Vertical fiscal imbalance, transfer payments, and fiscal sustainability of local governments in China

Abstract

This paper measures fiscal sustainability of local governments in China and analyzes the effects of vertical fiscal imbalance and transfer payments on fiscal sustainability under the framework of Chinese-style fiscal decentralization. We find that the current fiscal behaviors of local governments in China are unsustainable, but most local governments have sufficient space to establish a positive fiscal feedback mechanism through fiscal adjustment to achieve fiscal sustainability in spite of the existence of “fiscal fatigue”. Moreover, the effect of transfers from central government on fiscal sustainability depends on the degree of vertical fiscal imbalance. More specifically, the transfers have a negative impact when the vertical imbalance is low, and have a positive impact when it’s high. Finally, these results are robust to alternative model specifications and endogeneity issues.