Yardstick competition in a Federation: Theory and Evidence from China

While some scholars argue that fiscal decentralization gave Chinese local officials strong incentives to promote local economic growth, traditional fiscal federalism theories are not directly relevant to explain such an effect in the particular context of China. In this paper, we explain the existence of interjurisdictional competition among Chinese local officials using a model of yardstick competition "from the top", in which the central government (and not local voters) creates a competition among local officials by rewarding or punishing them on the basis of relative economic performance. Our model predicts that, in this context, local governments are forced to care about what other incumbents are doing and that public spending settings are strategic complements. Then, 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, simultaneity and endogeneity problems and spatial error dependence. The results are encouraging to the view that there are some strategic interactions among Chinese provinces, resulting from a yardstick competition created by the central government.