The Chinese State Council’s Development Research Center has recently announced proposals for a wide-ranging reform of regional and local governments (RLGs) that would lead to greater capacity to finance their governmental activities and increase the transparency of their operations.

The government think tank’s proposals would improve the RLGs’ budgetary framework by better aligning expenditure responsibilities and revenue-raising powers. The proposals would initially facilitate direct borrowing by expanding the government’s current pilot bond program, but later, and more importantly, by establishing a municipal bond market, while also constraining RLGs’ recourse to indirect borrowing.

The proposals seek to serve as a roadmap for reform that will be discussed at the Third Plenary Session of the 18th Communist Party Central Committee between November 9 and 12.

Based on our reading of the recommendations, we believe that there would be several key benefits, although the timeline for implementation of the reforms is still uncertain.

The reform would better align local government revenues and expenditures and reduce reliance on borrowing. Currently, RLGs’ expenditure responsibilities exceed their own-source revenues, creating a vertical fiscal imbalance that the central government funds through transfers. The reform would help rectify this imbalance by clarifying responsibilities for the provision of services between the central and local governments, and by providing greater revenue capacity for expenditures that remain with the RLGs.

RLGs’ revenue flexibility would be enhanced with a regime more focused on property and consumption taxes. Specific measures would include expanding nationwide the property-tax pilot program now operating only in Shanghai and Chongqing to county-level governments, allocating motor vehicle taxes, widening the tax base of resource taxes and levying environmental taxes. At the same time, as tax resources increase, the government plans to reduce and consolidate multiple non-tax fees and charges, some of which are less correlated with economic growth than the proposed taxes. In addition, the proposals include reforms to improve the administration of tax collections, including an improved land value appraisal system.

The reforms would improve RLG financial transparency by requiring public disclosure of RLGs’ accounts, including balance sheets. We expect that the reform will also clarify RLGs’ responsibilities for servicing the debt issued through their local government financing vehicles (LGFVs), leading to greater local government accountability. The central government will also make the methodology for their transfers to RLGs more transparent, a move likely to eventually replace the one-on-one negotiations with individual RLGs that occur now with a more formula-driven and objective system.

Development of a municipal market-based bond program, along with a reduction in RLGs’ recourse to indirect financing through LGFVs, would be beneficial to the sector because it would enhance monitoring and regulation of RLG indebtedness.

It would also improve RLG accountability for their own investment and borrowing decisions and discourage them from engaging in non-transparent irregular financing activities through their LFGVs. These proposals seek to widen the investor base for municipal bonds by allowing institutional investors such as insurance companies and pension funds to buy municipal bonds.