# 2.4. The Tack of Fiscal Polic Instruments of the Centl Government

Many studies on China's ccntral-local fiscal relations point out that the declining rtios of revenue to GNP and the central government revenue to total government revenue are a major problem of the fiscal contract system. They base this argument on a comparison of the Chinese figures with those in other countries'2. The Chinese government also stated clearly in the 8th Five Year Plan and th Decision of the 14th Party Plenum that the fiscal reform should proceed in the direction of increasing these two ratios. This section argues that simply looking at the two ratios is not enough for assessing the merit of a fiscal managemenL As counties differ vastly in size, population, level of develWpment, as well as poliical and cultral background, the opdmal ratios could be very different in different countries. To evaluate the performance of a fiscal management system, pariularly the intergovemental fiscal relations, the key is to look at whether the system enables the central gove t to effectively use fiscal policy instruments to perform its functions. This is the task of this and the next subsections.

The orginal purpose of introducing the fiscal contract system was to ensure the center's income while giving the regions more incentive to collect revenues. However, under the fiscal contract system, the localities have largely controled the _effecve tax rates and bases_ through controlling tax efforts and the channels through which taxes are coUected, although leplly the center controls the rates and bases of aU taxes. As a result, the center has to resort to various ad hoc instruments to influence revenue remittance from the localities, and these instruments often lead to perverse reactions from the localities. In addition, the center's flexibility in using expenditure policy is also undermined by the lack of centrally-controlled financial resources and the heavy burden of "capital constructions.' This subsection will discuss these issues in order.

_The first way in which local govemens control effecdve tax rates and tax bases is to control their tax efforts, mainly reflecued by their use of tax concessions._ Nominaly, all major taes are controlled by the central government and tax rates are uniform across regions, except for those in specal economic zones (SEZs) and certain open coastal areas. Tax rates and tax bases are set by the center, and only the center has the authority to abolish old taxes, introduce new taxes, or change tax rates. For central-fixed and shared taxes, only the center can offer tax concessions and exemptions. Howeer, under the fiscal system before 1994, the only binding constraint that a locality actualy faces is the fiscal contact with the level of government directly above. As long as the locality has fulfilled the revenue target specified in the contract, it tends to use exemptons as much as possible to keep the resource in the locality, even though many of the exemptions are illegal. The rationale is that, most of the efforts made for collecting revenues above the target will benefit not just the locality, but also the center. Moreover, there is no real, implementable, punitive measure against localities' illegal tax concessions.

Among the most influential studies is Hu and Wang (1994). Also see Wang (1994).

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