Fiscal decentralization and regional stabilization during transition: Evidence from China

The introduction of market reforms in China resulted in rapid economic growth but also in the widening of regional income disparities. Two differing views emerged from a controversy over the impact of fiscal decentralization: one suggesting that fiscal decentralization minimized the impact of inequitable transfers provided by the central government, and the second arguing that fiscal decentralization hindered redistribution and amplified regional disparities.; The present study contributes to the debate in the literature by examining the role of taxes and transfers in providing regional stabilization in China. In particular, the cyclical behavior of interregional net transfers is investigated in order to determine the amount of insurance against regional income shocks offered by the tax-transfer system. The results indicate that transfers were countercyclical due to the stronger response of revenue to movements in regional income as compared to expenditure. However, the amount of insurance via the fiscal system was modest given that the labor and capital markets were not able to provide any additional smoothing. By using a long sample period (1952--2001), it was possible to trace the changes in the amount of income smoothing over time. The findings suggest that fiscal decentralization led to a large decline in the acyclicality of interregional transfers and in the smoothing of shocks to provincial revenue. Moreover, poor provinces received significantly lower amounts of insurance than rich ones, and were affected to a larger extent by fiscal decentralization.; This study concludes that fiscal decentralization had a negative impact on regional stabilization in China and offers policy recommendations on how to improve the sensibility of net transfers to income fluctuations.