Summary:
The government considers fiscal expenditure as a key measure when making adjustments to resource allocation, income distribution, and macroeconomic policy. One of the main macroeconomic regulation and control methods advocated by Keynes is fiscal expenditure policy, which affects output by affecting aggregate demand. Furthermore, beginning with Arrow and Kruz (1970), who divided fiscal expenditure into productive and consumer expenditures and explored the impact of fiscal expenditure structure on economic growth and social welfare, a large body of literature has analyzed fiscal expenditure structure from both theoretical and empirical perspectives. In China, the proportion of local fiscal expenditure is much higher than that of central government expenditure, with the proportion of the former continuing to rise in recent years. A prominent feature of China's local fiscal expenditure structure is that local governments prefer productive fiscal expenditures but ignore non-productive fiscal expenditures. However, the literature ignores the importance of tax-sharing rates in the local fiscal expenditure structure. A local government's fiscal expenditure is derived from its own tax revenue and transfer payments by superiors. The local government's own tax revenue largely depends on the tax-sharing rate between the lower and upper levels of government. How tax revenues are divided between these levels of government will affect local government spending decisions. Because the local fiscal expenditure structure is closely related to local economic development and tax increases, any change in the tax-sharing rate will undoubtedly change the local government's spending behaviors. From the perspective of tax distribution system design, tax revenue division is the core of the intergovernmental fiscal system, and unreasonable tax-sharing methods will have an important impact on local government behaviors. Discussing the consequences of this tax-sharing approach, former Finance Minister Lou (2013) said, “It is not conducive to effectively curbing the local urge to pursue quantitative economic growth.” According to the endogenous growth theory of government expenditure (Barro, 1990), the structure of government expenditure will affect the scale and direction of investment in private capital. Therefore, it is intuitive that local governments will adjust the structure of fiscal expenditure because of changes in tax revenue. This paper theoretically and empirically studies the impact of tax sharing on the structure of local fiscal expenditure. Theoretically, we introduce tax-sharing factors within the framework of a local government competition model. An increase in the tax-sharing rate will directly cause local governments to increase productive public expenditures, exploit the output externalities of productive expenditures, increase output levels and tax revenues, and further maximize social welfare. On the empirical side, we use prefecture-level city data from 1996 to 2006 to analyze the impact of tax revenue on the structure of local fiscal expenditure. There is a strong difference in tax sharing between regions in China, which provides an excellent sample for studying the relationship between tax revenue sharing and the local fiscal expenditure structure. Although the tax-sharing rule between the central and local governments is uniform, that between provincial, municipal, and county governments varies across provinces. Empirical studies have found that as the tax-sharing rate of municipal governments increases, municipal fiscal expenditures will be more biased toward productive fiscal expenditures. The main contribution of this paper is to analyze the impact of local governments' preference for productive expenditures from the perspective of tax sharing. The theoretical model constructed in this paper helps uncover the mechanism of the effect of tax sharing on local government behaviors. The empirical analysis is helpful in explaining the changes in China's local fiscal expenditure structure. It also provides useful insight for policy makers on reforming tax distribution between central and local governments.
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