(Bloomberg) -- One of the big outcomes of the political meeting in Beijing last week was a decision to have the central government spend more to reduce the burden on cash-strapped local governments.
At a press conference last Friday, a senior Communist Party official in charge of the economy indicated that Beijing would restructure the fiscal system by providing more funds to local governments and helping them find new sources of revenue.
“In response to the financial difficulties of local governments and grassroots governments, it is proposed to improve the financial relationship between the central and local governments, increase local independent financial resources, expand local tax sources,” said Han Wenxiu, deputy director in charge of routine work of the Office of the Central Financial and Economic Affairs Commission.
It’s unclear yet exactly how that’s going to work, but at least it’s likely to involve a change to how taxes are levied and where the money goes, and may include more debt issuance to pay for spending.
Here are five charts explaining the problems Beijing is trying to solve.
Growing Local Deficits
The thousands of provinces, cities, counties and towns across the nation need help. Their combined budget deficit last year was a record 15 trillion yuan ($2.1 trillion) and it’s looking only a little smaller so far this year.
There are multiple reasons for this, but one key cause is the slump in the money they get from selling land to developers, which had been a source of funds to pay for local development. That revenue has fallen by double digits for two years through 2023, and in the first five months of this year it was less than half the level in the same period in 2021.
In addition, local governments need to spend money preparing that land for sale, meaning that last year they only made a surplus of 260 billion yuan from the sales.
Beijing Dominates
Another key reason for the large and growing local deficit is that since the tax system was reformed in 1994, much of China’s tax revenue has been paid to the central government, with some of that money then being dispersed to the local governments.
Read more from Bloomberg Economics: Fiscal Reform Is Needed — These Charts Show Why
However, that money has never been enough for most of them to pay for all they are required to fund, meaning they have to look for alternatives including land sales, bond sales, and using off-balance sheet companies called “Local Government Financing Vehicles” to borrow and spend.
Those LGFVs took on lots of debt to pay for construction and projects that local governments couldn’t fund from their official budgets, but many are now struggling to repay that as land prices drop and consumption growth stay weak. There was an estimated 66 trillion yuan worth of such debt this year, according to the International Monetary Fund, almost as much as all the official debt owed by the central and local governments.
Low-Taxing Country
Another problem is that China isn’t a very high-taxing country. The vast majority of people pay no personal income tax as they earn below the tax-free threshold, and while there are now mandatory social security contributions for workers, the levels are low and there has been payment holidays in recent years to encourage people to spend and support the economy.
The ratio of tax income to the size of the economy is much lower than many comparable countries, according to the Organization for Economic Co-operation and Development. China’s tax take in 2022 was a fifth the size of the economy, below the 34% average for the developed nations of the OECD.
Excluding social security contributions, it is even weaker, hitting a record low of 13.8% in 2022 before rebounding slightly. As a partial remedy, officials have tried to bring in a nationwide property tax which could be levied by local governments.
That would put their finances on a more stable footing, but Beijing has never found the right time to extend the ongoing trial nationwide. It is unlikely to happen anytime soon as home prices have been falling for years and a tax on the value of houses would likely accelerate that.
More Bonds
To fill the hole in their budgets, governments across China have been turning to debt financing, selling more and more bonds, with most of them being bought by state-owned banks and local investors looking for guaranteed returns.
In total (and excluding LGFVs), the central and local governments sold a record 20 trillion yuan worth of bonds in 2023, up a fifth from the year before. It looks likely to hit another record this year, with total sales up another 5% in the first half from the same period in 2023.
However, that increase in borrowing has all been done by the central government, with local government debt issuance down 20% in the first half of the year. That may give an indication of what the fiscal reforms Beijing is hinting at will look like.
“Fiscal policy is key for macroeconomic management in today’s China, with monetary policy constrained by overindebted local governments, reluctant private borrowers and an exchange rate policy that leaves little space for more monetary easing,” wrote Bert Hofman, formerly head of the World Bank’s China office. “To become an effective tool, major reforms in the tax system, intergovernmental fiscal system, and budget management are needed,” he wrote on Sunday, before the decisions of the Plenum meeting were announced.
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