Abstract Using a nationwide county-level panel dataset for the years 1995–2009,this paper conducts the first analysis in the literature to examine the impacts of fiscaldecentralization and fiscal equalization, both measured at the sub-provincial level, onintra-provincial inequality in China. While fiscal decentralization offers significantadvantages regarding public expenditure efficiency, a potentially large disadvantageis that it may lead to increased regional inequality. In this paper, in line with ourtheoretical hypotheses, we find that while fiscal decentralization at the sub-provinciallevel in China leads to larger intra-provincial inequality, fiscal equalization effortsperformed by provincial governments tend to mitigate the detrimental effect of fiscaldecentralization on intra-provincial inequality. Our results also indicate that the quan-titative effects of fiscal decentralization on regional inequality tend to be larger whenthey are measured from the expenditure side, which is consistent with the fact thatexpenditure decentralization is a much more meaningful measure of decentralizationin China. Overall, we provide evidence on the potential inequality costs of using fiscaldecentralization as a development strategy. At the same time, we emphasize the impor-tance of implementing a fiscal equalization program to ensure the overall success ofdecentralization policy.
Keywords Fiscal decentralization · Equalization · Intra-provincial Inequality · China
China’s economic growth over the past decades has been remarkable. However, thisgrowth has been uneven across the country, resulting in significant and still grow-ing regional inequality in economic development, with the inland regions laggingfar behind the coastal regions. An ever-increasing body of research has attemptedto describe and explain the patterns of regional inequality in China (see Wanget al. 2014 for a recent survey), even though the various dimensions of this issuehave not received the same degree of attention in the literature (Tsui 1993). Thegeneral research agenda has mainly focused on the dimensions of inland–coastalinequality, rural–urban inequality, and inter-provincial inequality at the aggregatedcountry level. Just a few studies have examined intra-provincial inequality at thesub-provincial level, in large part due to the lack of detailed data at the sub-provincial level in the early years of this research. Further investigation targetingthis type of inequality, nevertheless, is vital because intra-provincial inequalityaccounts for the majority of the overall regional inequality in the country (e.g.,Tsui 1993; Cheong and Wu 2012). As estimated by Cheong and Wu (2012),intra-provincial inequality based on county-level data contributed roughly 60% ofChina’s overall inequality in 2007, and an increase in intra-provincial inequal-ity contributed to 63% of the increase in overall inequality in China during the1997–2007 period. Thus, a better understanding of the patterns of intra-provincialinequality and especially of its determinants should play an important role in thedesign of national policies addressing the overall level of regional inequality inChina.
Given that the nature of intra-provincial inequality is naturally within provinces andthat there is substantial variation of this type of inequality across provinces, the generaldeterminants of the existing inequality need to be sought in some good measure at thesub-national level. Among those potential determinants, we are particularly interestedin the role played by fiscal decentralization policies at the sub-provincial level, whichare largely formulated at the discretion of provincial governments, especially on theexpenditure side of the budget.
Two key questions guide our analysis. First, does fiscal decentralization at thesub-provincial level contribute to higher intra-provincial inequality? While decen-tralization through empowering local governments and satisfying the heterogeneouspreferences of the constituents has been viewed as enhancing efficiency and eco-nomic growth, its implication for the evolution of regional inequality is stillunder active investigation. While early studies, based on cross-country data, ingeneral find a positive effect of fiscal decentralization in reducing regional inequal-ity (e.g., Shankar and Shah 2003; Ezcurra and Pascual 2008; Lessmann 2009),some more recent work concludes that the decentralization–regional inequality
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relationship depends on various conditions such as the development level of acountry and the presence of solid fiscal redistribution systems (e.g., Rodriguez-Pose and Ezcurra, 2000; Lessmann 2012; Lessmann and Seidel 2015).1 Second,what roles do fiscal equalization policies pursued by provincial governments playin offsetting the impact of provincial fiscal decentralization on intra-provincialinequality? As an important supplemental policy of decentralization reform inChina, fiscal equalization was introduced and scaled up over the past decade toameliorate regional fiscal disparities. However, a substantial variation of equal-ization efforts exists across provinces, and in addition, the actual performance ofthose equalization programs suffers from institutional deficiencies and the possi-ble predatory behaviors of some provincial governments (Martinez-Vazquez et al.2008).
Using county-level data for the years 1995–2009, this paper contributes to theliterature in several significant aspects. First, utilizing panel data information weconduct for the first time in the literature an examination of the impact of fiscaldecentralization policies at the sub-provincial level on intra-provincial inequalityin China. The extant literature, mainly focusing on inter-provincial inequality (byusing provincial-level data), has been unable to capture the dynamics of the pat-terns and variations of inequality below the provincial level. In addition, our analysisbased on both cross-sectional and time-series information provides more accurateand unbiased estimates for the impact of fiscal decentralization policies on regionalinequality than other past studies on China, which have relied only on time-seriesinformation at the aggregated country level (e.g., Kanbur and Zhang 2005; Song2013).
Second, we investigate the impacts of fiscal decentralization at the sub-provinciallevel in China. Although fiscal decentralization in China has attracted worldwideattention, research at the sub-provincial level has been much rarer.2 Nevertheless, ananalysis at the sub-provincial level appears to be more justified because sub-provincialgovernments in China provide the majority of essential public services such as edu-cation and health care (World Bank 2002; Gong and Wu 2012); therefore, withoutexamining the impact of decentralization at this level, it may be difficult to gauge theactual impact of decentralization on regional inequality.
In addition, provincial governments in China have been granted substantial discre-tion in determining their own fiscal decentralization policy within their borders, whichactually has given rise to a high level of variation in sub-provincial treatments. Thisvariation is so substantial that it even outweighs the variation of fiscal decentraliza-tion policies across European countries (Dollar and Hofman 2008). As the geographicareas of many Chinese provinces are equivalent to those of many European coun-tries, a panel study of sub-provincial decentralization in China presents the additionaladvantage of avoiding the potential unobserved heterogeneity that may exist in the rel-
1 The recent work argues that the negative effect of fiscal decentralization on regional inequality is onlysignificant for high-income countries, while in poor countries, fiscal decentralization may well increaseregional inequality.2 Recent studies by Uchimura and Jütting (2009), Brehm (2013), and Wu and Wang (2013) are notableexceptions in this regard.
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evant cross-country studies of fiscal decentralization (see Ezcurra and Pascual 2008;Lessmann 2009; Sorens 2014).3
Third, we explicitly explore the role played by the provinces’ fiscal equalizationefforts in offsetting the impacts of fiscal decentralization on regional inequality. Atpresent, all central government transfers have to go through provincial governmentsbefore reaching the various layers of sub-provincial governments, even in the caseof those transfers that have been specifically designed for sub-provincial govern-ments (Martinez-Vazquez et al. 2008). The availability of fiscal resources and thechoices of intermediate-level governments, and here we mean mostly provincial gov-ernments, can play an important role in determining the observed outcomes withinprovinces.
Fourth, we explicitly address the endogeneity issue of both fiscal decentralizationand equalization efforts in the estimations by employing an instrumental approach.As recently emphasized by Martinez-Vazquez et al. (2015), a crucial but yet unsolvedissuewith the existing vast empirical literature on the impacts of fiscal decentralizationis that most contributions fail to address the endogeneity of fiscal decentralization. Asa consequence, it is far from clear how to isolate its effect from other confoundingfactors and how to know whether decentralization is a cause or itself also an effect ofthe policies and institutional changes in which we are interested (e.g., the deteriorationof intra-provincial inequality in our context).
Lastly, our results complement the literature by providing support from the Chinesestory for the recent argument (which we mentioned above) that the decentralization-regional inequality relationship depends on the development level of a country and theeffectiveness of its fiscal redistribution system. That is, in poor countries like China,fiscal decentralization may lead to larger intra-provincial inequality, while effectivefiscal equalization may tend tomitigate the detrimental effect of fiscal decentralizationon regional inequality.
In what follows, in Sect. 2 we discuss the theoretical debate on the relationshipbetween fiscal decentralization and regional inequality and the potential role playedby fiscal equalization. We then set up the empirical methodology and discuss the datain Sect. 3. In Sect. 4, we present the main empirical results, and in Sect. 5, we providesome further robustness checks for the empirical results. In Sect. 6, we conclude.
2 Theoretical framework and hypotheses
The debate on the relationship between fiscal decentralization and regional inequal-ity dates back to Tiebout (1956) and Oates (1972), who justify decentralizationpolicy as a way to achieve economic efficiency in the allocation of resourcesin the public sector. Under the assumption that public officials respond to thedesires of their constituents, sub-national governments in a decentralized economyare better able to match differing preferences across jurisdictions. When taxpay-
3 These studies, based on data for OECD countries or European Union countries, tend to find a negativerelationship between fiscal decentralization and regional inequality. In advanced democracies, the detri-mental effect of fiscal decentralization on regional equity may be reduced by various institutional factors,including, of course, equalization transfer programs.
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ers are mobile, gains in efficiency are enhanced because individuals can migratesorting themselves out among the jurisdictions that best match their preferredtax-expenditure package. However, enhanced efficiency under a decentralized frame-work is only one of the widely accepted objectives that guide government policy;achieving greater equality is another desired objective and one that may not goside by side with the gains in efficiency associated with decentralization. A sur-vey of the literature reveals that there are at least several compelling mechanismsfor fiscal decentralization to lead to greater regional inequality; this is especiallythe case for countries like China at early stages of economic development andwhere decentralization policy has been implemented within weak institutional frame-works.4
First, in the presence of inter-jurisdictional competition, unfettered fiscal decentral-ization is likely to lead to a concentration of economic resources in rich jurisdictionsand thus increase disparities across sub-national governments (Martinez-Vazquezand McNab 2003). Several things may be at play here. First, due to the ini-tial regional heterogeneity in institutional, economic, and social endowments, byempowering local governments, decentralization tends to reinforce the competitiveadvantages of rich regions, which results in these regions competing and attract-ing more mobile and valuable resources, while the poor regions tend to have lessability to attract investment and recruit talent (Prud’homme 1995; Cai and Treis-man 2005). Second, not unrelated, richer regions have greater capacity for matchinglocal preferences with abundant resources, leading mobile factors to flow more eas-ily to these areas as opposed to the poorer regions. Third, richer regions can offersubstantial tax abatements and land write-downs to incoming businesses, while thepoorer ones, shorter on government revenues, can hardly do the same. Given thevast heterogeneity in terms of social, economic, and fiscal conditions across China’sprovinces, those predictions fit neatly in the Chinese context. Over the past sev-eral decades, China has experienced a high concentration of economic resourcesin the rich provinces (i.e., coastal/eastern provinces); at the same time, the coun-try has undergone an intense asymmetric inter-jurisdictional competition process. Itappears that fiscal decentralization in recent decades has not eased the problem ofthe regional overconcentration of resources in some areas of the country but ratherhas tended to reinforce the existing patterns (e.g., Zhao and Zhang 1999; Zhang2006).
Second, by forcing regional governments to rely mostly on revenues raised fromtheir own jurisdictions, fiscal decentralization has weakened the central government’srole in redistributing income from rich to poor regions, resulting in higher regionalinequality. In the fiscal decentralization literature, there is some consensus that theobjective of income redistribution should be a central government responsibility for
4 There may be circumstances under which fiscal decentralization has the opposite effect on regionalinequality. For instance, as pointed out by Rodríguez-Pose and Ezcurra (2010), decentralization is likely toenhance fiscal transparency and place central and local governments under pressure to equalize public goodsand services around the country, which eventually may contribute to lower levels of regional inequality.Nevertheless, this argument appears to be weak in the Chinese context where the main focus of the centralgovernment has been to foster strong fiscal and political incentives for local governments to promote localeconomic development as opposed to any emphasis on equalizing public goods and services delivery.
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two main reasons: One is that the benefits of redistribution spill over provincial andlocal boundaries; second, redistribution policies of sub-national governments will becompromised by the in-migration of poor families who are attracted by the higherbenefits and the out-migration of rich families trying to escape the redistributive taxes.Of course, this problem is anticipated to be weakened when the implementation offiscal decentralization is accompanied by fiscal equalization policies.
Third, from a political perspective, rich regions are likely to exert a greater influ-ence on central decision-making, thereby increasing their chance of being offeredmoreresources (Rodríguez-Pose and Ezcurra 2010). In many countries, though decentral-ization makes sub-national governments more financially independent through theassignment of tax powers to the local authorities, generally the central governmentstill tends to have a final say over discretionary funds, interregional coordination,and even the pace and scope of decentralization. Richer regions with better financialresources and possibly greater political influence can make the central governmentdevelop policies or allocate discretionary funds in favor of rich areas.
InChina, richer regions are indeed likely to receivemore resources due to their polit-ical advantageous position. For one thing, in the context of China’s political structure,the party secretary and the governor of a given province may exert a substantiallydifferent influence on the central decision-making apparatus. Some rich, influentialprovinces, such as Guangdong province, can have a greater say in Beijing as the partysecretary of Guangdong province is usually a member of the Central Politburo of theChinese Communist Party.5 This means that the top leader in Guangdong provincecan have a direct involvement in the central government’s decision-making process.
This reciprocal accountability, as observed by Shirk (1990), reveals that some localparty leadership may have a greater say in affecting the central government’s policymaking as the central leadership needs support from local governments. The leverageexerted by other local party leaders is substantially different. Some poorer, laggingregions have far less influence in the central policy-making process. As an example,this asymmetry in political influence was made evident by the introduction of the“tax rebates” as a major component of the fiscal transfer system introduced in the1994 Tax-Sharing reform, which in effect rewarded the richer regions of China withsubstantial additional funds.
From these various arguments above, we derive the following hypothesis:
Hypothesis 1 Fiscal decentralization is positively associated with regional inequalityat the sub-provincial level.
The above discussion provides valuable insights into the regional inequality effectof fiscal decentralization. However, the discussion relies heavily on the assumptionof the absence of an important supplementary policy under decentralized systems—fiscal equalization. Nevertheless, it is generally agreed that fiscal equalization exerts asignificant role in shaping thefinal net impacts offiscal decentralization and thus amorethorough investigation of fiscal decentralization needs to be taken into consideration.
5 The 25-member Politburo is one of the most powerful decision-making bodies in China.
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Given the nature of equalization policy, we expect that the possible detrimentaleffects of fiscal decentralization on equalitywill bemitigatedwith the presence of fiscalequalization [our Hypothesis 2]. This outcome can be anticipated for two reasons.
First, fiscal equalization by redirecting resources from the richer regions to thepoorer regions should improve horizontal fiscal balances, leading to a more levelplaying field for all jurisdictions (Oates 1999). More specifically, by funding a nation-wide standard of provision for public goods and services through an equalizationprogram, central governments make sure that richer regions do not have this type ofadvantage over poorer regions in the inter-jurisdictional competition for business andother mobile factors.
At the same time, poorer regions are provided with ways to catch up with the richerones based on joint programs of the local authorities with the central government.Equalization policymeans not only that poorer regionswill havemore public resourcesfor public goods provision but also that poorer regions now may have a strongercapacity to work on suitable solutions for local development.6
Second, since equalization systems distribute fiscal transfers to regions in away thatcorrelates inverselywith their fiscal capacities, a number of scholars have observed thatfiscal equalization induces significant incentive effects on the taxing and expenditurepolicy of regional governments. This takes place in a way that reduces the extent ofinter-jurisdictional competition among rich and poor regions, and so mitigates thedetrimental effect of fiscal decentralization on regional inequality (e.g., Boadway andFlatters 1982; Smart 1998; Liu 2014). This is because when a region attempts to attractmobile factors from other regions by cutting tax rates or increasing public expenditure,it increases its own tax base relative to the national average, which simultaneouslyreduces the region’s entitlement for higher grants.
Hypothesis 2 The positive effect of fiscal decentralization on enlarging regionalinequality is likely to be mitigated by fiscal equalization policies.
Finally, as we highlighted in the first section of the paper, all central governmenttransfers in China have to go through the provincial governments before reaching thevarious layers of sub-provincial governments (prefectures, counties, and townships).Thus, provincial governments enjoy a substantial degree of discretion in designingtheir own equalization policies to meet their diversified policy objectives. It is also thisfeature that is likely to generate large variations in equalization efforts across provinces.This high degree of variation provides us a good scenario to test Hypothesis 2 in theChinese context.
6 Drawing on a political economy model, Kotsogiannis and Schwager (2008) also point out that equaliza-tion programs may improve local accountability through enabling voters to compare public good suppliesbetween regions thus keeping politicians more accountable. As fiscal equalization efforts usually aim toensure the same standards for public services across regions, politicians will have to be more self-restrainedand be less rent-seeking; otherwise, poor public goods provision may make rational voters punish theincumbents.
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3 Econometric methodology, measurement of key variables, and data
3.1 Econometric specification
In this section, we discuss the empirical strategy with the objective of testing thepredictions that are explicitly summarized in Hypotheses 1 and 2. Specifically, toassess the causal impacts of fiscal decentralization on intra-provincial inequality, weestimate a standard two-way fixed effects model of the form,
where i represents province and tdenotes year. The dependent variable Iit is our mea-sure of intra-provincial inequality in the level of economic development based oncounty-level data; FDit is the fiscal decentralization indicator of a province; EQitis a proxy of the equalization effort conducted by the provincial government;7 andFDit ∗ EQit is the interaction term between the two variables.
On the grounds of Hypotheses 1 and 2, we expect to find a positive sign for coeffi-cient β and a negative sign for coefficient θ . Furthermore, the model includes provincedummies (ηi ) to control for unobserved heterogeneity across provinces that are con-stant over time and also year dummies (νt ) to control for year effects that affect allprovinces; εit is an idiosyncratic error term.
As control variables X it , we seek to capture the general factors of significancein determining regional inequality based on the extant empirical literature. Severalfactors have been identified as particularly important in explaining regional inequalityin China. These include real GDP per capita and its squared term, the share of thesecondary sector in total GDP, the share of state-owned enterprises (SOEs) outputs intotal industrial output, trade openness, and the urbanization rate.
Real GDP per capita serves as a proxy for the level of economic development of theprovinces. It is commonly agreed in the literature that economic development exerts asignificant impact on spatial inequality, though the net effect of this variable is theoreti-cally unclear. For example, from the viewpoint of the new economic geography school,economic growth has a tendency to be associated with agglomeration (economies),which eventually leads to an uneven spatial development (Krugman 1998; Fujita andThisse 2002).
On the other hand, it is suggested that advances in economic development mayendow the regions with a larger scope for redistributive politics through transmissionchannels besides interregional grants and transfers (Lessmann 2009). The squaredterm of real GDP per capita is introduced to capture the potential nonlinear effectof economic development on (spatial) inequality (Kuznets 1955; Williamson 1965),i.e., the classic Kuznets curve hypothesis,8 which is evidenced by the recent study ofLessmann (2014).
7 See the next subsection for detailed definitions of the intra-provincial inequality, fiscal decentralizationindicator, and equalization effort index.8 The Kuznets curve hypothesis suggests that inequality first increases with economic development andthen decreases with its further development.
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The share of the secondary sector in total GDP and the share of SOEs outputs intotal industrial output are employed to capture the impacts of economic structure onthe patterns of regional development within provinces. Over the years, a key sourceof regional inequality in China has been the location-biased national industrializationstrategy (particularly in the case of the heavy-industry development strategy) andrestrictive inter-regional migration policies (e.g., the Hukou system), which lead to anuneven spatial distribution of industrialization outcomes (see Tsui 1991; Kanbur andZhang 2005).
Trade openness has been consistently found to be one of the major contributors ofChina’s regional inequality, reflecting the dramatic changes in regional comparativeadvantage and industry clustering patterns as a result of trade liberalization (e.g.,Kanbur and Zhang 2005; Fan et al. 2011). In view of this, we include trade openness,measured as the ratio of total trade (exports and imports) to GDP at the provinciallevel, to control for this effect.
Lastly, the rural–urban gap has persistently accounted for a large share of regionalinequality in China (e.g., Tsui 1993; Kanbur and Zhang 1999, 2005; Sicular et al.2007), which, to a large extent, has been rooted in the institutional legacies of social-ism which gave rise to a series of urban-biased social and economic policies. Thus,the urbanization level, measured as the share of urban population in total provincialpopulation, is expected to reduce the rural–urban gap and contribute to a lower levelof regional inequality within the provinces.
Beyond the above most commonly discussed factors, there are possibly some othercontrol variables, such as human capital and inflation that may also help explain thepattern of regional inequality (e.g., Fleisher et al. 2010; Kyriacou et al. 2015).
In addition, by changing income taxes (i.e., personal and corporate income taxes)from local source taxes to shared taxes, the 2002 income tax reform in China signifi-cantly affected the revenue assignments among different levels of governments. This,in turn, may have eventually affected the patterns of regional development. We controlfor these three additional variables to check the robustness of our results. Following theliterature, human capital is defined as the average years of schooling in the provinces;9
inflation is measured as the annual percentage change in the consumer price index;and the 2002 income tax reform is captured by a dummy variable taking a value of 1for the years after 2002 (0 otherwise).
3.2 Measures of key variables
Below, we explain in further detail the measurements of our key variables of interest:intra-provincial inequality, fiscal decentralization, and equalization effort of provincialgovernments.
Intra-provincial inequalityAswe have stressed in the introduction, our primary focus is on the economic aspect
of disparities within provinces; thus, we follow the conventional empirical literature
9 Data on human capital are derived from Chen et al. (2004) for the year before 2001, and they areaugmented by the authors for the years after 2001.
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on regional inequality (e.g., Williamson 1965; Petrakos et al. 2005; Rodríguez-Poseand Ezcurra 2010) to define our dependent variable, intra-provincial inequality, as thepopulation-weighted coefficient of variation of per capita GDP of the counties withinthe province, which takes the following form,
Iit =√∑ni
j=1 pjt(yjt − μit
)2
μit(2)
where yjt and pjt are the per capita GDP and population share of county j in provincei for year t ,10 respectively; ni is the total number of counties in province i ; μitis the population-weighed average of per capita GDP in province i for year t , i.e.,
μit =ni∑j=1
pjt yjt . This measure of dispersion presents several appealing features. First,
it is independent of the number of regions considered; second, it satisfies the Pigou–Dalton transfer principle in the sense that an arithmetical transfer from the rich to thepoor regions reduces inequality (Cowell 2011); and third, by taking into account thedifferent weights in population across counties, this measure of dispersion is indepen-dent of scale and population size.
Fiscal decentralization indicatorsMeasuring the extent of fiscal decentralization has been long debated in both the-
oretical work and empirical studies. This has been the case largely because fiscaldecentralization unfolds along several dimensions and at different paces; thus, no sin-gle indicator is able to adequately capture the full picture of the process and ideally thatprocess should be measured separately for each of the dimensions (Martinez-Vazquezand McNab 2003; Stegarescu 2005).
Nevertheless, this issue can be at least partially overcome by considering alterna-tive indicators that reflect different aspects of the decentralization process (Liu et al.2013). For this reason,wemeasure the degree of fiscal decentralization in the provincesby simultaneously considering expenditure decentralization and revenue decentraliza-tion. Of these two indicators, expenditure decentralization, defined as the local share oftotal government expenditure, has been the most widely used indicator in the literature(e.g., Oates 1985; Davoodi and Zou 1998; de Mello Jr 2000) as it captures the degreeof local governments’ expenditure responsibilities in the public sector, quantifyingwho does what.
Beyond these arguments, there is even a stronger reason tomeasure decentralizationfrom the expenditure side rather than the revenue side in the Chinese context. Thisis due to the fact that fiscal revenues in China are reallocated between the centraland local governments in a complex web of flows (e.g., revenue sharing, rebates, and
10 Similar to other relevant studies that have used Chinese county data (e.g., Zhang 2006; Uchimuraand Jütting 2009), our basic unit for calculating intra-provincial inequality is county j , which does notinclude the city district (“qu”), as the latter differs significantly from the former in many aspects includingadministrative, economic, and fiscal aspects. In this regard, it has been highlighted in the literature thatwhen calculating regional inequality, it is necessary to use a territorial classification that creates relativelyhomogenous regions (Lessmann 2009).
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transfers) and local governments have virtually no authority in either determining theirtax rates or tax bases (Qiao et al. 2008; Wu and Wang 2013).11 Given this, we expectto find a stronger effect of decentralization from the expenditure side measurement.
Whilemost of the existing empirical studies on fiscal decentralization in China haverelied on data at the center-province level (e.g., Zhang and Zou 1998; Qiao et al. 2008),we utilize county data to measure fiscal decentralization at the province-local level.This is a more accurate measure of the degree of decentralization at the province levelbecause provincial governments in China enjoy almost full discretion in designingtheir decentralization policy for local governments within their borders.12
In addition, our measurement of fiscal decentralization at the sub-provincial levelfits much better in our context, as our interest is to explain the county variations inthe level of economic development within provinces. More specifically, followingand extending Wu and Wang (2013), we define (1) expenditure decentralization asthe share of sub-provincial expenditure (i.e., the aggregation of prefectural, countyand township public expenditures) in total expenditure of the province and (2) rev-enue decentralization as the share of sub-provincial revenue (i.e., the aggregation ofprefectural, county and township revenue) in total revenue of the province.
Equalization effortEqualization effort is a relative concept that reflects the extent of changes in the
distribution of fiscal resource within provinces with and without the presence of equal-ization transfers from provincial governments.13 Following this concept and drawingon the relevant work by Martinez-Vazquez and Timofeev (2008), we measure equal-ization effort of provincial governments as the percentage change in intra-provincialdisparities in fiscal revenues before and after taking into account the equalizationtransfers received by county governments. More specifically, the measure takes thefollowing form,
EQit = f bit − f aitf bit
(3)
where f bit is the population-weighted coefficient of variation of own source revenuein province i for year t , and it is calculated according to a formula similar to equation(2) on the basis of county-level data; f ait is the corresponding population-weighted
11 In contrast, local governments in China have significant levels of autonomy and discretion on theexpenditure side of the budget.12 Uchimura and Jütting (2009) andWu andWang (2013) are notable exceptions in that they also measurefiscal decentralization at the sub-provincial level in China.13 Separate transfers from prefectural governments should be negligible, if any. Under the current institu-tional setup in China, revenue assignments at the sub-provincial level are exclusively at the direction of theprovincial governments, and the prefectural-county fiscal relations are in general explicitly defined by theprovincial governments. Although, in some cases, prefectural governments do have some discretion on theassignment of revenues between them and county governments, prefectural governments offer little helpto county governments financially (World Bank 2002). First, sub-provincial level governments have beenassigned with very heavy expenditure responsibilities. Prefectural governments usually cannot help countygovernments out; instead, both levels of government rely heavily on transfers from the central government.Second, no institutional rules obligate prefectural governments to transfer their own revenues to lower-levelgovernments.
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coefficient of variation of total revenue14 taking into account the equalization transfersreceived by county governments in province i for year t .
Thus, a positive (negative) sign of the dispersion difference in the numerator of equa-tion (3) suggests that the introduction of the equalization transfers reduces (increases)revenue disparity within provinces. Since fiscal transfers at the sub-provincial level areat the discretion of provincial governments, a larger value of EQit , therefore, indicateshigher equalization efforts being pursued by provincial governments, which in turnaffects the final performance of the decentralization policy in the provinces.
It is worth noting here that intergovernmental fiscal transfers in China are mainlycategorized into three groups: tax rebates, equalization transfers, and ad hoc transfers.The one we take into account in the calculation of the “after” fiscal disparities (i.e.,f ait ) is the exact group of equalization transfers, which has been widely believed toprecisely reflect the actual equalization intention of upper-level governments. Morespecifically, the equalization transfer (also known as general purpose transfer) is theonly formula-driven transfer program in China, with an explicit purpose to equalizefiscal resources across and within provinces.
The equalization transfer received by a region is calculated on the basis of the gapbetween standard revenues and standard expenditures of the region, with coefficientsthat adjust for the size of the gap. Standard revenue is estimated by using the tax basesand standard tax rates, and standard expenditure is calculated by using a myriad ofexpenditure categories, including spending on administrative services, public safety,education, city maintenance, social assistance, and heating (see Zhang and Martinez-Vazquez 2003; and Liu et al. 2014 for more detailed discussion). Nevertheless, asrobustness checks we present in Sect. 5, we also consider the case where the totalamounts of fiscal transfers including tax rebates, equalization transfers, and ad hoctransfers are taken into account.15
3.3 Data
The panel dataset we use for the quantitative analysis covers 26 provinces in China forthe years 1995–2009. Similar to the relevant work by Uchimura and Jütting (2009) inusing county data, we exclude the four province-level municipalities, Beijing, Tianjin,Shanghai, and Chongqing for the following two reasons: First, the legal status ofcounties (and also districts) in these municipalities is non-comparable to the countiesin other provinces since they may differ dramatically in terms of administrative and
14 Total revenue=own source revenue+equalization transfers.15 The tax rebate was a compromised outcome to smooth the implementation of the Tax-Sharing reformin 1994. Specifically, the tax rebate was introduced to guarantee the vested interests of richer provincialgovernments prior to the 1994 reform. Its essence was to return to the provinces the amounts of VAT,consumption taxes, and income taxes that otherwise would have gone to these provinces under the oldsystem. By design the tax rebates did not perform any equalization role. The ad hoc transfers typicallyinvolve the central government response to high-priority emergencies or are generally associated withparticular programmatic objectives; this type of transfer is usually endowed with strong bargaining features.See Zhang and Martinez-Vazquez (2003) for a detailed discussion on the fiscal transfer system in Chinaand Huang and Chen (2012) and Liu et al. (2014) for analyses of its equalization effects.
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fiscal status; second, these municipalities only have a very limited number of counties,whichweakens their representativeness in calculating the intra-provincial inequality.16
Since the formal intergovernmental fiscal transfers system was put in place only in1995,17 we use year 1995 as the starting period in our analysis; the end year of thepanel dataset, 2009, is the last year that fiscal data at the county level were released.Finally, Tibet is also excluded from the sample due to data unavailability.
County-level data used for the calculations of the key variables discussed in theprevious subsection are taken from the Prefecture, City, and County Public FinanceStatistics (Quanguo Dishixian Caizheng Tongji Ziliao, 1996–2010), which providesthe most detailed and disaggregated data on sub-national public finances and somebasic economic and socioeconomic variables (such as GDP and population). It isalso noted that population data at the county level for year 2001 and onward arecomplemented from theChina Statistical Yearbook for Regional Economy (ZhongguoQuyu Jingji Tongji Nianjian, 2002–2010) as they are no longer reported in the previousdocuments. All other data at the provincial level are collected from various issues ofthe China Statistical Yearbook and the China Compendium of Statistics 1949–2008.Table 8 in theAppendix provides a detailed description and sources of all the variables,while their summary statistics are reported in Table 1.
4 Empirical findings
4.1 Baseline results
Table 2 presents the estimation results for our baselinemodel (1). All specifications areestimated using a two-way fixed effects model, correcting for robust standard errors.Overall, the baseline model has a R-squared value around 0.65, indicating that 65%of the variation of intra-provincial inequality is explained in our model.
To begin with, we examine the effect of fiscal decentralization on intra-provincialinequality by controlling only for the major explanatory variables. Columns (1) and(2) report the corresponding results with alternatively considering expenditure decen-tralization and revenue decentralization as the key variable of interest.
As shown in column (1), the coefficient of expenditure decentralization is positiveand statistically significant at the 1% level, supporting Hypothesis 1 that an increase infiscal decentralization leads to larger intra-provincial inequality. The estimated coef-ficient of the interaction term between expenditure decentralization and equalizationeffort is significantly negative, confirming Hypothesis 2 in the sense that the partialeffect of fiscal decentralization on intra-provincial inequality is decreasing with thelevel of equalization effort exercised by the provincial government.
Turning to the coefficients of revenue decentralization and its interaction term withequalization effort (i.e., column (2)), they are consistent with the previous finding thatfiscal decentralization is positively associated with intra-provincial inequality, while
16 For example, Shanghai has only one county and Beijing has only two by the year of 2009.17 The tax-sharing system reform was implemented in 1994.
equalization effort of the provincial governments tends to mitigate the detrimentaleffect of fiscal decentralization.
In addition, the magnitudes of the coefficients also reveal that the quantitativeimpacts of fiscal decentralization tend to be smaller when it is measured from therevenue side, which in turn is consistent with the conventional wisdom that expendi-ture decentralization appears to be a more accurate and practically more meaningfulmeasure of decentralization in China.18
18 Under the current Chinese system, tax legislation is highly centralized at the central level and there isvirtually no autonomy for local governments to determinate either tax bases or tax rates, leading to little for-mal, institutionalized variations of revenue decentralization across provinces. On the contrary, expenditureassignment has never been clearly defined by the central government and it was also largely ignored by thecentral government in the last three decades of intergovernmental fiscal relations reform in China, resultingin large direction for provincial governments to set up their own arrangements within the provinces. Thus,it appears that measuring fiscal decentralization on the expenditure side is more meaningful in the Chinesecontext. Additionally, while the current tax-sharing system (which was implemented in 1994) re-centralizedrevenue assignments, there has been considerable devolution of expenditure responsibilities to local gov-ernments. More importantly, the vertical imbalances caused by the opposite trends in revenue centralizationand expenditure decentralization have not been adequately offset by intergovernmental transfers (see forexample, Zhang and Martinez-Vazquez 2003; Liu et al. 2015). Our calculation of the simple correlationcoefficient (based on our sample data) also indicates a modest correlation between revenue decentralizationand expenditure decentralization (i.e., 0.65).
Share of secondary sector 0.614 1.179** 0.599 1.116**
(1.408) (2.432) (1.372) (2.357)
Urbanization −0.183** −0.163** −0.192** −0.169*
(−2.134) (−1.976) (−2.188) (−1.964)
Openness 0.047 0.163* 0.056 0.181*
(0.523) (1.668) (0.616) (1.818)
Tax reform 2002 −0.671*** −0.804***
(−3.306) (−3.760)
Inflation 0.006 0.005
(0.663) (0.568)
Schooling 0.012 0.056
(0.355) (1.556)
Constant −2.424*** −1.997*** −2.606*** −2.419***
(−4.327) (−3.745) (−3.951) (−3.697)
Province fixed effects Yes Yes Yes Yes
Year fixed effects Yes Yes Yes Yes
Observations 380 380 380 380
R-squared 0.652 0.640 0.653 0.642
Robust t statistics in parentheses; *** p < 0.01, ** p < 0.05, * p < 0.1
As robustness checks, columns (3) and (4) of Table 2 report the estimated resultsfrom adding more control variables. As shown, the inclusion of these additionalexplanatory variables does not alter the parameter estimates or conclusions regard-
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Notes: a and b are illustrated based on the results of column (3) in Table 2 and Table 3, respectively . Solid lines represent the estimated marginal effect of fiscal decentralization on intra-provincial inequality. Dashed lines represent confidence interval based on 95% confidence level for individual coefficients
-.01
0.0
1.0
2.0
3M
argi
nal E
ffect
of F
isca
l Dec
entra
lizat
ion
-.02 .08 .18 .28 .38 .48 .58 .68 .78
Fiscal Equalization--- 95% confidence interval
(a)
-.02
0.0
2.0
4.0
6.0
8
-.02 .08 .18 .28 .38 .48 .58 .68 .78
Fiscal Equalization--- 95% confidence interval
(b)
Fig. 1 Marginal effect of fiscal decentralization on intra-provincial inequality
ing the effects of fiscal decentralization on intra-provincial inequality. In both cases,expenditure and revenue decentralization remain positive and significant, while theinteraction term between fiscal decentralization and equalization effort remains neg-ative and significant.
While the results obtained above are clearly informative, they remain somewhatlimited. After all, the results do not directly indicate the net partial impact of fiscaldecentralization on intra-provincial inequality and whether fiscal decentralization hasa statistically significant impact on intra-provincial inequality when equalization effortof the provincial governments does not equal to zero.19 Therefore, based on column(3) of Table 2, which contains the full list of control variables in the specification andfocuses on expenditure decentralization, we graphically illustrate in Fig. 1a the mar-ginal effect of fiscal decentralization on intra-provincial inequality across the observedrange of equalization effort of the provincial governments.
The solid sloping line indicates how the marginal effect of fiscal decentralizationchanges as equalization effort of the provincial governments increases, while the twodashed lines, representing the 95% CI, allow us to determine the conditions under
19 In specifications with interaction terms, the statistical significance of an individual variable does notnecessarily imply that the marginal effect of it is statistically significant (see Brambor et al. 2006).
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which fiscal decentralization has a statistically significant effect on intra-provincialinequality—the net effect of fiscal decentralization is significant whenever the upperand lower bounds of the confidence interval are both above (or below) the zero line.
As indicated in Fig. 1a, the level of equalization effort, such that the partial effectof fiscal decentralization is zero, is 0.646. This takes place approximately on the top2.5th percentile from provinces with the highest effort in equalizing fiscal resourceswithin the provinces. In other words, the partial effect of fiscal decentralization ispositive if the level of equalization effort is below the threshold of 0.646 (i.e., 97.5%of our sample) and is negative if the level of equalization effort is above the threshold(i.e., 2.5% of our sample). Nevertheless, looking at the 95% CI of the estimates,it clearly indicates that for those provinces in certain years with equalization effortexceeding the threshold of 0.646, the partial effect of fiscal equalization is statisticallyinsignificant.
Quantitatively, evaluating at the sample mean of equalization effort (i.e., 0.32, seeTable 1), the estimated partial effect of fiscal decentralization is 0.011, implying that aone-percentage point increase in themeasure of expenditure decentralization increasesintra-provincial inequality by 0.011 points—a value that is equivalent to 1.7% of thesample average value of intra-provincial inequality across provinces and years.
Regarding the other variables included in the model, the equalization effort variable(in levels) has a positive and significant coefficient; however, considering together withthe negative and significant coefficient of the interaction term, the net partial effect ofequalization effort depends on the level of fiscal equalization. Nevertheless, evaluatingat the sample mean value of any of the two fiscal decentralization indicators, the netpartial effect of equalization effort is always negative and significant, suggesting that,on average, a higher level of equalization effort by provincial governments is associatedwith a lower level of intra-provincial economic disparities.
All other control variables in general have statistically significant coefficients,and the results are mostly consistent with those we predicted. Real GDP per capitaalong with the two measures of economic structure, the share of secondary industryin total GDP and the share of SOEs outputs in total industrial output, has positiveand significant coefficients, indicating that the provincial economic development andindustrialization process tend to enlarge regional inequality within provinces. Thecoefficient of the squared term of real GDP per capita turns out to be statisticallyinsignificant, which suggests that the Chinese provinces are still on the upward slop-ing part of the Kuznets curve.
Consistent with previous studies, urbanization is found to be an effective elementin reducing intra-provincial inequality in China, while trade openness contributes tolarger regional inequality within provinces, though this effect tends to be statisticallysignificant only at the margins in some specifications. Moreover, both human cap-ital and inflation appear to enlarge regional inequality within provinces, althoughthey are in general statistically insignificant. The 2002 income tax reform tendsto significantly reduce intra-provincial inequality—in a broad sense supporting ourexpectation that the centralization of revenues should help reduce regional inequal-ity.
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4.2 Instrumental variables
A potential concern is that the endogeneity of fiscal decentralization may bias ourestimates in Table 2. Endogeneity may be present because the deterioration of intra-provincial inequality may lead to a strong demand for centralization and so lower thelevel of fiscal decentralization and increase equalization efforts within provinces. Amore subtle argument for the existence of the endogeneity of fiscal decentralization isimplied by the findings of Sacchi and Salotti (2014). These authors find evidence thathigh regional economic disparities are associated with lower levels of fiscal decentral-ization in OECD countries for the years 1981–2005.
Previous studies on the impacts of fiscal decentralization have also acknowledgedthe potential endogeneity bias in their estimates, though they do not explicitly controlfor it,20—to a large extent due to small sample sizes and the lack of good instruments(e.g., Zhang and Zou 1998; Lin and Liu 2000; Jin et al. 2005; Qiao et al. 2008). In thissubsection, we account for the potential endogeneity issue of fiscal decentralizationand equalization by using an instrumental variable approach. The instruments we useinclude one-period lagged values of: (i) the weighted average of fiscal decentralizationfrom the neighboring provinces (weighed by both the inverse of the distance betweenprovinces and the population size of the provinces21); (ii) the share of minority popu-lation in total population of the province;22 and (iii) the degree of transfer dependenceexperienced by sub-provincial governments.
More specifically, theweighted average of fiscal decentralization from the neighbor-ing provinces and the share of minority population in total population of the provinces,both lagged one time period, are employed as instruments for decentralization indi-cators. The validity of the first instrument is justified by the fact that the design offiscal decentralization policy in a province will be correlated with the design of thedecentralization policies in the neighboring policies because of their geographic simi-larity and their potential competitive and mimicking behaviors, while intra-provincialinequality in a province should have virtually no direct impact on the design of fiscaldecentralization of the neighboring provinces in the preceding year.
The share of minority population in total population, representing the ethnic diver-sity in the province, captures the diversified need of public services at the local leveland it so may exert an influence on the design of fiscal decentralization within theprovinces, while, on the other hand, intra-provincial inequality should have no impacton the inherent demographic feature of the provinces. It is precisely these featuresthat make the two instruments to be correlated with the decentralization indicatorsbut not with trend of intra-provincial inequality over time and therefore work as goodinstruments.
20 Fisman and Gatti (2002) and Iimi (2005) are the two exceptions in the literature.21 That is, the weight is a product of the inverse of the distance between provinces and the populationsize of the provinces. By this construction, we assume that geographically closer provinces interact morestrongly with each other, and provinces with larger population exert more influence on the settings of theneighboring provinces’ policies.22 Data on minority population of the provinces were obtained from various issues of the “Major Figureson Population Census of China.”
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The one-period lag value of transfer dependence of sub-provincial governments,measured as the ratio of total sub-provincial fiscal transfers to total sub-provincialexpenditures, is used as an instrument for the equalization effort of provincial gov-ernments. The rationale is that the larger is the participation of fiscal transfers in totalexpenditures, the more flexibility or the more room there is to pursue an equalizationobjective by the provincial governments.23
At the same time, the distributional patterns of regional development withinprovinces appear to be less relevant for explaining the level of transfer dependence ofthe provinces; for instance, according to our data, both Guangdong province (a richprovince in the coastal region of China) and Gansu province (a poor province in thewestern region of China) have a large degree of intra-provincial disparity; however, thelevel of transfer dependence varies substantially in these two provinces with Guang-dong having a considerably lower degree of transfer dependence than Gansu. This isso because the level of transfer dependence of a province is mostly determined by theaggregated fiscal gap between sub-provincial revenues and sub-provincial expendi-tures, rather than the regional pattern of economic development within the provinces.This makes the level of transfer dependence a good instrument for the equalizationeffort of the provinces. Finally, the interaction term between fiscal decentralizationand equalization is instrumented by the corresponding interaction terms between theproposed instruments.
Tables 3 and 4 document the results we obtain utilizing the instrumental variablemethod, where fiscal decentralization, equalization effort, and the interaction termbetween the two variables are treated as endogenous variables. The Hansen J Statisticof over-identification restriction as well as some other tests are implemented to testthe validity of the instruments. For all specifications presented, the Hansen statistic(p value) noted at the bottom of Table 3 is higher than 0.30, implying that we cannotreject the null hypothesis of no correlation between the instruments and the error termin the regressions.
We then checkedwhether the instruments are closely related to the three endogenousvariables, which is another requirement for valid instruments. To investigate this, weregress the three endogenous variables on the instruments plus the included exogenousvariables in each specification and then performed F-tests for the joint significance ofthe instruments in these regressions. These complete first-stage results are reported inAppendix Table 9.24 As summarized in Table 4, for all specifications the F statisticis always over 10, indicating that our instruments are indeed significantly associatedwith the three endogenous variables. Moreover, we estimate the Shea’s partial R-squared, which is a measure of the relevance of instrumental variables in the case
23 As mentioned previously, under the current hierarchical system of China, although the central govern-ment directly determines the amount of transfers to local governments, practically, all central governmenttransfers have to go through the provincial governments before reaching the various layers of sub-provincialgovernments (prefectures, counties and townships); thus, provincial governments enjoy a substantial degreeof discretion in designing their own equalization policies to meet their diversified policy objectives.24 For space reason, we only report the first-stage estimation results for specifications controlling for thefull list of explanatory variables in the Appendix Table 9.
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Table 3 Main results: fixed effects with IVs estimation
Note: Instruments test for regressions presented in Table 3
of multiple endogenous variables (Shea 1997).25 As a rule of thumb, if an estimatedequation yields a large value of the standard partial R-squared and a small value of theShea’s measure of R-squared, one may conclude that the instruments lack sufficientrelevance to explain all the endogenous regressors, and the model may be essentiallyunidentified (Baum et al. 2003). As we can see in Table 4, there is not a significantdifference between the Shea’s partial R-squared and the standard partial R-squaredof excluded instruments; this again suggests that the instruments do indeed provideidentifying information.
Comparing the results in Tables 3 and 2 confirms our earlier findings: Fiscal decen-tralization leads to larger regional inequality within provinces, while equalizationefforts by provincial governments help reduce the detrimental effects of fiscal decen-tralization on regional equality, with the parameter estimates in Table 3 being largerthan those in Table 2, confirming our expectations that taking endogeneity into accountwould lead to higher estimated inequality impacts. Similarly, we present the new mar-ginal effect of fiscal decentralization in Figure 1b, based on column (3) of Table 3. Asshown, the corresponding points along the solid sloping line in Fig. 1b are everywherehigher than that in Fig. 1a, and the marginal effect of fiscal decentralization remainspositive across the entire observed range of equalization effort of the provincial gov-ernments, though it is not always statistically significant.
5 Robustness checks
In order to test for the robustness of the main results, we conduct sensitivity analysesalong two dimensions: using alternative measures of intra-provincial inequality and
25 Shea’s partial R-squared can pinpoint the possible presence of weak instruments if the partial R-squaredis sufficiently small.
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using alternative measures of equalization effort by provincial governments, respec-tively. In all robustness checks, we find results from the completed specificationsequivalent to those in columns (3) and (4) of Tables 2 and 3 with and without correct-ing for the endogeneity issue.
5.1 Alternative measure of regional inequality
Our first round for checking the robustness of our results consists of using alterna-tive known measures of regional inequality. This may be important because differentmeasures of inequality rely on varied approaches to the aggregation of informationcontained in the distribution, which in turn may lead to different orderings of thedistribution analyzed (Ezcurra and Pascual 2008; Rodríguez-Pose and Ezcurra 2010).For this reason, we re-calculate the measures of intra-provincial inequality and equal-ization effort using two other measures of inequality that have been widely used in theliterature on personal income distribution and in the study of regional inequality (e.g.,Terrasi 1999; Ezcurra and Pascual 2008; Rodríguez-Pose and Ezcurra 2010): Theyare the Gini coefficient and the Theil index. These two indices can be, respectively,calculated as follows,
G it = 1
2μit
ni∑
j=1
ni∑
k=1
pjt pkt∣∣yjt − ykt
∣∣ (4)
and
Tit =ni∑
j=1
pjt
(yjtμit
)log
(yjtμit
)(5)
where both j and kdenote counties; and the rest of the notation is the same as that inequation (2). Note that these two indices also satisfy the requirements that they areindependent of the number of regions considered, the scale and population size of theregions, and the Pigou–Dalton transfer principle.
Tables 5 and 6 summarize the results corresponding to the alternative measuresof intra-provincial inequality and equalization effort of provincial governments usingthe Gini coefficient and the Theil index. The results again suggest that greater levelsof expenditure and revenue decentralization lead to larger regional inequality withinprovinces, whereas greater equalization efforts by provincial governments help offsetthe detrimental effects of fiscal decentralization on regional inequality. Quantitatively,it would appear that the effect of fiscal decentralization on intra-provincial inequalitybecomes smaller when these alternative measures of inequality are adopted; however,this is, in large part, due to an overall smaller value of intra-provincial inequalitymeasured by these indices (see Table 1).
5.2 Alternative measure of equalization efforts
Lastly, it was noted earlier that in the calculation of equalization effort of provincialgovernments, we have only considered the equalization transfers component, which,
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Table 5 Robustness checks: Gini measure of regional inequality
Robust t-statistics in parentheses; *** p < 0.01, ** p < 0.05, * p < 0.1
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Fiscal decentralization, equalization and intra…
from a normative perspective, appears to be the best way to capture the equalizationintention of provincial governments. Nevertheless, it also seems to be warranted, asfurther robustness checks, to consider the casewhere the total amount of fiscal transfersis used in the calculation of the equalization effort; due to the bargaining features ofthe transfer system in China, some other components of transfers (e.g., the ad hoctransfers) may also result in a certain degree of equalization effects (e.g., Huang andChen 2012; Liu et al. 2014).
To investigate this, we re-calculate the equalization effort indicator based on thedistribution of total fiscal transfers within provinces and re-calculate equation (2).The results are presented in Table 7. The results are quite comparable to those inTables 2 and 3 where we do and do not control for endogeneity, confirming our con-clusions on the roles of fiscal decentralization and fiscal equalization. The magnitudesof the estimated coefficients for fiscal equalization are a bit smaller. This may bean indication that the other components of the transfer system may not be as equal-izing as our primary measure of equalization effort based on equalization transfersonly.
6 Discussion and conclusion
The link between fiscal decentralization and regional inequality has long been debatedin the literature. Empirical evidence has been mixed even when the studies haveonly focused on the same group of countries (e.g., OECD countries). After care-fully assessing this issue in the Chinese institutional context, we hypothesize thatfiscal decentralization is likely to result in larger regional inequality, while the equal-ization effort exercised by provincial governments is likely to work as an effectivetool in correcting some of the detrimental effects of fiscal decentralization. These twohypotheses are tested by employing county-level panel data, where fiscal decentral-ization, equalization, and regional inequality are all measured at the sub-provinciallevel.
Our results provide strong support to the two hypotheses. These results arealso shown to be robust across different specifications, alternative measures ofintra-provincial inequality, and alternative measures of fiscal decentralization andequalization efforts by provincial governments. The impact of fiscal decentralizationon economic inequality fits with the story presented by Rodríguez-Pose and Ezcurra(2010) and Lessmann (2012). Namely, in a developing context, decentralization mayresult in greater regional inequalities.26
In light of the fact that a large part of regional inequality in China arisesfrom intra-provincial inequality, it is surprising to see that these two factors (fis-cal decentralization and equalization efforts) contributing to this type of inequalityhave been so rarely investigated in the literature. Thus, our study contributes toa better understanding of the general determinants of intra-provincial inequalityand to the overall regional inequality in China, with a particular emphasis on the
26 A different pattern is observed in developed economies (Akai and Sakata 2009; Lessmann 2012)
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Table 7 Robustness checks: alternative measure of equalization effort
Robust t-statistics in parentheses; *** p < 0.01, ** p < 0.05, * p < 0.1
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Fiscal decentralization, equalization and intra…
role played by the fiscal decentralization policies pursued by provincial govern-ments.
From a policy perspective, the main results of this study provide valuable insightsfor how to reduce regional inequality within provinces, if that is the policy objectiveof the central government or provincial governments.
First, in China the sub-national government share in public expenditures is signifi-cantly larger than is the case even in the most decentralized countries. This is largelydue to the fact thatmany social expenditure responsibilities in publicwelfare, includingunemployment compensation and pensions, have been long assigned to sub-nationalgovernments, especially at the lowest level (Liu et al. 2015). Therefore, there is plentyof scope for China’s central government to reassign and centralize those expendi-ture responsibilities that currently are wrongly assigned since expenditures on socialwelfare and unemployment compensation should be the domain of the central govern-ment. As we have seen in this paper, this type of policy would contribute significantlytoward regional convergence in China.
The second set of findings in this paper reinforces the traditional wisdom highlight-ing the importance of maintaining an effective equalization program for the successfulimplementation of a decentralized system. The question remains open on whetherprovincial governments are currently sufficiently involved in implementing equaliza-tion programs pursuing more balanced regional development and more equal accessto public services for their residents. Greater equalization efforts at the provinciallevel will require further increasing the overall pool of funds dedicated to equaliza-tion and making this increased funding more stable and predictable, for example byadopting an explicit funding rule for the available pool of funds. Because provincialgovernments still have considerable discretion in setting these and other forms of fiscalinteractions with their subordinate governments, the central authorities need to weighthe need for introducing minimum performance standards in matters of equalizationat the provincial level.
There is more that central authorities can do to increase regional convergence. AsShankar and Shah (2003) have pointed out, past interventionist policies by centralgovernments aiming to promote regional development often have resulted in regionaldivergence. In the Chinese case, during the 1980s and early 1990s removing barriersto factor mobility and the opening of economic development zones were essential toeconomic prosperity and greater inequality across the regions. Further liberalization offactor mobility, including the removal of the internal migration (e.g., Hukou) restric-tions, should further contribute to regional convergence. But in fact when it comesto the minimum standards of basic services people are demanding in their regions,the Chinese institutional context in recent years has proved that a proactive approach,to some extent using interventionist policies, has been quite instrumental in reducingregional inequality: Through an improved centrally orchestrated equalization effortless developed regions are being equipped with improved fiscal capacity, althoughthis effort may still be falling short (Liu et al. 2014), calling for substantially increasedcentral equalization transfers.
Acknowledgments We would like to thank Guangrong Ma for providing some of the data used in thispaper. This research was supported by the National Natural Science Foundation of China (Nos. 71403276;
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71533006), the Fok Ying Tung Education Foundation (No. 151085), and the Program for New CenturyExcellent Talents in University (NCET-13-0573) of the Ministry of Education of China. We are gratefulfor helpful comments from session participants at the 2015 Annual Congress of International Instituteof Public Finance, the 2015 China Economist Society Annual Meeting at Chongqing University, the 2015China Public Finance Forum at Peking University, as well as seminar participants at Renmin University. Weare especially grateful to the editor and two anonymous referees formany helpful comments and suggestionsthat have substantially improved the paper.
7 Appendix
See Tables 8, 9.
Table 8 Description of variables and sources
Variable Definition Source
wcv_gdppc Population-weighted coefficientof variation of per capita countyGDP
Prefecture, City, andCounty Public FinanceStatistics (PCCPFS); andAuthors’ calculations
wgini_gdppc Population-weighted Ginicoefficient of per capita countyGDP
PCCPFS and Authors’calculations
wtheil_gdppc Population-weighted Theil indexof per capita county GDP
PCCPFS and Authors’calculations
Expenditure decentralization Sub-provincial expenditure as ashare of total expenditure of theprovince
PCCPFS and Authors’calculations
Revenue decentralization Sub-provincial revenue as a shareof total revenue of the province
PCCPFS and Authors’calculations
Equalization effort 1 Percentage change inintra-provincial inequality infiscal revenue before and aftertaking into account theequalization transfers received;based on C.V. measure
PCCPFS and Authors’calculations
Equalization effort 2 Percentage change inintra-provincial inequality infiscal revenue before and aftertaking into account theequalization transfers received;based on Gini coefficientmeasure
PCCPFS and Authors’calculations
Equalization effort 3 Percentage change inintra-provincial inequality infiscal revenue before and aftertaking into account theequalization transfers received;based on Theil index measure
PCCPFS and Authors’calculations
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Fiscal decentralization, equalization and intra…
Table 8 continued
Variable Definition Source
Equalization effort 4 Percentage change inintra-provincial inequality infiscal revenue before and aftertaking into account the totaltransfers received; based onC.V. measure
PCCPFS and Authors’calculations
GDP per capita, log Real GDP per capita, log China Statistical Yearbook
Share of SOEs outputs The share of SOEs outputs intotal industrial outputs
China Statistical Yearbook
Share of secondary sector The share of secondary sector intotal GDP
China Compendium of Statistics1949–2008
Urbanization The share of urban population intotal population
China Compendium of Statistics1949–2008
Openness The ratio of total trade (exportsand imports) to GDP
China Statistical Yearbook
Schooling Average years of schooling ofpopulation
Chen et al. (2004) and Authors’calculations
Inflation Annual percentage change inconsumer price index
China Statistical Yearbook
Tax reform 2002 =1 if year 2002 and after; 0otherwise
Authors’ calculations
W_expdec The weighted average ofexpenditure decentralizationfrom the neighboring provinces
Authors’ calculations
W_revdec The weighted average of revenuedecentralization from theneighboring provinces
Authors’ calculations
Perc_mino The share of minority populationin total population of theprovince
Authors’ calculations
Tran_dep The ratio of total sub-provincialfiscal transfers to totalsub-provincial expenditures
PCCPFS and Authors’calculations
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Table9
First-stageestim
ationresults
fortheIV
estim
ations
End
ogenou
svariable
Colum
n(3)in
Table3
Colum
n(4)in
Table3
Exp
enditure
decentralization
Equalization
effort
Exp
enditure
decentralization
×equalizationeffort
Revenue
decentralization
Equalization
effort
Revenue
decentralization×
equaliz
ationeffort
W_exp
dec,t−
1−3
.167
***
−0.010
−0.934
(−5.91
9)(−
0.66
7)(−
0.83
6)
W_revdec,t−
1−3
.220
***
−0.001
−2.014
**
(−5.89
4)(−
0.07
2)(−
2.09
8)
Perc_m
ino,
t−
172
.978
***
2.98
3***
262.85
4***
−18.86
32.77
5***
226.11
1***
(3.627
)(5.365
)(5.939
)(−
0.64
0)(4.988
)(4.934
)
Tran_
dep,t−
1−1
90.272
***
−1.453
−174
.612
**−1
06.049
*−0
.730
−269
.755
***
(−4.75
8)(−
1.46
1)(−
2.30
3)(−
1.89
5)(−
0.73
4)(−
3.22
3)
W_exp
dec*
2.46
5***
0.02
5*2.71
8***
Tran_
dep,t−
1(4.676
)(1.938
)(2.705
)
W_revdec*
1.26
2*0.01
43.66
0***
Tran_
dep,t−
1(1.875
)(1.187
)(3.577
)
Perc_m
ino*
-33.95
9***
−1.086
***
−116
.552
***
3.67
8−0
.836
***
−70.23
8***
Tran_
dep,t−
1(−
3.96
8)(−
4.63
9)( −
6.41
1)(0.262
)(−
3.42
4)(−
3.38
0)
GDPpercapita,
4.78
20.11
012
.472
*−2
7.09
5***
0.16
9*9.29
4
log
(1.452
)(1.231
)(1.858
)(−
5.81
5)(1.917
)(1.312
)
GDPpercapital,
0.18
20.00
20.09
74.85
0***
−0.016
−0.720
squared
(0.329
)(0.159
)(0.083
)(5.988
)(−
1.19
7)(−
0.67
8)
Shareof
SOEs
−7.252
***
0.02
2−3
.908
−14.41
6***
0.01
9−9
.404
outputs
(−2.61
3)(0.273
)(−
0.67
6)(−
4.15
1)(0.229
)(−
1.40
1)
123
Fiscal decentralization, equalization and intra…
Table9
continued
End
ogenou
svariable
Colum
n(3)in
Table3
Colum
n(4)in
Table3
Exp
enditure
decentralization
Equalization
effort
Exp
enditure
decentralization
×equalizationeffort
Revenue
decentralization
Equalization
effort
Revenue
decentralization×
equaliz
ationeffort
Shareof
second
ary
−2.423
−0.434
**−4
0.32
8***
13.139
−0.417
**−2
4.06
1
sector
(−0.30
5)(−
2.15
3)(−
2.79
3)(1.229
)(−
2.02
7)(−
1.42
9)
Urbanization
1.66
6−0
.049
−3.957
5.80
2**
−0.027
−0.957
(0.726
)(−
0.85
9)(−
0.90
2)(2.005
)(−
0.46
4)(−
0.20
6)
Openn
ess
4.27
9**
−0.052
−3.560
0.58
7−0
.064
−3.485
(2.021
)(−
1.21
0)(−
0.94
7)(0.310
)(−
1.54
2)(−
0.99
4)
Taxreform
2002
16.850
***
0.00
70.16
3−3
.284
0.07
54.22
7
(4.460
)(0.064
)(0.019
)(−
0.84
8)(1.213
)(0.794
)
Infla
tion
0.31
9**
0.00
20.32
7−0
.017
0.00
30.17
2
(2.577
)(0.471
)(0.995
)(−
0.09
3)(0.598
)(0.471
)
Scho
oling
−0.223
−0.019
−2.771
*0.09
4−0
.019
−1.208
(−0.34
9)(−
0.98
8)(−
1.90
4)(0.127
)(−
0.99
7)(−
0.79
6)
Con
stant
261.75
5***
−0.322
−11.42
640
0.09
2***
−1.001
95.154
(6.470
)(−
0.31
3)(−
0.14
4)(7.999
)(−
0.99
8)(1.039
)
Observatio
ns35
635
635
635
635
635
6
Robustt-statisticsin
parentheses;***p
<0.01
,**p
<0.05
,*p
<0.1
123
Y. Liu et al.
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