This paper examines the historical evolution of China ‘s rural taxationsystem and provides an initial assessment of the ongoing rural tax reform.It is argued that the issue of rural taxation and local governance inChina is one typical challenge arising from the inherent tension betweenan increasingly liberalized economic system and a still centralized politicalsystem.Though the rural tax reform has helped to reduce farmers’taxburden in the short term,the establishment of an effective local governanceregime requires coordinated reforms to downsize local bureaucracy by providingsocial security for laid-off cadres ,to strengthen local accountabilityby granting higher local formal tax autonomy,and to promote meaningfulparticipation by expanding local democracy.

  1 Introduction

  The market-oriented reforms launched in 1978have changed the economiclandscape of China and have improved the dynamism of both the rural andurban sectors.In the past 27years ,China has transformed itself froma centrally planned economy to an emerging market economy whilst achievingan average GDP growth rate of more than 9percent (Lin et al.2003)。Market-oriented reform also dramatically reshaped China ‘s countryside.During the early 1980s,agricultural productivity rose steadily withthe introduction of the Household Responsibility System (HRS )。Ruralindustrialization also took off rapidly in the second half of the1980sand continued to grow fast in the early half of the 1990s as town andvillage enterprises (TVEs)evolved quickly to meet a pent-up demandfor consumer goods and take advantage of a pool of cheap rural labor.

  However ,the transitional path China has been taking so far is notwithout problems.One of the most serious challenges is the ever-growingspatial inequality that disadvantages the nation‘s vast countryside.Though agricultural growth and rural industries expansion in the 1980ssignificantly raised farmers’income,urban-rural income disparity ,having dropped from a ratio of 2.6in 1978to 1.8in 1984,bounced backto a historical high of 3.2by 2005(see Figure 1)。

  

  Within rural areas,spatial disparity is also rising steadily.Economicgrowth has been much greater in coastal regions that are able to industrializefaster.However ,the more agriculture-dependent inland areas witnessedsomething close to stagnation in the second half of the 1990s.Accompanyingthe growth slowdown in these regions was a flood of angry public protestspowered by farmers‘frustrations arising partly from excessive tax burdens.In China’s major grain-producing provinces such as Anhui ,Hubei,Hunanand Sichuan ,the tax rates on the poorest farmers sometimes surpassed30percent of their incomes (Chen,2003)。Under some extreme circumstances,farmers opted to move to cities on a large scale leaving their land fallow,because they could not afford the heavy taxes (Berstein and Lu ,2000)。

  To address the bitter complaints from farmers about excessive taxburdens ,the central government initiated a series of governance reformsin recent years.The government under the leadership of President Hu Jingtaoand Premier Wen Jiabao started removing all local informal fee chargesand formal agricultural taxes on farmers when they took office in 2003.The fee and tax have been completely abolished at the beginning of 2006.Local bureaucracy streamlining was also initiated in the same period todownsize local government and reduce expenditure on personnel.Under themost recent move to construct a “New Socialist Countryside ,”the centralgovernment is planning to channel more transfers to the countryside toimprove the development of rural infrastructure and the provision of publicservices.

  This paper examines the evolution of China‘s rural tax regime andprovides an early assessment of the government’s rural policy initiativesthrough the first half of 2006.The objective is to provide an analyticalframework for investigating local governance issues during economic transitionand gain a better understanding of China‘s overall transition process.Compared with most other transition economies ,many economists considerChina to have adopted an unconventional reform approach in embracing“gradualism.”The experimental approach of“Crossing the River by Gropingfor Stones”has led to rapid economic growth,but it also complicateseconomic transition.Incomplete institutional changes frequently failedto resolve problems inherited from the plan period,even as they frequentlygenerated new challenges.In this paper ,we argue that the issues ofrural taxation and local governance in China are typical of the challengesthat arise from the inherent tension between an increasingly decentralizedand liberalized economic system and a still centralized political system.Therefore ,a full and smooth transition warrants more thorough,bettercoordinated governance reforms.

  The rest of the paper is structured as follows.Part 2describes theevolution of China‘s rural tax system since the plan period.Based ona newly available data set that covers periods both before and after therural tax reform,Part 3evaluates the impacts of the reform on farmers’tax burdens.Relating the ongoing rural tax and local governance reformsto China‘s overall transition process,Part 4provides an analyticalframework for China ’s local governance regime and pinpoints the remainingchallenges.Part 5concludes.

  2.The evolution of China ‘s rural tax system

  2.1 Plan Period :agricultural taxation through price scissors

  A formal state agricultural tax was present in the People ‘s Republicof China as early as the 1950s.The national average rate of this taxwas set then at 15.5percent of a state-defined tax base that was fixedfor several decades.In the 1950s and 1960s the tax base was on averagea third lower than the national grain output.Therefore ,the actualagricultural tax rate was around 10percent of grain output in China’s first and second“Five-year Plan”periods (1953-57and 1958-62)。As grain output grew in the 1960s and the 1970s ,the effective ratedeclined to 6and 5percent respectively in the third and fourth“Five-yearPlan periods”(1966-1970and 1970-1974)。Judged by these numbers,the formal agricultural tax was not very high during the command periodand even declined from the 1950s to the 1970s.

  However ,farmers were taxed much more heavily than the state agriculturaltax statistics suggest.By controlling the distribution of food and beingthe main or only supplier of such vital agricultural inputs as fertilizer,pesticides,water and electricity,during the plan period the Chinesestate was able to tax agriculture implicitly through the price scissors,increasing the prices of agricultural inputs and depressing the pricesof agricultural outputs [1]As Lin et al(2003)have argued,the choiceof a heavy-industry-oriented development strategy in China‘s plan periodcompelled the state to extract resources from agriculture through pricedistortions in order to subsidize the priority sectors.To facilitatesuch taxation ,production brigades and people ’s communes were setup in rural areas and a highly controlled allocation system of major agriculturalinputs and outputs was established.Compulsory procurement quotas wereimposed on farmers and farmers were entitled only to residual grain afterstate procurement.As a tax in kind ,the state agricultural tax wasalso collected via the mandatory procurement system.Between 1953and1978,the implicit taxation through price distortions was as high asCNY 280billion ,17percent of total agricultural output in the sameperiod.This greatly exceeds the formal state agricultural tax(CNY 89.8billion )in the period(Cui ,1988,Yan,1988)。

  Besides the formal agricultural tax and the implicit tax collectedvia the price scissors,farmers faced further levies imposed by localcommunes and production brigades.Before farmers received their incomesfrom rural collectives,the brigades and communes deducted their collectiveaccumulation fund ,welfare fund and cadre compensation.Only thereafterdid team members receive part of their work-points part in grain and partin cash (Lin ,1992)。Therefore,in the plan period the formal agriculturaltax was automatically collected through a mandatory procurement systemin which farmers were required to sell most of their agricultural outputto the state.Because rural collectives were able to control income distributionamong farmers through the work-point system ,local levies by communesand production brigades were also collected before farmers were paid forstate-procured grain(Lardy ,1983,Rozelle,1996)。

  2.2 The 1980s and early 1990s :gradual changes in agricultural taxinstruments

  The agricultural reforms since the late 1970s not only raised agriculturalproductivity dramatically ,but also gradually reshaped the way agriculturewas taxed.In the late 1970s,reform in the agricultural sector was mainlycharacterized by de-collectivization.The Household Responsibility System(HRS )adopted since then furnished individual rural households withincentives by making them the residual claimants to farming returns oncethey fulfill the state grain quota and agricultural taxes and fees(Lin,1992,Debraw e t al,2004)。In the early 1980s ,the mandatory grainquota system was abolished and replaced by grain procurement contractsin which every rural household was required to sell a certain amount ofits grain output at state-set procurement prices.With rare exceptions,the market prices exceed the state procurement prices and farmers thereaftercould market their surplus produce(Lin 1992)。This price margin enabledthe state grain sector,as the agent of the state,to continue tax agricultureimplicitly.

  However ,the introduction of the HRS deprived local governmentsand village community organizations of their power to distribute incomewithin villages.To collect revenue for townships and village collectives,the government introduced two major categories of fees,i.e.,the so-called“five township-pooling funds ”to township governments to provide basicpublic goods such as education,public security,law and order,andcivil service ,and carry out the state mandates of family planning andgrain procurement ,and the“three village levies”to village communityorganizations to provide for collective capital accumulation,collectivewelfare funds and cadres‘salaries.

  Beside the two major fee categories permitted by the state,townshipsand villages also collected revenue implicitly by adding a margin forhousehold grain procurement above the state quota.[2]Adding a marginover the state procurement quota would contribute to local revenue aslocal officials could exploit the price margin between the market pricefor grain and the state procurement price.[3]In practice ,farmers usuallyhad no way to know if there was such a margin and/or how large it was.In many places,implicit taxes on such economic crops as cotton,rapeseed,jute,hemp ,and tobacco;sideline products such as cocoons and pigs;and agricultural inputs such as fertilizers and pesticides were alsocollected by local governments through their control of the transactionchannels and prices.Under the state grain procurement system ,localgovernments had every reason to assert the necessity of regulating thewhole agricultural production structure in order to fulfill their stategrain quotas.In practice ,many local officials dictated farmers‘specificfarming operations.They not only required a specified share of the totalarable land be allocated to grain production,but also frequently mandatedthat farmers plant certain cash crops and sell to them at depressed prices.

  Therefore ,as in the plan period,the continued(though declining)existence of state grain procurement greatly facilitated the impositionof the agricultural tax and various local informal fees.Before farmersobtained the state payment for procured grain sold to the state grainsector,township governments and village community organizations ,withcooperation from the state grain sector ,deducted all the taxes andfees.Farmers were then paid the residual.Because state grain quotaswere still relatively large ,only in rare case was there nothing leftwhen farmers were required to pay more,either in cash or in kind(Bernsteinand Lu,2003)。Given that every rural household was allocated someland under the HRS,in practice both the agricultural tax and most localfees were mainly levied on land allocation,while some other fees werelevied on household members or laborers.Since the land is allocated largelyaccording to family size and labor force,agricultural taxes and feesin rural China can be largely viewed as land-based tax burdens.[4]Withthe introduction of HRS ,China‘s countryside witnessed a gradual transitionin which rural taxation began to change from the dominant tax instrumentof the price scissors to a combination of the pricing instrument and land-basedagricultural taxation with the latter becoming increasingly important.

  However ,rural taxation was still not a prominent issue in the 1980sand the early 1990s as some share of agricultural taxes and fees was collectedthrough the implicit instrument of the price scissors ,and almost allagricultural taxes and local levies could be deducted beforehand underthe remaining grain procurement arrangements.Neither was the issue oflocal illegal levies a very serious one in this period.Even when suchlevies existed,they were at least not very explicit since they wereeither deducted prior to the payment for grain procurement deliveries ,or through the over-procurement from farmers and the control of majoragricultural input distribution by local governments.

  2.3 The 1990s :the emergence of excessive informal taxation in agriculturalregions

  After the introduction of the HRS in the early 1980s,China‘s agriculturalsector in the witnessed a faster market liberalization that began in thelate 1980s continued through the 1990s(Weersink and Rozelle,1997)。The issue of excessive rural taxation emerged in the 1990s when many ruralareas (especially those in agriculture-based regions )experienced asurge of diverse,local illegal fundraising.These fees were imposedon farmers,without explicit government regulations or legislation ,for anywhere between a few dozen and more than one hundred items,rangingfrom charges for road and school construction and other local improvementprojects,to purchase of insurance ,to charges for marriage certificatesor housing construction ,to prohibitive prices for electricity and tapwater ,and so on.For example ,in some regions marriage certificatescost CNY 600,a quarter of the farmers ’average annual net income.Inmany localities ,villages were forced to purchase various newspapersor periodicals(State Planning Commission ,2000)。In the 1990s inrural China ,a large share of the village and township government expenditurecame from such informal charges.These fees did not enter into formalbudgets but constituted an important share of local extra-budgetary revenuefor township governments and village collectives.

  The emergence of excessive rural taxation and the surge of informalfee charges did not occur uniformly throughout China.It is a regional,though still relatively broad-based ,phenomenon that mainly involvedinland agriculture-based areas in the second half of the 1990s.Usinga 6000household panel data set from 1986to 1999collected by the Ministryof Agriculture,we calculate rural tax burdens as a share of farmers‘income for 10provinces (both developed and under-developed)acrossChina in 1986,1993and 1999.As shown in Table 1,on average ,therewas no significant increase in rural direct taxes as a share of ruralnet income in the period covered.In most provinces ,total tax burdenson rural households (both formal taxes and informal fee charges)grewonly by 1-4percentage points as a share of rural net incomes from 1986to 1999.In some more developed coastal provinces such as Guangdong andZhejiang,there was even some decline of tax rates in the period.

  

  However ,further investigation shows that rural taxation becamean acute problem because of a fast increase in rural income disparityafter the 1990s and the uneven tax and fee distribution among differentincome groups.Still using the same data from the Ministry of Agriculture,we find that rural income inequality in the 10provinces increased significantlyfrom 1986to 1999;over the same period the incidence of rural taxationamong different income groups did not change correspondingly.Figure 1and Figure 2show the rural tax burdens by income groups for 1986and1999,respectively.If we include all formal tax and informal fees paidby rural households ,the tax burden for the lowest-income group in 1986(annual per capita income less than CNY 200)was 10.5percent of netincome,while that for the highest-income group(annual per capita incomelarger than CNY 4000)was 9.5percent.However ,in 1999,the tax burdensfor the lowest-income group (with an annual per capita income less thanCNY 400)climbed to as high as 25.6percent of net income ,while thatof the highest-income group (with annual income larger than CNY 8000)was only 4.4percent.Therefore ,the increasingly regressive natureof rural taxes and the heavier burdens on poor farmers,rather than theincrease of average rural tax rate,is at the heart of the rural taxationissue in China.

  The reason that the poor farmers pay much higher shares of their incomesfor taxes and relates to the nature of the rural tax system in China‘s economic transition.Taxes on the Chinese rural households are predominantlyagricultural taxes levied on arable land.However ,since the early 1990s,an increasing share of rural income has derived from non-agriculturalsources ,such as township and village enterprises and migrants remittances,which have not been subject to state tax administration.This is especiallytrue for farmers in more developed regions.Since the poor usually comprisethe group of people with the lowest proportion of income from non-agriculturalsources ,they are more vulnerable to rural direct taxes (Tao and Liu,2005)。Therefore,rural taxation became an increasingly serious issueessentially because with rising rural income inequality the rural taxsystem failed to respond accordingly and taxes fell disproportionallyon the shoulders of the relatively poor farmers dependent on agriculture.As a result ,though the state formal tax,i.e.the agricultural tax,was ,in effect,only around 2-3percent of farmers ’average incomesacross the nation and 4-5percent in less developed agricultural regions,informal fees in many less developed regions are much higher,usuallyreaching 20-30percent of average incomes for the poor farmers.

  

  As a result ,though in effective tax rates the state formal tax ,i.e.the agricultural tax was on average only around 2-3%of farmers‘income across the nation and 4-5percent in less developed agriculturalregions ,informal fees in many less developed regions are much higher,usually reaching 20-30percent for the poor farmers.