Central Transfer and Fiscal Capacity in China: Evidence from the Tax-Sharing System

ABSTRACT

In 1994, the Chinese government introduced a new fiscal system. Using the provincial panel data during the following period 1995–2010, we find robust evidence that central transfer (measured as the ratio of net central transfer to budgetary expenditure for each province) has a significant, negative effect on the fiscal capacity of a province (the sum of budgetary and extra-budgetary incomes as a percentage of GDP). Therefore, when the central government favors the poor provinces in central transfers (the common pool problem), the rich provinces expand their extra-budgetary income more to avoid predation by the central government, which helps increase the fiscal capacity and thus the market-preserving behavior of the rich provinces. Our result helps explain China’s success, which has strong policy implications for other transitional economies.

KEY WORDS:

• Common pool problem
• extra-budgetary funds
• fiscal capacity

JEL CLASSIFICATION:

• H77 C23

Acknowledgments

We are grateful to Professor Ali Kutan and two anonymous referees for comments that substantially improved the article. We are also grateful to seminar participants at Renmin University of China and Fudan University for critical comments. Without these critics, this article would not have been written.

Additional information

Funding

Meng Sun thanks the financial support from “the Fundamental Research Funds for the Central Universities” (Grant No. SKZZX2013034) in China.