Formation Mechanism and Incentive Effect of Vertical Financial Imbalance

Abstract

This paper integrates vertical fiscal imbalance, transfer payments and fiscal sustainability into the framework of Chinese-style fiscal decentralization, and systematically interprets the relationship among them. Then we use the concept of effective fiscal space to quantify fiscal sustainability, and empirically study whether and to what extent the local public finance in China is sustainable, as well as the impact of fiscal vertical imbalance and transfer payment system on local fiscal sustainability. The results show that the current fiscal behaviors of China's local governments are unsustainable, but most of them have sufficient space to establish a positive fiscal feedback mechanism through fiscal adjustment to achieve sustainable development of debt. Moreover, the comprehensive impact of transfer payment on fiscal sustainability is positive, which suggests that the positive effect of transfer payments on governments' fiscal behaviors through incentives and accountability mechanisms and filling fiscal gap is greater than the distorting effect of the moral hazard and “flypaper effect.”