Lecture 5. Fiscal decentralization and the incentives of bureaucrats

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					Lecture 5. Fiscal decentralization
      and the incentives of
          bureaucrats.
                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.
              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).
            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.
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 >0. 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 >0, 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.
• First order condition:
• zvy’Y’(e)=c’(e)


            zvy’Y’(e)
                             c’(e)




                        e*           e
• First order condition:
• zvy’Y’(e)=c’(e)

                        Increase in z

            zvy’Y’(e)
                                        c’(e)




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