Editor's note: China's local governments, especially those at grassroots level, have long been plagued by expenditure requirements that exceed their income. This article, which is translated from an editorial in Caijing magazine on Nov 7, advocates allocating stable and abundant sources of tax to local governments to relieve their predicament.

The timetable for reform of value-added tax (VAT) has been decided, and Shanghai will be the pilot for the reforms next year. Because the reform means VAT will replace the business tax, the initiative has been warmly greeted by related enterprises.

Moreover, the current system of tax distribution, which has been in place for 18 years, may now be in further reform, thanks to the new VAT reform.

The State's fiscal revenue has risen steadily from 500 billion yuan ($79 billion) in 1994, when a major tax reform was introduced, to 8 trillion yuan in 2010, but the average annual increase in taxes has been much higher than that of GDP.

The tax reform in 1994 modified the sharing arrangements between central and local governments and the financial difficulties of grassroots governments have become ever more pressing as the central government takes the lion's share of the taxes, leaving local governments little financial capacity to fulfill their responsibilities to provide public services.

The governments at county and township levels have been leading an especially hard life, for even as the central and provincial governments' revenues have grown, the incomes of grassroots governments have shrunk while their expenditures have grown. Even if they are in debt they cannot avoid these duties.

The administrative duties and public service provision were arbitrarily assigned to grassroots governments in the tax distribution reform of 1994,

Although the transfer payments from the higher authorities have helped the county and township governments, the existing transfer payment system is problematic, because there are many kinds of transfer payments and they lack standards.

The amount each county government gets also depends on their ability to negotiate with the higher authorities, instead of being the amount they need to fulfill their duties. That is why local governments are heavily in debt and try to make money by selling land.

Statistics show that the central authority's revenue is now 50 percent of the overall government revenue, up from the 40 percent a decade ago. Meanwhile, local government expenditure accounts for 80 percent of total government expenditure, up from 60 percent 10 years ago.

The basic principle for the distribution of duties should be as follows: national public requirements, such as national defense, should be undertaken by the central government; local public services should be provided by local governments; and central and local governments should be responsible for cross-regional services together.

Decision-makers need to come up with a fairer division of labor for central and local governments as soon as possible.

The distribution of financial power might be more complicated. But the most important thing is to entitle local governments with the right to collect principal taxes.

All of the lucrative, reliable taxes are collected by the central government or high-level local governments, leaving only small, unreliable and scattered taxes for the grassroots governments.

At present the main tax for local governments is the business tax for the service sector, which will be replaced by VAT in the VAT reform, and it is still not known how this will be shared among the central and local governments when it comes into force.

However, in the pilot VAT reform in Shanghai, VAT, which is usually collected by the central government, will replace the business tax, which is usually collected by local governments, so in order not to cut local revenue, the new VAT collected from the service sector will still belong to the local governments.

Such an arrangement has obviously been made in order to win support for the reform from local governments. But it can only be an expedient solution, rather than an institutional adjustment.

As the largest tax category, the former 3 to 1 share of VAT between central and local governments may finally be adjusted, promoting progress in rationalizing the old tax distribution models.

Property tax and the natural resources tax are likely to be the two main tax sources for local governments in the future.

A property tax has been piloted in Shanghai and Chongqing since early last year. And a new natural resources tax system, based on prices, has been implemented for oil and gas since earlier this month.

Now local governments are more like agencies of the central authority than real governments. Only when they have truly independent financial revenue, can they be upgraded to real entities.

(China Daily 11/15/2011 page8)