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Fiscal Incentives and Local Government Behavior in China

Post Series: 2007: Volume 6, Number 1
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Fiscal Incentives and Local Government Behavior in ChinaLocal-central government relations are a hot issue in China today. Many problems result from fuzzy division of responsibilities and the difficulty of designing incentives to achieve multiple goals. These problems include local protectionism, trying to out-do each other in offering incentives to foreign investors, over-investment resulting in redundant construction, poor investment choices, and over-zealous growth.

In China “local government” refers to all types of sub-national governments. As a key part of the central-local dynamic, China’s fiscal system plays an important role of macro-regulation, exerting great influence upon local governmental behavior by defining the scope of fiscal revenue and expenditure, and the responsibilities and rights of fiscal management between the central government and local governments. China’s fiscal system has undergone a series of changes as part of the overall reform process in order to improve resource allocation and overall economic productivity. This article re-examines the previous narrow notion of a fiscal system as applied in China, analyzes the changes that have taken place, and offers suggestions for further reform.

The structure of China’s fiscal system has shaped local governments into “quasi-market agents” that demonstrate great enthusiasm in participating in resource allocation activities. As a result, they have made great contributions to recent national economic growth. At the same time the present fiscal system also brings many negative influences to local government behavior, and thereby is hindering the economy’s development of healthy growth in the future. The way China reforms its fiscal system from here will directly affect the behavior of local governments. It is critical that China deepen its fiscal system reform to optimize local governmental behavior to ensure economic development in the long run.

At present, the pivotal question for China’s economists and officials is what kind of fiscal system can promise the greatest success in maintaining economic stability and lead to the establishment of a more equitable redistribution of income and efficient allocation of resources. There seems to be consensus that a strong government has some advantages with regard to the functions of stabilization, redistribution and provision of public goods and services. Meanwhile, with the move to a more market-oriented system, governments should work to become macroeconomic regulators instead of direct organizers of microeconomic activities.

Local government behavior under different reform systems
Early Reforms
After years of under a very top-down fiscal system where local governments did not have control over their budgets, reforms in the early 1980s experimented with various contractual systems between different levels of government. The contractual fiscal system was characterized by defining a fixed sum paid (or received, if subsidized) to the central government by a local government. This approach clarified the tasks assigned to local governments and the benefits they would receive, and provided greater incentives to encourage local growth. Within the term of the contracts, local governments could arrange their own revenue and expenditure according to their goals of regional economic and social development. However, their increased independence also dramatically changed their behavior.

First, because local budgets increased with local revenue, local governments had a strong motive to develop their regional economies and new opportunities for profit generation. However, since they did not have taxation power and because of shortages in local revenue in the face of the need to develop infrastructure, local governments began to depend more on revenue that could be raised and spent outside of the official budget. This included the unwarranted pooling of funds, as well as arbitrary charges and fines that helped cover the gap between expenditure and revenue. The unintended consequences of these efforts were that they undermined fiscal discipline and distorted the internal mechanism of the contractual system.

Second, in order to take advantage of resource allocation and system arrangements, local governments bargained hard with the central government to win decisions on system choice and policy-making that were slanted in their favor. Many different contracts resulted, with little consistency across local governments, and the short timeframe of each contract led to short-term-oriented behavior.

Third, because local governments had control over extra revenue generated above their negotiated contract with the central government, local governments tended to interfere with the management and other decisions of firms within their jurisdiction, frustrating enterprise market reforms.

Tax Reform in 1994
Compared to China’s tax system prior to 1994, the Tax Sharing Reform, enacted in January 1994, instituted monumental change. The reform was aimed at (1) unifying and perfecting the tax system so that tax collection could be administered on the basis of law instead of on the basis of administrative discretion and bargaining; (2) simplifying the tax system; (3) assuring governmental revenue; (4) enabling reasonable sharing of tax revenue, and taxation authority between the central and local governments; (5) using taxation as an instrument to control the economy and adjust resource allocations; and (6) ensuring tax burden equity.

The 1994 Tax Reform divided tax revenue into three categories: central taxes, regional taxes, and central/regional government shared taxes. These divisions are close to those often used in countries with market-oriented economic systems. Administratively, two levels of tax administration were established: the state bureau of tax administration (responsible for central government tax and central/regional shared tax administration) and regional tax administration (responsible for regional/local tax only). The central and provincial tax administrations each levied its own taxes on the basis of the new tax laws. As a result, local governments could in theory enjoy more freedom over their own revenue, while helping to ensure the central government’s revenue. At the same time, the changes that resulted in decentralized tax authority would give incentives to local governments to work towards good economic performance to increase the tax revenue generated.

The appeal of the revenue-sharing system embedded in the 1994 Tax Sharing Reforms is that it put a highly elastic central revenue system at the disposal of local governments. With this system, local governments were allowed to disburse expenditures if they generated more revenue. This created powerful fiscal incentives for local governments to promote local economic growth in order to raise revenue and create employment.

Alongside these positive incentives a number of serious negative results also emerged, largely due to the lack of institutional guarantees, making the balance of power between central and local governments difficult. The changes lead to resentment due to the absence of popular representation, which meant local officials were appointed by the central government according to their ability to promote economic growth rather than being elected locally. Therefore, when local officials did not live up to the expectations of their constituents, they did not suffer any serious consequences, and they easily avoided transparency in their negotiations with the central government.

Policy Options to optimize local government behavior
Local governments play a very important role in national economic development. Without optimal local government behavior, it is impossible for a society to achieve a healthy development in the long run. Broadly speaking, there are a lot of factors affecting the negative behavior of local government in China. However, from the above analysis, we can see the fiscal system is one of the most important. In this context, taking measures to further fiscal-system reform can not only optimize local government behavior, but can also bring long-term positive effects for future development. Several policy reforms are needed.

Ultimately, no matter what the central or the local governments do, their power comes from the society they serve. But the self-inflation of power by the government sometimes exceeds the scope given by society. With no adjustment mechanism, the result is often inflation of government bureaucracy and rent-seeking, where the government officials impose hefty fees on productive economic activity. After 20 years of reform in China, the growing social strength of the citizens makes it more urgent that local officials monitor their own behavior. To accomplish this, the reforms should support the development of three kinds of social organizations: (1) those organizations that can improve the degree of self-discipline of the agents in the micro-economy, such as trademark and intellectual property protection, accounting and audit expertise, asset assessment and stock exchange information and transactions; (2) those organizations that can improve the organization and smooth functioning of markets, such as judicial process and other organizations that support social service and social welfare; and (3) those organizations that can improve the coordination between macro-control and micro-activities, such as trade associations, labor unions and professional associations.

Under the present fiscal system, local governments are both players and referees. In order to improve their local performance, there is need to separate the evaluation of local government officials from a simple measure of rapid growth in output, which to date has driven local officials’ promotion and their chances of winning favorable policies for the future. Freeing enterprises from government intervention in their operations and putting more resources in the hands of the populace would be more desirable. In the future, some of these types of measures must be taken to reshape local governments and turn them into lean and efficient governments by making clear their rights and responsibilities.

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