Local Government Debt in China: Implications for Reform

Abstract

Since the 1994 fiscal reforms, China's national public finances have been in a strong position, but public finances of local governments (including provincial, city and county governments) have been always under stress. This is because local governments in China are responsible for financing the provision of basic economic and social services, as well as for urban infrastructure, but they have limited access to tax revenues, have no power to introduce new taxes or to increase rates of existing taxes, and are prohibited under the 1994 Budget Law from borrowing. Consequently, local governments are heavily dependent on non-tax revenues and fiscal transfers from the central government. In spite of the prohibition on borrowing, most local governments have been borrowing informally for many years and the central government has ignored this breach of the Budget Law. Now the size of local government borrowing has reached levels that are causing concerns for the sustainability of local public finances and the stability of the Chinese banking system. This situation raises many policy issues, some requiring urgent policy interventions and other requiring medium-term policy responses. Thus, there is a need for broadening provincial powers over taxation, reforming intergovernmental fiscal transfers, and formally recognizing provincial borrowing powers. However, the focus of this paper is on the incidence of local debt on provincial and sub-provincial public finances, an aspect of local debt that has not attracted sufficient attention in the literature. The concentration of local debt and contingent liabilities at sub-provincial levels and the new annual limit imposed by the State Council on local debt in 2015 are discussed. Lessons learned from Australia's experience in relation to the management of subnational borrowing are also discussed, as these appear to be highly relevant to China's current situation.