Lecture 5 Fiscal decentralization and the incentives of

Lecture 5. Fiscal decentralization and the incentives of bureaucrats.

Introduction. • In Eastern Europe and the Soviet Union in particular, very little thought was given to reform of government administration and how to make it support reform instead of opposing it. Yeltsin team managed by decrees from above but gave little thought to incentives of bureaucrats. • In China, despite the absence of drastic political change (the power of the communist party remained unchallenged), various aspects of government reform played in the hand (consciously or not) of market reform.

Fiscal incentives • Fiscal contracting system between 1980 and 1993 (crucial first period of reforms). • Provinces signed five year contracts with central government to give over either a fixed sum (and keep the rest) or give a share of revenues. • Guangdong gave a fixed amount per year during 19801987 and then during 1988 -1993 an amount that increased by 9% a year. Many governments retained 100 % of local revenue at the margin. • These contracts had interesting incentive properties if they were credible (no ex post renegotiation over revenues or subsidies).

Fiscal incentives • After 1994, a new tax system was put in place giving local government rights over local taxes (taxes from enterprises other than central government enterprises, personal income tax and business sales taxes). Provincial government kept 25% of VAT. Also important category of extra-budgetary revenues which are not shared with central government. There has thus always been since the reforms a fiscal arrangement making local government residual claimants over taxes. Potentially, provincial government thus had a stake in the development of the tax base and economic growth, assuming that a higher tax base benefits provincial leaders.

A simple model (Jin et al. 2004) • Call Y(e) value created by local businesses and e the reform and pro-business policies and regulations pursued by local government, d. Y/de >0. There is however a cost associated to e, c(e) (convex) since status quo is not pro-business. • Call y(Y(e)) the tax revenue generated, dy/d. Y >0, y concave positive function of e. • Local government maximizes zvy(Y(e))-R- c(e) +T where v is local share of revenues, z is marginal retention rate of local revenues, R is lump sum remittances to central government and T is transfers received from central government.

• First order condition: • zvy’Y’(e)=c’(e) zvy’Y’(e) c’(e) e* e

• First order condition: • zvy’Y’(e)=c’(e) Increase in z zvy’Y’(e) c’(e) e* e*

• The more the local government is residual claimant of increase in revenues, the more effort it will make towards development of local businesses. • Local government has better knowledge than central government about what helps develop business. • Incentive aspects of fiscal arrangements important in transition economies.

• We see that the discrepancy between ex ante contracts and ex post implementation was not extremely large and declined over time. • Suggests credibility.

• Commitment problem more related to subsidization rather than rent-grabbing, i. e. soft budget constraints problem more serious than predatory behavior since more provinces spend more than specified in the contract rather than the opposite.

• Increasing correlation over time between budgetary expenditures and revenue. Suggests both that provinces were residual claimants over their revenue and that they were fiscally responsible. • Strong contrast with findings of Zhuravskaya (2000) for Russia.

Chinese and Russian fiscal arrangements. • In contrast to the long term fiscal arrangements in China, in Russia under Eltsin annual negotiations on tax-sharing and transfers. Creates ratchet effect and soft budget constraints. Variation in local revenues met one for one by variation in transfers, (Zhuravskaya, 1999) • Berkowitz and Li (1999) have analyzed “overgrazing” aspect of Russian taxation.

Fiscal decentralization • Qian-Roland (1998): Competition between local governments foreign capital creates incentives to overinvest in infrastructure and has the unintended consequence of hardening budget constraints; • Federalism does not necessarily harden budget constraints, it may soften them. Governments may strategically distort composition of expenditures in order to attract more subsidies.