China’s Fiscal Dilemma: Balancing Local and Central Debt in a Struggling Economy

In 1975, Zhou Enlai, the first premier of the People’s Republic of China, proudly declared in his final public address that the country was debt-free, boasting a balanced budget amidst global economic instability. Nearly 50 years later, while China’s central government debt remains modest at around 24% of GDP, local government debt has soared to approximately 93% of GDP, according to the IMF. This stark contrast between central and local government debt highlights a core challenge for China’s economy today: the central government’s desire to maintain control without assuming full responsibility for local fiscal issues.

China’s fiscal structure is unique in that local governments handle the majority of public spending but depend heavily on the central government for revenue. Local entities are responsible for critical services like education, health, social security, and housing, as well as local infrastructure, accounting for about 85% of total government spending. However, they directly collect only about 55% of the revenues, with the gap filled by central government transfers.

While decentralizing spending authority has benefits in a vast country like China, the imbalance between revenue and expenditure leads to significant problems. As funds trickle down through the governance hierarchy—from province to prefecture to county—each level retains what it needs before passing resources down, often leaving lower tiers underfunded. This results in erratic implementation of central policies. To compensate, local officials, who are under pressure to drive economic growth for career advancement, resort to creative financing methods.

The property boom in China was fueled partly by local governments’ reliance on land sales as a revenue source. Local government financing vehicles, which operated off the books, became a workaround to fund infrastructure projects despite revenue constraints. However, with land sales declining due to a housing market slump and increased central scrutiny on local borrowing, many municipalities have turned to fines, penalties, and delayed payments to manage their finances, further straining the private sector.

Aware of these structural issues, Beijing has long sought reforms. Fiscal reform was a key part of Xi Jinping’s agenda when he took office in 2012, leading to improvements in budget management and financial oversight. These reforms, however, have also tightened local government finances by restricting off-the-books practices that once masked fiscal shortfalls.

Despite its understanding of these problems, the central government under Xi has been reluctant to relinquish control. It often mandates the services local governments must deliver without providing the necessary revenue sources. Although it has cracked down on local debt, it remains unwilling to increase central government borrowing, resulting in an effective fiscal tightening over the past few years, even as the economy struggles to recover from the impacts of COVID-19.

In the latest “third plenum,” a significant economic policy meeting held every five years, Beijing pledged to address these issues. It announced plans to give local governments more autonomy over taxes and increase fiscal transfers from the central government. Proposed reforms include consolidating various local surcharges into a single local tax, shifting the consumption tax liability from manufacturers to retailers, and allowing local governments to collect this tax, thereby boosting their revenue.

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