Fiscal Decentralization and Growth Sustainability: An Analysis from the Markov Regime-Switching Clustering Perspective
JIA Junxue, CHAO Yunxia, LI Zixiao
School of Finance, China Financial Policy Research Center, Renmin University of China; School of Public Finance and Taxation, Capital University of Economics and Business; School of Finance, Renmin University of China
Summary:
Maintaining sustainable economic growth is a severe challenge facing policymakers in China. Obviously, the sustainability of growth is determined not only by growth rates, but also by growth stability. A typical fact related to China's economic growth that cannot be ignored is that the growth dynamics of regional economies exhibit rather substantial differences. Focusing only on economic growth rates may cause one to ignore this important fact and its inherent logical and theoretical implications. Meanwhile, fiscal system reforms with the central theme of “decentralization of power and transfer of profits” are generally considered one of the most important institutional changes since China's reforms and the opening up of its markets, and it is an important perspective to deeply understand China's economic sustainability. However, few studies explore the effects of fiscal decentralization on both economic growth and economic stability, and thus, on growth sustainability, using a relatively unified analytical framework. Studies on the characteristics of China's sub-provincial regional economic growth dynamics and the effects of fiscal decentralization on these dynamics are also relatively inadequate. This paper aims to comprehensively analyze the impact of fiscal decentralization on regional growth dynamics and, thus, on the sustainability of growth in China. Specifically, based on a panel dataset of 245 prefecture-level cities in China for the period from 1978 to 2014, we first study the dynamic characteristics of economic growth in these prefecture-level cities by using a Markov regime-switching clustering model from the perspective of regime switching and clustering; identifies different dynamic growth patterns; and reveals their differences in average growth rates, growth states and duration, growth volatility, and, ultimately, growth sustainability. Then, we use the logit panel model to investigate the effects of fiscal decentralization on growth sustainability from three dimensions: impact of fiscal decentralization on the belonging probabilities of growth modes, on the differences in growth states across growth modes, and on the occurrence probability of high growth states within each growth mode. We find that the growth dynamics of prefecture-level cities in China present three typical modes that differ significantly in terms of average growth rates, duration of growth states, growth volatility and, thus, their sustainability. Expenditure decentralization significantly increases the prefectural cities' probabilities of being clustered into the low-growth-and-high-volatility growth mode and, thus, reduces the sustainability of economic growth. However, it has relatively positive effects on the sustainability of economic growth after the reform of the tax-sharing system in 1994. Revenue decentralization is beneficial for the sustainability of economic growth overall, but after the tax-sharing system reform, its positive impacts are weakened due to increasing vertical fiscal imbalance. We also find that increasing fiscal self-capacity enhances the sustainability of economic growth. The above findings provide important insights for optimizing and improving the fiscal system to effectively promote sustainable economic growth in China. Although the decentralization of fiscal expenditure has played a positive role in enhancing the sustainability of economic growth after the reform of the tax-sharing system in 1994, it remains necessary to realize that the current expenditures undertaken by local governments in China are heavy, that the mismatch between revenue and expenditure responsibilities is growing, and that the local vertical fiscal imbalance is increasingly adversely affecting the sustainability of economic growth. Therefore, in the future, China should appropriately reduce the expenditure responsibilities of local governments and increase their autonomy over fiscal revenues to build a fiscal system that improves the match between revenue and expenditure responsibilities and provides a clearer arrangement of powers and responsibilities. Compared with existing studies, the main contributions of this paper are as follows. First, from a relatively new perspective, namely the Markov regime-switching and clustering view, this paper incorporates economic growth and economic volatility into a relatively unified analytical framework. Second, the application of the Markov regime-switching and clustering model is conducive not only to endogenously identify different nonlinear dynamic growth patterns of prefecture-level cities and better reveal the multidimensional differences in the growth sustainability of these dynamic growth modes, but also to facilitate a multifaceted analysis of the influences of fiscal decentralization. Finally, by using long panel data of China's prefecture-level cities spanning nearly 40 years (1978-2014), this paper enriches research on the dynamic mechanisms of China's regional economic growth.
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