Finance is the foundation of governance, while fiscal reform is necessary to facilitate overall reform and implementation of policies. There is need therefore to reform a tax-sharing system introduced in 1994 which established a hierarchical fiscal system to ensure local governments earn enough revenue in order to improve governance and better serve the people.

Although several programs have been implemented to optimize the fiscal system, the hierarchical fiscal system has not been introduced below the provincial level. Instead, most of the local governments still use the fiscal-sharing system, which has resulted in poor stability, lack of standardization and/or financial insecurity.

Hence, the fiscal-sharing system needs to be reformed, because it has created several problems including financial difficulties, hidden debt risks and dependence on the sale of land for revenue. For instance, measures should be taken to improve the local tax system by applying the statutory taxation principle, along with the transfer payment system, to properly define the respective fiscal powers and responsibilities of the central and local governments. This is essential to boost overall economic and social development.

The main revenue of provincial and lower-level governments comes from shared taxes that include added value tax, individual income tax and corporate income tax. The fiscal-sharing system divides the tax revenue among the central and local governments according to the proportion decided by the central government.

Yet property tax, which could be the main source of tax revenue for local governments, has not been introduced across the country as expected, despite real estate tax being piloted in two cities, Chongqing and Shanghai. Also, local governments still do not have the right to select or adjust tax treaties based on their real condition. Under such circumstances, the lack of a sound local tax system and self-development capacity could create problems such as financial difficulties, hidden debts and indiscriminate fines.

Therefore, the authorities should take steps to improve the local tax system, streamline the fiscal and administrative systems and implement the hierarchical fiscal system. But by far the most difficult task is property tax reform. Once a real estate tax law is drafted, the central government can authorize local authorities to collect real estate tax, while the authorities could also consider introducing an environment tax, inheritance tax and a gift tax.

China's fiscal revenue is heavily dependent on indirect taxes, but it is important to increase the percentage of direct taxes to facilitate the reform of the taxation system, which is related to adjusting income distribution, optimizing counter-cyclical adjustments and pursuing common prosperity. The measures should be integrated with policies such as those aimed at reducing tax, adjusting government functions and addressing local financial difficulties.

This means the sub-provincial fiscal system could expose local governments to hidden debt risks, because some local governments, in order to implement their own economic development plans, tend to violate established rules to increase revenue for want of stable sources of revenue.

However, the 2023 Government Work Report says the authorities have already "advanced reforms to divide fiscal powers and spending responsibilities between central and local governments, improved the system for managing local government debt, and established an individual income tax system based on both adjusted gross income and specific income types".

Nevertheless, the revised regulation on the implementation of the budget law in 2020, aimed at addressing the problem of hidden debt risks of local governments, cannot solve all debt-related problems. As such, the authorities should take measures to ease local governments' financial constraints that have resulted in the accumulation of hidden debts during the three years of the COVID-19 pandemic. To prevent and address the risks of hidden debts, it is necessary to take certain measures.

First, systemic innovation is a prerequisite for reforming the fiscal system of governments below the provincial level, and consolidating the hierarchical fiscal system based on the tax-sharing system is necessary to prevent hidden debt risks.

Second, management innovation is needed to better implement and supervise an array of rules which could facilitate fiscal system reform for the benefit of local governments.

Third, innovations in technology can develop advance technologies which can be used in government projects such as the "Golden Tax Project", a uniform countrywide computer network through which the tax authorities at all levels can better serve the taxpayers.

And fourth, the authorities should implement the budget law to prevent local hidden debts.

More important, to prevent and defuse local government debt risks, there is a need to improve the mix of debt maturities, reduce the burden of interest payments, and prevent a build-up of new debts while working to reduce existing ones.

The views don't necessarily reflect those of China Daily.

The author is chief economist of the China Academy of New Supply Side Economics.