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University of Nevada, Reno

The Effects of Fiscal Reforms on Economic Growth in Chinese Provinces: 1985-2007

A thesis submitted in partial fulfillment of the requirements for the degree of Master of Arts in Economics

Xingchen Wang

Dr. Mehmet Tosun/Thesis Advisor

May, 2010

THE GRADUATE SCHOOL

We recommend that the thesis prepared under our supervision by

XINGCHEN WANG

entitled

The Effects of Fiscal Reforms on Economic Growth in Chinese Provinces: 1985-2007

be accepted in partial fulfillment of the requirements for the degree of

MASTER OF ARTS

Mehmet Tosun, Advisor

Elliott Parker, Committee Member

Jiangnan Zhu, Graduate School Representative

Marsha H. Read, Ph. D., Associate Dean, Graduate School

May, 2010

Abstract

Fiscal reforms have played an important role in China’s development for the last thirty years. This paper mainly examines the effects of fiscal decentralization on

China’s provincial growth. Through constructing indicators for revenue and expenditure decentralization respectively, regression results indicate that they are both positively affecting economic growth in Chinese provinces. Along with the rapid development, the inequality issue has drawn much concern that fiscal reforms have indirectly hindered China’s even regional growth. Another model is set up to support this conclusion. However, as a distinct form of inequality, poverty has been largely alleviated in this process. Especially in the reform era of China, the absolute number of poverty population has declined dramatically. ii

Acknowledgement

I would like to express the deepest appreciation to my committee chair, Professor

Mehmet Tosun, with whose patient guidance I could have worked out this thesis. He

has offered me valuable suggestions and ideas with his profound knowledge in

Economics and rich research experience.

I would also like to thank my committee members, Professor Elliott Parker and

Professor Jiangnan Zhu, who have given many constructional suggestions that make the thesis more complete and insightful. Especially Professor Elliott Parker, he has generously shared the original dataset with me and offered help with model testing and paper writing.

Lastly, I offer my regards and blessings to all of those who supported me in any respect during the completion of this thesis.

iii

Table of Contents

I INTRODUCTION ...... 1

II LITERATURE REVIEW ...... 4

III FISCAL REFORMS IN CHINA...... 8

1. PRE -1979: FISCAL CENTRALIZATION ...... 8

2. 1979-1993: FISCAL DECENTRALIZATION (C ONTRACTING SYSTEM ) ...... 9

3. POST -1994: TAX ASSIGNMENT SYSTEM ...... 11

IV EFFECTS OF FISCAL REFORMS ON ECONOMIC GROWTH IN CHINESE PROVINCES ...... 14

1. DATA ...... 14

2. VARIABLES ...... 15

3. METHODOLOGY ...... 16

4. DESCRIPTIVE STATISTICS ...... 17

5. REGRESSION RESULTS ...... 19 1) The First Phase: 1985-1993 ...... 19 2) The Second Phase: 1994-2007 ...... 22 3) Regression Results with only Revenue or Expenditure Indicator Respectively ...... 24

V LINKAGE BETWEEN FISCAL REFORMS AND INEQUALITY ...... 31

1. EFFECTS OF FISCAL REFORMS ON CHINA ’S INEQUALITY ...... 31 1) Two Types of Inequality ...... 31 2) Horizontal (Intra-provincial) Inequality in China’s Reform Era ...... 36

2. EFFECTS OF FISCAL REFORMS ON CHINA ’S POVERTY REDUCTION ...... 41 1) How does Fiscal Decentralization Affect Poverty? ...... 41 2) Poverty Reduction in Contemporary China ...... 42

VI FUTURE OF FISCAL REFORMS IN CHINA ...... 47

1. IMPROVE INTERGOVERNMENTAL SYSTEM TO ENSURE THE CONSISTENCY OF FISCAL RIGHT AND

FISCAL CAPABILITY ...... 47

2. ESTABLISH A STANDARD FISCAL TRANSFER AND IMPROVE THE TRANSPARENCY OF THE TRANSFER

SYSTEM ...... 48

3. LINK FUTURE FISCAL REFORMS WITH MARKET -ORIENTED FACTORS AND GUARANTEE EVERY

CITIZEN HAS ACCESS TO PUBLIC GOODS AND SERVICES ...... 49

VII CONCLUSION ...... 51

REFERENCES ...... 53 iv

List of Tables

TABLE 1: DESCRIPTIVE STATISTICS —PROVINCIAL GROWTH AND FISCAL DECENTRALIZATION .... 18

TABLE 2: REGRESSION RESULTS FOR THE FIRST PHASE ...... 20

TABLE 3: REGRESSION RESULTS FOR THE SECOND PHASE ...... 22

TABLE 4: REGRESSION RESULTS WITH REVENUE INDICATOR FOR THE FIRST PHASE ...... 25

TABLE 5: REGRESSION RESULTS WITH EXPENDITURE INDICATOR FOR THE FIRST PHASE ...... 26

TABLE 6: REGRESSION RESULTS WITH REVENUE INDICATOR FOR THE SECOND PHASE ...... 28

TABLE 7: REGRESSION RESULTS WITH EXPENDITURE INDICATOR FOR THE SECOND PHASE ...... 29

TABLE 8: GINI COEFFICIENTS AT THE PROVINCIAL LEVEL (22 PROVINCES IN 2003) ...... 36

TABLE 9: DESCRIPTIVE STATISTICS —GINI COEFFICIENT AND FISCAL DECENTRALIZATION ...... 38

TABLE 10: EFFECTS OF FISCAL DECENTRALIZATION ON REGIONAL INEQUALITY (22 PROVINCES ) . 39

List of Figures

FIGURE 1: CHINA ’S INCOME INEQUALITY IN THE PERIOD OF 1985-2007 ...... 2

FIGURE 2: CHINA ’S POVERTY REDUCTION ...... 43

I INTRODUCTION

Fiscal decentralization is the devolution of fiscal power to regional and local governments. It specifically studies how public goods and services are provided by regional and local governments in a devolved government system (Skira, 2006).

Different countries have reached different degrees of decentralization on the fiscal side. For China, it is nowadays considered as one of the most fiscally decentralized countries in the world. Over the past 30 years, this largest developing country made substantial efforts to reform its highly centralized economic system. As a result,

China’s economy boosted dramatically. Among all the factors that push China’s growth, fiscal decentralization has been identified one of the most important elements in the transitional process started from the late 1970s. The pattern of how a decentralized fiscal system works in China is much similar as elsewhere in the world

(this paper focuses on the provincial level): provincial governmental incentives to develop local economies could be effectively enhanced through receiving more fiscal power from the center on both local revenue and expenditure. Local economy therefore would be stimulated with further provincial governmental participation.

However, the effect of fiscal decentralization is not single-dimensional. While it helped to accelerate China’s overall growth, it might have negatively acted on the even regional development and furthermore individual equality. Figure 1 illustrates income inequality at the national level in China from 1985 to 2007. The main trend of

China’s Gini coefficient was generally going up, and as estimated, it approached 0.50 in 2007. Usually, a higher Gini coefficient indicates a deeper degree of unequal distribution, and 0.40 is called the warning line for a country’s inequality. Since 1999,

China’s Gini coefficient has been keeping increasing at a level above the 0.40 line.

Apparently, with the expansion of China’s fiscal reforms, inequality issue has been

worsened. A linkage might exist between the two sides.

Figure 1: China’s Income Inequality in the Period of 1985-2007

China's Gini Coefficient at the National Level 0.6

0.5

0.4

0.3

0.2 Gini Coefficient Gini 0.1

0 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007

Poverty, as a severe form of inequality, has hindered China’s development for decades. Nonetheless, there is no doubt that China has received tremendous success in poverty alleviation through the years of efforts in its transitional era. Especially, along with the implementation of fiscal decentralization, the absolute number of China’s poor has declined constantly.

This paper first examines the relationship between fiscal reforms and China’s growth using panel data collected for 31 Chinese provinces from 1985 to 2007.

According to the different aims of reforms, the time period is divided into two phases:

1985-1993, fiscal decentralization; and 1994-2007, fiscal recentralization (negative decentralization), to run regressions separately. The main finding is that fiscal decentralization did positively affect China’s economic growth in the chosen period.

More specifically, in the first phase, further revenue decentralization had largely

facilitated provincial development, while in the second phase, expenditure

decentralization instead was crucial for growth. Moreover, due to the possible

relationship between fiscal reforms and inequality, the paper also attempts to

investigate the association of fiscal decentralization and regional (intra-provincial)

inequality at the provincial level, by applying cross-sectional data for 22 provinces in

2003. Even though the data collected for this regression is not statistically sufficient,

the results intuitively imply that a positive relationship exists between fiscal

decentralization and China’s regional inequality.

This paper is structured as follows. Section II reviews the theoretical and empirical results in this field that scholars have found. Section III gives a review of

China’s fiscal reforms from pre-1978 to present. Section IV focuses on the study of the relationship between fiscal reforms and China’s growth. Section V discusses the linkage between fiscal decentralization and inequality, and furthermore the effects of a decentralized fiscal system on poverty reduction. Section VI presents the trend of future fiscal reforms in China. The final section summarizes and discusses the above mentioned points.

II LITERATURE REVIEW

China’s steady increase in annual GDP has drawn much attention from the world.

Federalism scholars focus more on the study of China’s fiscal decentralization and its influence on the country’s growth. However, opinions are not always unanimous.

Many researches find a positive relationship between fiscal decentralization and economic growth. Lin and Liu (2000) use a production-function-based regression analysis framework to show that fiscal decentralization has made a significant contribution to China’s economic growth. Parker and Thornton (2006) focus on the period of 1994-2005, using panel data collected for 31 provinces in China mainland, to find a positive relationship. Also, by using panel data for 30 provinces in two separate periods (1979-1993 and 1994-1999), Jin and Zou (2005) conclude that expenditure and revenue should be further diverged to benefit provincial development; but, they also reinforce that at a given level of expenditure, more revenue centralization would contribute more to growth. In addition, from the federalism perspective, Jin, Qian and Weingast (2005) argue that the reforms have considerably strengthened fiscal incentives at the provincial level, and these incentives would positively act on the local economy.

A number of other studies fail to find any relationship between the two sides, or even identify a negative one. Knight and Shi (1999) present that the central government was faced with a trade-off, and that Chinese reform process itself makes it difficult to arrive at a lasting, non-bargaining center-province fiscal system. China has achieved impressive economic growth, but due to the existence of asymmetric information, local governments have incentives to retain more revenues from remitting to the central. In that case, they are virtually self-centralized, at the local

level (Young, 2000). Moreover, Wong (1991) argues that in the absence of

well-developed markets, the fiscal changes of forcing local governments to participate

even more actively in the economic sphere would offset much of the benefits of

decentralization. Zhang and Zou (1998) find a negative relationship. They also

attribute the negative association to the current state of China’s economic

development, where the central government is constrained by the limited resources for

public investment in national priorities. More generally, Davoodi and Zou (1998)

conclude that there is a negative relationship for developing countries and for the

world, but no relationship for developed countries.

However, along with the rapid development of China’s economy, certain social issues have emerged or gradually been exacerbated in China’s reform area. Inequality is one of the social issues that widely existing in China for decades. From the economic perspective, there are currently two major forms of inequality: the vertical and horizontal. The vertical inequality refers to the disparity of fiscal power and resource distribution between different levels of government. In this paper it especially refers to the uneven relationship between the central and provincial governments. Su and Zhao (2004) argue that the 1994 tax reform is an adverse adjustment of fiscal revenue distribution, when sub-national (provincial) governmental revenues decline dramatically while their share of expenditures does not fluctuate much. On the contrary, previous 1993, in order to accumulate enough revenue to balance expenditure, the central government was forced to face a trade-off

(Knight and Shi, 1999): contracting with the lower-level governments to share a certain proportion of their fiscal revenue.

For the horizontal inequality, it mainly consists of two aspects: the regional and individual disparities, between which, there is a causal relationship (in a great degree,

inequality between regions leads to individual disparity). Other than the association

between fiscal decentralization and economic growth, much attention has also been

paid to the effects of fiscal reforms on China’s horizontal inequalities. General

agreement has been made that China’s fiscal decentralization further widens the gap

between different local economies. Tsui (1989) shows that due to the redistribution of

fiscal power between the center and provincial governments, the rapid growth of

extra-budgetary funds has overwhelmed the effects of government budgetary transfers,

which leads to the worsening regional inequality. Also, Kanbur and Zhang (2005) find

that openness and decentralization has specifically contributed to the inland-coastal

disparity in the reform period of 1980s and 90s, by constructing a long-run time series

for regional inequality. Through presenting the phenomenon and forms of localism,

Zhao and Zhang (1999) argue that a decentralized fiscal system has created conditions

encourage regionalism that is unfair to the poor regions. Later, Su and Zhao (2004)

explain that along with the decentralization, fiscal disparities are expanded not only

among different regions (the east, middle and the west), but between different

provinces in the same area.

In addition, poverty is a long-existing inequality problem that hinders China’s even development, and it is also a social phenomenon that closely connected to regional disparity. However, while fiscal decentralization in China enlarges the economic gap between different regions, it, as agreed by most scholars, positively acts on poverty reduction. From the international general perspectives, UNDP primer

(2005) points out that under the assumption that decentralization allows poor people to voice themselves more clearly, and facilitate communication and information flows, fiscal decentralization would effectively reduce poverty worldwide. Boex,

Heredia-Ortiz, Martinez-Vazquez, Timofeev and Yao (2006) explain that

7 well-designed fiscal decentralization would support poverty reduction policies, but the poorly-designed would be harmful to the objective of fighting poverty. Moreover,

Rao (2008) argues that fiscal decentralization is very conducive to poverty reduction, where the center has to find the resources for poverty alleviation programs, while the local governments undertake actual design and implementation of these programs. For the specific case study of China, Riskin (2004) argues that there is no doubt that the rural poverty has fallen sharply in China in the transition period, but the measurement of poverty in China is somewhat disarray. Recently, according to the World Bank’s poverty line, Dollar (2007) finds that after the 1978 fiscal reforms, China’s sustained growth fueled historically unprecedented poverty reduction.

III FISCAL REFORMS IN CHINA

China’s fiscal reforms can be divided into three phases, according to the state of social development: pre-reform, 1979-1993, and post-1994.

1. Pre-1979: Fiscal Centralization

China’s fiscal system was highly centralized in the pre-reform period, and the regime is called the planned economy. Under this system, most revenue collected by the local governments had to be remitted to the center, and at the same time all the expenditure decisions were made by the center as well. Every year, according to the provincial annual fiscal performance, the center would transfer back a certain proportion of central revenue to each province, and the amount of the portion varied with provinces and time. Provincial governments therefore had no separate budgets from the center, but highly depended on the central provision. The centralized fiscal regime did result in, to some extent, an equal fiscal capacity among regions and received somewhat social achievements after the Cultural Revolution (1966-1976), but it led to the lack of provincial governmental incentives and efficiency to develop their own economies.

The rigid fiscal system “eating from one big pot” ( chi daguofan ) failed to enable provincial governments with power and capability to implement policies that going well with local characteristics, and provide sufficient public goods and services at the provincial level.

In fact, as Feltenstein and Iwata (2005) explain in their study that Chinese economy was a cycle of policy shifts; and in the pre-reform era, there were a few times of attempts to decentralize China’s fiscal system. The very first-time fiscal

9 decentralization happened in 1957, aiming to stimulate initiatives of local governments to develop production. Then in the early 1960s, recentralization began.

The center took back its control over the fast-rising large- and medium-sized state-owned enterprises. In 1964, two years before the Cultural Revolution

(1966-1976), another wave of decentralization was carried out and eventually lasted over ten years (Feltenstein and Iwata, 2005). Although all these attempts failed in the end, they became the starting point of China’s fiscal reforms in the early 1980s.

2. 1979-1993: Fiscal Decentralization (Contracting System)

Starting from 1980, a revenue-sharing system was established to fundamentally decentralize fiscal system in China, and soon in 1986 it was strengthened by the

“contracts” between the center and provincial governments. In 1988, the central government again introduced “fiscal responsibility” into the contracting system, under which, each province was responsible for a lump-sum revenue remittance to the center. At the same time, provinces accepted responsibility for meeting their expenditure requirements by their own, from retained revenue (Wong and Bird, 2005).

By the end of 1988, the fiscal contracting system had been gradually formed into six types, they were: (1) Incremental contract; (2) basic proportional sharing; (3) proportional sharing and incremental sharing; (4) remittance incremental contract; (5) fixed remittance; and (6) fixed subsidy 1. Along with the new reforms, China started to

1 As explained by Jin and Zou (2003): Incremental contract—based on 1987 revenues, the provincial retention rate of all tax revenues ranged from 28 percent to 80 percent, while local remittance the center needed was to increase from 3.5 percent to 6.5 percent on an annual basis. Tax revenues in excess of the stipulated growth rates were retained entirely by provinces; Basic proportional sharing—a fixed proportion of all revenues was remitted to the center; Proportional sharing and incremental sharing—a certain proportion of the actual revenue collection of the previous year was retained, and then a different proportion of revenues was retained for the incremental amount in excess of the total revenues for the previous year;

experiment market economy. Within the new economic pattern, the central and

provincial governments shared the same revenue base, and governments at the

provincial level began to have control over their local revenue, and they could make

expenditure decisions by their own. Therefore, the contracting system largely

encouraged provincial governments to retain more fiscal revenue locally, and regional

economy was consequently boosted in the nationwide.

However, problems of this system gradually unfolded. The nature of contracting led to the emergence of asymmetric problem. With hiding local actual fiscal information from the center, provincial governments could retain more revenue instead of remitting. Moreover, the center lacked effective mechanisms to supervise the channels of local tax collection and revenue remittance, and it could only depend on the information provided by provinces. Thus, by telling a lower level of local revenue, provincial governments even could receive more transfers (subsidies) back from the center. All the phenomena brought out by the contracting system eventually resulted in a continuous decline of the central share in the national fiscal revenue.

According to the official statistical records, in the period of 1985-1992, central revenue as a percentage of the national amount had fallen from 34.8% to 22%. This

substantial decline negatively affected the provision of certain important national

public goods, i.e., national defense, social security, etc. In addition, due to the rise of

state-owned enterprises in this period, provincial governmental extra-budgetary

revenue from this sector grew rapidly, and finally became a main source for local

funds. Concurrently, policy and location favored provinces began to have more

Remittance incremental contract—a specific nominal amount was transferred to the center in the initial year; in subsequent years, the remitted amount increased at a contracted rate. Fixed remittance—a specific nominal amount was transferred to the center with no annual adjustments; Fixed subsidy—deficit provinces received fixed subsidies.

11 bargaining power with the center. Thus, they would have much stronger incentives to collect revenue through off-budgetary channels, in order to better avoid sharing with the central government (Jin and Zou, 2003). As a result, affected by the “side-product” generated from the new fiscal regime, some regional inherent disparities were gradually enlarged. Rich provinces became richer, while poor regions stayed the same or even got worse.

3. Post-1994: Tax Assignment System

In 1994, a new wave of fiscal reforms was encouraged by the development of market economy in China. One highlighted characteristic of these reforms was to recentralize the fiscal system. They employed into three main components: tax sharing, tax modernization, and tax administration (Bahl, 1999). Under the tax sharing system, taxes were correspondingly assigned to central government, local government, or shared by the two levels (Wong and Bird, 2005). This change was a shift from the negotiated (contracting) system to a combination of tax assignment and tax sharing.

The second component, tax modernization, was carried out to specially simplify the tax structure, eliminate distortionary elements and increase transparency (Wong and

Bird, 2005). For the tax administration, it specified the work of local tax offices and divided them into two sections: a national tax administration and a local tax administration, two of which collected taxes for each level separately.

The three components above consistently embodied four objectives: (1) to simplify the tax system; (2) raise the overall revenue-to-GDP ratio; (3) raise the central-to-total revenue ratio; and (4) to make the fiscal system more stable and transparent by shifting the negotiated of general revenue to a tax assignment system

(Ahmad, Li, Richardson and Singh, 2002; Su and Zhao, 2004). Generally speaking,

after the 1994 reforms, it became a dual-track fiscal system that combined the former

revenue sharing with tax assignment, in order to recentralize fiscal power, especially

the power on the revenue side.

The 1994 reforms have so far received success in three aspects. First, the tax structure was largely simplified, i.e., excise taxes on tobacco, alcohol and other luxuries were introduced, a new value-added tax replaced the turnover based product tax (Ahmad, Li, Richardson and Singh, 2002), etc. Second, the boundary of revenue distribution was effectively cleared between different governmental levels, in which case, the center and provincial governments could keep their own exclusive sources for revenue collecting. Third, the ratio of overall revenue to GDP had significantly increased (from 10.7 percent in 1995 to over 20 percent in 2007). Correspondingly, the central governmental share of national revenue grew significantly as well.

However, some defects in the new system were also evident. The reforms only recentralized the revenue side but left the expenditure unchanged. The retained revenue at the provincial level then failed to balance the local governmental regular expenses. Therefore, the local governments would have strong intention to turn to collect more revenue from extra-budgetary funds. Also, recentralization generated pressure on the central fiscal work, because even some well-developed provinces started to depend on the central transfers to finance local expenditure, due to new restrictions on local revenue. When both the rich and poor provinces received subsidies from the center at the same time, the uneven regional inequality issue was further worsened. In addition, revenue recentralization led to less incentive for provincial governments to remit to the center but keep at the local. This reaction finally resulted in, again, a substantial decline in central governmental share of

13 revenue in 1990s (52.2 percent in 1995, 49.4 percent in 1996, and 48.9 percent in

1997 2), after a short period of increase.

2 Rodden, Jonathan, Eskeland, Gunnar and Litvack Jennie (Eds.). “Fiscal Decentralization and the Challenge of Hard Budget Constraints,” The MIT Press (2003): pp.300.

IV EFFECTS OF FISCAL REFORMS ON ECONOMIC GROWTH

IN CHINESE PROVINCES

As introduced in the second section, there are not unanimous opinions about the

relationship between China’s fiscal reforms and economic growth. In this section,

according to the methodology used in Feltenstein and Iwata’s (2005) study, I intend to

construct empirical models to find evidence for the effects of fiscal decentralization

on China’s provincial development in the two separate periods of pre- and post-1994.

1. Data

Data used in this paper is collected by the Chinese Statistical Yearbook and Chinese

Finance Yearbook (various issues). This is provincial-level panel data for 31 provinces in China mainland (including three municipalities: Beijing, Shanghai and

Tianjin. The fourth municipality Chongqing is combined with Sichuan province). Lin and Liu (2000) point out that the time before 1985 was a short-period “cycle” of

China’s fiscal reforms, because there was a great deal of uncertainty about the future fiscal policies of the central government 3. The major change in the decentralized system eventually occurred in 1985; and since then, the direction of fiscal reforms became much clearer and practicable. Therefore, the data period discussed in this paper is 1985-2007, in order to largely eliminate the uncertainties in the “cycle” time.

Moreover, according to the goals and policies for different phases, the data is further divided into two parts: 1985-1993 and 1994-2007 (separate model is constructed for each phase). In this dataset, there might be some minor errors because of

3 Lin, Justin Yifu and Liu, Zhiqiang (2000). “Fiscal Decentralization and Economic Growth in China,” Economic Development and Cultural Change , Oct 2000: 49 (1).

measurements and recalculation, but it is treated as if there are no serious problems

for econometric modeling and economic analysis.

2. Variables

Fiscal decentralization indicators are the key variables for discussion, and generally it

consists of both expenditure and revenue the two sides. Following Feltenstein and

Iwata’s (2005) method (they construct indicators for fiscal decentralization by using

time series data), variables used in this paper are created as below:

“Expenditure”, “revenue”, and “extra-budgetary revenue” stand for the three indicators of fiscal decentralization, respectively. Expenditure indicator is the share of provincial expenditure (including budgetary and extra-budgetary expenditure) in national total expenditure. Similarly, revenue indicator is the share of provincial revenue (both budgetary and extra-budgetary revenue) in national total revenue. For the extra-budgetary revenue indicator, it is measured as the ratio of provincial extra-budgetary revenue to the budgetary revenue at the same level. The first two indicators reflect the relative size of provincial governmental expenditure and revenue, and the third indicator represents the degree of independency of governments at the provincial level.

Since China’s economic growth is subject to comprehensive factors beyond fiscal reforms, some control variables are necessary to be employed into to strengthen the robustness of models. These control variables are: investment rate, measured by the

share of investment in GDP at the provincial level; international trade rate, measured

by the ratio of international trade (the sum of imports and exports) happened in the

province to the provincial GDP; and secondary education rate, calculated by the

proportion of provincial population who have enrolled in senior high schools. For the

international trade rate, it is expected to capture the effects of openness; and for the

investment rate and secondary education rate, they are the indicators for provincial

physical and human capitals, respectively. Moreover, as Jin and Zou (2005) present in

their study that since 1995, transfers from the center to provincial governments has

been recorded in the budget. Thus, the share of central transfers (approximately

measured by the difference of provincial expenditure and revenue) in the provincial

total expenditure is added into the model for the second phase (1994-2007) to capture

the change.

3. Methodology

Two similar models are set up to check for the effects of China’s fiscal reforms on

provincial economic growth, in the two separate phases of 1985-1993 and 1994-2007.

The basic econometric models are constructed as below:

(1) ln is for the first phase 1985-1993;

(2) ln is for the second phase 1994-2007.

For both models, is the real GDP at the provincial level, thus, stands

for the annual growth of provincial gross domestic product. is the vector of fiscal decentralization indicators that include three ratios: expenditure share, revenue

share and extra-budgetary revenue share. is the vector of control variables, including investment rate, international trade rate and secondary education

17 rate. For the second model, is employed to stand for the transfers from the center to the provincial governments.

4. Descriptive Statistics

Table 1 displays the statistics of observations considered in this paper. There are 270 and 420 observations for each phase, respectively. This variance is due to the different numbers of years included in each period. Also, through comparing the two groups of statistical numbers, it is not hard to find that except the values in the revenue column, all the others increased concurrently in the second phase. Intuitively, the slight decline in the mean value of revenue indicator implies the second phase is less fiscally decentralized than the first one. Increases in the values of control variables in the second phase suggest a trend of China’s overall growth.

Table 1: Descriptive Statistics—Provincial Growth and Fiscal Decentralization

Variables Mean Standard Deviation Min Max

1st Phase (1985-1993) Number of observations=270

Provincial GDP (in 100 million) 593.00 525.38 17.00 3225.30

FD indicators :

Revenue 1.97% 0.01 0.00% 7.49%

Expenditure 1.96% 0.01 0.16% 6.93%

Extra-budgetary revenue 32.94% 6.17 0.00% 146.34%

Control variables :

Investment rate 40.80% 0.12 0.00% 74.50%

International trade rate 7.59% 0.20 0.00% 162.56%

Provincial population 0.37 0.26 0.02 1.11 (in 100 million)

Secondary education rate 8.93% 0.04 1.30% 22.10%

2nd Phase (1994-2007) Number of observations=420

Provincial GDP (in 100 million) 4175.69 4442.77 45.80 30673.70

FD indicators :

Revenue 1.90% 0.02 0.04% 7.38%

Expenditure 2.50% 0.02 0.32% 7.78%

Extra-budgetary revenue 54.11% 0.25 8.68% 164.20%

Transfer rate 37.69% 0.19 0.00% 94.07%

Control variables :

Investment rate 47.07% 0.10 29.70% 90.10%

International trade rate 31.82% 0.43 3.16% 232.76%

Provincial population 0.42 0.28 0.02 1.18 (in 100 million)

Secondary education rate 12.13% 0.05 0.30% 29.00%

5. Regression Results

Regression results are shown in Tables 2 and 3, for the two phases respectively. They are displayed in the order of OLS, province fixed effects, and province-time fixed effects regressions.

1) The First Phase: 1985-1993

As Table 2 shows, there is a positive relationship between revenue decentralization and provincial economic growth. This effect was the major achievement of China’s

1978 reform. With being transferred more power on the fiscal side, provincial governments could retain more local revenue for self-accumulation and development, and furthermore stimulated capital mobility inter- and intra-regionally. They then also had more capital to manage and provide local public goods and services, i.e., infrastructure constructions, basic education improvement, and local resources exploitation, etc., all of which were crucial for local long-term development. For the expenditure decentralization, it negatively associated with local growth. This phenomenon might be due to the deficiency of provincial governmental spending, and therefore externalities were generated in this process. But these externalities could be largely internalized through centralizing expenditure. The results support Jin and

Zou’s (2005) study that “provincial governments appear to be efficient in collecting money, while the central government appears to be more efficient in spending”4. In addition, the effect of extra-budgetary revenue was so small that could be even

4 Jin, Jing and Zou, Heng-fu (2005). “Fiscal Decentralization, Revenue and Expenditure Assignments, and Growth in China,” Journal of Asian Economics 16 (2005) 1047-1064.

20 ignored. This result is probably because, during this period, the amount of off-budgetary revenue collected at the provincial level was relatively small.

Table 2: Regression Results for the First Phase

1st Phase (1985-1993) OLS Fixed Effects

Fixed Province Fixed Province & Time

FD Indicators :

Revenue 1.37960 4.09034 1.26578

(0.59915) ** (1.29629) *** (0.99165)

Expenditure -0.94289 -4.76838 -1.28614

(0.70540) (1.42895) *** (1.12787)

Extra-budgetary Revenue 0.00002 -0.00021 0.00055

(0.00045) (0.00045) (0.00034)

Control Variables :

Investment Rate 0.12825 0.11683 -0.05557

(0.02828) *** (0.04672) ** (0.03755)

International Trade Rate 0.08391 0.09108 0.04099

(0.01419) *** (0.01598) *** (0.01424) ***

Secondary Education Rate -0.35885 -0.80042 -0.62134

(0.08410) *** (0.33628) ** (0.40628)

Constant 0.05803 0.15086 0.04840

(0.01262) *** (0.03635) *** (0.01701) ***

R-squared 0.22700 0.37380 0.67660

Notes: ***The t-statistic exceeds the 1% (two tailed) level of statistical significance **The t-statistic exceeds the 5% (two tailed) level of statistical significance *The t-statistic exceeds the 10% (two tailed) level of statistical significance

Statistically, as Table 2 indicates, decentralizing revenue has a strong effect on local growth, one more degree of decentralization would raise provincial GDP by 1.38,

or even by 4.09 as the fixed effects regression implies. Estimate of the revenue

indicator in the first two columns is statistically significant, while that of the

expenditure indicator is only significant in the province fixed effects regression.

Extra-budgetary revenue does not show significant effects on local growth both

statistically and economically.

For the estimates of the three control variables, the signs of investment rate and international trade rate are consistent with expectation. As the results suggest, investment has a stronger effect on local growth, than international trade. It is possibly because during this time, openness was in a process of expanding, but the degree of it was still very low. The coefficient of secondary education rate in the three models is quite confusing. It is statistically significant in the first two regressions, but the results are indicating that higher education rate would negatively affect local growth, which contradicts the reality. Much successful experience has shown that the more human capital (although it obeys the law of diminishing returns) a region possesses, the better local economy would develop (especially for a long-term growth).

2) The Second Phase: 1994-2007

Table 3: Regression Results for the Second Phase

2nd Phase (1994-2007) OLS Fixed Effects

Fixed Province Fixed Province & Time

FD Indicators :

Revenue -1.05269 -2.64482 0.22639

(0.42960) ** (0.72400) *** (0.67005)

Expenditure 1.24050 3.00559 0.57050

(0.35423) *** (0.66733) *** (0.64368)

Extra-budgetary Revenue -0.00912 -0.01458 -0.01266

(0.00594) (0.00639) ** (0.00706) *

Transfers -0.01469 -0.01104 0.02761

(0.01127) (0.02337) (0.02415)

Control Variables :

Investment Rate 0.07917 0.08706 0.05053

(0.01248) *** (0.01466) *** (0.01227) ***

International Trade Rate 0.01003 0.01882 -0.00629

(0.00462) ** (0.00722) *** (0.00611)

Secondary Education Rate -0.05412 -0.16939 -0.12741

(0.03197) ** (0.07027) ** (0.07577) *

Constant 0.07326 0.06442 0.09389

(0.01122) *** (0.01937) *** (0.01976) ***

R-squared 0.18390 0.42100 0.65200

As Table 3 suggests, for the three indicators of fiscal decentralization, they are consistently presenting the opposite effects from the results in the first phase. The

1994 tax reform has completely changed the directions of revenue and expenditure

decentralization acting on provincial development. From 1994 to 2007, provincial

economic growth was negatively associated with revenue decentralization. This is

because in the first phase, local fiscal revenue was not as decentralized as the

expenditure. Therefore, with the application of tax assignment system, revenue

became more centralized (negative decentralization) while not much attention being

paid to the expenditure side. Provincial fiscal gap between the two aspects had

gradually generated an imbalanced situation for local growth. Combined with the

negative effect of revenue decentralization, the positive result of expenditure indicator

suggests a divergence of the two sides at the provincial level. The regression results

indicate that higher degree of expenditure decentralization would substantially

encourage growth, at a given level of revenue. Moreover, the negative effect of

extra-budgetary revenue implies the risks that high dependency on the off-budgetary

fund would potentially generate in provinces. The divergence of revenue and

expenditure resulted in the need for transfers from the center; however, in the

estimated results, the transfer variable does not seem to have a significant effect on

the local growth.

The fiscal revenue and expenditure indicators are statistically significant in the

OLS and province fixed effects regressions, and their estimates suggest that they are playing very important roles in local development. For the third indicator, extra-budgetary revenue, its coefficient is statistically significant in the two fixed effects regressions; and compared with the estimated result in the first phase, the effect is largely increased. Also, a negative sign of the off-budgetary revenue indicator is still consistent with expectation.

In addition, local growth is again positively responding to the changes in the first two control variables—investment rate and international trade rate. However, their effects have declined a little in the second phase. The estimate of secondary education rate is still not statistically significant, and its sign is not consistent with expectation.

3) Regression Results with only Revenue or Expenditure Indicator Respectively

The analysis above with both revenue and expenditure indicators in one model does make sense; however, the form may also cause significant multicollinearity problem.

So in this part, revenue and expenditure indicators are tested separately in each model.

Regression results for the first phase are presented in Tables 4 and 5, and results for the second phase are presented in Tables 6 and 7.

As Tables 4 and 5 indicate, both revenue and expenditure decentralization in the first phase positively affect economic growth in the OLS regression. One more degree of revenue and expenditure decentralization would raise local economy by 0.63 and

0.57, respectively. Their coefficients are only statistically significant in the OLS, but not in the two fixed effects models. The result of extra-budgetary indicator is showing the same pattern as estimated in Model (1). In addition, except the secondary education rate, all the other control variables are still consistent with expectation.

Table 4: Regression Results with Revenue Indicator for the First Phase

1st Period (1985-1993) OLS Fixed Effects

Fixed Province Fixed Province & Time

FD Indicators:

Revenue 0.63420 0.05259 0.28155

(0.21941) *** (0.47497) (0.48859)

Extra-budgetary Revenue -0.00004 -0.00024 0.00056

(0.00045) (0.00046) (0.00034)

Control Variables:

Investment Rate 0.12975 0.12340 -0.05803

(0.02830) *** (0.04767) *** (0.03752)

International Trade 0.08229 0.08440 0.03846

(0.01416) *** (0.01619) *** (0.01407) ***

Secondary Education Rate -0.31772 -0.96581 -0.58084

(0.07839) *** (0.33970) *** (0.40499)

Constant 0.05012 0.15086 0.07300

(0.01116) *** (0.03635) *** (0.01496) ***

R-squared 0.22170 0.34400 0.67470

Table 5: Regression Results with Expenditure Indicator for the First Phase

1nd Period (1985-1993) OLS Fixed Effects

Fixed Province Fixed Province & Time

FD Indicators:

Expenditure 0.56889 -0.55958 -0.03308

(0.26004) *** (0.52231) (0.55611)

Extra-budgetary Revenue -0.00003 -0.00025 0.00055

(0.00046) (0.00046) (0.00034)

Control Variables:

Investment Rate 0.12332 0.12893 -0.05656

(0.02843) *** (0.04744) *** (0.03760)

International Trade 0.08463 0.09009 0.04045

(0.01430) *** (0.01628) *** (0.01425) ***

Secondary Education Rate -0.26506 -0.83427 -0.62263

(0.07418) *** (0.34245) *** (0.40684)

Constant 0.04921 0.14934 0.07300

(0.01212) *** (0.03703) *** (0.01496) ***

R-squared 0.21140 0.34720 0.67420

For the second phase, as Tables 6 and 7 suggest, one more degree of revenue decentralization would encourage provincial growth by 0.39 in the OLS and 0.73 in the province-time fixed effects regression. At the same time, expenditure decentralization also plays a positive role in local development with a stronger effect.

One more degree of decentralized expenditure would raise growth by 0.41 in the OLS, and the estimate is even higher as the two fixed effects models suggest. In this phase, extra-budgetary revenue began to reveal some level of effect. As estimated, the extra-budgetary revenue negatively acts on the provincial growth, and the effect is not as strong as the other two decentralization variables. This is probably because in the second phase, provincial governments began to depend more on the off-budgetary funds, and gradually the risks of this part of revenue formed obstacles for local long-term development and stability. The two fixed effects regressions indicate that in the second phase, central transfers played a positive role in growth—it effectively made up the gap between fiscal expenditure and recentralized revenue at the provincial level. This result is consistent with expectation, but incompatible with the result from Model (2).

Table 6: Regression Results with Revenue Indicator for the Second Phase

2nd Period (1994-2007) OLS Fixed Effects

Fixed Province Fixed Province & Time

FD Indicators:

Revenue 0.39206 0.02272 0.73125

(0.12144) *** (0.42672) (0.35276) ***

Extra-budgetary Revenue -0.01444 -0.01637 -0.01313

(0.00582) *** (0.00654) *** (0.00703) **

Control Variables:

Investment Rate 0.07370 0.09852 0.05053

(0.01255) *** (0.01480) *** (0.01227) ***

International Trade 0.00300 0.02583 -0.00518

(0.00422) (0.00722) *** (0.00597)

Secondary Education Rate -0.03974 -0.19948 -0.13559

(0.03213) (0.07168) *** (0.07518) **

Transfers -0.00386 0.04416 0.03994

(0.01098) (0.02039) *** (0.01973) ***

Constant 0.07877 0.06871 0.09564

(0.01126) *** (0.03454) *** (0.03128) ***

R-squared 0.15960 0.39040 0.65200

Table 7: Regression Results with Expenditure Indicator for the Second Phase

2nd Period (1994-2007) OLS Fixed Effects

Fixed Province Fixed Province & Time

FD Indicators:

Expenditure 0.40695 1.01131 0.75538

(0.09940) *** (0.38992) *** (0.33856) ***

Extra-budgetary Revenue -0.01234 -0.01598 -0.01242

(0.00583) *** (0.00648) *** (0.00701) **

Control Variables:

Investment Rate 0.07725 0.09666 0.05045

(0.01253) *** (0.01465) *** (0.01225) ***

International Trade 0.00412 0.02388 -0.00664

(0.00396) (0.00719) *** (0.00601)

Secondary Education Rate -0.03725 -0.20117 -0.12658

(0.03140) (0.07084) *** (0.07564) *

Transfers -0.00339 0.04919 0.02163

(0.01034) (0.01683) *** (0.01640)

Constant 0.07238 -0.00042 0.09220

(0.01129) *** (0.03185) (0.03096) ***

R-squared 0.17200 0.40090 0.65190

With considering multicollinearity in this section, the results are indicating that no matter in the first or the second phase of China’s fiscal reforms, both revenue and expenditure decentralization are positively affecting provincial growth (even though the impact of fiscal decentralization in the first phase is not as significant as it in the second phase). Revenue decentralization played a bit stronger role than the

expenditure in the first phase, while expenditure decentralization displayed a stronger

effect in the second phase. This is probably because the revenue was not decentralized

as the expenditure in the first phase, so with recentralizing more in the second phase,

the effect of expenditure decentralization were reinforced. Also, extra-budgetary

funds began to negatively affect the economic growth after 1994, due to the rising

amount of provincial off-budgetary revenue. Meanwhile, because of the appearance of

divergence between the local revenue and expenditure in the second phase, transfers

from the center exhibited somewhat effect on narrowing the gap between the two

sides.

In addition, regressions with revenue and expenditure per capita variables at the provincial level are also operated, in order to compare the robustness of models.

However, the results are not satisfactory, and they are not statistically significant.

V LINKAGE BETWEEN FISCAL REFORMS AND INEQUALITY

1. Effects of Fiscal Reforms on China’s Inequality

1) Two Types of Inequality

Along with China’s economic reforms, two types of inequality are worsened or generated in its transitional process: the horizontal and vertical inequalities.

A. Horizontal Inequality

As mentioned before, horizontal inequality refers to the uneven regional economic growth and uneven distribution of income or services between individuals, both of which involve interregional and intraregional disparities. Geographically, regional economic inequality is usually explained by the economic gap between the east, middle and the west in China. Before fiscal reforms, due to the highly centralized system, provinces were almost keeping the same pace in local growth. However, with delegating more power to the provincial level, regional disparities began to reveal.

Some provinces had comparative advantages to support development, such as locations closing to the coastal areas (i.e., Shanghai, Zhejiang, Guangdong, etc.), larger amount of human capital in the population structure (i.e., Beijing, Shandong, etc.), larger tax base (i.e., Shanghai, Beijing, Jiangsu, etc.), and so forth. In this case, it was reasonable for such provinces to receive preferred policies from the center, and their relative advantages were intensified: because of the consideration for overall growth, the center would implement or allow certain policies that specially favor these areas; these areas would also be the first beneficiaries of advanced foreign

technologies; also, physical and human capitals would be attracted (even from

backward areas) to flow into such areas and then increment over time.

At the provincial level, according to the economic development status, 31 provinces in China could be divided into 4 categories 5, they are: economic developed

areas (Guangdong, Shanghai, Shandong, Jiangsu, Zhejiang, and Beijing, whose fiscal

revenue was over 50 billion yuan in 2001), economic developing areas (Liaoning,

Fujian, Henan, Hebei, Hubei, Heilongjiang, Hunan, and Tianjin, whose fiscal revenue

was between 20 and 49.9 billion yuan in 2001), economic undeveloped areas (Sichuan,

Anhui, Yunnan, Guangxi, Shaanxi, Shanxi, Jiangxi, Jilin, and Hainan, whose fiscal

revenue was between 10 and 20 billion yuan in 2001), and economic difficult areas

(Guizhou, Inner Mongolia, Xinjiang, Gansu, Ningxia, Qinghai, and Tibet, whose

fiscal revenue was below 10 billion yuan in 2001). Mapping the four categorized

regions, it is easy to find that almost all the provinces belong to the developed areas

spread along the coastal regions, but provinces in the economic undeveloped and

difficult areas are located in the western and northern China inland.

In addition, urban-rural economic gap is another way to interpret the regional

inequality (this is a form of intra-regional inequality). Wan (2007) explains in his

study that the urban-rural inequality contributes to a large portion of China’s overall

regional disparity, more than the east-middle-west division. By urban-rural inequality,

it refers to the differences between the group of people who live in the urban districts

and the group of people who live in the rural counties mainly depending on farming.

Even though in 2007 rural residents’ annual income per capita had risen by 9.5% (the

biggest increase since 1985), the urban-rural annual income per capita ratio was

5 Su, Ming and Zhao, Quanhou (2004). “China’s Fiscal Decentralization Reform,” The Research Institute for Fiscal Science, MOF. P.R.China.

33 further enlarged to 3.33:1, and the absolute income gap between the two groups became 9646 yuan (annual income per capita 4140 yuan for rural residents, and 13786 yuan for people living in the cities)—the largest once after 1978 reforms (China

Youth Daily, August 29, 2008) .

Urban-rural inequality is mainly caused by the system of urban-rural dual structure. This system divides citizens into the urban and rural residents, and distributes income and goods according to their residency. This structure leads to the severe unequal distribution between the urban and rural areas, because it enables the cities with much more priorities, such as favored policies, better social welfare, etc.

After the thirty years of reforms, this system has not substantially changed and resulted in a widening gap of disparities between the urban and rural areas. Also,

Chinese household registration system ( hukou ) has meanwhile prevented reforms in the dual structure system. Within the hukou system, each person has a registration in either an urban area or a rural area, according to his or her place of birth. Usually, a city gives registration to skilled people who have offers of employment in that city but reluctant to migrants from rural areas (Dollar, 2007). People are restricted to their hukous that largely hurt their mobility, especially for the people who were born in rural areas. This situation hinders urbanization. China’s rapid growth requires for urbanization, and conversely urbanization needs stable economic environment as the prerequisite. In recent years, China has realized the problem and adjusted its hukou system to some extent, through releasing restrictions on rural residents. As a result, a large number of migrants from the rural areas flow into cities. Nevertheless, China’s urban-rural inequality still stays at a high level, and for the rural migrants, they become a new part of the urban poverty.

Another important form of horizontal inequality is explained by the various uneven distributions between individuals. There is a causal relationship between the regional and individual inequalities. Individual inequality mainly involves the following aspects: distribution of individual income, education that people could receive, health status that people have, etc. Specifically in China, poverty is a common social phenomenon fully embodies all the individual disparities. There are two ways to define the poverty line in China: one is used by the World Bank that sets

USD 1 per day measured at Purchasing Power Parity (which has been reset to USD

1.25 since 2008) as the line. This standard guarantees about 2000 calories of nutrition per day for each person. The other one is set by Chinese National Bureau of Statistics.

According to the changes of price index over time, the department adjusts the line every year. The standard officially used by Chinese government was initially set at

200 yuan annual net income per person in 1985, and gradually lifted to 1300 yuan in

2008 (it was the first time that the line became consistent with World Bank’s one

dollar per day standard).

From the regional perspective, China’s poor could be further divided into urban poverty and rural poverty. Different provinces or cities have different standards for defining urban and rural poor. But within each province, rural poverty is usually the major part in the poor structure.

In addition, it is almost impossible for every single person to have the same political and economic rights or powers. So, it might lead to the “capture” of public resources and fiscal transfers by the local elites and administrations. It is believed that every person is self-profit maximizing. Without proper restrictions and supervisions, the actions from the local elites and administrations would result in corruption in provinces, and eventually nationwide.

B. Vertical Inequality

For the vertical inequality, it refers to the unequal distribution of political and fiscal powers between different governmental levels. In the pre-reform era, all the fiscal revenue belonged to the center, and the center controlled all the expenditure decisions.

Started from 1980, along with the decentralization reforms, central government suffered a continuous decline in its share of fiscal revenue, while provincial governmental revenue incremented dramatically. Due to the contracting system, both levels of government were facing a trade-off: provincial governments concealed their fiscal performance from the center for less remittance, but the center intended to receive more from provinces and avoid back transferring. After 1994, a new wave of fiscal reforms led to significant increases in the central share of national revenue but decreases in the shares of provincial governments. Thus, it is easy to notice that no matter what fiscal phase China is in, an imbalance of the distribution of revenue always exists between the center and provinces.

Moreover, similarly with individuals, within one province, each level of government is self-profit maximizing. Higher-level government usually has more power over revenue and expenditure than the lower ones. So, when the higher-level government makes fiscal decisions, they tend to care more about their own profits but less about the effects on the others. This phenomenon, as a result, generates intergovernmental externalities and finally leads to fiscal deficiencies at each level.

2) Horizontal (Intra-provincial) Inequality in China’s Reform Era

Table 8: Gini Coefficients at the Provincial Level (22 provinces in 2003)

REGION REG GINI

Beijing 1 0.3090

Tianjin 2 0.3260

Hebei 3 0.3600

Shanxi 4 0.3911

Inner Mongolia 5 0.4768

Liaoning 6 0.3605

Shanghai 9 0.3006

Jiangsu 10 0.3720

Zhejiang 11 0.3578

Anhui 12 0.4640

Fujian 13 0.3181

Jiangxi 14 0.4248

Henan 16 0.4320

Hubei 17 0.3398

Hunan 18 0.4571

Guangdong 19 0.4920

Guangxi 20 0.3949

Sichuan/Chongqing 22 0.4448

Yunnan 25 0.5214

Shaanxi 27 0.3567

Qinghai 29 0.5684

Xinjiang 31 0.5338

Source: Feng (2007)

Table 8 shows the income Gini coefficients for 22 provinces in 2003 6. From the

listed numbers, it is quite obvious that horizontal inequality (focusing on the

distribution of individual income) widely existed in each province. At the same time,

some provinces had much higher Gini coefficients, such as Qinghai and Yunan, than

the others; so inequality also widely spread inter-regionally.

In order to simply check for the effects of fiscal decentralization on individual inequality provincially, an econometric model is constructed to help analysis. The form of the model is taken as below:

(3)

where is the Gini coefficient of the th province in 2003, and is the vector of fiscal decentralization indicators. The three indicators are the same with

those introduced in Section III; except, using their logarithm terms here instead of

original forms, in order to magnify the results and analyze elasticities. Similarly,

is the vector of control variables which are also the same with the items created in Section III; except there is one more variable—rural population rate—is

included to indirectly reflect the rate of urbanization. The data used for this model is

cross-sectional, and all the variables are only applied for the year of 2003.

6 Calculated by Chao Feng in “Gini Coefficients of China’s Provincial Disparities,” Statistics and Decision 2007(1): 93-94.

Table 9: Descriptive Statistics—Gini Coefficient and Fiscal Decentralization

Variables Mean Standard Deviation Min Max

Year 2003 Number of observations=22

Gini coefficient (0~1) 0.41 0.08 0.30 0.57

Provincial GDP (in 100 million) 5286.48 3665.11 390.20 15844.60

FD indicators :

Revenue 2.08% 0.02 0.13% 7.02%

Expenditure 2.77% 0.02 0.46% 7.59%

Extra-budgetary revenue 44.47% 0.12 18.38% 64.75%

Control variables :

Investment rate 46.85% 0.09 33.20% 75.40%

International trade rate 38.72% 0.46 5.68% 148.11%

Provincial population 0.48 0.29 0.05 1.18 (in 100 million)

Secondary education rate 14.71% 0.05 4.90% 29.00%

Rural population rate 56.46% 0.17 13.90% 73.60%

Table 10: Effects of Fiscal Decentralization on Regional Inequality (22 provinces)

Year 2003 OLS

FD Indicator :

Revenue 0.85584

(0.26233) ***

Expenditure -0.72322

(0.20139) ***

Extra-budgetary Revenue 0.03923

(0.15134)

Control Variables :

Investment Rate -0.09723

(0.37711)

International Trade 0.0001

(0.00005) **

Secondary Education Rate -0.96948

(1.05305)

Rural Population Rate -0.0417

(0.48111)

Constant -0.50469

(0.59636)

R-squared 0.81700

After using OLS, the regression results are presented in Table 10. For the 22 provinces in 2003, there is not an identical effect for the three fiscal decentralization indicators. The estimate of revenue indicator suggests that 1 percent of increase in the

degree of revenue decentralization would lead to about 85.58 percent of rise in

provincial inequality. On the contrary, for the expenditure decentralization, 1 percent

of increase would lead to approximately 72.32 percent of reduction in the inequality.

Moreover, there is a slight positive association between extra-budgetary revenue

decentralization and provincial disparity. Through simple summation of their

estimates, it is intuitive that intra-provincial inequality has been exacerbated by fiscal

decentralization. Coefficients of the first two indicators are statistically significant,

while the third is not, which though does not change the direction of overall effects on

Gini coefficient at the provincial level.

For all the control variables, only the estimate of international trade rate is statistically significant and the sign is consistent with expectation. However, this estimate is approximately equal to zero, which could be ignored in analysis. Even though the other control variables are not statistically significant as the regression estimates, economically most of their signs are the same as expected and estimates are reasonable. Higher rates of investment (especially the investment in the public goods and services) and secondary education would be very helpful in narrowing disparities between different groups of individuals, and therefore reduce regional inequality. In addition, the coefficient of rural population rate indicates that the individual disparity would not be as severe as in the provinces that having urban residents as the major provincial population, if there are a large number of people living in the rural areas.

This finding is contradicted with expectation, because practically, urbanization should effectively alleviate disparities through enhancing individual mobility and encouraging competition between individuals and between regions.

However, with considering multicollinearity in this model, running regressions again with revenue and expenditure decentralization indicators separately, the

estimates are not consistent with expectation and are not statistically significant. Thus,

the widening gap of regional disparity is the result from the combined impact of

revenue and expenditure decentralization at the same time.

2. Effects of Fiscal Reforms on China’s Poverty Reduction

Poverty is a severe form of horizontal inequality, which has widely existed in China

for a long time and hindered the growth in the nationwide. But the history of China’s

economic reforms is also the history of China fighting with poverty. General

agreement has been reached that fiscal decentralization is conducive to poverty

reduction, and China is one of the successful cases of alleviating poverty through

fiscal reforms.

1) How does Fiscal Decentralization Affect Poverty?

As Rao (2008) presents in his study that there are mainly four important elements for

a successful poverty alleviation strategy: (1) have enough information about the poor

and their characteristics; (2) understand the causes of poverty; (3) necessary measures

are designed to effectively increase the poor’s income and consumption level; (4) the

implementation of the poverty policies should be cost efficient and be ensured to

benefit the targeted groups. According to the four elements above, fiscal

decentralization correspondingly renders several certain characteristics to meet the

requirements.

First, because of the proximity to local people, provincial governments have comparative advantages to know more about local preferences and needs. Thus, compared with the center, governments at lower levels would be more acknowledged

42 of the poor and their living conditions, or even the causes of their poverty status.

Fiscal decentralization would help them to collect such local information efficiently and accurately. Second, once provincial governments have been given more power on their own policies, they would take into account their regional characteristics to choose the just strategies that would best reflect local interests. Decentralization would largely enhance the efficiency of governance, especially when the economy shows significant interregional variances. Besides, the poor would be more benefited, if decentralized public provision links revenue and expenditure decisions together.

Third, fiscal decentralization would generate competition and economic spillover among regions, which further encourages local governmental fiscal incentives and relevant political innovations (Boex, Heredia-Ortiz, Martinez-Vazquez, Timofeev and

Yao, 2006).

2) Poverty Reduction in Contemporary China

As mentioned before, poverty in China is divided into the urban and rural, and rural poverty contributes to the major part of Chinese poor. First it is because the large proportion (nearly 62 percent) of Chinese population is living in the rural areas, most of which are resource-deficient; and also these places are usually located in the remote inland provinces that belong to the northern, northwestern and northeastern

China (Piazza and Liang, 1998). Second, it is due to the uneven distribution of public goods and services between the rural areas and cities. People in the remote rural areas lack the access to enjoy such basic rights. Third, rural poor includes a group of people who suffer severe deficiency in various resources that are necessary for daily life.

This group of people is living in the status of absolute poverty in China, and they are

the major target for poverty reduction.

Poverty reduction is an essential project for China’s long-term social stability and economic development. Before the reforms, China’s poverty population contributed to 67 percent of the poor in the world. After years of endeavor, China has received impressive achievement—dragging a large number of people out of poverty. Figure 2 illustrates the down-ward trend of China’s absolute poverty and national poverty rate.

Specifically, as Chinese National Bureau of Statistics (2004) reports, there are roughly four phases of China’s poverty alleviation in the fiscal reform era:

Figure 2: China’s Poverty Reduction

The Trend of China's Absolute Poverty and Poverty Rate 16 14 12 10 8 6 4 2 0

Absolute Poverty (in 100 million) National Poverty Rate (%)

Source: Poverty Monitoring Report of Rural China (various issues)

• 1978-1985 . Along with the reform and opening-up policy, China started to decentralize economy, and it thereafter received 7 years of continuous rapid growth in

GDP. This growth had generally stimulated increases in people’s income levels, and

correspondingly reduced poverty population from 250 million (headcount rate is

30.7%) in 1978 to 125 million (headcount rate is 14.8%) at the end of this phase.

• 1986-1993 . At the beginning of 1986, policies for fiscal decentralization was

eventually fixed. Provincial governments were given more rights to determine their

own expenditures, and their fiscal revenue increased dramatically. Thus, the

infrastructure was largely improved in each province, in order to “enhance both the

capacity of poor areas and poor rural households” 7 . Meanwhile, with further implementation of household responsibility system, farmers were encouraged to manage and invest by their own for capital-accumulation and development. In this phase, more achievements in poverty alleviation had been gained in rural areas: rural poverty population was then reduced to 80 million (headcount rate is 8.8%).

• 1994-2000 . A new anti-poverty strategy, the 8-7 Poverty Alleviation Plan, was launched in this period. This plan intended to carry out a series of programs, i.e., tax favorite policy, financial support, etc., to specially eliminate absolute poverty that were concentrated in the rural areas. Therefore, by the end of 2000, China’s poverty population had again dropped to 32.1 million (headcount rate is 3.4%).

• 2001-present . In this phase, the Development-orientated Poverty Reduction

Program was set up to solve the remaining absolute poverty issue, and also to help the low-income group of citizens. According to the latest records of the National Bureau of Statistics, by the end of 2007, China’s absolute poverty population had declined to

14.8 million. So far, about 235 million Chinese people have been dragged out of the absolute poor group.

7 “Poverty Statistics in China,” Rural Survey Organization of National Bureau of Statistics, China September 2004.

However, there are still some potential problems with the poverty issue that need to be paid more attention.

Riskin (2004) argues that there are two dimensions of China’s poverty, and all the reductions that have completed are from the rural areas, while urban poverty has actually risen. Admittedly, China has received success in alleviating the total number of the poor in the nationwide; however, the situation in the urban areas reveals somewhat uncertainty about the future trend of China’s overall poverty.

The poverty line set by Chinese government is questionable. Before 2008,

China’s official poverty line was always lower than the World Bank’s international standard of USD 1 dollar per day. This gap implies that China’s poverty reduction work was processed at a very low level. It would have generated much higher poverty, if the 1 dollar per day standard was adopted. In 2008, Chinese government lifted the poverty line to annual income 1300 yuan per person (785 yuan for the absolute

poverty line). Until then, China’s poverty line the first time became consistent with

the World Bank’s poverty benchmark.

Moreover, some social and natural problems hinder China’s further poverty

alleviation. First, because of the severe natural conditions and weak social security

system in the remote and resource-deficient regions, local residents are still vulnerable

to be dragged back to below the standard-living line. Second, the living conditions in

the rural areas that belong to the northwest, north and the southwest have not been

substantially changed. Those regions do not have sufficient physical and human

capitals, so they are unable to accumulate and develop sustainably by their own. Third,

China’s large population has generated big pressure on domestic employment, which

therefore creates obstacles for poverty alleviation. Because no matter in the urban or

rural, there seems no additional work opportunities in the market, other than farming,

46 for the poor. Under this circumstance, urbanization, even though it is very conducive to poverty reduction, is forced to be slow down.

VI FUTURE OF FISCAL REFORMS IN CHINA

Admittedly, fiscal reforms have played a significant role in China’s economic growth, but no system is perfect—it still needs to be improved.

1. Improve intergovernmental system to ensure the consistency of fiscal right

and fiscal capability

China has been considered one of the most fiscally decentralized countries in the world; however, there exists a contradiction between the assignment of fiscal right and fiscal capability at each governmental level. This phenomenon is primarily embodied on the revenue side. The central government controls most of the fiscal revenue rights in the aspects of management and arrangement (especially after the

1994 tax-assignment reform), while local governments usually contribute much more to the national revenue. This contradiction has led to an imbalance between power and capability at each level: the center has more power and rights to virtually plan and manage revenue but does not possess enough capital; on the contrary, provincial governments collect more revenue through various channels, but they comparatively lack the power to control and use it by their own.

Therefore, a readjustment of fiscal powers and responsibilities between the two levels (focusing on the central and provincial governments) is quite necessary. First, the provincial governments should be assigned more revenue autonomous rights. As

Su and Zhao (2004) present in their study that gradually transferring local-related legislative (i.e., taxation, bond, etc.), from upper levels to lower levels. Second, besides releasing more fiscal rights to the lower level, it is crucial that the central

government is in a dominant position for collecting tax revenue. This is because the

central fiscal conditions are directly related to a nation’s macroscopic readjustment

and control, and also the provision of national public goods and services, such as

national defense. A good central condition with adequate fiscal support would largely

enhance a nation’s social stability.

2. Establish a standard fiscal transfer and improve the transparency of the

transfer system

Fiscal transfer is a two-way system, which mainly aims to reduce the horizontal

inequalities, especially the regional economic disparities. By “two-way”, it means

while provincial governments transfer a certain amount or a share of their local fiscal

revenue to the center, the central government may transfer back some of the

remittance to the local to subsidize their budgetary expenditure. However, transfers

from the center do not effectively narrow the disparities between provinces. Because

of the existence of asymmetric information problem, some well-developed provinces

could also receive subsidies by hiding true financial information from the center. This

phenomenon not only aggravates fiscal pressure on the central government, but

greatly widens the economic gap inter-regionally.

A couple of points need to be adjusted in the transfer system in the near future.

First, when making transfer payment, the vertical inequality between higher- and lower-level governments should be considered as well. Extra fiscal pressure from the provinces that actually do not need subsidies should be effectively avoided. As concluded by Shen, Jin and Zou (2006), the principle for a healthy central-local transfer is: central transfer should focus on national minimal standard of public

services, and provincial transfer should focus on equity of local service provision.

Second, improving the transparency of transfer system ought to specifically consider

two aspects: provincial governments should properly report local fiscal information to

the center; and also, they should fairly let local residents know about the use of fiscal

expenditure, especially the part given back (subsidy) from the center. For

transparency improvement, the former modification would largely abate the problem

of asymmetric information, and it is therefore helpful for the center to make efficient

fiscal decisions. Through the latter adjustment, provincial governments could be

virtually supervised by local people, which would, theoretically, avoid governmental

corruption effectively.

3. Link future fiscal reforms with market-oriented factors and guarantee

every citizen has access to public goods and services

Fiscal decentralization is a multi-dimensional reform, not only the center-provincial

relationship has been changed, but the market economy is deeply affected. Basically,

it is the rapid development of market economy requires adjustment in fiscal system.

Thus, a series of reforms would have to consider the market-oriented factors, such as

competition. The center should realize that at a balanced level of revenue and

expenditure, further decentralization on the two sides could effectively stimulate

competition among provinces, which therefore enhances fiscal efficiency. Also, with

less restriction of hukou system, more rural labors would flow into urban markets. It is necessary for the local governments to adjust relevant fiscal policies to consider the fluctuation of local labor force, in order to provide adequate public goods and services.

Uneven distribution of public goods and services is one of the main causes contribute to the individual inequality and furthermore poverty. Most of the people

who are living under the poverty line fail to have sufficient basic public goods and

services that should be provided by local governments, to support daily necessities or

self-improvement. Within this situation, besides modifying the three points mentioned

above, governments should also set up special funds to particularly spend on the

residents who are living at the lowest level in the society—subsidizing their bad living

conditions, providing equal access to basic education and health care, etc. In addition,

local governments should meanwhile make use of their fiscal resources in a more

efficient way, and avoid unnecessary waste.

VII CONCLUSION

This paper basically follows the methodology introduced in Feltenstein and Iwata’s

(2005) study, through constructing fiscal decentralization indicators for both revenue and expenditure, to check for the association between fiscal reforms and economic growth in Chinese provinces. In this way, the effects of revenue and expenditure decentralization could be examined separately. A panel data is collected for China’s

31 provinces in the period of 1985-2007, and it is then divided into two phases:

1985-1993 and 1994-2007, according to the different goals of reforms. Regression results indicate that fiscal decentralization did positively stimulate provincial growth; and more specifically, revenue decentralization had a stronger effect than the expenditure in the first phase, while the impact of expenditure decentralization was stronger in the second phase. The results also recommend for a convergence of fiscal revenue and expenditure at the provincial level. Otherwise, inter-governmental externalities would be generated in the process of fiscal collecting and spending.

Even though fiscal reforms facilitate regional growth, inequality issue brings about concerns for China’s long-term development and social stability. This paper goes a little further to check for the linkage between fiscal reforms and inequality.

Using the Gini coefficients that Feng (2007) calculated for 22 provinces in 2003, a simple cross-sectional model is set up to examine the effects of fiscal decentralization on horizontal (intra-provincial) inequality. Intuitively, the results present that one more degree of revenue decentralization would largely reduce regional inequality, while one more degree of expenditure decentralization would work in the opposite way. Their overall effect is negatively acting on China’s even regional economic growth. However, this conclusion still needs verification, because the time period

used in this paper is not long enough and some provinces lack data to calculate local

Gini coefficients.

Also, as one severe form of horizontal inequality, China’s poverty issue and its relevant reduction achievements are also introduced in the inequality section. There lack sources for collecting data in this field for empirical studies. But historically, with going further in the fiscal reforms, China’s poverty alleviation has received impressive positive results. Through decentralization, local governments are given more fiscal power and are more capable to provide public goods and services that would eventually benefit the poor, and to implement local pro-poor policies to reduce poverty in a great degree.

Finally, three suggestions are pointed out for China’s future fiscal reforms.

Because no fiscal system is perfect and everything is changing over time, certain readjustment and improvement are quite necessary and even crucial; especially for

China, a country is still experiencing huge changes in its transitional era.

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