The effects of vertical and horizontal incentives on local tax efforts: evidence from China

ABSTRACT

Tax effort is a measure of a government’s effort to collect taxes. This study explores what impacts both vertical and horizontal incentives have on local governments’ tax efforts in China. For consistency with the literature, we first include typical economic and institutional factors in our analysis. We find that the effects of economic factors on local tax efforts are significant, but the effects of institutional factors tend to be weak. Fiscal decentralization, as a vertical incentive, has a significantly positive effect on tax efforts at the provincial level. Meanwhile, fiscal interaction, as a horizontal incentive, is also taken into account in a spatial specification to explain tax competition among local governments. The results show that local tax effort in China also depends on the horizontal incentive. Hence, to improve local tax effort, the central government should let the locals have more autonomy in collecting taxes and evaluate local tax effort by referring to tax collection in adjacent provinces simultaneously.

KEYWORDS:

• Tax effort
• fiscal decentralization
• tax competition
• local government

JEL CLASSIFICATION:

• H71
• R51

Disclosure statement

No potential conflict of interest was reported by the authors.

Notes

¹ Qiao, Martinez-Vazquez, and Xu (2008) provide a description of this system enforced before 1994.

² Characterizing intergovernmental relationship by using moral hazard models is complicated in theory. Under the principal-agent framework, the central and local governments have different objectives and we cannot speculate what will happen with different assumptions of informational asymmetries, mobile/immobile consumers, redistribution motive, and taste for local public good. For example, Wellisch (2002) argues the locals make their own effort which central government cannot observe, to avoid becoming a net contributor to central government. Cornes and Silva (2002) and Lockwood (1999) indicate that immobile consumers can induce inter-regional externalities for local governments in a principal-agent model. In addition, Breuille and Gary-Bobo (2007) uses a principal-multi-agent model to characterize the hidden characteristics and actions of local governments. The above theoretical analysis reveals that rearranging the fiscal relationship between central and local governments may have different effects on local economic development. There are only a few theoretical studies on central-local fiscal relationship in the context of China, with or without moral hazard model. For example, Ma (1995) shows that the central-local fiscal game in China causes incentive problems and makes the locals tempt to reduce their tax efforts. Actually, there are many special mechanisms in Chinese intergovernmental relationship, so it is hard to specify these characteristics in a theoretical model. Since this manuscript is an empirical study, it will be too lengthy if we construct a moral hazard model to describe the fiscal relationship. We just follow Jin et al. (2005) by assuming the central government cannot dictate local effort level because local effort is not easily observable or measurable.

³ Note that it is hard to find a widely accepted measurement of institutional quality or governance at local level, especially for China.

⁴ We have tried to look for other variables to specify shadow economy at provincial level in China. Unfortunately, most studies that estimate shadow economy are based on country level, because the estimation approaches usually used are based on variables across the whole country. The approaches estimate the discrepancy between national expenditure and income statistics, or between official and actual labour force, or by using monetary flowing (Feige 1986; Feige and Urban 2008). We find that the shadow economy index from Yang and Sun (2010) is the unique decent measurement of underground economy at provincial level for China.

⁵ The corruption cases are usually used in many related studies (Zhou and Tao 2009; Dong and Torgler 2013). Jiang and Nie (2014) argue that this corruption statistics is much reliable.

⁶ Tax effort can also be calculated based on tax capacity indexes in the literature, such as Macroeconomic Indicators and Revenue Indicators. However, these indices also have some weaknesses. For example, all jurisdictions are assumed to be capable of setting tax rates at the national average.

⁷ We have estimated random-effect models for all the specifications throughout the article. Hausman tests are used to compare fixed-effect models and random-effect models. Most regressions support the fixed-effect models, in which the coefficients are not different very much from those in random-effect models. To save space, we do not report the results in the text.

⁸ However, the coefficient of public employment gets negative and the private investment share is significantly positive under the spatial framework. These results show the institutional effects are inconsistent.

Additional information

Funding

This work was supported by the National Nature Science Foundation of China [71673044]; Fundamental Research Funds for the Central Universities in UIBE [CXTD7-01]; Humanities and Social Science Fund of MOE, China [15YJA790070]