Local expenditure policy

China Economic Review 28 (2014) 107–122

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China Economic Review

Fiscal decentralization and local expenditure policy in China☆

Junxue JIA 1, Qingwang GUO 2, Jing ZHANG⁎

China Financial Policy Research Center, School of Finance, Renmin University of China, 59 Zhongguancun Street, Beijing 100872, China

a r t i c l e i n f o

☆ The research is supported by the Fundamental Re(2013030214).⁎ Corresponding author. Tel.: +86 1082500614; fax

E-mail addresses: [email protected] (J. Jia), guoq1 Tel.: +86 1082500646; fax: +86 1082509287.2 Tel./fax: +86 1082509287.3 These studies include cross-sectional, time series

1043-951X/$ – see front matter © 2014 Elsevier Inc. Ahttp://dx.doi.org/10.1016/j.chieco.2014.01.002

a b s t r a c t

Article history:Received 24 March 2012Received in revised form 10 January 2014Accepted 10 January 2014Available online 21 January 2014

Since the tax-sharing reform in 1994, the Chinese fiscal system has exhibited a marked verticalfiscal imbalance—a mismatch between expenditure and revenue assignments—at the locallevels, which may cause the common-pool problem in local governments' behavior. Using alarge fiscal dataset at the county level from 1997 to 2006, this paper studies the effects of fiscaldecentralization on local expenditure policy and analyzes how the vertical fiscal imbalanceshapes these effects. The estimation results show that expenditure decentralization increasesgovernment spending and leads to a fund allocation with a larger weight on capital constructionand smaller weights on education and administration. In contrast, revenue decentralization haslittle influence on local government expenditures. We show that the differences in the effects ofexpenditure and revenue decentralization can be attributed to the distortionary effects caused bythe vertical fiscal imbalance and, thus, offer support to the importance of the common-poolproblem at the county level of China's fiscal system.

© 2014 Elsevier Inc. All rights reserved.

Keywords:Fiscal decentralizationLocal expenditure policyCommon-pool problemVertical fiscal imbalance

1. Introduction

Conventional wisdomholds that fiscal decentralization enhances government efficiency by restraining the size of public sectorsor by providing public goods that better cater to local residents' preferences (Brennan & Buchanan, 1980; Hayek, 1948; Oates,1972; Qian & Roland, 1998; Tiebout, 1956). However, whether the benefits of fiscal decentralization do materialize depends oncomplementary institutions in a country (Rodden, Eskeland, & Litvack, 2003). In fact, one strand of the literature argues that fiscaldecentralization could boost government size if governments' expenditure and revenue responsibilities are not adequatelybalanced, which has been described as the common-pool problem (Ehdaie, 1994; Grossman, 1989; Rodden, 2003; Stein, 1999). Inaddition to the overall effects, how different components of government expenditures (for example, spending on capitalconstruction, education or social security) react to fiscal decentralization is another important issue that is under-explored.Understanding the effects of fiscal decentralization on specific components of fiscal expenditures sheds light on the preference ofthe local governments when they are granted more autonomy. Indeed, it has been conjectured that local governments tend toinvest in the expenditure categories that are useful for attracting mobile factors and to neglect those benefiting immobile factors(Keen & Marchard, 1997). Whether this conjecture holds is of interest to both researchers and policy advisors.

The existing empirical evidence on the relations between fiscal decentralization and government expenditure is mainly based oncross-country or state-level data (for example, Ehdaie, 1994; Fiva, 2006; Jin & Zou, 2002; Oates, 1972, 1985; Rodden, 2003; Stein,1999).3 Nevertheless, it is reasonable to expect that a country's politics, history, culture, and other institutions can simultaneouslyaffect the levels of fiscal decentralization and government expenditure. For instance, a new governor who supports the free marketand competition would alter the fiscal structure by allowing a more decentralized governance mode. Meanwhile, because the new

search Funds for the Central Universities, and the Research Funds of Renmin University of China

: +86 [email protected] (Q. Guo), [email protected] (J. Zhang).

and panel data analysis.

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108 J. Jia et al. / China Economic Review 28 (2014) 107–122

governor may prefer to be less involved in the economy, the government expenditure may shrink as well. If we are ignorant of suchpolitical transitions, we could reach an incorrect conclusion that decentralization itself restrains government size. Without perfectproxies for this institutional background, the estimation of the relationship between government decentralization and governmentbehavior may not be accurate.

Our paper studies the influences of fiscal decentralization on government size and its composition by using the mostcomprehensive fiscal data of 1920 Chinese counties from 1997 to 2006. The contribution of our studies lies in the followingseveral aspects. First, in contrast to the joint fiscal and political decentralization found in most democratic countries, China has adecentralized fiscal regime coupled with a highly centralized political system (World Bank, 2002; Xu, 2011; Zhang, 2006).Particularly, since the 1994 tax-sharing reform, China's fiscal system has demonstrated a strong mismatch between expenditureand revenue responsibilities, that is, vertical fiscal imbalance. This specific governance structure with a significant vertical fiscalimbalance provides us with an interesting context to examine the relevance of the current theories of fiscal decentralization.Second, understanding the performance of fiscal decentralization among sub-provincial governments is essential to evaluate theefficiency of current governance structure and to guide future government reforms in China. So far, the fiscal relations betweenthe central and provincial governments in China have been well documented and studied (Bai, Tao, & Tong, 2008; Huang & Chen,2012; Jin, Qian, & Weingast, 2005; Lin & Liu, 2000; Qiao, Martinez-Vazquez, & Xu, 2008; Zhang & Zou, 1998). Yet, correspondingknowledge of the sub-provincial governments remains sparse. Only a few studies have been conducted to understand theirdecentralization practice (Shih & Zhang, 2007; Tsui, 2005; World Bank, 2002; Zhang, 2006). Our study sheds some new light inthis area. Third, we use the county-level panel data from 1997 to 2006 for the empirical test of theoretical hypothesis in fiscaldecentralization. One advantage of employing this county-level data is that some aforementioned unobserved aggregate shockscan be captured by year or provincial-times-year fixed effects in this context. Thus, our analysis better avoids omitted variablebias caused by macro- or provincial-level unobservables. Meanwhile, employment of this panel data allows us to control for thetime-invariant county heterogeneity in the analysis.

By employing a dynamic panel data model to account for county heterogeneity and persistence in government expenditures,we find that expenditure decentralization raises the amount of county governments' total expenditures and the ratio of capitalconstruction spending but reduces the proportions of education and administrative expenditures. In contrast, revenuedecentralization has little influence on the size or the composition of county governments' expenditures. These two findingsimply that the divergence of expenditure and revenue assignments is associated with a larger government. By splitting thesample based on counties' average degrees of vertical fiscal imbalance, we further find that the influences of expendituredecentralization are stronger in the counties with higher levels of vertical fiscal imbalance.

The above findings suggest that the common-pool problem is prevalent in China's fiscal system. In China, the 1994 tax-sharingreform initiated a series of fiscal reforms that recentralize the tax revenues while devolving expenditure responsibilities to thelower levels of governments. In this fiscal regime, county governments do not have enough revenue capacities to finance thepublic goods and services that they are assigned and have to resort to transfers from the upper-level governments or to othercommon-pool resources to finance their expenditures. This fiscal arrangement provides the county governments with incentiveto overspend because their residents only pay for part of their government expenditures. Indeed, only expendituredecentralization without matched revenue decentralization in China undermines government efficiency. Furthermore, since inChina capital is mobile while labor is much less so due to the current household registration (hukou) system, the countygovernments prefer to spend much more in infrastructure construction to attract capital inflow rather than in education to attractlabor.

The rest of this paper is organized as follows. Section 2 summarizes the theoretical and empirical literature that discusses therelationships between fiscal decentralization and government expenditures. Section 3 describes the fiscal system in China andseveral major reforms of fiscal disciplines during our study period (1997–2006). The descriptions of the data, estimation strategy,and variables are in Section 4. Section 5 presents the regression results, and the final section concludes.

2. Literature review

2.1. Theoretical framework

In the literature, two classic theories—asymmetric information and fiscal competition—explain the mechanisms throughwhich fiscal decentralization might influence government behavior. Oates (1972) first brings up the role of asymmetricinformation in determining the fiscal structure. He emphasizes that local governments are better informed of diverse localconditions and of preferences than the national government. In that case, devolving expenditure responsibilities to localgovernments can make such governments meet the needs of local residents better, and the allocation of government resourcesbecomes more efficient. This prominent strand of literature does not put forward a conclusive conjecture on the correlationbetween fiscal decentralization and government size.

Nevertheless, the theories of fiscal competition render the most unambiguous predictions of the links between fiscaldecentralization and smaller governments. Assuming a benevolent government that seeks to maximize civil welfare, severalstudies have argued that fiscal competition could lead to a “race to the bottom” in public goods provision and inefficiently lowlevels of government expenditures (Wildasin, 1991; Wilson, 1986, 1999; Zodrow & Mieszkowski, 1986). In contrast, rested on amore realistic assumption that governments, as the Leviathan, always maximize revenues instead of social welfare, Brennan andBuchanan (1980) predict that interjurisdictional competition in attracting mobile factors (such as capital and labor) limits

109J. Jia et al. / China Economic Review 28 (2014) 107–122

governments' excessive taxing power. Through intensifying interjurisdictional competition and enforcing accountabilities of localgovernments to their own jurisdictions, fiscal decentralization serves as a disciplinary device to mitigate agency problems. Hence,the Leviathan model implies that fiscal decentralization induces smaller governments.

Despite its theoretical appeal, the Leviathan model may not suit the reality well. In fact, central and local governments usuallycollude to avoid such interjurisdictional competition by allowing central governments to collect a majority of the revenues andthen to transfer money to local governments to finance their expenditures (Ehdaie, 1994; Grossman, 1989). One problem that hasbeen discussed about this fiscal arrangement is that the expenditure decisions of local governments are not independent of fundsource. Right now, local public expenditures come partially from the taxes collected from residents outside the jurisdictions,which incentivizes the local governments to spend more than they would when using their own tax revenues. This outcome hasbeen described as the common-pool problem in the literature (Rodden, 2003; Stein, 1999). The larger the gap is betweenexpenditure and revenue responsibilities, the weaker the disciplinary role of fiscal decentralization is and, thus, the larger thelocal governments may become.

As for the fiscal decentralization and government expenditure composition, Tiebout (1956) argues that interjurisdictionalcompetition leads to efficient public goods provision when both labor and capital are free to move. Under the scenario with onlymobile capital, Keen and Marchard (1997) show that fiscal competition may cause systematic inefficiencies in the composition ofgovernment expenditures; that is, local governments are willing to spend more on public inputs to attract capital and tounderprovide public services that benefit local residents.

2.2. Empirics

Starting with Oates (1972), numerous studies have tested the relationship between fiscal decentralization and governmentexpenditures in a variety of contexts, with special focus on the Leviathanhypothesis that fiscal decentralization restrains governmentexpenditures. The results of these studies become inconclusive (Feld, Kirchgässner, & Schaltegger, 2010;Marlow, 1988; Oates, 1985).To reconcile the findings of the empirical literature, one section of the literature has created the concept of vertical fiscal imbalance tomeasure the gap between expenditure and own-source revenue and has emphasized its role in shaping the relationship betweenfiscal decentralization and government size. Ehdaie (1994), Stein (1999), Jin and Zou (2002), Rodden (2003), and Fiva (2006) all findthat vertical fiscal imbalance is associated with the expansion of governments. Studies on the influences of fiscal decentralization onthe composition of government expenditures are relatively limited. Faguet (2004) finds that decentralization increases governmentresponsiveness to local needs—leading to larger public investments in education and other social services in Bolivia. Fiva (2006)shows that social security transfers decrease with revenue decentralization and that government consumption increases withexpenditure decentralization. Kappeler and Välilä (2008) present that tax revenue decentralization boosts public infrastructureinvestments and reduces economically less productive investments, such as recreational facilities.

In the case of China, the existing studies have been conducted mostly at the provincial level. Zhu and Krug (2005) usetime-series data at the national level from 1953 to 2002 and cross-sectional data at the provincial level for 2000 to test theLeviathan hypothesis. They find that expenditure decentralization imposes constraints on government size at both the nationaland provincial levels. In contrast, Chen (2004) shows a positive correlation between expenditure decentralization and provincialgovernment size using panel data from 1986 to 1998. Similarly, using provincial-level panel data from 1998 to 2006, Wu and Lin(2010) find that both expenditure and revenue decentralization increase government size, while vertical fiscal imbalance doesnot have any statistically significant influences. Nonetheless, as Jin and Zou (2005) point out, there is no reason to believe that thefindings at the provincial level also hold true at the lower levels of governments. With special interests in Chinese countygovernments, this paper explores the relationships between fiscal decentralization and both the size and the composition of theirgovernment expenditures. By using the most comprehensive fiscal data of 1920 Chinese counties from 1997 to 2006, our studyprovides a new piece of evidence on the practice of fiscal decentralization at the county-level in China.

3. Institutional background (1997–2006)

China has a decentralized fiscal system coupled with a highly centralized political system (World Bank, 2002; Xu, 2011; Zhang,2006). Its fiscal system contains five hierarchical levels: Central, provincial, prefectural, county, and township. As of 2006, thesystem comprises one central government; 31 provincial-level units (4 municipalities, 22 provinces, and 5 autonomous regions)4;333 prefectures; 2860 county-level units5; and 41,040 townships (National Bureau of Statistics, 2007).

With the introduction and development of a market economy since 1978, the fiscal relations between central and provincialgovernments have been revamped by several major reforms. Those reformsmainly focused on the revenue-sharing rules and onlymade a few changes in expenditure responsibilities. The current tax-sharing scheme stipulated in 1994 recentralized the majorityof the tax revenues. The share of total budgetary revenues assigned to the central government increased from 22.0% in 1993 to55.7% in 1994 and has remained at around 52.0% since then (National Bureau of Statistics, 2011). Nevertheless, the fiscal regime at

4 Hainan was established as a province in 1988, and Chongqing was designated as a municipality in 1997. In this paper, we do not include Taiwan Province andthe two special administrative regions of Hong Kong and Macau in China.

5 For simplicity, county-level units are called counties in the rest of the paper.

1020

3040

5060

70pe

rcen

t

1997 1998 1999 2000 2001 2002 2003 2004 2005 2006year

expenditure decentralization revenue decentralization

vertical fiscal imbalance

Fig. 1. Expenditure decentralization, revenue decentralization, and vertical fiscal imbalance at the county level, 1997–2006. Notes: Expenditure decentralizationand revenue decentralization are the ratios of the per capita expenditures/revenues of a county government in the total of per capita expenditures/revenues of(1) its own and (2) the governments that the county is subordinated to, including the prefectural, provincial, and central governments. Vertical fiscal imbalance ismeasured by the ratio of the county governments' fiscal gap (including grants net of remittances and deficits) to their expenditures.Data sources: Statistical Material for Prefectures, Cities, and Counties Nationwide (Ministry of Finance, 1998–2007).


the sub-provincial level is quite autonomous and complex. In China, the upper-level governments usually have the decisivepower on the fiscal schemes of their directly subordinate governments with little discretion of the central government. That is, theprovinces specify the revenue sharing with their respective prefectures, which, in turn, set the rules with their counties.Consequently, the fiscal schemes of prefectural and county governments are the results of case-by-case ad hoc negotiation andpresent a substantial variety throughout the country. For example, the sub-provincial (prefectural, county, and township)governments in Jiangsu Province was allowed to retain 50% of the local revenues collected from value-added taxes (VATs) in2000, as compared to 80% in Hunan Province (World Bank, 2002).

Because governments' revenues have been centralized, local governments have fewer financial resources than before and havethe tendency to devolve expenditure responsibilities to the lower levels (World Bank, 2002). As the second-lowest tier in the fiscalhierarchy, county governments have faced greatly expanded expenditure obligations, including support to agricultural production,finance of compulsory education, provision of public health services, and so forth. Furthermore, since China's social security netstarted to rebuild in the 1990s, they are even assigned to manage some of the social security programs that are usually run bycentral or provincial/state governments in international practice (for example, the New Cooperative Medical Scheme for ruralresidents and support for low-income families). During our study period (1997–2006), county governments on average accountedfor 28.98% of total government expenditures and 49.38% of government education expenditures.6 Fig. 1 plots the index ofexpenditure and revenue decentralization of counties in our sample over those years. The expenditure decentralization—the shareof a county government's per capita spending in the total of per capita spending of its own and its superordinate governments—hasincreased continuously since 2000. This number was around 41.97% in 2006. On the contrary, the proportion of the countygovernments' per capita revenues, defined as revenue decentralization, has decreased from 23.61% in 1997 to 15.2% in 2006. Thisdownward trend of revenue decentralization is attributed to several tax reforms during this period. One of the most prominentreforms concerned the sharing of income taxes in 2002. Before 2002 the local governments were allowed to retain all individualand enterprise income tax revenues except for those collected from centrally owned enterprises. The reform on income taxes in2002 reassigned the revenue split: The central government owned 50% of income taxes in 2002 and 60% thereafter. Anothersignificant adjustment in the revenue collection of local governments was the Rural Tax for Fee reform in 2000, which revoked avariety of user fees and surcharges levied by county and township governments and cut the agricultural tax rate at the same time.

Along with expenditure decentralization and revenue centralization in China's fiscal system, the fiscal gap in countygovernments' budgets continues to increase. Transfers from upper-level governments and other common-pool resources mainlyfill this fiscal gap. Our data show that in 1997 county governments' expenditures amounted to 108.7 million Chinese Yuan onaverage, of which 44.91% was financed by intergovernmental grants (net of remittances to upper-level governments). And thisratio rose to 69.81% in 2006. Albeit the large scale of transfers, some counties still run significant budget deficits and have toborrow directly or indirectly from banks or other sources to supplement the budget (Li, 2010; World Bank, 2002). In our data, 609counties registered budget deficits in 2006 with the average level at 12.36 million Chinese Yuan. Given that Chinese countygovernments face a severe mismatch between their expenditure responsibilities and revenue capacities, uncovering whether andto what extent their expenditures may be distorted would have profound policy implications to future government reform.

6 These percentages are calculated using data from the Statistical Material for Prefectures, Cities, and Counties Nationwide (Ministry of Finance, 1998–2007) andChina Statistical Yearbook (National Bureau of Statistics, 2011).


4. Data and variables

4.1. Data

The data used in this paper are collected primarily from Statistical Material for Prefectures, Cities, and Counties Nationwide(Ministry of Finance, 1998–2007), the most comprehensive disaggregated data on public finance in China. The data cover allcounty-level administrative units, including counties, county-level cities, and urban districts and contain detailed information onthe local governments' revenues, expenditures, and transfers in various categories as well as some basic socioeconomic variablesin these units (for example, gross domestic product (GDP) and population size). We limit our sample period between 1997 and2006 because some of the key variables, such as GDP and the main categories of government expenditure, are consistentlymeasured and recorded in those yearbooks during that period. All the county-level urban districts are excluded because they arebelieved to be systematically different from their rural counterparts in the literature (Ahmad, 1998; Shih & Zhang, 2007; Shih,Zhang, & Liu, 2010; Zhang, 2006).7 The county population data after 2001 are collected from China Statistical Yearbook for RegionalEconomy (National Bureau of Statistics, 2003–2007) because they are no longer recorded in the previous yearbooks. The area dataare from China County Statistical Yearbook (National Bureau of Statistics, 2001–2007).8 To select the sample for this study, weexclude counties in accordance with the following rules: (1) counties that changed their judiciary boundaries from 1997 to 2006,(2) all of the counties in Tibet because of vast missing values, and (3) county observations whose values of the regressionvariables themselves are above the 99.5th percentile or below the 0.5th percentile.9,10 Finally, our sample comprises 1920counties, and it is unbalanced panel data because some counties were newly formed during the study period.

4.2. Estimation strategy

Considering the slow adjustments in both the size and the composition of county government expenditures, we use a dynamicpanel model to investigate the influences of fiscal decentralization:

7 Ahmfiscal desome d

8 Bec9 To

percentexpenddensity10 Ourcontribexclude11 To ktruncatoutcomadminis54,915.choose

Gipt ¼X

mαmGipt−m þ Fdeciptβ þ Xiptδþ upt þ υi þ εipt ; ð1Þ

Gipt refers to the variables that depict local expenditure policy: The government expenditure size or the share of each
whereexpenditure category of county i in province p in year t. Gipt − m is the m-th lag of dependent variable accounting for thepersistence of government expenditures and their structure. Fdecipt includes the two types of decentralization index—expendituredecentralization and revenue decentralization. β stands for the corresponding coefficients for those two variables. Xipt representsa set of control variables that shape local government expenditures. And δ is the vector of the coefficients of those controlvariables. To capture the time patterns of the outcome variables that might be different across the provinces, we control for a fullset of province-times-year fixed effects, denoted by upt. υi refers to the county-level fixed effects that capture any unobservedtime-invariant county heterogeneity. And εipt is the idiosyncratic error term.
To decide the maximum lag length to be included in the regression specification, following Han, Phillips, and Sul (2012), wetruncate the sample to the observations for t ≥ 3 and choose the optimal lag length based on the Schwarz (Bayesian) InformationCriterion (BIC). The results suggest the inclusion of both the first- and the second-period lags of the dependent variables,11 andthe basic specification becomes:

Gipt ¼ α1Gipt−1 þ α2Gipt−2 þ Fdeciptβ þ Xiptδþ upt þ υi þ εipt : ð2Þ

ad (1998) suggests that district governments are less fiscally independent. Yang (2011) shows district governments have very limited autonomy in theircision. They usually follow the planning of the prefectural governments and collaborate in public goods provision for whole urban districts. For example,istricts are classified as the high and new technology development zone, while some districts are mainly for recreation or tourism.ause China County Statistical Yearbooks have only been published from 2001, the data of counties' area before 2000 are proxied with the data in 2000.eliminate the possibility of misreports, we delete the observations whose values of regression variables are below 0.5th percentile or above 99.5thile. The variables are the following: Government expenditure size, the shares of capital construction, education, social security subsidy, administrativeitures in total expenditures, expenditure decentralization, revenue decentralization, vertical fiscal imbalance, log of real GDP per capita, log of population, fiscally supported population (percentage of total population), and own-source revenue size.regression specification controls for the province-times-year fixed effects. Therefore, Chongming County, the only county in Shanghai, does not

ute to our estimation. In addition, “any dummy that is 0 for almost all individuals, or 1 for almost all, might cause bias” (Roodman, 2009a, p. 115). Thus, wethe observations whose values of the province-times-year dummy variables are very close to 0. The Stata code is available on request.eep more observations, our choice on the optimal lags concerns whether to include the second-period lag. Following Han, Phillips, and Sul (2012), wee the data to the observations for t ≥ 3 and calculate BIC for the specifications with and without the second-period lags of dependent variables for eache. For the regressions with only lag 1, the BICs for government expenditure and the ratios of capital construction, education, social security, andtration are 84,499.07, 54,931.84, 73,827.18, 56,597.49, and 79,397.93, respectively. And for the specifications with both lag 1 and lag 2, BICs are 83,975.52,6, 73,819.89, 56,567.98, and 79,405.63, respectively. A lower BIC indicates a better fit of specification. Considering the consistency of our specification, weto include both the first- and the second-period lags in our model.


The regular Ordinary Least Squares (OLS) estimates of the coefficients are biased because of the correlation between the lags ofdependent variables and county fixed effects. We take the first differences of Eq. (2) to cancel the county fixed effects:

12 The13 To gfor somcoefficie14 In oin Shan15 Her16 Aut

ΔGipt ¼ α1ΔGipt−1 þ α2ΔGipt−2 þ ΔFdeciptβ þ ΔXiptδþ Δupt þ Δεipt : ð3Þ

Here Δ is the first-difference operator—for example, ΔGipt = Gipt − Gipt − 1. Given that cov(ΔGipt − 1, Δεipt) ≠ 0 because of thecorrelation betweenGipt − 1 and εipt − 1, Holtz-Eakin, Newey, and Rosen (1988) and Arellano and Bond (1991) introduce all furtheravailable lags Gipt − j for j = 2,…, t − 1 as the instruments for ΔGipt − 1. This method is named the difference GMM estimation.

However, if the dependent variable is highly persistent over time, then the past levels of the dependent variable become weakinstruments for differenced lags, and the difference GMM estimation suffers from finite sample bias. To deal with this problem,Arellano and Bover (1995) and Blundell and Bond (1998) propose the system GMM estimation that combines regressions both indifferences and in levels into one system, where the differenced lags of the dependent variable are instrumented by the furtherlags as the difference GMM. For the equation in levels, the instruments are the differenced lags of the dependent variable. In thispaper, we use the two-step system GMM method with the small sample correction for robust standard errors developed byWindmeijer (2005). All of the standard errors are clustered at the prefectural level.

The consistency of the two-step system GMM estimation relies on the validity of the instruments, which is usually addressed bythree specification tests. Two of them are the over-identification tests to check the orthogonality conditions between instruments anderror terms in difference and level equations—the Hansen and difference-in-Hansen (incremental Hansen) tests.12,13 Their nullhypothesis is that the instruments are exogenous, and themodel gains better support with the failure to reject the null. The third testis the second-order serial correlation test, AR(2), which examines whether the first-differenced error term is second-order seriallycorrelated. This second-order serial correlation indicates that the non-differenced error term is serially correlated, which implies thatthe chosen instruments are inadequate.We report the p-values of those tests for each regression result. In addition, Roodman (2009b)shows that the conventional approach to choose instruments could cause an instrument proliferation problemandweaken the powerof the Hansen over-identification tests in a finite sample. Based on this concern, we substitute one-period lags of the endogenousvariables for all their further lags as the instruments to ensure the robustness of the estimation results.

4.3. Variables

Next, we explain our key variables and present their descriptive characteristics in Table 1.

4.3.1. Local expenditure policyThe size and composition of county governments' expenditures are used to describe local expenditure policy. Government

expenditure size is measured by a ratio of the county governments' expenditures over their local GDPs. In Table 1, the average ofthe government expenditure size is 13.32%, varying from 2.29% to 104.6%.14 Following Hsiao, Shen, and Fujiki (2005), we draw a5% random sample of the counties15 and plot their government expenditure size over time in Fig. 2. The figure shows thatcounties' government size varies substantially across those counties and yet presents persistence over time. Moreover, Fig. 3 laysout that, on average, county government size increased rapidly during this period, from 9.76% in 1997 to 16.7% in 2006.

As for the composition of county governments' expenditures, we study fourmajor categories that are consistently recorded in ourdata: Capital construction, education, social security subsidies, and administration. Note that the categories of education expendituresand social security subsidies are available only from 1998. According to the functional classification of fiscal expenditures used inChina before 2007, capital construction expenditures mainly comprise infrastructure investments, such as road construction andwater conservancy facilities. These expenditures generate the most direct influences in stimulating local economies. Table 1 showsthat they amount to only 4.68% of total county government expenditures on average. This number indicates that county governmentshave relatively limited capacities to make such investments in the economy, as compared to prefectural and provincial governmentswith around 12.9% and 18.09%, respectively, of expenditures on capital construction during this period.16 Nevertheless, counties'average proportion of capital construction spending kept rising and almost tripled during our study period—from 2.08% in 1997 to5.55% in 2006 (see Fig. 3). Chinese county governments take the main responsibility of providing local education: They finance theoperation costs of basic education (elementary and middle schools), vocational education, adult education, and teachers' training.Around a quarter (24.75%) of county government expenditures are used on education on average.

The third category of government expenditures, social security subsidies, includes subsidies to social security funds,employment support, and support to laid-off workers of state-owned enterprises. Different from international practice, China hasassigned some social security programs to county governments, such as the New Cooperative Medical Scheme, and subsidies forlow-income families. In reality, county governments usually need to subsidize those programs using money in their budget. The

difference-in-Hansen tests are implemented to check the validity of system GMM instruments for the level equations (Roodman, 2009b).ain valid instruments and to pass the Hansen or difference-in-Hansen tests, we use the forward orthogonal deviation transformation of the instrumentse of the outcome variables (see notes under the regression tables), as suggested by Roodman (2009a). The magnitudes and significances of the estimatednts are barely affected by the use of this transformation.ur sample, some national poverty counties' government expenditures are larger than their GDPs. For example, government expenditure of Shilou Countyxi Province is 156.93 million Yuan in 2004 and its GDP is 150 million Yuan.e we only include the counties whose government expenditures are not missing in all 10 waves.hors' calculation based on the data from Statistical Material for Prefectures, Cities, and Counties Nationwide (Ministry of Finance, 1998–2007).

Table 1Descriptive statistics of key variables.

Variable Observations Mean Std. dev. Min. Max. P25 P50 P75

Government expenditure size (% of GDP) 18,309 13.32 11.35 2.29 104.60 6.14 9.61 16.31Capital construction expenditure (% of government expenditure) 11,845 4.68 5.27 0.01 34.44 1.01 2.91 6.41Education expenditure (% of government expenditure) 16,456 24.75 6.22 8.01 42.75 20.47 24.66 29.09Social security subsidy (% of government expenditure) 16,277 2.49 2.31 0.04 16.09 0.87 1.77 3.38Administrative expenditure (% of government expenditure) 18,227 20.30 5.26 7.46 39.05 16.80 20.03 23.48Expenditure decentralization (%) 18,382 36.41 9.83 16.83 73.09 29.37 34.99 41.86Revenue decentralization (%) 18,382 18.50 10.14 2.79 62.74 10.96 16.60 23.79Vertical fiscal imbalance (% of government expenditure) 18,268 56.87 22.07 −4.76 96.94 40.38 59.32 74.60Dummy variable of the PGC fiscal system 18,382 0.08 0.28 0.00 1.00 0.00 0.00 0.00Number of counties in one prefecture 18,382 9.05 4.95 1.00 43.00 6.00 8.00 11.00Log of real GDP per capita 18,382 3.92 0.71 1.53 6.12 3.44 3.90 4.38Log of population density 18,382 5.11 1.30 −0.52 7.13 4.54 5.31 6.09Fiscally supported population (% of total population) 18,382 3.19 1.27 1.53 11.31 2.40 2.87 3.59Own-source revenue size (% of GDP) 18,382 4.20 2.36 0.98 38.01 2.75 3.76 5.04

Notes:

1. Government expenditure size is the ratio of a county government's expenditure to its local GDP. The variables of capital construction expenditure, educationexpenditure, social security subsidy, and administrative expenditure refer to the shares of the corresponding items in total government expenditures. The twovariables—expenditure decentralization and revenue decentralization—are the ratios of the per capita expenditures/revenues of a county government in the total ofper capita expenditures/revenues of (1) its own and (2) the governments that the county is subordinated to, including the prefectural, provincial, and centralgovernments. Vertical fiscal imbalance is measured by the ratio of the county governments' fiscal gap (including grants net of remittances and deficits) to theirexpenditures. Dummy variable of the PGC fiscal system equals one if a county adopts the Province Directly Governing County (PGC) fiscal system in a certain yearand zero otherwise. Real GDP per capita is deflated by the provincial-level consumer prices in 1997 and its unit is 10,000 Chinese Yuan. Population density isconstructed by dividing the population by the area, and its unit is 1/km2. Fiscally supported population size is the ratio of fiscally supported population of a county toits local population. Own-source revenue size is measured by the ratio of the own-source revenue of a county to its local GDP.

2. P25, P50, and P75 refer to the 25th, 50th, and 75th percentiles of the variables, respectively.Data sources: Statistical Material for Prefectures, Cities, and Counties Nationwide (Ministry of Finance, 1998–2007); China Statistical Yearbook for Regional Economy(National Bureau of Statistics, 2003–2007); China County Statistical Yearbook (National Bureau of Statistics, 2001–2007).


mean of the share of such subsidies was only 2.49% from 1998 to 2006, but it has increased steadily over time (see Fig. 3). Onaverage, more than 20% of county government expenditures are on government administration, public safety, judiciaries, andinspectorates. Note that administrative expenditures here are an incomplete count of all costs associated with governmentadministration; some items, such as the spending of local tax bureaus, are not included (World Bank, 2002).

4.3.2. Fiscal decentralizationFollowing relevant studies on fiscal decentralization (Fiva, 2006; Jin & Zou, 2002; Stein, 1999; Wu & Lin, 2010), twomeasures are

usually created to describe the decentralization level of a government: Expenditure and revenue decentralization. The construction ofthese two variables at the county level in China is slightly complicated because of some unique features in China's hierarchical fiscalmanagement system. Generally, county governments are subordinated directly to their prefectural governments in both fiscal and

020

4060

8010

0

perc

ent

1997 1998 1999 2000 2001 2002 2003 2004 2005 2006year

Fig. 2. The variation of the county government expenditure size, 1997–2006. Notes: Government expenditure size is measured by the ratio of the countygovernments' expenditures to their local GDPs.Data sources: Statistical Material for Prefectures, Cities, and Counties Nationwide (Ministry of Finance, 1998–2007).

810

1214

16pe

rcen

t1997 1998 1999 2000 2001 2002 2003 2004 2005 2006

yearratio of government expenditure to GDP

05

1015

2025

perc

ent

1997 1998 1999 2000 2001 2002 2003 2004 2005 2006year

share of capital construction expenditure share of education expenditure

share of social security subsidy share of administrative expenditure

Fig. 3. Size and composition of county government expenditures, 1997–2006. Notes: The shares of capital construction expenditure, education expenditure, socialsecurity subsidy, and administrative expenditure refer to the shares of the corresponding items in county governments' expenditures.Data sources: Statistical Material for Prefectures, Cities, and Counties Nationwide (Ministry of Finance, 1998–2007).


administrative systems. Yet, some counties exist as exceptions: They circumvent prefectures and interact directly with theircorresponding provinces in fiscal disciplines, which we call the Province Directly Governing County (PGC) fiscal system.17 For thosecounties, we measure their levels of decentralization by comparing their own expenditures and revenues only with the central andtheir superordinate provincial governments.

In light of Zhang and Zou (1998) and the differences in the vertical fiscal management system across counties, we constructthe index of expenditure decentralization as follows:

17 Thisfiscal syHenan,systemand somand, thucountie

Expendituredecentralization ¼ CexpCexpþ Pexp� 1−PGCð Þ þ Sexpþ Eexp

; ð4Þ

Cexp, Pexp, Sexp, and Eexp refer to expenditures per capita of the county, prefectural, provincial, and central governments,
whererespectively. The PGC is a dummy variable, which equals one if a county adopts the PGC fiscal system in a certain year and zerootherwise. Revenue decentralization is measured in a similar way:
Revenuedecentralization ¼ CrevCrevþ Prev� 1−PGCð Þ þ Srevþ Erev

; ð5Þ

Crev, Prev, Srev, and Erev are the own-source revenues per capita of the county, prefectural, provincial, and central
wheregovernments, respectively. These two measures of fiscal decentralization are not perfect because they do not fully present theextent of local governments' autonomy in the fiscal regime. However, they do inform their decentralization levels in some wayand, hence, are widely used in the literature.
To capture the extent of the discrepancy between expenditure responsibilities and available funding resources confronted by thecounty governments, we follow the literature and create another variable—vertical fiscal imbalance. In China's current fiscal transfersystem, counties may submit remittances and receive grants at the same time (Shih & Zhang, 2007; Tsui, 2005; World Bank, 2002).Sometimes the differences between their expenditures and their own-source revenues cannot be completelymet by the grants net ofremittances. And thus, those counties register budget deficits even though such deficits are not legally allowed (World Bank, 2002).Considering these features of China's fiscal system, we define the variable of vertical fiscal imbalance as the ratio of a countygovernment's fiscal gap to its expenditures, where the fiscal gap includes (1) grants net of remittances and (2) deficits. In some

specific fiscal arrangement first showed up in Zhejiang Province in the early 1990s. Because of its success in improving government efficiency, the PGCstem has expanded to other provinces since the early 2000s (Li, 2010). By 2006, all counties in Ningxia Province and some selected counties in Anhui,Hubei, Jilin, and Jiangxi Provinces had switched to this fiscal system (the information is collected from the official documents in regard to the PGC fiscalreform in every province). Moreover, all counties in the four municipalities of Beijing, Chongqing, Shanghai, and Tianjin; all counties in Hainan Province;e counties in other provinces (for example, Jiyuan City in Henan Province) have been directly subordinated to the provinces in the administrative systems, perform under the PGC system as well. In our sample the total number of counties with the PGC fiscal system increased from 107 (5.93% of total samples) in 1997 to 271 (15.24% of total sample counties) in 2006.

Table 2Regression results of fiscal decentralization on local expenditure policy.

DVt Estimation method: two-step system GMM

Governmentexpendituresize (% of GDP)

Capital constructionexpenditure(% of governmentexpenditure)

Education expenditure(% of governmentexpenditure)

Social security subsidy(% of governmentexpenditure)

Administrativeexpenditure(% of governmentexpenditure)

(1) (2) (3) (4) (5)

DVt − 1 0.329⁎⁎⁎

(0.059)0.382⁎⁎⁎

(0.026)0.631⁎⁎⁎

(0.015)0.581⁎⁎⁎

(0.156)0.617⁎⁎⁎

(0.021)DVt − 2 0.128⁎⁎⁎

(0.025)0.052⁎⁎

(0.021)0.124⁎⁎⁎

(0.013)0.192⁎

(0.110)0.185⁎⁎⁎

(0.015)Expenditure decentralizationt (%) 0.481⁎⁎⁎

(0.051)0.273⁎⁎⁎

(0.058)−0.163⁎⁎⁎

(0.024)−0.007(0.052)

−0.119⁎⁎⁎

(0.027)Revenue decentralizationt (%) 0.159

(0.129)−0.080(0.096)

0.077⁎

(0.046)0.024(0.141)

0.110⁎⁎

(0.048)Log (real GDP per capitat) −12.111⁎⁎⁎

(2.065)−0.006(1.526)

−1.108(0.726)

−0.343(2.252)

−1.109(0.803)

Log (population densityt) −0.419(0.381)

−0.174(0.262)

−0.220⁎

(0.129)0.009(0.423)

−0.476⁎⁎⁎

(0.141)Fiscally supported population sizet(% of total population)

−0.074(0.521)

−1.186⁎⁎

(0.568)0.160(0.225)

−0.003(0.633)

0.459(0.299)

Own-source revenue sizet (% of GDP) −0.476(0.503)

0.096(0.201)

−0.238⁎⁎

(0.094)−0.062(0.279)

−0.188⁎

(0.098)PGCt −7.800⁎⁎⁎

(2.902)−2.625(2.525)

0.972(1.009)

0.367(3.475)

1.274(1.586)

Number of counties in one prefecturet −0.043(0.058)

−0.082⁎⁎

(0.038)0.032⁎⁎

(0.016)−0.013(0.050)

0.031(0.023)

Constant 47.703⁎⁎⁎

(9.857)0.384(8.394)

17.209⁎⁎⁎

(3.736)2.241(11.435)

8.678⁎

(4.636)AR(1) test 0.001 0.000 0.000 0.000 0.000AR(2) test 0.730 0.630 0.047 0.735 0.427Hansen test 0.605 0.999 0.185 0.226 0.703Difference-in-Hansen test 1.000 1.000 0.160 0.103 1.000Number of instruments 415 373 369 375 417Observations 14,338 8100 12,674 12,446 14,468Counties 1913 1396 1904 1904 1910

Notes:

1. Government expenditure size is the ratio of a county government's expenditure to its local GDP. The variables of capital construction expenditure, educationexpenditure, social security subsidy, and administrative expenditure refer to the shares of the corresponding items in total government expenditures. DVdenotes dependent variable. The two variables—expenditure decentralization and revenue decentralization—are the ratios of the per capita expenditures/revenues of a county government in the total of per capita expenditures/revenues of (1) its own and (2) the governments that the county is subordinated to,including the prefectural, provincial, and central governments. Real GDP per capita is deflated by the provincial-level consumer prices in 1997 and its unit is10,000 Chinese Yuan. Population density is constructed by dividing the population by the area, and its unit is 1/km2. Fiscally supported population size is theratio of fiscally supported population of a county to its local population. Own-source revenue size is measured by the ratio of the own-source revenue of acounty to its local GDP. The PGC is a dummy variable, which equals one if a county adopts the Province Directly Governing County (PGC) fiscal system in acertain year and zero otherwise.

2. The province-times-year fixed effects are also controlled for each regression. Standard errors clustered at the prefectural level are reported in parentheses.p-Values of AR(1), AR(2), Hansen, and difference-in-Hansen tests are reported in their rows. We use the forward orthogonal deviation transformation of theinstruments for the outcome of capital construction expenditure.

Data sources: Statistical Material for Prefectures, Cities, and Counties Nationwide (Ministry of Finance, 1998–2007); China Statistical Yearbook for Regional Economy(National Bureau of Statistics, 2003–2007); China County Statistical Yearbook (National Bureau of Statistics, 2001–2007).

⁎ Denote the significance at 10%.⁎⁎ Denote the significance at 5%.

⁎⁎⁎ Denote the significance at 1%.


counties, governments' remittances to the upper-level government are greater than the grants they receive, a factor that generatesnegative values of vertical fiscal imbalance.18

The expenditures of county governments in our sample are, on average, 17.91 percentage points more decentralized than therevenues from 1997 to 2006 (see Table 1) and are 26.77 percentage points in 2006 (see Fig. 1). As compared to only 9.67percentage points for U.S. local governments in 2006 (calculated from Baicker, Clemens, & Singhal, 2011), Chinese countygovernments have presented relatively larger unbalanced fiscal responsibilities. The mean of vertical fiscal imbalance is 56.87%,ranging from −4.76% to 96.94%, and has displayed a significant growth trend since 1998 (see Fig. 1).

18 For example, in our sample, Akesu City in Xinjiang Province in 1998 made two types of remittances totaling 33.72 million Chinese Yuan while receivinggrants of 25.77 million Chinese Yuan, and its deficits were 5.65 million Chinese Yuan.

Table 3Regression results of fiscal decentralization on local expenditure policy: Reducing the number of instruments.


Governmentexpenditure size(% of GDP)





(1) (2) (3) (4) (5)

DVt − 1 0.507⁎⁎⁎

(0.106)0.409⁎⁎⁎

(0.148)0.593⁎⁎⁎

(0.014)0.559⁎⁎⁎

(0.062)0.699⁎⁎⁎

(0.069)DVt − 2 0.066⁎⁎

(0.031)0.045(0.054)

0.112⁎⁎⁎

(0.012)0.193⁎⁎⁎

(0.028)0.083⁎

(0.048)Expenditure decentralizationt (%) 0.387⁎⁎⁎

(0.080)0.208⁎⁎⁎

(0.067)−0.117⁎⁎⁎

(0.031)−0.007(0.015)

−0.079⁎⁎⁎

(0.024)Revenue decentralizationt (%) 0.132

(0.153)−0.088(0.122)

0.063(0.050)

0.028(0.033)

0.100(0.063)

Log (real GDP per capitat) −9.846⁎⁎⁎

(3.331)0.454(1.899)

−1.234(0.837)

−0.538(0.540)

−1.575(0.994)

Log (population densityt) −0.027(0.381)

−0.022(0.201)

−0.069(0.152)

0.036(0.063)

−0.182(0.135)

Fiscally supported population sizet(% of total population)

−0.711(0.649)

−0.561(0.624)

−0.264(0.328)

0.011(0.169)

0.385(0.282)

Own-source revenue sizet (% of GDP) −0.238(0.548)

0.085(0.274)

−0.264⁎⁎⁎

(0.097)−0.034(0.085)

−0.070(0.147)

PGCt −6.091⁎⁎

(2.900)−0.157(0.918)

−0.013(0.996)

−0.434(0.994)

−0.451(1.867)

Number of counties in one prefecturet −0.031(0.073)

−0.066⁎⁎⁎

(0.025)0.016(0.018)

−0.014⁎

(0.008)0.062⁎⁎⁎

(0.019)Constant 32.444⁎⁎

(14.402)−3.304(8.207)

15.545⁎⁎⁎

(4.756)3.337(2.733)

4.950(5.129)

AR(1) test 0.000 0.001 0.000 0.000 0.000AR(2) test 0.384 0.276 0.329 0.189 0.000Hansen test 0.058 0.652 0.524 0.160 0.750Difference-in-Hansen test 0.112 0.692 0.298 0.196 0.266Number of instruments 293 251 260 260 295Observations 14,338 8100 12,674 12,446 14,468Counties 1913 1396 1904 1904 1910

Notes:

1. Government expenditure size is the ratio of a county government's expenditure to its local GDP. The variables of capital construction expenditure, educationexpenditure, social security subsidy, and administrative expenditure refer to the shares of the corresponding items in total government expenditures. DVdenotes dependent variable. The two variables—expenditure decentralization and revenue decentralization—are the ratios of the per capita expenditures/revenues of a county government in the total of per capita expenditures/revenues of (1) its own and (2) the governments that the county is subordinated to,including the prefectural, provincial, and central governments. Real GDP per capita is deflated by the provincial-level consumer prices in 1997 and its unit is10,000 Chinese Yuan. Population density is constructed by dividing the population by the area, and its unit is 1/km2. Fiscally supported population size is theratio of fiscally supported population of a county to its local population. Own-source revenue size is measured by the ratio of the own-source revenue of acounty to its local GDP. The PGC is a dummy variable, which equals one if a county adopts the Province Directly Governing County (PGC) fiscal system in acertain year and zero otherwise.

2. The province-times-year fixed effects are also controlled for each regression. Standard errors clustered at the prefectural level are reported in parentheses.p-Values of AR(1), AR(2), Hansen, and difference-in-Hansen tests are reported in their rows. In the regressions we substitute one-period lags of theendogenous variables for all their further lags as the instruments. We use the forward orthogonal deviation transformation of the instruments for theoutcomes of capital construction expenditure, education expenditure and administrative expenditure.




4.3.3. Other control variablesIn addition to the lags of dependent variables and the decentralization indicators, we control for other factors that could possibly

affect local expenditure policy in the regressions. One is the aforementioned PGC fiscal system to capture the mechanisms throughwhich this specific fiscal arrangement could affect local expenditure policy other than through fiscal decentralization. Themean of thedummy variable of PGC is 0.08 during the study period. Moreover, we control for the number of counties in one prefecture19 toaccount for the effects of interjurisdictional competition, including both expenditure and tax competition. In our sample, the numberof counties in one prefecture is 9.05 on average.

Several other possible determinants of government expenditures are also included in the regressions. Real GDP per capitadeflated by the provincial-level consumer prices in 1997 is considered to capture Wagner's Law (government size increases with


19 For the counties that are directly subordinated to their provinces in the administrative system, we use the total number of those counties in their provinces.


income growth). Population density accounts for possible scale effects in the provision of public services. We use their log valuesin the regressions. Another control variable is the size of the fiscally supported population (caizheng gongyang renkou), whichconsists of civil servants and employees in public service sectors. This variable is measured by the share of fiscally supportedpopulation expressed as a percentage of local population. Following Baicker, Clemens, and Singhal (2011), we control forown-source revenue size, measured by the proportion of a county's own-source revenue in its local GDP.

In this paper, we use the two-step system GMM to estimate the influences of fiscal decentralization on county governments'expenditure policy in China. Three control variables—real per capita GDP, own-source revenue size, and the fiscally supportedpopulation—are treated as endogenous.

5. Results

5.1. Effects of fiscal decentralization on local expenditure policy

Table 2 presents the regression results for the effects of fiscal decentralization on local expenditure policy: Column (1) for thegovernment expenditure size and columns (2)–(5) for the shares of different expenditure categories. To ensure the validity of GMM

Table 4Regression results of vertical fiscal imbalance on local expenditure policy.







(1) (2) (3) (4) (5)

Panel A: Baseline resultsDVt − 1 0.353⁎⁎⁎

(0.061)0.408⁎⁎⁎

(0.024)0.609⁎⁎⁎

(0.014)0.585⁎⁎⁎

(0.022)0.630⁎⁎⁎

(0.018)DVt − 2 0.142⁎⁎⁎

(0.023)0.074⁎⁎⁎

(0.020)0.108⁎⁎⁎

(0.012)0.195⁎⁎⁎

(0.022)0.186⁎⁎⁎

(0.015)Vertical fiscal imbalancet(% of government expenditure)

−0.160⁎⁎⁎

(0.043)0.073⁎⁎

(0.035)−0.063⁎⁎⁎

(0.016)−0.0004(0.008)

−0.036⁎


Panel B: Reducing the number of instrumentsDVt − 1 0.852⁎⁎⁎

(0.065)0.492⁎⁎⁎

(0.131)0.611⁎⁎⁎

(0.123)0.524⁎⁎⁎

(0.058)0.697⁎⁎⁎

(0.073)DVt − 2 −0.002

(0.024)0.047(0.057)

0.119⁎

(0.063)0.191⁎⁎⁎

(0.026)0.070(0.050)

Vertical fiscal imbalancet(% of government expenditure)

0.009(0.040)

0.068⁎⁎

(0.030)−0.114⁎⁎⁎

(0.027)0.006(0.010)

−0.063⁎⁎⁎


Notes:

1. Government expenditure size is the ratio of a county government's expenditure to its local GDP. The variables of capital construction expenditure, educationexpenditure, social security subsidy, and administrative expenditure refer to the shares of the corresponding items in total government expenditures. DVdenotes dependent variable. Vertical fiscal imbalance is measured by the ratio of the county governments' fiscal gap (including grants net of remittances anddeficits) to their expenditures. Other control variables are the same as the ones in Table 2.

2. The province-times-year fixed effects are also controlled for each regression. Standard errors clustered at the prefectural level are reported in parentheses.p-Values of AR(1), AR(2), Hansen, and difference-in-Hansen tests are reported in their rows. In panel B, we substitute one-period lags of the endogenousvariables for all their further lags as the instruments in the regressions. We use the forward orthogonal deviation transformation of the instruments for theoutcomes of capital construction expenditure and education expenditure in panel A, and for the outcomes of government expenditure size, capitalconstruction expenditure, and administrative expenditure in panel B.





estimation strategy, the results of theAR(2),Hansen, anddifference-in-Hansen tests are listed inTable 2. Thep-values of those tests are allgreater than 0.1 except for the AR(2) test for the outcome of education expenditure. This result suggests that there are no second-orderserial correlations of the differenced error terms and that the instruments are orthogonal to the error terms in most of the regressions.And we obtain similar results for those tests when decreasing the number of instruments as shown in Table 3. The results of those testsconfirm the validity of the two-step GMM estimation strategy. Moreover, the relatively large and statistically significant coefficients onthe lags of the dependent variables imply strong persistence of local expenditure policy, which coincides with the fact that the counties'budget formation has been built up incrementally on the resource allocations of past years. The dynamic panel data model thus suits thecontext.

Table 5Regression results of fiscal decentralization on local expenditure policy for different levels of vertical fiscal imbalance.







(1) (2) (3) (4) (5)

Panel A: Counties with high vertical fiscal imbalance (above the 70th percentile)Baseline resultsExpenditure decentralizationt (%) 0.738⁎⁎⁎

(0.085)0.267⁎⁎⁎

(0.051)−0.142⁎⁎⁎

(0.018)−0.006(0.008)

−0.064⁎⁎⁎

(0.015)Revenue decentralizationt (%) −0.788⁎⁎⁎

(0.227)0.159(0.120)

0.088(0.086)

−0.043(0.031)

0.198⁎⁎

(0.079)AR(1) test 0.000 0.000 0.000 0.000 0.000AR(2) test 0.333 0.867 0.013 0.157 0.121Hansen test 0.705 0.999 0.414 0.361 0.750Difference-in-Hansen test 1.000 1.000 0.407 0.362 0.995Number of instruments 193 193 173 173 193Observations 4255 2407 3768 3645 4267Counties 574 429 571 569 571

Reducing the number of instrumentsExpenditure decentralizationt (%) 0.417⁎⁎⁎

(0.055)0.205⁎⁎⁎

(0.077)−0.117⁎⁎⁎

(0.026)−0.020⁎⁎

(0.008)−0.055⁎⁎⁎

(0.022)Revenue decentralizationt (%) −0.076

(0.389)0.084(0.228)

−0.010(0.167)

−0.060(0.047)

0.175(0.122)

AR(1) test 0.000 0.000 0.000 0.000 0.000AR(2) test 0.356 0.015 0.571 0.065 0.835Hansen test 0.179 0.181 0.416 0.131 0.057Difference-in-Hansen test 0.579 0.216 0.276 0.124 0.325Number of instruments 64 71 64 64 71Observations 4255 2407 3768 3645 4267Counties 574 429 571 569 571

Panel B: Counties with low vertical fiscal imbalance (below the 30th percentile)Baseline resultsExpenditure decentralizationt (%) 0.224⁎⁎⁎

(0.022)0.122⁎⁎⁎

(0.027)−0.122⁎⁎⁎

(0.020)0.009(0.008)

−0.075⁎⁎⁎


(0.033)−0.160⁎⁎⁎

(0.040)0.043(0.047)

0.013(0.016)

0.083⁎⁎⁎


Reducing the number of instrumentsExpenditure decentralizationt (%) 0.192⁎⁎⁎

(0.019)0.110⁎⁎⁎

(0.033)−0.100⁎⁎⁎

(0.028)−0.004(0.012)

−0.078⁎⁎⁎


(0.075)−0.096(0.063)

−0.003(0.054)

0.008(0.023)

0.099⁎⁎



As for the influences of decentralization, as shown in column (1) of Table 2, expenditure decentralization has a positive effect ongovernment expenditures, and it is statistically significant at the 1% level. In contrast, revenue decentralization does not present astatistically significant effect on this outcome. These findings stay when the number of the instruments is reduced in Table 3. Theregression results of the asymmetric influences of expenditure and revenue decentralization are in line with some studies in othercountries (Ehdaie, 1994; Fiva, 2006; Jin & Zou, 2002; Rodden, 2003) and also echo some provincial-level studies in China (Chen, 2004;Wu & Lin, 2010). As wemention before, this phenomenon is described as the common-pool problem in the literature (Fiva, 2006; Jin &Zou, 2002; Rodden, 2003). Our data shows more than half (56.87%) of county governments' expenditures are financed throughintergovernmental grants and other common resources (see the mean of vertical fiscal imbalance in Table 1). This fiscal arrangementloosens the connection of the benefits and the costs of government expenditure because the amount a county government spends in itsown jurisdiction partially comes from the tax revenues collected from the residents outside the jurisdiction. Under this situation, thecounty governments are apt to spendmore than they would if their revenues were fully collected from their own jurisdictions. Hence,the disciplinary role of fiscal decentralization becomes weaker, and expenditure decentralization itself induces an overspending bias.

With regard to the specific components of government expenditures, in both Tables 2 and 3, expenditure decentralizationshows positive and statistically significant effects on the share of capital construction expenditures, with the coefficients around0.27 at the 1% significance level. Revenue decentralization does not present any statistically significant effects on this outcome. Incontrast, decentralization's influences on education expenditures portray a different picture: Expenditure decentralization showsnegative and statistically significant effects on its share, whereas revenue decentralization presents positive effects but the effectdoes not stay statistically significant with fewer instruments. A similar pattern is also found for administrative expenditures.Neither of the decentralization indicators shows a statistically significant influence on the share of social security subsidies.

The estimation results on the composition of government expenditures suggest that fiscal decentralization does not encourage thecounty governments to be more responsive to the needs of local residents on education and social security services. On the contrary,grantingmore fiscal autonomy to the local governments incentivizes them to investmore on infrastructure construction. The findingsare consistent with the empirical evidence by Kappeler and Välilä (2008) and the prediction of fiscal competition theory. Keen andMarchard (1997) illustrate the idea of fiscal competition that jurisdictionswould like to investmore on public inputs to attract capitaland are reluctant to provide public goods and services benefiting local residents. The key assumption of their model lies in mobilecapital and immobile labor, which fits the Chinese institution well where the household registration (hukou) system restricts freelabor mobility. The results on administrative spending seem counterintuitive because the governments normally would like toconsume more when they have more autonomy in spending (Fiva, 2006). We do not have a clear explanation for the results, but wesuspect that it might be because the administrative spending used here does not cover all of the costs associated with governmentadministration, such as the management costs of local tax bureaus (World Bank, 2002).

The institutional variable of the PGC fiscal system shows a negative and statistically significant effect on the government size, but doesnot have any robust effects on the composition of government expenditures. The number of counties in one prefecture is negativelycorrelatedwith the government size, but this correlation is not statistically significant. The coefficients of the log of real GDP per capita incolumn (1) of Tables 2 and 3 are negative and statistically significant, thereby suggesting that Wagner's Law does not hold true at thecounty level in China. This result corresponds to the evidence at the provincial level in China found byWu and Lin (2010). They argue thatthe fact that poorer localities have larger governments might be because of more prevalent rent-seeking behavior in those areas. Neitherlocal population density nor fiscal supported population generates a robust influence on the county government's expenditure policy, asseen inTables 2 and3.Own-source revenue size has a negative and statistically significant influence on the share of education expenditure.

5.2. Common-pool problem

In the previous section, we argue that asymmetric influences of expenditure and revenue decentralization are rooted in themismatch between benefits and costs of government expenditures (defined as vertical fiscal imbalance) at the county level of

Notes to Table 5:

1. Government expenditure size is the ratio of a county government's expenditure to its local GDP. The variables of capital construction expenditure, educationexpenditure, social security subsidy, and administrative expenditure refer to the shares of the corresponding items in total government expenditures. Verticalfiscal imbalance is measured by the ratio of the county governments' fiscal gap (including grants net of remittances and deficits) to their expenditures. DVdenotes dependent variable. The two variables—expenditure decentralization and revenue decentralization—are the ratios of the per capita expenditures/revenues of a county government in the total of per capita expenditures/revenues of (1) its own and (2) the governments that the county is subordinated to,including the prefectural, provincial, and central governments. Other control variables are the same as the ones in Table 2.

2. The year fixed effects are also controlled for each regression. Standard errors clustered at the prefectural level are reported in parentheses. p-Values of AR(1),AR(2), Hansen, and difference-in-Hansen tests are reported in their rows. We substitute one-period lags of the endogenous variables for all their further lags asthe instruments in the regressions when the number of instruments is reduced. For counties with higher levels of vertical fiscal imbalance, we use the forwardorthogonal deviation transformation of the instruments for the outcome of social security subsidy under “Baseline results” and for the outcomes of capitalconstruction expenditure and administrative expenditure under “Reducing the number of instruments.” For counties with lower levels of vertical fiscalimbalance, we use the forward orthogonal deviation transformation of the instruments for the outcome of education expenditure under “Baseline results” andfor the outcome of government expenditure size under “Reducing the number of instruments.”


⁎ Denote the significance at 10%.⁎⁎ Denote the significance at 5%.⁎⁎⁎ Denote the significance at 1%.


China's fiscal system. In this section, we study how the discrepancy in expenditure and revenue assignments shapes the localgovernment expenditure policy directly. First, we substitute the variable of vertical fiscal imbalance for the decentralization indexin all of the regressions, as suggested by Stein (1999), Jin and Zou (2002), and Wu and Lin (2010). The regression results arepresented in Table 4. The vertical fiscal imbalance shows a negative effect on county governments' expenditure size with the 1% levelof significance, but this effect does not exist in the regression with smaller number of instruments. Yet, it presents statisticallysignificant influences on the expenditure composition. The vertical fiscal imbalance raises the share of capital construction spendingand reduces the share of education and administrative spending in the total county governments' expenditures.

Next, we select two subsamples based on the average level of counties' vertical fiscal imbalance across years: One comprisesthe counties whose average level of vertical fiscal imbalance is above the 70th percentile of the distribution of all the samplecounties, and the other only includes the counties below the 30th percentile.20 Employing the baseline specification, we run theregressions for those two subsamples separately, and the results are shown in Table 5.21

The signs and significances of the coefficients of expenditure decentralization for both subsamples are quite similar and also inaccordance with the estimation results for the whole sample. Expenditure decentralization shows positive influences on countygovernment expenditure size and the share of capital construction and has negative influences on the shares of education andadministrative spending.

Moreover, a comparison of the magnitudes of the coefficients for the two subsamples further proves the existence of thecommon-pool problem in China's fiscal system. We find that the estimates for expenditure size, capital construction, and educationare larger in absolute values for counties with higher levels of vertical fiscal imbalance than for those with lower levels. For example,the coefficient for government expenditure size is 0.738 for the counties exceeding the 70th percentile of vertical fiscal imbalance, andit is 0.224 for the counties below the 30th percentile. Consistentwith the empirical study by Stein (1999), the results imply that in thecounties with a severer mismatch between benefits and costs of government expenditures their expenditure policy would bedistorted to a larger extent when they are granted more fiscal autonomy over the spending. Meanwhile, revenue decentralizationdoes not generate statistically significant and robust effects on the size and the composition of counties' expenditures in countieswithhigher levels of vertical fiscal imbalance, but a negative effect on government size and a positive effect on administrative spending forcounties with lower levels of vertical fiscal imbalance (both effects are statistically significant at least at the 5% level.)

These regression results for the subsamples with different levels of vertical fiscal imbalance reveal that the disciplinary effects ofdecentralization on government expenditures are relatively weaker in the counties with a larger unbalanced budget betweenexpenditure and revenue assignments. These results reiterate the findings in the existing literature that fiscal decentralization tends tobe associatedwith faster growth in the size of governmentwhen common-pool resourcesmainly fund local governments (Ehdaie, 1994;Jin & Zou, 2002; Rodden, 2003; Stein, 1999). To summarize, our regression results offer the first empirical evidence that the common-pool problem is influential in shaping the effects of fiscal decentralization on county governments' expenditure policy in China.

6. Conclusion

Since the tax-sharing reform in 1994, China has experienced expenditure decentralization and revenue centralizationsimultaneously in its fiscal regime, thereby leading to a marked vertical fiscal imbalance at the local levels. This imbalance maydistort local governments' expenditure policy and result in larger government size. The underlying reason is this fiscal structureattenuates the link between the benefits of public goods and services and their costs to local taxpayers. Consequently, the localgovernments have incentive to spendmore because they only bear part of the costs of their spending. This phenomenon is describedas the common-pool problem in the literature. To examine the prevalence of such a problem in China's fiscal system, this paper uses alarge county-level fiscal dataset from 1997 to 2006 to study the influences of China's fiscal arrangements on the size and compositionof county government expenditure during this period.

The regression results show that expenditure decentralization creates more government spending, with an increase in its weight oncapital construction and declines in itsweights on education and public administration. Nevertheless, revenue decentralization does nothave robust correlationswith the size or the composition of government expenditures. The differences in the effects of these two types ofdecentralization on expenditure size suggests an expansion of government size caused by the mismatch between governments'expenditure and revenue responsibilities at the county level in China's fiscal system. The findings about the influences of fiscaldecentralization on the composition of local government expenditure echo the predictions of fiscal competition theories. Given that theirautonomy on tax revenue is limited, the jurisdictions choose to invest more in public inputs to attract mobile capital and underprovidepublic services for local residents. This inclination becomes stronger with the severity of the imbalances in their fiscal budget.

Most theories on federalism claim that fiscal decentralization can serve as a disciplinary and incentive device to enhancegovernment efficiency. However, this hypothesis depends critically on complementary institutional arrangements that aregenerally lacking in developing countries (Rodden, Eskeland, & Litvack, 2003). Our findings suggest that unbalanced expenditure–revenue fiscal structure at the local level stimulates opportunistic behaviors of overspending among local governments in China.To mitigate the opportunistic urge, a feasible reform for the current fiscal regime would be to grant the local governments morepower of revenue collection or to give them a lighter expenditure burden. This proposed fiscal scheme generates better-matchedfiscal responsibilities of local governments and bolsters their accountabilities on spending. In that case, local governments are

20 Each county's relative position for vertical fiscal imbalance is quite stable in the sample period. The 70th and 30th percentiles of the distribution of the averageof vertical fiscal imbalance for the sample counties are 67.54 and 46.97%, respectively.21 Given the much smaller sample size, we choose to control for year fixed effects instead of province-times-year fixed effects to save power.


expected to manage their resources prudently and efficiently. Moreover, because local officials are not elected directly by localcitizens and labor is not freely mobile in China, local governments are also less incentivized to invest in public goods and services(such as education and social security subsidies) that benefit their residents. They would rather devote more resources toinfrastructure to attract mobile capital to boost local economy. To combat this distorted expenditure tendency, China needs moreinstitutional adjustments. One proposal would be to further relax the household registration system and to loosen the currentrestrictions of labor mobility in China. When jurisdictions need to attract labor, local governments may start to put their residents'well-being first and be more willing to supply needed public goods for the area.

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