Skip to main content
SpringerLink
Log in

Central-local government fiscal relations and cyclicality of public spending: evidence from China

  • Published:
International Tax and Public Finance Aims and scope Submit manuscript

Abstract

In this study, we analyze how fiscal decentralization affects the cyclicality of government spending. We focus on China, which experienced fiscal decentralization during 1979–1993 and then partly centralized its revenue with the 1994 fiscal reform. By employing both time series and province-level panel data, we show that Chinese provincial and total government spending was strongly procyclical during the decentralization period before the reform, but both became significantly less procyclical with respect to nationwide output fluctuations after the reform. We suggest several channels through which the procyclicality of subnational government spending in decentralized fiscal federations could be restrained. We further find that less procyclical provincial government spending is associated with smaller output volatility.

This is a preview of subscription content, log in via an institution to check access.

Access this article

Log in via an institution

Price excludes VAT (USA)
Tax calculation will be finalised during checkout.

Instant access to the full article PDF.

Institutional subscriptions

Fig. 1
Fig. 2
Fig. 3
Fig. 4
Fig. 5

Similar content being viewed by others

Notes

  1. For example, Rodden and Wibbels (2010) find that ‘Subnational finance in several of the world’s most decentralized federations is overwhelmingly pro-cyclical.’ (p. 59).

  2. Prud’homme (1989) and Bogoev (1991) are earlier studies that illustrate how decentralization in Brazil and Yugoslavia weakened the capability of the central government to implement stabilization policies.

  3. While fiscal policy is viewed as a central macroeconomic tool by Keynesian economists, discretionary fiscal policy for stabilization purposes faces significant timing problems. Fiscal policy played a secondary role to monetary policy in countries like the USA for decades before the 2008 global financial crisis.

  4. Some local taxes may by acyclical because the tax base is acyclical. This is true, for instance, for property taxes in many countries.

  5. Empirical evidence from Latin America (for example, Stein et al. 1999) supports this theory. The “voracity effect” is likely to be especially strong in countries with weak institutions and fractionalization.

  6. There were four types of revenue sharing between provinces and the central government in the early 1980s (Oksenberg and Tong 1991) and six basic forms of fiscal sharing contracts starting from 1988 [see Bahl and Wallich (1992); Oi (1992) and Montinola et al. (1996)]: some provinces remitted a fixed percentage of revenue to the central government while others remitted a fixed quota. For the former, provinces usually retained a substantial proportion of revenue. For the latter, provinces could keep all revenue exceeding the agreed “quota.” The content of the contracts differed across provinces and the rules were often set based on negotiations.

  7. There is no consensus on the growth effect of decentralization in China. For example, Zhang and Zou (1998) find that decentralization led to lower economic growth in China, as central government investment has more positive externality on growth than subnational government investment.

  8. Very recently this restriction was relaxed for a few selected cities. Local government could borrow to finance its budgetary spending indirectly via the central government, but only a small percentage of local expenditure is financed in this way. Local government also borrows via channels such as a Local Government Financing Vehicle (LGFV), but borrowing via the LGFVs is mainly to finance off-budgetary infrastructure investment [see Zhang and Barnett (2014)].

  9. Government revenue during the early 1980s heavily relied on profit remittance from state-owned enterprises, the majority of which were controlled by local governments (Montinola et al. 1996). Formal taxes on profits of state-owned enterprises briefly replaced profits remittance in 1984. In 1986, state-owned enterprises reversed to contracts over multiple years on profits remittance to the government.

  10. Appendix A reports the categories of taxes and the associated revenue-sharing rules between the central and the provincial government.

  11. We calculate the fiscal gap for each province in each year and then average this ratio across provinces to construct the time series in Fig. 3.

  12. Wang and Herd (2013) provide a detailed analysis of the Chinese intergovernmental transfer system.

  13. The VAT was introduced and expanded mainly to replace product taxes which were based on turnover.

  14. We test this hypothesis in Sect. 5.2.

  15. Government spending does not include net lending. However, this figure contains interest payments on domestic debt since 2002. We do not adjust the spending figures for interest payments because we do not have this information for local and central government. In a separate exercise, we obtain figures for interest payments on domestic debt for total government from the China Fiscal Yearbooks and adjust the total government spending series from 2002 accordingly. The growth rates of real total government spending based on the unadjusted and the adjusted data, however, are almost identical.

  16. We exclude Tibet from this analysis to be consistent with empirical estimations in this study.

  17. One alternative method is to regress the cyclical component of government spending on the cyclical component of GDP. The cyclical components of these variables can be obtained by applying filters such as the Hodrick-Prescott (HP) filter. We obtain similar results when using this alternative strategy.

  18. We exclude the year 1994 from the regression analysis as there were substantial changes in the growth rate of government expenditure and revenue in this year due to the fiscal reform. Including the year 1994 will hence bias our estimation results.

  19. It is worth noting that in their cross-country study on graduation from fiscal pro-cyclicality, Frankel et al. (2013) classified China as “still in school”. Using the GFS data provided by the International Monetary Fund, they find a positive correlation between the cyclical component of government spending and that of real GDP during the period 2000–2009. However, the government spending figures in their study include general government net lending, which is not included in the government spending figures we use. In a separate exercise using the GFS data, we find that general government net lending in China is procyclical during 2000–2009 but the budgetary spending is not.

  20. As a robustness check, we replace \(\Delta \ln \hbox {GDP}_t \) with \(\Delta \ln \hbox {GDP}_{t-1} \) in Eq. (2) and re-estimate it with and without additional control variables. The results are similar to those in Table 2. We do not report these results for brevity.

  21. We exclude Tibet from our regression analysis as data for Tibet is missing for many years.

  22. In Appendix C, we investigate the time-series properties of local government expenditures, revenues, and net transfers. We find that the levels of these variables are likely to be nonstationary but the first differences of these variables are all stationary.

  23. The results are very similar when we use national GDP deflator as the common deflator for all provinces.

  24. We test the time-series properties of relevant variables in Appendix C.

  25. We include two linear trends in Column 6 to capture potential structural breaks. Provincial-specific trends are included in separate exercises and similar results are found.

  26. To be consistent across different columns in Table 4, we report the results based on subsample regressions without controlling for time trends. Estimations became imprecise especially when we control for province-specific trends as the sample size shrinks.

  27. We report the unweighted average coefficients for these parameters.

  28. Net transfers are defined as transfers received by provinces from the central government minus transfers from provinces to the central government.

  29. We cannot accurately infer the level of transfers and grants by calculating the difference between local government revenue and spending, since the budget contains other items such as rollovers of last year’s revenue and expenditures and loans from the central government.

  30. In an unreported exercise, we construct the treated and control groups based on whether the actual net transfers in a certain province, averaged between 1995 and 2013, is above or below the sample median. We then conduct similar Difference-in-Differences analysis as in Sect. 4.3.1. We obtain similar results.

  31. Business tax in China is based on turnover.

  32. Ideally, we need to know the percentage of VAT in tax revenue before 1994 and consider the changes in this percentage before and after 1994. However, we only have VAT information at the province level since 1995. Our analysis then is justified by the observation that many provinces did not have VAT before 1994.

  33. Similar to the estimation of the cyclical pattern of spending, we first detrend the output growth data and then calculate the standard deviation of the detrended growth rate.

  34. The standard deviation of total government revenue growth rate is around 4.7 and 4% before and after 1994, respectively.

References

  • Abbott, A., & Jones, P. (2012). Intergovernmental transfers and procyclical public spending. Economics Letters, 115, 447–451.

    Article  Google Scholar 

  • Abbott, A., & Jones, P. (2013). Procyclical government spending: a public choice analysis. Public Choice, 154, 243–258.

    Article  Google Scholar 

  • Aghion, P., & Marinescu, I. (2007). Cyclical budgetary policy and economic growth: what do we learn from OECD panel data? NBER Macroeconomics Annual, 22, 251–278.

    Article  Google Scholar 

  • Aghion, P., Hémous, D., & Kharroubi, E. (2014). Cyclical fiscal policy, credit constraints, and industry growth. Journal of Monetary Economics, 62, 41–58.

    Article  Google Scholar 

  • Alesina, A., & Tabellini, G. (2008). Why is fiscal policy often procyclical? In CESifo Working Papers, No. 1556.

  • Arena, M. & Revilla, J. E. (2009). Procyclical fiscal policy in Brazil: Evidence from the states. In World Bank Policy Research Working Paper No. 5144.

  • Bahl, R., & Martinez-Vazquez, J. (2003). Fiscal federalism and economic reform in China. In J. S. Wallack & T. N. Srinivasan (Eds.), Federalism and economic reform: International perspectives. Cambridge: Cambridge University Press.

    Google Scholar 

  • Bahl, R., & Wallich, C. (1992). Intergovernmental fiscal relations in China. In World Bank Working Paper No. 863.

  • Baskaran, T., Feld, L. P., & Schnellenbach, J. (2016). Fiscal federalism, decentralization and economic growth: A meta-analysis. In Freiburg Discussion Papers on Constitutional Economics 16/02

  • Baskaran, T., & Feld, L. P. (2013). Fiscal decentralization and economic growth in OECD countries. Public Finance Review, 41(4), 421–445.

    Article  Google Scholar 

  • Blanchard, O., & Shleifer, A. (2000). Federalism with and without political centralization: China versus Russia. In NBER Working Paper No. 7616. National Bureau of Economic Research, Inc.

  • Blanchard, O., Dell’Ariccia, G., & Mauro, P. (2010). Rethinking macroeconomic policy. Journal of Money, Credit and Banking, 42, 199–215.

    Article  Google Scholar 

  • Blöchliger, H., & Égert, B. (2013). Fiscal consolidation across government levels-part 3. Intergovernmental grants, pro- or counter-cyclical? In OECD Economics Department Working Papers No. 1072. OECD Publishing.

  • Bogoev, K. (1991). The dangers of decentralization: The experience of Yugoslavia. In: R. Proud’homme (Ed.), Public Finance with Several Levels of Government, Foundation Journal Public Finance (pp. 99–112). Haag/Koenigstein.

  • Brandt, L., & Zhu, X. (2000). Redistribution in a decentralized economy: Growth and inflation in China under reform. Journal of Political Economy, 108(2), 422–439.

    Article  Google Scholar 

  • Clemens, J., & Miran, S. (2012). Fiscal policy multipliers on subnational government spending. American Economic Journal: Economic Policy, 4(2), 46–68.

    Google Scholar 

  • Fatás, A., & Mihov, I. (2006). The macroeconomic effects of fiscal rules in the US states. Journal of Public Economics, 90, 101–117.

    Article  Google Scholar 

  • Frankel, J. A., Végh, C. A., & Vuletin, G. (2013). On graduation from fiscal procyclicality. Journal of Development Economics, 100(1), 32–47.

    Article  Google Scholar 

  • Jin, H., Qian, Y., & Weingast, B. R. (2005). Regional decentralization and fiscal incentives: Federalism, Chinese style. Journal of Public Economics, 89, 1719–1742.

    Article  Google Scholar 

  • Lane, P. R. (2003). The cyclical behavior of fiscal policy: Evidence from the OECD. Journal of Public Economics, 87, 2661–2675.

    Article  Google Scholar 

  • Lane, P. R., & Tornell, A. (1996). Power, growth and the voracity effect. Journal of Economic Growth, 1, 213–241.

    Article  Google Scholar 

  • Lane, P. R., & Tornell, A. (1999). The voracity effect. American Economic Review, 89(1), 22–46.

    Article  Google Scholar 

  • Ma, J. (1996). Intergovernmental relations and economic management in China. New York: St. Martin’s Press.

    Google Scholar 

  • Maddala, S. G., & Wu, S. (1999). A comparative study of unit root tests with panel data and a new simple test. Oxford Bulletin of Economics and Statistics, 61, 631–652.

    Article  Google Scholar 

  • Montinola, G., Qian, Y., & Weingast, B. R. (1996). Federalism, Chinese style: The political basis for economic success. World Politics, 48(1), 50–81.

    Article  Google Scholar 

  • Musgrave, R. M. (1959). The theory of public finance. New York: McGraw-Hill.

    Google Scholar 

  • Oates, W. E. (1972). Fiscal federalism. New York: Harcourt Brace Jovanovich.

    Google Scholar 

  • Oates, W. E. (1999). An essay on fiscal federalism. Journal of Economic Literature, 37, 1120–49.

    Article  Google Scholar 

  • Oksenberg, M., & Tong, J. (1991). The evolution of central-provincial fiscal relations in China, 1971–1984 the formal system. The China Quarterly, 125, 1–32.

    Article  Google Scholar 

  • Oi, J. C. (1992). Fiscal reform and the economic foundations of local state corporatism in China. World Politics, 45(1), 99–126.

    Article  Google Scholar 

  • Pesaran, M. H., & Smith, R. (1995). Estimating long-run relationships from dynamic heterogeneous panel. Journal of Econometrics, 68(1), 79–113.

    Article  Google Scholar 

  • Pesaran, M. H., Shin, Y., & Smith, R. (1999). Pooled mean group estimation of dynamic heterogeneous panels. Journal of the American Statistical Association, 94, 289–326.

    Article  Google Scholar 

  • Prud’homme, R. (1989). State and local finance and public policy in Brazil. In L’OEIL. IUP, University of Paris XII, Creteil.

  • Prud’homme, R. (1995). The danger of decentralization. The World Bank Research Observer, 10, 201–220.

    Article  Google Scholar 

  • Qian, Y., & Weingast, B. R. (1997). Federalism as a commitment to preserving market incentives. Journal of Economic Perspectives, 11, 83–92.

    Article  Google Scholar 

  • Ramey, G., & Ramey, V. (1995). Cross-country evidence on the link between volatility and growth. American Economic Review, 85(5), 1138–1151.

    Google Scholar 

  • Rodden, J., & Wibbels, E. (2010). Fiscal decentralization and the business cycle: An empirical study of eight federations. Economics & Politics, 2, 37–67.

    Article  Google Scholar 

  • Roland, G. (1999). Politics, Markets, and Firms: Transition and Economics. Cambridge, MA: MIT Press.

    Google Scholar 

  • Seitz, H. (2000). Fiscal policy, deficits and politics of subnational governments: The case of the German Laender. Public Choice, 102, 183–218.

    Article  Google Scholar 

  • Sorensen, B. E., Wu, L., & Yosha, O. (2001). Output fluctuations and fiscal policy: U.S. state and local governments 1978–1994. European Economic Review, 45, 1271–1310.

    Article  Google Scholar 

  • Stein, E., Talvi, E., & Gristani, A. (1999). Institutional arrangements and fiscal performance: The Latin American experience. In J. M. Poterba & J. von Hagen (Eds.), Fiscal institutions and fiscal performance (pp. 103–134). Chicago, IL: University of Chicago Press.

    Google Scholar 

  • Talvi, E., & Végh, C. A. (2005). Tax base variability and procyclical fiscal policy in developing countries. Journal of Development Economics, 78, 156–190.

    Article  Google Scholar 

  • Tanzi, V. (1995). Fiscal federalism and decentralization: A review of some efficiency and macroeconomics aspects. Annual World Bank Conference on Development Economics. Washington, DC: The World Bank.

  • Tiebout, C. M. (1956). A pure theory of local expenditures. Journal of Political Economy, 64(5), 416–424.

    Article  Google Scholar 

  • Tornell, A., & Lane, P. R. (1999). The voracity effect. American Economic Review, 89, 22–46.

    Article  Google Scholar 

  • Wang, S. (1997). China’s 1994 fiscal reform: An initial assessment. Asian Survey, 37(9), 801–817.

    Article  Google Scholar 

  • Wang, X., & Herd, R. (2013). The system of revenue sharing and fiscal transfers in China. In OECD Economics Department Working Paper No. 1030, OECD.

  • Wong, C. P. W., Heady, C., & Woo, W. T. (1993). Economic reform and fiscal management in China: Report of technical assistance project, Asian Development Bank and Ministry of Finance of China.

  • Wong, C. P. W. (2000). Central-local relations revisited: The 1994 tax sharing reform and public expenditure management in China. China Perspectives, 31, 52–63.

    Google Scholar 

  • Zhang, Y., & Barnett, S. (2014). Fiscal vulnerabilities and risks from local government finance in China. In International Monetary Fund Working Paper No. 14/4.

  • Zhang, T., & Zou, H. (1998). Fiscal decentralization, public spending, and economic growth in China. Journal of Public Economics, 67(2), 221–240.

    Article  Google Scholar 

Download references

Acknowledgements

We are grateful to Alan Auerbach, Stephen Bond, Wei Cui, Irem Guceri, Lovleen Kushwah, Lei Zhang, participants in the 2016 International Institute of Public Finance Annual Congress, and seminar series at Antai College of Economics and Management, Shanghai Jiao Tong University, University of Glasgow, and Catholic University of Milan, for their helpful comments.

Author information

Authors and Affiliations

  1. Antai College of Economics and Management, Shanghai Jiao Tong University, 1954 Huashan Road, Shanghai, China

    Jing Xing

  2. ifo and University of Munich, Munich, Germany

    Clemens Fuest

Authors
  1. Jing Xing
    View author publications

    You can also search for this author in PubMed Google Scholar

  2. Clemens Fuest
    View author publications

    You can also search for this author in PubMed Google Scholar

Corresponding author

Correspondence to Jing Xing.

Appendices

Appendix A

See Table 13.

Table 13 Tax revenue sharing between central and local government (China Statistical Yearbook)
Full size table

Appendix B: Variable definitions and data sources

  1. DEF

    Total government deficit, defined as (Total government expenditure-Total government revenue)/GDP (China Statistical Yearbook).

  2. EXP

    Real government spending. The nominal data is obtained from the Zhongguo caizheng tongji nianjian. The nominal data is the transformed into real one using province-specific deflators.

  3. GDP

    Real gross domestic product (China Statistical Yearbook). To transform the nominal GDP into real GDP, we use the GDP deflator provided by the World Bank.

  4. GR_TOT

    The growth rate of trade openness, which is defined as the sum of exports and imports divided by GDP (China Statistical Yearbook).

  5. GSP

    Real provincial output (China Statistical Yearbook). To transform the nominal output into real ones, we use province-specific deflators.

  6. REV

    Real government tax revenue (Zhongguo caizheng tongji nianjian).

  7. TRANSFER

    Real net transfers the local governments receive from the central government. It is defined as transfers from central government minus transfers to central government (Zhongguo caizheng tongji nianjian).

Appendix C

See Table 14.

Table 14 Time-series properties of key variables
Full size table

Appendix D

See Tables 15 and 16.

Table 15 Short-run and long-run cyclicality of net transfers: OLS, Pooled Mean-groups and Mean-groups estimations
Full size table
Table 16 Short-run and long-run cyclicality of revenue: OLS, Pooled Mean-groups and Mean-groups estimations
Full size table

Appendix E

See Table 17.

Table 17 The cyclicality of VAT, business tax (BT), and corporate income tax (CIT): 1995–2013
Full size table

Rights and permissions

Reprints and permissions

About this article

Check for updates. Verify currency and authenticity via CrossMark

Cite this article

Xing, J., Fuest, C. Central-local government fiscal relations and cyclicality of public spending: evidence from China. Int Tax Public Finance 25, 946–980 (2018). https://doi.org/10.1007/s10797-017-9478-8

Download citation

  • Published:

  • Issue Date:

  • DOI: https://doi.org/10.1007/s10797-017-9478-8

Keywords

JEL Classification

Search

Navigation