China’s Hidden Fiscal Crisis Is Tearing the System Apart

China's internal power struggles are often described as factional battles at the top, but there's another less visible conflict, one that has been building and ongoing for decades. That is the struggle between the central and local governments, and the fight is over money. And this time, that struggle may matter more than any factional fight, because it goes to the foundation of how the system works and how money is controlled and distributed. I found this quote interesting. It's from a mainland Chinese economist, his name is Li Yang, who is a member of the Chinese Academy of Social Sciences. He once put it very clearly, he said, all economic problems ultimately trace back to fiscal issues. When fiscal conditions are strong, everything is manageable. When fiscal conditions deteriorate, everything becomes a problem. And that brings us to the real issue. China's fiscal condition is not strong, it's under pressure. And this is where the real problem begins, because the weakest link is the local government or governments. Because the pressure we just talked about, it doesn't stay at the central level. It moves downward into the part of the system that's already the most fragile, the local governments. And this is where the real risk lies. So we know local governments are responsible for infrastructure, public services, salaries of public employees, social stability, but they no longer have the revenue to support it. And to understand why it cannot be fixed, you have to go back to how the system was designed in the first place. This imbalance is not just an economic issue. It has the potential to become a source of social instability, because the pressure is ultimately borne by grassroots governments and officials. And they are the ones least able to withstand it. To understand why, we need to go back to how the system was built. So a little bit of history. Since the CCP came to power, the relationship between the central and local governments has always been a struggle over revenue and control. After 1978, during reform and opening up, China moved away from a highly centralized planned fiscal system. It shifted toward what was known as a system of what they call separate kitchens. You have your kitchen, I have mine. Where revenue and expenditure were divided and responsibilities were contracted across different levels of government. So under this system, local governments gained more autonomy, and they have bigger incentives to run, to undergo economic reforms and stimulate the economy. Because local governments have the incentives. They make more money, they keep more money. And for a time, they thrived financially. In fact, the balance shifted so much that the central government itself, at one point, had to borrow from local governments to cover its expenses. But that was never sustainable, because the system has always favored central control. So in 1994, China introduced the tax sharing system. The goal was clear. Increase the central government's share of revenue. Under this system, taxes were divided into central taxes, local taxes, and shared taxes. And it worked, at least on the revenue side. The central government's share of national revenue increased significantly. But here's the problem. The reform only changed who collects the money. It didn't change who spends it. And that created a structural imbalance, because financial power flows upward, whereas responsibilities flow downward. Or in another way to put it, money and revenues flow upward. Expenditures go downward. So over time, this produced a very clear pattern. The central government is overflowing with revenue and resources. Provincial finances are relatively stable. Municipal finances are struggling. And county-level governments are constantly in stress. And this is precisely the reason why we're seeing so many public sector employees complaining about their pay cuts or backload wages. So let me now show you a chart, because this is where the problem is visually illustrated. It came from the dean of Tsinghua University's School of Economics and Management. I think his name is Bai Chong En. I think it came from either an essay or a book he wrote called China's Economy and Fiscal Policy in the New Stage. All right, I translated it into English. So what you're seeing are two charts. On the left, you see the share of government revenue across four levels. On the right, you see the same breakdown for expenditures. And the colors represent four different levels of government. The central government is in blue. The provincial is orange. Prefecture, gray. County level, yellow. So before we read the chart, just keep this in mind. China's system is massive. It has 31 provincial-level governments, including four direct municipal governments, over 300 prefectures, and nearly 3,000 counties. And it's at the county level where most of the real pressure sits. So now let's look at the trend. So these two charts track how revenue and expenditure shares have evolved over the past 30 years. On the revenue side, the chart on the left, so let's take a look at that. From 1994 to 2020, the central government's share shows just a slight decline. I mean, there are ups and downs, but a slight decline while the county-level share adds up modestly. Meanwhile, provincial and prefecture-level shares remain largely flat. Okay, now look at the expenditure side, the chart on the right. And this is where things change. The two lines cross. The central government's share of spending drops sharply from a peak of around 35% to below 15%, a decline of about 20% points. At the same time, county governments move in the opposite direction. Their share rises from roughly 30% to nearly 50%, an increase of about 20%. So you see the cost, the expenditures got transferred from central government to lower-level governments. Now let's break down the revenue pictures more clearly, looking again at the chart at the left. Central government consistently takes the largest share of revenue at around 50%. The rest is split among provincial, prefecture, and county governments. Even between 2012 and 2020, during Xi Jinping's tenure, although the gap between central and county level narrows slightly, the central government still controls about 45% of total revenue. Now let's move to the right, the expenditures. The pattern is very different. County-level governments now shoulder about half of total spending, while central, provincial, and prefecture levels together make up the other half. And now let's put the two charts side by side. The imbalance becomes very clear. The central government collects about 45% of the revenue, the blue line, but accounts for less than 15% of the spending. County-level governments receive only about 25% of the revenue, but are responsible for close to half of total expenditures. The gap for provincial and prefecture governments is much smaller, which means the real pressure is concentrated at the bottom of the system. And that gap is the problem. And this is not a temporary issue. This is the institutional root cause of China's fiscal crisis today. Grassroots governments are financially exhausted, while central government still controls most of the resources. And that's why this system keeps running into the same problem. Local governments don't have enough money to pay people, but Beijing still has the resources to keep the system running. And this is precisely, like I said, the second political struggle within the CCP, the struggle between local and central government. It has existed for decades. The authorities have long been aware of this imbalance. And for years, they tried to fix it. The first attempt was in 2007 and 2008. The 17th Party Congress report, for the first time, explicitly proposed aligning fiscal capacity with administrative responsibilities between the local and central governments. And in 2008, at the two sessions, then Premier Wen Jiabao stated firmly that fiscal reform will be pushed forward over the next five years. In the end, nothing came of it. The second attempt was in 2013. The third plenary of the 18th Central Committee introduced the 60 reform measures. 2013 was the first year when Xi Jinping took over. So they proposed something called 60 reform measures, trying to solve this problem by 2020. But in reality, progress fell short. Nothing was done. And there was a third attempt since 2023. The top leadership once again proposed planning a new round of fiscal and taxation reform. But none of them put forward any breakthrough or systemic reform ideas. So this has left a series of fundamental problems. While the tax sharing system exists between central and provincial levels, below the provincial level, it has never been fully implemented because it has failed to achieve full vertical integration. That's according to experts. Fundings don't go down vertically into the county level. So provincial governments do well, but grassroots doesn't or don't. And the fiscal hierarchy itself remains unresolved. The system has never been clearly defined as a multi-level, central, provincial, municipal, county, multi-tier structure. It has never been clearly defined. So finances at county and grassroots level can be chaotic and messy. And this makes it more prone to corruption. Without clarity on the future path, current fiscal problems, such as grassroots fiscal distress, short-term dependence on land finance, and hidden government debt, these are all problems related to the structural deficiency.