Transfers-based Decentralization, Local Endowment and Public Employment: A theoretical inquiry and empirical evidence from China

Based on the theoretical literature of fiscal decentralization, we discuss the political economy of inter-governmental fiscal arrangements in China and examine how a transfer-based decentralization impacts on local public employment. A theoretical model is built to show that compared to their counterparts in better-endowed localities, local governments in worse-endowed localities that are more heavily dependent on upper level fiscal transfers to finance their spending have higher incentives to increase public employment to build local political support rather than invest in growth-promoting public goods. Using a county-level panel data set from 1994 to 2003, we empirically identify the causality from higher transfer dependency to the expansion of public employment with an instrumental variable approach. It is argued that under a governance regime in which local governments are more accountable to the upper level than to local constituency, transfer-based decentralization, either through general-purpose transfer or through earmarked transfer, would both lead to serious problems. The policy implication is that expenditure decentralization needs to be accompanied by both revenue and political decentralization to achieve better local governance outcomes.