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| Intergovernmental Transfers and the Expansion of Subnational Government Expenditure: An Empirical Explanation based on China's Budgetary System |
| WU Min, LIU Chang, FAN Ziying
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School of International Trade and Economics, University of International Business and Economics;
The Paul and Marcia Wythes Center on Contemporary China, Princeton University & School of Economics and Management, The Chinese University of Hong Kong, Shenzhen;
School of Public Economics & Administration, Shanghai University of Finance and Economics |
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Abstract Since the Tax-sharing Reform of 1994, fiscal relations between China's central and local governments have shown the characteristics of “centralization of fiscal revenue and decentralization of fiscal expenditure and responsibilities.” Accordingly, the central government provides a large number of intergovernmental transfer payments to cope with the mismatch between financial resources and responsibilities. Studies have shown that intergovernmental transfer payments can reduce the financial gap and income inequality between regions (Yin and Zhu, 2009; Mao et al., 2011; Su and Xie, 2015; An and Wu, 2016), promote the equalization of basic public services (Guo and Jia, 2008; Fan and Zhang, 2013), increase the economic growth rate (Guo et al., 2009; Ma et al., 2016), and improve the quality of the ecological environment (Fu and Miao, 2015). At the same time, intergovernmental transfer payments also bring negative effects such as the flypaper effect. The flypaper effect refers to the phenomenon whereby intergovernmental transfer payments lead to greater fiscal expenditure by local governments than if the equivalent fiscal revenue was raised by local governments themselves (Gramlich, 1969; Inman, 2008; Dahlberg et al., 2008; Lundqvist, 2015; Gennari and Messina, 2014; Leduc and Wilson, 2017). The flypaper effect indicates that although intergovernmental transfer payments only redistribute financial resources across different regions, they affect the scale of fiscal expenditure by changing the revenue structure of local governments.
As shown by many empirical studies, the size of the flypaper effect varies between countries. The estimated size of the flypaper effect is 0.25–1.06 in the U.S. (Hines and Thaler, 1995; Brennan and Pincus, 1996; Knight, 2002; Gordon, 2004; Lutz, 2010; Leduc and Wilson, 2017) and about 1 in Europe (Dahlberg et al., 2008; Lundqvist, 2015; Gennari and Messina, 2014). Astonishingly, based on a limited number of studies, the estimated size of the flypaper effect in China is considerably larger than in Western countries. For example, Liu and Ma et al.(2015) find that a 1-percent increase in general and special transfer payments leads to a 1.5 and 3-percent increase, respectively, in the county government's fiscal expenditure. The county-level estimation in Mao et al. (2015) shows that the flypaper effect of general transfers is as high as 2.2–2.5. As a result, it is necessary to explain China's high flypaper effect in light of China's particular budgetary and intergovernmental transfer systems.
Using China's province-level panel data from 1994 to 2015, we find that a 1 RMB increase in general and special transfer payments is associated with a 1.61 and 2.12 RMB increase, respectively, in fiscal expenditure, revealing a large flypaper effect. We also find that the flypaper effect of general transfer payments reduced after 2010 when the central government began to release the transfer payment quota to subnational governments in advance. Further investigation using monthly data indicates that special transfer payments augment the flypaper effect through a well-known mechanism: the year-end crash expenditure. Our findings add to the impression that the uncertainty of merited transfer payments to subnational governments, delays in the distribution and appropriation process of transfer payments, and the rigidity of China's budgetary system jointly contribute to the larger flypaper effect in China.
This paper adds to the literature in the following ways. First, based on the interaction between China's special fiscal budget management system and the intergovernmental transfer payment system, this paper explains why China's flypaper effect as found in the empirical literature is so large. This paper is also the first to use provincial fiscal data to calculate the monthly contribution to the annual flypaper effect. This decomposition helps us to observe details concealed by the annual data. Our study indicates that the central government should regulate the intergovernmental transfer payment system, expand the scope of intergovernmental transfer targets, expedite the progress of funding, build a cross-annual budget balance mechanism, and prevent the moral hazard problem of intergovernmental transfer payments. Subnational governments should in turn improve their implementation of budget management and strengthen their adherence to governmental budgets.
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Received: 04 April 2018
Published: 12 April 2019
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