Yardstick competition in a federation: Theory and evidence from China

In this paper, we test empirically for competition among Chinese provinces embedded in a centralized political system. To motivate the empirical work, we adapt Besley and Case's model (American Economic Review, 1995) to a model of yardstick competition ‘from the top’. In this model, the central government (rather than local voters) creates competition among local officials by rewarding or punishing them on the basis of relative performance in providing public services. Our theoretical framework predicts that, in this context, the central government spurs strategic interactions among governors with similar environments as voters do in democratic countries. Then, for the first time in our knowledge, by estimating a spatial lag dynamic model for a panel data of 29 Chinese provinces from 1980 to 2004, we provide empirical evidence of the existence of such public spending interactions. We propose a rigorous empirical framework which takes into account heterogeneity, endogeneity problems and spatial error dependence. The results tend to confirm the existence of strategic interactions among geographically and economically close Chinese provinces, operating in a vertical bureaucratic control system.