A contract theory analysis to fiscal relations between the central and local governments in China

Abstract

We use a contract theory/mechanism design framework to analyse the fiscal relations and reforms between the central and local governments in China, which are said to have made great contributions to economic growth since the ‘economic reform’. First, we present the mechanism (a fiscal incentive contract model), which has created incentives for the development agent (local government), and clarify theoretically how the concept of bao (contract) works. We then comprehend the concept of bisai (contest) within the framework of the yardstick competition between local governments, and review the mechanism which encourages proper information revelation through intergovernmental comparison and competition. Lastly, we make a theoretical comparative analysis on the fiscal system reform (from the fiscal contracting system to the tax sharing system), from the perspective of how much room was left for the ‘ratchet effect’ in the dynamic relation between the central and local governments, and how it was solved (or mitigated) in the two fiscal systems.