Lou Jiwei on Key Challenges in China's Next Fiscal and Tax System Reform
Former Finance Minister says Beijing must spend more via fiscal deficits and centralize responsibilities, rather than delegating them locally. Also, raise the retirement age and VAT rate, he says.
As you may have observed, I have been rushing to put out public advice by noted speakers on China’s reform ahead of the Third Plenary Session of the 20th Central Committee of the Communist Party of China scheduled on July 15-18, which will, according to Beijing, focus on “comprehensively deepening reforms and advancing Chinese modernization.
Below is a speech by Lou Jiwei, China’s former Finance Minister (2013-2016) at the 9th International Insurance Festival and IMA Insurance Masters Award Annual Conference 2024 from July 5-8.
The occasion is apparently to celebrate leading insurance salespeople but Lou, who on March 29 said structural reforms are now imperative, showed up with a lengthy speech on Key Challenges in Planning the Next Round of Fiscal and Tax System Reform.
The speech is sourced from a WeChat blogpost by the organizer of the occasion with a note that 以下为部分演讲内容，有删减 the WeChat blog isn’t Lou’s full speech and redactions have been made. NOT BY ME, but by the organizer! But all the emphasis is mine. - Zichen Wang
谋划新一轮财税体制改革的若干难点问题
Key Challenges in Planning the Next Round of Fiscal and Tax System Reform
Ladies and gentlemen, esteemed experts, I know everyone is interested in the planning of the next round of fiscal and tax reforms. Today, my main theme is 谋划新一轮财税体制改革的若干难点问题 "Key Challenges in Planning the Next Round of Fiscal and Tax System Reform."
The Central Economic Work Conference and the Government Work Report have both proposed planning the next round of fiscal and tax system reforms. Since the reform and opening-up, we have experienced two rounds of fiscal and tax reforms, the most important of which was in 1994, laying the foundation for our current fiscal and tax system. The Third Plenary Session of the 18th Central Committee in 2013 summarized budget management practices, formed a transparent and standardized budget management system, and proposed that “finance is the foundation and important pillar of national governance,” “a scientific fiscal and tax system is the institutional guarantee for optimizing resource allocation, maintaining market unity, promoting social fairness, and achieving long-term national stability,” elevating the fiscal and tax system to the height of national governance.
The new round of fiscal and tax system reform should build on the previous two rounds, facing some current practical issues while looking to the future. Currently, the real estate market continues to adjust, the macro tax burden continues to decline, local fiscal conflicts intensify, and debt risks increase. Planning the new round of fiscal reform should focus on solving some key issues to alleviate the current fiscal difficulties and provide institutional guarantees for achieving the 2035 vision.
I will discuss five aspects:
First, it is necessary to increase the proportion of fiscal revenue to GDP.
In 2018, this proportion was 28%-29%. Starting in 2019, large-scale tax cuts and fee reduction policies were implemented, reducing this proportion to 26% by 2023. Of this, the proportion of tax revenue to GDP is only 14.3%. Some articles suggest that our fiscal revenue as a proportion of GDP is over 33%, which is completely wrong! The error lies in mechanically adding China’s four budgets. Our national budget consists of four parts: 一般公共预算 the general public budget, 政府性基金预算 the government fund budget, 国有资本经营预算 the state-owned capital operation budget, and 社会保障基金预算 the social security fund budget, with overlapping and repetitive items. The largest is the general budget subsidy to the social security fund budget, which reached 2.5 trillion yuan last year. When adding the four bugets, overlapping and repetitive items must be deducted and cannot be double-counted.
In 2023, the government fund budget revenue was 7 trillion yuan, with the largest item being land transfer fees, accounting for about 90%. Of the 7 trillion yuan, the gross land transfer revenue is included, but costs such as land acquisition, demolition, and infrastructure must be deducted to arrive at net revenue. What is the current net revenue? Only 30%, down from 40% in the past. In some areas with very low land prices, it is only 10% - the cost has not decreased much, and nobody has purchased the land, so the net revenue is low.
Based on this calculation, our fiscal revenue as a proportion of GDP was indeed only 26% last year, lower than the 30% of countries with similar incomes and much lower than the 35% of developed countries. To become a moderately developed country by 2035, we should increase the proportion of fiscal revenue to GDP. China has already entered a moderately aging society, and by 2035 it will enter a severely aging society. Without sufficient fiscal resources, it will be difficult to cope.
Developed countries that have entered an aging society have gradually increased the proportion of fiscal revenue to GDP, but reducing taxes is easy, and increasing taxes is hard. It is especially difficult in the current economic situation.
Second, how to increase fiscal revenue?
Aside from tax revenue, the largest items in national fiscal revenue are social security fund income and land transfer income. However, the potential for increasing these two revenues is limited. Social security fund income currently exceeds 11 trillion yuan, including 2.5 trillion yuan in general public budget subsidies, which is already unsustainable. Moreover, the contribution for basic urban employee pensions are 8% + 16%[the employee contributes 8% of the income, and the employer contributes 16% of the employee’s income] and basic medical insurance is 2% + 8% [the employee contributes 2% of the income, and the employer contributes 8% of the employee’s income], which are already very high compared to other countries. Increasing contribution further is unlikely. The most appropriate action is to implement a delayed retirement policy to reduce pressure on the social security fund and improve sustainability.
Currently, the real estate market is in a downturn. Although most cities have lifted price and purchase restrictions, the real estate market will gradually come out of the downward cycle. However, the real estate industry will not return to the abnormal situation of high turnover, high leverage, and high land prices. Land prices cannot rise significantly, and land transfer income will not rebound sharply. Increasing government fiscal revenue mainly depends on taxes, with the most likely increase coming from value-added tax (VAT). Our corporate income tax standard rate is 25%, roughly equivalent to the international average level, while the U.S. has reduced its rate to 21%. There is little room to increase the rate, but eliminating fragmented preferential policies could increase corporate income tax revenue.
Although there is room to increase the proportion of personal income tax in fiscal revenue, structural weaknesses make it very difficult to reform. In 2019, the Personal Income Tax Law was passed, establishing a tax system that combines comprehensive and classified elements but did not transition to a fully comprehensive tax system. The comprehensive tax section includes five special deductions. After adding these five special deductions, the basic deduction amount should have been reduced; however, it was instead increased from 3,500 yuan to 5,000 yuan, which is higher than the national average wage. As a result, the number of personal income taxpayers is very limited, accounting for no more than 5% of the total population.
[Zichen’s note:
1. Comprehensive and Classified Tax System: This refers to a mixed system where some types of income are taxed comprehensively (i.e., income from various sources is aggregated and taxed as a whole), while other types of income are taxed separately under different categories.
2. Five Special Deductions: These typically include deductions for education, healthcare, housing loan interest, rent, and elder care. These deductions are intended to reduce the taxable income, thereby lowering the tax burden on individuals.
3. Basic Deduction Amount: The basic deduction is the amount of income exempt from taxation. In many countries, this is designed to ensure that low-income earners do not pay income tax.]
In contrast, the U.S. personal income tax is a comprehensive tax system, filed by family, where any income must be reported, along with family details. The basic deduction is $3,300, which is only about 10% of the national average family income. Therefore, the reporting population accounts for over 90% of the total population, with 55% paying taxes. Why must everyone report taxes? There are two reasons: first, incentives—if family income is below the national minimum or there are children in school, tax rebates can be obtained; second, penalties for false reporting. The U.S. personal income tax is its largest tax category, serving not only to collect national fiscal revenue but also to redistribute wealth. Changing our personal income tax to meet international standards would involve significant interest adjustments, making reform extremely difficult. According to international standards, the basic deduction should be reduced to 1,000 yuan instead of 5,000 yuan, which would be hard to fly [in China].
Currently, VAT has a 13% standard rate, with two preferential rates of 9% and 6%. The 13% rate is indeed low. When VAT was introduced in 1994, the standard rate was 17%, and the preferential rate was 13%, roughly equivalent to European levels. Now, countries with VAT have an average standard rate of 20%, and European countries are at 21%, due to aging populations requiring more fiscal revenue to cope. In 2018, China reduced the 17% standard rate to 16%, and in 2019 to 13%, decreasing fiscal VAT revenue.
In 1994, when we introduced the value-added tax (VAT) in China, we adopted a production-based VAT system. Under this system, the cost of equipment and buildings could not be deducted, so most enterprises had minimal end-of-period remaining deductible VAT. VAT was collected at each stage of the production process, with the portion not fully deducted at the previous stage being carried over to the next period. This carryover is known as the 期末留抵 end-of-period remaining deductible VAT, which did not impose significant cost pressure on businesses.
Starting in 2012, we began piloting a shift to a consumption-based VAT system. In this system, the cost of equipment, buildings, and office buildings can be deducted. As a result, the amount of end-of-period remaining deductible VAT increased significantly, necessitating timely VAT refund procedures.
The consumption-based VAT, combined with a system for refunding remaining deductible VAT, is the best tax type for raising government fiscal revenue without distorting the market. In this system, businesses act as tax pass-through entities, meaning the ultimate burden of the tax falls on the consumers. VAT inherently has a regressive nature. To mitigate this regressiveness, lower tax rates or preferential rates are set for daily necessities and basic food items, which constitute a larger share of consumption for low-income households.
[Zichen’s note:
1. Production-Based VAT: This type of VAT does not allow deductions for the costs of equipment and buildings, meaning businesses cannot offset these expenses against their VAT liability.
2. End-of-Period Remaining Deductible VAT: This refers to the portion of VAT that has not been fully deducted by the end of a tax period and is carried over to the next period.
3. Consumption-Based VAT: This type of VAT allows businesses to deduct the costs of equipment, buildings, and office buildings, leading to higher amounts of remaining deductible VAT at the end of a tax period.
4. Regressive Nature of VAT: VAT can disproportionately affect low-income households, as they spend a higher percentage of their income on taxed goods and services. Setting lower or preferential rates for essentials helps alleviate this burden.
5. VAT Refund Procedures: Timely refunding of the remaining deductible VAT is crucial to prevent undue financial pressure on businesses and ensure a smooth functioning tax system.]
In 2016, the VAT reform was completed, and VAT revenue was split 50:50 between the central and local governments, making it very difficult to refund remaining deductible VAT. Why? Because businesses in underdeveloped regions needed to purchase equipment mainly from developed regions, VAT was collected in the equipment supply area but refunded in the underdeveloped region, leading to potential multi-year deficits with no VAT revenue in underdeveloped regions, making the refund very difficult.
【Zichen’s note: for unfulfilled VAT refunds, refer to]
In 2019, the State Council introduced a policy where the local government of the region that refunds the VAT would bear 50% of the VAT refunds, with 15% borne by the local government of the region where the businesses asking for VAT refunds are located and 35% by each region based on their VAT share. This initially solved the problem. However, in recent years, the end-of-period remaining deductible VAT has accumulated to nearly 3 trillion yuan. In 2022, a special policy allowed full refunds for small and micro enterprises' remaining deductible VAT, with the central government bearing 92% of the 2.4 trillion yuan in refunds that year. Currently, the remaining deductible VAT balance has basically been cleared. We can consider adjusting the standard VAT rate back to 17%, implementing immediate refunds for remaining deductible VAT, and strictly curbing tax prepayment, without significantly increasing the tax burden on enterprises.
Third, how to set up suitable local taxes?
Currently, local fiscal revenue mainly relies on taxes shared by central and local governments. Corporate income tax, personal income tax, and domestic VAT are all shared 50:50 between the central and local governments, forming the main source of local government revenue. Local independent taxes mainly include deed tax, resource tax, and stamp tax - all small taxes. Previously, the independent tax was 营业税 business tax, which was abolished with the VAT reform in 2016. The Third Plenary Session of the 18th Central Committee in 2013 proposed "considering tax attributes in conjunction with tax system reform to further rationalize the division of central and local revenues."
Ten years have passed, and there has been no significant establishment of suitable local taxes. The main reason, considering tax attributes, is the lack of local taxes. Some suggest further increasing the local share of VAT or classifying VAT as a local tax, which is completely wrong. VAT is collected in stages across production, distribution, and consumption, with unified tax collection and refunds at import and export stages. All countries classify VAT as a central tax to form a unified large market. An opposite example is Brazil, where VAT is a state tax. Half of Brazil's manufacturing is concentrated in São Paulo. Developing industrial chain relationships between São Paulo and other states raises the issue of how to handle VAT. Faced with insufficient local tax sources, some countries allocate a certain percentage of VAT to local governments through equalization transfers. Australia does this. Other countries allocate based on the proportion of retail sales in each region, like Germany, later followed by Japan. In the 1994 tax reform, due to the lack of local taxes, VAT was shared 75:25 between the central and local governments. After the VAT reform in 2016, local governments lacked major taxes, leading to a 50:50 split, which has many drawbacks. The difficulty of handling VAT refunds is one example. Therefore, when discussing local taxes, tax attributes must be considered.
In 2019, the State Council issued the 《实施更大规模减税降费后调整中央和地方收入划分改革推进方案》 "Reform Plan to Adjust the Division of Central and Local Revenues After Implementing Larger Scale Tax Cuts and Fee Reductions," which, aside from clarifying the VAT refund sharing mechanism mentioned just now, also proposed moving the collection of consumption tax downstream and steadily transferring it to local governments. Subsequently, the collection of consumption tax on luxury items such as high-end watches, jewelry, and luxury goods was moved from the production and import stages to the wholesale and retail stages and transferred to local governments. However, this only accounted for 2% and significantly increased the complexity of tax collection, making retail-stage tax evasion easy. Consumption tax mainly covers four items: tobacco, alcohol, vehicles, and fuel. Consumption tax on vehicles and fuel is used specifically for highway construction and maintenance. Compared to developed regions, underdeveloped regions have fewer vehicles and less traffic but higher highway construction and maintenance costs. In regions like Yunnan, Guizhou, and Sichuan, construction costs are 2-3 times higher than in plains areas. This part of the tax is centrally allocated to balance different regions. If the collection of this consumption tax is moved downstream and transferred to local governments, developed regions will get a larger share, reducing fairness.
The central government could consider arranging special expenditures to support local highway construction and maintenance fairly, while moving the collection of this consumption tax downstream and transferring it to local governments. From a health perspective, tobacco and alcohol have negative externalities. All countries set high tax rates to raise prices and suppress consumption of these products, classifying them as central taxes. If the collection of tobacco and alcohol consumption taxes is transferred to local governments, each region will encourage the sale of tobacco and alcohol, which is not conducive to correcting negative externalities. China's consumption tax is a special consumption tax and in effect a sales tax, unlike the consumption tax in some countries like the U.S. The 2019 proposal to move the collection of consumption tax downstream and steadily transfer it to local governments has made little progress, likely due to handling the aforementioned challenges.
Real estate tax, based on its attributes, is the most suitable local tax. It is levied annually on the market value of real estate, with a typical rate of around 1%. Owner-occupied housing gets a certain exemption, and it has a positive effect of deterring speculators by requiring them to pay more real estate tax on multiple properties. Improving public services and living environments by local governments increases real estate value, gradually increasing real estate tax revenue. Real estate tax is the best tax for promoting the transformation of local government functions. In 2003, the Third Plenary Session of the 16th Central Committee proposed 物业税 property tax, essentially real estate tax. Subsequently, pilots were carried out in Shanghai and Chongqing but were not extended nationwide. The Third Plenary Session of the 18th Central Committee in 2013 proposed accelerating real estate tax legislation and pushing forward reform at an appropriate time. After more than 20 years, it has not been implemented mainly due to conflicting interests. If reforms had been implemented timely, the real estate price surge might have been avoided. Currently, the real estate market is in a downturn and in the destocking phase, making real estate tax reform more difficult.
Fourth, how to balance central-local fiscal relations.
Currently, both central and local finances are strained, especially for some grassroots governments even lacking operational funds. Some suggest 财力下沉支持地方 moving more financial resources to local governments. Under current circumstances, the central government needs to moderately increase deficits to transfer funds to local governments, especially grassroots. However, planning the new round of fiscal and tax system reforms should address long-term structural issues and resolve overall mechanism problems. National fiscal data shows an imbalance in central-local fiscal relations. In 2023, the central general public budget revenue was nearly 10 trillion yuan, local revenue was 11.7 trillion yuan, totaling 21.7 trillion yuan nationwide, with local revenue accounting for 54% and central revenue 46%. Central transfer payments to local governments amounted to 10.3 trillion yuan, more than the central government's total revenue, partially financed by deficits. The central government's own expenditure was 3.82 trillion yuan, with a deficit of 4.16 trillion yuan, meaning complete reliance on deficits for central expenditure, an unusual situation globally.
Two international comparison figures highlight this imbalance. In mature market economies, central government revenue usually accounts for over 60% of national revenue, much higher than in China. In mature market economies, central government expenditure typically accounts for over 50% of total expenditure, averaging 61% in OECD countries, while in China, it is less than 12%. This situation mainly arises from unreasonable central-local division of responsibilities, with some responsibilities that should belong to the central government being assigned to local governments or shared responsibilities.
In 2023, shared responsibility transfer payments amounted to 3.67 trillion yuan, the largest central transfer to local governments. Assigning responsibilities affecting a unified national market to local governments often leads to lax management locally for local interests. Social security, which concerns the unified national labor market, should be a central responsibility but has long been a shared responsibility between the central and local governments. In 2018, basic urban employee pension insurance began transitioning to national pooling. Although now centrally collected by the State Taxation Administration, it is still managed by local governments’ social security agencies. To maintain local competitiveness, the benchmarks against which to pay social security, set locally, are generally lower than national standards.
In 2022, it was proposed to accelerate national pooling, but it is still in transition. Ultimately, central government collection and management is a must. The unreasonable division of responsibilities leads to China's central government employees accounting for only 6% of total civil servants, compared to an OECD average of 41%. This central-local division also extends to lower levels. Upper-level governments prefer issuing documents and setting targets for lower-level governments, monitoring implementation through inspections, a system often inefficient overall. Further decentralizing financial resources should not be the direction of future reforms. Instead, increasing central expenditure proportion and centralizing appropriate responsibilities is necessary.
Fifth, how to adjust fiscal policy under current conditions.
Although manufacturing is stable and import-export trade is normal, there is insufficient consumer and business confidence, weak consumption, and insufficient private investment. Future economic development may face more difficulties, requiring timely budget adjustments to increase deficits. Preferably, this should be proposed during the August National People's Congress Standing Committee meeting, increasing the national fiscal deficit rate by over three percentage points, adding more than 4 trillion yuan in deficits based on this year's GDP, primarily increasing central government deficits.
Part of the increased fiscal revenue can be used for phased direct subsidies to low- and middle-income households to boost consumption. With the “金税四期” "Golden Tax Phase IV" system now operational, household income levels can be clearly identified, and central fiscal subsidy funds can be directly allocated. Most funds can be transferred to local governments to alleviate financial difficulties and curb excessive local tax and fee collection. Local governments could also increase deficits by about 1 trillion yuan. According to the Budget Law, local deficits need to be covered by issuing general bonds for construction expenditure. However, no new construction projects are necessary. Nowadays government investment has diminishing effects, and many recent projects have hurt government credibility due to government’s delaying payments to companies, undermining business confidence. The general bond financing should be used to repay debts to enterprises, boosting business confidence and private investment.
Recognize that systemic reform and transitioning economic operation mechanisms are most crucial. The main obstacle to high-quality economic growth is the urban-rural dual structure. The Third Plenary Session of the 18th Central Committee pointed out that the urban-rural dual structure hinders integrated urban-rural development. The Central Rural Work Conference in 2021 stated that from now until 2035 is the window period to eliminate this dual structure. Given current economic conditions, reform should accelerate. Reforming the urban-rural land divide is more challenging; initially, the labor divide should be reformed by reforming the urban-rural household registration system. Eliminating distinctions between urban and rural registration allows about 200 million migrant workers to confidently consume, buy homes, and find employment, increasing their consumption by 30%, and creating significant housing demand. The challenge lies in providing corresponding basic public services. Some responsibilities and expenditures that should be the central government’s burden should be centralized. Correspondingly, reduced specific or transfer payments for shared responsibilities to local governments. Any shortfall in central fiscal funds can be temporarily covered by deficit financing, but long-term tax sources must increase for fiscal sustainability. A feasible approach is raising VAT rates and timely implementing immediate VAT refunds, which effectively increases fiscal revenue with relatively low difficulty.
The above analysis shows that finance is indeed the foundation and important pillar of national governance. Planning the next round of fiscal and tax system reform involves addressing unavoidable challenges, especially increasing the proportion of fiscal revenue to national income, improving and reforming the tax system, establishing local taxes, and balancing central and local fiscal relations. These all require adjustments and improvements in national governance methods, various perspectives, and related interests. Under current economic conditions, balancing short-term policies with the timing of fundamental reforms is also essential.
Thanks for making these public debates about fiscal reform accessible to an international audience. One reform I would suggest is to establish an equivalent of the US Congressional Budget Office (CBO) which independently assesses the government’s fiscal budget to see how sustainable it is. Ideally, the government needs to manage sustainability over business cycles, spending more during bad times, and tightening during good times. A CBO-like institution would help institutionalise this, pushing the government to “tighten up” during good times, and “loosen” during downturns.
Raising tax rates is always difficult politically, but most countries (including in the West( achieve this through inflation. I sometimes come across proposals to “benchmark” tax thresholds with inflation, so that thresholds rise with inflation, but I think this would be a bad idea given how difficult it is politically to raise nominal tax rates. Better to let inflation gradually erode the tax thresholds.