Regional Decentralization and Fiscal Incentives: Federalism, Chinese Style

March 1999 Second generation theories of federalism extend traditional approaches by systematically studying the role of government incentives in economic performance. Providing government with the incentive to promote markets is especially acute for developing economies or those in transition from central planning. In these countries, governments have often been the central barrier to economic development. In this paper, we investigate empirically decentralization and fiscal incentives in the central-provincial relationship during China's reform. We find strong correlations between local government revenue collection and local government expenditure. Further, we show that China's fiscal contracting system provides local governments with strong (marginal) fiscal incentives and at the same time improves horizontal distribution across provinces in budgetary spending. We also find that stronger fiscal incentives — measured in terms of higher marginal revenue retention rate — implies faster development of non-state enterprises and more reform in state-owned enterprises. Finally, we compare federalism, Chinese style, with federalism, Russian style.