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The authors are grateful to several of their colleagues, especially Charles Adams, Sandy Mackenzie, and Howell Zee, for helpful comments and suggestions on this paper. Responsibility for the contents of the paper, however, rests with the authors alone.
Ter-Minassian (1997) represents a comprehensive recent discussion of various countries’ experience with fiscal federalism.
See, for example, Tanzi (1996), who argues that tax competition between nations to attract mobile tax bases (particularly enterprise profits and returns from financial saving instruments) may lead to so-called tax degradation or suboptimal levels of taxation.
See Oates (1992) and Musgrave and Musgrave (1989). In addition, please note that in discussing decentralization it is customary to distinguish between administrative decentralization, where local governments act solely as “agents” of the central government, and fiscal decentralization, where local governments are assigned a degree of fiscal autonomy. This section is concerned with fiscal decentralization.
This conclusion assumes that local public goods have limited externalities, which could be felt beyond the local population, and that the costs of providing the goods can be internalized to the local population.
Tiebout (1956)describes this market as representing the outcome of choices made by mobile voters (who can “vote with their feet”) that best satisfies individuals’ demands for local public services.
Recently, however, some authors have argued in favor of assigning at least some responsibilities for stabilization policies to subnational levels of government on the basis that economic cycles may not always be highly correlated across regions (see, for example, Gramlich (1987)).
A given tax may thus be administered (i.e., levied, audited, collected) by the central tax administration while the yield ultimately accrues to the relevant local governments who may also have determined the rate.
Although a local tax share may be considered appropriate to cover the infrastructure and other costs of local governments associated with hosting natural resource industries.
The amounts received by individual authorities may also depend on their own tax efforts, that is, the extent to which they actually exploit their tax sources.
For example, to promote preventative medicine or environmental protection, or to ensure equal national standards in the provision of certain basic public services like health or education (so-called “merit” goods).
Chongqing became the fourth such municipality on January 1, 1997 joining Beijing, Tianjin, and Shanghai.
On July 1, 1997 Hong Kong became China’s first Special Administrative Region (SAR). The present paper is, however, concerned only with fiscal arrangements in the People’s Republic of China and not in Hong Kong SAR. For a discussion of the Hong Kong SAR economy, including its institutional arrangements, see Dodsworth and Mihaljek (1997).
There were a few exceptions. For example, customs duties and taxes paid by large centrally-owned state enterprises were collected by the customs administration and the central government, respectively.
For a comprehensive discussion of the pre-1994 system, and subsequent developments, see Ma (1997).
The contracts were sometimes altered at the discretion of the central government. In addition, a small part of shared revenue was divided in a fixed proportion. For example, the central and local governments received 50 percent each of the revenue from the urban land use tax.
Moreover, the minority areas received from the center an additional 10 percent above their entitlement under these arrangements, and shortfalls of revenue in the case of natural calamities were covered entirely by the center, outside the regular arrangements.
However, after 1981 the central government stopped stipulating specific expenditures in local budgets, leaving these to be determined by local governments within the overall limits of the state budget.
Most administrative functions were the responsibility of local governments. The main exclusively central functions were defense, foreign affairs and monetary affairs.
See Wong (1991) for further discussion. While the distribution of the costs of price subsidies changed often, in the early 1990s local governments bore over two thirds of the costs. Essentially, the central government transfers a fixed amount to localities to cover the difference between the cost of grain procurement at controlled prices—the “grain quota”—and the market value of procurement. Localities must bear the cost of any consumption of subsidized grain above the quota.
In 1993, SOEs’ retained earnings ceased in principle to be under the control of the government. However, there continued to be reports of local governments imposing arbitrary charges on SOEs to tap into these funds. (See Ma (1997).)
Complete data are not available for the late 1970s, but Ma (1997) suggests that in 1978 the ratio of local extrabudgetary to budgetary funds was 66 percent. For the period after 1992, due to a change in the definition of extrabudgetary funds in the official data, comparable data are not available. A new time series suggests, however, that the size of extrabudgetary funds has remained relatively high in the last few years.
In addition, one of the contracts formulated in 1988 required the center to pay localities a revenue-sharing transfer. Central government transfers that comprised subsidies or grants were of three kinds. “Quota grants” compensated local governments for the local budget deficit in the base year (i.e., the year in which the contract was made). “Special purpose grants” were given to finance specific tasks of national priority that were undertaken by local governments. “Account-settlement grants” were in relation to revenue-sharing contracts, changes in the ownership of fixed assets, or general compensation to local governments (for example, in response to any adverse effects on their budgets resulting from central government measures).
For example, the changes to the revenue-sharing system in 1988 allowed several local governments to retain a higher share of revenue if revenue growth was sufficiently strong. The changes included requiring ten provinces to share with the center a fixed proportion of revenue if revenue grew within a range of 3.5–6.5 percent in a year, but allowing them to retain all of the revenue in excess of 6.5 percent growth; and requiring three other provinces to transfer to the center a fixed proportion of revenue until a pre-specified level (in millions of yuan) was attained, beyond which a smaller proportion needed to be transferred.
Expansion was also often achieved through policies that were uncoordinated among regions, contributing to inefficiencies (discussed below).
Tax rates and bases, while legally determined by the central government, were thus increasingly influenced by local governments, who were responsible for tax collection.
Funds were shifted to extrabudgetary accounts for other reasons as well, such as to avoid central government scrutiny.
These consisted of price subsidies for “daily living necessities” and subsidies to cover the operating losses of SOEs.
Of course there were other reasons for duplicate and irrational investment. One reason was declining central authority and oversight with regard to investment planning. A second reason was that since capital markets were not well developed, and financial intermediation was thus limited, investible funds tended to be reinvested locally regardless of the rates of return in other regions. See Bell and others (1993).
These criteria include items such as population, a benchmark level of expenditure, and tax capacity.
In order for the benefits from decentralization to be maximized, it is necessary for local officials to be fully accountable for their policies. Ensuring accountability in turn has implications for both expenditure and tax assignment. On the expenditure side, for example, expenditure responsibilities assigned to local governments should cover only goods and services of a clearly local nature. On the tax side, local governments might be assigned a tax source (or a few tax sources) over which they have a measure of autonomy in determining tax rates. (Appropriate tax sources, which have the required immobile tax bases, include land and property taxes and personal income taxes.)