Cover Story: China Plans Fiscal Overhaul to Fix Crisis in Local Government Finance

By Cheng Siwei and Denise Jia

In the wake of China’s slow post-pandemic economic recovery and local governments’ shrinking revenue from land sales amid a prolonged real estate slump, the country is launching an overhaul of its fiscal system to redefine central-local financial relations.

The reform push, outlined at the Communist Party’s Third Plenary Session in July, calls for a series of tax and budgetary changes to be completed by 2029. Beijing aims to expand local governments’ financial autonomy, adjust tax-sharing mechanisms and increase the central government’s spending share. The changes build on past efforts, including the landmark 1994 tax overhaul that strengthened central control. But current economic conditions are far more challenging, with local governments burdened by excessive spending obligations and dwindling income streams. Despite growing central transfer payments—now exceeding Beijing’s own fiscal revenue—local governments have little discretion over these funds, exacerbating financial stress. Some regions have even struggled to meet basic expenses like civil servant salaries.

Experts said the urgency for reform is widely acknowledged, but the path forward is unclear. The biggest challenge is how to balance central oversight with local financial independence. Questions remain over whether to raise taxes, redistribute revenue or shift more spending responsibilities to Beijing. Adjustments to the tax-sharing system, particularly for value-added and consumption taxes, are also under debate.

Unlike the 1994 reforms, which followed years of consensus-building, this round is still in flux. Deeper discussions are needed before action, said Lv Bingyang, a fiscal policy expert at Renmin University. With China’s economy facing slower growth and rising debt risks, the stakes for getting it right are higher than ever.

Financial crunch

China’s local governments are facing a tightening financial squeeze, with shrinking revenue and rising expenditures fueling urgent calls for fiscal reform.

In recent years, signs of distress have become increasingly visible, from halted subway and bus services to delayed civil servant salaries. The root of the crisis goes beyond the economic shock of the pandemic and the slump in property prices, experts say—it stems from structural imbalances in how financial responsibilities are distributed between Beijing and local governments.

According to Caixin’s calculation, China’s broad fiscal revenue—combining general public budget income and government fund revenue from land sales—fell 2% to 28.2 trillion yuan ($3.9 trillion) in 2024. In 2019, before the pandemic, total revenue increased 6.2%. While Covid-related spending created a temporary budget gap of roughly 4 trillion yuan, according to estimates by Bai Chongen, dean of the School of Economics and Management at Tsinghua University, financial strain persisted even before the outbreak.

The real estate slump delivered a major blow. Land sales, a key revenue source for local governments for decades, have plummeted for three straight years, declining 23.1% in 2022, 13.3% in 2023 and 16% in 2024—resulting in a cumulative loss of revenue exceeding 3 trillion yuan. Even when land sales were booming prior to the pandemic, local finances were under stress.

At the heart of the problem is an outdated fiscal framework. The 1994 tax-sharing reform significantly increased the central government’s revenue share but left expenditure responsibilities largely with local governments. While the reform boosted Beijing’s control—raising its share of fiscal revenue from 22% in 1993 to 55.7% in 1994, later stabilizing at around 45%—it did not clarify which level of government should bear the cost of public services.

In 2016, Beijing attempted to reform central-local fiscal responsibilities, outlining plans for education, healthcare, environmental protection and other public services. However, the introduction of “shared fiscal responsibilities” left room for ambiguity, with local governments still shouldering much of the financial burden.

This imbalance is evident not only in public services but also in macroeconomic policy. Local governments have increasingly taken on financial risks, with special-purpose bonds—a key tool for economic stimulus—expanding rapidly. As a result, local fiscal expenditures have surged, rising from around 70% of total government spending before the 1994 reform to 85.7% in 2024.

Former Finance Minister Lou Jiwei, speaking at the Caixin-hosted 2024 Asia Vision Forum in September, warned that the push to “moderately strengthen central fiscal responsibilities” remains unfinished. He argued that fiscal authority must come with management control, criticizing the current system where higher-level governments issue mandates while leaving local governments with the financial burden. “The lower you go, the greater the responsibility and the tighter the finances,” Lou said.

China’s fiscal spending patterns also have room to improve. Research by the Chinese Academy of Social Sciences suggests that China allocates a disproportionately large share of government spending to infrastructure and economic development—more than three times the level for OECD member countries. Lou called for reducing these expenditures and allowing market forces to play a greater role in resource allocation.

Meanwhile, rising social security costs are further straining government budgets. With China’s baby boomers now reaching retirement age, pension and welfare expenditures are soaring. Fiscal subsidies to social security funds have increased annually, reaching 2.69 trillion yuan in 2024, with a planned budget of 2.91 trillion yuan for 2025.

With mounting debt, slowing economic growth and an outdated fiscal structure, experts warn that without substantial reform, local governments may face a more severe financial crisis in the years ahead.

Redefine central-local fiscal responsibilities

China’s latest fiscal reforms seek to address a longstanding problem: the mismatch between local government spending responsibilities and financial resources. Experts such as Lv at Renmin University argue that the key lies in clarifying the division of administrative responsibilities and spending obligations, adjusting revenue distribution between central and local governments, and improving the transfer payment system.

The starting point, Lv said, should be determining the scope of government responsibilities before allocating financial resources, with transfer payments bridging any gaps. “This requires top-down planning,” he said. “Deciding what falls under central or local authority isn’t just a fiscal issue but a broader governance challenge.”

The 2013 Third Plenary Session of the 18th Communist Party Congress laid the groundwork for this reform, mandating stronger central oversight in national security, defense, diplomacy and market regulation, while assigning regional public services to local governments. The latest blueprint, unveiled at the 2024 Third Plenary Session, proposes increasing central government responsibilities, reducing reliance on local governments for implementing national programs, and curbing unfunded mandates that require local co-financing.

Former Finance Minister Lou Jiwei has long emphasized the difficulties in restructuring fiscal responsibilities, calling it a core issue of governance. “It’s challenging because it affects the fundamental structure of government and high-level legal frameworks,” he said.

One proposal under discussion involves a hybrid approach of centralizing key responsibilities while decentralizing others. Lv suggested granting county-level governments greater autonomy in managing local education, healthcare and market supervision—services where local knowledge is crucial. At the same time, Beijing should take on more national responsibilities and fund them through larger-scale fiscal transfers, ensuring balanced regional development.

China’s current system includes a large number of shared responsibilities between central and local governments, with Beijing often delegating tasks to lower levels through earmarked transfers. This arrangement has led to inefficiencies. Liu Shangxi, former head of the Chinese Academy of Fiscal Sciences, argued that local governments often lack the administrative and financial capacity to handle these responsibilities effectively, leading to waste, project duplication and misallocated funds. “The issue isn’t just that local governments aren’t trying hard enough—their capacity is simply limited,” he said. “If responsibilities keep shifting downward, no amount of transfer payments will fix the problem. It’s like trying to hitch a small horse to pull a heavy cart.”

Liu suggested a “matching principle” approach: responsibilities should align with the administrative capacity of each level of government. Local governments should manage only those functions within their capacity, while complex, cross-regional and high-stakes responsibilities should be reassigned to higher levels. He proposed raising the share of central government spending from the current 10% to 40% of total public expenditures, shifting investment and infrastructure planning from counties to cities.

Boost local revenue

As China restructures its fiscal system, policymakers are grappling with how to expand the financial autonomy of local governments. While much of the reform discussion has focused on rebalancing fiscal responsibilities, experts argue that the more immediate priority is adjusting revenue distribution between central and local governments.

The latest reform blueprint signals a shift in fiscal policy by calling for expanded local tax authority and revenue sources.

One proposal would allow local governments to set tax rates within a regulated range by consolidating the urban maintenance and construction tax and local education surcharge into a single local surtax. However, experts such as Zhu Qing, a professor of finance at Renmin University of China, warn that many local governments may keep rates low to attract businesses, limiting its impact on revenue.

A more controversial measure involves shifting consumption tax collection from the central government to local governments. The tax, currently a major central revenue source, is levied on tobacco, alcohol, fuel and automobiles. Critics argue that local control could lead to unintended consequences, such as authorities promoting harmful consumption of tobacco and alcohol for financial gain. There are also concerns about enforcement costs, tax evasion and regional disputes over revenue distribution.

Despite these challenges, the government is accelerating plans to implement the tax shift. Following the release of the 2025 Government Work Report, a senior State Council official confirmed that authorities are committed to expediting the reform this year, citing its potential to ease financial pressure on manufacturers and boost local economies.

Debate also continues over whether to adjust China’s value-added tax (VAT), the country’s largest revenue source, which is currently split evenly between central and local governments. Some experts advocate increasing the local share, while others, including former Finance Minister Lou, argue that the VAT should remain a central tax to preserve a unified market. Lou suggested returning to a 75-25 central-local split or fully centralizing VAT while redistributing part of the revenue based on regional consumption.

Another option being considered is redistributing corporate and personal income tax revenue, which in 2024 generated a combined 5.54 trillion yuan. Some economists suggest allocating a greater share to local governments rather than altering VAT distribution, which could disrupt national economic coordination.

Compared to raising corporate income tax, which would significantly impact business investment and operations, adjusting VAT is more neutral and would cause the least economic disruption, Zhu told Caixin. Its biggest drawback is that higher VAT rates can drive up prices, disproportionately affecting low-income groups, he said.

While increasing local revenue is a clear priority, experts caution that hasty changes could spark tax competition among regions, eroding market stability. Policymakers must weigh the risks of fiscal decentralization against the need to sustain local governments.

Better incentives

As China embarks on a new round of fiscal reform, experts warn that one of the biggest challenges is addressing the erosion of fiscal discipline and the weakening incentive constraints that have emerged since the 1994 tax reform.

Local governments have fallen into a recurring cycle of debt expansion and partial bailouts. Despite Beijing’s efforts to curb reckless borrowing, implicit local government debt continues to grow, raising concerns about long-term fiscal sustainability.

The 1994 reform established a system in which the central and local governments shared tax revenue, with local governments incentivized to attract investment and boost tax collection. At the same time, strict budget rules barred local governments from running deficits or issuing debt. However, a 2014 revision to the Budget Law lifted the debt ban, allowing local governments to raise funds through bond issuance—effectively opening the door to more borrowing.

A key paradox in the current system is that despite local governments receiving substantial transfers from the central government, many still struggle to meet financial obligations. The root cause, experts argue, is that excessive transfer payments have weakened fiscal discipline.

In 2020, for the first time, Beijing’s transfer payments to local governments exceeded the central government’s tax revenue. By 2023, these transfers reached 10.29 trillion yuan, surpassing the central government’s total fiscal revenue of 9.96 trillion yuan. This means Beijing not only redistributed all its tax revenue but also tapped into non-tax income, reserves and debt to fund local governments.

Lv at Renmin University warned that the current transfer system discourages high-performing regions by allocating fewer funds to wealthier regions. Earmarked transfers, which require local governments to seek approval for specific projects, have further led to inefficiencies, with local officials often focusing on securing funds rather than optimizing spending.

Beyond transfer payments, the most alarming trend is the continued expansion of implicit local government debt, despite repeated efforts to contain it. Many local governments, pressured by GDP-driven performance metrics and eager to fund infrastructure projects, have bypassed budget constraints by borrowing through local government financing vehicles (LGFVs).

Despite efforts to crack down on off-the-books borrowing—such as a 2015 regulation restricting local governments from raising funds through non-official channels—the problem has persisted. China’s local debt crisis escalated after the 2008 global financial crisis and has been worsening ever since.

Authorities have responded with multiple rounds of debt restructuring, including major audits in 2018 and 2023 to assess hidden liabilities. The latest move, approved in November, authorized a 10 trillion yuan debt swap, allowing local governments to replace off-balance-sheet debt with official government bonds. While this does not constitute a direct bailout, it reduces short-term financial strain by lowering interest payments on outstanding debt.

China’s strategy has been to “buy time” by rolling over debt while hoping for economic recovery and moderate inflation to ease fiscal pressures. However, experts caution that without deeper reform, debt accumulation will continue, requiring repeated interventions.

Former central bank governor Zhou Xiaochuan suggested that China must go beyond debt restructuring and introduce a comprehensive reform package that strengthens fiscal incentives. This includes clarifying the role of different levels of government, ensuring spending responsibilities align with financial resources, and reducing excessive reliance on central transfers. The challenge will be finding a balance between preventing reckless borrowing while ensuring local governments have enough financial flexibility to maintain economic stability.

Legal framework

The reform requires a clearer legal framework for central-local financial relations. Zhou emphasized that fiscal reform isn’t a binary choice but a spectrum of policy options. He highlighted the trade-offs in tax revenue distribution: allowing local governments to share more tax revenue could impact the efficiency of China’s unified national market, while limiting local access to funds could weaken their financial stability and fiscal discipline.

A fundamental principle should be defining the boundaries of government functions through the rule of law, and within those boundaries, local governments should be allowed to explore solutions, Zhou said.

Liu, former head of the Chinese Academy of Fiscal Sciences, pointed to persistent uncertainty in fiscal policy, which complicates financial planning for local governments. Shifting responsibilities and flexible policymaking make it difficult for local authorities to predict expenditures, while revenue-sharing between central and local governments remains in flux, Liu said.

Recent property market adjustments have worsened the situation, slashing land sale revenue that many local governments rely on—some counties have seen that income vanish entirely. In response, local governments have resorted to increased borrowing and creative revenue generation, sometimes through excessive fines and fees, which have hurt the business environment.

China’s non-tax revenue surged to 4.47 trillion yuan in 2024, accounting for 20.3% of the general public budget—the highest proportion since the 2008 financial crisis. While much of this growth came from leveraging state-owned assets, fines and confiscations exceeded 10% of non-tax revenue in recent years. Some regions have drawn criticism for aggressive law enforcement tactics, such as issuing excessive fines in unrelated jurisdictions.

In response, this year’s Government Work Report explicitly called for a crackdown on profit-driven law enforcement, aligning with growing concerns over financial misconduct at the local level.

Shi Zhengwen, professor at China University of Political Science and Law, said reforms should prioritize legal, standardized and transparent fiscal governance. A stable and predictable financial system, he argued, would encourage local governments to focus on long-term economic growth rather than short-term revenue schemes.

Shi also urged China to accelerate discussions on a Fiscal Law or Basic Fiscal Law to formalize financial relations between central and local governments—an idea that has circulated among policymakers for years.

Contact reporter Denise Jia (huijuanjia@caixin.com)

caixinglobal.com is the English-language online news portal of Chinese financial and business news media group Caixin. Global Neighbours is authorized to reprint this article.

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