Fiscal decentralization has been an important aspect of the reforms in China in the past two decades (Wong, 1992). The pre-reform fiscal regime of China was adapted to the highly concentrated planning economy. Not only did the government do everything, but sub-national governments were totally dependent on the central government.
Along with the planning economy transiting to market-oriented economy, China began its fiscal decentralization reform in the early 1980s, with the goal of giving sub-national governments more autonym to finance their own needs. The initial strategy involved a variety of contracting methods, which basic spirit was to apportion the incremental revenue between central and local governments on the base of negotiations. However, the contracting revenue system failed in two principle drawbacks. First the central government shares of fiscal revenue decline sharply because the local governments “tricked” the system by producing just enough budget revenue to satisfy the contract and hided further revenue to extra-budget that did not have to share. Second, the distinct bargaining power of different provinces enlarged the fiscal difference among regions and the central governments gradually fell into an inefficient track of constantly bargaining with sub-national governments over revenue-share term.
Consequently, another fiscal decentralization reform was undertaken in 1994, which mainly formed the current fiscal system in China. More importantly, this reform brought obvious changes to the financial statue of local governments and influenced its public expenditure financing actions, including infrastructure spending decisions. So this paper used data after this reform to evaluate the effects of fiscal decentralization on infrastructure spending decision-making.
On the one hand, the new tax-sharing system took place of old contract system so that this reform was known as “Tax Assignment System”. It divided taxes into three categories: national, local, and joint. The primary fixed tax revenues were distributed to central government, such as consumption tax and custom duties. Most large tax resources became joint revenue and central government held larger proportion, for example, Value Added Tax (75%:25%), Corporate Income Tax(60%:40%), and Individual Income Tax(60%:40%). The local taxes only generated fractional revenue and mostly were related to land value, such as Land Appreciation Tax, Land Appreciation Tax, City and Township Land Use Tax.
Chart 1. Ration of central and local tax revenue of total during 1994 to 2006
Source: Monthly Statistic Report of State of Administration of Taxation (www.chinatax.gov.cn) and China Statistical Yearbooks (1994–2007).
After this reform, central tax revenue proportion had been expected to increase from 59.59% in 1994 to 63.81% in 2006. While local tax revenue had declined from 40.42% to 36.19% at the same period.
On the other hand, this reform mainly focused on the revenue side, the expenditure responsibilities among central governments and local governments are still unclear. Actually, most of the service delivery functions, along with the corresponding investment in local infrastructure are the responsibilities of local governments. The local level is also responsible for economic development and economic planning—which involves pro-active direction of the local enterprise sector. Local governments in China also have much greater responsibility for poverty alleviation and social protection of displaced workers than is true in the West, where these functions are assumed primarily by central government (see Table 1).
Table 1 Sub-National Expenditure Responsibilities
In other words, the tax revenue of local governments had been constrained but the expenditure responsibilities did not adjust to this change. Both sides have effects on the local governments’ infrastructure spending.
Firstly of all, in the tax revenue context, local governments want to attract more investment inflows to increase the tax incremental revenue because the biggest joined revenues from VAT and CIT are depending on the trade flourish and profits of residential companies. Whether an area has good infrastructure becomes one of the decision factors of investors, so governments have to make efforts to improve the local infrastructures.
Secondly, the local taxes are mostly related to land value. The most efficient way to increase the land value is to ameliorate basic infrastructures, such as road, green land, and post service. In other words, local government can gain more revenue from local taxes if the infrastructures get improvements.
Thirdly, the increasing infrastructure spending because the infrastructure expenditure responses are mainly in local governments and yardstick competitions among local governments promote governors to use every effort to improve infrastructure. The latter one is related to the fiscal centralization incentive. Next part will talk about this.
1.2 Political Centralization
In order to better understand the infrastructure spending in China, we cannot ignore the impact from its unique political system. Not only fiscal reform appears to have been successfully pursued without any political reform, but also central government retains considerable political discretion. Under such centralized control, the main propose of increasing infrastructure spending by Chinese local governments is to produce better performance instead of a way to redistribute public resource assumed in classical public finance literature.
The Tiebout (1956) established public expenditure theory on the assumptions that consumer-voters can fully mobile and can “vote by feet” by moving to the community where their preference are best satisfied. The fiscal federalism made by Oates (1972) emphasized the active effect of improving public good supply and government efficiency. However, in China’s situation, neither fits so well. Its distinct characteristics which relate to infrastructure spending can be summarized as follows.
Firstly, in China, recent lessening of controls over migration, obstacles to labor movement- particularly from rural areas to cities- remains. So the citizens have little freedom to “vote by their feet”. What can vote by feet in China is mainly referred to investment, especially foreign direct investment (FDI). Obviously, it is hard for any businesses to operate in areas where roads are unpaved and power supply is unreliable. So even poor areas have to improve their infrastructure in order to attract investment and develop local economy.
Then, local government officials in China are not generally elected, and their preferences may be inconsistent with those of their constituents. In the bureaucracy system, the officials are more responsible to “the above” (super leaders) instead of “the down” (voters), because the super leader has the authority to their demotion and promotion. The performance in their tenure which is mainly reflected by FDI and GDP number determines their bureaucrats pursuing career prospect.
In addition, the size of local government is largely determined at the central level, based on criteria that have little to do with local needs. During 1994-2006 periods, the increase of FDI and GDP are goals set by central government. In order to gain better score, local governments revoked the yardstick competition between each other. Generally, increasing infrastructure input became one of most popular ways.
Admittedly, to some extent, these political incentives promote the infrastructure booming in last decades. However, it also made potential problems in infrastructure financing of local governments. For example, there are lack of transparency and cost-benefit valuation in the infrastructure projects. The infrastructure spending decisions are largely depending on the official’s personal preference but not the local need.