CSC's Zhou Junzhi: Fiscal Expenditure in the Relationship between Central and Local Governments

Abstract:

The central-local relationship contains very rich content, which can be summarized in one word, that is finance and taxation. Finance and taxation not only involve political relationships, but also economic relationships, and all central-local finance and taxation relationships can be approached from one point—the financial accounts.

The central-local finance and taxation relationship includes three levels: financial power, responsibilities, and debts. When discussing the central-local finance and taxation relationship, we cannot avoid these three levels.

As the first article in the series on central-local finance and taxation relationships, we first focus on the local expenditure relationship.

Combining the financial accounts, we provide a clear description from a quantitative perspective—what are the rules of the central-local responsibilities, that is, what are the rules of the central-local expenditure relationship in China? Where will the future central-local financial and fiscal relationship go?

I. General Budget Expenditure of Central and Local Relations: Local Expenditure Accounts for a Vast Majority.

The general budget expenditure describes three rules of the central-local responsibilities:

(1) Local expenditure accounts for an absolute majority in general budget expenditure (86% share), indicating that local areas bear the absolute expenditure responsibility. Structurally, expenditures related to people's livelihood, infrastructure, and administration are mainly borne by local areas, while the central government mainly handles defense and diplomatic expenditures.

(2) The total amount of fiscal expenditure fluctuates, mainly driven by local finances. The reason is that past infrastructure expenditures have played a countercyclical role, so the cyclical fluctuations in infrastructure expenditure drive the cyclical fluctuations in local general public expenditure.

(3) There is a huge difference in expenditure structure among local areas, with underdeveloped regions having a higher proportion of infrastructure and interest payment expenditures, while developed regions lead in technology expenditures.

II. Government Fund Expenditure in Central-Local Relations: A Key Pillar of Local Expenditure

There are three rules to grasp in government fund expenditure.

(1) Government funds are an important expenditure for local areas. The scale of government expenditure accounts for 30% of the two accounts (general public budget + government funds). Government expenditure mainly consists of land transfer-related expenditures and special bond expenditures.

(2) About 30% of land transfer expenditures are invested in infrastructure, including the "seven connections and one leveling" during land development, as well as other urban construction. Over half of the expenditure is for land acquisition and demolition compensation, forming local residents' real estate and consumption demand.

(3) The scale of land transfer fee expenditures is mainly concentrated at the county and city levels, with relatively low proportions at the provincial and municipal levels.

III. Social Insurance Fund Expenditure in Central-Local Relations

(1) In social insurance expenditures, pension and medical insurance expenditures account for over 95%, with pensions holding an absolute weight (70%) and medical expenditures rising rapidly.

(2) The feature of social insurance expenditure is nonlinear growth, which does not synchronize with GDP. As the degree of population aging deepens, the social insurance expenditure burden per unit of GDP continues to increase.

(3) The structure of social insurance expenditure is contradictory, with weak correlation between social insurance surplus capacity and inter-provincial GDP scale, and strong correlation with population structure and migration trends. Regions with high aging rates and net population outflows have relatively less social insurance fund surplus and face greater expenditure pressure

Four, There are three future trends in the relationship between central and local finances

1. The proportion of land transfer fee expenditure will decrease, leading to a contraction in the proportion of local government expenditure in the final fiscal expenditure, with a more significant decrease in county-level government expenditure.

As real estate transitions from an investment product to a consumer product era, the proportion of land transfer fee revenue and expenditure will decrease in the future, with a particularly noticeable decrease in the proportion of land transfer fee expenditure by local (especially county-level) governments.

2. Local governments are gradually transitioning from construction investment functions to livelihood security functions.

With the centralization of basic urban construction expenditure at the local level, the proportion of livelihood expenditure will continue to rise, especially in terms of medical health expenditure and social security expenditure, which are relatively low compared to other countries and will be the main direction for the expansion of livelihood expenditure in the future.

This fiscal expenditure intention has gradually been reflected in recent years, especially with a significant expansion in subsidies for social security.

3. The focus of the relationship between central and local finances is shifting from infrastructure to social security, with differentiated social security pressures at the local level and increased central coordination.

The central government will increase its coordination of social security, and since the establishment of a national coordination system in 2022, the scale of cross-provincial transfer of pension funds under national coordination has been continuously increasing. The future trends of population mobility and population structure differentiation in various regions will further evolve, leading to further differentiation in pension insurance expenditure pressures. The central government will further increase the cross-provincial transfer of the national coordination adjustment fund.

Main Text:

General Budget Expenditure between Central and Local Governments

1. Local Governments Focus on Infrastructure and Livelihood, While the Central Government Focuses on National Defense and Diplomacy

In the national general public budget, local governments bear the absolute expenditure responsibility.

In 2023, the total expenditure of the national general public budget is 27.5 trillion yuan, with local expenditure accounting for 86.1% and central expenditure accounting for 13.9%.

Structurally, a large amount of expenditure on livelihood, infrastructure, and administrative categories is mainly borne by local governments, while the central government is mainly responsible for defense and diplomatic expenditures.

According to the detailed accounts of the national financial final accounts in 2022, in the category of administrative general public services expenditure, local governments account for 92.4%.

In several livelihood expenditures such as education, social security, and health, local governments account for 96.1%, 97.7%, and 99% respectively.

In infrastructure expenditures such as energy conservation and environmental protection, urban and rural communities, agriculture, forestry, water, and transportation, local governments account for 96.7%, 100%, 98.9%, and 94.7% respectively.

Expenditures on diplomacy and national defense are mainly borne by the central government.

2. A Large Portion of Local Expenditure is in Infrastructure, and Infrastructure Expenditure Shows Periodic Expansion

The fluctuation of total fiscal expenditure is mainly driven by local finances, particularly by the cyclical expansion of expenditure in the infrastructure sector.

In terms of the structure of local fiscal expenditure, the growth rate of expenditure in infrastructure categories fluctuates significantly, especially in transportation. In some years, the growth rate of transportation expenditure can even double, showing a clear cyclical pattern. This is mainly because local infrastructure often serves as a countercyclical policy, playing a role in counter-cyclical regulation Expenditure growth in livelihood-related categories has been relatively stable, especially in social security and employment expenditure. Since 2016, the growth rate of other livelihood-related expenditures has also been stable.

(III) Underdeveloped regions have higher infrastructure interest payments, while developed regions have higher technology expenditures

In terms of infrastructure expenditure, economically developed provinces have a lower proportion of infrastructure expenditure. Provinces in the northwest, southwest, and northeast regions (Tibet, Qinghai, Ningxia, Inner Mongolia, Heilongjiang, Xinjiang, Gansu, Jilin, Yunnan) generally have a higher proportion of infrastructure expenditure as a percentage of general public budget expenditure, ranging from 30% to 40%. Developed provinces in the eastern region (Tianjin, Guangdong, Fujian, Shandong, Zhejiang) rank lower in terms of the proportion of infrastructure expenditure, ranging from 20% to 25%.

In terms of interest payments, underdeveloped provinces have a higher proportion. Guizhou, Qinghai, Liaoning, Inner Mongolia, Ningxia, Jilin, Yunnan, Guangxi have the highest proportions, while Shanghai, Beijing, Guangdong, Jiangsu, Anhui, etc., rank lower.

Developed provinces have a higher proportion of technology expenditures. Beijing, Anhui, Zhejiang, Guangdong, etc., are in the range of 5% to 7%. Whereas most underdeveloped regions are below 1%.

There are also significant differences in livelihood expenditures among provinces, but they are not directly related to the level of economic development. For example, Liaoning and Shandong both have proportions around 48%, ranking at the top, while Qinghai and Shanghai are around 37%, ranking lower, and Zhejiang, Jiangsu, Hainan, Gansu are all around 40%, ranking in the middle.

Government Fund Expenditure in Central-Local Relations

(I) Expenditure Focuses on Local Infrastructure, Real Estate, and Consumption

Government fund expenditure mainly consists of land transfer-related expenditures and special bond expenditures, mainly directed towards infrastructure, real estate, and consumption.

Looking at the detailed items of the 2022 national government fund expenditure final accounts, out of the total expenditure of 11.1 trillion, the expenditure arranged for state-owned land use rights transfer income amounts to 6.3 trillion, accounting for 57%; other government fund expenditures (mainly special bonds) amount to 3.5 trillion, accounting for 32% Land transfer income-related expenditures:

• 53% is used for land acquisition and demolition compensation, mainly forming residents' housing purchases and consumption expenditures.
• 19% is used for land development expenditures, mainly forming infrastructure expenditures, including related road, water supply, power supply, gas supply, drainage, communication, lighting, land leveling, etc.
• 11% is used for urban infrastructure expenditures, including urban roads, bridges, public green spaces, public toilets, fire facilities, etc.

Special bond-related expenditures:

• About 60% is invested in the infrastructure sector. The 11 major areas where special bonds are invested are mostly in infrastructure projects, including transportation infrastructure, energy, agriculture, forestry, water conservancy, ecological environment protection, social undertakings, urban and rural cold chain logistics infrastructure, municipal and industrial park infrastructure, national major strategic projects, affordable housing projects, new infrastructure, and new energy.

Expenditures fluctuate with land transfer income:

Compared to general public budget expenditures, government fund budget expenditures have greater volatility.

In 2010, 2013, and 2017, state-owned land transfer income increased by 97.8%, 46.7%, and 40.3% respectively, with corresponding national government fund expenditures increasing by 111%, 39%, and 30.1%.

In 2012, 2015, 2022, and 2023, state-owned land transfer income declined, and national government fund expenditures correspondingly decreased. Overall, influenced by the prosperity of the land market, expenditures fluctuate significantly.

Government expenditures mainly fall on county and municipal governments:

National government fund expenditures account for about 30% of the total expenditures of the two budgets, with a higher proportion at the local level.

The proportion of national government fund expenditures to the total expenditures of the two budgets (general public budget + government fund) is around 30%. It reached a peak of 32.5% in 2020, gradually decreasing as the land market weakened, but still at 27% in 2023. At the local level, the proportion is even higher, reaching 35.4% in 2020 and 29% in 2023.

Government fund expenditures are mainly at the county and municipal levels, with limited expenditures at the provincial and municipal levels. Taking Jiangsu Province as an example, in 2022, the government-funded expenditures in Jiangsu Province amounted to 11.6 trillion yuan, with only 14.2 billion yuan at the provincial level, accounting for 1.3%. The municipal level accounts for around 25%, while the district, county, and city levels account for over 70%.

Social Security Expenditure in the Relationship between Central and Local Governments

(1) Mainly Pension Expenditure, Rapid Increase in Medical Expenditure

Social insurance funds are mainly used for pensions and medical care (accounting for over 95%), with pensions having absolute weight (70%) and medical care increasing rapidly.

In 2022, total social insurance fund expenditures amounted to 9.1 trillion yuan. Among them, basic pension insurance expenditures were 6.3 trillion yuan, accounting for 69.5%, mainly for employees with a small proportion for residents; basic medical insurance expenditures were 2.5 trillion yuan, accounting for 27.1%, with little difference between employees and residents. Pensions and medical care together accounted for 96.6%. The rest is for work-related injury and unemployment insurance expenditures, which account for a smaller proportion.

From a dynamic perspective, in the early years, medical insurance was underdeveloped, with pension expenditures dominating social insurance funds, reaching as high as 85% in 2001. With the development of medical insurance, the proportion of basic medical insurance expenditures increased from 8.9% in 2001 to 27.1% in 2022.

(2) Non-linear Expansion of Social Security Expenditure under Aging Trend

Social insurance fund expenditures do not synchronize with GDP, and the burden of social insurance expenditures per unit of GDP continues to increase.

In 2001, China's social insurance fund expenditures were 274.8 billion yuan, accounting for 2.5% of GDP at that time. By 2023, social insurance fund expenditures reached 9.9 trillion yuan, accounting for 7.9% of GDP at that time.

As the population ages, the burden of social insurance expenditures per unit of GDP continues to increase.

(3) Weak Correlation between Social Security Surplus Capacity and Provincial GDP Scale

The driving logic behind the pressure of social insurance fund expenditures in each province is the population structure and migration trends, rather than economic strength.

Measuring the pressure of social security expenditures by the ratio of the surplus of pension and medical funds to annual expenditures in each province in 2022, provinces with relatively low surplus ratios include not only provinces with relatively low per capita GDP such as Heilongjiang and Jilin, but also provinces with higher per capita GDP such as Tianjin and Hubei The economic strength does not constitute the dominant factor affecting the proportion of relative surplus.

Comparing the relative surplus with the aging rate, it can be observed that the higher the proportion of elderly population, the less the relative surplus, indicating greater pressure on social security expenditures, such as in the Northeast region, Tianjin, Hubei, Hebei, Shandong, etc.

Comparing the relative surplus with population mobility, it can be seen that regions with a net outflow of population have relatively less social security fund surplus and greater expenditure pressure.

Three Future Trends in the Relationship between Central and Local Finances

(1) Infrastructure Functions, Decrease in the Proportion of Local (Especially County-level) Government

Nearly 70% of infrastructure investment is led by counties and cities, mostly for urban basic construction expenditures.

According to the China Investment Statistical Yearbook, the proportions of infrastructure investment at the central, provincial, prefectural, county, and below levels are approximately 9%, 9%, 15%, and 67% respectively. A large amount of infrastructure expenditure is carried out by counties and cities. Looking at the structure of county-level infrastructure investment, about 47% is for public facilities, 19% for roads, 15% for electricity, heat, gas, and water, totaling 81% of infrastructure expenditure mostly related to basic urban construction.

Real estate is transitioning from an investment product to a consumption product era, and the central focus of local basic urban construction expenditure will shift downwards.

After 2021, the urban resident housing unit ratio (total housing units owned by urban residents divided by the total number of urban resident households) in China exceeded 1, indicating a shift in the supply-demand pattern of real estate from undersupply to basic balance, marking that the demand for commodity housing of four generations (born between 1950-1980, one generation every ten years, totaling 4 generations) has been basically met. In the future, the sales and investment volume of real estate will be determined by the new housing demand of the current young people (only one generation) every decade.

Clearly, real estate sales, investment, and county-level basic urban construction expenditure will systematically decline. Especially in vast third- and fourth-tier cities, where the housing unit ratio is close to 2, the proportion of urban construction expenditure will continue to shift downwards. Meanwhile, the proportion of central-led national major project expenditure in total infrastructure expenditure will continue to rise.

(2) Local Expenditure, Gradual Reduction in Infrastructure, Continuous Increase in Livelihood Expenditure

As the central focus of local basic urban construction expenditure shifts downwards, the proportion of livelihood expenditure will continue to rise. Reference to the fiscal expenditure structure of different countries, the proportion of economic affairs expenditure in China is significantly high at 23%, and the proportion of basic urban construction expenditure in the future will continue to decrease. In the field of people's livelihood, China's education expenditure is only second to the UK and the US at 11%, higher than Canada and Germany.

The proportion of healthcare expenditure at 8% and social security expenditure at 27% is relatively low compared to other countries, indicating that expanding people's livelihood expenditure will be a major direction in the future.

Financial expenditure intentions are often more sensitively reflected in the accounts. In fact, for a long time, the proportion of people's livelihood expenditure in financial expenditure has continued to rise, especially the significant expansion of subsidies for social security. Interest payment expenditure has also shown an upward trend, while the proportion of administrative and infrastructure expenditure has decreased.

The proportion of people's livelihood expenditure has increased from 29.2% in 2007 to 37.7% in 2023, an increase of 8.5 percentage points. The proportion of fiscal subsidies to social security funds in social security and employment expenditure has increased from 2.2% in 2007 to 9.1% in 2023, an increase of 6.8 percentage points, contributing significantly to the increase in people's livelihood expenditure.

The proportion of general public service expenditure decreased from 17.1% in 2007 to 8% in 2022 as the government continues to promote "tight days". Infrastructure expenditure showed an upward trend before 2015, reaching a peak of 28.7%, and then gradually decreased to 22.7% in 2023.

The proportion of interest payment expenditure increased from 2.7% in 2016 to 4.3% in 2023.

(III) Social security coordination, differentiation of local social security pressures, and increased central coordination

As the aging population deepens, the pressure on the social security system becomes increasingly heavy, and some regions find it difficult to balance.

We consider the population over 60 years old for men and over 50 years old for women as the retired population. Based on the United Nations' age-specific population forecast data for China, the results show that the number of retired people in China will continue to increase until it reaches a peak of 590 million in 2051 and then gradually decrease. The marginal changes in the increase of retired population around 2014, 2023, 2031, and 2047 mainly correspond to the baby boom of those years. The peak of China's birth population basically occurred around 1954, 1963, 1970, and 1987, which is about 60 years apart from the years when the increase in retired population accelerates. Therefore, from now until 2051, as the elderly population continues to rise, the pressure on social security fund expenditures will increase year by year. In the phase where the incremental growth of retirees accelerates, the marginal increase in social security expenditure pressure will become more pronounced.

Future population mobility and demographic differences will be further highlighted, and the central government's coordination efforts will be further intensified

The national coordination of pension insurance work is progressing in two steps. In the first step, the central adjustment system of the fund was launched in 2018 as a transitional measure. From 2018 to 2021, the central government transferred more than 600 billion yuan across provinces, with the scale and proportion of basic pension insurance expenditures for enterprise employees increasing year by year. Looking at the situation of contributions and allocations from various provinces, Guangdong, Beijing, Jiangsu, Fujian, Zhejiang, and Shandong are the main net contributing provinces, while Liaoning, Heilongjiang, Jilin, and Inner Mongolia are the main net allocating provinces. The net allocation amount of the three northeastern provinces accounts for over 65%.

In the second step, the national coordination system was officially implemented in January 2022. In 2022, 244 billion yuan of pension funds were transferred across provinces through national coordination adjustment funds, and this further increased to 271.6 billion yuan in 2023, a growth of 11.3%.

Currently, some provinces are facing significant pressure on pension fund balances, with Heilongjiang and Qinghai having less than 10 billion yuan, while Guangdong has as much as 1.6 trillion yuan. Against the backdrop of deepening aging, the trend of future population mobility and demographic differentiation in various regions will continue to evolve. The pressure on pension insurance expenditures will further differentiate, and the central government will further increase the transfer of pension funds across provinces to support difficult provinces in ensuring timely and full payment of pensions.

Authors: Zhou Junzhi, Wang Zexuan, Source: CSC Macro Research Team, Original Title: "Fiscal Expenditure of Central-Local Relations [CSC Macro·Zhou Junzhi Team]"

Zhou Junzhi Practicing Certificate Number: S1440524020001

Wang Zexuan Practicing Certificate Number: S1440520070003