Intergovernmental Fiscal Transfer System

—A new model from a comparison between Sweden and China

Kristianstad University Authors:

The Department of Business Studies Jun Gan
Master degree dissertation Hongfei Wang
Public Administration and International Gang Chen
Business Tutors:
Peter Gustavsson
May 2005 Annika Fjelkner
 Acknowledgements

In the course of composing this dissertation, we are enjoying our life and study here

at Kristianstad University. The fine environment and kind teachers at this university

have become an indelible part of our memory. As a team working on international

business, we have obtained not only rich knowledge and strong competence but also

much useful experience that will be beneficial to our future. We also find that good

cooperation and a high sense of responsibility are indispensable to the writing of this

dissertation.

Taking this opportunity, we want to express our sincere gratitude to our tutor Peter

Gustavsson, for all his enthusiastic support and guidance throughout the process.

Without his kind help the dissertation would not be possible. In addition, we would

like to say thanks to our English teacher Annika Fjelkner, who has given us valuable

suggestions for improvement on the language of the whole dissertation.

We also want to express our great appreciation to Christer Ekelund and Lisa Nilsson,

who offered us a lot of useful information, with which we were able to conduct our

research more easily.

Finally, we would like to thank all our interviewees for their help and for being very

friendly and patient.

Kristianstad, May 2005

Jun Gan Hongfei Wang Gang Chen

 Abstract

Intergovernmental fiscal transfer is a kind of transition of fiscal revenues between

the central government and a local government; it plays an important role in leveling

social disparities, furthermore, it further promotes the long-term development of a

country’s economy. As a well-known social welfare state in the world, Sweden has a

rich experience of social equalization. Our dissertation carries out a comparison

between Sweden and China in respect of the intergovernmental fiscal transfer system,

by means of case study. In addition, we conduct some research into related theories,

such as the rationale of intergovernmental grants and the decentralization issue, to

provide necessary support for our argument. In conducting our research we adopt an

inductive approach. The case studies help us identify nine factors that impact the

fiscal transfer system, along with the performances they respectively have in these

two countries. We make a further investigation into their impacts and propose

suggestions to improve China’s transfer system. As the result of our research, we

finally develop a new model which may help push China’s intergovernmental fiscal

transfer system towards the direction of equalization.

Key words: intergovernmental fiscal transfer, equalization, comparison

 Table of Contents
CHAPTER 1 INTRODUCTION ............................................................................................................ 1

1.1 PRACTICAL PROBLEM IN CHINESE SOCIETY ................................................................................... 1

1.2 DEFINING INTERGOVERNMENTAL FISCAL TRANSFER.................................................................... 2
1.3 RESEARCH PROBLEM ........................................................................................................................ 3
1.4 RESEARCH OBJECTIVES.................................................................................................................... 3
1.5 RESEARCH QUESTIONS ..................................................................................................................... 3
1.6 LIMITATION ........................................................................................................................................ 4
1.7 STRUCTURE OF THE DISSERTATION.................................................................................................. 4

CHAPTER 2 METHODOLOGY........................................................................................................... 6

2.1 CHOICE OF METHODOLOGY............................................................................................................. 6

2.2 RESEARCH PHILOSOPHY................................................................................................................... 7
2.3 DATA COLLECTION............................................................................................................................ 7
2.4 VALIDITY ............................................................................................................................................ 8
2.5 RELIABILITY ...................................................................................................................................... 9

CHAPTER 3 THEORETICAL REVIEW ...........................................................................................11

3.1 INTRODUCTION ................................................................................................................................ 11

3.2 ISSUES IN LOCAL GOVERNMENT ECONOMICS .............................................................................. 13
3.2.1 Public Expenditures Growth Theories................................................................................... 13
3.2.2 The Economic Roles of Central and Local Governments ..................................................... 15
3.2.3 The Decentralization Issue..................................................................................................... 17
3.3 THE RATIONALE OF INTER-GOVERNMENT TRANSFER ................................................................ 19
3.3.1 Finance of Sub-Government .................................................................................................. 19
3.3.2 The Purpose of Grants ........................................................................................................... 20
3.3.3 The Principle of Grants Design ............................................................................................. 22

CHAPTER 4 THE INTERGOVERNMENTAL FISCAL TRANSFER SYSTEM IN CHINA ... 24

4.1 CHINA’S CURRENT FISCAL DISTRIBUTION SYSTEM: TSS (TAX SHARING SYSTEM) .................... 24
4.1.1 A Brief Introduction to Fiscal Relation Levels ...................................................................... 24
4.1.2 Political Motivations of China’s Fiscal System Reform ........................................................ 26
4.2 THE MAIN CONTENTS OF THE TSS................................................................................................ 27
4.2.1 The Fiscal Expenditure Assignments on Central and Provincial Levels .............................. 27
4.2.2 The Coverage of Fiscal Revenue at Central and Local Levels............................................. 27
4.2.3 A Brief Introduction to China’s Fiscal Transfer System ........................................................ 28
4.3 CASE STUDY: NINGBO ..................................................................................................................... 30
4.3.1 Scope and Coverage of This Case Study................................................................................ 30
4.3.2 The Composition of Local Fiscal Revenue in Ningbo........................................................... 31
4.3.3 Analysis of Disparities of Fiscal Revenue Per Capita Since 1994 ....................................... 31
4.3.4 Primary Factors Leading to Disparities on County-Level.................................................... 32
4.3.5 Two Primary Conclusions About The Disparities in Fiscal Revenue Per Capita ................ 35
 4.3.6 The Further Research about the Disparities in Fiscal Transfer System ............................... 35
4.3.7 The "Hold Harmless" Principle: a Knife with Double Blades.............................................. 37
4.3.8 Negative Aspect of Earmarked Grant.................................................................................... 39
4.4 SOME CONCLUSIONS FROM NINGBO’S CASE STUDY .................................................................... 41

CHAPTER 5 THE FISCAL TRANSFER SYSTEMS IN SWEDEN............................................... 44

5.1 WELFARE STATE AND SOCIAL EQUALIZATION.............................................................................. 44

5.2 THE DEVELOPMENT OF SWEDISH EQUALIZATION SYSTEM ........................................................ 48
5.2.1 Income Equalization............................................................................................................... 51
5.2.2 Cost Equalization ................................................................................................................... 51
5.2.3 General Government Grants ................................................................................................. 52
5.2.4 Transitional Regulation/Introduction Grants ........................................................................ 52
5.2.5 A Per Capita “Regulation” Grant or Fee............................................................................. 52
5.3 A CASE IN STOCKHOLM—SOME PROBLEMS OF THE SYSTEM .................................................... 53
5.4 SOME CONCLUSION ABOUT THE SWEDISH FISCAL TRANSFER SYSTEM .................................... 56
5.4.1 Responsibilities Assignment Must Be Identified Clearly....................................................... 57
5.4.2 Guideline of the System and the Target of Transfer Fund Should be Identified Clearly...... 58
5.4.3 Some Specific Regulations and Scientific Formulas Are Indispensable............................... 59
5.4.4 Different Diverse Means Can Be Adopted ............................................................................ 60
5.4.5 A Professional Administration Needs to Be Established and a Monitoring System Is Also
Important................................................................................................................................................ 60

CHAPTER 6 A NEW MODEL............................................................................................................. 61

6.1 THE FACTORS................................................................................................................................... 61

6.1.1 Political Legitimacy ............................................................................................................... 62
6.1.2 Legislation .............................................................................................................................. 62
6.1.3 Responsibility Assignment...................................................................................................... 62
6.1.4 Tax Autonomy ......................................................................................................................... 63
6.1.5 Formulation............................................................................................................................ 63
6.1.6 Motivation............................................................................................................................... 63
6.1.7 Supervision ............................................................................................................................. 64
6.1.8 Information............................................................................................................................. 64
6.1.9 Structure of Grants ................................................................................................................. 64
6.2 A FURTHER COMPARISON BETWEEN SWEDEN AND CHINA ......................................................... 65
6.2.1 Political legitimacy................................................................................................................. 66
6.2.2 Legislation .............................................................................................................................. 66
6.2.3 Responsibility Assignment...................................................................................................... 67
6.2.4 Tax Autonomy ......................................................................................................................... 67
6.2.5 Formulation............................................................................................................................ 68
6.2.6 Motivation............................................................................................................................... 69
6.2.7 Supervision ............................................................................................................................. 69
6.2.8 Information............................................................................................................................. 70
6.2.9 Structure of Grants ................................................................................................................. 70
 6.3 THE NEW MODEL ............................................................................................................................ 71
6.3.1 Suggestions............................................................................................................................. 71
6.3.2 The New Model....................................................................................................................... 76

CHAPTER 7 CONCLUSIONS............................................................................................................. 78

7.1 SUMMARY OF DISSERTATION .......................................................................................................... 78

7.2 MODIFICATIONS TO THE CREATED SYSTEM.................................................................................. 80
7.3 SUGGESTIONS FOR FURTHER RESEARCH ...................................................................................... 81
7.4 METHODOLOGICAL CRITICISM...................................................................................................... 82
7.5 PRACTICAL IMPLICATIONS ............................................................................................................. 83

BIBLIOGRAPHY ......................................................................................................................................... 84

APPENDIX..................................................................................................................................................... 87

INTERVIEW QUESTIONS: MR. PER PERSSON IN KRISTIANSTAD FINANCIAL DEPARTMENT AND MR.
MATS HANSSON IN MALMÖ FINANCIAL DEPARTMENT .......................................................................... 87
INTERVIEW QUESTIONS: MR. LENNART TINGVALL IN FINANCIAL MINISTRY IN STOCKHOLM .......... 88
INTERVIEW QUESTIONS: POLITICIAN IN STOCKHOLM........................................................................... 89
 Chapter 1 Introduction
The introduction sketches a general picture of the background of the dissertation.

The research problems and the objectives are also discussed. Moreover, the

limitations, definitions and research questions are defined. In addition, an outline is

introduced.

1.1 Practical problem in Chinese Society

In recent years, Chinese economy has experienced unprecedented progress because

China has embarked on a wide-ranging set of reforms. According to statistics

released by the Chinese government, its GDP has grown by more than 7% annually

over the past decades with the average GDP per capita reaching $1087 in 2003.

However, the reforms have brought some negative effects while improving the

quality of life of the Chinese people significantly. One severe social problem

accompanying the development of society is the emergence of a widening gulf

between the wealthy and the poor, an obvious gap between the city and the rural

areas, and a visible income disparity among different industries. The Giniceffcent, a

famous international yardstick, can clearly illustrate this situation in China. The

figure changed from 0.3 in 1980 to 0.458 in 2000, which means that the situation has

reached an alarming level and may possibly trigger social unrest in the Chinese

society. Consequently China is facing a dual pressure of developing the economy at

a high speed and narrowing the income disparity at the same time.

As for the government of China, a priority issue is the serious financial imbalance

between the eastern and western region in the country. Local governments in poor

western regions holding a poor financial position cannot provide vital public services,

while more advanced eastern cities are pursuing to fulfill their modernization. For

instance, nearly 90 percent of the rural population in the western areas is without any

1
protection from risk-pooling schemes. A similar case can be found in the educational

sector, as most of the western provinces in China still have difficulties in providing

nine years of compulsory schooling. In order to solve this problem, the central

government of China is experimenting with a new series of measures. An

intergovernmental fiscal transfer system has acquired much attention as a useful and

important tool and is currently established by the central government of China.

As public administration and business students in Sweden, we have learned a lot

about the Swedish model. One outstanding feature of the model is that everyone can

enjoy benefits from the welfare system equally. The Swedish government has

displayed a sound performance to limit the distance between the rich and the poor.

The intergovernmental fiscal transfer system in Sweden is both effective and

scientific. Therefore, we think it is meaningful and practical for us to do some

research in this area. We hope to find the most applicable theory in this area. In

analyzing the most important factors in the Swedish transfer system, our main

purpose is to create a suitable series of theoretic guidelines and institutions that can

be effectively applied in China, will promote the establishment of a welfare state,

and contribution to the formation of an equal society.

1.2 Defining Intergovernmental Fiscal Transfer

Intergovernmental fiscal transfer is a kind of transition of fiscal revenues between

the central government and a local government, or between an upper-level

government and a lower-level government. International experiences indicate that

the intergovernmental fiscal transfer system impacts the equity and the efficiency of

the whole fiscal system in many areas (Ma Jun, 1998, pp1).

In this dissertation, the concept of “intergovernmental fiscal transfer system” used in

China’s case has the same signification as the concept of “equalization system” that
2
is used in Sweden’s case.

1.3 Research Problem

As an instrument in dealing with the fiscal relations between the central government

and sub-national governments in China, the intergovernmental fiscal transfer system

plays an important role. Nevertheless, this system has so far remained slack and

capricious. The responsibilities and fiscal revenue assignments between the central

and sub-national governments are the premise (or basis) of a fiscal transfer system,

and yet they still remain quite ambiguous at present in China. The forms of transfer

are not conducive to equalization either. In addition, the current transfer system lacks

transparency and publicity. From the central government to sub-national

governments, efficient control and appraisement mechanisms within the system are

also in need.

1.4 Research Objectives

In this dissertation, we plan to do careful research concerning the intergovernmental

fiscal transfer system and its supporting theories, to develop a model which

illustrates the establishment of a scientific transfer system with a direction of

equalization.

1.5 Research Questions

This dissertation addresses the following research questions:

z What conclusions can we reach through analyzing the intergovernmental fiscal

transfer system of both China and Sweden?

z Which factors should be considered when we establish a new model for

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 promoting the intergovernmental fiscal transfer system in China?

1.6 Limitation
We have tried to look for as many research results as possible in the field of financial

grants. However, only a limited size of publications is available and this has largely

restricted our investigations. In addition, we mainly focus on Chinese and Swedish

cases and draw a comparison so that we can discover implications for the Chinese

equalization system. However, the Chinese government emphasizes more on the

economic growth than the equalization society achievement. Thus, for the practical

use, our research will face the political obstacle. Further, due to the limit of time, we

could not extend our research to include other developing countries that the social

and economic conditions are similar to China, like India. Lastly, in the process of

detecting this system we examine the examples in three cities in Sweden and one

city in China. The instance of the Chinese city, however, may not fully represent the

situation of local governments in the country, because of regional disparities.

1.7 Structure of the Dissertation

The dissertation is organized in the following chapters:

Chapter 2: This chapter presents the design of our research, our methodological

strategy and scientific approach.

Chapter 3: In this chapter the theoretical framework is presented.

Chapter 4: This chapter presents a case study of China’s intergovernmental fiscal

transfer system, focusing on the case of Ningbo from which we draw a few

conclusions.

4
Chapter 5: This chapter provides a case study of the Sweden’s intergovernmental

fiscal transfer system, followed by corresponding conclusions.

Chapter 6: This chapter presents the factors that should be considered when creating

a new model concerning the intergovernmental fiscal transfer system in China.

Chapter 7: This chapter presents a summary of the dissertation, and proposes

possibilities for future research.

5
 Chapter 2 Methodology
In this chapter the methodology of our research is presented. The primary and

secondary data collections are explained. Furthermore, research validity and

reliability are put forward, followed by the research approach adopted in the

dissertation.

2.1 Choice of Methodology

We conducted our research on the inter-government fiscal transfer system through a

case study in China, since the system can promote social equalization, economic

growth and political stability. Furthermore, we tried to review some already existing

literature in this area and analyzed the Swedish experience of social equalization.

Our aim was to be able to find some important factors that are vital to a successful

fiscal transfer system. After that, a new model was formulated, which can be carried

out in China in a short time.

For this purpose, we adopted an inductive approach where an established theory

comes from case study and data collection. We did not want to pay much attention to

the need to generalize, instead, our intention was to get a thorough understanding of

the system. The dissertation planed to mainly describe the relationship between the

fiscal transfer system and social equalization. The comparison between the Swedish

fiscal transfer system and the Chinese transfer system had been done by means of

case studies, which finally led to our new model. In addition, we identified the

factors that are indispensable to an effective and successful transfer system through

the case study on Swedish experience. So for these reasons and the fact that there is a

wealth of cases, we founded the inductive approach the most suitable for our

dissertation (Saunders, Lewis&Thornhill, 2003).

6
2.2 Research Philosophy
There are different ways of thinking of the development of knowledge, e.g.

positivism, interpretivism, and realism. A positivistic research philosophy can be

used when the researcher is an objective viewer who can draw general conclusions

of the social reality (Saunders et al, 2003). This dissertation follows the lines of the

positivistic philosophy as we feel the efficacy of it. We believe that we are able to

reach general conclusions by studying social reality. However, we had simplified the

theories that are important to our own model. We conducted an objective analysis of

the cases in Sweden and China. In the meantime, we also borrowed some principles

from the interpretivistic philosophy, as we made our interpretations through

structural interviews.

2.3 Data Collection

To fulfill the purpose of this dissertation, data had to be collected and analyzed. We

found a lot of secondary data that fit the purpose of the research. Many developed

countries have done intensive research on the fiscal transfer system, which provide

us with much useful information and data. We chose Sweden as our main target and

some internationally well-known and representative nations as our main references,

such as the USA, Japan, Germany and Australia. Our tutor recommended us several

useful books, which saved a lot of time. Also, we spent much time collecting nearly

two hundred related articles on the Internet and in the library of Kristianstad

University.

On the other hand, we tried to find as much as primary data as possible through

interviews and contact with the Swedish Ministry of Finance as well as with

Ningbo’s Financial Department, in order to best describe the present situations of the

two systems and examine their changes and development. Fortunately, we obtained a

lot of useful information and first-hand data from Mr. Persson, Mr.Tingvall and
7
Mr.Hansson. All of them are specialists with the Swedish Financial Department. In

addition, thanks to our work experiences at the local financial departments in Ningbo

Municipality, we have collected abundant and authentic data about the Ningbo’s

system, which was very helpful to our research.

Secondary and primary data could be classified into quantitative and qualitative

categories, the two having distinct differences. Qualitative data base their meaning

on what is expressed in words. As the collected data are not standardized, we classify

them into categories and analysis is conducted using conceptualization (Saunders et

al, 2003). For our plan, the data collected are largely qualitative, since they mainly

come from case studies and surveys. We designed ten different questions and raised

these questions to our interviewees.

2.4 Validity
Validity is defined as to what degree the findings really measure what they are aimed

at measuring and if the findings are what they appear to be about (Lekvall &

Wahlbin, 1993; Saunders et al., 2003). A good research should have a high validity.

In our research, we tried to locate some related materials and secondary data from

some authorities. For instance, our collected data mainly come from the Ministry of

Finance in Sweden and the Financial Department of Ningbo in China. Meanwhile,

we acquired a lot of information from written reports by the Swedish government.

Based on these materials and data, our research can avoid incredibility as much as

possible. In addition, we chose to focus on Stockholm and Ningbo because these two

cities are typical and meaningful in terms of their fiscal transfer system in Sweden

and China. Through analyzing the two cases, we can find some typical problems that

need to be addressed and researched. Then we reached a conclusion with sufficient

certainty as to which factors are indispensable to a successful fiscal transfer system,

which is crucial for our newly created model.

8
2.5 Reliability
Reliability is related to how well the research method yields the same results on

other occasions and if other researchers could reach similar results. In other words,

reliability is high if the survey results in the same findings each time it is conducted

(Saunders et al., 2003). In our research, we made arduous attempts to give our

scheme a high reliability. As a start, we spent much time reviewing the most typical

theories in connection with the fiscal transfer system to achieve an overall

understanding of the theoretic framework. Meanwhile, we surveyed the whole

process of the development of the Swedish transfer system from 1992 to 2005,

especially the three reforms which occurred in different periods. Then we selected

some representative persons as respondents in our interview. These persons include

leaders and professional employees from the Financial Department and members of

certain political parties. We followed a semi-structural interview and designed ten

related questions, with our aim of making our research as objective as possible.

Finally, we tried to analyze the case of Stockholm in Sweden, as the city is a main

contributor to the Swedish transfer system, where a heated debate is currently

developing about the system.

On the side of China, we chose Ningbo to be the centre of our case study. Since 1987,

Ningbo has become a sub-provincial-level city further opening up to the outside

world entitled to decisions in economic planning and management independent of

the provincial government. It means that Ningbo is directly subordinated to the

central government of China rather than Zhejiang Province in dealing with economic

management issues, such as fiscal distribution.

There are six urban districts under Ningbo's jurisdiction, Haishu, Jiangdong, Jiangbei,

Zhenhai, Beilun, and Yinzhou, three county-level cities of Yuyao, Cixi and Fenghua,
9
and two counties Xiangshan and Ninghai. This means Ningbo Municipality also has

its subordinate regions. Thus, Ningbo is sandwiched between the central government

and local administrations appear as a very meaningful example for a study about

inter-government fiscal relations. We hope such an analysis can be both typical and

credible to some extent.

10
 Chapter 3 Theoretical Review
The theoretical framework is presented. First, we give the definition and classify

different typology of inter-government grants. Second, we analyze local government

economies by reviewing public expenditures growth theories, the economic roles of

central and local governments and decentralization issues. Third, we discuss the

rationale of inter-government transfer, including the finance of the local government,

the purpose of different grants and the principles of grant designs.

3.1 Introduction
In 1928, the economist Pigou first revealed the conception of transfer. In his view,

fiscal redistribution can help establish an equal welfare system (a study in public

finance, 1928). Oates (1972) implies that redistribution has to be carried out by

higher levels of the government.

In Article 9 of the European Charter of Local Self-Government, the necessity of

grants to the governing system is presented.

Local authorities’ financial resources shall be commensurate with the

responsibilities provided for by the constitution and the law. The

protection of financially weaker local authorities call for the institution

of financial equalization procedures or equivalent measures which are

designed to correct the effects of unequal distribution of potential

sources of finance and of the financial burden they must support. Such

procedures or measures shall not diminish the discretion local

authorities may exercise within their own sphere of responsibility.

Grants shall not be embarked for the financing of specific projects As

far as possible. The provision of grants shall not remove the basic

freedom of local authorities to exercise policy discretion within their

11
 own jurisdiction.

According to the World Bank, inter-government fiscal transfer is a prime source of

revenues of sub-national governments among most developing countries. The

transfer mainly functions is maintaining efficiency and equality of local service

provision and fiscal health of sub-national governments (Internet 1).

Stephen J. Bailey (1999) put grants into two main categories: specific grants and

general grants, described as follows:

Graph3.1 A typology of inter-government grants

Grant

Special grants General grants

(Conditional/categ (Unconditional/blo
orical/earmarked) ck)

Lump-sum special Matching special Lump-sum general Effort-related

grants grants grants general grants

Closed-ended Open-ended Closed-ended Open-ended

matching specific matching specific effort-related effort-related
grants grants general grants general grants

Source: Bailey, 1999, p.181

Specific grants are used for specific purposes defined by the granter. It can be

12
classified as conditional, categorical or earmarked grants. They function as an

inducement for local services provision when spillover effects are substantial, or

when a minimum standard of service is required by the central government. Specific

grants can be lump-sum or matching (local government matches a certain percentage

of the total expenditures).

General grants are paid to finance the local authorities to provide a broad range of

services. They are also referred to as unconditional or block grants, the main function

of which is to achieve horizontal and vertical equality, for example, grants used in

education, leisure and so on. General grants maybe lump-sum or effort-related.

Effort-related grants are related to the tax revenue that local authorities raise, in other

words, the greater the revenue raised, the more grants the local authorities receive.

3.2 Issues in Local Government Economics

In a democratic society, local governments can be regarded as elected bodies whose

jurisdiction is of local size, supported by powers to levy taxes by which they exert

genuine role over local service provision (Cole and Boyne 1995). Although varying

in geographic and democratic sizes, they have general power and obligation to

undertake any activities related to local public interests.

3.2.1 Public Expenditures Growth Theories

Public expenditures rose rapidly in most countries during the 20th century. In the UK

and the US, public expenditures occupied 42% and 35% of the GDP in 2002

respectively, while the figure at the start of the 20th century was about 10% (Miles,

Myles, &Preston, 2003, p1).

Public expenditures encompass two categories: exhaustive expenditures and transfer

payments. Exhaustive expenditures refer to government purchases that are used for
13
public goods, investment, consumption, etc. A transfer payment refers to the

payment in which government transfers the money from taxpayers to recipients.

Transfer payments largely go to welfare benefits, such as income support,

unemployment benefits and pensions.

There are some macro models that explain the current increase of exhaustive public

expenditures. 1) The Development model. Public expenditures are prerequisite of

economic development. Initially, governments construct roads, railways, and water

utilities. When the economy develops, governments invest in human capital like

education, health, and a welfare system. Structural factors, for example industrial,

demographical, and social factors determine the need for public expenditures. 2) The

Organic state model. The state is assumed to be like a human organism. The

organism will grow when the society’s demands for services increase as per capita

incomes grow. These services can be done by the private sector, but government

intervention (subsidy, direct provision) is necessary to make economic allocation

optimal. Due to the risk of market failure, the state is suggested to stabilize the price

system for the market to function smoothly. 3) The Political constraints model. In a

democratic society, taxpayers have great influences on what levels they would like to

pay for public expenditures. People’s willingness to pay taxes is connected with their

expectations for what kind of services the government can provide. 4) The Leviathan

model. This model assumes that government departments and agencies tend to

promote the public sector, and that government employees have more political

influence on public spending than the general public (Bailey, 2002, p49).

As for transfer expenditures, some factors are at play and lead to growth or decrease.

The first is the demographic structure. The transfer payments are influenced by the

elderly pension, child-care, health care, and personal social services. The second is

the household structure, such as the increasing rate of single parent families. The

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third is the economic situation. When unemployment increases, the government has

to increase public spending on the jobseeker’s allowance, income support, etc. The

fourth is the equity consideration. The transfer payments and taxes, the government

expenditures are based on the equality conception nation-wide. However, a complete

equality has disincentive effects. For individuals, disincentive-to-work effects of

high taxation plus high social security leads to lack of motivation to work. High

taxation on private areas furthermore weakens the competition ability of private

companies. In addition, as to local governments, equality payments reduce their

desire to raise taxes. Usually, the median voters would favor a high redistribution

income system (Bailey, 2002, p58.).

3.2.2 The Economic Roles of Central and Local Governments

In most countries, there are clear divisions between local and central governments.

The local government usually provides services based on local interests, such as

local roads, water supply, parks, and recreation facilities. As for the central

government, it is mainly in charge of defense, diplomatic relations, motorways, etc.

In some cases, where benefits extend beyond local boundaries, like education and

health care, the responsibilities are often in the hands of both levels of governments.

The rational division services of is determined by economic and political factors, and

also related to the historical relationship between different levels of governments.

The four main economic roles of a government are the allocation, distributive,

regulative and stabilization roles (Bailey 1995, ch.2). Among these roles, resource

allocation is mainly the concern of local governments, while income distribution and

stabilization are undertaken by the central government. Regulatory function is done

primarily by the central government (Oates 1972; King 1984).

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In a perfect market economy, resources allocation can reach the Pareto optimum1

because all the product and factor prices can match their costs. Under such

circumstances, it is impossible to relocate resources for the purpose of increasing

output and impossible to alter the distribution of commodities to increase the welfare.

But, in an imperfect market, which lacks perfect competition or where market prices

do not reflect the costs and benefits of the products, it is hard to achieve the Pareto

optimum. In this case, government intervention is justified if it corrects market

failure (Bailey 1999, ch.1).

Many economic theories suggest that to provide public goods is the main resource

allocation activity for the government. Public goods can be divided into two groups:

national public goods and local public goods. Their assignment division is said to

depend on how large an area benefits from the public goods. If the goods benefit all

citizens, they should be provided by the central government, like defense. On the

other hand, when the goods only benefit local voters, local governments take the

responsibility. Services such as education, public order, etc, are dealt with on a local

or lower level government in the UK, Germany and the US (Miles, Myles, &Preston,

2003, p26).

Another factor should be taken into account. That is the externality of public goods.

For example, when citizens outside the local area mainly use a road within the

territory, it is the up-level government that should take responsibility for building or

managing the road (Jackson, 1993. p158).

Instead of simply dividing public goods into national and local ones, Oates (1972)

and King (1984) attempted to find the optimum size of authority for the production

of each of them. The optimum size should, on the one hand, have a greater ability to

1
Pareto optimum refers to that allocation of resources is in the most efficient situation. The status cannot move
without leading at least one person to be worse off.
16
exploit the economies of scale and diminish external effects, and on the other hand,

be able to meet the variable preferences. Where economies of scales and external

effects are very important, central provision may be the best, like defense. Where

economies of scale and externalities are modest, the local government is suitable to

take the responsibility to provide public products, such as parks, etc.

In practice, many local authorities provide education, elderly-care, and other social

services. These products are called merit goods. Governments provide these products,

because people tend to neglect their benefits or cannot afford them. As what happens

to public goods, similar with merit goods, as to whether the central or local

government provides the merit goods. When the redistribution responsibility is in the

hand of the local government, the varying preferences from area to area can easily be

met, but the externality can weaken the local government responsibility. For example,

people may migrate from a poor area to a high welfare area and rich people may

emigrate because of high taxes. The prescription for the problem could be that the

central government controls the amount of redistribution and meanwhile permits

local governments to consider the type of local services. In the U.S.A, local

authorities rely on grants from state authorities to solve the education problem that

population migration incurs, because migration makes it harder for local authorities

to establish their own tax policy (Jackson, 1993. p162).

3.2.3 The Decentralization Issue

The World Bank defines Decentralization as “the transfer of authority and

responsibility for public functions from the central government to subordinate or

quasi-independent government organizations and/or the private sector—it is complex

concept”(Internet 2).

According to Bailey (1999), decentralization has three forms: economic

17
decentralization, political decentralization and administrative decentralization.

Within the EU, the decentralization principle has been broadly adopted. Most people

agree that the government should exert powers at the lowest possible level. The

European Charter of Local Self-Government declares the principle that the local

government should be divided into entities as small as possible. Oates (1972) in his

decentralization theorem notes that local governments are created under that

preferences vary little within localities but vary largely between them.

Centralized public provision is subject to uniformity, failing to consider the local

variations in preferences. National uniform services can lead to the loss of

consumers’ surplus, thus the local government is preferable to take the tasks as it

increases efficiency of service provision (Bailey, 1999, cp.2).

There are two choices concerning the local authority discretion. The first is the

centralized constraints model. In this model, the central government set out

regulations for the local government and the local governments enjoy autonomy

within the regulations. The second is the bargaining model, where the local

governments are empowered by the constitution and the different levels of

government should negotiate with each other in order to set up or implement national

policies consistently and coherently. The historic evolution of the state also

determines the local government’s discretion (Bailey, 1999, cp.1).

Administrative decentralization refers to the transfer of responsibility of planning;

budgeting and management of some public services form the central level to the

local government or other public authorities. Financial responsibility is the core of

administrative decentralization. In order to function their responsibilities effectively,

the local government should make its revenue meet the financial demands of

undertaking the responsibilities. In this sense, financial decentralization is

18
substantial and significant (Internet 2).

3.3 The Rationale of Inter-Government Transfer

3.3.1 Finance of Sub-Government
Sufficient revenue is indispensable for governments to fulfill their responsibilities.

Broadly speaking, the revenues for sub-central authorities can be recruited from four

sources: loans, charges, taxes and grants. David King analyzed the four resources as

follows (Jackson, 1993, p168):

z Loans. The implication of loan finance and tax finance is identical if people

were fully rational. The problem may occur when people migrate from one area

to another area. The emigrants will benefit from the public spending without

paying costs of loans. In addition, the loans are usually confined by the capital

available.

z Charges. When providing the public services, both efficiency and equity factors

need to be considered. Equity arguments generally favor charges. For it seems

equitable for road costs to fall chiefly on the heaviest road users. On the other

hand, efficiency requires zero-price tax-financed services. Due to public goods

characteristics, excessive charges are not suitable.

z Taxes versus grants. Local demands for public services vary from area to area.

In order to meet the preferences, local governments should have their own

expenditures. From this point, it is important for sub-governments to determine

their own policies of levying taxes. If they depend largely on the central

government grants, they will lose control over local affairs. The effort-related

grants can solve this dilemma. Under such a system, grants are transferred to

19
 any area according to how much the area raises its taxes. But, the system may

encourage excessive or super-optimal spending. In addition, the central

government is answerable to its voters nation-wide for how revenue and grants

are spent. So, it is entitled to set up regulations concerning local authority

services, and consequently limits the strength of local governments to make

decisions by their wishes. In western countries, a Robin Hood tax is adopted

which transfers tax incomes from a rich area to a poor area.

3.3.2 The Purpose of Grants

It is common in developing countries or even in developed countries that

sub-governments rely on grants from higher-tier governments in some degree.

David King (1984) pointed out that there are three reasons for grants. The first is to

correct for externalities. Some sub-central services yield benefits to non-residents,

for example a road that passes beyond the territory. In this case, grants are needed for

sub-governments to meet a certain share of the total road cost. The second is the

problem of finding suitable taxes for sub-central governments. Usually, the different

levels of authorities levy different taxes to supplement their revenue. When the taxes

levied are less than their need, the central government pays out revenue-sharing

grants. The third is that inequalities between different areas should be diminished by

means of equalization grants.

The purpose of equalization grants is to diminish the financial inequality between

different areas. The fiscal horizontal inequality exists due to different taxable

resources and local expenditure at per capita levels. The vertical inequality occurs

because the jurisdiction for local governments levying taxes is not necessarily proper.

The inequalities will have some consequences. First, people in different areas pay

different taxes for the same standard of service. According to David King (1984), the

20
inequalities in tax rates for same public service standards could encourage migration

from unfavorable areas to favorable areas. Such migration will use up resources in

itself; in addition, it could result in people locating themselves in areas where their

contributions are less than before if lower taxes can offset the lower wages (Jackson,

1993). Second, a local welfare state may collapse due to the fiscal stress. Third, high

taxes imposed for enhancing the revenue, may force the population and business

activities move out of the local area. Such a situation will further deteriorate the local

economy. Therefore, the inter-government equalization grants should be provided to

poor tax resources or high expenditure areas (Bailey, 1999, p191).

In the local tax revenues, the income and property taxes are the important resources

in practice. But, the distribution of economic activities is uneven between central

cities, towns and rural areas. It is the main cause of tax resources inequality.

As for the local expenditure needs per capita, inequality exists because of the

differences in demographic, socioeconomic, geographic and other factors, such as

population density, the proportion of elderly and children and the employment

situation. These factors are so complicated that it is difficult to calculate the local

expenditure needs accurately. Blair (1993) described some principles to assess the

expenditure needs and to distribute the consequent inter-government grants: first,

common needs indicators should be used in all local governments and over different

periods; second, the needs indicators must be easy and objective; third, the indicators

should link to the expenditures clearly; fourth, the indicators are not highly

inter-dependent.

In Europe, some countries pursue full equalization by the grant system, like the UK

and Denmark. Some countries seek partial equalization, such as France, Ireland, Italy

and Switzerland. Adopting the partial equalization grants system has two reasons:

21
one aims at preserving local financial autonomy; the other is the central government

lacks sufficient fiscal resource for full equalization (Bailey, 1999, p.195).

3.3.3 The Principle of Grants Design

As we analyzed above, inter-government transfer can help diminish fiscal gaps and

inequity among the governments. Basically speaking, general grants are used to

achieve these purposes, while the matching specific grants will be an incentive to

solve the problem when externalities are existing. In this case, the share of benefit

spillover to local benefit should be measured firstly. As public provision is the

responsibility of the central government, the non-matching conditional grants will be

provided to local governments to achieve the goal. Equity and efficiency are desired

when setting up the pattern of a transfer system, from the view of public sector and

local government economics, and decentralization issues.

The appropriate form of a transfer depends upon its objective in general. Regardless

of the particular design, good intergovernmental transfer programs observe certain

principles (Internet 1):

z Transfers should be designed in an objective and open way, ideally by some

well-established formula. They maybe decided by the central government alone,

or a grant commission, or some formal committees.

z Transfers are relatively stable to permit rational sub-national budgeting during a

certain period, but also ensure that national stabilization objectives are not

constrained by sub-national finances. Thus, stability and flexibility are both

taken into account.

z The transfer formula should be transparent, and based on credible and objective

22
 factors. In addition, it should be simple to understand and implement. In most

developing countries, there are difficulties to design the formula, because of

disputes about the regional and local population size.

z Transfers can assist local governments by both equalization purpose and special

objective, such as education, local infrastructure. Clarity and effectiveness are

preferable when different transfers are targeted for separate purposes.

Meanwhile, decentralization thematic term of the World Bank (2003) revealed

several criteria for the transfer design besides the above principles, including: 1, the

local governments have autonomy to decide their priority, and right to enjoy tax-base

sharing, formula-base revenue sharing and block transfer; 2, the central and local

governments should arrange the transfers equitably and efficiently; 3, local

governments need have adequate finance to undertake the designated responsibilities;

4, the grant recipient should adhere to the purpose of the granter. “This is

accomplished by proper monitoring, joint progress reviews, and providing technical

assistance, or by designing a selective matching transfer program” (Internet 1).

According to Jorge Martinez-Vazquez (2002), some institutions are required to

implement the transfers. From the beginning, credit data collection is necessary

before deciding transfers. In addition, central government agencies or a special

independent “Grants Commission” take the responsibility to design and monitor the

transfers. The local governments should have the capacity to implement the transfer.

Furthermore, adequate adjustment can be done when necessary. Finally, periodical

evaluation is desirable in order that the transfers are done efficiently and equitable.

23
Chapter 4 The Intergovernmental Fiscal Transfer System

in China
In this chapter, we will present a case study about the intergovernmental fiscal

transfer system in China, focusing on the example of Ningbo. A background of

China’s current fiscal distribution system will be introduced in the beginning of the

chapter, and then we turn to analyzing factors that result in disparities of fiscal

revenues among the different counties in Ningbo, along with an investigation into the

reasons behind these factors. At the end, we draw some conclusions about China’s

current fiscal transfer system.

4.1 China’s current fiscal distribution system: TSS (Tax

Sharing System)
4.1.1 A Brief Introduction to Fiscal Relation Levels
There are five levels of governments in China (Graph 4.1) and they are: the central

government, the provincial (municipality and autonomous region) level government,

the prefecture level government, the county level government and the township-level

government. Below is a table indicating the five levels.

Graph4.1 Levels of government in China

Central Government

Provinces &Autonomous Regions Municipalities

Prefectural-Level Units

County-Level Units

Township-Level Units

24
According to the Chinese Budget Law, each level should have an independent

budget that is approved by the People's Congress at that level (article 2 and article 13,

1995). Consequently there are also five levels in China's fiscal system.

Before 1987, Ningbo was a prefecture-level city, subordinate to the Zhejiang

Province. However, in 1987, to quicken its opening to the outside, the State Council

lifted Ningbo to the status of a sub-provincial city, giving it the same rights as a

province in economic planning and management. In other words, Ningbo is

coordinate to Zhejiang Province in China's fiscal system but not in the political

system, see Graph 4.2.

Graph4.2 Ningbo as a sub-provincial city

Central Government

Ningbo Municipality

Urban Districts County-Level Cities Counties

Township Units Township Units Township Units

Due to its double identities (both provincial and prefectural), we can see the

municipality of Ningbo contains four levels of government dealing with economic

issues. In accordance with the Budget Law, there are also four correspondingly fiscal

levels.

25
4.1.2 Political Motivations of China’s Fiscal System Reform
From the end of the 1970s to 1994, China experienced three important reforms in its

fiscal distribution system. They are: the assignment of revenue and expenditure

based on the concept of "cooking in separate kitchens”2 in 1980, the proportional

sharing system in 19823, and the fiscal contracting in 1988. 4

The main political

motivation behind these three reforms was the shift of the system from the fiscal

centralization in the command-economy system to the fiscal decentralization during

a transition period (1979-1993), accompanied by the incentives for local

governments to increase their fiscal revenues. Particularly, with the introduction of

fiscal contracting in 1988, the central government formally ended its responsibilities

for financing local expenditure (the World Bank, 2001, p53). However, the negative

sides of these reforms were also obvious. For example, the central government’s

share in the fiscal revenue was dramatically reduced, and as a result, the central

government’s ability to undertake macroeconomic control was weakened.

The fiscal reform in 1994 was a comprehensive package of measures designed to

achieve three political goals: firstly, to stem fiscal decline and provide adequate

revenues for governments, especially the central government; secondly, to eliminate

the distortionary elements of the tax structure and enhance its transparency; finally,

to renew central-local revenue sharing arrangements (the World Bank, 2001, p57).

The TSS (Tax Sharing System) is a combination of tax sharing on a derivation basis

and own revenue assignment. Under the TSS, all taxes are assigned to the central

government, local governments, or are shared (the World Bank, 2002, p5). The TSS

marks a sharp break from the previous system in China. It has fundamentally

2
“Cooking in separate kitchens” refers to the separation of both fiscal revenue and expenditure assignment
between the central government and local governments ( Zhang Zhihua, 2003, p2)
3
The proportional sharing system is a system in which fiscal revenues are classified into fixed central revenues ,
fixed local revenues and shared revenues between the central and local governments (Zhang Zhihua, 2003, p2)
4
The fiscal contracting is a system in which the central-local revenue sharing rate and the yearly growth rate of
local revenues are based on the revenue performance of the province over recent years and negotiated by the
central government and the local governments (Zhang Zhihua, 2003, p3)
26
changed how local governments are financed, and it has adjusted the central-local

share and raised the share of local expenditures financed by central transfers (the

World Bank, 2002, p5).

4.2 The Main Contents of the TSS

4.2.1 The Fiscal Expenditure Assignments on Central and Provincial
Levels
According to The Decision on Implementation of TSS's Fiscal Administration System,

the central finance is mainly responsible for the running costs of national securities,

foreign issues and central level organs, expenditures for adjustment of national

economic structure, harmonizing regional development, and executing the

macroeconomic control. Local finance is mainly responsible for local organs and

local economic development. Table 4.1 shows the specific expenditure items in

central and local finance.

Table 4.1 Expenditure items of central and local finance

Defense; armed polices;diplomatic issues; central level administration;

Central central controled infrastructure; technical upgrading and R&D of national
government's enterprises; geographic survey; agriculture; governmental debt services;
expenditure central courts, public security, procuratorial and judicial organs; national
culture, education, health, science.

Local governmental administration; local courts, public securty,

Local procuratorial and judicial organs; parts of armed polices; militia; local
government's infrastructure; local enterprises' technical upgrading and R&D;agriculture;
expenditure urban maintenance and construction; local culture, education, health; price
subsidies and other expenditures.
(Source: The Decision on Implementation of TSS's Fiscal Administration System , the State
Council, 1994)

4.2.2 The Coverage of Fiscal Revenue at Central and Local Levels

According to the policies devised in the reform, taxes related to the national

sovereignty and macroeconomic control are identified as central taxes, taxes directly
27
connected with economic development are identified as shared taxes, and taxes

collected by local governments are identified as local taxes (the State Council, 1994,

p4). Table 4.2 indicates the sources of fiscal revenue between central and local levels.

Table 4.2 Sources of fiscal revenue at central and local levels

Custom duties; consumption tax; VAT revenues collected by customs;

income taxes from national enterprises; remitted profits, income taxes, and
Central
business taxes of banks and non-bank financial intermediaries; urban
taxes
construction and maintenance taxes of railroads, bank headquarters and
insurance companies; resources taxes on offshore oil extraction

Business taxes (excluding those named above as central fixed incomes);

income taxes and profit remittances from local enterprises; urban land use
taxes, personal income taxes; fixed assert investment orientation tax; urban
Local taxes construction and maintenance tax; real estate taxes; vehicle utilization tax;
stamp tax; animial slaughter tax; agricultrural tax; title tax; capital gains
tax on land; state land sales revenues; resource taxes derived from land-
based resources
Shared VAT (central 75%, local 25%); securities trading tax (central 88%, local
taxes 12%)
(Source: The Decision on Implementation of TSS's Fiscal Administration System, the
State Council, 1994)

4.2.3 A Brief Introduction to China’s Fiscal Transfer System

The fiscal transfer system is an essential element of the current TSS, and it consists

of four kinds of grants:

Tax Rebate: A tax rebate is done in a transition manner, aiming to maintain local

vested interests. The value-added-tax (VAT) rebate, which came into being in the

reform of the TSS in 1994, takes the actual VAT revenues of local governments in

1993 as its base figure.

Earmarked Grant: An earmarked grant is special grant aiming to ensure that

upper-level government's policies are implemented efficiently on lower-levels.

28
Equalization Grant: An equalization grant is a general grant with the function of

equalization, calculated by a set of formulas designed to distribute the fiscal funds

equally among the various sub-national governments.

Final Account Settlement Grant: A final account settlement grant is a grant

originated from the former command economy in China, and it still deals with the

transactions between upper-level government and lower-level government as a

supplement to other fiscal transfer forms (Meng Lizhen, 1996, p228).

From 1991 to 2002, the amount of fiscal transfers experienced a distinct increase,

with an annual increase rate of more than 40%. Graph 4.3 shows the stable share of

fiscal transfer in annual fiscal expenditure of China, in which there ever been a

dramatic jump from 1993 to 1994, but since then it maintains on the similar level of

20%. Since the TSS was first implemented in China in 1994, it is undoubtedly that

the TSS reform had a far-reaching impact on the current fiscal transfer system.

Graph 4.3 Fiscal expenditure and fiscal transfer in China (1991-2002)

100%
80%
60%
40%
20%
0%
1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002
Fiscal expenditure 361 439 529 639 779 938 1113 1319 1516 1758 2098 2459
(Billion RMB Yuan)
Fiscal transfer (Billion 55.4 59.6 54.4 239 253 272 286 332 409 467 602 736
RMB Yuan)

(Source: The State Budget and Settlement Collection (1991-2000), Financial Ministry, the Budget

Report of 2002/2003)

29
4.3 Case Study: Ningbo
4.3.1 Scope and Coverage of This Case Study
This case study focuses on the status of the municipality-to-county fiscal transfer

system. It which means we mainly study the system at the second level (Ningbo) and

the third level (Urban districts, county-level cities and counties) of the fiscal levels in

Ningbo, in accordance with Graph 4.4.

Graph 4.4 Fiscal levels in of Ningbo

Central
Government

Ningbo Municipal
Government

Urban Districts County-Level Counties

Cities

Haishu District Yuyao City Xiangshan County

Jiangdong District Cixi City Ninghai County

Jiangbei District Fenghua City Yin County

Zhenhai District

Beilun District

These two intermediate levels are the core of Ningbo's fiscal system, whose fiscal

revenues account for 70% of the total fiscal revenue (Ningbo Municipal Government,

1997, p3). In addition, there are 165 towns subordinated to the county level, but it is

impossible for us to do research on all these towns in such limited time.

30
We have chosen to concentrate on three county-level cities and the three counties in

the third level units: Yuyao City, Cixi City, Yin County, Fenghua City, Xiangshan

County and Ninghai County.

4.3.2 The Composition of Local Fiscal Revenue in Ningbo

Similar to the revenue assignments on central and provincial levels, fiscal revenue in

Ningbo consists of local tax revenue and fiscal transfer revenue. However, there are

no equalization grants on the county level. In the table below, we can see that the

local tax revenue and tax rebate play a dominant role in county-level fiscal revenue.

Table 4.3 Components of fiscal revenue of Ningbo

1994 1996 1998 2000 2002

Local tax revenue 46% 54% 55% 59% 62%

Tax rebate 49% 40% 35% 30% 31%

Earmarked grant 4% 4% 7% 9% 5%

Final account settlement

1% 2% 4% 2% 2%
grant

Total 100% 100% 100% 100% 100%

(Source: Ningbo Municipal Fiscal Revenue and Expenditure (1994-2002) )

4.3.3 Analysis of Disparities of Fiscal Revenue Per Capita Since 1994

Table 4.4 and Graph 4.5 below both display fiscal revenues per capita within these

six counties from 1994 to 2002. The differences between the highest and the lowest

per capita are 318 Yuan, 330 Yuan, 390 Yuan, 416 Yuan, 498 Yuan, 533 Yuan, 813

Yuan and 1334 Yuan respectively, and the difference of fiscal revenue per capita

between these six counties are steadily increasing.

31
Table 4.4 Fiscal revenue per capita (1994-2002) Unit: RMB Yuan

1994 1995 1996 1997 1998 1999 2000 2001 2002

Cixi 400 459 488 517 586 708 900 1353 1835

Yuyao 464 537 576 608 682 760 900 1347 1644

Fenghua 379 436 482 523 576 671 842 1155 1318

Xiangshan 301 387 412 543 613 650 802 1039 1289

Ninghai 288 352 380 446 498 579 694 1010 1245

Yin County 606 683 770 862 996 1112 1384 1823 2579

(Source: Ningbo Municipal Fiscal Revenue and Expenditure (1994-2002) )

Graph 4.5 Fiscal revenue per capita (1994-2002)

Per capita (RMB Yuan)

6000
5000
4000
3000
2000
1000
0
1994 1995 1996 1997 1998 1999 2000 2001 2002
Year

Min level Max level Difference between min and max

Two important questions arise at once: why is there a disparity? Does the fiscal

transfer system work well in equalizing the fiscal revenue? Just as explained in

earlier chapters, fiscal revenue on county-level consists of four different forms.

Hence, we will try to analyze the disparity factor by factor: local tax revenue, tax

rebate, earmarked grant and final account settlement grant.

4.3.4 Primary Factors Leading to Disparities on County-Level

According to Table 4.5 and Graph 4.6, there are two extreme counties Yin County

and Ninghai County. The former has the highest tax revenue in these nine years,

32
while the latter has the lowest. In drawing a comparison of these two counties’

economic performances, we select three indexes such as GDP, output of large

enterprises and the amount of import and export. Normally, local tax revenue reflects

the degree of local economic development, which is also true in this case. In 2000,

Yin County reached a GDP of 15.39 billion Yuan, while that of Ninghai County was

6.37 billion Yuan; output of large enterprises in Yin County was 24.69 billion Yuan,

and in Ninghai County’s 6.65 billion Yuan; as to the amount of export and import,

Yin County figure was 731 million US dollars, and Ninghai County merely 183

million US dollars (Ningbo Yearbook 2001, p510-512). Generally speaking, Yin

County performs better than Ninghai County in local economic development and it

has more powerful tax resources than Ninghai County. Other data of 1999 further

proves this point. The more developed economy a county has the more local tax

revenue it can raise.

Table 4.5 Local tax revenue per capita (1994-2002) Unit: RMB Yuan

1994 1995 1996 1997 1998 1999 2000 2001 2002

Cixi 198 233 269 288 339 433 579 988 1231

Yuyao 220 271 316 338 393 453 541 979 1026

Fenghua 170 208 248 247 274 321 419 705 741

Xiangshan 128 192 225 246 293 350 441 669 722

Ninghai 128 158 192 195 232 301 375 672 714

Yin County 273 347 423 482 588 680 866 1307 1637

(Source: Ningbo Municipal Fiscal Revenue and Expenditure (1994-2002) )

33
Graph 4.6 Local tax revenue per capita (1994-2002)

Per capita (RMB Yuan)

3500
3000
2500
2000
1500
1000
500
0
1994 1995 1996 1997 1998 1999 2000 2001 2002
Year

Difference between min and max Max level Min level

Table 4.6 and Graph 4.7 indicate the fiscal transfer per capita of six counties from

1994 to 2002. To our surprise, the extent in disparities of transfer revenue per capita

is similar to that displayed in the former two tables--the richer counties receive a

higher level of grants from the municipality, while the poorer counties obtain a lower

level. For example, Yin County, the richest county in Ningbo, received the largest

amount of grant in these nine years, yet by contrast, the relatively undeveloped

counties such as Xiangshan County and Ninghai County, got the lowest level grants

most of these nine years. It is obvious that the transfer system does not work well in

fiscal equalization.

Table 4.6 Fiscal transfer per capital (1994-2002) Unit: RMB Yuan

1994 1995 1996 1997 1998 1999 2000 2001 2002

Cixi 202 226 218 229 247 275 321 364 604

Yuyao 244 267 261 270 289 307 359 368 618

Fenghua 209 228 234 276 303 350 423 450 577

Xiangshan 173 195 187 298 321 300 361 370 567

Ninghai 159 195 188 251 266 278 319 338 531

Yin County 333 336 347 380 408 432 518 517 942

(Source: Ningbo Municipal Fiscal Revenue and Expenditure (1994-2002))

34
Graph 4.7 Fiscal transfer per capita (1994-2002)

2000
Per capita (RMB Yuan)
1500

1000

500

0
1994 1995 1996 1997 1998 1999 2000 2001 2002
Year

Difference between min and max Max level Min level

4.3.5 Two Primary Conclusions About The Disparities in Fiscal

Revenue Per Capita
First, due to different levels of economic development, local tax capacities vary both

within the different regions and different periods. If we look at the share of tax

revenue in local fiscal revenue (Table 4.3), we will find that degrees of local

economic development justify the disparities in fiscal revenue between the six

counties.

Second, the fiscal transfer system fails to reduce the differences of fiscal revenue

between the different regions. Hence its equalization function does not work

efficiently. In contrast, the amount of the grant a county received from the

municipality is highly correlative to the degree of its local economy development in

the positive direction.

4.3.6 The Further Research about the Disparities in Fiscal Transfer

System
As mentioned above, Ningbo's municipality-to-county fiscal transfer system is

realized in three different forms: tax rebate, earmarked grants and final account

35
settlement grants. In order to analyze the effects of equalization of these three kinds

of grants, we have selected Yin County and Ninghai County as examples.

Table 4.7 The roles of three kinds of fiscal transfer in equalization in two selected
counties (1994-2002) Unit: RMB Yuan

1994 1995 1996 1997 1998 1999 2000 2001 2002

Earmarked grants per capita
Ninghai County 15 21 26 59 76 81 103 68 91
Yin County 19 26 11 26 31 36 62 54 84
Final account settlement grants per capita
Ninghai County 4 28 12 37 27 26 24 66 38
Yin County 5 0 10 15 20 16 18 11 18
Fiscal transfer per capita 1
Ninghai County 19 48 37 96 104 107 127 134 128
Yin County 25 26 21 41 50 52 79 65 102
Tax rebate per capita
Ninghai County 141 146 150 155 162 171 192 204 403
Yin County 308 309 326 339 357 380 439 452 839
Fiscal transfer per capita 2
Ninghai County 159 195 188 251 266 278 319 338 531
Yin County 333 336 347 380 408 432 518 517 942
Note: Fiscal transfer per capita 1=earmarked grant per capita + final account settlement grant per capita

Fiscal transfer per capita 2=fiscal transfer per capita 1 + tax rebate per capita

From Table 4.7, we can see that from 1995 to 2002, Ninghai County received a

higher level of both earmarked grants and final account settlement grants than Yin

County. In association with the economic development level of these two counties,

we can see that both earmarked grants and final account settlement grants have an

equalization function. However, if the tax rebate is added, then the situation is

immediately reversed, which means that Yin County's fiscal transfer is higher than

that of Ninghai County, if the tax rebate is considered.

It is clear that both earmarked grants and final account settlement grants have an

equalization function, but tax rebate is not only unable to reduce the gap of fiscal

revenue between different counties, but also appears to have exacerbated the growth
36
of regional disparities. Tax rebates are in the absolute majority of the three kinds of

fiscal transfers (See Table 4.7), and this is the direct factor leading to the disparities

in county-level fiscal revenue.

4.3.7 The "Hold Harmless" Principle: a Knife with Double Blades

Now, let's come back to the TSS itself. When China's central government decided to

establish the TSS instead of the fiscal contract in 1993, it encountered resistance,

mainly from the local governments, who were afraid that the central government

would substantially deprive them of fiscal revenue. In order to follow through the

TSS in 1994, the central government adopted the "Hold Harmless" principle (the

World Bank, 2001, p13) to relax the tension between central and local government.

"Hold Harmless" means that the central government guarantees local vested interest

formed before the 1994’s fiscal reform. According to the 1994’s TSS, the central

government will collect 75% of the VAT, while 25% belongs to the local

governments. As a compensation of the local tax revenue loss, the central

government committed to give each province tax rebates. This principle was also

adopted in dealing with the distribution relation on sub-national levels, such as the

relation between municipal level and county level in Ningbo.

How was the base year tax rebate determined on? According to the Decision on

Implementation of TSS's Fiscal Administration System, the base year tax rebate = PBR

- (LT + 0.25 x VAT), where PBR is the Province's Base retained Revenue in the base

year 1993. The new tax base consists of the newly designated Local Taxes (LT) plus

25% of the VAT.

In addition, tax rebates in the following years are calculated by using the following

formula: tax rebate for province i in the year t =tax rebate i t-1 × {1 + 0.3 × [0. 75 ×

VATi increase + CTi increase]} (CT refers to Consumption Tax) (the World Bank,

37
2001, p13). This means that the tax rebate will be increased if the VAT or CT increases

in the following years.

Graph 4.8 Variations of tax rebate from 1994-2002

70000
Tax Rebate (RMB Yuan)

60000
50000
40000
30000
20000
10000
0
1993 1994 1995 1996 1997 1998 1999 2000 2001 2002
Year

Cixi City Yuyao City Fenghua City

Xiangshan County Ninghai County Yin County

Note: 1993 is the base year, it is included in graph.

(Source: Ningbo Municipal Fiscal Revenue and Expenditure (1994-2002))

Graph 4.8 shows the increase tendency of tax rebate of the six counties since 1993.

In fact, the tax base itself has the characteristic of disparity in fiscal revenue when it

emerged, because it belongs to “vested interest” under the “Hold Harmless” principle,

and has nothing to do with the purpose of equalization. In 2002 and 2004, two other

important fiscal reforms—income tax reform and export tax rebate mechanism

reform—were introduced by the central government. Similarly, the "Hold Harmless"

principle was adopted again. Graph 4.8 shows a significant leap of the share of tax

rebate in 2002, indicating the further enlargement of disparity of regional fiscal

transfer revenue.

In sum, tax rebates are products of the “Hold Harmless" principle. Everything has

two sides. Tax rebates promoted the TSS reform in the middle of 1990s, at the

expense of increased regional disparities of fiscal revenue.

38
4.3.8 Negative Aspect of Earmarked Grant
4.3.8.1 Less Regulated Expenditure of Earmarked grant

As mentioned above, the earmarked grant is designed to ensure the central (or upper

level) government's policies to be implemented efficiently at the sub-national level.

Hence, we conduct a study in an attempt to identify the effects of earmarked grant

expenditure.

The percentages of selected expenditure items of earmarked grants on county-level

in Ningbo shows the expenditure shares all seem ill-regulated. For example, the

capital construction item accounted for 13.8% of total earmarked grants in 1996, but

for 7.9%, 41.6% and 18.4% in 1998, 2000 and 2002 respectively; technological

upgrading and R&D was 8.6% both in 1996 and 1998, but amounted to more than

18% in 2000 and 2002.

As stated in the former chapter, in 1994, the TSS provided a broad but brief

guideline on how to assign expenditure responsibilities between the central

government and provincial governments. Accordingly, the situation was the same in

Ningbo, as described in a paragraph of a document from the Ningbo Municipal

Government on the main expenditure responsibilities between the municipal

government and the county level governments:

The expenditure assignment should be determined on the basis of

assigned responsibilities. The municipal government is mainly

responsible for the running costs of municipal organs, of promoting and

controlling local economic development, and of balancing the

intra-municipal economic development; county (city, and urban district)

level governments are responsible for the running costs of their own

organs, along with the costs of developing the local economy and

39
 society (Ningbo Municipal Government, 1994, p4).

With no specific government guidelines on the distribution of responsibilities

between the municipal and county levels, each county can potentially have a

different assignment of expenditure responsibilities. Furthermore, one county may

have different assignment of expenditure responsibilities in different years, as

demonstrated above. In other words, earmarked grants lack stability.

4.3.8.2 The lack of Legislation and Supervision in Managing Earmarked Grants

The construction of legislation lags behind the evolution of earmarked grants. In

Ningbo, all earmarked grants are appropriated following the release of written

documents of the municipality rather than as a result of legislation. Therefore, such

actions lack the effect of law and there is a very large space for finance department

and other departments to arrange the schedule of appropriation. Table 4.10 sums up

the appropriation schedule of the county-level earmarked grants in 2000, with the

schedule referring to the share of each season’s grants appropriated. We can see that

a big proportion of the grants delivered to counties arrived in the last two quarters of

2000, which amounted to 72% of the total that year’s grants. This means that county

level governments would not receive most of their grants until the latter half year,

and consequently they could not plan their budget accurately in advance.

Table 4.10 Schedule of appropriating earmarked grants in 2000

Season Ⅰ Ⅱ Ⅲ Ⅳ Total

Schedule 4% 24% 30% 42% 100%

(Source: Ningbo Municipal Fiscal Revenue and Expenditure (1994-2002) )

Due to the shortage of a legislative backup, decisions and operation of appropriations

sometimes lack democracy and would proceed with less transparency. Besides the

40
financial departments, other departments may also decide the appropriation of fiscal

grants, and to some degree, the amount of fiscal grants that a local government will

acquire depends on its ability to bargain with the upper level government.

Furthermore, calculation of grants is not scientific. In Ningbo, no equalization grants

follow any well-designed formulas to calculate the proper amount of grants to

deliver, and some earmarked grants are actually settled at a rigid size to a county

government. Such flaws lead to results which may deviate from the original purposes

of an earmarked grant.

The feedback system of the fiscal grants is also not efficient enough, either. Rules of

financial management require all units using earmarked grants submit a report on the

efficiency of the grants to the financial departments on a regular basis. However,

such work is always omitted from the agenda of the grants users. Financial

departments cannot acquire information concerning fiscal grants, and it is also

difficult for them to enhance the supervision on the usage of fiscal grants. Some

earmarked grants are misused by lower-level governments.

4.4 Some Conclusions from Ningbo’s Case Study

As one example of Chinese intergovernmental financial transfer system, the Ningbo

case study gives the following perspectives about the current fiscal transfer system of

China:

The fiscal transfer system plays an important role in dealing with intergovernmental

fiscal relations, it launches the TSS as an integral system, together with the

assignment of both revenue and expenditure between the central and local

government. The fiscal grants have been one of the irreplaceable elements of the

local government’s fiscal revenue. Especially to those local governments with

weaker fiscal capacities, where fiscal grants can reduce the differences between their
41
fiscal revenue and expenditure, ensuring the local finance to operate with stability.

Although taking up a marginal share in the whole fiscal transfer system, earmarked

grants and final account settlement grants are helpful in equalizing the disparities of

both fiscal revenue and expenditure among different regions in China.

The “Hold Harmless” principle has become the core of China’s recent fiscal reforms

in dealing with the fiscal relations between the central and local governments. It has

demonstrated its advantages in promoting fiscal reforms in China, where tax rebate

is made the primary tool of compensating the local government’s loss of fiscal

revenue, but it also enlarges the gap in fiscal revenues of different regions, which

leads to a result that deviates from the original function of fiscal transfers. We think

it conflicts with the original intention of the fiscal transfer system. The lower level of

both equalization and stability of society will finally affect the development growth

of China’s economy in the long term.

With no specific government guidelines on the distribution of responsibilities

between different levels of government, a government at each level can reveal a

different picture of expenditure responsibilities; furthermore, one local government

may shift its budget to different expenditure areas in different years. Therefore, it is

very difficult for an upper level government to establish a stable earmarked grant

mechanism.

The lack of legislation and supervision lead to some weaknesses in the decision and

supervision of fiscal grants. Without a legislative procedure, there is a very large

freedom for the central or local government to arrange the schedule of appropriation.

And it makes difficult for the sub-level government to prepare their budget

accurately in advance. At the same time, the upper-level government cannot

implement an efficient supervision of the spending of fiscal grants through an

42
information system, which may easily result in misuse.

43
 Chapter 5 The Fiscal transfer Systems In Sweden
In this chapter, we will analyze the Swedish fiscal transfer system in detail. We try to

give a general picture of the system. Through a case study, we identify five important

factors that are indispensable to an effective and fair fiscal transfer system.

Most of information and data in this chapter come from Mr. Persson, Mr.Tingvall

and Mr.Hansson through interview. All of them are specialists with the Swedish

Financial Department. Here we want to say thanks to them again. This chapter could

not be finished without their help.

5.1 Welfare State and Social Equalization

As a Northern European country located on the Scandinavian Peninsula, Sweden has a

territory of 450 000 square kilometers and a population of 8.7 million inhabitants. This

is a developed, highly industrialized nation noted for its social democratic welfare

system, where everyone has the equal right to enjoy social welfare benefits. The

Swedish government guarantees all Swedes a similar high standard of living even if

they live in different areas. On the other hand, the central government aims at

developing the economy in every region by making use of their different advantages.

To our astonishment, Sweden once was one of the poorest and most undeveloped

nations in Europe in the past centuries. From the beginning of the 20th century until

1970, Sweden experienced the fastest growth in the economy, only second to Japan.

It attained remarkable achievements in the 20th century leading to the well-known

Swedish model. The Swedish model has four famous features. One is high levels of

welfare provision; second, high rates of tax; third, uniform standards based on equity

and fairness, and local authorities play an important role in the delivery of these

services. Among these distinguished performances what is especially noteworthy is

44
the founding of the Swedish equal welfare state. A typical feature of the state is that

rapid development of economy and social equity are both regarded as a priority by

the Swedish government so that the gap between wealth and poverty is expected to

be minimized as much as possible.

The Swedish welfare state is based on the idea that everyone has an equal right to

obtain health care, family services, old-age pensions and other social benefits

regardless the differences of income, class and area. Certainly, since everyone is

entitled to these benefits, everyone must pay for them through their taxes.

Meanwhile, every local government needs to have the same opportunity to develop

its economy so as to be able to afford these public expenditures. The idea has been

universally accepted by the Swedish people and has become their belief in some

sense.

In making the idea come true, the Swedes tried to create some effective institutions

to form an equal welfare state. A series of scientific inter-government fiscal transfer

systems named by Equalization system were established by the central government

that have played a significant role in Sweden’s process of forming the equal welfare

state. The Swedish welfare state has become a very valuable example for other

countries in that it created a new pattern of welfare, which has been described as a

model of equalization, even though in recent years Sweden encountered some

serious problems with its equal welfare state such as low efficiency and overloaded

taxation that need to be reformed and readjusted.

The Swedish society revolves around an effective system of local self-government.

The local government dates back to 1862 and plays a vital role in the political and

economic life in Sweden. There are two types of local government in Sweden

nowadays, including the smallest unit, municipalities (Kommun) and the regional

45
unit, the county council (Landsting). The country is made up of 20 county councils

and 290 municipalities. According to the Swedish constitution and the Swedish local

government law, the local governments have a certain degree of political and

financial autonomy and they have an extensive freedom of deciding and organizing

activities, although in fact the decision of a local government is also to some extent

influenced by the central government. Also, the local government assumes a major

responsibility to provide public services and social welfare. The county councils are

mainly in charge of medical services while the municipalities are responsible for a

lot of community programs, such as education, health, care services and local

infrastructure.

According to the Social Services Act, municipalities are responsible for helping

people who cannot support themselves. The government must provide a reasonable

standard of living for its citizens. The law guarantees the right for individuals to

receive social assistance and this right can be enforced by bringing legal action in a

court. Today the activities of the Swedish local government cover almost every

corner of community life. Sweden has the world's largest local government sector,

which runs 70 percent of public sector activities and handles most of the

expenditures. For instance, in 2003, the total expenditures of the Swedish local

governments amounted to SEK 608 billion, of which municipalities spent almost 70

percent of aggregate costs in the public sector and county councils spent just a little

over 30 percent (Swedish Ministry of Finance, 2003). On the other hand, the local

government is also a major source of jobs. Over one million people are working in

municipalities and county councils. This means that almost 30 percent of the

country’s labor force works in local governments.

46
Graph 5.1 Fiscal expenditure in municipalities and county councils in 2004

(Source: Swedish Ministry of Finance)

However, local governments are now facing new challenges. One of the main

problems is that they have to increase productivity and reduce costs. In Sweden,

public expenditures have reached almost two thirds of the gross domestic product,

GDP now. Another pressure comes from the changes in the population structure,

particularly the increase in the numbers of the elderly people. Economically active

people only occupy a small proportion. Therefore, the government will have

difficulties raising money and assuring that those elderly people can get equal

treatment. As for the local government, the most important financial burden is from

education and social welfare even if constitutional laws empower the local

authorities to raise sufficient taxes to deal with the problem. Greater costs result from

a lot of public expenditures so that some local governments need to be guided by the

central government by using the fiscal transfer system. Some local governments

need to develop their economy through the system too due to less resource. In

addition, the Swedish EU membership has created a new situation for the local

government.

47
5.2 The Development of Swedish Equalization System
A big difference between population and territory exists in different local

governments. Although the average population density in Sweden is about 19

inhabitants per square kilometers, the majority of the population lives in the southern

part of the country. For instance, Stockholm is the largest city with about 1850 000

inhabitants. The least populated is Bjurholm, with less than 3 000 inhabitants.

Although the government hopes the flow of young and educated people would stay

in sparsely populated regions, these people have not ceased to move to larger cities.

Now over half the Swedish people lives in regions around the three biggest cities,

Stockholm, Gothenburg and Malmö.

The main source of income for the municipalities and county councils is local

income tax. For example, in 1992, this revenue amounted to Skr 270 billion. In other

words, 67 per cent of total revenues were tax revenues. Local government tax

revenues in 1992 take up 19 per cent of the GDP. In 2004 the average municipal tax

rate was 20.80 percent and county council tax rate was 10.71 percent (Swedish

Ministry of Finance, 2004). Therefore, it is easy to understand that there are a lot of

imbalances in different municipalities in terms of financial resources.

In order to ensure that everyone can enjoy equal public services and social welfare

across the country, the central government has set a uniform standard for public

service, which is an important precondition. It means unless a uniform standard is

defined by the central government, a highly centralized fiscal transfer system will be

quite unlikely or even unnecessary. As local governments in poor financial positions

are unable to maintain the uniform standards of social welfare central government

grants are introduced to support the local governments. Grants accounted for 26 per

cent of municipalities’ total revenues in 1992, whereas the corresponding figure for

county councils was 15 per cent. All these grants are paid by the central government
48
from the State budget. Different municipalities and county councils have different

degrees of dependency upon revenues from grants. Some municipalities get more

than 50 per cent of their revenues from State grants, while a few get only less than 10

per cent. Most municipalities, however, receive 20 per cent to 35 per cent of their

revenues from the equalization system.

The target of the system is to ensure that all municipalities and county councils will

be able to operate on equivalent economic terms. The state grant is a popular means

that can be used in the system. State grants can usually be divided into general and

special grants. Before the grant system was reformed in 1993, the majority of local

governments’ revenues from grants could be described as special grants. Special

grants are earmarked both for compulsory and voluntary operations and are used for

special purposes. They are normally related to the scale of the activities and, in some

circumstances, to their quality. Special grants have often been designed with the aim

of stimulating local governments to develop and maintain certain services. Some

special grants have been regarded as a useful tool to support local governments as

part of the central governments’ overall economic and labor market policy. General

grants are intended to equalize different financial conditions among different local

governments that vary in tax potentials or costs. In addition, general grants are given

to regions traditionally put in the poor bracket. The grants do not need to be spent on

any special activities and can be budgeted by local governments freely, according to

their own decisions. The general State grants are mostly made up of tax equalization

grants and the new block grant for municipalities.

49
 Table 5.1 Major state grants to local governments Unit: Skr billion

Item 1990/91 1991/92 1992/93

Tax equalization grants 18.2 20.8 14.9
New State grant to municipalities 18.6
Grant for the health-care system 15 14.5 10.3
Child care 12.2 13 11.4
Education 32.7 31 22.3
Reception of refugees 2.6 3.4 3.2
(Scouce: the Swedish Ministry of Finance)

In 1993, a new central government grants system was introduced, and it which was

implemented to set with an extensive decentralization of responsibilities and powers.

In the new system most of the grants were replaced by a general government grant.

The regular tax equalization grant was transferred to municipalities and county

councils whose tax base per capita was below a guaranteed base. This guaranteed

base was defined in advance by law. In addition, local governments could receive an

extra tax equalization grant from the central government if they had any special

needs. This grant would be carried out in special cases and was designed to eliminate

the drawbacks of the regular grant. The most important special grants were mainly

used for schools, childcare and care of the elderly. To encourage local government to

shape operations in accordance with the intention of the central government, the

grant system must provide some incentives too.

In one way, the equalization system is a kind of balance. Some municipalities and

county councils pay the money while others get it. Although general government

grants actually have accounted for the largest sums of money transferred since 1993,

starting from 2003, some changes in the system have decreased general government

grant levels dramatically. The system distributed 43.1 billion SEK in general

government grants in 2003, compared to 66.6 billion SEK the year before.

50
The equalization system has brought new significant changes for municipalities and

county councils since January 1, 2005. The aim is to create more equal opportunities

for local authorities across Sweden like before regardless of their different structural

circumstances. The new equalization system includes five segments: income

equalization, cost equalization, a structural grant, a transitional grant and a per capita

“regulation” grant or fee.

5.2.1 Income Equalization

Municipalities with a per capita taxable income below 115 % and county councils

with a per capita tax base below 110 % of the national average have the right to

receive equalization grants while those exceeding the national average have to hand

in some fees to the central government. The revenue equalization has been altered

from a horizontal type to a mainly vertical one; although some part of it still remains

horizontal type. Since this fee only accounts for a small proportion of the revenue

equalization grant, the central government has to make use of the former general

grant and previously earmarked grants to supplement the main parts of it. The total

amount of earmarked grants transformed into grants for revenue equalization will go

up in the next three years.

5.2.2 Cost Equalization

This equalization was considered due to some uncontrollable structural factors. If the

per capita cost of those factors is more than the national average, the local

government can receive equalization grants from the state. If the costs are lower than

the average, the municipality or county council will pay an equalization charge to the

state. This is horizontal by nature, in that the equalization for spending needs or cost

equalization is maintained as a horizontal equalization system, which try to equalize

differences in the age distribution of the population or some additional costs. The

51
central government has adapted a new structural grant. This grant covers costs for

the promotion of business and employment and gives much attention to low

population density.

5.2.3 General Government Grants

The municipalities and county councils receive government grants calculated in

relation to their respective number of inhabitants. There is also a grant – which the

range is only available to municipalities – calculated according to the age structure.

A transitional grant is aimed to dampen the income loss for some local authorities

due to the changing of the equalization system. The transitional grant will gradually

be cancelled during the years 2005–2010.

5.2.4 Transitional Regulation/Introduction Grants

These grants are planned to reduce the effect of recent political reforms and they

have a marginal part in the whole policy. They were already removed this year.

5.2.5 A Per Capita “Regulation” Grant or Fee

In 2005, the Swedish parliament (Riksdag) approved that 55.2 billion SEK can be

used for the new equalization system, of which 42.6 billion SEK is distributed to the

municipalities and 12.6 billion SEK to the county councils. The per capita

“regulation” fee is calculated as the residual between the appropriations made by the

Riksdag and the net of the equalization grants and fees, the structural grant and the

transitional grant to the municipalities and county councils respectively. If the

residual has a positive sign it can be defined as a per capita “regulation” grant

(Swedish Ministry of Finance, 2005).

52
 Table 5.2 the new equalisation system, 2005 (Billion SEK)

Municipalities County council Total

Revenue equalization grant 45 14.9 59.9

Revenue equalization fee -3.4 -2.2 -5.6

Cost equalization grant 4.6 1.2 5.8

Cost equalization grant -4.6 -1.2 -5.9

Structural grant 1.5 0.7 2.2

Transitional grant 1.5 0.6 2.2

Sum of above 44.6 14 58.6

"Regulation" fee -2 -1.5 -3.5

Total 42.6 12.5 55.1

(Source: the Swedish Ministry of Finance)

The new equalization system has obvious merits compared with the products of

previous reforms, in that fewer local governments have to pay a fee in income

equalization. Regional aspects are now contained in the equalization system, while

cost equalization is somewhat simplified. Different models in cost equalization are

registered up and updated.

5.3 A Case in Stockholm—Some Problems of the System

Stockholm is the capital of Sweden, which is often described as the economic engine

of the country with the largest population and much higher average incomes than

other regions. For instance, the Swedish average GNP per capita was 255,000 kronor

while that of Stockholm County was 349,000 kronor in 2001. None of the other 20

counties could exceed that average level. Since the 1960s, a number of political

measures have been carried out to support less well-off regions through the use of

transfers from the richer ones.

Therefore, it is natural that the municipalities and county councils in Stockholm

53
became the main contributors to the equalization system and the rest of other regions

in Sweden became the receiver in certain sense, except a few municipalities in the

Skåne region. The regions that receive the largest money per capita are the sparsely

populated northern regions and the island of Gotland. In 2004, the Stockholm

County paid 5.4 billion kronor into the equalization system, which accounted for 9

percent of the total revenues. People can find enough evidences in the following

table to testify this conclusion.

Table 4.3 the Stockholm region’s net contributions to the equalization system 1996-2004, SEK

1996 1997 1998 1999 2000 2001 2002 2003 2004

Billons 5.7 4.6 5.3 5.8 7.7 10 13.2 16.9 16.4
Per capita 3268 2609 2972 3216 4223 5439 7133 9133 8813
(Source: the Swedish Ministry of Finance)

Graph 5.2 Stockholm region net equalization transfers

(Source: the Swedish Ministry of Finance)

54
However, some problems of the Swedish equalization system can be recognized

though analyzing Stockholm’s case. There are at least five problems that have

caused a hot debate in the Swedish parliament.

For a start, some people think it is unfair for the citizens of Stockholm to pay too

much money to the equalization system, as the general price level is higher in

Stockholm than in other parts, such as costs for housing in spite of much higher

salaries. Since the calculation of transfer base in the equalization system is related to

the price level, people in Stockholm need to make more contributions to the

equalization system than people in other regions.

The second problem is as the fastest growing region and the capital, many people

always want to move into the city. But unfortunately they become a financial burden

due to this transfer system. Local governments have to raise taxes to compensate for

the loss. In addition, the system forces poor people in Stockholm to pay high taxes to

support rich people in other regions in some ways.

The third problem is the system hampers the development of regional economy. This

is problematic because the system puts regional needs before individual needs. The

poor region has no incentive to improve their situation and pursue economic reforms.

The notion exists with some people that one must be poor if one wants to obtain

money, and consequently although the system plays an important part in the

formation of an equalization society, on the other hand, it has some negative effects

on the development of some regions.

The fourth problem is, some critics claim, that the system violates the principle of

local self government, which means the government should have a self-finance

position. According to the Swedish constitution, the local government has the right

55
to impose taxes to finance its own public expenses rather than getting subsidies from

other regions. In addition, the local government Act says that the budgets of a local

government must balance.

The last problem is the complicated nature of the system. A structural grant and a

transitional grant are still necessary in the system for a lot of local governments even

if the new reform were introduced before 2005. So the problem is even if some

professional employees are working at the local Swedish financial department, they

do not know how to calculate the exact figures of the transfer funds.

To the concern of the government, it was pointed out recently that the economy of

Stockholm is declining and the region’s tax base is decreasing partly due to the

equalization system. Some local politicians from the conservative party and their

coalition partners have put forward some suggestions to improve the system. In some

municipalities in Stockholm, privatizations and a voucher system has been

implemented and proved very successful in reducing financial burdens. People are

looking for some more reasonable ways to deal with the dilemma between

equalization and development.

5.4 Some Conclusion About the Swedish Fiscal Transfer System

Through analyzing these cases above, we notice that three different reforms played

an important role in the development of the Swedish equalization system. We can

draw a brief conclusion from these three reforms.

1993: All large earmarked state grants for the municipalities were put into a new

block grant system, used for a far going system for equalization of differences in

taxation resources. The system was intended to guarantee all municipalities an

equivalent economic basis irrespective of their particular structural circumstances.

56
1996: Identical equalization systems were introduced for municipalities and county

councils. All municipalities and county councils were included into the equalization

system and the system was financed by fees from those with tax capacity over

average and structural costs under average. A new and more ambitious system for

equalizing all differences in structural expenditures was introduced. The general

grants were calculated in relation to the number of inhabitants.

2005: The general grant has been replaced by a new income equalization grant where

the municipalities guarantee an income that is 115 % of the average tax capacity and

the county councils 110 %. The fee-paying municipalities in income equalization are

reduced to 13 and the county councils to one. The fees for the still fee-paying

municipalities and county council have been strongly reduced. At the same time no

local governments become recipients of general grants calculated in relation to the

number of inhabitants. Earlier included regional aspects have been lifted from cost

equalization and replaced by a structural grant. A regulation grant/fee is introduced.

The fiscal transfer system is important in the process of establishing an equalization

society. Then what are the most important factors to be included if the system can be

described as a successful and effective one? In our point of view, at least five factors

should be taken into account.

5.4.1 Responsibilities Assignment Must Be Identified Clearly

One reasonable and clear definition of respective responsibility is the priority

between the central government and the local government in terms of revenue

assignment and expenditure assignment.

Generally speaking, self-finance is the most important power for the local

government. Otherwise the local government will have to rely on the central
57
government more. The precondition of self-finance is the defining of different

inter-government responsibilities. In Sweden, there is a very clear division between

the central government and the local government set by local government law. The

local government is responsible for most public services and need provide social

welfare for its citizens. Also, an indispensable role for the Swedish central

government is to divide revenue assignment and expenditure assignment

scientifically on the basis of the definition of local government's uniform service

standards.

In Sweden, the central government is mainly responsible for national defense,

diplomacy, international trade, bank policy, national legislation, and judicial affairs

etc, while local government mainly provide social welfare and public services such

as transportation, education, health care, environmental protection, security, fire

protection, infrastructure etc. Usually, financial power belongs to the central

government. In order to ensure the leading position of the central finance, the central

government in Sweden takes the majority of taxes, and maintains the stability of tax

revenues among governments.

5.4.2 Guideline of the System and the Target of Transfer Fund Should
be Identified Clearly
The Swedish equalization system has been nicknamed after Robin Hood. It means

that the rich areas have to make contributions to these poor areas so as to guarantee

that every area will have the ability to provide uniform public services to their

citizens. Also, every region has the same opportunity to develop the local economy.

The guideline of the Swedish equalization system is very clear, and it regards

fairness and equality as the priority of the financial policy. On the other hand, in

order to ensure that funds can be used effectively in accordance with the intention of

the central government, the target of transfer fund should be identified clearly in

58
advance.

As for Sweden, before 1992, the majority of transfer fund came in the form of

special grants, which made great contribution to the formulation of an equalization

society. The special grants guarantee the citizens can enjoy social welfare with a

same standard no matter where they live. Special grants are not allowed for

productivity. However, with the development of economy, general grants are getting

more popular in Sweden, which can solve the financial imbalance between different

local governments and have more flexibility. Another advantage in the Swedish

system is that the local governments can know the exact amount of transfer funds in

the next fiscal year in advance. This makes planning easier.

5.4.3 Some Specific Regulations and Scientific Formulas Are

Indispensable.
Sweden’s experience suggests that some specific regulations and scientific formulas

are indispensable to a fiscal transfer system that can be carried out effectively. As the

amount of fiscal transfer fund is large and the structure is very complicated, its

operation needs to be designed regularly and in accordance with law. Sweden has

drawn up laws and designed some scientific formulas which can ensure fairness and

effectiveness, at the same time of increasing the transparence of the whole system.

In the process of operation, the coefficient of the fiscal transfer formula is decided by

the legislative body. The target and scale of fiscal transfer have been defined by the

law clearly. On the other hand, the fiscal transfer system still needs to own flexibility.

The form, structure and the calculated formula of the system are not unalterable; they

should keep up with the development of the economy and try to adapt to new

situations. For instance, Sweden has changed its equalization system several times so

as to realize its different intentions in different periods.

59
5.4.4 Different Diverse Means Can Be Adopted
Sweden releases both general grants and special grants in the transfer system at the

same time. Generally speaking, in order to balance the financial differences of

different districts, the central government often gives general grants to realize social

fairness. If the central government wants to enhance the efficiency of local

governments in providing public services, special grants are usually considered.

Moreover, to inspire the motivation of the local government, the central government

normally provides partial money while asking the local government to provide the

rest of the fund. For instance, the Swedish Riksdag usually makes the budget of

transfer fund after an open discussion. Then the Ministry of Finance will decide on

specific means in line with the objective that has been settled by the Riksdag.

5.4.5 A Professional Administration Needs to Be Established and a

Monitoring System Is Also Important.
Sweden has established an effective monitoring and operational system. The

equalization system is decided by the Swedish Parliament and the regulation

concerning how to calculate the different parts of the system is decided every year by

the central government. Statistics Sweden calculates the equalization system and

Swedish national tax board decides the grants and the fees for each

municipality/county council. In October every year Statistics Sweden presents a

primary calculation for the next year. Each local government has the right to

complain about the result of calculation. Swedish national tax board executes the

grants/fees in connection with the monthly payment to the local governments of their

own taxation incomes. At one time, a powerful monitoring system has been executed

to monitor the transfer system so that the transfer fund can be used in a fair and

effective way. The transfer system also needs to be audited and examined by some

independent departments.

60
 Chapter 6 A New Model
In this chapter, we will develop a new model from the preceding theoretical review

and case studies. We mainly follow an inductive approach in this chapter. First, we

will identify the factors that should be considered when establishing an

intergovernmental fiscal transfer system, and then we will compare between China’s

case and Sweden’s case based on the analysis of those factors. In the end, a new

model that aims at promoting China’s intergovernmental fiscal transfer system will

be formulated.

6.1 The Factors

In each case study, we have introduced the background concerning the fiscal transfer

system, the main content of the system; furthermore, both the merits and problems of

these two countries’ fiscal transfer system were analyzed. In the theoretical review,

we also studied decentralization, economic roles of local governments, and the

finance of local government, along with the principles governing the design of a

transfer system.

Based on the theoretical review and case studies, we think the following nine factors

should be considered when establishing or improving an intergovernmental fiscal

transfer system:

z Political legitimacy

z Legislation

z Responsibility assignment

z Tax autonomy

z Formulation

z Motivation

61
 z Supervision

z Information

z Structure of grants

6.1.1 Political Legitimacy

Political legitimacy means the political purpose which an intergovernmental fiscal

transfer system should adhere to. In our theoretical review, we noted that an

intergovernmental fiscal transfer system is actually a kind of interest distribution

between the central government and the local governments in the fiscal area.

Furthermore, the case studies also indicate that political legitimacy determines the

design of the fiscal distribution system. It is a precondition of establishing or

promoting an intergovernmental fiscal transfer system.

6.1.2 Legislation
Legislation means that all available regulations within an intergovernmental fiscal

transfer system (including such factors as political legitimacy, responsibility

assignment, and tax autonomy) should be approved by way of legislative procedures.

Legislation is an important guarantee that enables the intergovernmental fiscal

transfer system to be more stable and transparent in the long run; in addition, it can

prevent willful actions during the decision-making processes concerning the

distribution of fiscal transfer.

6.1.3 Responsibility Assignment

In the context of our research, responsibility assignment means the identification of

expenditure responsibilities between the central government and the local

government, between an upper-government and a lower-government. Responsibility

assignment is another precondition of establishing a stable and efficient

intergovernmental fiscal transfer system. Without a lucid expenditure assignment,

62
most of the grants committed to lower level governments within the transfer system

will be more difficult to be classified and measured.

6.1.4 Tax Autonomy

Tax autonomy means the local government’s right to decide whether to levy a local

tax or not, along with a given tax rate. Tax autonomy is always consistent with the

degree of decentralization, which means the local government with a higher level of

decentralization will enjoy the higher level of tax autonomy. As we know, local tax

revenues and the grants from the central government compose the main source of a

local government’s fiscal revenue, so tax autonomy provides the possibilities for a

local government to expand local fiscal revenue, which is regarded as an efficient

way to help fulfilling their increasing responsibilities, with less dependence on the

fiscal transfer system. So, from the angle of intergovernmental fiscal transfer system,

tax autonomy is a kind of “buffer” when the system is facing the increasing

expenditure pressure from local governments.

6.1.5 Formulation
Formulation refers to the degree in which the mathematic expressions are used to

calculate the exact amount of each grant. In a fiscal transfer system, formulation also

includes the use of the indexes that helps to indicate the differences between regions.

Formulation is a technical issue to the whole intergovernmental fiscal transfer

system; however, the way of designing the formulas actually reflects the extent to

which the transfer system sticks to the purpose (i.e. political legitimacy), and it is

crucial to achieve both transparency and equity of the system.

6.1.6 Motivation
Motivation is the inherent mechanisms of an intergovernmental fiscal transfer system,

aiming at pushing the local government to implement the fiscal reforms (or policies),

63
which are decided by the central government. Obviously, motivation is a “generator”

for the intergovernmental fiscal transfer system, which means that it would make the

system work more efficiently if the motivation measures are enforced appropriately.

However, it is also a knife with double-blades, because the experiences of both

Sweden and China have provided us lessons.

6.1.7 Supervision
Supervision here refers to the mechanism that aims to examining and evaluating the

performances of grants used by local governments. In addition, supervision plays a

favorable role in finding out and overcoming the weaknesses of a certain grant,

enabling the political legitimacy of the intergovernmental fiscal transfer system to be

realized as expected.

6.1.8 Information
Information also refers to a mechanism that consists of the data and the channels to

share the data within the whole intergovernmental fiscal transfer system. Such data

are mainly the historical figures of all kinds of grants and the feedback of evaluation.

In addition, the channels include the networks and the relative authorities that deal

with the data. So information is the basis of an intergovernmental fiscal transfer

system.

6.1.9 Structure of Grants

Structure of grants refers to the detailed structure and design of the grants (for

example, the ratio of general grants and special grants). During the process of

building a system, the other eight factors we have discussed above all have their own

effects on the structure of grants, in this sense, structure of grants is the core of an

intergovernmental fiscal transfer system, and the other factors will lose their

significance without this factor.

64
To sum up, we can divide these nine factors into three groups: external factors,

internal factors and the core factor. Among them structure of grants serves as the

core factor, and political legitimacy, legislation, responsibility assignment and tax

autonomy are external factors, because they have indirect impacts on structure of

grants, and the other factors—formulation, motivation, supervision and information

are the internal factors, since they exert their direct impacts on structure of grants.

Graph 6.1 The three groups of factors

Political legitimacy Legislation

Formulation

Motivation Structure of Supervision

grants

Information

Responsibility Tax autonomy

assignments

6.2 A Further Comparison Between Sweden and China

Based on the two case studies we made in the previous chapters, we would like to

make a further comparison concerning the performance of these nice factors between

China and Sweden, and at the same time, the impacts (including favorable and

unfavorable) of each factor on these two countries will also be mentioned. In the end,

we will bring forward suggestions for improving China’s intergovernmental fiscal

transfer system, along with a graph with regards to the new model.

65
6.2.1 Political legitimacy

Table 6.1 Comparison of political legitimacy

Sweden's case China's case

The current fiscal transfer

The fiscal transfer system serves system pays more attention on
as a vital political tool, which the protection of local vested
Political aims at making Sweden a social interests to promote the fiscal
Legitimacy welfare state with an equal reform, with less consideration
society and a long-term of the equalization of the fiscal
developed economy. revenue and expenditure among
different regions in China.

z Impacts on Sweden: All designs of grant to local governments are consistent

with the purpose of equalization of fiscal revenue and expenditure among

regions.

z Impacts on China: The fiscal transfer system promotes the implementation of

the TSS reform and the subsequent income tax reform, but it does not restrain

the increasing fiscal imbalance among different regions.

6.2.2 Legislation

Table 6.2 Comparison of legislation

Sweden's case China's case
The basic structure and elements
of the fiscal transfer system are There is no law in respect of
all stipulated by legislation, intergovernmental fiscal transfer
including the 15 indices in China. The procedure of
Legislation concerning calculating the legislation has been replaced by
transfer amounts. Each of the the administrative manner in
expenditure concerning fiscal dealing with the distribution of
transfer in central budget is grants.
approved by the parliament.
66
z Impacts on Sweden: Under the authorities from legislation, all grants are

distributed and used through a uniform and transparent way, which guarantees

the efficient functioning of the transfer system.

z Impacts on China: With the lower degree of legislation, the management of

fiscal transfer is lack of authorities, and the flexibility of fiscal transfer budget is

too large, as a result, the stability of the system is lower too.

6.2.3 Responsibility Assignment

Table 6.3 Comparison of responsibility assignment

Sweden's case China's case
The Local Government Act There is no legislation on
identifies the assignment identifying the responsibility
between central and local assignment by far, and the
Responsibility government very clearly, and as responsibility assignment is not
Assignment the supplementary of this law, clear between central and local
there are adequate local government, or between the
legislations to define the detailed upper-government and lower-
issues. government.

z Impacts on Sweden: The fiscal transfer is stable, because the responsibility

assignment is clear.

z Impacts on China: The transfer system is unstable, due to the undefined

responsibilities between various levels of government.

6.2.4 Tax Autonomy

(See next page)

67
Table 6.4 Comparison of tax autonomy
Sweden's case China's case
Local governments are not
Local governments are entitled entitled to have any tax
to have some tax autonomy, autonomy, which means they
Tax Autonomy
which means they can determine cannot decide whether to levy a
the local tax rate by themselves. local tax or not, let alone the tax
rate.

z Impacts on Sweden: Due to the higher level of local tax rate, the revenue

motivation for the local governments has been limited so far.

z Impacts on China: The local government's motivation to increase their fiscal

revenue by levying new tax or rising tax rate is limited, and it leads to heavier

pressure on the grant expenditure of the central government.

6.2.5 Formulation

Table 6.5 Comparison of formulation

Sweden's case China's case

The uniform formulas are widely

used in the transfer system,
Formulas are seldom applied in
including income equalization
the current transfer system,
Formulation grant and cost structure grant,
except the calculation of tax
but the formulas seem too
rebate.
complicated and professional to
ordinary people.

z Impacts on Sweden: Both the results and the procedure of calculating grants are

fair and transparent to each local government, but at the same time, the formula

itself is somewhat difficult for people to understand.

z Impacts on China: The results of calculation of the grant calculations, except

68
 those of tax rebate and other few grants, are merely the product of human

estimates, or of negotiations between the central government and local

governments. Consequently, the results of calculations always lack persuasion.

6.2.6 Motivation

Table 6.6 Comparison of motivation

Sweden's case China's case
In the past,the equalization
system was a kind of
Tax rebate is a main kind of
motivation, when most kinds of
Motivation motivation within the current
special grants were converted
TSS.
into general grants in 1993's
reform.

z Impacts on Sweden: The motivation of the local government (especially the

richer regions) has been restrained; the incentive to attract residents by

improving the quality of services or making the services more efficient has been

significantly reduced (Deborach Roseveare, 2002).

z Impacts on China: Tax rebate stimulates the local government to develop local

economy and acquire more tax revenue, but it has obviously exacerbated

regional disparities.

6.2.7 Supervision

Table 6.7 Comparison of supervision

Sweden's case China's case
The central government pays
more attention to examining and Supervision mainly focuses on
evaluating the performances of the use of earmarked grants, but
Supervision
public services that local the system is not so sound
governments provide, rather either.
than the grant itself.

69
z Impacts on Sweden: The supervision is suitable for the current transfer system,

in which general grants dominate fiscal transfer, however, such supervision is

not easy for central government institutes to implement completely, and the

process is not so operational.

z Impacts on China: Due to the lack of supervision, some grants are misused by

local departments, and the efficiency of these parts of grants is lower.

6.2.8 Information

Table 6.8 Comparison of Information

Sweden's case China's case
The information system is
There are a set of perfect
independent from the central
information systems supporting
government and local
the transfer system, which
governments. Cooperation
integrally consist of a central
between the financial
Information financial department, local
department and the statistic
financial departments, the tax
department is not regular, and
board and statistic department.
most of the information cannot
Information can be shared
be shared between central and
within this system.
local governments.

z Impacts on Sweden: Such an information system makes the transfer system

more effective and efficient, especially in the process of decision-making.

z Impacts on China: Such an information system makes the transfer system less

effective and efficient.

6.2.9 Structure of Grants

(See next page)

70
Table 6.9 Comparison of structure of grants
Sweden's case China's case
There are five segments in the
There are mainly four segments
transfer system: revenue
in the transfer system: tax
Structure of equalization grant, cost
rebate, earmarked grant, final
Grants equalization grant, structural
account settlement grant and
grant, transitional grant and per
general grant.
capita "regulation" grant or fee.

z Impacts on Sweden: The system enables all municipalities and county councils

to offer the same standard of service at the same price anywhere in the country;

the present system is designed to be self‑financing across the local government

sector, under the "Robin Hood" principle.

z Impacts on China: The design of the grants is favorable to the promotion of the

fiscal reforms, but it is helpless when facing the increasing disparities among

different regions in China; the effect of "Robin Hood" is not obvious.

6.3 The New Model

So far, we have analyzed nine factors pertaining to the fiscal transfer system, paying

attention to their definitions, roles and their relations with the system. We have also

brought forward comparisons between the two countries, focusing on the different

performances of these factors, along with their impacts on the system itself. As the

consequence of our research, some suggestions have also come into being to

improve China’s fiscal transfer system. This chapter will conclude with a new model

based on these suggestions.

6.3.1 Suggestions
6.3.1.1 Political legitimacy

Political legitimacy is a guideline to the intergovernmental fiscal transfer system. In

71
current China, with the development of market economy, the disparities in fiscal

revenues and expenditures among different regions are increasing and as a result, a

lot of social problems are emerging and may harm the stability of the society,

furthermore, it will be harmful to maintain the stable growth of China’s economy in

the long term. So, for the sake of prompting both the stable society and economy,

equalization should evolve to be the political legitimacy of China’s transfer system,

replacing the protection of local vested interest (the “Hold Harmless” principle).

Though there will be a transition period during the evolvement, the goal is

unassailable.

6.3.1.2 Responsibility Assignment

The expenditure responsibilities among all government levels should be clearer. This

is one of the preconditions of establishing a regular and efficient intergovernmental

fiscal transfer system in China. Under the framework of market economy, the

functions of the government are mainly linked to sovereignty, macro management

and public services, and the first two functions are the duties of the central

government, while public service is the responsibility of the local government. No

doubt, these assignments should be made on a legislative basis.

6.3.1.3 Legislation

The law regulating intergovernmental fiscal transfer should be constituted as soon as

possible, so that it could offer legal guarantee to the principle, form, purpose of the

fiscal transfer, as well as the formula and its variables. Furthermore, a specialized

transfer budget should be recommended and approved by the legislation annually,

ensuring the transfer system will work orderly within the legislation framework.

6.3.1.4 Tax Autonomy

Local governments should be entitled to have some tax autonomies, so as to have an

72
adequate and fixed tax base to support their administrative activities. Certain

measures can be considered:

z Taxes that are crucial to regional economy but indifferent to macro economy

should be decentralized to the local government, so that the latter can decide

whether to levy a given tax or not, and how to adjust the tax rate.

z To pave the way for tax autonomy, the two administrative levels— Prefecture

and Township in China can be removed. This means the five levels of

government in China will be transformed into three levels: Central

government-Provincial government-County government.

6.3.1.5 Formulation

The scope in which formulas are applied should be enlarged, and factor analysis, in

the light of the Sweden experience, should gradually replace the traditional way of

subjective estimate. As for factor analysis, we think these variables are worthy of

consideration:

z General factors: such as population, area and the setting of administrative

authorities, and so on;

z Social development factors: such as the service level of science, education,

culture, sanitation, the scale of administrative authorities and their staffs;

z Economic development factors: such as the difference of prices among

regions, per capita GDP, and so on;

z Special factors: such as poverty-stricken areas, autonomous ethnic minority

areas, and so on;

73
 z Natural environment factors: such as climate, resources, transportation

conditions, and so on.

The central government is responsible for classifying and scoring these factors

according to their impacts on local development, and then deciding on the amount of

grants delivered to the local government.

6.3.1.6 Motivation

From the experiences of both Sweden and China, we should learn to balance the

richer regions and the poorer regions during the process of motivation:

z With the implementation of tax autonomy at the local government level, the

scale of tax rebate of VAT should be limited. The central government should no

longer pay the local government the increase of VAT, which means the tax

rebate will finally be a grant with a fixed amount.

z The policy of rewards should be implemented in the regions with financial

problems. The rewards should be delivered by way of general grants, aiming at

stimulating those regions to increase local tax revenue, or streamline their

organs.

6.3.1.7 Supervision

It is necessary to enhance the supervision system within an intergovernmental fiscal

transfer system. But at the same time, it should be operational in practice. China

should further improve its regular report system, auditing system and punishment

system, monitor the use of earmarked grants, and avoid unreasonable distributions.

In addition, an evaluation system that aims to judge the performance of grants (i.e.

74
the standard of public services provided by the local governments) should also be set

up.

6.3.1.8 Information

Both the collection and the integration of data (input and output of intergovernmental

fiscal transfer system) should be enhanced for an efficient and effective system, and

the following two issues should be paid attention to:

z The resource of the information. A shared data base should be established

between the financial department, the tax department and the statistic

department; furthermore, a system that promotes the cooperation between these

departments is also needed.

z The credibility of the information. The newest information should be updated as

soon as possible; in addition, the calculation caliber must be uniform between

the financial department and other departments.

6.3.1.9 Structure of Grants

The central task is to adjust the form of fiscal transfer, decline share of the tax rebate

till finally terminate it. At the same time, the design of grants should be consistent

with the principle of “Robin Hood”, enabling the citizens in different regions to

receive public services at similar levels, and fulfilling the political legitimacy of

equalization in the society. Three measures should be considered in practice:

z Reduce the share of tax rebate while increase the share of general grants. China

should narrow the scope of tax rebate, and alter certain proportion of it into the

resource of general grants. With the gradual reduction in the amount of tax

rebate in several years, general grants based on tax rebate will finally replace tax

75
 rebate.

z Set up the revenue equalization grant and cost equalization grant in separation

within the framework of general grants. Local governments with a

higher-than-average tax base per capita and a lower-than-average expenditure

level will pay charges to those local governments with a lower-than-average tax

base per capita and a higher-than-average expenditure level. In other words,

these two kinds of grants should be basically self-financing across the local

government sector.

z Improve the design of earmarked grants. Based on the expenditure assignments,

those earmarked grants for the central government duties will continue to exist;

as to the duties shared by the central government and the local governments,

relative earmarked grants should be paid by these two level governments

together at a calculated ratio.

6.3.2 The New Model

Basing on those suggestions mentioned above, along with the structure of these three
groups of factors (see Graph 6.1), we can now develop the new model concerning
the improved China’s intergovernmental fiscal transfer system as following:

76
Graph 6.2 The new model of intergovernmental fiscal transfer system of China

Political Legitimacy Responsibility Assignment

For the sake of promoting both the Responsibility must be clearer and
stable society and economy, confirmed through legal procedure
equalization should be evolved to be
the political legitimacy

Supervision

Report System
Auditor System
Evaluation System
Sanction System

Motivation Formulation
Structure of Grants
General
Reduced Tax Tax Rebate Social
Rebate Revenue Equalization Grant Development
Reward Policy Cost Equalization Grant Economic
Earmarked Grant Development
Special Factor
Natural
Environment

Information
Financial
Shared & Tax
Updated Data Statistic

Legislation Tax Autonomy

Law of intergovernmental fiscal Some taxes should be

transfer and decentralized, and the
Specialized transfer budget administrative level should be
should be established streamlined

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 Chapter 7 Conclusions
The conclusions are presented. In this part, we first summarize the dissertation. Then

we suggest modifications to the created transfer system, make improvements on the

chosen methodology and offer suggestions for further research. Finally, the practical

implications of the research are discussed.

7.1 Summary of Dissertation

Recently, public expenditures have increased rapidly in some developed countries,

due to rising demands from median voters and needs for adjusting market failures,

etc. Transfer payments are determined by demographic situations, household

structures, economic situations and equity considerations. Theories of local

government economies argue that responsibility assignment of providing public

goods between governments depends on how large an area the public goods benefit.

Decentralization issues encourage local governments to earn more autonomy in

deciding on their social affairs by considering variations in preferences and

efficiency of service provision. In order to fulfill its responsibilities effectively, the

local government should make its revenue meet the financial demands of

undertaking the responsibilities.

Grants are important financial resources for many local governments. Grants can be

distributed to correct for externalities, to supplement the revenue gap of local

governments and to diminish horizontal and vertical inequalities. Grants given with

this purpose are called equalization grants. According to the European Charter of

Local Self-Government, inter-government grants “correct the effects of unequal

distribution of potential sources of finance and of the financial burden they must

support”. In Europe, some countries like the UK and Denmark, pursue full

equalization by the grant system. Other countries including France and Italy, adopt a

78
partial equalization grants system.

A good inter-government grants program observes certain principles, grants should

be: (1) determined in an objective and open way; (2) the program stays relatively

stable over a certain period; (3) transparent; (4) grants assist local governments in

achieving its equalization purpose and special objectives, such as education and

infrastructure. Besides, the World Bank suggests that local governments should have

autonomy in deciding their priorities and have adequate finance to undertake its

responsibilities.

According to Jorge Martinez-Vazquez, a special independent “Grants Commission”

is required to design and monitor the whole grants system. Periodical evaluation is

desirable in order that grants are distributed efficiently and equitably.

In order to create our own equalization transfer model, we integrated all the related

theories that have mentioned in the theoretical review chapter. In addition, we made

detail research in the Chinese and Swedish inter-government transfer system. In a

previous chapter we analyzed both the Swedish grants system and the Chinese grants

system. In China, there are 5 fiscal levels. The current fiscal distribution system is a

tax-sharing one. As a part of tax-sharing system, the fiscal transfer system consists of

tax-rebate, earmarked grants, equalization grants and final account settlement grants.

In the Ningbo case, we discovered some problems with this system, a major one

being the horizontal fiscal disparity. The disparity is caused by tax rebate. Other

problems have to do with lack of legislation and supervision, lack of clear division of

responsibility assignments between different levels of governments.

The Swedish welfare state is known as the Swedish model in the world. Its basic

idea is egalitarian and, therefore, the Swedish fiscal grants system is based on the
79
equalization principle. There are valuable aspects in the Swedish grant system. First,

a reasonable and clear definition of respective responsibilities serves as the basis for

the central government and the local government in realizing revenue assignment

and expenditure assignment. Second, the guideline of the system and the target of

transfer fund are identified clearly. Third, some specific regulations and scientific

formulas are indispensable. Fourth, diverse means can be adopted in accordance with

different objectives and situations. Finally, a professional administration needs to be

established to execute the specific operation and a monitoring system is also

important.

After a comparison of the two systems, we summed up nine important factors in our

equalization transfer system. We placed the nine factors into three levels. One level

is external factors, which are political legitimacy, responsibility assignment, tax

autonomy and legislation; the second level is internal factors, which include

formulation, motivation, supervision, information; the third level is the core factor,

which is the structure of inter-government structure. They constituted the created

equalization transfer system which could provide advices for Chinese transfer

system reform in future.

We applied an inductive approach, which includes a review of the theories that relate

to the inter-government fiscal transfer system. Through the case studies on Sweden

and China, our new model can be developed and outlined. Our conclusion can be

supported by qualitative data collected and gathered by a semi-structure interview,

which will contribute to the validity and reliability of our dissertation.

7.2 Modifications to the Created System

We created a new grants system as modification to the present Chinese grants system.

Our intention is leading the grants system into the direction of horizontal

80
equalization. For this purpose we design internal and external institutions.

For external institutions, political legitimacy should function as an orientation for the

establishment of an equalization society, rather than merely as an instrument of

protecting local interests. The local government has a greater tax autonomy to ensure

their adequate revenue. In addition, Chinese legislation needs to draft a law for

grants. Furthermore, the division of responsibility needs to be stable and clear.

About internal institutions, an easy and objective formula is introduced. Some

variables are considered when calculating the grants to local governments. The

variables include general factors, economic development factors, natural

environment factors, etc. In the process of motivation, the role of tax rebate of VAT

will be diminished and on the contrary, general grants will be increased. Besides, the

new system calls for improvements on the regular report, audit and punishment

system. In addition, data and information about transfer design and supervision

should be collected with sufficient credibility. Finally, the structure of grants--the

core factor should be adjusted towards larger shares of revenue equalization grants

and cost equalization grants in the framework of general grants. Earmarked grants

design needs to be improved as well.

7.3 Suggestions for Further Research

As the created grants system is proved feasible by theories and experiences in

Sweden, we have reason to believe that China can adopt the system for equalization

purposes. We also believe that further research is necessary to make the system

perfect.

In order to apply the system to China’s actual situation, further research should

examine these issues:

81
Some factors are related to political decisions. We have to discuss the possibility of

this kind of reform, or propose a reform not only including grants system but also

political ideology and government implementation systems.

There are more data to collect when considering applicability. In China, regional

gaps are huge. In order to obtain more accurate results, we should carry out

investigations in more cities of China. In addition, we should collect experiences

from developing countries that are similar to China, like India.

In our model, the important step is to reduce the tax rebate rate and increase general

grants intended for poor areas. It may be a disincentive for rich area to collect taxes.

Thus, how to keep the rich government collecting taxes while performing full

equalization nation-wide will be an important research project in current Chinese

situation.

7.4 Methodological Criticism

Our research was conducted through a semi-structural interview. We designed ten

different questions that are important for our analysis of the Swedish case. According

to our original plan, we would interview with some leaders in different political

parties. We hope they would give us some different ideas from political perspectives.

We tried to contact several parties in Kristianstad and Malmö. However, finally, we

failed to have a dialogue with these leaders who could have given us a better

understanding of the Swedish equalization system and modifying these important

factors and our new model we inducted in our dissertation.

On the other hand, as far as information resource is concerned, we only chose

Ningbo and Stockholm as our main research cases. It would have been good to select
82
more cases so that we could make our research more objective and comprehensive.

Due to the time constraint, we only focused on some most important theories that are

directly related to our new model. If our theoretical review had been conducted

during a longer period of time it might have been possible to get more information.

7.5 Practical Implications

The new system is most important for Chinese financial leaders, even state leaders

who are confronted with the increasing gap among different areas. It has provided a

complete picture of how to use fiscal transfer to establish an equalization society. It

is beneficial to Chinese government as an advice to modify their political ideology,

and also helpful to the Chinese administrations in that it helps rearrange fiscal

resources in order to achieve an equalization society.

For fiscal or grants monitoring departments, we also give details how to design and

monitor the grants system. We hope the created model will be beneficial for the

Chinese administration to implement the equalization policy in the near future.

83
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86
 Appendix

Interview Questions: Mr. Per Persson in Kristianstad Financial Department

and Mr. Mats Hansson in Malmö Financial Department

What are the roles of local government? Is the responsibility assignment between
central and local government clear?
1. Can the local tax revenue meet the financial needs? If cannot, how to

supplement it?

2. How to prepare the budget of local expenditure? Which factors are important in

terms of arranging the local expenditure?

3. What are the influences on local tax basement and local government affairs

caused by the decentralization?

4. What are the main objective of transfers and the whole picture of equalization

system? Is it indispensable in the process of forming an equalization society in

Sweden?

5. How about the influences of transfers on local government, society and

economy?

6. What are the principles of equalization system design?

7. What is the decision-making procedure about a certain grant, whether it is

according to bargaining or by a series of formulas?

8. How to supervise the use of grants?

9. What are the main advantages and problems related to the current system? How

about the tendency in future?

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Interview Questions: Mr. Lennart Tingvall in Financial Ministry in Stockholm

1. What are the main ideas behind the three reforms of Sweden's equalization

system respectively initiated in 1993, 1996 and 2005?

2. What are the merit and the shortcoming of the new (2005's) equalization

system?

3. What're the roles respectively played by the local financial department and the

statistic department during the process of preparing the state's subsidy budget?

88
Interview Questions: Politician in Stockholm

1. What factors are important in prompting the process of equalization? Does the

equalization system play a vital role during this process in Malmö (an example

will be better)?

2. How to assess the current equalization system? Is it both effective and fair?

3. Can you give us any proposal for the future reform of equalization system in

Sweden?

89