Does fiscal decentralization promote economic growth? An empirical approach to the study of China and India

Abstract

PurposeThe authors test the effect of expenditure decentralization and fiscal equalization on short- and long-run economic growth and estimate two-step generalized method of moment (GMM) simultaneous equations models, using panel data for China and India for the period 1985 to 2005. The authors estimate two simultaneous equations: a growth equation and equalization equation and find that expenditure decentralization has a negative and statistically significant effect at conventional levels on short-run economic growth for both China and India. However, the authors also find that this result is sensitive to the set of included explanatory variables. This leads the authors to conclude that expenditure decentralization has no effect on short-run economic growth for either country. The authors also find that expenditure decentralization has a positive and statistically significant effect on fiscal equalization for both countries but find no evidence that fiscal equalization affects short-run economic growth for either China or India. In contrast, the authors find that expenditure decentralization has a positive effect on long-run economic growth in the case of India, but not in the case of China. Finally, the authors report evidence that fiscal equalization has no effect on long-run economic growth in the case of China; however, the authors find that equalization has a positive and statistically significant at conventional levels effect on long-run economic growth in India.Design/methodology/approachThe authors estimate two-step GMM simultaneous equations models, using panel data for China and India for the period 1985 to 2005. To examine the effect of fiscal decentralization (FD) policies on economic growth in China and India, the authors estimate two equations: a growth equation and an equalization equation. For the growth equation, the authors adopt a production-function-based model that is widely used in the empirical literature on growth; however, the authors do make some compromises with this specification due to the unavailability of certain data. For the equalization equation, the authors include variables that economic theory and empirical evidence suggest influence fiscal disparities among subnational governments which in turn influence the demand for horizontal fiscal equalization (HFE). To the extent possible, the authors employ the same econometric specification, variable constructions and sample periods for both China and India. The authors believe this strategy provides a more rigorous test of the FD hypothesis.FindingsThe authors find that expenditure decentralization has a negative and statistically significant effect at conventional levels on short-run economic growth for both China and India. However, the authors also find that this result is sensitive to the set of included explanatory variables. This leads to conclude that expenditure decentralization has no effect on short-run economic growth for either country. The authors also find that expenditure decentralization has a positive and statistically significant effect on fiscal equalization for both countries but find no evidence that fiscal equalization affects short-run economic growth for either China or India. In contrast, the authors find that expenditure decentralization has a positive effect on long-run economic growth in the case of India, but not in the case of China. Finally, the authors report evidence that fiscal equalization has no effect on long-run economic growth in the case of China; however, the authors find that equalization has a positive and statistically significant at conventional levels effect on long-run economic growth in India.Research limitations/implicationsDue to the importance of FD policies, especially to many developing countries that are currently pursuing decentralization reforms, future research should examine the effect of FD on economic growth for other countries. Furthermore, although it would be difficult to do so, future research should examine whether FD promotes political stability on ethnically diverse countries.Originality/valueTo the best of the authors’ knowledge, no one has examined the effect of FD policies on India's growth experience. What is more is that this is also the first of its kind to have a comprehensive empirical investigation into these two major developing countries with very interesting similarities and differences in FD policies. It is thus of great importance to examine the effect of expenditure decentralization and HFE on economic growth in China and India.