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29-07-2016

Fiscal decentralization and China’s provincial economic growth: a panel data analysis for China’s tax sharing system

Authors: Zao Sun, Chun-Ping Chang, Yu Hao

Published in: Quality & Quantity | Issue 5/2017

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Abstract

Theoretical studies suggest that there is a close association between fiscal decentralization and economic growth. However, whether this linkage holds in China or not is a matter of ongoing debate in recent empirical studies. In this paper, we investigate the impact of the 1994 tax sharing system on economic growth in China. Using a panel dataset for 29 provinces in China over the 1995–2014 period in a simultaneous equations system that controls for the simultaneity of fiscal decentralization, physical capital accumulation and economic growth, the influence of decentralization on economic growth is estimated. The estimation results indicate that there is an inverted-U shaped relationship between fiscal decentralization and economic growth. Because the optimal level of fiscal decentralization that maximizes economic growth is higher than the data for most provinces, further decentralization is in general helpful to China’s economic growth.

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According to the statistics from China’s Statistic Yearbooks, China’s capital formation rate had increased from 38.2 % in 1978 to 45.9 % in 2014, while the final consumption rate had decreased from 62.1 to 51.4 % during the same period. The empirical estimations of Chow and Lin (2002) and Miyamoto and Liu (2005) indicated that investment has indeed played an important role in China’s economic growth in the post-reform era since 1978.

For instance, Qiao et al. (2008) have tried to control for the simultaneity of economic growth and the geographic distribution of fiscal resources. However, the simultaneous problem discussed here is probably more important and relevant considering the important role of investment in China’s economic growth.

For example, Lin and Liu (2000) use the marginal retention rate on the revenue increments by the provincial governments as the measure of fiscal decentralization. Therefore the subsidy-receiving provinces have a 100 % retention rate, similar to the provinces that remit a fixed amount of their revenues to the central government. As shown in Table 1 of their paper, the fiscal decentralization for 25 out of 28 provinces reached 100 % in 1988.

Before 1993, China’s state-owned enterprises (SOEs) were generally controlled and operated by local governments. Local governments were allowed to keep the retained revenues of the local SOEs as extra-budgetary revenue; hence, they tended to provide various types of advantageous conditions to the local SOEs, such as tax relief and administrative privileges to keep the local SOEs from cross-regional competition. In turn, many local SOEs were required to share the spending responsibilities of the local governments. To a certain extent, the local governments played the role of a de facto agency of the local SOEs (Steinfeld 1999).

A recent case for the mismatch of financial resources and responsibilities between the central and the local governments was the stimulation program that was designed to cushion China’s economy from the eruption of the global financial crisis in late 2008. The central government supplied only 1.2 trillion yuan of the total 4 trillion yuan project, with the other 2.8 trillion yuan being contributed by the local governments and private investors. Eventually, the local governments additionally spent up to 10.7 trillion on the various complementary local stimulation programs.

See http://www.bloomberg.com/news/2010-06-28/china-tackling-local-government-debt-risks-may-undermine-growth-cicc-says.html. Some analysts believed that the National Audit Office's figure failed to count certain types of local government debt, implying that the actual total could be even higher. For example, soon after the release of China’s official report, Moody’s said that according to their own estimate, the debt levels of China’s local governments might be RMB 3500 billion higher than the officially admitted number.

For example, the rocketing real estate prices in China have already become a social and political problem. However, because the real estate market boom is the premise for local governments to obtain high land granting revenue from the real estate developers, they do not have an incentive to curb the recent, rampant speculation in the real estate market.

For more information, please refer to http://www.reuters.com/article/us-china-economy-tax-idUSKCN0V31AB and https://www.dlapiper.com/en/us/insights/publications/2016/03/global-tax-news-mar-2016/china-expands-vat-reform-to-new-sectors/.

The real interest rate is defined as the difference between the nominal interest rate and the inflation rate. In this study, we use the difference in the one-year benchmark loan interest rate and the GDP deflator as the measure of the real interest rate. Although China’s monetary policy, including the decisions on key interest rates, has been tightly controlled by the central authority and the commercial banks and financial institutions have no right to set nominal interest rates on their own, the different inflation rates in the different provinces cause real interest rate variation among provinces.

Panizza (1999) and Arzaghi and Henderson (2005) have described a similar relationship that economic development determines fiscal decentralization.

According to Panizza (1999) and Arzaghi and Henderson (2005), other factors that influence fiscal decentralization include ethnic fractionalization, geographic area and the level of democracy. The geographic area of a province does not change over time, and its effect is reflected in the time-constant error u3i. The other two factors change slowly over time, and their effect is incorporated in the first lag of fiscal decentralization.

There are currently 23 provinces, four Centrally Administered Municipalities, and five autonomous regions in the mainland of China’s territory. Because these entities are administratively equal, we use the term “province” throughout the paper. Chongqing was a prefecture-level city in Sichuan province and only became a new municipality in 1997. Therefore, in my database, Chongqing’s statistics are added back to those of Sichuan for the years after 1997. Tibet is dropped from the dataset because of data unavailability.

China’s fiscal system has five hierarchical levels of government: (1) central, (2) provincial, (3) prefecture, (4) county, and (5) township. In the context of China, the fiscal revenue and expenditure arrangements of the lower-level governments are tightly controlled by the higher-lever counterparts; therefore, the fiscal rights of the last three tiers of the government are essentially in the hand of the provincial governments.

These four aspects of fiscal decentralization belong to “the first generation theory” of fiscal decentralization, according to Vo (2010). The second generation theory of fiscal decentralization, characterized in terms of two motivating issues, incentives and knowledge (Vo 2008), is only newly emerging and does not appear to represent a coherent system of analysis yet. Therefore, in this paper, we only focus on the mature first generation theory of fiscal decentralization.

The composite fiscal expenditure is the sum of the budgetary expenditure and the extra-budgetary expenditure. The composite fiscal expenditure is utilized instead of its components (e.g., Expenditure for Education and Expenditure for Medical and Health Care) because the fiscal arrangement of the TSS is primarily for the distribution of total fiscal resources between central and local governments.

For example, according to chart 4 of Shen et al. (2012), in 2004, the largest three central-provincial fiscal transfer programs were the revenue sharing transfers (469.5 billion yuan), the tax rebate (404.97 billion yuan) and earmarked grants (322.33 billion yuan), which together amounted to over 80 % of the total central-provincial transfers. Comparatively, the equalization transfer that year was a mere 74.5 billion yuan, or approximately 5 % of the total transfers.

In the empirical studies regarding the relationship between fiscal decentralization and economic growth, other human capital indicators have also been used, such as the illiteracy rate (RODRÍGUEZ-POSE and KRØIJER 2009) and the high school graduation rate (Akai and Sakata 2002). However, these indicators only reflect a particular facet of education and are therefore not used in this study. Other factors beyond the scope of education, such as on-the-job training and firm-specific human capital investments, could contribute to the improvement of the human capital stock. Unfortunately, because of measurement difficulties and missing data, these factors are excluded from this study.

For example, Curran et al. (2007) employ the ratio of FDI to local GDP as one regressor in the growth regression for China. Using cross-sectional data at county- and city-levels, they report a significant positive contribution of FDI to local economic growth.

Akai and Sakata (2002) utilized the percentage of high school graduates in the total population as the measure of human capital stock and reported its coefficients ranging from 0.09 to 0.12 in the panel regression results. RODRÍGUEZ-POSE and KRØIJER (2009) investigated the influence of fiscal decentralization on economic performance in central and eastern European transition countries. They employed the illiteracy rate as the proxy for human capital and their estimation results implied that a one-percent decrease in the illiteracy rate could contribute to economic growth of between 0.01 and 0.1 %, depending on how many years of lags were considered.

The EAST dummy is equal to 1 for the following provinces while 0 for all of the others: Beijing, Tianjin, Hebei, Liaoning, Shanghai, Jiangsu, Zhejiang, Fujian, Shandong, Guangdong and Hainan.

Please refer to http://online.wsj.com/article/SB10001424052970204485304576642470825957018.html.

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Title: Fiscal decentralization and China’s provincial economic growth: a panel data analysis for China’s tax sharing system
Authors: Zao Sun
Chun-Ping Chang
Yu Hao
Publication date: 29-07-2016
Publisher: Springer Netherlands
Published in: Quality & Quantity / Issue 5/2017
Print ISSN: 0033-5177
Electronic ISSN: 1573-7845
DOI: https://doi.org/10.1007/s11135-016-0386-2

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