The trade-off between growth and equity in China's decentralization policy

Despite the role played by decentralization in economies, little work, if not any, has been done to incorporate the impact of decentralization on economic growth and on resource allocation, and the potential trade-off between growth and equity in the distribution of fiscal resources among subnational governments. This research develops and tests a theory to explain why there is sacrifice of equity of distribution in fiscal resources to achieve higher economic growth. The findings presented here should also have relevance because of the increasing implementation of decentralization as a tool to improve economic growth in transition economies.; A theoretical model of a benevolent social planner is developed that makes the social welfare function a function of the central expenditure and the shares of contribution from different jurisdictions. How the benevolent planner's concerns on overall economic growth and equity of distribution in the fiscal resources affect the optimal fiscal resources allocation and both the social planner's and local jurisdictions behavior are investigated. The theoretical model shows that decentralization helps economic growth but decreases the equity of distribution of fiscal resources; there exists a trade-off between overall growth and equity of distribution in fiscal resources; the richer jurisdiction has an incentive to hide its fiscal resources and the poorer jurisdiction has an incentive to release its fiscal resources.; A simultaneous equation model is derived to estimate the relation among growth rate, equity, and decentralization using provincial level panel data for the time period 1985–1998 for China. Results obtained indicate that fiscal decentralization did significantly improve the economic growth of China, but the impact of fiscal decentralization on growth is not linear. In particular, China's current fiscal system is over-decentralized. Fiscal decentralization significantly increased the inequality of fiscal resources distribution in China, and China sacrificed some equity of distribution of fiscal resources to achieve higher economic growth. Meanwhile, the existence of an extrabudgetary fund helped the inequality of distribution of fiscal resources. The result also indicates that the fiscal reform of 1994 did not improve both economic growth and equity in the distribution of fiscal resources because of the over-decentralized fiscal system.