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International Tax and Public Finance

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19.02.2016

Fiscal incentives and political budget cycles in China

verfasst von: Pi-Han Tsai

Erschienen in: International Tax and Public Finance | Ausgabe 6/2016

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Abstract

Political budget cycles in democracies have been extensively analyzed, but few studies of non-democracies exist. This paper explores political budget cycles in China’s provinces. Using data from Chinese provinces from 1980 to 2006, the analysis finds that the effects of a provincial leader’s tenure on political budget cycles are minimal, implying a weak causal relationship between spending composition and a politician’s time in office at the provincial level. However, there exists a national coordinated cycle associated with the timing of the National Congress of the Communist Party (NCCP). Two years prior to the NCCP, politicians are likely to shift public spending toward capital expenditures, such as innovation funds and capital construction, and away from current expenditures, such as agricultural subsidies. The opposite pattern occurs during the year of the NCCP, when politicians increase current expenditures, such as social expenditures and government administration, and decrease capital expenditures. The increased capital expenditures 2 years prior to the NCCP are accompanied by an increase in taxation and total aggregate spending. The empirical results indicate that provincial budget cycles are mainly driven by national policies rather than by provincial leaders’ personal career incentives. Chinese leaders’ fiscal behaviors are constrained by the dynamics of the national leadership transition, resulting in similar distortions to those found in the democratic countries.

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One of the explanations is that political budget cycles are inconsistent with the concept of rational and forward-looking voters (McCallum 1978). In addition, voters may be fiscally conservative, disliking budget deficits, so they will punish politicians who promote election-year deficit spending at the polls instead of rewarding them (Brender and Drazen 2008). Lastly, voters in more advanced democracies are better informed about fiscal outcomes and also more experienced with electoral politics, making them less likely to be “fooled” by pre-electoral fiscal manipulation (Brender and Drazen 2005).

In Rogoff’s signaling model (1990), current expenditures are considered as salient expenditures whereas capital expenditures are considered as less salient ones. Following Rogoff, there has been a significant amount of empirical work, both international comparisons and sub-national case studies, devoted to finding the election-year effects on the composition of spending. Empirical findings utilizing international comparisons are consistent with the predictions of Rogoff’s model. Vergne (2009) looks at 42 developing countries from 1975 to 2001 and finds that during an election year, public spending on capital expenditure decreases while current expenditure increases. Katsimi and Sarantides (2012) also find a surge in current expenditure prior to elections in established democracies. However, the determination of visible spending varies from country to country due to differences in political and social institutions, political roles, and varying responsibilities of local authorities. For example, Kneebone and McKenzie (2001) find the effect of political budget cycles on investment projects, such as construction of roads and structure, for Canadian provinces. Similarly, Gonzalez (2002) studies the changes in Mexico and finds the expansion in investment expenditure prior to federal elections.

Roeder (1985) disagrees with Bunce (1980) and argues that the timing of the policy shift follows a “consolidation connection” instead of a “succession connection.” He suggests that Soviet leaders seek to consolidate their positions, wishing to increase mass-oriented policies in the early post-succession period, and not in the succession period as suggested by Bunce (1980). Yet, in either case, there exists a national budget cycle in the Soviet Union.

These five categories are the most important categories in the Provincial Statistical Yearbook and the only five recorded continuously and consistently from 1980 to 2006 across different provinces.

Innovation funds refer to funds, loans, or subsidies for enterprises to modernize or create new technology.

Agricultural subsidies are funds that support the production of rural collective units and households, and funds which promote sustainable rural development; these include subsidies to water conservancy projects, irrigation projects, the rural aquatic products industry, and the development of grain production.

Social expenditures consist of operating expenses for the department of Culture, Education, Science, and Public Health, such as expenditures for cultural preservation and publications, broadcasting, education, traditional Chinese medical science, public health, free medical services, family planning, so forth.

Government administration refers to expenditures for corrections and security spending. According to the Provincial Statistical Yearbook, the detailed items include subsidies to the parties and mass organizations, expenditure for administration, expenditure for diplomacy, expenditure for public security, judicial and procuratorial expenditure, law court expenditure, and subsidies to the expenses for treating cases handled by the public security departments, procuratorial organs and law courts.

The 1994 Tax Sharing Reform strengthened the fiscal power of the central government to collect revenue from the local government, but the local governments were still responsible for balancing their own budgets. So, each level of authority imposes fiscal responsibilities on the next lower level of government, resulting in dire financial straits at the local government level. To avoid serious budgetary shortfalls, local governments then heavily relied on the subsidies from upper-level governments, thus increasing both fiscal and political dependence. After the Tax Sharing Reform took place, the central and provincial governments held more leverage over sub-provincial governments (Shen et al. 2012).

Due to a lack of a clear guideline of fiscal responsibilities at the sub-provincial government level, the provincial governments bear enormous leverage over sub-provincial governments. Thus, the sub-national budgetary revenue and expenditure are used instead of provincial budgetary revenue and expenditure.

Another condition conducive for political budget cycles is assumed to hold in general, which is the existence of imperfect information about politicians’ abilities (Rogoff 1990). Because the abilities of agents (politicians) are unobservable, fiscal manipulations serve as signals to principals (either voters or the central committee, as in our case) about agents’ competence. Thus, rational principals would respond to agents’ fiscal manipulations, which is effective in gaining political power and achieving political goals.

The power to establish the annual budget is in the hands of the Provincial Governor, who is supervised by the Provincial Committee Secretary. Because both provincial leaders have discretionary power over the appropriation of public spending, this paper examines not only the tenure of the Provincial Committee Secretary but also that of the Provincial Governor.

However, by applying a novel Bayesian method, Shih et al. (2012) find no evidence that strong growth performances was correlated to higher party rank when examining the data of 12th through 16th Party Congresses from 1982 to 2007.

These numbers are calculated by the author.

The number of provincial governors and provincial committee secretaries are not the same in Panel A and Panel B, because Panel A considers the provincial leaders who left their offices during the sample period from 1980 to 2006, whereas Panel B only takes into account the provincial leaders who started their office during the sample period.

Frequent turnover of provincial leaders largely stems from a fear of the rise of localism. During the late 1980s, the CCP imposed several institutional mechanisms, such as term limits and age limits for retirement, in order to avoid the formation of province-based factionalism. In 1999, “The Regulation of Cadre Exchange” was issued and one of the important rules emphasized and institutionalized the frequent reshuffling of provincial leaders (Li 2004).

Hainan and Chongqing were separated from Guangdong and Sichuan in 1988 and 1997, respectively. Due to a lack of data for the years before they were separated, the data for Hainan and Guangdong are from 1988 to 2006, and the data for Chongqing and Sichuan are from 1997 to 2006.

The highest level Chinese administrative divisions are classified as provinces, municipalities, autonomous regions, and special administrative regions. Tibet, one of the autonomous regions, is omitted for two reasons. The first reason is due to its uniqueness, from the perspective of political instability and ethnic composition. The second reason is because of potential measurement problems. Because the subsidies to state enterprises are treated as negative revenue instead of an expenditure in official Chinese statistics, in certain years provincial budgetary revenue in Tibet shows negative numbers, which may result in potential measurement errors (Tochkov 2007). In addition to Tibet, two special administrative regions, Hong Kong and Macau, are also omitted because these two regions were once colonized by the United Kingdom and Portugal, respectively. Today they are largely self-governing, even though they are now officially part of China.

The regression results are robust if the registered population is used instead of total population.

For the regression using total expenditure, lagged revenue is controlled, whereas for the regression using tax revenue, lagged expenditure is controlled. In addition, for the regressions using disaggregated expenditure, both total expenditure and total revenues are controlled. All are expected to have positive coefficients.

Central–provincial intergovernmental transfers can be classified into two broad categories: general purpose transfers, and specific purpose transfers. The general purpose transfers account for the largest proportion of central–provincial intergovernmental transfers. According to the definition in the Finance Yearbook of China, general transfers are under the provincial government’s control. Thus, provincial governments are responsible for most expenditures supported by intergovernmental transfers. For example, in 2004, 63.8 % of total central–provincial transfers were general purpose transfers (Shah and Shen 2006). The details of the description of intergovernmental transfers can be found in Shah and Shen (2006).

When using the subsample from 1995 to 2006 and controlling for central–provincial intergovernmental transfers (collected from various issues of Finance Yearbook of China.), the results (reported in Table 4 in the Appendix) do not change significantly compared to our main empirical findings reported in Table 3. In Table 4 in the Appendix, all the coefficients of intergovernmental transfers are insignificant, showing that provincial spending is not affected by the fiscal behavior of the national government. The pattern of political budget cycles associated with the NCCP cycles is prominent.

The bias resulting from this missing variable is expected to be minimal, because the central government has limited influence on how the funds are spent, shown in Table 4 in the Appendix. In addition, intergovernmental transfers were designed to compensate the province for its revenue loss after adopting the tax sharing system. The 1994 reform reduces the revenue collection at the provincial level, so some provinces resisted complying. The intergovernmental transfers ensure that the provincial revenue would not be lower than the 1993 level. According to the study of Jin and Zou (2005), intergovernmental transfers are the compromise made between the central government and provinces to implement the tax sharing reform in 1994. Such transfers are not at the discretion of the central government; central transfers from 1994 to 1999 were not associated with provincial growth.

The age variable takes the value of “1” if the politician is over 65 years old, but otherwise has the value of “0.”

The education variable takes the value of “3” if the politician has a post-graduate degree, takes the value of “2” if he has a college degree, takes the value of “1” if he has a high school degree or its equivalent, and takes the value of “0” if he has anything less than a high school degree.

The tenure variable of Provincial Committee Secretaries captures how long the Provincial Committee Secretary has been in office, whereas the tenure variable of Provincial Governors captures how long the Provincial Governor has been in office. For example, if a Provincial Committee Secretary started his position in 1980, then this variable takes the value of “1” for that province in 1980, the value of “2” in 1981, and so on, until he leaves his position, at which point the variable once again reverts to the value of “1.” The data comes from the Chinese Politics Website www.zt360.cn (Zheng Tan Wang).

The NCCP years are 1982, 1987, 1992, 1997, and 2002 and 1985. 1985 is included because a special meeting of the National Conference of Delegates of the CCP was held September 18–23 of that year, producing sizable political turnover in the CCP (Goodman 1986). The pattern of political budget cycles is more apparent when considering 1985; however, excluding 1985 does not alter our results significantly.

The control variables in the regressions of aggregate expenditure and disaggregated expenditure are slightly different, as previously mentioned.

Given the rapid growth of the Chinese economy in last few decades, a linear time trend is included in the panel unit root test regressions in differences. Note that the Fisher-type test shows that the time series process of capital construction, innovation funds, and agricultural subsidies in differences without time trend are stationary; however, the rest of the fiscal variables (tax revenues, aggregate expenditure, social expenditures, and government administration) without time trend still preserve the unit root (fail to reject the panel unit root test). Thus, for these variables, either a time trend or year dummies should be added as control variables in our baseline regressions. For simplicity, all the regressions estimating the effects of a politician’s tenure control for year fixed effects whereas those estimating the effects of the NCCP control for a time trend.

When estimating the effects of the NCCP, year fixed effects are not controlled in the regressions. Because the NCCP were held at the same year across provinces, once both NCCP dummies and year dummies are included, it is impossible to identify the NCCP effects from other time effects, making the estimated results very difficult to interpret. Thus, a time trend, rather than year dummies, is used in the second estimated model.

The results are robust if including 4-year dummies. However, this paper only focuses on the effects during the NCCP year and 2 years prior to the NCCP, and there is no clear pattern of the spending effects 3 years prior to the NCCP. To avoid confusion, the baseline model uses 3-year dummies, rather than 4-year dummies.

Note that the system GMM, instead of the difference GMM, is applied in our case. When the dependent variable is close to a random walk, previous changes are more predictive of current levels than previous levels are of current changes; the difference GMM estimation performs more poorly than the system GMM (Roodman 2009a). As in our case, all the fiscal variables fail to reject the panel unit roots test, so that the system GMM is utilized.

To avoid the bias resulting from an excessive number of instruments, control variables used in the baseline model are excluded in Table 6.

Using longer lags of the dependent variables as instruments do not change the results, leading to the same signs as shown in Table 6, but in order to avoid overfitting of the instrumented variables, only one lag of the dependent variable is employed.

In the generalized method of moments estimation, first-order serial correlation is expected in differences, because \(\Delta \varepsilon _{{it}}=\varepsilon _{{it}}-\varepsilon _{{i,t-1}}\) and \(\varepsilon _{{i,t-1}}=\varepsilon _{{i,t-1}}-\varepsilon _{{i,t-2}}\) both have the same term \(\varepsilon _{{i,t-1}}\). The test for second-order serial correlation in the first-difference residuals is carried out instead (Roodman 2009a).

The serial correlation of the regressions of agricultural subsidies may potentially invalidate the subset of the instruments, so the results here should be read with caution.

Connection variables are specified for provincial committee secretaries and provincial governors, respectively. A connection dummy takes the value of “1” if a provincial leader is the full member of the Central Committee, and takes the value of “0” if not. The results are robust when the data consider both the full and alternate member of the Central Committee.

Both the interaction term and the quadratic term are trying to estimate a part of the interaction in the model. Including both terms may lead to insignificance of both terms.

A provincial leader’s fifth year in office dummy takes the value of “1” if the provincial leader is in his fifth year in office, and takes the value of “0” if not.

A reform dummy takes the value of “1” from 1994 to 2006, and takes the value of “0” if before 1994.

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Titel: Fiscal incentives and political budget cycles in China
verfasst von: Pi-Han Tsai
Publikationsdatum: 19.02.2016
Verlag: Springer US
Erschienen in: International Tax and Public Finance / Ausgabe 6/2016
Print ISSN: 0927-5940
Elektronische ISSN: 1573-6970
DOI: https://doi.org/10.1007/s10797-016-9392-5

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