China's Changing of the Guard: State Capacity on the Rebound

Despite China's stellar record of economic growth since the late 1970s, skepticism about the country's future abounds. Serious questions have been raised about the picture created by China's economic statistics and, by extension, about its growth record. ¹ Even if we accept the official statistics at face value, conventional wisdom holds that China faces daunting challenges in creating jobs, shoring up its shaky banking system, dealing with rising income inequality, and protecting the environment. While an increasing number of Chinese cities, particularly along the coast, have become global manufacturing centers, unemployment among state-sector workers has skyrocketed. In recent years, the rural population has fallen on especially hard times from the triple whammy of a prolonged slump in farm prices, a major slowdown in non-farm employment creation, and local-government rapacity. For these reasons, it has become almost de rigeur to speak of China as being in crisis.

Yet more than a decade after the Soviet Union fell apart, the Chinese Communist Party (CCP) remains in power. On the surface, the Chinese leadership appears to have weathered the myriad challenges it has faced by sticking to its roots. Aside from beefing up its coercive apparatus, the leadership has kept tight control over the nomenklatura system, placing trusted lieutenants in key positions and rotating officials to prevent them from building personal fiefdoms. The opacity with which the ongoing political succession has been conducted seems to underscore just how much the Party has resisted changing with the times. ²

Beneath the surface, however, China's leaders have worked furiously over the past decade to remake the institutions of governance. Leaving aside the promotion of elections in villages and urban neighborhoods (as these are not part of the state apparatus), the central leadership has dramatically revamped the fiscal and tax systems to strengthen the central state's revenue base over the long haul. It has also launched a major restructuring of the government and strengthened its regulatory institutions in the interest of promoting orderly market competition and financial stability. Yet the drive for a more effective state has been coupled with serious initiatives to curb bureaucratic discretion and rent-seeking and strengthen horizontal accountability.

The Center and the Purse Strings

While the post-Tiananmen leadership took up Deng's call for reforms, its first order of business was to rebuild the central government's fiscal sinews, which had been enervated by particularistic arrangements (namely, fiscal contracting between the center and the provinces) in the first decade of reforms. Leveraging the Party's political and organizational resources, China's central leaders pushed through comprehensive tax and fiscal reforms in 1993-94. These reforms replaced the country's particularistic fiscal-contracting system with a modern tax-assignment system. ³ In contrast to the old system, which had given the central government only a set amount of revenue, the new system designates different categories of taxes to the central and local governments, respectively—in a way similar to the federal taxation schemes used in a number of Western countries—so that central-government revenues grow along with the economy.

The implementation of these tax and fiscal reforms, coupled with the construction of a separate tax administration for the central government, quickly raised the central government's share of budgetary revenue— relative to that of the provinces—to 55.7 percent in 1994, up 33.7 percentage points from a year earlier. It remained at 52.4 percent in 2001. At the same time, total government budgetary revenue as a percentage of GDP has also recovered substantially, rising from a low of 10.7 percent in 1995 to 17.1 percent in 2001. ⁴ Whereas much of the increased central revenue finds its way back to the provinces as rebates and transfer payments, the central government's effective control over the revenue stream has gotten much stronger—a fact that has undergirded the Chinese government's fiscal stimulus program in recent years and made possible major increases...