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In the early 1980’s the Chinese government made attempts to decentralise their fiscal and taxation systems to open up the Chinese economy allowing for more growth and prosperity. While the decentralisation promoted growth in many regions, it also caused many unintended problems including rising deficits, increasing regional disparities and weakening macroeconomic management. In this essay, I will outline how the government employed fiscal decentralisation through the tax system and what consequences it had on the tax system. As a way of critiquing the reforms, I will then look at the effects the decentralised tax structure had on the economy.
 
 Before Decentralisation  
 
Before the 1980’s, the tax system in China was typical of one seen in a poor, underdeveloped country. The primary source of government revenue came from the taxing of large government-owned capital-intensive firms. The statutory tax on profits was extremely high, and there was also a significant amount of additional fees. However, even with high tax rates, the level of tax collected remained low, as a result of high-levels of tax evasion and corruption. Due to the high number of ‘under-the-table’ and ‘over-the-table’ payments, investors would be unwilling to invest in these firms as profit margins remained low (Gordon et al, 2002). To compensate for the lack of investment, the government provided cheap loans to these businesses through state-controlled banks or directly funded new product developments. This source of funding went almost entirely to the large firms who were responsible for a large part of government revenue (Wong 2000).  
 
This type of tax structure, made up of high tax rates on a narrow base, can cause substantial efficiency costs for the economy, as it discourages private-activity. As the government is highly dependent on these firms for income, they will often distort their decision making in an attempt to allow these businesses to prosper. In essence, this means the government stifles the entry and development of new industries and sectors to protect those who contribute the most money in tax. This tax system often results in a largely stagnant and closed economy dominated by state-owned firms (SOE’s) allowing for little innovation and new product development. 

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Decentralisation in the 1980s  
 
Beginning in the 1980’s, the party-state led by Jinping, began to transfer control and oversight of many of its small and medium-sized enterprises to local governments, in an attempt to open up the economy and make it more prosperous. To speed the process along, they began signing contracts with all local and regional government’s allowing them to collect local taxes from the firms under their control. They were allowed to keep the net profit minus pre-determined lump-sum payments paid to the central government, in return for providing a range of local public goods. In addition, governments at the local level gained control over the allocation of loans from local banks. This led to a system, not unlike its predecessor where the provincial government would provide funding to the companies which it received the most revenue.

Consequences of the Decentralised Tax Structure  
 
A number of consequences stem from this type of tax system, including the distortion of the tax system, over-saturation of different industries and the prevention of a free and open market.  A tax system based on a bottom-up structure rarely works as the lower down governments do their utmost to reduce the amount of money passed up. Moreover, the incentives between local and central governments remain in conflict. The central government raises its revenue from the large SOE’s, while local governments gain their revenue from the small to mid-size firms (Lin et al, 2003). As a result, the allocation of funds is based on the changing political influence and conflict between local and central governments rather than relative rates of return. 
 
In addition, specific industries become over saturated. The allocation of investment within jurisdictions became inefficient as local governments gave cheap credit to the companies who had higher tax rates in an attempt to bolster their revenue. In an open-market economy, you would expect highly taxed industries to shrink in size relative to the more lightly tax industries. In China, they increased in size as they were propped up by the low-cost funding provided to them by local banks under the control of the local government (Gordon et al, 2002). A good example of the is the development of the Chinese refrigerator industry. Before decentralisation in 1978, China had a small refrigerator industry made up of twenty producers with an output of around 28,000 units. The central government’ tax was set at 20%, so the local government earned around 130-140% of the input cost. As a result, local governments began funnelling money into the industry allowing for  huge growth. By 1985 the number of producers had jumped to 115, with an annual output of 1.45 million units (Gordon et al, 2002). 
 
Another consequence was the prevention of the development of cross-regional firms. In a capitalist economy, banks make their money from the interest payment on loans. In China, these rates remained low, and so there was no incentive for local banks to lend to people outside of their jurisdiction (Agarwala 1992; Lou 2008). As a result, there was not a flow of funds allowing authorities to mutually gain from cross-region financing which stopped the development of large cross-region industries and businesses. 
 
Effects of the Decentralised Tax Structure on the Economy  
 
A tax system which is based on local production rather than local consumption can distort the economy: effects include, inefficient firms, tax competition driving down revenue and over-lending of funds leading to large government deficits. 

As effective tax rates differed from industry to industry, local governments did not want to allow unrestricted trade between regions. Instead, they increased trade barriers for those sectors from which they could make the most revenue. This defies David Ricardo’s law of comparative advantage which states that all regions, at all times, can mutually benefit from cooperation and low barriers to trade, as it allows them to produce the goods in which they have the comparative advantage in relation to other states (Ruffin, 2002). The result is high levels of inefficient firms who often produce more than is needed for local consumption and so therefore, needed to be subsidised by the provincial government while trading on the market. 
 
This sort of system is also highly susceptible to tax competition as entrepreneurs can go between local governments bartering the effective rate of tax down (Djankov et al, 2010). This became an especially large problem as the economy becomes more complex and entrepreneurs have more of a choice over where they would like to set up. Entrepreneurs played local governments against each other and set up where they were given the best terms, e.g. low tax-rates, cheaper funding etc. This leads to a situation whereby the local government had less control over the collection of taxes, as the power shifts to the business owners.
 
Moreover, this type of system allowed for significant differences between private enterprises owned by entrepreneurs, and township enterprises (TVEs) ran and owned by municipal governments. As owners, authorities were able to keep a close eye on the TVEs and often had members of the government sitting on their boards. This meant that monitoring profits and tax on TVE’s were much easier than monitoring the mostly cash-based private firms. As a result, the government would have an incentive to keep them out to cut down the competition faced by the TVEs (Peng, 2001). In order to deter this from happening, the private enterprises allowed CCP representatives onto their boards,and agreed to pre-determined tax payments and ownership sharing agreements. This led to a reduction in their autonomy and freedom from governmental control.

Lastly, government deficits increased, as local government over-provided liquidity to companies in order to  enhance their revenue. Government banks often over-lend to firms with money provided to them by the local banks. This resulted in substantial deficits as local governments lent out more and more money to prop up already failing firms. The result was an expansion in credit far beyond what the government was bringing in revenue through taxes or interest (Oi, 1995). The central government had to increase the money supply to stop the economy from going into a mass recession which increased both inflation and the living costs for ordinary citizens.  
 
Before decentralisation the Chinese economy was similar to one which we would see in a developing country. There was a heavy reliance on certain industries which led the party-state to have a strong incentive to stop the entry of new firms, which led to economic stagnation. The opening up of the tax system by Deng allowed for economic decentralisation, and a growth of new industries followed. While this did at first allow for a rapid economic growth, it also some unintended consequences, these included inefficient firms, tax competition driving down revenue and over-lending of funds leading to large government deficits. This led to further reforms which were needed to counteract the problems listed above and to allow for continual economic growth.

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