The mutual effects between the fiscal relations of central and local governments and economic growth in post-reform China

Abstract

The fiscal relation between central and local governments is one of the main institutional forms that have affected economic growth of China since its reform and opening up. This article examines its impact on China’s economic growth from the viewpoint of financial budgeting and further analyses the mechanism how economic growth and financial structure of local and central governments influence each other. This article describes the interaction of local and central fiscal entities in China throughout the whole period of its economic growth from 1978 till 2014. Dividing it into the first sub-period (1978–1992), the second (1993–2001) and the third (2002–2014), it explains peculiar features of the relationship between public finance and economic growth in China. In the first period (1978–1992) since the fiscal system of China was designed to strengthen the centralized budgetary control, local governments had to rely much on the extra-budgetary finances. They gained extra-budgetary income from their investment on township enterprises, which also generated economic growth on the local level. In 1993, facing the decline in GDP growth due to the squeeze of the extrabudgetary fund, central government loosened restrictions of the sale of land by local governments to raise extra-budgetary revenues. This provided the local government with new resources, and formed a new mechanism of “land finance” to promote economic growth. This mechanism opened the way to a bubble economy, particularly associated with the rise of land and housing prices, as well as the cost of China’s economy. Thus, the root cause of the present slowdown of China’s economy is not cyclical one, but the institutional structure, mainly the special local/central fiscal relationship and its interaction with economic growth.