Lecture 5' Fiscal decentralization and the incentives of bureaucrats'

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Lecture 5. Fiscal decentralization and the
incentives of bureaucrats.
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Introduction.

• In Eastern Europe and the Soviet Union in
  particular, very little thought was given to
  reform of government administration and how to
  make it support reform instead of opposing it.
  Yeltsin team managed by decrees from above but
  gave little thought to incentives of bureaucrats.
• In China, despite the absence of drastic
  political change (the power of the communist
  party remained unchallenged), various aspects of
  government reform played in the hand (consciously
  or not) of market reform.

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Fiscal incentives

• Fiscal contracting system between 1980 and 1993
  (crucial first period of reforms).
• Provinces signed five year contracts with central
  government to give over either a fixed sum (and
  keep the rest) or give a share of revenues.
• Guangdong gave a fixed amount per year during
  1980-1987 and then during 1988-1993 an amount
  that increased by 9 a year. Many governments
  retained 100 of local revenue at the margin.
• These contracts had interesting incentive
  properties if they were credible (no ex post
  renegotiation over revenues or subsidies).

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Fiscal incentives

• After 1994, a new tax system was put in place
  giving local government rights over local taxes
  (taxes from enterprises other than central
  government enterprises, personal income tax and
  business sales taxes). Provincial government kept
  25 of VAT. Also important category of
  extra-budgetary revenues which are not shared
  with central government. There has thus always
  been since the reforms a fiscal arrangement
  making local government residual claimants over
  taxes. Potentially, provincial government thus
  had a stake in the development of the tax base
  and economic growth, assuming that a higher tax
  base benefits provincial leaders.

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A simple model (Jin et al. 2004)

• Call Y(e) value created by local businesses and e
  the reform and pro-business policies and
  regulations pursued by local government, dY/de
  gt0. There is however a cost associated to e, c(e)
  (convex) since status quo is not pro-business.
• Call y(Y(e)) the tax revenue generated, dy/dY gt0,
  y concave positive function of e.
• Local government maximizes zvy(Y(e))-R- c(e) T
  where v is local share of revenues, z is
  marginal retention rate of local revenues, R is
  lump sum remittances to central government and T
  is transfers received from central government.

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• First order condition
• zvyY(e)c(e)

zvyY(e)
c(e)
e
e
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• First order condition
• zvyY(e)c(e)

Increase in z
zvyY(e)
c(e)
e
e
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• The more the local government is residual
  claimant of increase in revenues, the more effort
  it will make towards development of local
  businesses.
• Local government has better knowledge than
  central government about what helps develop
  business.
• Incentive aspects of fiscal arrangements
  important in transition economies.

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• We see that the discrepancy between ex ante
  contracts and ex post implementation was not
  extremely large and declined over time.
• Suggests credibility.

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• Commitment problem more related to subsidization
  rather than rent-grabbing, i.e. soft budget
  constraints problem more serious than predatory
  behavior since more provinces spend more than
  specified in the contract rather than the
  opposite.

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• Increasing correlation over time between
  budgetary expenditures and revenue. Suggests both
  that provinces were residual claimants over their
  revenue and that they were fiscally responsible.
• Strong contrast with findings of Zhuravskaya
  (2000) for Russia.

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Chinese and Russian fiscal arrangements.

• In contrast to the long term fiscal arrangements
  in China, in Russia under Eltsin annual
  negotiations on tax-sharing and transfers.
  Creates ratchet effect and soft budget
  constraints. Variation in local revenues met one
  for one by variation in transfers, (Zhuravskaya,
  1999)
• Berkowitz and Li (1999) have analyzed
  overgrazing aspect of Russian taxation.

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Fiscal decentralization

• Qian-Roland (1998) Competition between local
  governments for foreign capital creates
  incentives to overinvest in infrastructure and
  has the unintended consequence of hardening
  budget constraints
• Federalism does not necessarily harden budget
  constraints, it may soften them. Governments may
  strategically distort composition of expenditures
  in order to attract more subsidies.