# PART IV. A FORMULA-BASED EQUALIZATION TRANSFER SYSTEM FOR CHINA: MODEL AND SIMULATIONS

The current Chinese central-provincial fiscal transfer system mainly consists of three mechanisms.22 The first mechanism is based on the old contract system prevailing during 1988-1993. That is, after 1994, the localities (provinces and cities with independent planning status) continue to remit revenues to or receive transfers from the center according to their fiscal contracts in effect in 1993. The second type of transfer is "returned revenue" from the center according to a calculation that ensures each locality retains no less than what it did in 1993. These two types of transfers are general purpose transfers, or unconditional transfers. The third type of transfer includes various specific purpose grants, such as those for price subsidies, educational projects, environmental projects, disaster relief, and the development of poor regions.

The general purpose transfers from the center to the localities account for the major part of the total transfers. In 1994, the central government's net transfer to the local governments amounted to about 181 billion Yuan, of which two-thirds were general purpose grants. However, these general purpose transfers suffer from at least two major flaws. First, they were not designed to address the increasingly significant regional disparity issue; rather, they were largely designed to recognize the vested interests of the localities.23 Second, the criteria by which these transfers are allocated are rather ad hoc, that is, the transfer system lacks scientific measurements of fiscal capacities and fiscal needs. This can easily lead to an unjustified distribution and encourage the localities' bargaining activities.

T'his part presents an illustrative equalization transfer model and the simulation result using 1994 data on China. It provides the estirnates of fiscal capacities and fiscal needs of 30 Chinese provinces using the methods discussed in the paper. Based on a formula that aims to ensure that provinces with similar levels of tax effort be able to provide similar levels of public services, the calculation results in a set of hypothetical transfers from the center to the provinces in 1994. These results are then compared with the actual transfers made to the provinces in 1994.

The method used to calculate the provincial fiscal capacities and fiscal needs may be considered overly simplified and the quality of data can certainly be improved. Nevertheless, the estimation carried out here is simply intended to provide an illustrative example of how an equalization transfer formula with a minimum data requirement can be constructed. The following sections discuss the methodology and the results.

# **4.1.** Estimating Fiscal Capacities

> 22 In 1996, a formula-based equalization transfer system was introduced on an experimental basis. This system applies a formula that uses objective variables to calculate local fiscal capacities and needs. However, the size of this transfer program was only $2 billion Yuan, or 0.5 percent of the central governnent revenue.

2 According to some studies, China's regional disparity is among the highest in the world.

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