Present Value offers insights from our Beijing-based think tank partners ANBOUND. Researcher Wei Hongxu and Senior Researcher He Jun give us their thoughts on state and local government policy in China, comparing it to government policy in the U.S.

In America, there is currently an ongoing debate on raising the highest marginal federal income tax rate to 70 percent before next year's presidential election. In general, it is about national policy interventions in response to a growing concentration of wealth. How does China view these debates? Are there any similar discussions on national tax policy in China?

Wei Hongxu, ANBOUND: Personal income tax is an important means to adjust the income gap and realize the balance between fairness and efficiency. In theory, the increase in the U.S.'s highest marginal federal income tax rate would increase the federal fiscal capacity and improve the government's regulatory function of taxation. However, this kind of regulatory function is not necessarily effective in practice. For example, those who make a higher income can take various measures to evade tax legally.

The situation in China is very different. Personal income tax in the United States is the main source of fiscal revenue, but it accounts for a relatively lower proportion in the Chinese fiscal revenue. In 2018, China's personal income tax revenue was RMB 1.3871 trillion, accounting for only 8.9% of the total tax revenue [1]. Under this circumstance, raising the personal income tax rate for those who make a higher-income in China will have little effect on income adjustment. China's approach is to raise the threshold of personal income tax, and more importantly, to increase the income of lower-income people, including raising the minimum wage and strengthening social protection.

In terms of similarities between China and the United States, the tax cuts implemented by both countries will put pressure on their respective finances. The U.S. fiscal deficit rose sharply in 2018. This is mainly due to the Trump administration's massive tax cuts and a substantial increase in federal government spending. China's tax cuts have placed significant pressures on the finances of some local governments.

In America, there is currently an ongoing debate driven in part by the recent Amazon HQ2 sweepstakes, concerning the efficacy and fairness of state and local tax incentives to attract big corporations. China has implemented numerous special incentive zones that appear to achieve what they were intended to, which is to stimulate significant amounts of economic activity. What lessons can be derived from each country that can be applied in the other?

He Jun, ANBOUND: China has established a multitude of special zones all over the country, like special economic zones (SEZ), economic development zones, free-trade zones and high-tech industry development zones. The most successful special economic zone is Shenzhen. After nearly 40 years of reform and opening policy, Shenzhen has grown from a small fishing village adjacent to Hong Kong to a modern metropolis with an economy that surpassed Hong Kong's in 2018.

While it is true that the SEZ model has been rather successful in the past, it faces new challenges in the current stage of development. The essence of the SEZ is that it is a typical policy zone that special policies are implemented to conduct targeted affairs in the planned area. So its success heavily relies on how resources are allocated to a specific sector in the SEZ. However, the marginal policy effect of the SEZ model has been significantly reduced. As the era of developing special zones is now ending, China needs to improve the investment environment and production efficiency, create a fair and law-based market in a larger market space, and turn its past advantages of special zones into the overall environment of the Chinese market.

In the future, China's development should shift from taking advantage of the special economic zone to geographical advantages. This is because the policy advantages of the special economic zone are enclosed, while the geographical advantages emerge from regional attributes. The convenience brought by geographical advantages could facilitate the sharing of economic factors, forming collaboration, and jointly create a larger regional market. Thus, from the perspective of geographical advantages, the Greater Bay Area, which integrates Guangdong, Hong Kong, and Macao, has more prospects than the Hainan free-trade zone.

In America, there is constantly a discussion about the distribution of power between federal, state, and city government. Currently, some American cities that feel left out of Trump's agenda and/or under-funded by their state capitols are trying to figure out how to be more self-sufficient. These cities in general are more assertive about controlling their own destiny rather than waiting for help from the federal or state government. We understand that things are similarly dynamic in China, in terms of the relationship between and distribution of power across national, provincial, and local government. Tell us more.

He Jun, ANBOUND: Unlike the decentralized federal system in the United States, China implements a centralized system. The Chinese central government is in a relatively strong position in terms of financial and administrative power, and it is also relatively efficient in promoting and implementing national affairs. However, having a strong position in the central government creates certain problems as well. The contradictions between the central and local governments' financial and administrative powers have become increasingly prominent. From a historical perspective, before the tax reform in 1994, the proportion of central government revenue in the total national fiscal revenue was significantly lower and the national financial resources were weak, which restricted the country's macro-control ability to the economy. After the 1994 reform, the fiscal revenue of the central government has increased significantly, and the proportion of local government revenue in the total national fiscal revenue declined steadily. At the same time, local government expenditure had soared as the scope of administration and local services had been expanding. This undoubtedly leads to a serious mismatch between the financial and administrative power of local governments. In recent years, the central government has continued to centralize power, further highlighting the financial and economic contradictions between the central and local governments. However, the Chinese government is aware of this problem, and in the current reform of the relationship between the central and local governments, the central government has begun to take back some administrative power, while increasing the financial power of local governments. It is said that the real estate tax to be levied in the future is a new local tax.

It should be pointed out that the centralization of power in the central government tends to lead to the "one-size-fits-all" management malpractice — that is, a unified national policy to govern different local governments with huge differences. China is a country with significant development differences, with large regional, urban-rural and income gaps. Under this circumstance, it is not appropriate for all local affairs to be managed by the central government's "one-size-fits-all" manner. For example, the developed southeast coastal areas such as Shenzhen and Shanghai differ greatly from the backward western areas such as Qinghai and Gansu. If these areas governed by only one standard, it would create other problems that such policy fails to adapt.

The Chinese government has been extremely aggressive about infrastructure investment, to catch the country up from an economic competitiveness standpoint and to harness the growing population and economy. Meanwhile, much of the U.S.'s infrastructure is aging to the point of disrepair and collapse. What can be learned from the politics, financing mechanisms, and economic case for infrastructure investment in our respective countries?

He Jun, ANBOUND: There are differences in infrastructure development between China and the US. First, China and the United States are at different stages of development. The US is a developed country, its national infrastructure has essentially been completed; China is a developing country and is undergoing large-scale infrastructure construction. Second, the economic structure is different. The United States is a consumption-driven economy, the main driving force of the economy is consumption, technology, and finance; China is a manufacturing-dominated economy, and it is in the process of urbanization and industrialization. Therefore, China is vigorously developing its infrastructure. China has played to its institutional strengths in infrastructure investment. For a long time, China's central government has implemented a performance evaluation system for local officials based on economic growth. Infrastructure investment has led to significant economic growth and is crucial to local officials' performance. Large-scale investment in infrastructure construction is the secret weapon for China's economic success. In the three years of 2015, 2016 and 2017, the scale of national infrastructure investment was RMB 10.13 trillion (up 17.2% YoY), RMB 11.89 trillion (up 17.4% YoY) and RMB 14.00 trillion (up 19.0% YoY), accounting for 18.4%, 19.9% and 22.2% of fixed asset investment respectively[1]. Infrastructure development has brought tremendous progress, but it should also be noted that China's economic growth rate and the progress of infrastructure construction are slowing down; hence, the Chinese economy needs to find new impetus and to transform as a consumption-driven economy. The debt problems caused by the excessive scale of infrastructure construction have become a risk to the Chinese economy. For instance, China Railway Group's staggering total debt of RMB 5.2 trillion in 2018 has become an important case of China's infrastructure development[2].

China's massive infrastructure construction has been growing at double-digit rates since the 1990s. The financing of infrastructure investment mainly relies on two sources: First, "land financing". In China, agricultural land is owned by collectives while urban construction land is owned by the state. The municipal and county governments have the right to exercise land ownership on behalf of the state. They expropriate land from farmers at a low price, convert it into construction land and transfer the land right to certain units, to obtain considerable income. The proportion of such land transfer fees in the general fiscal revenue of local governments climbed from 10% in the late 1990s to 63.4% in 2013 and then fell back to around 35%[3]. Second, local financing platforms. When the financial crisis broke out in 2008, China proposed an RMB 4 trillion stimulus plan to stabilize the economy and invested heavily in infrastructure and public services. Among the RMB 4 trillion funds, the central government provided RMB 1.18 trillion of funds for investment, while the remaining funds were mainly raised by local governments, enterprises, and bank loans. Local governments raise funds through local financing platforms such as urban investment enterprises, land mortgage (land finance), equity injection, financial allocation or local credit. These financing platforms have expanded rapidly and played an important role in raising funds. However, in pursuit of political achievements, some local governments have borrowed heavily through these platforms, resulting in the implicit debt burden of local governments, which has led the central government to regulate local governments' financing behavior in recent years.

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Mr. He Jun takes the roles as Director of China Macro-Economic Research Team and Senior Researcher. His research field covers China's macro-economy, energy industry and public policy. During his 20 years in ANBOUND, Mr. He Jun has led many major consulting projects that involved the central and state governments, large-sized state-owned banks, and foreign corporations. Mr. He Jun is now an associate Lecturer for the Institute of Scientific and Technical Information of China. He was one of academic experts for the School of Public Policy and Management of Tsinghua University.

Wei Hongxu, Ph.D. is a researcher with ANBOUND Consulting. He is a graduate of the School of Mathematics of Peking University, and earned a Ph.D. in Economics from the University of Birmingham, UK in 2010.

[1] Data from the National Bureau of Statistics of China

[2] http://www.chinanews.com/cj/2019/05-01/8825907.shtml.

[3]Data from the National Bureau of Statistics.