At the trough, the government budget had shrunk to less than 11 per cent of GDP, and the central government’s revenues just 3 per cent. Though the depth of the retrenchment was masked by the resort to extrabudgetary sources of finance, and by devolving the funding shortfalls to local governments and especially to the rural sector, the outcomes were costly. Not only did it lead to inadequate provision of vital services, but the government played virtually no role in ameliorating differences in fiscal capacity across localities, resulting in huge disparities in offerings.

In the twenty-first century, China’s fiscal position has changed markedly for the better. Since the introduction of a large scale reform package in 1994 (the Tax Sharing System), China has rebuilt its revenue mechanism, and the recent growth spurt has brought annually double-digit increases in revenue that have filled government coffers to overflowing, especially at the central government. It was this strong fiscal position that enabled the government to roll out the biggest fiscal stimulus program in the world in late 2008 to combat contagion from the global financial crisis. The improved fiscal outlook has also enabled the government to embark on an ambitious effort to try to reverse or alleviate the problems created in the 1990s. Over the past decade, numerous programs have been introduced: the rural fee reform abolished all fees and taxes in the rural sector, the free rural compulsory education program ensures that rural children can attend basic education free of charge, and the new rural cooperative medical scheme has enrolled virtually all rural residents in a highly subsidised medical insurance program. These programs are impressive; they serve huge populations (for example 935 million rural residents are enrolled in health insurance, and 140 million children are enjoying free rural education). They are clearly aimed at reducing inequalities, promoting fairness and improving public services, as part of the shift to a ‘service-oriented government’ and building social harmony.

The new ‘harmonious society’ programs are laudable, but they are addressing only one part of the problematic legacy of the earlier retrenchment. A far bigger challenge is to repair the damage wrought by the decade-long ad hoc devolution of authority from the centre, which, driven by crumbling public finances, had broken the intergovernmental fiscal system. With local governments assigned too little revenue to fulfill their responsibilities, the system became unable to support national policy implementation. The era also saw a severe erosion of accountability, since no government, agency or person could be held accountable for results. The dependence on extrabudgetary revenues in turn distorted incentives for government agencies and public service providers. Even today, the government is hobbled, throughout the whole administrative apparatus, by agents whose (own) revenue-hunger dominates decision making. These legacies make China’s public finance opaque and difficult to manage, and lie at the root of the current problems of weak governance, regulatory failures and growing inequality.

The problems of the intergovernmental fiscal system and distorted incentives were created when China muddled through the brutal fiscal decline without a strategy for reshaping the public sector. This structure and incentives are now hardened and deeply embedded, and undoing them will take time and a determined effort. A program of comprehensive reforms will be required: building new accountability mechanisms and information systems, reorganising and streamlining government, and, most of all, repairing the intergovernmental fiscal system.

These are large and politically difficult reforms. Until revenue and expenditure assignments are realigned, and the revenue-driven orientation of government agencies and public service providers is fundamentally altered, pushing more money through the system will not solve the problems of weak governance, and will likely have only limited effect on improving the government’s capacity to ensure fairness, public safety, and consumer protection.

Christine Wong is Senior Research Fellow and Chair, Chinese Studies School of Interdisciplinary Area Studies, Oxford University.

This article was published in the most recent edition of the East Asia Forum Quarterly, ‘Governing China‘.