Organski and Kugler, extractive power has been regarded as the most
important ingredient of state capacity.3 However, the approach has been
under criticism on two grounds. The original purpose of Organski and
Kugler's study was to investigate national differences in the military
capability to launch and win international wars. They intended to explain
why the "weak" were beating the "strong." However, they did not take
note of the political constraints that prevented governments from taxing
to the utmost in peacetime where survival of the nation is not at stake.
More importantly, the approach fails to explain why a given state does
better or worse than it should. What is missing is a theory that explains
what and how political forces lead to success or failure in extracting
revenues from the subordinate.
Jackman proposes an alternative analytical framework in his study of
national political capacity. He holds that political capacity rests on
routinization of organizations and political legitimacy. A legitimate state
is one that is able to induce compliance and consent from the ruled
without resort to physical force. A state can be viewed as possessing high
capacity if it can create durable institutions that survive the strains of
leadership transition and if disputes are resolved through non-violent,
political means.4 But Jackman's conceptualization of legitimacy begs a
fundamental question: how can a state generate consent and conformity
without using physical force? To answer the question, one has to take a
normative perspective to investigate the norms and values invoked as
justification for a particular political order.
Legitimacy may refer to two dimensions: legal and moral. Power can
be said to be legitimate if the power-holders acquire and exercise it in
accordance with established rules, whether formal or informal. Secondly,
legitimacy derives from a personal sense that the orders of the authorities
accord with one's own sense of rightness. They provide the subordinate
with moral grounds for compliance with the powerful.5
Snider argues in a similar vein that political extraction, or the ability to
extract human and material resources from society and deploy them to
achieve the national goals set by the government, constitutes only one of

3. Gabriel A. Almond and G. Bingham Powell, Jr., Comparative Politics: A Developmen-

talApproach (Boston: Little, Brown and Co., 1966), ch. 7; A.F.K. Organski and Jacek Kugler,
The War Ledger (Chicago: Chicago University Press, 1980).
4. Robert W. Jackman, Power without Force: The Political Capacity of Nation-States
(Ann Arbor: University of Michigan Press, 1993).
5. David Beetham, The Legitimation ofPower (Atlantic Highlands, NJ: Humanities Press
International, 1991), Part 1.

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 China's Tax-Assignment Reform 1009

the elements of state capacity. More important is the institutional aspect

of political capacity. The growth of institutional credibility improves
extractive capacity, but not vice versa. Strengthening the ability to
provide a policy environment with secure and well-defined property
rights and reliable contract enforcement is key to encouraging a flow of
resources from the constituent population to the national government.6 It
is also noted that the absence of political credibility and institutional
stability, often resulting from the lack of effective control on the discre-
tionary power of the state to revise announced policies as it wishes, leads
to strategic reactions on the part of entrepreneurs. In anticipating frequent
reversions in policies, the private sector will protect its interests by
withholding resources or by investing in liquid assets only.' A likely
consequence is that the state will extract less wealth from the population
than it should have had otherwise.
Holsti also relates state strength to political legitimacy. He suggests
that legitimacy can be examined from vertical and horizontal aspects.
Vertical legitimacy is concerned with voluntary compliance between
rulers and ruled; horizontal legitimacy deals with the boundary of the
political community over which formal rule is exercised. A fundamental
prerequisite of vertical legitimacy is to maintain "a reasonable balance
between the demands of extraction, the expectations of service deliveries,
and participation."8
This article argues from a normative perspective that while state
capacity denotes the ability or effectiveness of a political system to
mobilize human and material resources required to advance its chosen
goals, it has a close relationship with political cohesion rather than with
military and economic capabilities. To strengthen the foundation for
the political cohesion, the state or the national government must secure
and honour the property rights alignments with the population and
simultaneously allow all parties concerned equal effective access to the
policy-making process. Without these preconditions, any move to in-
crease tax extraction by a fiscally weak state will further destroy the
mutual trust and political cohesion between the state and its subordinates,
and perpetuate its weakness.

Central-Provincial Bargaining over the Tax-Assignment Reform

The idea of tax-assignment reform originated in the mid-1980s when

China's Ministry of Finance proposed substituting taxes for profits (li gai
shui) in the enterprises and correspondingly implementing a system of

6. Lewis W. Snider, Growth, Debt, and Politics: Economic Adjustment and the Political
Performance of Developing Countries (Boulder, CO: Westview Press, 1996).
7. Aymo Brunetti and Beatrice Weder, "Political credibility and economic growth in less
developed countries," Constitutional Political Economy, Vol. 5, No. 1 (Winter 1994), pp.
23-43; Silvio Borner, Aymo Brunetti and Beatrice Weder, Political Credibility and Economic
Development (Basingstoke: Macmillan Press, 1995).
8. Kalvei J. Holsti, The State, War, and the State of War (Cambridge: Cambridge
University Press, 1996), p. 92.

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1010 The China Quarterly

dividing taxes between the central and provincial governments. Although

the central leaders, primarily Zhao Ziyang, initially approved the reform
idea, the system met resistance from subnational governments and enter-
prises. The latter feared that the new system would diminish their
revenues and thus opted for a preservation of the status quo in tax
distribution. Fearing that the new reform measure would dampen local
incentives to collect revenue, the central leaders took the initiative to
abandon the tax-for-profit programme in favour of "enterprise manage-
ment contracts" and "general fiscal contracting system" (dabaogan). The
arrangement whereby total revenue (excluding central revenue) was
shared between central and provincial governments survived in the
majority of provinces until 1988.'
The macroeconomic problems caused by fiscal contracting were evi-
dent in 1988.10 To strengthen macroeconomic regulation by the central
government, the CCP laid down the principle of "adequate centralization"
in its Fifth Plenum of the 13th Central Committee at the end of 1989."
Early in the autumn of 1990, it was intended to recentralize the sharing
of budgetary revenues between central and provincial governments.
However, because of serious discord within the central leadership and
tremendous resistance from provincial leaders, the measures were
shelved.12 Therefore, all the central government could achieve in the
Seventh Plenum in December 1990 was to allow a pilot scheme of the
tax-assignment system in nine provinces and cities during the Eighth
Five-Year Plan period (1991-95). In other words, the fiscal contracting
system remained intact during the period.
In 1992, experiments of the tax-assignment scheme were conducted. It
was originally expected that the system would be implemented nation-
wide in 1993 or 1994.13 However, ample evidence shows that in early

9. Susan Shirk, The Political Logic of Economic Reform in China (Berkeley: University
of California Press, 1993), ch. 9. Hu An'gang, "Background to writing the report on state
capacity," The Chinese Economy, Vol. 31. No. 4 (July-August 1998), pp. 4-29.
10. The problems of the post-Mao fiscal reforms have been superbly discussed by Jae Ho
Chung, "Beijing confronting the provinces: the 1994 tax-sharing reform and its implications
for central-provincial relations in China," China Information, Vol. 9, Nos. 2/3 (Winter
1994-95), pp. 7-13. For a Chinese source, see Jia Kang and Yan Kun, Zhuangui zhong de
caizheng zhidu biange (The Institutional Reform of Public Finance in a Transition Economy)
(Shanghai: Shanghai yuandong chubanshe, 1999), pp. 63-70.
11. "Opinion," China Economic News, 29 October 1990, p. 1.
12. In September 1990 when Premier Li Peng spoke on the dangers of excessive
decentralization, Ye Xuanping, the then governor of Guangdong province, openly challenged
the Premier's assertion. See Richard Baum, "The paralysis of power: Chinese politics since
Tiananmen," in William A. Joseph (ed.), China Briefing, 1991 (Boulder, CO: Westview Press,
1992), p. 26; Ling Zhijun, Chen fu: Zhongguo jingji gaige beiwanglu (1989-1997) (Sink or
Swim: A Memorandum of China's Economic Reforms, 1989-1997) (Shanghai: Dongfang
chuban zhongxin, 1998), p. 122n. Deng Xiaoping also reportedly rejected a draft blueprint
of the Eighth Five-Year Plan for emphasizing central control over the economy rather than
commitment to continuing economic reforms. Jing bao (The Mirror) (Hong Kong),
November 1990, p. 41; "Deng rejects draft of Five Year Plan," South China Morning Post,
9 October 1990.
13. China News Analysis (Taipei), No. 1508, 15 April 1994, p. 5; Renmin ribao, 14 June
1993, pp. 1-2; Lok Sang Ho, "Central-provincial fiscal relations," in Joseph Yu-shek Cheng
and Maurice Brosseau (eds.), China Review 1993 (Hong Kong: Chinese University Press,
1993), p. 12.9.

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 China's Tax-Assignment Reform 1011

1993 the central government made no preparation to implement it. Fiscal

reform did not appear in the 11-point proposal on revising some of the
targets of the Eighth Five-Year Plan that the Second Plenum of the 14th
Central Committee specifically submitted to the first session of the Eighth
National People's Congress (NPC) in March 1993.14 Therefore, in his
government work report delivered to the NPC session Premier Li Peng
did not spell out the fiscal reform in any detail.
No major advance in breaking the status quo took place until April
1993 when the Chinese economy was once again plagued by overheating,
inflation and speculation in property and security markets." As early as
July 1992, central leaders had been alarmed by the growth of capital
construction and the development of various economic development
zones in the localities. Comparisons with the conditions in 1988 were
made. However, because of the lack of consensus among central and
local leaders and economists on whether the national economy was
overheated, there were no determined efforts to rein in the localities in
economic management.16 The NPC session in March 1993 was dominated
by Deng Xiaoping advocating seizing the opportunity to accelerate the
development made in early 1992 and early 1993. The impact of his
remarks was reflected in the defiance of the central proposal to cool down
the economy on the part of provincial, particularly coastal, leaders. The
most notable example was Jiangsu. Chen Huanyou, the then governor,
stressed that he and Shen Daren, the then provincial Party secretary,
received personal instructions from Deng Xiaoping in February 1992 that
Jiangsu's economy should grow faster than that of other provinces. Chen
even advised against debating whether or not the economy was over-
heated." However, the harsh situation prompted top leaders to believe
that it was absolutely necessary to strengthen macroeconomic regulation
of the national economy.18
On 1 April 1993, Jiang Zemin called for strengthening macroeconomic
control to achieve a balance between aggregate demand and supply, and
to straighten out the distribution relations between the central and provin-
cial governments by reforming the public finance system. He argued that
this was the proper attitude fully, correctly and positively to implement

14. Ming bao, 12 March 1993, p. 7, in Foreign Broadcast Information Service, Daily
Report - China (FBIS-CHI), 15 March 1993, pp. 9-10.
15. Compared with the same period in 1992, gross industrial output value and fixed
investment in the first half of 1993 rose by 25.1% and 61% respectively (Xinhua News
Agency, 19 July 1993, in FBIS-CHI, 19 July 1993, p. 24).
16. Senior officials in the capital were said to harbour worries about whether an overheated
economy would spark inflation; local officials were rather enthusiastic about making
investments; and economists argued that some signs of overheating notwithstanding, overall
economic conditions were basically sound. A commentator's article in the Jingji ribao
(Economic Daily) in January 1993 pointed out that no local government admitted that it had
to cool down the overheated economy, but the article warned of the danger of imposing
uniformity on the localities. Jingji ribao, 17 January 1993, p. 1.
17. Renmin ribao, 18 March 1993, p. 2; Ling Zhijun, Sink or Swim, p. 307.
18. Wenhui bao, 8 November 1993, p. 2, in FBIS-CHI, 8 November 1993, pp. 39-40; Ling
Zhijun, Sink or Swim, p. 318.

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1012 The China Quarterly

Deng Xiaoping's instructions (emphasis added)." Jiang instructed the

Ministry of Finance and the State Administration of Tax (SAT) to
examine the issues regarding fiscal and tax reforms in the same month.20
In late June 1993, he emphatically asserted that macroeconomic control
was key to establishing a socialist market economy.21 Monetary and fiscal
policies were regarded as two indispensable components of China's
macroeconomic stabilization policy. In contrast to a commentator's arti-
cle in the Jingji ribao, which argued against "seeking uniformity of
everything," the Renmin ribao editorial on 12 July 1993 stressed the need
to unify the understanding of the economic conditions on the part of the
Party and society. Twenty work teams were dispatched to regions to
enforce macroeconomic control over the national economy by the central
authorities. When receiving delegates from provinces between July and
August 1993, Deng Xiaoping allegedly stepped in to criticize localism.22
Concomitant with financial reform was the attempt to reform public
finance in order to gather more funds into state coffers. Zhu Rongji
asserted in July 1993 that the fiscal contracting system, as a transitional
system, no longer suited the needs of a market economy.23
The policy advice by Wang Shaoguang and Hu An'gang in mid-1993
served as a catalyst for the Centre's acceptance of the tax-assignment
reform.24 In late May 1993, they published their report on state capacity
at the Chinese Academy of Sciences. Hu made the fullest use of the major
channels of communications to let the central and provincial leaders read
the report. An extract of it appeared first in a Xinhua internal publication,
Guonei dongtai qingyang (Final Proof of Internal Development) in June
1993, and then in a Renmin ribao internal report, Neibu canyue (Internal
Reference), in July 1993.25 In the report, Wang and Hu stressed the
importance of the extractive capacity of China's central government in
pushing ahead economic development of the country. Both also argued
elsewhere that there are limits to decentralization, beyond which it would
lead to disintegration. They attributed the disintegration of the former
Yugoslavia to the shortage of fiscal revenue in the federal government

19. Zijing (Bauhinia) (Hong Kong), June 1993, pp. 6-9. Later, in November 1993, the
central authorities, in invoking the authority of Deng Xiaoping to justify the macroeconomic
regulation, argued that while Deng advocated the necessity of grasping opportunities to
accelerate development, Deng warned at the same time that it was necessary to be prudent
and prevent losses, especially major losses. The commentator's article, Renmin ribao, 9
November 1993, p. 1.
20. Hu An'gang, "Background to writing the report on state capacity."
21. Renmin ribao, 1 July 1993, p. 1.
22. "More teams to help push uniformity," South China Morning Post, 20 July 1993;
"Deng Xiaoping huijian difang zhengyao de neili qiankun" (The real purposes of Deng
Xiaoping's meeting with local politicians"), Xinbao caijing xinwen, 20 August 1993.
23. Xinhua News Agency, 26 August 1993, in FBIS-CHI, 27 August 1993, pp. 34-35. See
also Renmin ribao (haiwai ban), 14 September 1993, p. 1.
24. Hu An'gang said that the joint report was accepted by the central authorities when they
devised financial and taxation policies to strengthen macroeconomic regulation (Xinhua News
Agency, 25 July 1993, in FBIS-CHI, 27 July 1993, pp. 33-34).
25. Hu An'gang, "Background to writing the report on state capacity."

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 China's Tax-Assignment Reform 1013

and the huge regional income disparities.26 The policy advice was well
received by the central government because the authors called for setting
up a new institution to govern central-local relations while taking a broad
perspective by considering the political risks of adhering to the old fiscal
system. These fitted in well with the prevailing thought and needs of the
central leaders.27
Although the central leaders were committed to the new fiscal system,
they still had to mitigate negative reactions from recalcitrant provincial
leaders. Zhu Rongji, along with 62 senior cadres, had visited 15 or 16
provinces and municipalities, including the prosperous coastal ones of
Guangdong, Shanghai and Jiangsu, since August 1993.28 While such
inland provinces as Shaanxi, Qinghai and Gansu reportedly welcomed the
new system, believing that it would enable the central government to
allocate more funds to backward areas, some coastal provinces enter-
tained serious misgivings. Guangdong, Shanghai and Jiangsu reportedly
opposed the tax reform.29 To induce provincial compliance, the central
authorities used a carrot-and-stick approach. In anticipation of major
resistance to the reform from Guangdong, both Jiang Zemin and Zhu
Rongji visited the province in September 1993 to secure support for the
plan.30 In Guangdong, Zhu allegedly offered a special injection of 1.6
billion yuan in credit to the province in the last months of 1993 to
maintain the normal production of key industrial enterprises there. In
chairing a regional economic work conference in Guangzhou, Jiang
warned that economic regionalism, after corruption, had become a threat
to the rule of the Communist Party.31' Having received the political
support of Guangdong, Zhu emphatically praised the province as a model
for subordinating partial interests to national interests in the Third Plenum
of the 14th CCP Central Committee in November 1993.32 Zhu went to
Shanghai in October to solicit support for the impending reform. Orig-
inally, Shanghai wanted to keep the dabaogan system it attained in 1988.

26. Hu An'gang, "Fenquan shi you dixian de - qian Nansilafu fenlie de jiaoxun yu qishi"
("There is a bottom line of decentralization: the lessons and inspiration from the break-up of
the former Yugoslavia"), Gaige (Reform), No. 2, 1996, pp. 123-26; Wang Shaoguang,
"Fenquan de dixian" ("The bottom line of decentralization), Zhanlue yu guanli (Strategy and
Management), No. 2, 1995, pp. 37-56.
27. Senior officials of the Ministry of Finance told Wang and Hu in their meeting in June
1993. Hu An'gang, "Background to writing the report on state capacity."
28. South China Morning Post, 19 January 1994, cited in Jae Ho Chung, "Beijing
confronting the provinces," p.16; Asian Wall Street Journal, 10-11 December 1993, p. 1.
29. "Tighter control of cash order," South China Morning Post, 4 December 1993;
" 'Warlords' warned on tax reform," ibid., 6 December 1993; "Strange case of the missing
economic czar," ibid., 8 December 1993; Zhongguo tongxun she (Hong Kong), 18 January
1994, in FBIS-CHI, 27 January 1994, pp. 54-55.
30. Yang Jisheng, Deng Xiaoping shidai 1976-1997 (The Era of Deng Xiaoping
1976-1997) (Hong Kong: Sanlian shudian, 1999), p. 408.
31. Xianggang shangbao (Hong Kong Commercial Daily), 21 September 1993, p. 2, in
FBIS-CHI, 23 September 1993, pp. 43-44; Xianggang shangbao, 23 September 1993, p. 8,
in FBIS-CHI, 24 September 1993, pp. 36-37; South China Morning Post, 24 September 1993,
p. 11, in FBIS-CHI, 24 September 1993, p. 37; Hong Kong Standard, 5 October 1993,
pp. 1, 7, in FBIS-CHI, 5 October 1993, p. 22.
32. South China Morning Post, 23 November 1993, p. 1, in FBIS-CHI, 23 November 1993,
p. 46; Wenhui bao, 29 November 1993, p. 2, in FBIS-CHI, 30 November 1993, pp. 22-23.

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1014 The China Quarterly

In a bid to win its compliance, Zhu pledged that the preferential policies
offered to the Pudong development zone in east Shanghai in 1990 and
1992 were to remain intact under the new system. In return, Shanghai
agreed to turn over an additional sum of 600 million yuan on the top of
the originally agreed sum of 11.5 billion yuan to central coffers in 1993.33
However, the central authorities sacked the Party Secretary of Jiangsu,
Shen Daren, in October 1993 for his defiant attitude towards the tax
reform.
In addition, a number of concessions and pledges were added to the
reform scheme to make it more appealing to local governments. The first
one was to guarantee that the 1994 revenue of each province would not
be less than it was in 1993. For this purpose, the retained revenue of a
province in 1993 was used as the base figure and the net loss in accepting
the new system was calculated. The central government would reimburse
an amount equivalent to the net loss to the province to compensate, if the
province's revenue in 1994 fell below the base figure.34 Originally, the
central government set the year 1992 as the base year; however, after
bargaining between Guangdong and the central government it was de-
cided in September 1993 to use 1993 instead.35 Because of the economic
boom and the concomitant rise in fiscal revenues in 1992-93, it was
advantageous for provincial governments to use 1993. Secondly, the
central government promised the provinces that, starting from 1994, the
central tax rebate would be pegged to the growth of consumption tax and
value-added tax. Originally, the amount of rebate was to be determined
by a coefficient of 1:0.3 on the basis of the national growth of the two
taxes. However, the formula was changed in August 1994 into one
linking the rebate with the growth of a province's taxes.36 Thirdly, the
Centre pledged that once its share of the national budgetary revenue
reached 60 per cent, it would transfer at least one-third of its revenue to
the less developed provinces to redress regional economic inequalities.37
Finally, the Ministry of Finance pledged that under the new tax system,
the central government would not shift expenditure burdens to the
localities.38
In early December 1993, a national work conference on finance was
convened in Beijing to work out the details for the implementation of the
decision adopted by the Third Plenum. But the conference was over-
shadowed by central-local discord over tax reform. The Minister of

33. Linda Chelan Li, Centre and Provinces: China 1978-1993: Power as Non-Zero-Sum
(Oxford: Clarendon Press, 1998), p. 228; South China Morning Post, Business Post section,
8 November 1993, p. 2, in FBIS-CHI, 9 November 1993, pp. 32-33.
34. Shaoguang Wang, "China's 1994 fiscal reform: an initial assessment," Asian Survey,
Vol. 37, No. 9 (September 1997), p. 804.
35. Li, Centre and Provinces, p. 160.
36. Jun Ma, "The reform of intergovernmental fiscal relations in China," Asian Economic
Journal, Vol. 8, No. 1 (March 1995), n. 34; Zhongguo caizheng nianjian (China's Fiscal
Yearbook), 1995, p. 62.
37. Shaoguang Wang, "China's 1994 fiscal reform," p. 804.
38. Renmin ribao, 23 November 1993, p. 2.

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 China's Tax-Assignment Reform 1015

Finance, Liu Zhongli, urged the local governments to carry out the reform
without continuing to bargain with the central government.39
The above discussion reveals that for a number of reasons, the central
government failed to launch fiscal reform in the early 1990s. The lack of
policy consensus among the top and provincial leaders was one of the
factors. Anticipation that economic growth would be undermined by the
aftermath of the political crisis in 1989 strengthened local government
determination to protect their fiscal vested interests. In contrast, the
economic crisis of 1993 - the spectre of that of 1988, which resulted in
the 1989 demonstrations, still haunted the central authorities - strength-
ened the hands of central leaders in putting the longed-for tax-assignment
reform plan into practice. Moreover, the economic boom of 1992-93
softened local objection to the reform. However, the rush to prepare and
implement the complex, comprehensive intergovernmental fiscal reform
scheme in a couple of months instilled instability and volatility into the
whole measure. Details had not been worked out by the end of 1993.
During the first three months of 1994, the Ministry of Finance and the
SAT had reportedly issued more than 80 documents to supplement or
refine the "Decision on Implementing the Tax-Assignment System"
issued by the State Council on 15 December 1993.40 Reliable institutions
to support fiscal reform and ensure the security of property rights over
fiscal revenues were not in place when the reform was launched. The
short period of negotiation helped little in solving the central-local
conflicts in the distributive politics of tax reform and in building up a
broad consensus in the country on the merit of the reform. The repercus-
sions of the policy volatility for state capacity are discussed below.

The Effects of the Tax-Assignment System on Strengthening State

Capacity

This section addresses the issue of whether the new fiscal system
succeeds in helping the central state to strengthen its capacity to mobilize
fiscal resources. Has the central government achieved its self-proclaimed
goals of arresting the continued decline in budgetary revenues as a share
of GNP and of increasing its share of the total fiscal revenues after 1994?

Tax slippage: weakening state capacity. The new fiscal reform seems
to fail to arrest the deterioration in the formal revenue-producing capacity
of the Chinese state. National budgetary revenues as a share of GNP in
the period 1994-98 fell below the levels of 1992 and 1993 (see Table 1).
The table shows that the Centre's share of total budgetary revenues
jumped from 27.9 per cent in 1993 to 50.8-56.7 per cent in 1994-98. On
the surface, it suggests that the central government has succeeded in

39. Wenhui bao, 26 November 1993, p. 2, in FBIS-CHI, 29 November 1993, pp. 36-37;
Xinhua News Agency, 5 December 1993, in FBIS-CHI, 7 December 1993, p. 25; Renmin
ribao, 6 December 1993, p. 1.
40. Jia Kang and Yan Kun, The Institutional Reform of Public Finance in a Transition
Economy, p. 157.

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1016 The China Quarterly

Table 1: Size of National and Central Fiscal Revenues (billion yuan)

Share of national
National fiscal Gross national fiscal revenue to
Year revenue product (GNP) GNP (%)

1992 423.00 2,665.19 15.87

1993 513.32 3,456.05 14.85
1994 605.55 4,667.00 12.98
1995 711.98 5,749.49 12.38
1996 857.28 6,685.05 12.82
1997 957.46 7,314.27 13.09
1998 1,064.57 7,801.78 13.65

National Gross
Central fiscal fiscal national
Year revenue(l) revenue(2) product(3) (1)/(2)% (1)/(3)%
1992 144.94 423.00 2,665.19 34.26 5.44
1993 143.24 513.32 3,456.05 27.90 4.14
1994 343.54 605.55 4,667.00 56.73 7.36
1995 386.83 711.98 5,749.49 54.33 6.73
1996 456.02 857.28 6,685.05 53.19 6.82
1997 487.77 957.46 7,314.27 50.94 6.64
1998 540.29 1,064.57 7,801.78 50.75 6.93

Net central fiscal revenue after intergovernmental

National central fiscal National fiscal

Year revenue(]) revenue (2) (1)/(2)%
1992 141.16 423.00 33.37
1993 148.81 513.32 28.99
1994 161.64 605.55 26.69
1995 194.42 711.98 27.31
1996 244.16 857.28 28.48
1997 262.48 957.46 27.41
1998 267.85 1,064.57 25.16

Notes:
Net central fiscal revenue = central fiscal revenue - transfers from centre to localities +
transfers from localities to centre.

To follow the definition of fiscal revenue in the International Monetary Fund's Government
Finance Statistics, China's fiscal revenues are adjusted by including all the negative revenues
such as subsidies to loss-making state-owned enterprises and export rebates.

Sources:

Zhongguo tongji nianjian (China's Statistical Yearbook), various years; Zhongguo

caizheng nianjian (China's Fiscal Yearbook), various years.

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 China's Tax-Assignment Reform 1017

recentralizing the control of the flow of fiscal resources. However, if both

the remittance to central coffers by the provinces and central subsidies to
the provinces (including tax refunds) are taken into account, the share of
central government's disposable revenues accounted for only 25.2-28.5
per cent over 1994-98, lower than the 1992 and 1993 levels. This was
accompanied by the fact that although the share of central government
revenues in total revenues increased significantly in 1994, it has declined
since then. The above data show first that the tax-assignment reform
really did give the central government a one-shot, tremendous increase in
its revenue extractive capacity, but that the momentum was consistently
subdued afterwards; and secondly that after intergovernmental transfers,
the central government held less revenue than it had in the pre-1994
years. An ensuing issue is: why have the national budgetary system and
the central government failed to collect and retain more taxes?
Local officials have pointed out that the chief deficiency of the new
system is its failure to get rid of the vestiges of the old system.41 The most
obvious are the first two concessions the central government offered to
the provinces (see above). Because of the pledge to offer a central tax
rebate that would be pegged to the growth of the nation's (each prov-
ince's since August 1994) consumption tax and value-added tax, the
central government's disposable revenue has been substantially lowered.
As noted above, it was after the intense lobbying effort of Guangdong
that the central government decided to use 1993 instead of 1992 as the
base year for the new system. As a consequence, all provinces began in
October 1993 to collect as much tax (and even arrears of tax) as possible
from local enterprises to raise the base figure of their retained revenue in
1993. Tax efforts in the better-off provinces of Jiangsu and Guangdong
were particularly high. The fiscal revenue collected by Guangdong surged
by 70-150 per cent in the final quarter of the year over the same period
of 1992.42 Inflated base figures imply a higher-than-normal retained
revenue in the coastal provinces in 1993, which in turn indicates that the
central government would have to refund more revenue to them.
The central pledge that tax refunds would be pegged to local growth in
the consumption and value-added taxes has worked in favour of the more
urbanized, industrialized coastal regions. The tax rebate constitutes the
bulk of the central subsidies. Table 2 presents a breakdown of the central
subsidies in 1996. Of 267 billion yuan, tax rebates accounted for nearly
73 per cent. No data are available about regional distribution of tax
rebates, so data about central subsidies are used to illustrate indirectly
their geographical distribution. Table 3 demonstrates that per capita
central subsidies were highest in Tibet, Shanghai, Beijing, Tianjin and
Qinghai, followed by Ningxia, Xinjiang, Liaoning, Inner Mongolia,

41. Author's interview in Xi'an, Shaanxi, November 1997.

42. Ming bao, 14 November 1993, p. B2, in FBIS-CHI, 17 November 1993, pp. 39-40;
Shaoguang Wang, "The institutional roots of central-local rivalry: China, 1980-1996," in
Chong-Pin Lin (ed.), PRC Tomorrow: Development under the Ninth Five-Year Plan
(Kaohsiung: Graduate Institute of Political Science, National Sun Yat-sen University, 1996),
p. 31; Li, Centre and Provinces, p. 161.

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1018 The China Quarterly

Table 2: The Breakdown of Central Subsidies to Local Governments,

1996

Amount Percentage share of

Types of central subsidies (billion yuan) the total

Tax rebate 194.864 72.92

Central subsidies under the 11.092 4.15
pre-1994 original system
Earmarked grants 48.88 18.29
Transfer payment 3.465 1.30
Final accounts subsidies 4.269 1.60
Others 4.665 1.75

Total 267.235 100.00

Source:
Caizheng bu yusuan si, Difang caizhengjuexuan wenjian ziliao 1997 (Collected
Documents of the Final Accounts of Local Budgets 1997) (Beijing: Zhongguo
caizheng jingji chubanshe, 1998), pp. 10-19.

Yunnan, Jilin and Heilongjiang. The recipients of the lowest subsidies

were the provinces of Anhui and Henan in central China and Sichuan in
the south-west. In this way, two groups of provinces - those along the
border, especially those inhabited by ethnic minorities, and those along
the industrialized coast - received much more central subsidy than
provinces in central China.43
Another reason for tax slippage is that local governments, notably
those in the more developed areas, tend to be lax in tax collection and
instead raise revenue through arbitrary extrabudgetary or off-budget
(zhidu wai) levies and charges. Nontax fees and charges, believed to be
a major source of extrabudgetary and off-budget revenues, are estimated
to account for almost 60 per cent of local budgetary revenue." Related to
the lax collection of tax are pervasive tax frauds and tax evasion. The
share of the major taxes collected by the central National Tax Bureau in
total budgetary revenues has been consistently falling since 1994, while
the share of the business tax, the major component of local revenues, has
been steadily increasing. Table 4 demonstrates that in 1994 value-added
and consumption taxes accounted for 51.5 per cent of the national
budgetary revenues, but the share fell to 47 per cent four years later. In
contrast, business tax constituted 10.7 per cent of total revenues in 1994,

43. It is understandable that the central government provides ethnic minority regions with
huge fiscal subsidies so as to stimulate economic growth and consequently undermine the
influence of centrifugal political forces there.
44. Fang Gang, "Lun gonggong shouzhi de xin guifan" ("On the new norms of public
revenues and expenditures"), Jingji yanjiu, No. 6 (1995), pp. 34-43; Christine P.W. Wong,
"Fiscal dualism in China: gradualist reform and the growth of off- budget finance," in Donald
J.S. Brean (ed.), Taxation in Modem China (New York & London: Routledge, 1998), pp.
187-208.

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 China's Tax-Assignment Reform 1019

Table 3: Per Capita Central Subsidies in All Provinces, 1995-98

(percentage of national average)

Province 1995 1996 1997 1998

East 127.48 123.66 119.13 114.21

Beijing 354.28 321.68 357.67 320.23
Tianjin 315.31 283.27 299.64 252.91
Hebei 69.22 70.56 74.08 66.24
Liaoning 177.83 174.13 144.42 163.60
Shanghai 604.64 625.44 651.85 553.69
Jiangsu 109.70 107.17 114.09 100.27
Zhejiang 128.11 125.24 107.06 115.79
Fujian 98.23 94.06 84.26 85.00
Shandong 71.20 72.22 59.35 66.91
Guangdong 132.62 115.02 103.65 102.78
Guangxi 69.06 72.22 75.62 68.36
Hainan 87.27 91.83 99.47 88.54

Central 73.58 75.39 80.90 82.99

Shanxi 78.48 78.13 81.87 74.67
I. Mongolia 131.22 142.87 158.78 150.16
Jilin 116.96 126.16 150.21 133.12
Heilongjiang 121.83 106.54 117.69 123.63
Anhui 49.17 54.25 57.47 59.74
Jiangxi 58.74 61.90 65.65 81.85
Henan 53.84 53.29 56.42 54.67
Hubei 73.89 76.29 80.17 86.41
Hunan 65.32 70.44 70.54 79.19

Western 91.79 95.89 95.42 101.10

Chongqing 85.50
Sichuan 54.64 59.14 42.42 54.68
Guizhou 65.77 69.53 75.53 72.54
Yunnan 165.24 160.83 170.30 149.72
Tibet 620.10 580.59 652.46 616.56
Shaanxi 69.72 70.98 78.61 79.08
Gansu 90.99 97.33 107.51 106.31
Qinghai 188.23 203.10 233.88 224.13
Ningxia 149.54 155.65 172.17 191.12
Xinjiang 149.38 175.35 185.93 171.47
Source:
China's Fiscal Yearbook, various years.

climbing to 14.8 per cent in 1998. These figures reveal that local officials
can still exert influence on the tax effort of the central National Tax
Bureau, which is supposed to protect the interests of the central govern-
ment.

In an attempt to crack down on tax evaders, the Ministry of Finance

has launched an annual, nation-wide tax, financial and price inspection

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1020 The China Quarterly

Table 4: The Share of Consumption, Value-added and Business Taxes

in Total Budgetary Revenue (Units: billion yuan; %)

Total
consumption
and value- Total
added taxes Business tax budgetary
Year (1) (2) revenue (3) (1)/(3) (2)/(3)

1994 312.06 64.74 605.55 51.53 10.69

1995 352.68 82.82 712.27 49.51 11.63
1996 403.08 100.63 857.28 47.02 11.74
1997 447.01 116.10 957.46 46.69 12.13
1998 499.89 157.51 1,064.57 46.96 14.80

Notes:
1. Total consumption and value-added taxes = consumption tax + value-added
tax + consumption and value-added taxes on imports
2. Total budgetary revenue is adjusted to conform to the standard international definition.
Source:
China's Fiscal Yearbook, various years.

since 1985. Between 1991 and 1997, taxes totalling more than 115 billion
yuan were recovered. In 1997 alone, more than 23 billion yuan was
recovered, of which 13.7 billion yuan (nearly 59 per cent) was related to
frauds in paying value-added and consumption taxes to the central
government.45 To crack down on tax evasion, the SAT and the Ministry
of Public Security have decided to establish a joint special police force
for tax collection, to be housed under the SAT.46
In sum, for the Centre, the tax-assignment reform fails to deliver the
hoped-for results of increasing the tax buoyancy of the budgetary system
and of concentrating more fiscal resources of the country at its hands. The
disposable revenue of the central government was reduced because of the
policy concessions offered to local governments in winning their support
for the tax reform, and widespread tax evasion.

Institutional credibility in question. To understand why the central

government has failed to strengthen its extractive capacity, it is necessary
to pay particular attention to the more fundamental questions of the
institutional instability of the fiscal reform policy and central-local
disputes about the distributive effects of the reform. These have, in turn,
provoked the strategic behaviour of tax evasion on the part of local
governments. As noted above, on 1 January 1994 when the tax-
assignment reform was implemented, the reform measures were only in

45. China's Fiscal Yearbook, 1992, pp. 251-53; 1993, pp. 149-151; 1994, pp. 149-151;
1995, pp. 126-28; 1996, pp. 130-32; 1997, pp. 192-96; 1998, pp. 125-28.
46. "Special force to chase tax dodgers," South China Morning Post, 13 March 1999,
p. 8; "Guowuyuan chouzu shuiwu jingcha" ("The State Council is planning to set up taxation
police"), Ming bao (Internet edition), 30 July 1999.

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 China's Tax-Assignment Reform 1021

their embryonic forms. It was repeatedly reported that after January 1994
the central authorities issued regulations to take over tax revenues from
the localities incrementally. In various regions, business taxes on county
fair market and private business, and taxes on foreign-owned enterprises
are collected by the National Tax Bureau rather than by the originally
assigned collector, the Local Tax Bureau.47
Furthermore, central - local fiscal relations have never been secure and
credible since the commencement of the reforms in 1980. Throughout the
1980s and well into the early 1990s, there were both centralizing and
decentralizing shifts. Between 1980 and 1993 the central government had
augmented its tax base and modified the rules of the game in order to
raise the central share of national budgetary revenues, and at the same
time transferred expenditure responsibilities downwards to lower-level
governments.
First, the central government frequently broke its agreements with the
provincial governments in the various rounds of fiscal reform in the
1980s. When the fiscal responsibility system was introduced in 1980, 23
provinces adopted a system, also known as the Sichuan model, whereby
budgetary revenues were divided into (central, local) fixed revenues,
shared revenues, and "adjustment revenues," of which the bulk was the
industrial and commercial tax. Originally, the responsibility system was
supposed to run for five years until 1985. During 1982-83, however, 22
provincial units shifted to a system of sharing total revenue adopted in
Jiangsu since 1977. However, the reform measure was soon overtaken by
the tax-for-profit scheme. Following its institution, a new fiscal system,
under which budgetary revenues were to be divided between central and
local governments based on different types of tax rather than on owner-
ship of the enterprises, was established in March 1985. As discussed
above, the new round of fiscal reform and the tax-for-profit programme
were deserted in the face of resistance from local governments and
enterprises. The 1983 revenue-sharing framework survived until 1988. In
1988 a new system of central-local revenue-sharing contracts was intro-
duced for a three-year period, but because of the deadlock in introducing
the tax-assignment system in 1991, the 1988 arrangement survived up to
1993. The numerous attempts to modify the central-local fiscal arrange-
ments during 1980 to 1993 impaired the institutional credibility of the
arrangements that were put into practice. In anticipation of a forthcoming
alteration of the rules, local governments tended to conceal their wealth
so that they would be in an advantageous position when the central
government launched the next round of reforms.
Starting with the reform of 1980, the central tax base was never
included in the revenue-sharing scheme, and the power to impose new

47. Li Lifeng, "Dui woguo fenshuizhi de fenxi yu fansi" ("The analysis and introspection
of China's tax-assignment system"), Jingji wenti (Economic Problems), No. 12 (1996), pp.
56-59; Yang Weihua, "Zhongguo fenshuizhi yunxing de chengxiao wenti yu duice" ("The
problems of implementation of the Chinese tax-assignment system and the ways to deal with
them"), Zhongshan daxue xuebao (shehui kexue ban) (Journal of Sun Yat-sen University,
Social Science edition), No. 5 (1996), pp. 10-17.

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1022 The China Quarterly

taxes and to determine tax rates remained the prerogative of the central
government. The central government increased its share of total tax
collection through a variety of means, including establishing an Energy
and Transport Key Construction Fund and a Budgetary Adjustment Fund
in 1983 and 1989 respectively; reclaiming control over the enterprises in
the petrochemical industry, the automobile industry and the nonferrous
metals industry between 1982 and 1987; and from 1983 onwards divert-
ing the industrial and commercial tax generated from the cigarette and
liquor industries to central coffers.48 More complicated was the preva-
lence of ex post tax contributions made by provinces to the central
government. Ex post tax contributions usually took the form of ad hoc,
involuntary loans to the central government, but they were never repaid.49
Although data are scattered, part of the cumulative effect of the manoeuv-
ring of the central-local fiscal relations can be shown by the rising share
of the central fiscal revenues in the national budgetary revenues in the
course of reforms.50
At the same time, there was a downward trend of dividing expenditure
responsibilities among levels of government in China. Since 1980, the
share of local expenditures as a percentage of national budgetary expen-
ditures has persistently risen. The expenditures of subnational fiscal

Table 5: The Share of Central and Local Expenditures (%)

Year Central expenditure Local expenditure

1992 44.54 55.46

1993 40.06 59.94
1994 34.44 65.56
1995 33.84 66.16
1996 33.51 66.49
1997 31.34 68.66
1998 31.44 68.56

Note:
The fiscal data have been adjusted to conform to the standard
international classifications. Subsidies to cover enterprise losses and
export rebate, which are treated as negative revenues by the Chinese
government, have been added to the expenditure side.
Source:
China's Fiscal Yearbook, various years.

48. Renmin ribao, 14 December 1982, p. 3 and 25 October 1983, p. 1; Cui Shukun and
Zhao Bokun, "Tan tan 1983 nian caizheng guanli tizhi" ("A discussion of the 1983 fiscal
management system"), Caizheng (Finance), No. 7 (1983), pp. 37-38; Li, Centre and
Provinces, p. 212; Roy Bahl, Fiscal Policy in China: Taxation and Intergovernmental Fiscal
Relations (South San Francisco: The 1990 Institute, 1999), p. 23.
49. Yasheng Huang, Inflation and Investment Controls in China: The Political Economy
of Central-Local Relations During the Reform Era (Cambridge: Cambridge University Press,
1996), pp. 53-55; Christine P.W. Wong, Christopher Heady and Wing T. Woo, Fiscal
Management and Economic Reform in the People's Republic of China (Hong Kong: Oxford
University Press, 1995), p. 94.
50. Before intergovernmental transfers, the central share was only 14.7% in 1971-75; it
rose to 34.9% in 1981-85 and 33.4% in 1986-90. The budgetary revenue is not adjusted.
China's Fiscal Yearbook, 1999, p. 467.

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 China's Tax-Assignment Reform 1023

responsibilities accounted for only 50.3 per cent of total budgetary

expenditures in 1976-80; they rose to 71.7 per cent in 1993."5 After 1994,
the central authorities have not taken any steps to reduce the burden to the
local budget. Table 5 shows that the share of central government expen-
ditures (in IMF definition) in the national budget has steadily decreased
from 34.4 per cent in 1994 to 31.4 per cent in 1998. In 1992-93, before
the tax-assignment reform, the share was between 40.1 per cent and 44.5
per cent. For local governments, notably those in poorer areas, the new
round of fiscal reform continues to impose a squeeze on their budgets.
The centralization of fiscal revenues and the simultaneous decentraliza-
tion of expenditure responsibilities generate disincentives to local govern-
ments to contribute an increasing proportion of their revenues to the
central government.

Legitimacy deficit. In a previous section, this article argues that state

capacity relates less to military and economic capabilities than to legiti-
macy and socio-political cohesion. The problem with the weakness of the
state lies with the fact that the central government has suffered from a
vertical legitimacy deficit.
The central government justifies the tax-assignment reform by claiming
that it serves a common interest. It allegedly improves the state's capacity
of macroeconomics regulation, which in turn contributes to a more stable
and healthy growth of the national economy. From such a perspective, it
is the failure of the reform to provide the central and local governments
with reciprocal benefits that erodes its legitimacy. As noted above, under
the tax-assignment reform, while the central government has augmented
its extractive capability (before making intergovernmental transfers), it
has not honoured its former promises not to decentralize the burden of
delivering public services. Available evidence also indicates that among
all provinces, only Guangdong could effectively alter the terms of the
tax-assignment arrangement in favour of local governments. Other
provinces, particularly those further from the coast, were excluded from
meaningful access to the policy-making process. The frequent revisions
of the rules of the game after 1994 have also added to already substantial
cynicism towards the central government on the part of local govern-
ments. In failing to foster a sense of participation and to guarantee
reciprocal benefits, the central government has not been able to command
voluntary compliance by provincial powers with its attempt to reassert its
power to extract resources from society. In the face of the erosion of
legitimacy, there is little wonder that widespread tax frauds and evasion
as well as shifting of fiscal revenues to extrabudgetary and off-budget
revenues are found.
The central government is caught in a vicious circle of "state-strength
dilemma." It lacks the fiscal resources to create legitimacy by providing
social services to offset extraction. To increase state capacity, it central-
izes the collection of major taxes on the one hand, and continues to
51. Ibid. p. 468. Information on the central and local shares of fiscal subsidies before 1992
is not available, so fiscal data based on the Chinese definition are used.

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1024 The China Quarterly

decentralize spending obligations to the lower-level governments on the

other. These measures combine to undermine the mutual trust and
political cohesion between them. The measures the Centre takes to
become a strong government paradoxically perpetuate its weakness.

Conclusion

The purpose of this article has been to examine the politics of the
tax-assignment reform and its impact on strengthening state capacity. The
central government failed to reform the fiscal system alongside the
economic readjustment policies in 1990-93 because of the lack of
consensus among the central leaders on the urgency of the reform, and
the strong resistance of the better-off coastal provinces. As soon as the
concern of the central leaders turned to focus on the adverse effects of
economic localism on socio-political stability in 1993, the central govern-
ment had the upper hand in launching the reform measure.
However, fiscal decline has continued under the tax-assignment sys-
tem. Two factors have led to the continued deterioration in the extractive
capacity of the Chinese state as well as of the central government. The
first is the concessions the central government offered to the richer
provinces in order to enlist their acquiescence to taxation reform.
Although the concessions made the reform more easily accepted by all
provincial actors, they in effect undermine the capability of the central
government to extract revenue from affluent provinces. The second factor
is the widespread evasion of central and shared taxes collected by the
central government. Nevertheless, behind the fiscal decline are the more
fundamental questions of institutional volatility of the fiscal reforms and
the legitimacy deficit of the central government. Coupled with the history
of the various fiscal policy reversals between 1980 and 1993, the swift
advance to implement sweeping reform measures in half a year imperils
the institutional credibility of the latest round of taxation reform. The
frequent breach of the "contract" by the central government with its
subordinates also weakens its legitimacy claim. To counteract the Cen-
tre's breaking of its promise, local governments often defraud the central
government in taxes and reduce the size of revenue entering the state
budget. The failure of the reform to realign the vertical distribution of
expenditure responsibilities between the central and provincial govern-
ments to relieve the latter's fiscal strain, and that few provinces were
given a say in the policy formation process, have further undermined the
legitimate base of the tax-assignment system.
The efforts to strengthen the state capacity of revenue extraction may
need to focus squarely on the root cause of the present weakening state
capacity. To rebuild mutual trust and political cohesion between the
central and local governments and a credible institution governing the
central-local fiscal relations, there has to be constitutional constraints on
the discretionary power of the central state to change announced regula-
tions frequently at will. It is a political issue that deserves further
research.

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