The following OECD assessment and recommendations summarise Chapter 4 of the  Economic Survey of China 2005 published on 16 September 2005.

Reforms to the pension system are needed to avoid future fiscal burdens

A greater role for capital markets is all the more important given the rapid ageing that will occur in the population over the next two decades. Since the nationwide reform of 1997, the public pension system, which only covers 14% of the active population, has been a two-part system. The first part provides a basic flat rate pension while the second part provides a pension proportional to contributions, revalued by the bank deposit rate. This second part could, eventually, be developed into a fully-funded individual account system, with the balances invested in capital market instruments that would yield more than bank deposits. A trial reform in this sense has been launched in several provinces. At present, all contributions are needed to pay existing pension entitlements and so the pilot programme requires transfers from government revenues to meet the transition costs. A generalisation of such trials would likely require a reduction in prospective pension outlays in order to fund these costs and so avoid fiscal deficits. This could be achieved by equalising and raising retirement ages for men and women, phasing out early retirement schemes and bringing benefits from the second part of the system into line with life expectancy at retirement. In addition, the government is committed, in principle, to using part of the proceeds from selling participations in state-owned companies to create a fund to smooth the spending of the pension system. Such a policy has considerable scope for raising funds given that state assets are equivalent to 80% of GDP. Over the longer term, consideration will need to be given to widening the coverage of the pension systems to rural areas as, with increasing migration, traditional support systems for the elderly may function less well.

But elsewhere public finances are in good shape.

Public finances are in good shape. The reform of public finances introduced in 1994 has permitted a strong rise in government revenues with a larger part coming from indirect taxation rather than from levies on income. The management and transparency of public finances has also been improved. These reforms have provided a strong basis for restoring public expenditure after the crisis of the first half of the 1990s that was linked to the fall in profitability of state-owned enterprises. Between 1994 and 2000, public expenditure rose by almost 7 percentage points of GDP but is still fully 13 percentage points below the OECD weighted average. Such a difference is mainly due to low payments for both social security and debt interest. Indeed, apart from these two areas, public spending absorbs a similar share of GDP as in the OECD area. More recently, rapid growth of revenues and tight control over expenditure has been used to bring the overall budget deficit down to below 1% of GDP and to keep public debt stable at around 23% of GDP.

Some reforms of taxation are being considered,

If government revenues continue on the buoyant path of the past few years, a number of reforms could be considered with the objective of reducing distortions. One change already envisaged by the government is the equalisation of the rate of company taxation for domestically and foreign–owned companies. The basic rate of corporate income taxation, at 33%, is in the upper quartile of rates in the world. On the other hand, foreign companies are taxed at a rate (15%) that is amongst the lowest in the world. The unified rate will need to be set at a competitive level for firms in China in order to encourage domestic capital formation, suggesting a unified rate close to that currently paid by foreign companies. At the same time, dividends paid to domestic shareholders could be exempted from any further taxation, so bringing the tax rates on risk capital more into line with the tax on government bonds. The government is testing the deductibility of VAT on investment goods in a number of provinces. If this change is generalised, it will be important to ensure that there is no discrimination in the tax treatment of investment in different industries. At the same time, the base of VAT could be widened to include all services, with consequent changes made to the business tax.

and further changes to taxation might be desirable,

Over the medium term, some changes could also be envisaged to personal income taxation. In this area, the system has been kept simple, with few deductions and a flat tax on income from capital. At present, few people have sufficiently high incomes to pay the highest marginal tax rate of 45% and the average marginal tax rate is low. But, given rapid growth in incomes, this situation could change if allowances and thresholds remain without any indexation to wages or prices, as has been the case since 1980. A strong signal of the intention of the government to continue its support for private sector entrepreneurial activity would be to reduce top marginal income tax rates, a move that would cost little in revenue but would align China with a number of other transition countries that have found that a low tax rate encourages the declaration of income and improves incentives for economic activity. At the same time, an increase in thresholds below which income tax is not paid would help preserve equity.

along with some restructuring of public expenditure.

There has been a marked recovery in public expenditure, particularly in the area of investment, in the past decade. Public outlays on education and health are low relative to OECD countries and moreover have tended to favour better off groups in society. On the other hand, in recent years, total government-financed capital outlays, including direct capital formation and investment financed by capital transfers, have, on a national accounts basis, amounted to over 9% of GDP and helped create, inter alia, a freeway system. However, there is evidence that some of this investment has been wasteful, suggesting that some re-orientation of spending may be needed. The government has started to increase health and education expenditure but a further effort will be needed, especially in the poorer parts of the country as outlays are still low relative to needs. Achieving such a result may require another overhaul of fiscal relations between different levels of government. The reform of the mid-1990s has allowed a major increase in transfers from central to sub-national government that has helped stabilise inequalities in public spending across the country. However, health and education expenditure is undertaken at the lower levels of government which have inadequate sources of tax revenue and are dependent on transfers whose importance varies considerably across the country. Greater attention needs to be paid to aligning the revenues of local government to their expenditure mandates and to designing an equity-oriented national scheme for sub-national fiscal relations.

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For further information please contact the China Desk at the OECD Economics Department at webmaster@oecd.org.  The OECD Secretariat's report was prepared by Richard Herd, Sean Dougherty and Margit Molnar, under the supervision of Silvana Malle. Consultancy support was provided by Charles Pigott, Ping He and Xin Zhang.

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