Growth and Equity Tradeoff in Decentralization Policy: China's Experience

The paper uses China's recent experience to investigate the potential tradeoff between economic growth and regional equity in the design of fiscal decentralization policy. Although present in other countries, this policy tradeoff has been particularly relevant to China over the last two decades. We build a theoretical model of fiscal decentralization, where overall national economic growth and equity in the regional distribution of fiscal resources are the two objectives pursued by a benevolent policy maker. Solutions that emphasize regional equity tend to have larger central government expenditures and higher contribution to the central budget by the richer jurisdictions. The reverse is true for solutions emphasizing growth. The model is tested using panel data for 1985-98. We find that fiscal decentralization in China led to economic growth, but this relationship was non-linear. Decentralization also led to significant increases in regional inequality. Overall, the historical record shows that pushing for a more equitable distribution of fiscal resources across provinces in China is likely to lead to lower national economic growth. The tradeoff between economic growth and regional equity is the most important and difficult decision in intergovernmental fiscal reform currently facing the Chinese authorities.