INTRA-PROVINCIAL FISCAL DISPARITIES AND THE ROLE OF THE PROVINCIAL FISCAL TRANSFER SYSTEM IN CHINA: A CASE STUDY OF HENAN PROVINCE.

Author:Li, Hui
  1. INTRODUCTION

    While the efforts over the last two decades to reform China's fiscal system through decentralization have driven tremendous economic growth, there are growing concerns about the fiscal decentralization reform's negative effects on fiscal disparities throughout the country. The issue of fiscal disparities, referred to as differences across subnational governments in their ability to raise revenue to meet public expenditure needs (Otter, 2008), has been widely studied, but this strand of literature has mainly addressed fiscal disparities between coastal and inland regions, rural and urban areas, and across provinces. The focus has been the role of central equalization policies in mitigating the growing fiscal disparities resulting from uneven regional economic development. Intra-provincial fiscal disparities and the role of provincial equalization policies have not gained much attention in large part due to the lack of detailed data at the sub-provincial level in the early years of this research. Yet provincial-level data might disguise intra-provincial fiscal disparities, and an improvement in a province's overall fiscal capacity as a result of central fiscal equalization efforts does not necessarily translate into reduced intra-provincial fiscal disparities. Based on sub-provincial information and relevant decomposition techniques, a few recent studies have demonstrated that intra-provincial fiscal disparities are actually more profound than inter-provincial fiscal disparities and account for the majority of the overall fiscal disparity in the country, although the relative contributions of the two types of disparities vary in different studies (Liu et al 2014; Wang and Herd, 2013: Zhang, 2013). These studies have also found that the extent of intra-provincial fiscal disparities differs across provinces (Wang and Herd, 2013; Zhang, 2013; Zhou and Yan, 2010), which implies that individual provincial fiscal transfer systems play a varying role in equalization.

    A few scholarly efforts have been made to examine the effects of China's fiscal transfer system in reducing overall national fiscal disparities at the subprovincial level (primarily the county level), but the results are inconsistent (Liu et al, 2014; Tsui, 2005; Wang and Herd, 2013; Yin, 2008). Those using conventional equalization measurement methods find some equalization effects of the fiscal transfer system (e.g. Liu et al, 2014; Wang and Herd, 2013), while those using the techniques of decomposition by revenue sources reveal opposite results due to the decomposition method's much stricter criterion of equalization effects (e.g. Tsui, 2005; Yin, 2008). Nevertheless, a shortcoming of this body of literature is that the approach of pooling more than 2,000 county-level governments together ignores the variation of provincial fiscal transfer systems and their different effects on intra-provincial fiscal disparities within individual provinces. These aggregate analyses can shed some light on the redistributive outcome of provincial transfer systems at the aggregate national level, but they do not present the fiscal equalization performance of individual provincial fiscal transfer systems. Zhou and Yan (2010) presented the level of intra-provincial fiscal disparities and the contributions by different types of transfers in each individual province. Their findings demonstrate the varying extent of fiscal equalization across provinces and underpin the importance and urgency of single-province studies to look into the details of individual provincial fiscal systems and their equalization effects on intra-provincial fiscal disparities.

    This study differs from previous studies as it is the first single-province analysis to investigate the level of intra-provincial fiscal disparities and explicitly explore the role of fiscal equalization policies pursued by a provincial-level government. Through a case study of Henan Province, it examines the extent to which the undesirable fiscal inequalities at the county level can be traced to the provincial fiscal transfer system. The study of the provincial government's role in fiscal equalization policies is vital because in a multi-level government structure, the effectiveness of national equalization efforts greatly depends on the further degree of vertical decentralization and the equalization efforts of intermediate-level governments, particularly the provincial governments (Martinez-Vazquez et al, 2008).

    The main features of China's current sub-provincial fiscal relations date back to the Tax Sharing System (TSS) Reform of 1994, which determined fiscal relations between the central and provincial governments. This reform gave provincial governments the discretion to stipulate fiscal arrangements between the provincial and local levels. As a result, provinces vary in their assignment of revenue powers and expenditure responsibilities between the provincial and local levels and also in the design of the provincial fiscal transfer system. The provincial fiscal transfer system can potentially align with or nullify the equalization efforts of central transfers, depending on how the fiscal transfer system has been designed in individual provinces. Provincial governments as "economic agents" have their own preferences, incentives, development strategies and availability of fiscal resources, and their efforts in implementing national equalization policies might therefore be different (Qiao et al, 2008). The key puzzle to be unraveled is how sub-provincial fiscal relations in individual provinces have shaped within-province fiscal capacity and contributed to intra-provincial fiscal disparities at the local level.

    This research is designed as a case study of Henan Province to understand the equalization effects of its provincial transfer system. Single-province analysis is much-needed because the provincial transfer system itself and the context in which the provincial transfer system develops varies across provinces. Variations include sub-provincial fiscal arrangements such as revenue power and spending responsibility assignment, the major policy concerns when the provincial transfer system was designed, as well as redistributive results the system is expected to achieve or economic and fiscal conditions in that province. Thus, it is important to investigate the research questions with a contextual perspective. By concentrating on the fiscal equalization efforts in one province, this study affords the opportunity to capture the provincial transfer system in the context that produced and sustained it.

    The paper is organized as follows: the first section reviews the research literature, followed by an overview of the fiscal transfer system in Henan Province and county-level disparities, then an empirical analysis of the equalization effects of different components of the provincial-local transfers. The last section summarizes the findings and concludes the paper.

  2. LITERATURE REVIEW

    Intergovernmental fiscal transfers as a policy instrument to address different policy objectives have been well-documented in the public finance literature. Several objectives justify some fiscal transfers to lower levels of government: (i) to deal with the fiscal gap, resulting from insufficient own-source revenues to meet the expenditure responsibilities assigned to subnational governments (vertical imbalance); (ii) to achieve equalization among subnational governments so that they can provide a comparable level of service by levying comparable tax rates (horizontal imbalance); (iii) to correct for interjurisdictional spillovers (externalities); and (iv) to achieve national objectives (Shah, 1994).

    Broadly, unconditional transfers (revenue sharing, general-purpose transfers and block grants) are more appropriate for achieving objectives (i) and (ii), while conditional or specific-purpose transfers (earmarked transfers) are better intended for achieving objectives (iii) and (iv). The general purpose of unconditional transfers is either to improve the vertical fiscal balance by providing general-purpose funding to the subnational level or to improve the horizontal fiscal balance by compensating for fiscal disparities across jurisdictions (Otter, 2008). Addressing horizontal fiscal imbalance, i.e. objective (ii), is a key concern for the design of intergovernmental transfer systems. Fiscal equalization transfers are conceptually justified on equity, efficiency and stability grounds, but the primary objective is to promote horizontal equity among residents across jurisdictions, i.e. ensuring that, subject to local preferences, all persons or firms in a country can obtain comparable public services at comparable tax rates (Blochliger and Charbit, 2008). It can be seen as the natural companion to fiscal decentralization to potentially ameliorate horizontal fiscal disparities resulting from regional autonomy (Blochliger and Charbit, 2008).

    Fiscal equalization is above all evaluated on how it reduces fiscal disparities,1 measured either by fiscal capacity (revenue-raising capacity) or fiscal needs (differentiated expenditure needs). Equalization based on fiscal capacity tends to equalize the difference between standard local revenue and effective local revenue at standardized tax rates, using the so-called Representative Tax Systems (RTS), while equalization based on fiscal needs tends to cover the difference between a standardized local need expenditure (measured on the basis of the so-called Representative Expenditure System) and some benchmark (Dafflon and Mischler 2008; Otter, 2008; Shah, 2012). Fiscal need equalization is more comprehensive and accurate but also more complicated to implement because expenditure needs are more difficult to define and derive than fiscal capacity (Shah, 2012). In practice, while some countries only have revenue equalization arrangements, most countries--including China-equalize both...

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