Tax reform, fiscal decentralization, and regional economic growth: New evidence from China

- This paper examines heterogeneous responses to fiscal decentralization.
- The study helps reconcile contradicting evidence in the literature.
- Fiscal decentralization has the largest impact on the secondary sector.
- The effect turns negative if the degree of decentralization is excessively high.
- Fast-growing areas are more responsive to policy changes than slow-growing ones.

This paper is the first to examine heterogeneous responses to changes in fiscal decentralization policy associated with the 1994 tax reform in China and the nonlinearity of these responses. Using panel data for 29 Chinese provinces over the period 1990-2012, the paper shows that the effects of revenue and expenditure decentralization on economic growth vary across the three main sectors, with the largest impact on the secondary sector. The results also suggest there is an inverted U-shaped relationship between the degree of revenue (expenditure) decentralization and the growth of the secondary sector. In addition, slow-growing and fast-growing provinces respond differently to changes in both revenue and expenditure decentralization with greater responses from fast-growing provinces. The responses from fast-growing provinces appear to be nonlinear, indicating that fast-growing provinces benefit from appropriate revenue (expenditure) decentralization, but the effect turns negative as the degree of decentralization becomes excessively high. The study provides a way to reconcile the contradicting evidence found in the literature. In addition, the finding on heterogeneous responses to fiscal decentralization has important policy implications.