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.