china's fiscal decentralization and regional economic growth

CHINA’S FISCAL DECENTRALIZATION ANDREGIONAL ECONOMIC GROWTH*

By JIAN CHU† and XIAO-PING ZHENG‡

†Finance Bureau, Jiangsu Province ‡Ritsumeikan University

The present paper applies Lucas’s theory of endogenous growth and Stiglitz’s theory oflocal public goods to build an econometric model consisting of five simultaneous equationsto study China’s fiscal decentralization effects on regional economic growth. The model isestimated by two-stage least squares using a set of panel data on 31 Chinese provincesduring 1996–2005. The estimated results show that China’s fiscal decentralizationincreased the local governments’ expenditure on physical infrastructure and education,which led to the rising local physical capital stock and human capital levels, respectively,and then resulted in the growth of regional economies.JEL Classification Numbers: H3, O1, P3, R5.

1. Introduction

Since the end of the 1970s, economic reforms and open-door policies have brought aboutgreat changes to the Chinese economic institutions. Among them, the Chinese fiscal systemhas been changed greatly by public finance reforms. The basic characteristic of suchreforms is fiscal decentralization. As a result, over the past 30 years, China’s fiscal systemhas evolved from being highly centralized to being relatively decentralized. The process ofChina’s fiscal decentralization can be summarized briefly as follows.

Before the economic reforms, the Chinese fiscal system was characterized by unifiedrevenue collection and budget appropriation. The central government collected all revenuesand prepared consolidated budgets for local governments; local governments had noseparate budgets. Hence, the fiscal system was highly centralized. During the periodbetween 1980 and 1993, a fiscal contract system was established between the central andlocal governments: this constituted a revenue-sharing fiscal arrangement between thecentral and local governments. Each provincial government was expected to meet specifiedrevenue remittance targets and was given certain amounts of subsidies. Local governmentsbecame more responsible for balancing their own budgets than previously; hence, thedecentralization of the fiscal system was set in motion.

In 1994, when a law regarding the sharing of tax revenues was enacted, the former fiscalcontract system was replaced by a tax-sharing system. In the tax-sharing system all taxesare divided among the central government and local governments. Moreover, the centralgovernment provides compensation to local governments based on their local conditions.

* The authors wish to express their deep thanks to the Editors of the Journal, an anonymous referee and thefaculty members of the Graduate School of Economics at Ritsumeikan University for their valuablecomments on an earlier version of this paper. The authors also grateful to Professor Jun Zhang of FudanUniversity in Shanghai for permission to use his estimated Chinese regional capital stock data. This paperwas supported by Japan Society for the Promotion of Science KAKENHI Grant Number 23530300. Theviews expressed in this paper are those of the authors and should not be attributed to their affiliations.

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This tax-sharing system became the basis of the current Chinese fiscal institutions, andsome public finance reforms have been implemented in order to establish a more decen-tralized fiscal system. For instance, in 2000, department budget reform commenced, in anattempt to make government budgets more detailed and strict, with the zero-base budgetingprinciple, and in 2006, fiscal reforms for counties and towns were launched to give localgovernments greater power to collect and use their revenues.

China’s fiscal decentralization and its effects on recent economic growth have attractedattention from many scholars. Among them, Ma (1997) finds a positive relationshipbetween fiscal decentralization and provincial economic growth in China. Lin and Liu(2000) use a production function approach assuming fiscal decentralization as a factoraffecting the technological level, and confirm that fiscal decentralization has made apositive contribution to Chinese provincial economic growth. Jin et al. (2005) indicate thatChina’s fiscal decentralization strengthened the fiscal incentives of provincial govern-ments, which were associated with faster development of the non-state sector in theprovincial economies, resulting in rapid regional economic growth. Unfortunately, thesestudies do not explicitly show which economic growth theories their empirical investiga-tions are based on. Hence, the theoretical reasoning regarding how fiscal decentralizationaffects regional economic growth remains unclear.

In contrast, there have been several works on the effects of China’s fiscal decentraliza-tion using recent economic growth theories. Zhang and Zou (1998) apply Barro’s theory ofendogenous growth, which uses government spending as an input in a regional productionfunction, to analyse a panel data set of 28 Chinese provinces for 1980–1992. They showthat a higher degree of decentralization of government spending is associated with lowerprovincial economic growth over the past 15 years. Jin and Zou (2005) use the same theoryto study a set of panel data on 30 Chinese provinces for the period of 1979–1999, and findno significant relationship between fiscal decentralization and regional economic growth.

Although the above two empirical studies have solid reasoning based on recent devel-opments in endogenous growth theories, there seem to be at least two important issues tomention with regard to how fiscal decentralization is associated with regional economicgrowth.

First, what role do local governments play in the regional production function? InBarro’s endogenous growth model with government spending (1990), the spending ofgovernments is an input of the production function. Generally speaking, a region’s outputis produced from the inputs of capital and labour, and the spending of governments canaffect the level of output mainly by means of the accumulation of capital stocks and/orimprovement of the human capital level. Of course, the spending could be considered as anexternality to shift the production function to a higher level, but how it effects theproduction function should be made clear. In this sense, Barro’s method of incorporatinggovernment spending into regional production function needs to be reconsidered. In thispaper, we argue that Lucas’s (1988) original endogenous growth theory can be used as abasis to study the effects of fiscal decentralization, and that the spending of governmentscould affect the level of physical and human capital stocks.

The second issue to mention is the local government’s behaviour in the determination ofits spending. In Barro’s model (1990), there was no analysis of how governments deter-mine their spending. As a matter of fact, the spending of governments is an outcome oftheir behaviour, which is dependent on the degree of fiscal decentralization and the level ofGDP of the region in question. Thus, the behaviour of governments should be analysed,with the factors determining their spending made clear. In doing so, in this paper, we

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introduce Stiglitz’s (1977) theory of local public goods into a study on fiscal decentrali-zation, and show that government spending is associated with fiscal decentralization.

In short, the purpose of this paper is to use Lucas’s theory of endogenous growth (1988),instead of Barro’s model (1990), as a basis to study the effects of fiscal decentralization onregional economic growth. It supposes that the spending of local governments directlyincreases the levels of local physical and human capital stocks and then affects the outputof the regional economy. Meanwhile, it applies Stiglitz’s theory of local public goods(1977) into the determinants of local governments’ spending, and shows that the spendingis a result of the behaviour of local governments, which is affected by the degree of fiscaldecentralization. That is, the degree of fiscal decentralization is assumed to affect theeffectiveness of local governments’ taxation on the disposable regional output, whicheventually influences their spending on local physical infrastructure and education. Basedon the economic theories of Lucas and Stiglitz, this paper builds an econometric model, asimultaneous equations model (SEM), that consists of five simultaneous equations.

To estimate the econometric model, the paper applies two-stage least squares (2SLS)with fixed effects (FE) to a set of panel data on 31 Chinese provinces during 1996–2005.Consequently, it confirms that the degree of fiscal decentralization increased the spendingof local governments on physical infrastructure and education, which led to increases inlocal physical capital stock and human capital levels, respectively. The expansion ofphysical and human capital stocks then resulted in the growth of regional economies. Thatis, fiscal decentralization in China contributed to its regional economic development. In theestimation, Barro’s endogenous growth theory with government spending is also testedusing the same set of panel data, which shows that Lucas’s endogenous growth theory hasgreater power to explain the recent Chinese provincial economic growth than Barro’stheory.

The rest of the paper is organized as follows. In the following section, we build aneconometric model based on theories of endogenous growth and local public goods.Section 3 discusses the data and methods used to estimate the econometric model, andSection 4 provides the estimated results and the related interpretations. Finally, we con-clude the paper in Section 5.

2. Econometric model

Following Lucas’s theory of endogenous growth (1988), a region’s production function canbe expressed as follows:

Y e K hLt= −λ α α( ) ,1 (1)

where Y denotes the output, elt the total factor productivity at time t, K the physical capital,L the total labour forces, and h the level of human capital. a is a constant between zero andunity, or 0 < a < 1.

Taking a logarithmic form and then differentiating with respect to time t yields thefollowing expression:

dY Y dK K dh h dL L= + + − + −λ α α α( ) ( )( ) ( )( ).1 1 (2)

Since dx/x is the growth rate of the variable x, and can be denoted by x, Equation (2) canbe rewritten as:

J. Chu and X-P. Zheng: China’s Fiscal Decentralization and Regional Economic Growth


� � � �Y K h L= + + − + −λ α α α( ) ( ) ,1 1 (3)

where Y, �K , h and �L imply the growth rates of the output, physical capital stocks, humancapital level and labour forces, respectively. That is, the growth of a regional economy canbe expressed as an increasing function of the accumulation of physical capital stock, theimprovement of human capital level and the increase in labour forces.

As regards the growth rates of physical capital stock, human capital level and labourforces, we suppose that the local government’s spending on physical infrastructure andeducation would affect the growth of physical and human capital, respectively. Morespecially, because the accumulation of physical capital stocks is always associated withinvestments by local governments and foreign investors in China, we assume that thegrowth rate of physical capital stock can be written as follows:

�K K K= + +β β β1 1 2 2ln ln , (4)

where K1 denotes the local government’s spending on physical infrastructure, K2 is theinvestment from foreign countries, and b, b1 and b2 are parameters to be estimated.

Meanwhile, because improvement in the human capital level is closely related withpublic and private investments in education, we can assume that the growth rate of thehuman capital level is determined as follows:

�h E E= + +γ γ γ1 1 2 2ln ln , (5)

where E1 and E2 imply the investments in education from local government and privateorganizations, respectively, and g, g1 and g2 are parameters to be estimated.

Next, to determine the local government’s spending on physical infrastructure andeducation, i.e. K1 and E1 in Equations (4) and (5), respectively, we need to consider thebehaviour of local governments. Following Stiglitz’s theory of local public goods (1977),local governments behave so as to maximize local residents’ utility function under theirbudget constraints. More specifically, we assume that the utility function of a representativeof local residents can be written as follows:

U a X b G N c G N d G N= + + +ln ln( ) ln( ) ln( ),1 2 3 (6)

where U is the utility level, X denotes the consumption of private goods, and G1, G2 and G3

are the local government’s spending on physical infrastructure, education and other publicexpenditures, respectively. N is regional population, and a, b, c and d are parameters to beestimated.

In contrast, the local government’s budget constraint can be expressed as:

( ) ,Y NX G G G− = + +φ 1 2 3 (7)

where Y is the output of the regional economy as defined in Equation (1) and f is aparameter that indicates how much of the regional output net of the consumption by localresidents can be taxed to be the revenue for the local government to spend on physicalinfrastructure, education and other public expenditures. Because such a process of taxationand the determinants of spending are affected by a country’s fiscal system, with its degreeof fiscal decentralization being key, we can specify f to be a function of tax rates as follows:



φ μτδ= D, (8)

where t denotes the tax rate, D is the degree of fiscal decentralization, and m and d arepositive parameters to be estimated. Equation (8) implies that the degree of fiscal decen-tralization could affect the effectiveness of taxation on the disposable regional output sothat it would eventually influence the local government’s spending on infrastructure,education and other public expenditures.

In this way, the behaviour of local governments can be expressed as the followingmaximization problem:

max ln ln( ) ln( ) ln( )

. . ( )

, , ,X G G GU a X b G N c G N d G N

Y NX

1 2 31 2 3= + + +

−s t μτδδ D G G G= + +

⎧⎨⎪

⎩⎪ 1 2 3

. (9)

That is, the local government allocates appropriate amounts of private goods and publicgoods (e.g. spending on physical infrastructure and education) to local residents so as tomaximize their utility level under the balance constraint on its tax revenue and expenditure.

It should be noted that here we implicitly assume that local governments do not behavein a rational, forward-looking manner; hence, they cannot fully anticipate that the output ofregional economy (Y) is, in fact, ultimately dependent upon regional physical capital stock(K) and human capital level (h), and their growth rates are related to local governments’spending on physical infrastructure and education. That is, the maximization problem oflocal governments, expressed by Equation (9), can be solved without treating Equations (1)(or (3)), (4) and (5) as constraints.1

Relating to such an assumption on the local government’s behaviour, Campbell andMankiw (1990) propose the “l-model”, assuming that spending is partly determined bypermanent resources and partly by current resources. Holtz-Eakin et al. (1994) use aggre-gate time-series data for state and local government spending in the USA to verify thel-model and reject the hypothesis that local governments behave in a rational, forward-looking manner. As for the behaviour of the Chinese local governments, few empiricalstudies have been published in international academic journals. However, given that mostof China’s local government officials are assigned by higher levels of government (see Xu,2011), and that most local governments form their fiscal budgets under a balanced-budgetconstraint for only a single fiscal year, it is reasonable to assume that Chinese localgovernments are also not rational and forward-looking, like their counterparts in the USA.Furthermore, as Ma (2006) suggests, using the example of Hubei Province, China is stilltransitioning from a planned economy to a market economy, and there exist many phe-nomena of fragmented authoritarianism in its local fiscal system. For instance, in manyprovincial governments, departments in charge of collecting taxes are separated fromfinance departments, and the latter still do not have strong budgeting authority. As a result,finance departments do not have an accurate grasp of the fiscal resources and they tend totreat them as given when determining local government spending. These circumstancescould be used to further justify the assumption made here that the local government doesnot care very much about how the output of the regional economy is related with otherproduction factors.

1 The authors are grateful to an anonymous referee for pointing out the possibility that Equations (3)–(5)could also be the constraints for the maximization problem of Equation (9).



The first-order conditions of the maximization problem yield the local government’sspending on physical infrastructure and education as follows, respectively:

G K b a b c d YD1 1*( ) [ ( )]≡ = + + + μτδ (10)

G E c a b c d YD2 1*( ) [ ( )] .≡ = + + + μτδ (11)

The above two equations indicate that the local government’s spending on physicalinfrastructure and education mainly depend on the output of the regional economy (Y), thetax rates (t) and the degree of fiscal decentralization (D).

As a result, we derived five important equations relating to the determination of thegrowth rates of regional output, physical capital stock and human capital level, and thedetermination of local governments’ spending on physical infrastructure and education.They are Equations (3), (4), (5), (10) and (11), which can be rewritten in the followingeconometric fashion:

� � � �Y K h L uit i it it it it= + + − + − +λ α α α( ) ( ) ( )1 1 1 (3′)

�K K K uit i i t i t it= + + +− −β β β1 1 1 2 2 1 2ln( ) ln( ) ( ), , (4′)

�h E E uit i i t i t it= + + +− −γ γ γ1 1 1 2 2 1 3ln( ) ln( ) ( ), , (5′)

ln( ) ln ln ( ), , , ,K D Y ui t i i t i t i t it1 1 1 1 1 1 4− − − −= + + +δ δ τ (10′)

ln( ) ln ln ( ) ., , , ,E D Y ui t i i t i t i t it1 1 1 1 1 1 5− − − −= + + +μ μ τ (11′)

In the above five equations, i denotes region, t is year and (uk)it (k = 1, 2, 3, 4, 5) are theerror terms. Except for Y, �K , h and �L, all the other variables (K1, K2, E1, E2, D, t and Y) arelagged 1 year. That is, at the year of t, the growth rate of regional output (Y) is determinedby the increasing rates of physical capital stock, human capital level and labour forces(denoted by �K , h, and �L, respectively) of the same year (t), but the growth rates of physicalcapital stock and human capital levels result from the local government’s spending onphysical infrastructure and education (K1 and E1, respectively) and private investments inthem (K2, and E2, respectively) over the last year (t - 1). Among them, the local govern-ment’s spending on physical infrastructure and education is dependent on regional output(Y), tax rates (t) and the degree of fiscal decentralization (D) of the same year, i.e. the yearof t - 1. In this way, these five equations are related with one another in that some variablesappear in different equations. In this sense, they constitute an SEM.

In short, the derived SEM suggests that fiscal decentralization implies the expansion ofthe local government’s ability to collect taxes from local residents, which would lead toincreases in its tax revenue. Because the increased tax revenue could bring about increasesin the local government’s expenditure, which involve the local public investments inphysical infrastructure and education, there would be increases in local physical capital



stock and human capital levels in the regional economy. As a result, the total regionaloutput would rise. That is, fiscal decentralization would positively contribute to regionaleconomic growth.

3. Date and estimation methods

We use panel data on 31 Chinese provinces from the period of 1996–2005 to estimate theeconometric model. The variables used in the model are defined in Table 1. All data, exceptfor those on the provincial real capital stocks, are collected from Comprehensive StatisticalData and Materials for the 55th Anniversary of New China (National Bureau of Statistics,2005) and the China Statistical yearbook, published by the Chinese Government (NationalBureau of Statistics, various years). The data on provincial real capital stocks are obtainedmainly from Zhang et al. (2004) and their related websites.

It should be noted that we use these data on provincial real capital stocks to calculatetheir growth rates (for �K ). Zhang et al. (2004) apply the perpetual inventory method toestimate the provincial physical capital stocks for each year during 1952–2000, based onthe data on provincial investment flow, capital deflators and depreciation, and those on thecapital stocks of 1952. They have extended their estimation to 2005, with the resultspublished on the Internet (http://www.cces.fudan.edu.cn/UploadFile/Capital.rar). To ourknowledge, the previous studies on China’s fiscal decentralization and economic growthhave not used the data on provincial capital stocks directly, because they were not available.The use of provincial capital data is a key factor of the empirical part of this present study.

As regards the degree of fiscal decentralization, we note that the previous studies onChina have used the marginal retention rate of the local government’s budgetary revenue(e.g. Lin and Liu, 2000; Jin et al., 2005) or used ratios of provincial spending to centralspending (e.g. Zhang and Zou, 1998; Jin and Zou, 2005). However, these indicators areinappropriate for describing the Chinese fiscal system after 1995. In 1994, a tax-sharing

TABLE 1Variables and definitions

Variables Definitions

Y The growth rate of provincial real GDP�K The growth rate of provincial real capital stock

h The growth rate of the ratio between university students and total population of a province�L The growth rate of provincial labour forcesK1 The provincial government’s expenditure on infrastructure (in 100 million yuan)K2 The investment from foreign countries (in 100 million yuan, using the foreign exchange rate of

the last working day of each year)E1 The provincial government’s expenditure on education (involving provincial tuition fee and

incidental expenses, in 100 million yuan)E2 The social donation to education (in 100 million yuan)Y The provincial real GDP (in 100 million yuan at the 1995 price)t The provincial average tax rate, calculated by dividing the provincial total tax revenue by the

provincial GDPD The provincial degree of fiscal decentralization, calculated by dividing the sum of provincial

government revenue and expenditure by the sum of revenue and expenditure of the central andall provincial governments.



http://www.cces.fudan.edu.cn/UploadFile/Capital.rar

fiscal system was established, under which all taxes are shared by the central and provincialgovernments. Under the new (tax-sharing) system, provincial governments no longer needto reserve their revenues, and the marginal retention rate used so far becomes meaningless.Furthermore, they have a certain power to share taxes with the central government, and thefiscal decentralization progresses both in terms of collecting taxes and spending revenues.In this sense, the degree of fiscal decentralization should involve both aspects of spendingand revenue. To represent the degree of fiscal decentralization, we use the ratio of the sumof provincial revenue and expenditure to the sum of revenue and expenditure of the centraland all provincial governments. Such an indicator has also been used in the fiscal decen-tralization literature concerning other countries (e.g. the production–revenue indicator inAkai and Sakata, 2002).

Table 2 presents summary statistics for all the variables explained so far.The econometric model that we estimate involves a system of five simultaneous equa-

tions, i.e. equations (3′), (4′), (5′), (10′) and (11′). Within it, there are five endogenousvariables (Y, �K , h, K1 and E1) and six exogenous variables ( �L, K2, E2, Y, t and D). Becauseall five equations are overidentified by the order condition for identification of the SEM,2SLS can be used to estimate each equation in order to obtain unbiased and consistentestimates.

Meanwhile, because we use panel data to estimate an SEM, it is necessary to apply theFE estimators. One reason for this is that the unobserved effects may have a correlationwith other explanatory variables so that the error term can be correlated with explanatoryvariables, and the condition for using the random effect estimators is not met. Anotherreason is that there are many different geographical units in our data set and each of themhas a different intercept, so the FE should be considered. Thus, the estimation method usedhere is 2SLS with FE, which could control the unobservable effects in the estimation.

4. Estimated results

Table 3 presents the estimated results concerning the growth rate of regional economies,i.e. Equation (3′) of the SEM. To show that Lucas’s theory of endogenous growth (1988)

TABLE 2Summary statistics of major variables

Variables Mean Minimum MaximumStandarddeviation

Growth rate of provincial real GDP ( )�Y 0.13 0.01 0.27 0.04Growth rate of provincial real capital stocks ( )�K 0.13 0.06 0.37 0.04Growth rate of provincial human capital level ( )�h 0.18 -0.28 0.54 0.12Growth rate of provincial labour forces ( )�L 0.01 -0.27 0.21 0.03Government expenditure in infrastructure (K1) 38.91 1.44 345.35 42.91Foreign investment (K2) 123.74 0.00 995.08 203.51Government expenditure in education (E1) 71.25 3.97 399.18 60.16Social education donation (E2) 4.30 0.00 28.29 5.08Provincial real GDP (Y) 3236.07 56.11 19,314.55 2991.76Degree of fiscal decentralization (D) 0.019 0.002 0.073 0.014Provincial average tax rate (t) 0.06 0.03 0.14 0.02

Notes: Except for the growth rates of GDP, physical capital, human capital and labour forces, all the othervariables are calculated by lagging 1 year.



could be used as a basis to study the effects of fiscal decentralization on regional economicgrowth instead of Barro’s theory (1990), we report results based on both Lucas’s andBarro’s theories in the same table. Column (1) presents the estimated result using Lucas’stheory, where a stands for a parameter in Equation (3′). Column (2) gives the result usingBarro’s theory, which can be represented by the following regional production function:

Y e K L Gitt

it it it= < < < <− −λ α β α β α β1 0 1 0 1, , , (12)

where Yit, Kit and Lit are the output, physical capital and labour forces of province i at yeart, respectively, and Git is the government’s spending in province i at year t, The growthexpression of Equation (12) can be easily written as the following regression form:

� � � �Y K L G uit i it it it it= + + + − − +λ α β α β( ) ( ) ,1 6 (13)

where (u6)it is the error term, and the estimates of a and b are given in column (2) ofTable 3.

Although all of the estimates for the main parameters in both Lucas’s and Barro’smodels have the same expected signs with significance, the R2 and F-statistic for Lucas’smodel are greater than those for Barro’s model. This means that Lucas’s model has greaterpower to explain the Chinese provincial panel data of 1996–2005 than Barro’s does. Interms of the explanatory variables used in these models, use of a variable that represents thehuman capital level (i.e. h) seems to be more appropriate to account for regional economicgrowth than direct use of the local government’s spending (i.e. G). In this sense, Lucas’stheory of endogenous growth can be considered as a sound basis to study the effects offiscal decentralization on regional economic growth in China, and could replace Barro’smodel with government spending.

Using the estimated result for Lucas’s model in Table 3, we can interpret that in the caseof the Chinese provinces, if the physical capital stock increases by 1%, the provincial GDPwould rise by 0.84%. Meanwhile, a 1% increase in the labour force or in the level of humancapital would result in 0.16% of growth in provincial GDP. The effect of physical capital

TABLE 3Estimated results concerning regional economic growth rates

Dependent variable:Provincial GDP growth rate

(1) (2)Lucas’s theory Barro’s theory

a 0.843 0.447(0.029)*** (0.090)***

b 0.197(0.078)**

R2(within) 0.902 0.784F 2.41 0.95p-value 0.000 0.550

Notes: The number of observations is 310. Standard errors arein parentheses. *** and ** indicate significance at the 1 and 5%levels, respectively.



stock on GDP is greater than that of human capital, which is consistent with the evidencethat China’s economic growth has been associated with increases in fixed asset investment(see Lin and Liu, 2000).

Second, in relation to the increasing physical capital stock and human capital levels,Table 4 provides the estimated results for Equations (4′) and (5′) of the SEM. Column (1)shows that the growth rate of physical capital stock is affected by the local government’sexpenditure on physical infrastructure and foreign investments. Column (2) suggests thatthe local government’s expenditure on education has a positive impact on the growth ofhuman capital level. However, private investment in education, represented by data forsocial donation to education, has not been identified as having significant effects on thegrowth of the human capital level.

Third, Table 5 reports the estimated results for the local government’s expenditure onphysical infrastructure and education, based on Equations (10′) and (11′) of the SEM. It isevident from columns (1) and (2) that the local government’s expenditure on physicalinfrastructure and education are dependent on local tax rates and the degree of fiscaldecentralization.

TABLE 4Estimated results about the growth rates of physical capital stock and human capital level

Dependent variables

(1) (2)Growth rate of physical

capital stocksGrowth rate of human

capital level

Government’s expenditure on infrastructure(lagged by 1 year, logarithm)

0.018 (0.003)***

Government’s expenditure on education(lagged by 1 year, logarithm)

0.148 (0.053)**

Foreign investment(lagged by 1 year, logarithm)

0.016 (0.004)***

Social donation to education(lagged by 1 year, logarithm)

-0.019 (0.035)

R2 (within) 0.227 0.178F 8.04 2.95(p-value) 0.000 0.000

Notes: The number of observations is 310. Standard errors are in parentheses. *** and ** indicate significanceat the 1 and 5% levels, respectively.

TABLE 5Estimated results for the local government’s expenditures

Dependent variables

(1) (2)Logarithm of government’s

expenditure oninfrastructure

Logarithm of government’sexpenditure on

education

(Degree of fiscal decentralization)¥ (Logarithm of tax rate)

20.997 (5.349)*** 15.306 (2.109)***

(lagged by 1 year)R2 (within) 0.052 0.159F 17.92 22.87p-value 0.000 0.000

Notes: The number of observations is 310. Standard errors are in parentheses. *** indicates significance at the1% level.



In this way, the SEM of this paper, composed using Equations (3), (4′), (5′), (10′) and(11′), has been estimated, and the hypotheses involved in the SEM have been confirmed tobe basically true. That is, fiscal decentralization caused the local governments to increasetheir expenditure on physical infrastructure and education, which led to increases in localphysical capital stock and human capital levels, respectively, and, hence, resulted in thegrowth of regional economies.

It can be interpreted that fiscal decentralization influences local governments’ behaviourthrough expanding their ability to collect fiscal revenue. With the increases in fiscalrevenue, the local government could also increase its expenditures. The increases in fiscalexpenditures could lead to local public investments in physical infrastructure and educa-tion, as these are two basic needs of local residents. These expenditures from the localgovernment would naturally contribute to the accumulation of physical capital stock andimprovement of the human capital level. Examples of the former are the construction andcompletion of regional network systems of transportation, sewerage and other publicutilities. Examples of the latter are the expansion of the capacities and enrollments ofcolleges and universities. According to Lucas’s theory of endogenous growth, the accu-mulation of physical capital stock and the improvement of human capital levels will leadto regional economic growth.

Our empirical result that China’s fiscal decentralization contributes to its regionaleconomic growth is consistent with many previous studies on the same subject, such asthose of Ma (1997), Lin and Liu (2000) and Jin et al. (2005). However, these previousworks do not explicitly demonstrate the economic growth theories that their empiricalstudies were based on, and the data on the Chinese provinces that they use are mainlyrestricted to the periods of the 1980s and 1990s. In contrast, our positive result on the roleof China’s fiscal decentralization is in opposition to the negative results obtained by Zhangand Zou (1998), and Jin and Zou (2005). Unlike the present study, they use Barro’s modelwith government spending as the basis for empirical investigation, and estimate the modelusing the Chinese provincial data for the period of 1979–1999. The present study appearsto be the first on China’s fiscal decentralization using Lucas’s endogenous growth theoryand China’s provincial data for the period between 1996 and 2005.

5. Concluding remarks

This paper presented an empirical study on the effects of China’s fiscal decentralization onits regional economic growth. As one difference from the previous works on the samesubject, we focused on the most recent period, i.e. from 1996 to 2005, during which timea tax-sharing fiscal system has been established between China’s central and provincialgovernments, and the Chinese fiscal system has been considerably decentralized. China’sfiscal decentralization seems to have reached a stage where people believe that furtherdecentralization is necessary. It is important to use data for the period with the establishedtax-sharing system to study the effects of fiscal decentralization.

Another difference between the present study and previous studies is that we usedLucas’s theory of endogenous growth (1988) and Stiglitz’s theory of local public goods(1977) as a theoretical basis to study the influence of fiscal decentralization on regionaleconomic growth. Indeed, some of the previous works have applied Barro’s theory ofendogenous growth with government spending (1990) into their empirical investigations,but the role and behaviour of local governments remain unstudied. In this paper, we



assumed that local governments behave so as to maximize the utility level of local residentsand that they could affect regional economic growth only through their spending onphysical infrastructure and education. We believe that this assumption is more consistentwith the current Chinese regional economic system, which has become highly marketizedbecause the economic reforms and open-door policies were adopted in the end of 1970s. Asthe marketization of economic systems progresses, local governments become increasinglyconcerned with the local economic growth. They come to realize that economic growthmainly results from the inflows of capital and labour, which closely relate with the personallevel of regional welfare. As a result, more and more local governments would choose themaximization of local residential utility levels as their main objective in forming theirpolicies.

Based on the economic theories of Lucas and Stiglitz, we built an econometric model tostudy the effects of fiscal decentralization on regional economic growth, which is an SEMconsisting of a system of five equations. We estimated this model by applying 2SLS withFE to a set of panel data on 31 Chinese provinces during the period of 1996–2005. We alsoused the same set of panel data to estimate Barro’s endogenous growth theory withgovernment spending (1990), which indicated that Lucas’s theory of endogenous growthhas greater power to explain the recent Chinese provincial economic growth than Barro’stheory. According to our estimated results, China’s regional economic growth is mainlydue to increases in physical capital stock, labour force and human capital. Meanwhile, theincreases in physical capital stock are dependent on the provincial government’s expendi-ture on physical infrastructure, and growth of the human capital level on the government’sspending on education. Furthermore, the provincial government’s expenditures on physicalinfrastructure and education are all affected by regional GDP, local tax rates and the degreeof fiscal decentralization. China’s fiscal decentralization increased local governments’expenditures on physical infrastructure and education, which led to the growth of localphysical capital stocks and human capital levels, respectively, and then resulted in thegrowth of regional economies.

Final version accepted 25 January 2013.

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china's fiscal decentralization and regional economic growth

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