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More than a year into Chinese President Xi Jinping’s tenure, Beijing’s economic mantra has remained remarkably consistent and clear: China’s growth model is broken and needs to change.
The Chinese Communist Party enshrined that pledge in its economic reform agenda at last year’s Third Plenum, and then reaffirmed it in March at the annual session of China’s legislature, the National People’s Congress. But such clarity of purpose cannot obscure the fact that the actual execution of economic reforms will not succeed unless the Chinese state reshapes itself in far-reaching ways.
For one thing, as we argued last December, the scope of state power in China needs to be rolled back. The plenum’s most important policy decision was to announce that the market would now play a “decisive” role in allocating resources. If that is to be true, then many of the functions that the state currently performs, such as setting prices, must instead be left to the market.
Yet even as China needs to curtail certain state powers, it still requires a resilient and effective state -- to enforce rules and standards, provide public goods, and perform a vast array of administrative functions. And it needs those tasks to be handled at the right administrative level. Beijing too often does things that would be better left to provinces and municipalities. Local governments, for their part, frequently take on responsibilities that Beijing could handle more effectively. This has led to several significant problems: unfunded mandates, confusion about who is in charge, and policy paralysis.
Put bluntly, China needs a new “federalism” -- a realignment of central and local government power -- that can adapt to the conditions of a rapidly changing economy. And that is precisely what is under debate in China today.
STATE OF CHANGE
What will this emerging Chinese federalism look like? It most certainly will not turn provinces and cities into autonomous actors vested with the sort of independent decision-making power that states have in the U.S. and Indian systems. Chinese-style federalism will instead decentralize some powers and recentralize others, rebalancing governing responsibilities in a more rational way.
China is no stranger to the challenges of federalism. But its leaders have long preferred to prohibit a true devolution of authority for fear of empowering local warlords or jeopardizing the country’s hard-won unity. Indeed, the searing historical experiences of the country’s dynastic and modern leaders continue to shape the Chinese view of governance in the contemporary era. Especially in the nineteenth and twentieth centuries, the Chinese state repeatedly fractured into autonomous fiefdoms or powerful regional viceroyalties, only to be reunified under new, but sometimes weak, central authorities. As a result, both the Nationalists and the Communists tended to prefer a strong centralized state that circumscribed the authority of the provinces.
Deng Xiaoping’s early reforms in the late 1980s included several experiments with economic decentralization. One example of this approach was the creation of special economic zones in coastal cities such as Shenzhen, which were allowed to incubate market reforms and experiment with private enterprise. Once these experiments proved workable, the top leadership allowed them to be scaled up and replicated nationally.
The provinces, in turn, competed fiercely based on the logic of China’s socialist political economy. While pledging fealty to the party’s policy mandates, provincial authorities poured money into local efforts to attract businesses, spur investment, and sustain growth, sometimes at the expense of national standards or consistency across provinces and cities. The central government maintained control and laid down rules and guidelines. But when Beijing pursued competing priorities -- promoting environmental sustainability at the expense of growth, for example -- localities frequently ignored these mandates.
That kind of haphazard decentralization now stands in the way of Beijing’s new reform priorities. The lack of alignment between central and local goals has become endemic and unsustainable. Ultimately, Xi’s ambitious reform agenda requires an overhaul of how Beijing and the provinces share costs, finance projects, raise funds, regulate the economy, and incentivize local and municipal governments to carry out the reforms.
Take, for example, the leadership’s sweeping commitment to urbanization, through which it aims to boost productivity, personal incomes, and domestic consumption. Beijing has pledged to move some 300 million people into cities over the next two decades. And although that reform looks impressive on paper, it requires increased spending on public goods, such as health care, with much of the cost passed back onto local governments that lack broad authority to raise revenue through taxes or bonds.
TAX AND SPEND
For these reasons, Xi’s reform efforts may yet die in the provinces if Beijing does not rejigger Chinese federalism to reflect the practical demands of local governance. Specifically, three sets of powers -- fiscal power, administrative-approval power, and enforcement power -- need to be recalibrated in ways that rebalance authority among different levels of government to increase the chances that market reforms succeed and endure.
China needs to overhaul a fiscal system that is beset by inefficiencies and contradictions. At the bottom, localities theoretically adhere to Beijing’s mandates to provide services such as health care, but they often lack sufficient revenue to do so. At the top, meanwhile, Beijing worries that dispensing more tax and bond-raising power will fuel corruption and lead to the accumulation of more local debt, which is already pressuring China’s fiscal system to the tune of some 18 trillion yuan ($3 trillion).
China last overhauled its tax system in 1994, when Beijing moved to claw back a larger share of revenue and strengthen the central government. During the 1980s, the central government’s revenue had drastically declined, in large part because localities were overspending without sending enough tax revenue back to Beijing. In 1994, the central government introduced a value-added tax (VAT), eliminated several other local taxes, and essentially centralized the entire tax collection process.
Over the next two decades, Beijing fattened its coffers -- the central government netted about $1 trillion in 2013, for example -- but at the expense of local budgets. And this happened at a time of increasing public demand for more government services and better local infrastructure. As a result, provincial governments came to rely on other sources of income -- namely, land seizures and sales to property developers as well as shadowy local financing vehicles and other off-the-books revenue sources.
Centralizing the fiscal system seemed to make sense in 1994, but the negative consequences are now apparent: as local governments have come to rely on alternative revenue schemes, China has seen a wasteful spree of infrastructure-intensive growth and housing bubbles, which has further contributed to the rapid accumulation of destabilizing local debt.
Such spending pressures will not let up anytime soon. Indeed, they will probably grow worse as China’s urbanization and reform efforts progress. Meeting Xi’s aggressive urbanization goals, for example, will require more spending on social services for millions of new city dwellers, in addition to huge investments in new infrastructure. Local governments will need more revenue, and will likely continue to exchange land for funds.
For its larger reform project to succeed, then, Beijing must adapt its fiscal policies. This will require a further centralization of revenue authority, even as more sources of local revenue are created. Beijing will ramp up existing taxes or create new taxes that it collects directly, only to redistribute the funds back to the local level. That way, Beijing can better control local-level spending -- by allocating funds to local governments on the condition that they will be spent on social services rather than apartment complexes and empty shopping malls.
And reform should devolve certain other authorities to help the system strike a proper balance between levels of government. For instance, Beijing will almost certainly implement its long-delayed effort to expand property taxes, thus assuring more local revenue tied directly to home ownership. Imposing a local property tax will also increase transparency by disclosing the assets of those who are taxed. Other additional revenue streams could come in the form of new local tax categories, since many local taxes are currently being wiped out by the expansion of the national VAT.
Making the market “decisive” will require that the state retreat from some economic activities altogether. And one way to do that is to change the state’s function from a highly interventionist micromanager to an umpire-like regulator. Beijing has already begun this process, through Premier Li Keqiang’s continuing effort to eliminate hundreds of central administrative approvals. Cutting through China’s mind-boggling maze of red tape comports with Li’s oft-repeated mantra to “let the market do what it does best.”
Administrative federalism needs to achieve two principal goals: first, to grant localities more authority to approve investment projects and licenses for private businesses that make sense for the local economy; and second, to demonstrate at least some effort to reduce central bureaucratic meddling in local projects.
Fundamentally, Beijing’s new emphasis on administrative federalism reflects a recognition that the central government needs to become more of a macro regulator than an active meddler in how business and investment are conducted, especially in the private sector, which is now the principal source of job creation in China.
A proper balance among levels of government is also required for Beijing to achieve its other reform goals. Xi has pledged, for example, to balance breakneck economic growth with its social and environmental costs. But although growth requires decentralization to free the market from the shackles of uppity bureaucrats in Beijing, local governments frequently ignore environmental regulations and standards, yielding severe pollution and toxic conditions. To ensure that localities do not simply flout air, water, and food safety standards, Beijing needs more consistent and predictable enforcement.
One way to do all of this would be to further reform the system used to evaluate and promote local politicians, which is currently regulated by the central government. Beijing is attempting to realign incentives by holding provincial and local cadres accountable for not just growth but also social services and environmental protection, as part of their job evaluations.
Another potential solution under debate is to modestly empower China’s court system to act as a quasi-independent enforcer of certain regulations and policies. This would surely be difficult in a system controlled by a single party that lacks independent judicial checks. It would require eliminating all political interference and corruption in local courts, and creating a legion of well-trained legal professionals. But legal checks would be a more sustainable means of shaping incentives than politicized anti-corruption campaigns that scare localities and officials into compliance.
AN AGE OF REFORM?
The opening line of the classic Chinese novel Romance of the Three Kingdoms offers a useful explanation of why China's rulers have, for centuries, feared true federalism: “The Empire, long divided, must unite; long united, must divide.” Throughout the modern era, especially against the backdrop of debilitating warlordism in the 1920s, the country’s leaders have feared that a decentralization of authority would lead to competing power centers, which would threaten the integrity of the Chinese state.
But a twenty-first-century state needs checks, balances, and a rational division of powers. And a twenty-first-century economy, especially one with a more “decisive” role for the market, requires the division of authority among multiple levels of government. A rational division of the state need not mean a fragmentation of the state.
Beijing has clearly articulated its political commitment to economic reforms. But it now needs to show the same political audacity to refigure its own role, and that of the provinces it governs, in meaningfully executing those reforms.