Fiscal Decentralization and Local Economic Growth: Evidence from China

Dr Nam, Kyung-min   (Principal Investigator (PI))

36

2016-06-01

2019-05-31

34490

Fiscal Decentralization and Local Economic Growth: Evidence from China

China, economic growth, fiscal decentralization, Granger causality test

Urban Studies and Planning,Public Administration and Political Science

201511159035

Seed Fund for PI Research – Basic Research

2015

Completed

In this study, we examine the interplay between fiscal decentralization and local economic growth by focusing on China’s post-1994 reform period. Our research questions are: (i) in which direction does the decentralization-growth causality run in China? (i.e., does fiscal decentralization affect local economic performance, or vice versa?); (ii) what is the sign of the causality? (i.e., have China’s local economies gained or lost from the fiscal reform, from an economic-growth perspective?). By extending the Granger causality test, we test two sets of hypotheses with a 12-year provincial and prefectural level panel dataset. What distinguishes our method from others is that our model controls not only for inter-temporal but also spatial autocorrelation at the same time. Given its methodological ingenuity and close relevance to on-going policy debates, the proposed project can potentially interest both academic and policy circles, appealing to a wide audience and generating broad impacts. The 1994 tax reform was a crucial turning point in China’s public financing. The essence of the reform was to introduce a system of sharing tax bases between central and local governments. Besides those items that are exclusively for either the central or local governments, a pool of revenue and expenditure items, such as a value-added tax and health care spending, is shared by them at certain agreed-upon ratios. The central and local allocation of shared incomes and burdens, however, is not balanced. A much greater portion of the shared revenue sources goes to the central government, while local governments are primarily responsible for the shared expenditure items. In 2012, for example, local governments were responsible for 85% of China’s total public expenditure, while the local share of the total tax revenues was only 52%. A main consequence of the reform, as suggested above, was that local governments have constantly faced increasing fiscal deficits. Until the early 1990s, local governments had more revenues than their actual expenditures, and thus fiscal deficits were not a critical issue. However, the situation has changed dramatically since the mid-1990s. The local share of China’s total tax revenues plummeted from 78% in 1993 to 44% in 1994 and then rose slightly, converging around at 52% in 2012. This contrasts the local share of the total public expenditure, which has presented a constantly increasing trend from 72% in 1993 to 85% in 2012. This increasing gap between local revenues and expenditures has forced local governments to aggressively seek alternative—often non-budgetary—revenue sources, such as land grant fees associated with land use conversions (Shen et al., 2012). This situation may be a double-edged sword for local economies. On the one hand, spending decentralization, as is often theorized, can increase local economic efficiency, as local governments may outperform the central government in terms of identifying local needs and delivering relevant public services and infrastructure in a timely manner. On the other hand, expanding fiscal deficit may hinder local economic performance by constraining local governments’ financial capacity. The reform has continuously expanded fiscal deficit among local governments: China’s aggregated local fiscal balance turned into a RMB4.6 trillion deficit in 2012, from a RMB6.1 billion surplus in 1993. Given these dualistic aspects of the 1994 reform, its net impacts on local economies are uncertain and thus subject to rigorous scientific testing. For the following two reasons, existing studies that look into a causal link between decentralization and growth fail to offer a direct and reliable answer for this question. First, their findings are inconclusive (see Table 2 in Section VI). Some find a positive decentralization-growth causality, some find a negative link, some find a reverse causality, and others fail to find any statistically significant relationship. Second, disagreeing results themselves may mean that causal channels linking decentralization and growth are diverse by region. Accordingly, empirical findings from other countries may not be directly applicable to the Chinese context. Despite this need, the literature attempting to test the decentralization-growth hypothesis in the Chinese setting is sparse, and our proposed study is motivated to fill this gap. So far, we have found only four China-focused studies published in major academic journals; what makes the matter worse is that even these studies draw conflicting conclusions (see Table 1 in Section VI). From their provincial level analysis, for example, Lin and Liu (2000) and Jin et al. (2005) found positive effects of fiscal decentralization on China’s local economic growth, while a provincial level study by Zhang and Zou (1998) claims a negative link between them. Given the sparse literature and incongruent results, increasing the pool of relevant empirical research may, in and of itself, help China’s policy makers better assess existing policies. Those studies listed in the table also urge caveats regarding generalization of their findings, as they are subject to limitations in terms of unit of analysis and time periods of interest. The four studies are conducted at either provincial or national level, but this unit of analysis may be too coarse for exploring local impacts of fiscal decentralization in China. For this reason, we go deeper, conducting our analysis at both provincial and prefecture levels. Another critical problem in generalizing their findings for China’s post-reform period is potential time-specific effects. Here, it needs to be noted that all four studies focus on the mid-1990s or earlier, in terms of time, but this time frame is largely irrelevant or premature in exploring the impacts of China’s fiscal decentralization of the post-1994 reform period. Recognizing this limitation, we focus instead on a recent 12-year period (2000-2011), and this is another dimension that our work can contribute to the literature.