Municipal Budgetary And Fiscal Processes

The most distinctive feature of China's local budgetary and fiscal process is how closely, and routinely, investment and taxation decisions are interwined. What economists have called the "soft budget constraint" does not mean simply that enterprises can expect to be bailed out if they run into financial difficulty. It means that the decision to invest in industry is paired with a decision about changes in the division of revenues between enterprise and government, such that conditions for repayment will be created. Each decision about an investment loan is accompanied by a decision about the flow of revenues.

China's tax-for-profit reform (li gai shui ) and its budgetary reform (caizheng baogan ) have reinforced the tendency of local government to monitor closely the division of revenues between enterprise and government. The revenue share for the central or provincial budget, for local roads, hospitals, housing, and much of the funds for expansion of local industry (and thereby the further expansion of the local revenue base), all must come from locally collected taxes.

Since these reforms took effect in the early 1980s, local actors have had much more latitude in initiating industrial projects and have allocated greatly increased proportions of national investment.^[24] Through the new tax system they have also become involved for the first time in continuous negotiation over the revenue flows between the city and industrial enterprises. This involves the development and evaluation of project proposals (xiangmu jianyi shu ) and feasibility studies (kexingxing baogao ); it requires successive rounds of meetings and approvals on each proposal; and it requires local actors to put together the funding from central, provincial, or local budgets, or from bank loans, to augment the funds provided by the enterprise.

In this short period of time a regular pattern of behavior and accompanying attitudes have already become evident. There is a marked tendency to appropriate and redistribute enterprise revenues when they are deemed inordinately high, to build consensus and thereby parcel responsibility among all local actors for specific investment decisions, and to reduce the risk of failed ventures beforehand by granting favorable terms to important projects. This behavior is accompanied by a clear set

[24] The percentage of national investment made by local governments increased from 40 to 62 percent from 1977 to 1984. See Carl Riskin, China's Political Economy: The Quest for Development Since 1949 (New York: Oxford University Press, 1987), 364.

of local attitudes toward the business environment and managerial responsibility, about welfare and employment, local development needs, and the legitimacy of claims to enterprise profit.

The Redistribution of Local Resources

Ironically, the same arguments that reformers use to argue for thorough price reform and greater enterprise autonomy are also used by local officials as the justification for their intervention in enterprise activities. Reformers argue that in today's half-reformed economy, unreformed prices do not yet send the proper signals to enterprises, and a number of objective conditions beyond the control of managers—transportation links, energy supply, state pricing decisions, existing state of capital stock—make the link between efficiency and profit tenuous and threaten to exacerbate existing distortions and imbalances. In the terminology of reform, these "objective conditions" (keguan tiaojian ), beyond the control of enterprise managers, make it impossible for such "subjective factors" (zhuguan yinsu ) as good management or hard work to be measured by factory profits. Local officials are highly conscious of this, and they take it as their right, indeed their duty, to protect enterprises under them from the consequences of unequal "objective conditions," ensure the balanced and stable growth of the local economy, and protect the welfare of local citizens.

The first consequence of this situation is a practice popularly referred to as "whipping the fast oxen" (bianda kuai niu )—in effect, tailoring effective taxation rates to rates of profit. As one factory director stated to me in a matter-of-fact fashion, "If our profits increase in future years, there will be supplementary taxes to adjust for changed performance."^[25] This is often said, both in China and abroad, to reflect the desire of local officials to restrict enterprise autonomy and maintain their power. But even if local officials fully supported enterprise autonomy (and I encountered some very critical and outspoken advocates in various bureaus and banks), they would be compelled by circumstances to behave in this fashion.

Every city government will have a set of enterprises, typically producing raw or intermediate materials, whose products are in short supply and badly needed by other local enterprises, but whose price niche ensures that their profitability will be very low. These enterprises, typically producing steel or fabricated metal products, nonferrous metals, industrial chemicals, or simple components for engines or electrical equipment, will at best make profits that are quite small compared with their capitalization, and will frequently operate near the break-even point or below. They will be unable to cover more than a fraction of their badly

[25] Interview 81, August 1984.

needed investments for plant renovation and expansion. Yet these are precisely the industries that need to develop most rapidly.^[26]

At the same time, every local government will have a set of enterprises that are highly profitable and that succeed, not because their products are generally in short supply, but because the quality or specifications of their products are such that they find steady markets. These enterprises typically fabricate finished consumer or producer's goods; various kinds of machinery, electrical equipment, or consumer electronics are common examples. Their profit rates are much higher than those of older, inefficient plants and those producing raw or semifinished materials. Yet these high profits are arguably due to state pricing policies, which keep materials' prices relatively low and finished products' relatively high.

Unless it is to allow current bottleneck industries to stagnate, the city government has no choice but to favor the disadvantaged enterprises across a broad range of financial measures and administrative practices. The first measure it takes is to ration investment by setting its own priorities in local construction and renovation programs (guihua ), allocating investment projects to those enterprises the city wishes to develop fastest, regardless of prevailing profit rates.^[27] Every city and every industrial bureau has five-year investment plans that allocate investment quotas down to each enterprise. Every construction or renovation project must be approved by the industrial bureau, the planning commission, or higher authorities, depending on its size, and put into this plan, even if it is relatively small and funded entirely by the enterprise. Enterprises with the financial wherewithal to substantially fund investment projects are allowed to do so, but only up to the limits established in the plan. Those who have been allocated a place in the plan, but who cannot substantially cover their needed investment, will receive tax cuts or subsidized loans to allow them to complete the construction or renovation plans decided upon by their leading organs.

Effective taxation rates are tailored to the profit rates of each enterprise. The adjustment tax (tiaojie shui ), designed to compensate for unequal competition due to price niches, different capital endowments,

[26] A typical example was a large and important machine-building plant in Dalian, which was considered an excellent firm, based on the high quality and demand for its products, but which suffered from very low profitability. Despite the fact that it received tax breaks allowing it to keep 90 percent of its realized profits, it still could afford to contribute only 4–5 of the 77 million yuan earmarked for its investment in the Seventh Five-Year Plan (interview 125, August 1986).

[27] Another reason for the investment quotas and tight controls over investment is the tendency for enterprises to overinvest, creating an "overheating" of the economy that feeds inflation, creates severe shortages of construction materials, and lowers the productivity of investment. It should be noted, however, that these controls were placed by the central government in order to restrain local governments and enterprises.

and other "objective factors," was instituted with the shift to enterprise taxation and is the best known of these leveling mechanisms.^[28] But in practice it was found that this tax was too small and too inflexible to allow local officials to guide industry effectively (tax regulations specified that this tax rate remain unchanged for a certain number of years).^[29] In fact, on paper the entire tax structure looks quite inflexible, since localities, as it was explained repeatedly to me, do not have the power to change centrally determined rates of taxation.

Localities do, however, have a free hand in deciding how much of a factory's profits shall be exempted from taxation during any given year, and for most products they also have the right to exempt any amount of sales revenues from taxes on products. The only limit on these tax breaks, other than central regulations forbidding sales tax breaks on such products as alcohol and tobacco, is the finance bureau's calculation of the effect they will have on local revenues.

Tax breaks are routinely considered in three kinds of situations. In the first, enterprises that have habitually operated at a loss, yet which continue to turn out badly needed materials or components for other local industries, will receive tax breaks to allow them to continue to operate. On occasion, such enterprises will receive even larger concessions to subsidize large investments if local officials deem it necessary to turn the situation around. In the second situation, a plant that normally operates with a profit may, because of "objective conditions," find itself in financial difficulties. The objective conditions may be any number of things: shortages of raw materials, energy blackouts, price rises for raw materials. A temporary tax break will be negotiated to permit the firm, which is in trouble through circumstances beyond its control, to keep operating. The third situation is when a sizable renovation or construction project is undertaken. Because nominal tax rates are so high, very few can afford to repay investment loans within the customary time period. Every such project has a variable tax subsidy in its "loan repayment contract" (huankuan hetong ).

Although we have no data on the prevalence or magnitude of such tax

[28] In an earlier article, based on the 1984 interviews, I described how the adjustment tax was set initially. One enterprise director (interview 84, August 1984) referred to five criteria, one of which was "how much profit the government thinks the factory should be making." See Andrew G. Walder, "The Informal Dimension of Enterprise Financial Reforms," in The Chinese Economy Toward the Year 2000 , vol. 1, The Four Modernizations , Joint Economic Committee, Congress of the United States (Washington, D.C.: U.S. Government Printing Office, 1986), 630–45.

[29] When that time period was up, which in some areas was three years and fell in the year of my 1986 interviews, the adjustment tax was readjusted only after a long process of "arguing, begging, and compromising" between the factory and the finance bureau (interview 90, May 1986).

breaks, one gains the impression from interviews—particularly in the detailed knowledge that people at all levels have of the subsidies and the conditions under which they may be secured—that favorable tax treatment is common. This means that the upper limit on taxation is the nominal tax rate, with widespread reductions in the effective tax rate through exemptions of varying magnitudes. The actual rate of profit retention appears to average between 20 and 25 percent.^[30]

There is another important redistributive mechanism known as "the concentration of funds" (jizhong zijin , or jizi ). These are administrative levies, usually by industrial bureaus but sometimes by planning commissions, on the retained profits of enterprises. One bureau official explained, "This is like an additional adjustment tax. We take more from those with more money, and less from those with less. All sixteen industrial corporations (bureaus) in Beijing do this."^[31] The administrative agency simply takes away part of the factory's retained profits. At the industrial bureaus that described the practice to me, these levies ranged from 7 to 15 percent.^[32] The bureau deposits the funds in a local bank or an investment and trust corporation and loans or grants them to needy enterprises under its supervision at preferential rates. In other cases, in a practice called "apportionment" (tanpai ) in one city, the city government simply places a levy on the profits of a particularly large and profitable firm in its jurisdiction.^[33] These practices were controversial in 1986, and since the press at that time carried articles critical of them, enterprise officials openly complained to me about such "arbitrary practices."^[34]

[30] A 1985 survey of 429 enterprises in 27 cities found these enterprises to retain an average of 22 percent of their gross profits. See Bruce L. Reynolds, ed., Reform in China: Challenges and Choices (Armonk, N.Y.: M. E. Sharpe, 1987), 89.

[31] Interview 102, June 1986.

[32] Interview 101, June 1986 (10%); interview 102, June 1986 (10–15%); interview 117, July 1986 (7.5%, but only for collectives, since the state firms successfully resisted). In Dalian, one bureau official explained, "We borrow without interest from our well-off plants to finance investment in others. The ones we take from don't like it but there's nothing they can do about it" (interview 122, August 1986).

[33] One large factory claimed that the city put a special levy on its retained profits because the firm was by far the biggest in town and the city was revenue hungry (interview 128, August 1986). In Shenyang, various interviews revealed that in 1986 the city placed a 15 percent "construction" levy on retained profits of a number of enterprises that could bear it in 1986. It was to last for three years. In a large enterprise in a third city, the city kept 33 percent of the retained profits in 1985 and wanted to take 42 percent in 1986. "The proportion is different every year according to our profit level. We get to keep very little of the profits. This is because this is a very profitable line of production. This readjusts the profit earned between sectors. In effect, we are taxed three times" (interview 123, August 1986). Note that levies of this sort are not considered taxation and therefore are not divided with the Center.

[34] "They shouldn't do this, but they do it anyway. There's no policy, they just have the power. They take more from the factories that make more money" (interview 101, June 1986).

Sharing Risk

One important consequence of the city government's mission to compensate for "objective conditions" is the provision of a kind of insurance against the risk of industrial undertakings. This is an ironic consequence of the new stress on having enterprises repay investment loans. The bank examines every feasibility study and loan application for the firm's ability to repay out of increased profits. Not uncommonly, an application will be flagged by the bank as having too much risk (fengxian ) and as unacceptable, without awarding the firm favorable conditions.

At this point, industrial decision-makers are faced with a conflict between two principles, which they refer to as "economic efficiency" (jingji xiaolu ) and "social utility" (shehui xiaolu or shehui xuyao ). The prevailing attitude among those I interviewed is that the former is a rather narrow, blind, and calculating criterion, whereas the latter takes into account the greater public good. By the time a project application is rejected or flagged by a bank as unprofitable, it has already been approved by the industrial bureau involved, placed in the plan, and if it is large, already approved by the planning commission. In other words, the planning apparatus of the city has already pronounced upon its social utility.^[35] There follows a protracted negotiation among industrial bureau, bank, tax bureau, finance bureau, and planning commission. The usual result is a set of "favorable conditions" (youhui taiojian ) that will allow the venture to succeed.

The finance and tax bureaus have four mechanisms that, in combination, allow them to fashion "favorable conditions" of widely varying attractiveness. The first is to reduce or eliminate the interest rate on the loan. The financial system simply pays the interest directly to the bank, and the enterprise repays only the principal. This is an "interest free loan" (wuxi daikuan ) or a "subsidized interest loan" (tiexi daikuan ). The second mechanism allows the enterprise to deduct its annual debt repayment from the profit subject to taxation. But it is common practice on construction loans financed by budgetary funds ("special project loans," texiang daikuan ) to allow up to a 100 percent income tax deduction on the debt repayment, or as the Chinese put it, to repay loans before taxes (shuiqian huankuan ).^[36] Since the various taxes on enterprises usually add up to a nominal tax rate of 70 to 85 percent, this can be a large subsidy,

[35] Some cities routinely dispense with bank profitability studies if there is a pressing social need for the project (interview 110, July 1986).

[36] For basic construction loans in Shenyang out of public finance funds, the standard treatment is for all projects to get 100 percent deductions (interview 113, July 1986). The treatment varies for different kinds of loans (it is different for technical-renovation loans), for the source of funds (it varies greatly for bank credit), and by local policy.

equal to the percentage the factory is allowed to repay before taxes times the tax rate.^[37]

The third mechanism is to allow the enterprise an exception from the principle that it repay a loan out of new profits generated by the investment project. Enterprises whose projects are judged to be economically unprofitable but socially necessary will be granted the right to repay their loans out of their "old" profit, in addition to the new. The fourth mechanism, usually used only in projects with urgent social justification but poor financial prospects, is simply to treat loan repayments as taxes (shitong shangjiao renwu ).^[38] In this case, loan repayments are simply counted toward the factory's tax obligation, releasing them from their normal tax obligations until the loan is repaid. With so many mechanisms at their disposal, local officials can tailor tax breaks of any size. They can, and do, fine-tune loan and tax packages to create in advance the conditions for repayment.^[39] One might reasonably ask, given this ability to fine-tune financial conditions, whether there is any criterion financial bureaus use to determine how much preferential treatment to give a firm, and if so, what.

The only clear standard that I was able to discover was evident in all the cities I visited: the factory's bonus and welfare funds shall not be allowed to fall below the level of the year reforms began (1983 or 1984). Even if, in extreme cases, the factory must use all of its reserve funds to repay loans or cover losses, wages and benefits must not be allowed to fall.^[40] This standard was usually justified by the argument that "objective conditions" necessitate tax breaks in the first place, so the work force should not suffer from circumstances beyond their control. Others stated the point more baldly and said that workers' incomes should not be allowed to suffer in the course of reforms.

These practices reduce significantly the element of risk in enterprise operations. Enterprises can depend on leading organs and other agencies to devise an investment package designed to secure success. If the enterprise still runs into difficulties repaying because the feasibility study

[37] The amount that a factory repays before taxes can, it is reported, be readjusted annually, at least in one enterprise's experience (interview 97, June 1986).

[38] One factory I visited had 50 percent of its loan repayments counted toward its tax quota, in addition to being allowed to repay entirely before taxes, "because we are a high-priority development sector" (interview 101, Beijing, June 1986). Some cities have done the reverse: allowed tax payments to count as loan repayments, called yishui huandai , but this probably is limited to loans from government funds (interview 130, August 1986).

[39] One city is reported to have spent 13.7 percent of its annual budget on subsidies for investment projects in 1985. It subsidized just under 30 percent of all debt obligations for construction projects that year.

[40] In Beijing the common procedure is to exclude a factory's bonus and benefit funds from realized profit before the tax base is determined (interview 106, July 1986).

was too optimistic, or because of objective conditions, a firm can apply for a "hardship tax break" (kunnan jianmian ). The plea of "objective conditions" is ruled out in only three cases: if labor costs go up; if materials use rises; or if sales go down because of poor quality of product. The loan repayment contract is viewed as legitimately open to renegotiation. After confirming this, one enterprise manager said, "Usually this is no problem if you are a well-run factory and aren't a chronic money loser."^[41]

If poor financial performance can be traced to "subjective factors," this is a blight on the manager's record. But tax breaks are still given, usually for one year but sometimes longer, to help turn the situation around: "Whether it is due to bad management or not, we still reduce taxes if we want to save the enterprises in a certain line of production. We are after all a socialist country, and we don't want enterprises to go bankrupt."^[42] If the problems persist, local authorities may eventually decide, if the plant is important, to give the firm a large renovation project to increase its technical productivity and start with a clean slate.

The Shared Responsibility of Collective Decisions

Just as much of the risk of investment projects is absorbed by local industrial circles, so is the responsibility for investment decisions. Since government agencies have taken it upon themselves to intervene actively and compensate for "objective conditions," they take up much of the responsibility for investment decisions.

An enterprise's initial project proposal (xiangmu jianyi shu ) is submitted to its industrial bureau, but after that point various government agencies become involved. The industrial bureau commissions a feasibility study and may order revisions. Depending on its size, the project will then be taken to the planning commission, or to higher levels of government, for approval and to arrange a funding package. Finance bureaus and banks will examine the project proposal and arrange funding; when a tax break is required, the tax bureau must also be consulted. The loan repayment contract represents prolonged discussions by these agencies. Symbolically, it must be affixed with the seals of the enterprise itself, its industrial bureau, the finance bureau, bank, and tax bureau.^[43]

[41] Interview 87, August 1985. Another said, oversimplifying the matter but reflecting a common relaxed attitude on the subject, "If you have problems repaying your loans, you just talk it over with the finance bureau and they will lower your taxes" (interview 91, May 1986).

[42] Tax bureau (interview 104, June 1986). Another tax bureau official said, when referring to the same practice, "We have to make sure that people can eat" (interview 112, July 1986). This official estimated that from fifteen to eighteen enterprises received this kind of treatment in his city annually.

[43] Interview 133, August 1986.

In effect, the investment is not the enterprise's decision: it is a collective one of all of the local agencies that have discussed and approved it. "The responsibility is unclear, however, who it is that gives final approval, or who it is that has the right of final denial. If any one of these organs turns you down, you can't get it. So the responsibility is unclear. No one is entirely responsible."^[44] In controversial cases, the decision follows from a long process of consensus building, which may in the end be settled by the planning commission or the mayor's office. The manager's plans have been scrutinized and approved by the entire local industrial circle. If something goes wrong that cannot be attributed directly to the manager's subsequent actions, all of the departments involved share responsibility for the initial decision to go ahead. This is one important reason, in addition to the more obvious economic ones, why local industrial circles are prone to save firms in financial difficulties. Not only can "objective conditions" be blamed, but they are themselves implicated, since they set the financial conditions under which firms operate.