Shanghai piloted a tax reform program in January 2012 that replaced the business tax with a value-added tax to avoid double taxation and ease the tax burden on the transportation industry and other service areas. The nationwide expansion of the program and the incorporation of a few more industries starting from August this year, as well as the government's plan to extend the reform "at a due time" to cover more industries will undoubtedly accelerate deeper tax reforms that will change the fiscal relations between the central government and local governments.

The upcoming Third Plenary Session of the 18th Communist Party of China Central Committee will likely issue some guidelines and chart the course and set the timetable for deepening fiscal and taxation reform, in which changes to the finance relations between the central and local governments will be the centerpiece.

Under the current tax regime, the central government collects 75 percent of the revenue from value-added tax. Given the pilot reform to replace the business tax, which is an important source of income for local governments, with a value-added tax, the question remains how local authorities can sustain their financial resources and how to institute local tax systems and accelerate the reform of the fiscal and taxation systems, as tasked by the 18th National Congress of the CPC.

Reform of the tax distribution system in 1994 established the basic institutional framework for the finance relations between central and local governments, setting out how tax revenues are apportioned to the central and local coffers. However, in recent years, the debt problems of local governments, their reliance on land sales and the financial difficulties of grassroots governments have led to claims that local governments are not being granted sufficient financial power to fulfill the responsibilities assigned them by the central authority.

However, the root cause of these problems does not lie in the tax-sharing system per se, but rather in the fact that many local authorities below the provincial level have not yet been fully incorporated in the system, and they still stick to tax-sharing practices that fail to accommodate the development of a market economy. Any tax reforms should therefore ensure the implementation of a workable tax-sharing system below the provincial level.

It is actually not that difficult to figure out why the introduction of a tax-sharing system has met resistance below the provincial level. The organizational system of local governments in China is divided into provincial, prefecture-city, county that also includes county-level city and township levels. These, together with the central authority, form a five-layered tax-sharing system, which adds to the technical difficulties of allocating more than 20 categories of taxes among the different levels of authorities. It is no wonder then, that from 1994 onward, the tax-sharing system has achieved concrete results only at the central and provincial levels. Therefore, as the country presses ahead with taxation reform, the current tax-sharing structure must be reduced to three layers, with county-level finance placed directly under the management of provincial governments and township-level finances under the management of county governments.

To deepen tax-sharing reform within a three-layered framework and better the finance relations between central and local governments, policymakers need to reasonably decentralize power among governments at all levels and proceed with building a fiscal and taxation system that matches financial power with corresponding responsibilities. This system should be supplemented with transfer payments, mostly from central to local governments, but also from one region to another. With such a system in place, the whole country, including the least developed regions, would have the financial resources needed to curb debts and reduce local governments' reliance on land sales, while promoting public services and easing the financial difficulties of grassroots governments.

The establishment of such a system entails various tasks, the first of which is specifying the respective and shared responsibilities of authorities at central, provincial and city levels. Measures should also be taken to speed up the interlinking and upgrading of e-government projects, such as the Golden Tax and Golden Finance projects, which will help optimize the distribution of public resources and serve as an information sharing platform for different government sectors.

Of course, fiscal and taxation reform will not be completed at one go and must be pursued step by step. At the moment, the process of replacing the business tax with a value-added tax obviously outpaces the process of designing new tax categories for local governments, which calls for a transitional plan. The introduction of new consumption tax categories in the area of circulation tax should be an option, which can optimize production and adjust consumption structure and ensure the source of income for local governments. Resources tax, environmental tax and property tax and personal income tax are all areas in which reform efforts should be phased in.

The fiscal and taxation reform, aimed at optimizing and reshaping the fiscal relations between central and local governments is inevitable in the context of economic restructuring and social transformation. Local governments have to fully realize this and actively interact and cooperate with the central government to work out viable solutions and blaze a trail for more imperative pilot reforms.

The author is director of the Research Institute of Fiscal Science under the Ministry of Finance

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