Fiscal decentralization, public spending, and economic growth in China

POLICY RESEARCH WORKING PAPER 1608 Fiscal Decentralization, Fifeenyears of efforts to promote flscal Public Spending, and decentralization in China have tfailed to promote economic Economic Growth in China grhinChinasprovinces Ths finding is surprising in the Tao Zhang light of arguments that fiscal Heng-fu Zou decentralzation usually promotes provincial or local economic growth. The World Bank Policy Research Department Public Economics Division May 1996  I POLICY RESEARCH WORKING PAPER 1608 Summary findings Zhang and Zou use data on China to demonstrate how reforms begun in China in the early 1980s have probably the allocation of fiscal revenue and expenditures between failed to promote the country's economic growth. central and local governments has affected economic This result is consistently significant and robust in their growth since reforms that began in the late 1970s. empirical examinations. It is also surprising, in the light They find a higher degree of fiscal decentralization of the argument that fiscal decentralization usually associated with lower provincial economic growth over contributes positively to provincial or local economic the past 15 years in China. This implies that fiscal growth. This paper - a product of the Public Economics Division, Policy Research Department - is part of a larger effort in the department to study fiscal decentralization and economic growth. The study was funded by the Bank's Research Support Budget under the research project "Fiscal Decentralization and Economic Growth" (RPO 680-02). Copies of this paper are available free from the World Bank, 1818 H Street NW, Washington, DC 20433. Please contact Cynthia Bernardo, room N1O-053, telephone 202-473-7699, fax 202-522-1154, Internet address prdpe@worldbank.org. May 1996. (46 pages) The Policy Research Working Paper Series disseminates the findings of work in progress to encourage the exchange of ideas about development issues. An objective of the series is to get the findings out quickly, even if the presentations are less than fully polished. The papers carry the names of the authors and should be used and cited accordingly. The findings, interpretations, and conclusions are the authors' own and should not be attributed to the World Bank, its Executive Board of Directors, or any of its member countries. Produced by the Policy Research Dissemination Center  Fiscal Decentralization, Public Spending, and Economic Growth in China* Tao Zhang and Heng-fu Zou Policy Research Department, World Bank 'We thank Hamid Davoodi, Shantayanan Devarajan, Gang Fan, Bert Hofman, John H. Jia, Hongyi Li, Stephen McGurk, Richard Newfarmer, Yingyi Qian, Terry Sicular, Christine Wong, and Danyang Xie for their comments and suggestions. The authors also acknowledge financial assistances from the Washington Center of China Studies, Ford Foundation, and the World Bank (Research grant RPO #680-02).   1 Introduction Many developing countries and transitional economies have a mandate to de- centralize some aspects of their public finance. In addition, many developed economies such as the United States, the United Kingdom, and Canada are reviving their policy debates on devolution. Decentralization of expenditure and revenue decisions of the central government is seen as part of a package to improve the efficiency of the public sector, cut the budget deficit, and pro- mote economic growth (Bird and Wallich, 1993; Bahl and Linn, 1992; Rivlin, 1992; Gramlich, 1993; Oates, 1993; and Bird, 1993). The argument is that decentralization will increase economic efficiency since local governments are better positioned to deliver public services that match local preferences and needs than the national government (Oates, 1972). Over time, efficiency gains will lead to fast local as well as national economic growth. This wisdom is shared by numerous studies on intergovernmental fiscal relations in China (Bahl and Wallich, 1992; World Bank, 1990, 1992, 1995). Many proposals favor assigning more revenue and expenditure responsibil- ities to localities from the center. However, a concern has emerged that decentralization in China has been implemented too fast and has gone too far, and that this is threatening macroeconomic control and stability. Fur- thermore, in this process, national priorities in public spending have often been crowded out by local public projects. Despite the foregoing policy concerns, there has been no empirical at- 3  tempt to explore the relationship between fiscal decentralization and eco- nomic growth in developing countries in general and China in particular. In this paper, we use the Chinese case tS demonstrate how the allocation of fiscal revenues and expenditures between the central government and local governments has affected economic growth since reforms of the late 1970s. The outline of this paper is as follows. A theoretical model of fiscal decen- tralization and growth is laid out in the next section. Section 3 summarizes the trends in fiscal allocations between the center and provincial govern- ments. Section 4 contains the empirical application of the theoretical model to the Chinese economy. Section 5 concludes the paper. 2 A Growth Model with Different Levels of Government Spending Following Barro (1990)1, we begin with an endogenous growth model consist- ing of a production function with two inputs: production capital and public spending where the function exhibits constant returns to scale in the two in- puts. We depart from the Barro model by assuming that public spending is carried out by two levels of government: central and provincial governments. Let k be the capital stock, g the total government spending, f central gov- ernment spending and s local government spending: f +s=g (1) 'Some related models are presented in Devarajan, Swaroop and Zou (1993), and Davoodi, Xie, and Zou (1995). 4  The production function is CES: y = [ak4 + OfI + 7ysl] /l,) -oo < < 1 (2) where a, ,B, and -y are all in (0,1) and a + /3 + y = 1. The CES production functions include the Cobb-Douglas specification as a special case (o = 0). The introduction of public spending by different levels of government creates a potential link between fiscal decentralization (i.e. differential effects of spending by the two levels of government) and growth. As in Barro (1990), when specifying the production function we abstract from human capital and labor, but we allow for these additional inputs in the empirical work. The consolidated government spending g is financed by a flat output tax at rate T: g = 'ry (3) To derive the long-run growth rate of the economy, we first analyze the decisions made by the production-consumption sector. We consider a long- lived producer-consumer unit which maximizes its discounted utility, max i [C l] e-Ptdt (4) where c is the consumption of a single good produced in this economy; a is the inverse of the intertemporal elasticity of substitution; and p is the rate of time preference. The dynamic budget constraint for the producer-consumer unit is: = (1- r) [aek' +