Fiscal decentralization: Incentives, redistribution and reform in China

Abstract China's great size and diversity give rise to serious principal‐agent problems among tiers of government. The fiscal relationships between central and provincial governments over the period of economic reform are examined within an agency framework. Provincial governments have been responsible for most revenue collection and public spending, but they have done so within the consolidated state budget: central government takes, or gives, the difference between a province's revenue collection and expenditure. Five interrelated questions are posed. Does provincial expenditure depend on provincial revenue collection, i. e. to what extent are provinces fiscally self‐sufficient? How does the pattern of provincial expenditure relate to provincial revenue and income level? Is fiscal redistribution equalizing, i.e. to what extent does central government redistribute revenue from rich to poor provinces? Does central government's marginal propensity to tax the provinces serve as a deterrent to their revenue collection? Do the arrangements create greater fiscal instability for central or provincial governments? The provincial governments retained an increasing proportion of their revenue collected over the reform period, and the extent of fiscal redistribution by the centre from the rich to the poor provinces correspondingly declined. An important reason for these trends is that revenue effort was sensitive to the various marginal tax rates—mostly high—imposed by central government on the provinces: the Laffer curve is alive and well and living in China. This helps to explain the fiscal reforms of the mid‐1990s, the effects of which are not yet discernible.