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International Tax and Public Finance

Erschienen in:

19.09.2017

Central-local government fiscal relations and cyclicality of public spending: evidence from China

verfasst von: Jing Xing, Clemens Fuest

Erschienen in: International Tax and Public Finance | Ausgabe 4/2018

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Abstract

In this study, we analyze how fiscal decentralization affects the cyclicality of government spending. We focus on China, which experienced fiscal decentralization during 1979–1993 and then partly centralized its revenue with the 1994 fiscal reform. By employing both time series and province-level panel data, we show that Chinese provincial and total government spending was strongly procyclical during the decentralization period before the reform, but both became significantly less procyclical with respect to nationwide output fluctuations after the reform. We suggest several channels through which the procyclicality of subnational government spending in decentralized fiscal federations could be restrained. We further find that less procyclical provincial government spending is associated with smaller output volatility.

Vorheriger Artikel The effect of investment tax incentives: evidence from China’s value-added tax reform

Nächster Artikel Electoral cycles in MPs’ salaries: evidence from the German states

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For example, Rodden and Wibbels (2010) find that ‘Subnational finance in several of the world’s most decentralized federations is overwhelmingly pro-cyclical.’ (p. 59).

Prud’homme (1989) and Bogoev (1991) are earlier studies that illustrate how decentralization in Brazil and Yugoslavia weakened the capability of the central government to implement stabilization policies.

While fiscal policy is viewed as a central macroeconomic tool by Keynesian economists, discretionary fiscal policy for stabilization purposes faces significant timing problems. Fiscal policy played a secondary role to monetary policy in countries like the USA for decades before the 2008 global financial crisis.

Some local taxes may by acyclical because the tax base is acyclical. This is true, for instance, for property taxes in many countries.

Empirical evidence from Latin America (for example, Stein et al. 1999) supports this theory. The “voracity effect” is likely to be especially strong in countries with weak institutions and fractionalization.

There were four types of revenue sharing between provinces and the central government in the early 1980s (Oksenberg and Tong 1991) and six basic forms of fiscal sharing contracts starting from 1988 [see Bahl and Wallich (1992); Oi (1992) and Montinola et al. (1996)]: some provinces remitted a fixed percentage of revenue to the central government while others remitted a fixed quota. For the former, provinces usually retained a substantial proportion of revenue. For the latter, provinces could keep all revenue exceeding the agreed “quota.” The content of the contracts differed across provinces and the rules were often set based on negotiations.

There is no consensus on the growth effect of decentralization in China. For example, Zhang and Zou (1998) find that decentralization led to lower economic growth in China, as central government investment has more positive externality on growth than subnational government investment.

Very recently this restriction was relaxed for a few selected cities. Local government could borrow to finance its budgetary spending indirectly via the central government, but only a small percentage of local expenditure is financed in this way. Local government also borrows via channels such as a Local Government Financing Vehicle (LGFV), but borrowing via the LGFVs is mainly to finance off-budgetary infrastructure investment [see Zhang and Barnett (2014)].

Government revenue during the early 1980s heavily relied on profit remittance from state-owned enterprises, the majority of which were controlled by local governments (Montinola et al. 1996). Formal taxes on profits of state-owned enterprises briefly replaced profits remittance in 1984. In 1986, state-owned enterprises reversed to contracts over multiple years on profits remittance to the government.

Appendix A reports the categories of taxes and the associated revenue-sharing rules between the central and the provincial government.

We calculate the fiscal gap for each province in each year and then average this ratio across provinces to construct the time series in Fig. 3.

Wang and Herd (2013) provide a detailed analysis of the Chinese intergovernmental transfer system.

The VAT was introduced and expanded mainly to replace product taxes which were based on turnover.

We test this hypothesis in Sect. 5.2.

Government spending does not include net lending. However, this figure contains interest payments on domestic debt since 2002. We do not adjust the spending figures for interest payments because we do not have this information for local and central government. In a separate exercise, we obtain figures for interest payments on domestic debt for total government from the China Fiscal Yearbooks and adjust the total government spending series from 2002 accordingly. The growth rates of real total government spending based on the unadjusted and the adjusted data, however, are almost identical.

We exclude Tibet from this analysis to be consistent with empirical estimations in this study.

One alternative method is to regress the cyclical component of government spending on the cyclical component of GDP. The cyclical components of these variables can be obtained by applying filters such as the Hodrick-Prescott (HP) filter. We obtain similar results when using this alternative strategy.

We exclude the year 1994 from the regression analysis as there were substantial changes in the growth rate of government expenditure and revenue in this year due to the fiscal reform. Including the year 1994 will hence bias our estimation results.

It is worth noting that in their cross-country study on graduation from fiscal pro-cyclicality, Frankel et al. (2013) classified China as “still in school”. Using the GFS data provided by the International Monetary Fund, they find a positive correlation between the cyclical component of government spending and that of real GDP during the period 2000–2009. However, the government spending figures in their study include general government net lending, which is not included in the government spending figures we use. In a separate exercise using the GFS data, we find that general government net lending in China is procyclical during 2000–2009 but the budgetary spending is not.

As a robustness check, we replace \(\Delta \ln \hbox {GDP}_t \) with \(\Delta \ln \hbox {GDP}_{t-1} \) in Eq. (2) and re-estimate it with and without additional control variables. The results are similar to those in Table 2. We do not report these results for brevity.

We exclude Tibet from our regression analysis as data for Tibet is missing for many years.

In Appendix C, we investigate the time-series properties of local government expenditures, revenues, and net transfers. We find that the levels of these variables are likely to be nonstationary but the first differences of these variables are all stationary.

The results are very similar when we use national GDP deflator as the common deflator for all provinces.

We test the time-series properties of relevant variables in Appendix C.

We include two linear trends in Column 6 to capture potential structural breaks. Provincial-specific trends are included in separate exercises and similar results are found.

To be consistent across different columns in Table 4, we report the results based on subsample regressions without controlling for time trends. Estimations became imprecise especially when we control for province-specific trends as the sample size shrinks.

We report the unweighted average coefficients for these parameters.

Net transfers are defined as transfers received by provinces from the central government minus transfers from provinces to the central government.

We cannot accurately infer the level of transfers and grants by calculating the difference between local government revenue and spending, since the budget contains other items such as rollovers of last year’s revenue and expenditures and loans from the central government.

In an unreported exercise, we construct the treated and control groups based on whether the actual net transfers in a certain province, averaged between 1995 and 2013, is above or below the sample median. We then conduct similar Difference-in-Differences analysis as in Sect. 4.3.1. We obtain similar results.

Business tax in China is based on turnover.

Ideally, we need to know the percentage of VAT in tax revenue before 1994 and consider the changes in this percentage before and after 1994. However, we only have VAT information at the province level since 1995. Our analysis then is justified by the observation that many provinces did not have VAT before 1994.

Similar to the estimation of the cyclical pattern of spending, we first detrend the output growth data and then calculate the standard deviation of the detrended growth rate.

The standard deviation of total government revenue growth rate is around 4.7 and 4% before and after 1994, respectively.

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Titel: Central-local government fiscal relations and cyclicality of public spending: evidence from China
verfasst von: Jing Xing
Clemens Fuest
Publikationsdatum: 19.09.2017
Verlag: Springer US
Erschienen in: International Tax and Public Finance / Ausgabe 4/2018
Print ISSN: 0927-5940
Elektronische ISSN: 1573-6970
DOI: https://doi.org/10.1007/s10797-017-9478-8

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