An Incomplete Reform: Understanding Horizontal Fiscal Equalization in China

Abstract

This dissertation uses theory and empirical analysis to explain how political incentives impact provincial governments' efforts to improve horizontal fiscal equalisation in China. Research on fiscal federalism demonstrates fiscal decentralisation can potentially increase horizontal fiscal inequality due to fiercely interjurisdictional competition, whereas research on political budget cycles indicates that political incentives can encourage politicians to manipulate fiscal policy due to career concern. Building on these two strands of theoretical literature, the thesis argues that a decentralised fiscal system, coupled with a centralised political system that rewards economic performance based on gross domestic product (GDP) growth, has substantially discouraged provincial leaders in China from improving horizontal fiscal equalisation within their jurisdictions. The coupled effects are twofold: First, due to fiscal decentralisation, provincial governments show little interest in improving horizontal fiscal equalisation, since they tend to externalise their costs to the central government. Second, a top-down cadre-evaluation system that is likely to reward subnational officials who achieve higher GDP performance with promotions provides political incentives for governors to manipulate fiscal policy and thus distributes more fiscal resources to wealthier regions to generate higher GDP growth. My empirical analysis reveals that there is a curvilinear relationship between governors' time in office and their fiscal equalisation efforts. In particular, in governors' first tenures, when they have an age advantage, their efforts to improve fiscal equalisation are much lower than in their second. However, when entering into their second tenure, governors start to promote fiscal equalisation within their jurisdictions because career promotion is unlikely to happen in their second tenure due to the age ineligibility rule. Given that only a few governors have had the chance to serve a second tenure, this thesis demonstrates how the current cadre-evaluation system further contributes to horizontal fiscal inequality in China. Based on these findings, the central argument herein is that, while it is established that fiscal decentralisation can increase regional inequality, in China, political institutions provide yet another incentive for provincial leaders to manipulate fiscal policy, which further undermines the goal of fiscal equalisation. Therefore, the thesis presents a lesson for developing countries. Far from enhancing efficiency and accountability, decentralisation, where democratic institutions are missing, may serve as a vehicle for strengthening the powers of political elites. To ensure the overall success of decentralised reform, therefore, democratic institutions are still needed to ensure government accountability. Show more