off balance: the unintended consequences of fiscal federalism in china

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OFF BALANCE: The Unintended Consequences of Fiscal Federalism in China*

KELLEE S. TSAI

This paper argues that neither the developmental state nor the market-preserving federalism models are applicable to contemporary China. Despite superficial similarities with elements of each model, the political economy of reform in China violates key assumptions and expectations in both. In contrast to the expectations of the developmental state model, the center has not systematically allocated credit to the most productive sectors of the economy; instead the latter has had to rely on informal finance. And in contrast to the expectations of market-preserving federalism, fiscal decentralization has lead to a host of unintended consequences at the local level—namely, the hoarding of off-budget revenues for public goods provision, reliance on informal finance for private sector development, and local protectionism. These unintended and informal coping strategies depart substantially from the core components of both the developmental state and market-preserving federalism models.

At present, China’s financial order is very chaotic. For example, a lot of funds have been lost through off-budgetary channels and systems. It is quite common for [local governments and agencies] to wantonly collect fees and fines, to levy various charges, and to set up “little money lockers” without authorization… Such chaotic situations have not only seriously affected the government in exercising macro-economic regulations and control over fiscal revenues, and disrupted the unity in our national administrative order, but also provided an environment and conditions for corrupt behavior.

─ President Jiang Zemin, January 20001 INTRODUCTION

In the study of political economy, two paradigms have gained credence for explaining economic dynamics in developing and transitional countries – the developmental state and market-preserving federalism models, respectively. * Kellee S. Tsai is Assistant Professor in the Department of Political Science at Johns Hopkins University, and the author of Back-Alley Banking: Private Entrepreneurs in China (Cornell University Press, 2002). The earliest version of this paper was presented at the 2000 Annual Meeting of the American Political Science Association in Washington D.C. For their constructive suggestions, the author thanks Jenna Bednar, Davis Bookhart, Shaun Breslin, John Gerring, Megan Mentrek, Penny Prime, Elizabeth Remick, Lawrence Saez, Aseema Sinha, Steve Solnick, Tan Quicheng, Eric Thun, Christine Wong, Julie Jin Zeng, and two anonymous reviewers. They are, of course, absolved from the paper’s inadequacies. © Journal of Chinese Political Science, vol. 9, no. 2, Fall 2004

JOURNAL OF CHINESE POLITICAL SCIENCE

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Although both are ideal types derived from the experiences of particular countries, comparativists have applied them to a range of different regions and countries. The theoretical appeal of these models relates to their contributions to on-going debates over the relative role of the state and the market in explaining economic performance. While the developmental state (DS) model indicates that disciplined state intervention in the economy can promote rapid catch-up growth in late industrializing countries,2 market-preserving federalism (MPF) depends on a structural market-oriented logic to explain economic growth in decentralized and federal systems.3 The key policy mechanism in the DS model is effective allocation of finance in targeted, productive sectors of the economy, while MPF involves fiscal incentives to promote local economic growth. Taken together, the two models suggest that sustained economic development requires states that are neither too strong nor too weak in terms of fiscal capacity. The construction of decentralized, yet effective financial and fiscal institutions thus represents a central and practical concern in transitional and developing economies: how can states allocate investment capital and fiscal responsibility among different levels of government in an effective manner?

It is in this context that both the DS and MPF models have been used to explain the political economy of reform-era China. Some studies have found Beijing to be relatively successful in encouraging local investment and pursuing redistributive policies through both fiscal measures and the state banking system.4 At the same time, political scientists have made convincing arguments about the growth-promoting effects of fiscal decentralization during the reform era.5 These observations lend apparent support to the DS model.6 They also represent the basis on which China has been described as a case of MPF.7 The conditions of MPF are as follows: MPF requires a hierarchical structure of government with clearly specified realms of authority, such that the national government polices the common market while sub-national governments possess authority over the economy in their jurisdictions (Conditions 1-3). As localities compete with one another for factors of production, the central government must ensure that localities do not engage in protectionist behavior. An additional requirement of MPF is that both the national and local governments must face hard budget constraints, meaning that they cannot expect external sources of revenue to bail them out (Condition 4).8 If all these conditions are well institutionalized (Condition 5), MPF exists, and healthy economic competition and growth is expected.

Although the People’s Republic of China (PRC) is not a federal system, the extension of MPF to the case of China has attracted theoretical attention and serves as a potential competing explanation to the developmental state model, which emphasizes the role of the central state in economic development. Notwithstanding the causal differences inherent in MPF and developmental state explanations, however, proponents of both perspectives agree on one comparative observation: China’s apparent enhancement of state capacity contrasts sharply from that of Russia

FISCAL FEDERALISM IN CHINA

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and other transitional economies, where the combination of political and economic decentralization has correlated with official predation, dramatic decline in extractive capacity, and lower growth rates.9 Part of the initial ease in applying the two models to China is the fact that both start with the country’s positive economic performance as a dependent variable and then inductively identify various attributes of the system – whether they characterize a coherent developmental state or a decentralized market-oriented system – in a post-hoc manner.

While recognizing the relative effectiveness of the PRC’s fiscal and financial policy instruments, this article challenges the applicability of both the MPF and developmental state models to contemporary China. To be sure, the Chinese economy has experienced decentralization as well as rapid industrialization. Increasing the economic autonomy of sub-national units, however, has also inspired informal coping strategies that have weakened central state capacity and contributed to market-thwarting conditions. Rather than promoting market-preserving federalism or a coherent developmental state, China’s fiscal reforms unleashed a remarkable diversity of informal adaptive practices and developmental strategies among local governments. In aggregate, these local strategies may have correlated with national economic growth for over two decades, but they also produced three major unintended consequences in the fiscal, financial, and macroeconomic realms.10 I argue that these unintended consequences defy key conditions and causal expectations of the DS and MPF models.

First, fiscal reforms created incentives for local governments to hoard “extra-budgetary” and “self-raised” funds, which are not remitted to the center as taxes and encroach on the center’s share of fiscal revenues. Second, local governments have implicitly permitted the rise of informal finance, which violates the integrity of the formal financial system, but serves the local non-state sector and persists due to local political protection. In other words, the most productive sector of the economy has had to rely on informal finance rather than targeted state credit. Third, fiscal decentralization has inspired market-thwarting behavior among sub-national units. Fiscal reforms have created incentives for inter-jurisdictional competition in the form of local protectionism.11 In reaction to these unintended outcomes, the national government has attempted to reinvigorate its authority in successive rounds of recentralizing reforms, which has produced on-going uncertainty in intergovernmental fiscal relations. These empirical realities call into question the relevance of MPF to China and challenge the more general arguments that the Chinese economy is either converging upon the neo-liberal prototype of free market competition or becoming a developmental state.12

The theoretical implication of these observations is that focusing solely on formal institutions and official policies – such as the structure of intergovernmental relations or fiscal and financial policy interventions, respectively – obscures important dynamics that may be unintended and informal in character. As such, I propose that we pay more attention to the informal coping strategies of actors at the


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sub-national level. In the case of reform-era China, these strategies include hoarding off-budget revenues for public goods provision, relying on informal finance for private sector development, and protecting local industry from national market competition. This article proceeds as follows: the first section briefly discusses the case for treating China as if it were a federal system and reviews the key components of fiscal reform. The second section examines the unintended fiscal, financial, and macroeconomic consequences of China’s fiscal reforms. The third section evaluates the analytical implications of intergovernmental relations in China, with a critical focus on the applicability of market-preserving federalism. It also addresses the potential objections of alternative arguments concerning the threshold at which disconfirming evidence invalidates the relevance of MPF to China. The article concludes by explicating how the case of reform-era China presents students of political economy with an alternative pattern (though not necessarily a “model”) of development, namely one that incorporates market-thwarting fiscal incentives at the national level and developmental diversity at the local level. FISCAL FEDERALISM IN A UNITARY SYSTEM?

China has a unitary political system, meaning that the national government possesses ultimate authority over its territorial units.13 Unlike political systems with constitutional federalism, sub-national governments in China lack formal political autonomy vis-à-vis the center. Nonetheless, economic reforms over the last two decades have clearly had a decentralizing effect on intergovernmental fiscal relations – to the extent that some scholars have described the nature of central-local relations in contemporary China as quasi-federal or federal.14 Hence, “local government” refers to any of the four administrative layers below the central government (province, prefecture/municipality, county/city, and township/district); and “decentralization” refers to any devolution of authority or responsibility from the center to the lower levels of government.15 For clarity, this article distinguishes between “central-provincial” relations and “provincial-local” relations in reviewing the implications of key fiscal reform measures, while “central-local” relations refer to a general distinction between the center and all sub-national units.

Regardless of whether the PRC becomes a federal system de jure, the fact is that the balance and texture of central-local relations have changed during the reform era. Indeed, scholars disagree about the extent to which local governments have become stronger relative to the center versus the center’s continuing ability to exercise authority over sub-national units.16 A parallel strand of contention concerns the economic effects of China’s evolving fiscal federalism, that is, whether China’s impressive economic performance is due to the structural laissez-faire logic of market-preserving federalism or the entrepreneurial intervention of local developmental states. The evidence presented in the next section demonstrates the limits of both the market- and state-centric perspectives. Fiscal decentralization has


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inspired the coexistence of incentives for developmental, predatory, and entrepreneurial behavior on the part of local governments. Sub-national units now have a greater stake in the economic performance of their jurisdictions and market mechanisms are operating at the sub-national level. However, local governments have hoarded off-balance sheet revenues for non-productive economic purposes, and the most vibrant markets have developed in form of informal finance rather than in open inter-jurisdictional trade. THE POLITICAL AND ECONOMIC IMPLICATIONS OF CHINA’S FISCAL REFORMS Major Phases of Fiscal Reform – In Brief

At the outset of reform in 1978, revenue collection was highly centralized such that local governments remitted most of their taxes and profits to the central government and then received transfers for expenditures from the national budget.17 This system was modeled after the Soviet Union and typical of most command economies.18 The fiscal reform in 1980 introduced a revenue-sharing system called the “fiscal contracting system” (caizheng chengbao zhi), which was also popularly known as “eating in separate kitchens” (fenzao chifan) because the central and provincial governments started to tap different revenue bases rather than “eating from one big pot” (chi daguofan).19 Specifically, three categories of revenues were created: i) central revenues, ii) local revenues, and iii) shared revenues. The contractual terms of shared revenues were negotiated between the center and each province, which gave the latter a greater incentive to collect taxes. Meanwhile, localities were also granted authority over expenditures and expected to balance their own budgets. Over the course of 1980-1984, however, substantial surpluses accumulated in wealthier provinces, while poorer provinces were in a chronic deficit situation.

To redress the growing fiscal inequality among provinces, reforms in 1985 adjusted how shared revenues were distributed by permitting poorer provinces to retain a higher portion of receipts and requiring wealthier ones to remit a portion of their surplus receipts to the center. This reform bolstered the revenues of poorer provinces, but it also limited the incentive of wealthier provinces to collect revenues. Hence, in 1988 another round of reforms introduced six different types of revenue-sharing contracts, which marked a return to the type of fiscal bargaining that occurred between the center and the provinces in the original 1980 reform.20

Due to on-going decline in the center’s share of budgetary revenue, the 1994 reform sought to recentralize fiscal revenues by replacing the eating-in-separate-kitchens (revenue sharing) system with a tax sharing system (fenshuizhi).21 Besides enhancing the revenues of the center, it was also meant to simplify the tax system

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Table 1 Summary of Chinese Fiscal Reforms and their Effects, 1980-1994

TAX SYSTEM

DESCRIPTION

EFFECT ON LOCAL GOVERNMENTS’ INCENTIVES

BROADER EFFECTS

Pre-1980, Centralized Centralized revenue collection and centralized transfers

No particular incentive to enhance revenue collection

Entire government & economy has a soft budget constraint.

1980, Fiscal Contracting System, a.k.a. “eating in separate kitchens”

Created three categories of revenues: i) central-fixed revenues ii) local-fixed revenues iii) shared revenues

(negotiated with each province)

Wealthier provinces have incentive to collect more revenues because they can retain above-quota revenues.

Wealthier provinces have fiscal surpluses; poorer provinces have fiscal deficits.

1985, Revenue-sharing revised Revenue-sharing proportions based on budget balance of localities in previous years. Poorer provinces allowed to retain more revenues.

Wealthier provinces less enthusiastic about revenue collection because large positive balances must be remitted to the center.

Slowdown in growth of revenues from previously revenue-rich provinces. Revenues decline as % of GDP.

1988, Switch to six different types of revenue-sharing arrangements

Marks a return to negotiated fiscal contracting with provinces.

Generally increased revenue collection incentives.

i) Basic Sharing With Growth

Using 1987 figures, provinces keep certain portion and increase by a certain rate.

Incentive to collect revenues because they can retain above-quota revenues.

Most popular arrangement; used by 10 provinces/cities.

ii) Basic Sharing Province retains fixed proportion of revenues.


iii) Fixed Quota Delivery

Flat nominal remittance. No annual increase.

Very strong incentive to collect revenues since they can retain above-quota revenues and the rate of remittance would decline over time.

Applied to Fujian and Guangdong in 1980; extended to Heilongjiang, Shandong, and Shanghai in 1988. Best arrangement for provinces.

iv) Fixed Quota with Growth Contracts nominal amount for first year with a set rate of increase.


Used by Guangdong and Hunan.

v) Fixed Quota with Subsidies Specific amount contracted to be transferred from center to localities.

Applied to 15 localities.

vi) Incremental Sharing

Retain fixed proportion of revenues up to base figure and higher retention rate on incremental revenues.

Phased out in 1992 since the three cities (Dalian, Qingdao, and Wuhan) switched to the tax-sharing system.

(1992) 1994, Tax Sharing System (fenshuizhi)

- Revenues still divided into 3 types (central-fixed, local-fixed, & shared), but rate of sharing fixed. - Tax structure simplified. - All provinces receive transfers based on 1993 retained revenues.

Reclassification of most shared taxes to local fixed revenues increases collection incentive.

Hoarding of revenues in 1993. 1st introduced in 6 cities and three provinces.

SOURCE: Summarized from Wong, Heady, and Woo, Fiscal Management, 86-89.

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and increase its transparency. With the exception of the value-added tax (VAT), which remained a shared tax (75 percent central, 25 percent local), all other taxes were classified as either central or local taxes.22 Another major change was that all provinces would receive net transfers from the center based on retained revenues in 1993.23 To administer these reforms, a National Tax Services office was established in each province to collect central taxes as well as shared taxes. (Note, however, that certain components of the fiscal contracting system were retained to ensure provincial support for the reform). Table 1 summarizes the above fiscal reforms.

Having mapped out the basic contours of fiscal reform, we can now turn to their fiscal, financial, and macroeconomic implications in greater detail. In fiscal terms, the overarching effect of the pre-1994 fiscal reforms was weakening the state’s fiscal capacity, as evidenced by a decline in the central government’s share of budgetary revenues. This may be attributed to significant increases in the expenditure requirements of local governments and the related proliferation of extra-budgetary and self-raised funds at the sub-national levels. The recentralizing efforts of the 1994 fiscal reform managed to bolster the center’s share of revenues, but other key objectives of the reform – strengthening the center’s redistributive capacity, increasing fiscal transparency, and reducing uncertainty in intergovernmental fiscal responsibilities—were not fully achieved.24 In the financial system, the dramatic expansion of informal finance may be traced to the shifting of state sector subsidies from government budgets to the banking system. As the central government sought to commercialize the operations of state-owned enterprises by reducing state subsidies in the form of fiscal transfers, the state-dominated banking system absorbed much of this financial burden, thereby reducing the availability of funds for the most productive part of the economy, the private sector. The latter has therefore relied primarily on informal finance. And at the macroeconomic level, fiscal decentralization has yielded increasing inter-jurisdictional competition and local protectionism. In aggregate, these mutually reinforcing trends depart substantially from both the expectations of MPF and the developmental state model. Fiscal Consequences: Local Off-budget Funds + Increased Local Expenditures => Declining Central Tax Ratios

Under the fiscal contracting system prior to 1994, local governments had a

strong incentive to minimize the amount of revenues remitted to the center through the shared revenues category. After 1985 the central-provincial revenue-sharing arrangements were based on the budget balances of previous years, such that provinces with surpluses were expected to remit more revenues to the center while deficit provinces could retain more revenue. Therefore, instead of enhancing “budgetary revenues” – namely the taxes and profits from the state sector – sub-


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national governments focused more on raising “off-budget” revenues, which are not considered a formal part of China’s consolidated state budget.

There are two basic categories of off-budget revenues, “extrabudgetary funds” (yusuanwai zijin) and “self-raised funds” (zichou zijin). Extrabudgetary funds (EBFs) date back to the early 1950s when local governments were permitted to levy nominal fees to finance activities outside of the formal state budget. Their popularity ebbed and flowed throughout the Mao years,25 but they were minimal compared to their dramatic growth during the 1980s.26 Official statistics show that EBFs grew at an average annual rate of 29.9 percent between 1982 and 1992; and by 1992 the total amount of extrabudgetary revenue was 110.7 percent of within-budget revenue.27

At the provincial and city/county levels, EBFs consist of the retained earnings and depreciation of local state-owned enterprises (SOEs), as well as various user fees and public utility charges levied by agencies involved in the administration of SOEs. These latter fees generally remain with the levying agencies or departments rather than going through the local government. Until 1993, the retained earnings of SOEs had a greater impact on local finance since SOEs were known to collaborate with local officials in taxing the retained earnings or allocating the funds for local capital expenditures.28 In 1993, however, the central government redefined EBFs by excluding revenue from SOEs.29 This redefinition lead to a substantial decline in the official value of EBFs (approximately 29.9 percent of within-budget revenue in 2000),30 but it is commonly acknowledged that EBFs are underestimated in official records.31

The counterpart to EBFs below the county level are self-raised funds (SRFs). SRFs include fees for specific public goods, profits from township and village enterprises (TVEs), donations from overseas Chinese, contributions from local

Ratio of Extrabudgetary Revenue toBudgetary Revenue, 1952-2000

0%20%40%60%80%

100%120%

1952

1955

1958

1961

1964

1967

1970

1973

1976

1979

1982

1985

1988

1991

1994

1997

2000

YearSOURCE: China Statistical Yearbook.


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entrepreneurs, and assorted surcharges and fines collected by townships and villages. As with EBFs, in many cases SRFs are diverted into illegal accounts and slush funds; in Chinese the latter are also called “extra-extra budgetary funds” (yu yusuanwai zijin) or “little money lockers” (xiaojinku). Various studies have found that SRFs often exceed the amount of budgetary revenues,32 and that is certainly the case when the unreported portion of SRFs is taken into account. Furthermore, since the mid-1990s, the rise in farmers’ protests and court cases lodged by peasants against local governments suggests that the proliferation of local fees often poses an excessive financial burden on rural citizens.33

The 1994 reforms tried to eliminate some of the venues and incentives for local governments to maximize off-budget revenues at the expense of within-budget revenues.34 For example, because enterprise income taxes were re-classified as local revenues rather than shared revenues, local governments no longer had a reason to underreport them; meanwhile, the takeover of the Value-Added Tax by the center limited one of the key ways that localities transferred budgetary revenues off the budget. In substance, the 1994 reforms vastly increased the amount of revenue that local governments are required to hand over to the center, which means that localities have continued to experience fiscal pressures. In 2002, Minister of Finance Xiang Huaicheng announced another plan to centralize the collection and management of extra-budgetary funds, although the effectiveness of this effort is not clear due to the continuing demand-side push for off-budget financing.35

One key reason that sub-national governments have shifted vast portions of budgetary revenue into off-budget accounts is because they have needed it: the expenditure responsibilities of local governments have outstripped budgetary allocations from higher administrative levels. Local governments are now expected to finance a greater portion of various social services such as education, health, and welfare.36 Meanwhile, the number of local officials in rural China has expanded significantly, thereby creating the need for more funds.37 Between 1979 and 1984, sub-national governments experienced a decline in their share of fiscal revenues (from 79.8 to 59.5 percent), while their share of expenditures remained relatively constant at an average of 46.7 of total budgetary expenditures. By 1997, the gap between local revenues and expenditures became even more exaggerated: localities’ share of revenues declined to 51.2 percent, while their expenditures ballooned to 72.6 of the total. (See Table 2 for more detail.) Since then, the center has increased its transfer payments to localities by an annual average of 21.9 percent.38

Despite this increase in central government transfers, off-budget funds have continued to play a significant role in financing local expenses. In addition to social expenditures, off-budget funds are used for infrastructural construction, administrative costs (e.g., wages), consumption by government units (e.g., offices and housing for state employees), and in short, to make up the deficit in budgetary allocations for officially approved projects.39 Christine Wong calls this phenomenon


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“fiscal dualism” because the uses of within-budget and off-budget funds are often identical.40

As a result of increased local need for off-budget finance, the pre-1994 fiscal system experienced a substantial decline in the “two ratios” – budgetary revenue as a percentage of GDP and the central government’s share of revenues.41 Between 1978 and 1993, the ratio of total (central and local) budgetary revenue-to-GDP fell from 28.4 percent in 1979 to 11.2 percent in 1994, a percentage that is much lower than the average for Asian countries and developing countries more generally.42 Over the 1984 to 1993 period, the center’s share of budgetary revenue dropped from 40.5 to 22 percent.43 Table 2. Ratio of Budgetary Revenue to GDP, and Share of Revenues and Expenditures between Central and Local Governments, 1979-2002

BUDGETARY REVENUE EXPENDITURE YEAR Revenue/GDP Central (%) Local (%) Central (%) Local (%) 1979 28.4 20.2 79.8 51.1 48.9 1980 25.7 24.5 75.5 54.3 45.7 1981 24.2 26.5 73.5 55.0 45.0 1982 22.9 28.6 71.4 53.0 47.0 1983 23.0 35.8 64.2 53.9 46.1 1984 22.9 40.5 59.5 52.5 47.5 1985 22.4 38.4 61.6 39.7 60.3 1986 20.8 36.7 63.3 37.9 62.1 1987 18.4 33.5 66.5 37.4 62.6 1988 15.8 32.9 67.1 33.9 66.1 1989 15.8 30.9 69.1 31.5 68.5 1990 15.8 33.8 66.2 32.6 67.4 1991 14.6 29.8 70.2 32.2 67.8 1992 13.1 28.1 71.9 31.3 68.7 1993 12.6 22.0 78 28.3 71.7 1994 11.2 55.7 44.3 30.3 69.7 1995 10.7 52.2 47.8 29.2 70.8 1996 10.9 52.2 50.6 27.1 72.9 1997 11.6 48.8 51.2 27.4 72.6 1998 12.6 49.5 50.5 28.9 71.1 1999 13.9 51.1 48.9 31.5 68.5 2000 18.3 52.2 47.8 34.7 65.3 2001 17.1 52.4 47.6 30.5 69.5 2002 18.0 55.0 45.0 30.7 69.3

Source: State Statistical Bureau, China Statistical Yearbook, various years.

In an attempt to uncover hidden sources of revenue, the center has taken desperate ad hoc measures – or as Jun Ma puts it, “nonstandard fiscal policy instruments in order to influence revenue remittance by the localities.”44 As


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Christine Wong, Christopher Heady, and Wing Woo have detailed, these instruments include, “revenue-grabbing outside the (revenue-sharing) system by changing the scope of central fixed revenues, ‘borrowing’ etc. and unilaterally resetting contract terms in mid-course.” 45 In addition, the center has taken over profitable enterprises from localities and coerced the latter into purchasing central government bonds. As might be expected, the ad hoc strategies have reinforced the rationale for revenue concealment and further eroded trust between central and local governments. In other words, the center has not demonstrated a credible commitment to upholding the fiscal arrangements that it has negotiated or imposed on provincial governments. This violates one of the key conditions of MPF, namely, that institutionalized structures specify areas of fiscal responsibility and authority in a manner that prevents the national government from making unilateral changes (Condition 5). Financial Consequences: State Sector Subsidies Transferred to Banking System => Rise of Informal Finance

Weaknesses in the fiscal system have had spillover effects on the financial

system that ultimately limit the availability of formal bank credit to the most productive and market-oriented part of the Chinese economy, the private sector. Specifically, an important consequence of the decline in budgetary revenues to GDP is the de facto shifting of SOE subsidies from the fiscal budget to the banking system. During the Mao era, the fixed and working capital needs of SOEs were financed primarily through local government budgetary expenditures rather than loans from the state banking system.46 It was not until the rise of reform-era fiscal pressures, and related efforts to create greater separation between SOEs and the state, that SOEs turned to the banking system for alternative sources of soft finance. As Nicholas Lardy explains,

Since 1994 the entire government deficit has been financed by the sale of bonds. As the option of borrowing from the central bank was reduced and then foreclosed, the Ministry of Finance simply reduced subsidies to loss-making state enterprises, forcing these institutions to borrow from state-owned banks rather than relying on funds channeled through the budget in order to stay in business.47

The banking system has in effect turned into a fiscal arm of the government by shouldering the losses of the state sector. Local governments have pressured state banks to lend to troubled SOEs in their jurisdictions, which has not only infringed upon the operational autonomy of the financial sector, but also compromised its health. Indeed, between 25 and 40 percent of the loan portfolio of state banks consist of nonperforming loans, which were extended on a “policy” rather than “commercial” basis.48 When policy loans on the books of state banks are taken into account, Tamar Atinc and Bert Hofman point out that the consolidated budget deficit


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(CBD) of the government surpassed 9 percent of the GDP in 1993, which is much larger than the general government budget deficit of an average 2.1 percent of the GDP over the 1986 to 1995 period.49 While a CBD level of 9 percent of the GDP is not extreme by international standards, analysts have been concerned about its negative impact on the sustainability of banking system. Because the specialized state banks depend on loans from the People’s Bank of China (PBC) for on- lending to SOEs, the PBC has essentially been financing between 60 and 80 percent of the policy-based lending in the banking system.50 Moreover, up through the 1990s, state banks extended loans to SOEs at artificially depressed interest rates with minimal spreads relative to their commercial deposit rates. The financial consequences of such subsidization have been declining rates of bank profit – from 1.2 percent of assets in 1987 to 0.3 percent of assets in 1993 – as well as declining capital-asset ratios.51 The 1995 Commercial Banking Law attempted to separate the policy and commercial lending activities of state banks by establishing policy banks that would be devoted to credit allocation based on developmental/welfare objectives. This aimed to commercialize the operations of the four specialized state banks so that they would extend loans based on creditworthiness rather than political considerations.52 The restructuring of the banking system along regional lines in 1999 also sought to reduce local interference in lending activities. Nonetheless, local governments have continued pressuring state banks to extend loans to SOEs in their areas to prevent mass unemployment and social unrest. The theoretical import of this is that contrary to the expectations of the developmental state model, PRC banks have remained dedicated to serving the ailing state sector rather than lending to the most productive part of the Chinese economy.53 And contrary to the expectations of MPF, the most market-oriented part of the economy lacks access to formal banking sources of credit.54 As of year-end 2003 less than one percent of all loans extended by the state banking system were going to private enterprises.55

As such, one of the byproducts of fiscal decentralization and the state sector burden on the formal financial system has been the rise of informal finance, or what economists call the curb market, to serve the private sector. Table 3 shows the range of informal financing mechanisms, most of which are not sanctioned by state financial authorities. While banking officials generally condone casual lending among friends and relatives as an innocuous form of mutual assistance, financing practices like rotating credit associations and short-term trade credit reside within the gray area of quasi-legality in China.56 Others, such as private money houses and high-interest brokering, are explicitly forbidden by the central bank.

The actual scale and volume of each of the financing mechanisms in Table 3 is difficult to assess since they reside beyond the official banking system. In another study, I have estimated that informal finance accounts for at least one quarter of all financial transactions in the Chinese economy, and up to three-quarters of private sector finance.57


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Although private entrepreneurs share the structural condition of restricted access to formal bank credit, it is noteworthy that substantial variation exists among localities in the scope and scale of curb market finance. Vibrant informal financial markets have flourished where the local government has protected curb market operators from the repeated disciplining efforts of state banking regulators. As the next section suggests, this variation in curb market activity reflects differences in the developmental orientation of local governments. In some areas fiscal decentralization gave localities an incentive to permit the development of illegal financial institutions that compete with one another and infringe upon the business of official state banks; in other areas, fiscal decentralization motivated localities to pressure state banks to extend soft loans to local SOEs or collective enterprises.58 Neither MPF nor the developmental state model would expect such subversive and diverse informal coping strategies among sub-national governments. MPF expects interventionist localities to mimic more successful market-oriented localities, while developmental state theory expects localities to comply with centrally mandated fiscal and financial policies.

Table 3 Overview of Curb Market Activities in China

Legal

Quasi-Legal

Illegal

Interpersonal Lending

Trade Credit

Rotating Credit Associations (in some areas)

Pawn Shops

(in some areas)

Rural Cooperative Foundations

(illegal since 1999)

Cooperative Stock Enterprises

Red Hat/Hang-on Enterprises

Financial Societies/ Capital Mutual Assistance

Associations

Pawn Shops (in some areas)

Professional Brokers and

Money Lenders (Loan Sharks)

Private Money Houses

Rotating Credit Associations (in some areas)

Pyramidal Investment

Schemes (scams)

Note: None of the practices/institutions in the second and third columns are sanctioned by the People’s Bank of China. Those in the first column are only “legal” if they do not entail the use of interest rates. “Quasi-legal” practices are those registered by a bureaucracy outside of the financial hierarchy. Macroeconomic Consequences: Local Economic Autonomy => Inter-jurisdictional Competition and Local Protectionism


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The eating-in-separate-kitchens fiscal reform provided sub-national governments with a revenue-based incentive to promote local economic development, but not necessarily to do so in market-oriented terms. As Jean Oi explained in her article on local state corporatism, in some cases local governments functioned as the de facto board of directors in a corporation.59 At the sub-provincial level, township and village governments granted collective enterprises within their jurisdictions preferential tax treatment and access to credit. On aggregate, many have credited this guiding hand of the local developmental state for the remarkable pace of rural industrialization during the 1980s.60

Yet local governmental leadership in TVE growth (i.e., local state corporatism) is only one of several models of local development. In addition to the “Sunan” model of collective-sector oriented rural industrial development, some local governments have focused their energies on promoting private enterprises.61 Named after the well-known success of Wenzhou’s early-flourishing private sector in Zhejiang, this is known as the “Wenzhou” model of development,62 though private entrepreneurship has also flourished in other southern coastal provinces, especially Guangdong and Fujian. Meanwhile, local governments that inherited large state sectors from the Mao era have been more pre-occupied with subsidizing SOE payrolls in the interest of political stability rather than devoting scarce resources towards the private or collective sectors. Ironically, the parts of China that received the preponderance of capital investment during the 1950s and 1960s are now burdened with the need to reform what were once considered their unique advantages – massive factories that employ tens of thousands of workers. In contrast, areas that were systematically deprived of industrial development (i.e., for geostragetic reasons) have enjoyed the “advantages of backwardness” in the sense that they can develop their non-state sectors without having to contend with pre-existing, outdated industrial infrastructure. In short, fiscal reforms have given local governments a greater financial stake in the performance of local industry and commerce than they did during the Mao era, but the particular developmental strategies taken during the reform era vary widely.63

Associated with the heightened concern for improved economic performance is the rise of competitive dynamics among localities for markets and investment capital, including foreign direct investment.64 Local governments have granted tax exemptions to domestic and foreign businesses in this competitive spirit, and this in turn has contributed to the erosion of the center’s budgetary revenues. Of equal concern, however, is continuing local protectionism.65 Cigarettes and beer produced by SOEs and TVEs in one province often cannot be purchased in other provinces.66 Provinces impose extremely high taxes and non-tariff barriers on automobiles manufactured in other regions.67 Local military forces (minbing) are used to enforce export embargos on the transport of commodities to other jurisdictions.68 And joint-venture partners are frequently required to choose one investment locale to the exclusion of others. Due to concerns about China’s ability to comply with the terms


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of its WTO agreements, in 2001 the PRC State Council issued detailed regulations prohibiting local protectionism;69 and since then, senior officials have continued to reiterate its importance.70 The prevalence of local protectionism violates the expectations of both MPF and the developmental state model. THEORECTIAL IMPLICATIONS OF CHINA’S “FISCAL FEDERALISM” Most explanations for China’s impressive economic performance since the late 1970s concur that fiscal decentralization motivated local officials to promote local economic growth, but disagreement remains over the causal logic: has growth been driven by market forces or by the prudent intervention of developmental states at the local and central levels? Theoretically, the parsimonious expectations of MPF are compelling, but the preceding sections of this article suggest that its parsimony excludes two important complicating factors – non-market alternatives to development, and the fragmented rationality of local governments. In addition, MPF relies too heavily on the need for regulatory capacity and consistency on the part of the center. While the developmental state model recognizes the first point, i.e., that growth may occur under imperfect market conditions, it requires local officials and bureaucrats to comply more reliably with central-level mandates, and requires the center to project greater clarity about its fiscal expectations.

First, fiscal decentralization has indeed given local governments a greater incentive to support the local economy, but not always in a market-oriented manner. Localities in China have used a wide range of strategies to pursue industrial development and generate local revenue. They have promoted the collective versus private sectors with varying levels of fiscal and financial support; and few governments encouraged wholesale privatization of SOEs until the formal mandate to do so was announced at the 15th Party Congress in late 1997. Furthermore, recall that local governments have been using state-owned commercial banks to subsidize inefficient enterprises, while private businesses have had to turn to non-banking financial institutions and underground credit markets. In short, the assumption that increasing marginal rates of revenue retention at the local level would inspire market-oriented policies is overly simplistic. Local governments – especially those with a prior political and ideological commitment to full-employment – do consider the non-fiscal consequences of their development strategies.

The second limitation of MPF, which is shared with the developmental state model, concerns the assumption that China’s local governments are sufficiently disciplined to operate as a coherent growth-promoting unit. Private businesses in China frequently complain of predatory behavior on the part of local officials. In any given week, the typical factory owner may be approached by dozens of different agencies requesting seemingly random user fees, surcharges, and contributions for local projects.71 Some fees are collected for the legitimate provision of local public goods, but others simply line the pockets of rent-seeking bureaucrats. If the assumption of economic rationality implicit in MPF were extended to the level of


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inter-agency competition for local revenues or underpaid grassroots cadres, it would recognize the reality of fiscal constraints and corruption in China.72 The developmental state model similarly requires well-disciplined bureaucrats and state agencies to devise and implement policy.73

The third limit of MPF concerns the delicate balance in state authority that the center needs to strike in order for the market-preserving logic to hold. In the tradition of Douglass North, this goes to the core of what Weingast calls the “fundamental political dilemma in an economic system,” which is that any “government strong enough to protect property rights is also strong enough to confiscate the wealth of its citizens.”74 As it turns out, many de jure federations overstep the boundary for achieving the market-preserving balance. The economic and fiscal authority of the federal government in India, for example, would be considered over-centralized,75 while the use of interjurisdictional transfers to reduce inequalities in advanced industrial federations like Canada, the United States, and Germany interferes with free competition among its sub-national units.76 The argument has been made that finding the critical balance of intergovernmental authority is a fundamentally political dilemma because it is an unstable institutional equilibrium. In their critique of MPF, Jonathan Rodden and Susan Rose-Ackerman point out that any government strong enough to police the common market probably has considerable fiscal and regulatory capacity, which would contraindicate economic decentralization.77 This delicate condition of MPF is also implicit in the developmental state model.78 Yet China’s central government still lacks the capacity to enforce free internal flows of goods and services to the extent required under MPF. To date, central and sub-national controls remain on markets in the basic factors of production – land, labor, and capital;79 local protectionism is pervasive; governmental budgets remain soft; and ultimately, China’s version of fiscal federalism is far from institutionalized as the center has engaged in on-going efforts to re-negotiate and re-centralize its fiscal authority.

Given all of these restrictions, I propose that “market-thwarting federalism” describes the structure of contemporary China’s political economy more accurately.80 This is not to imply that MPF is theoretically flawed or empirically impossible—the nature of decentralization in the US before the New Deal and even in 18th century England, which was not federal in the conventional sense, provide fitting historical examples of the model’s logic. But fiscal decentralization in reform-era China has created incentives at the sub-national level that defy broader market-preserving outcomes. In particular, the fiscal contracting system motivated local governments to use protectionist measures to meet the revenue quotas agreed upon in the fiscal contract and to maximize locally-retained revenues. In the 1980s, both tariff and non-tariff barriers were used to keep lower priced commodities within certain localities so that local governments could fulfill the central government procurement plan under the multi-tier price system, and lower priced materials would be retained


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to enhance the profitability of “domestic” industry.81 These expressions of local protectionism are market thwarting, not market promoting.

At this point, the proponents of MPF and other skeptical readers might raise two objections to the present claims: first, the degree of local protectionism has declined since the 1980s; and second, some degree of local protectionism and informal finance does not invalidate the logic of MPF and the DS model as ideal types. I will address both counterarguments in turn and show that neither objection undermines the claims made in this article.

First, while liberalization of commodity prices and marketing has reduced certain types of regional trade barriers, data is lacking to show that overall levels of local protectionism have declined. The only study that indicates growing unification of China’s domestic market presents provincial data on input-output tables from only one year, 1992, and contrasts it from one other data point, 1987.82 Yet the period between 1987 and 1992 is politically unique because it includes China’s post-1989 downturn in international trade and excludes the post-1992 recovery in external trade levels.83 In other words, domestic trade in 1992 was probably unusually high relative to external trade due to the 1989 crisis. Furthermore, the 1992 data cannot tell us much about trends during the 1990s. In contrast, studies drawing on more recent data have identified continuing trends in local protectionism rather than a market-oriented shift towards increasing regional specialization according to comparative advantage. Alwyn Young, for example, examined sectoral data between 1978 and 1997 and found declining levels of regional specialization, leading him to conclude that China’s economic reform has “resulted in a fragmented internal market with fiefdoms controlled by local officials.”84 Other economists have also traced China’s fragmented regional markets to local protectionism based on both empirical and theoretical analyses.85 In brief, local governments continue to engage in market distorting, protectionist behavior even if it is not as extreme as it was during the 1980s.

The second potential critique of the present argument is that MPF and the DS model are only meant to be ideal typical models, not empirically detailed descriptions of any particular country. Thus, one might question whether the case of China can be used to invalidate these theoretical models. The point of this article, however, is not to challenge the internal logic of MPF or the DS. Instead, the objective is to demonstrate that the DS and MPF models do not apply to China because the case of China fails to meet key assumptions in both. The fact that both the DS and MPF models are popular explanations for economic growth makes it tempting for scholars to interpret actual conditions in high growth countries in a manner that fits the expectations of these pre-existing models. This article argues that economic reform in China has yielded unintended consequences that deviate too far from the core components of the two models. Unlike the countries that are usually regarded as being the original developmental states of East Asia, Beijing has not demonstrated a comparable level of fiscal and financial capacity required for effective policy


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interventions. And unlike the federal market economies that inspired MPF, China’s local governments still face strong fiscal incentives to protect their main revenue generators from external competition and ample evidence exists that they are continuing to do so. The limited relevance of MPF to China lies not only in the claim that local protectionism violates the market mechanism, but of equal analytic concern, the observation that the very structure of China’s “fiscal federalism” fosters protectionist policies among localities as a rational coping strategy. CONCLUSION

Ultimately, the case of China does not conform fully to the expectations of any single, tightly construed model of political economy because the PRC contains dozens of cases at the provincial level and thousands more at the sub-provincial levels. Within a single province, evidence can be mustered for market-preserving federalism,86 local state corporatism, and even klepto-patrimonialism. Fiscal decentralization has simultaneously created incentives for local officials to promote economic prosperity and enhance the revenue requirements of localities. These trends, in turn, have inspired extractive behavior that seems unacceptably predatory for a local developmental state.

In reality, the Chinese economy has flourished for two decades as localities pursued widely diverse, apparently irrational, and informal developmental strategies. This is reflected in the accumulation of funds circulating beyond the formal fiscal and financial systems, and the manner in which they are being allocated. Self-raised funds and extra-budgetary funds generally function as local taxes, which are allocated at the discretion of local governmental agencies. Informal finance, on the other hand, is essentially private finance. Meanwhile local state banks are being used for fiscal purposes (i.e., to subsidize state-owned enterprises), as non-banking financial institutions and local curb markets have emerged as the primary source of truly commercial finance. Because most of these financing mechanisms are technically illegal, however, the more institutionalized forms require political support by the local government to survive. Yet local governmental support for private financial intermediation varies widely depending on the mix of political and economic resources vested in the state versus collective and private sectors. Localities with fewer SOEs and government-run TVEs have more sophisticated curb markets. In such areas, local officials insulate their private bankers from the scrutiny of higher-level financial regulators. In brief, whether it takes the form of subsidizing SOEs, TVEs, or shielding private financial institutions, local governments have become extremely protective of local economic actors. Economically, local protectionism facilitated the early stages of rural industrialization, but it has also fueled inefficient allocation of resources, duplication of investment, and illegal financing strategies.

Politically, it has been suggested that fiscal reforms have weakened the central government and strengthened localities to the point that the PRC faces the threat of


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political disintegration.87 Indeed, until the 1994 reforms, the center experienced a declining share of budgetary revenue and as a result, its redistributive capacity through the fiscal system remains compromised.88 By the same token, the proliferation of off-budget coffers and increase in expenditure responsibilities of the localities suggests a relative strengthening in the fiscal positions of sub-national governments. But does this mean that the center has lost the political capacity to hold its sub-national units together? Not necessarily. Ultimately, the monetary division of the fiscal pie is only one dimension of central-local relations.89

From a more nuanced perspective, we can see that fiscal decentralization has been accompanied by local state building as localities have taken on functions formerly performed and financed by the center.90 In other words, local governments have grown bureaucratically in size and extended their administrative reach to lower levels in the process of providing new services and collecting revenues to finance these services.91 By 1985, for example, the average number of government agencies at the provincial level exceeded the number of central agencies for the first time in PRC history.92 Yet growth in the institutional density of local governments has not come at the expense of the central party-state’s political authority. As Huang Yasheng points out, the center has retained the authority to appoint top provincial officials who serve as agents of the center rather than being captured by local interests.93 This nomenklatura-based power over the allocation of personnel explains why the center has generally been able to enact macroeconomic stabilization policies that may harm the short-term economic interests of certain localities.94 As such, it is inaccurate to claim that fiscal decentralization has translated symmetrically into political decentralization, and it would be misguided to diagnose political collapse on this basis.95

We can conclude, however, that economic development in reform-era China has occurred unevenly under conditions of extensive local governmental intervention in the economy, fiscal decline in the center, and political uncertainty in intergovernmental relations. Rather than the emergence of a single, market-oriented pattern of national economic development, remarkable developmental diversity persists at the local level. On balance, China is off balance.

Theoretically, the implication of this imbalance is that neither market-centric nor state-centric explanations are adequate for capturing the complex dynamics that may ensue from fiscal decentralization. The case of reform-era China presents students of political economy with an alternative pattern of development, namely one that incorporates market-thwarting fiscal incentives at the national level and developmental diversity at the local level. Although the central government intended to build effective fiscal and financial institutions, those efforts had informal, unintended consequences that depart significantly from the expectations of popular models in political economy. Over time, this type of distorted development may not be sustainable – and it is unlikely that another country would retrace this particular path out of socialism and/or underdevelopment. But the observation that such


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apparently contradictory processes have correlated with economic growth introduces realistic informal and unintended variables into our conventional narratives about the causal dynamics of development. Notes 1“We Should Study More About Finance and Taxation To Upgrade Our Administrative Capability Over Economic Work,” People’s Daily [Renmin ribao], January 20, 2000. 2Alice Amsden, Asia’s Next Giant: South Korea and Late Industrialization (New York: Oxford University Press, 1992); Peter B. Evans, Embedded Autonomy: States and Industrial Transformation (Princeton: Princeton University Press, 1995); Chalmers Johnson, MITI and the Japanese Miracle: The Growth of Industrial Policy, 1925-1975 (Stanford: Stanford University Press, 1982); Robert Wade, Governing the Market: Economic Theory and the Role of the Government in East Asian Industrialization (Princeton: Princeton University Press, 1990); Meredith Woo-Cumings, ed., The Developmental State (Ithaca: Cornell University Press, 1999). 3Barry R. Weingast, “The Economic Role of Political Institutions: Market-Preserving Federalism and Economic Growth,” Journal of Law, Economics, and Organization, vol. 11, no. 1, April 1995, pp. 1-31; and Yingyi Qian and Barry Weingast, “Federalism as a Commitment to Market Incentives,” Journal of Economic Perspectives, vol. 11, no. 4, Fall 1997, pp. 83-92. 4This does not mean that redistribution has been economically efficient. Albert Park and Kaja Sehrt, “Tests of Financial Intermediation and Banking Reform in China,” Journal of Comparative Economics, vol. 29, 2001, pp. 608-644; and Yasheng Huang, Inflation and Investment Controls in China: The Political Economy of Central-Local Relations During the Reform Era (New York: Cambridge University Press, 1996). 5Jean C. Oi, “Fiscal Reform and the Economic Foundations of Local State Corporatism in China,” World Politics vol. 45, no. 1, October 1992, pp. 99-126; Oi, Rural China Takes Off: Institutional Foundations of Economic Reform (Berkeley: University of California Press, 1999); and Susan Shirk, The Political Logic of Economic Reform in China (Berkeley: University of California Press, 1993). 6Besides Jean Oi’s work on local state corporatism, the following studies have referred to reform-era China as a developmental state: Mark Blecher and Vivienne Shue, Tethered Deer: Government and Economy in a Chinese County (Stanford: Stanford University Press, 1996); Gordon White, ed., Developmental States in East Asia (New York: St. Martin’s Press, 1988); and Ming Xia, The Dual Developmental State (Brookfield, VT: Ashgate, 2000). 7Barry R. Weingast, “Gabriella Montinola, Yingyi Qian, and Barry R. Weingast, “Federalism, Chinese Style: The Political Basis for Economic Success,” World Politics vol. 41, no. 1, October 1996, pp. 50-81. 8Ronald I. McKinnon, “The Logic of Market-Preserving Federalism,” Virginia Law Review, vol. 83, no. 7, 1997, pp. 1573-1580. Cf. Yingyi Qian and Gerard Roland, “Federalism and the Soft Budget Constraint,” American Economic Review, vol. 88, no. 5, December 1998, pp. 1143-1162. 9Olivier Blanchard and Andrei Shleifer, “Federalism with and without Political Centralization: China versus Russia,” unpub. ms., February 15, 2000. 10This article distinguishes between “fiscal” and “financial” issues. “Fiscal” concerns include taxes and fees collected by government entities that are meant to fund various public goods and services. Hence, off-budget, extrabudgetary, and self-raised funds are all informal fiscal phenomenon. In contrast, “financial” sector issues relate to funds that finance economic production. The formal financial system consists of officially sanctioned financial institutions, while informal finance refers to curb market finance and financial institutions that are not sanctioned by banking authorities.


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11Christine Wong made this case most persuasively in many works, including “Between Plan and Market: The Role of the Local Sector in Post-Mao Reforms,” Journal of Comparative Economics, September 1987, pp. 385-398; “Ownership and Control in Chinese Industry: The Maoist Legacy and Prospects for the 1980s,” in Joint Economic Committee, US Congress, China’s Economy Looks Toward the Year 2000 (Washington DC: USGPA, 1986), pp. 571-603; and “Material Allocation and Decentralization: Impact of the Local Sector on Industrial Reform,” in Elizabeth J. Perry and Christine Wong, eds., The Political Economy of Reform in Post-Mao China (Cambridge: Harvard University Press, 1985), pp. 253-278. 12On the “convergence school” of explanations, see Wing Thye Woo, “The Real Reasons for China’s Economic Growth,” The China Journal, vol. 41, January 1999, pp. 115-137. 13Directly below the central government are 22 provinces, five autonomous regions, and the four municipalities of Beijing, Shanghai, Tianjin, and Chongqing. The provinces, autonomous regions, and municipalities are equal in political rank with the national ministerial bureaucracies. Below the provincial level are over 300 prefectures and municipalities at the prefectural level. The county level consists of over 2,100 counties, autonomous counties, and cities. The lowest formal political layer comprises of rural townships and urban districts. At the grassroots level, there are approximately one million village committees and nearly 100,000 neighborhood committees. They are not considered a formal part of the government, but rather, according to the 1982 PRC Constitution, “mass organizations of self-management at the grassroots level” (Article 111, Appendix A). 14For example, Montinola, Qian, and Weingast, “Federalism, Chinese Style”; Huang, Inflation and Investment Controls in China. 15Scholars have distinguished among three forms of “decentralization”: i) “deconcentration,” where some responsibilities are transferred from the central to sub-national units; ii) “delegation,” where local governments act as agents of the central government; and iii) “devolution,” where local governments are given decision-making authority. Richard M. Bird and Duanjie Chen, “Intergovernmental Fiscal Relations in China in International Perspective,” in Donald J.S. Brean, ed., Taxation in Modern China (New York: Routeledge, 1998), pp. 151-186. 16Shaun Breslin, China in the 1980s: Centre-Province Relations in a Reforming Socialist State (Basingstoke: Palgrave, 1996); Jia Hao and Lin Zhimin, eds., Changing Central-Local Relations (Boulder: Westview Press, 1994); Shirk, The Political Logic of Economic Reform in China; Dali L. Yang, “Reform and the Restructuring of Central-Local Relations,” in David S. G. Goodman and Gerald Segal, eds., China Deconstructs: Politics, Trade and Regionalism (New York: Routledge, 1994). 17Note that the tax system was simplified several times during the Mao era since leftist theory stipulated that socialist countries do not require taxation. See Jinyan Li, Taxation in the People’s Republic of China (New York: Praeger, 1991). On the redistributive nature of the system, see Nicholas R. Lardy, Economic Growth and Distribution in China (New York: Cambridge University Press, 1978). 18P.T. Wanless, Taxation in Centrally Planned Economies (New York: St. Martin’s Press, 1985). 19An excellent source for more detail on the fiscal reforms is Christine P. W. Wong, Christopher Heady, and Wing Thye Woo, Fiscal Management and Economic Reform in the People’s Republic of China (Hong Kong: Oxford University Press, 1995). 20A listing of fiscal contracting arrangements by province is in Wong, Heady, and Woo, Fiscal Management, pp. 88-93. 21The tax sharing system was introduced in 1992 in six cities and three provinces on an experimental basis. For an early evaluation of the impact of the 1994 reforms, see the special issue of Chinese


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Economic Studies, vol. 29, no. 4, July/August 1996, Guo Xiaolin, ed. and trans., “Readjusting Central-Local Relations in Revenue Distribution China's 1994 Fiscal Reform.” 22Later on the excise tax and securities trading tax became shared taxes as well. Christine Wong, China National Development and Sub-National Finance: A Review of Provincial Expenditures (Washington: D.C.: Poverty Reduction and Economic Management Unit, East Asia and Pacific Region, The World Bank, April 9, 2002), p. 13. 23This led many provinces to increase their efforts at revenue collection in 1993 because transfers from the center to the provinces would be calculated according to 1993 retained revenues via the following equation:

PBR – LT – 0.25 x VAT where PBR is the province’s base retained revenue, LT is the province’s local tax revenue in the 1993 base year, and VAT is the VAT revenue from the province. See Christine P.W. Wong, ed., Financing Local Government in the People’s Republic of China (New York: Oxford University Press, 1997), pp. 32-37. Some localities pressured banks to extend loans to enterprises so they could pay back taxes. Jun Ma, “Macroeconomic Management and Intergovernmental Relations in China,” World Bank Policy Research Working Paper, no. 1408, January 1995, p. 18. 24Shaoguang Wang, “China’s 1994 Fiscal Reform: An Initial Assessment,” Asian Survey,vol. 37, no. 9, September 1997, pp. 801-817; and especially Wong, China National Development and Subnational Finance. 25They grew during the Great Leap Forward (1958-1961) and the Cultural Revolution (1966-1976). 26Christine P.W. Wong, “Fiscal Reform and Local Industrialization: The Problematic Sequencing of Reform in Post-Mao China,” Modern China, vol. 18, no. 2, April 1992, p. 205. 27China Statistical Yearbook, various years. 28Bahl, Fiscal Policy in China, p. 85. 29The definitions of EBFs are reported in the annual China Statistical Yearbooks. 30Fan Gang, “Market-Oriented Economic Reform and the Growth of Off-Budget Local Public Finance,” in Brean, ed., Taxation in Modern China, p. 211. 31Le-Yin Zhang, “Chinese Central-Provincial Fiscal Relationships, Budgetary Decline and the Impact of the 1994 Fiscal Reform: An Evaluation,” China Quarterly, vol. 157, no. 1, 1999, pp. 123-26. 32Bahl, Fiscal Policy in China; Gang, “Market Oriented Economic Reform”; Oi, Rural China Takes Off; Wong, ed., Financing Local Government; and Jieh-min Wu, “Local Property Rights Regime in Socialist Reform: A Case Study of China’s Informal Privatization,” Ph.D. diss., Columbia University, 1998. 33For example, Kevin O’Brien and Lianjiang Li, “Villagers and Popular Resistance in Contemporary China,” Modern China, vol. 22, no. 11, January 1996, pp. 28-61; and Thomas P. Bernstein and Xiaobo Lü, Taxation without Representation in Contemporary Rural China (New York: Cambridge University Press, 2003). 34A succinct summary is in Bahl, Fiscal Policy in China, p. 87. 35“Xiang Huaicheng at NPC Meeting: PRC to Build Clean Government by Financial Reform,” Xinhua, March 6, 2002, reported in FBIS-CHI-2002-0306. In 2003, Minister Xiang reiterated the need to strengthen “collection and management of non-tax incomes” as well as taxes themselves. “PRC Finance Minister Urges Strengthening Collection, Management of Revenue,” Xinhua, March 6, 2003, reported in FBIS-CHI-2003-0306. 36Elizabeth J. Remick, “Big Plans and Empty Pockets: Local Exactions in Republican and Post-Mao China,” Twentieth-Century China, vol. 25, no. 1, November 1999, pp. 43-70; Loraine A. West, “Provision of Public Services in Rural PRC,” in Wong, ed., Financing Local Government, pp. 213-


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82; and Wong, Heady, and Woo, Fiscal Management, pp. 81-134. During 1980s, price subsidies and the costs of grain procurement constituted a larger component of local budgets. Christine P.W. Wong, “Center-Local Fiscal Relations in an Era of Fiscal Decline: The Paradox of Fiscal Decentralization in Post-Mao China,” China Quarterly, vol. 128, December 1991, pp. 691-715. 37Bernstein and Lü, Taxation without Representation. 38Xiang Huaicheng, “Report on the Implementation of the Central and Local Budgets for 2001 and on the Draft Central and Local Budgets for 2002,” China Statistical Yearbook (Xinhua Publishing House, 2002). 39Oi, Rural China Takes Off, pp. 162-66; Yi-min Lin and Zhanxin Zhang, “Backyard Profit Centers: the Private Assets of Public Agencies,” in Jean C. Oi and Andrew Walder, eds., Property Rights and Economic Reform in China (Stanford: Stanford University Press, 1999), especially pp. 217-19. 40Christine P.W. Wong, “Fiscal Dualism in China: Gradualist Reform and the Growth of Off-Budget Finance,” in Brean, ed., Taxation in Modern China, pp. 187-208. Cf. Andrew Wedeman, “Budgets, Extra-budgets, and Small Treasuries: illegal monies and local autonomy in China,” Journal of Contemporary China, vol. 9, no. 25, 2000, pp. 489-511. 41The declining profitability of SOEs has also contributed to the center’s shrinking revenue base. Xiao Geng, “Central Local Relations from the Perspective of State and Non-State Industries,” in Jia and Lin, eds., Changing Central-Local Relations. Cf. International Monetary Fund, People’s Republic of China: Selected Issues (Washington, DC: International Monetary Fund, 1997), Table I.6 shows an increase in SOE “lossmakers.” Another way of looking at this is that SOE profits actually increased in the late 1980s, while their remittances remained constant; see Wong, Heady, and Woo, Fiscal Management, Table 2.1, pp. 48, 57. 42See Table 2.3 in Roy Bahl, Fiscal Policy in China (San Francisco: The 1990 Institute, 1999), p. 12. 43To put this in comparative perspective, in Canada and India (two federal systems) the central government receives over 70 percent of total revenues; and the UK government receives over 90 percent. Wong, Heady, and Woo point out that this is how the three countries are able to implement relatively effective equalization policies in areas like education and healthcare. See pp. 16, 212-225. 44Ma, “Macroeconomic Management and Intergovernmental Relations in China,” p. 12. 45Wong, Heady, and Woo, Fiscal Management, p. 134. 46During the 1960s, bank loans were only supposed to supply twenty percent of the SOEs’ working capital requirements (as determined by a quota system). William Byrd, China’s Financial System: The Changing Role of Banks (Boulder: Westview Press, 1983); and Katherine Huang Hsiao, Money and Monetary Policy in Communist China (New York: Columbia University Press, 1971). 47Nicholas R. Lardy, China’s Unfinished Economic Revolution (Washington, DC: Brookings Institution Press, 1998), p. 34. 48Nicholas R. Lardy, “Op Ed: China’s Worsening Debts,” Financial Times, June 22, 2001. Official statistics indicate that as of year-end 2002, the non-performing asset ratios of the Industrial and Commercial Bank, Bank of China, and China Commercial Bank had declined to 25.5%, 22.4%, and 15.4%, respectively. The reduction of non-performing loans since 1999 is due to the fact that asset management companies (AMCs) were established to take over the bad loans from state banks. 49Tamar Manuelyan Atinc and Bert Hofman, “China’s Fiscal Deficits, 1986-1995,” in Brean, ed., Taxation in Modern China, pp. 34-40. A measure of the deficit that is even more conservative than the government budget deficit or the consolidated budget deficit (CBD) is the public sector deficit (PSD), which includes all net lending to the government and SOEs. The difference between the CBD and PSD is that the former only includes the policy component of bank lending whereas PSD includes both policy and commercial lending by state banks. Over 1987-1995, the PSD averaged 10 percent of the GDP.


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50Estimates by ibid, p. 35. 51Éric Girardin, The Dilemmas of Banking Sector Reform and Credit Control in China (Paris: OECD Development Centre, 1997), p. 32. Until the AMCs were established in 1999, all four of the specialized state banks were technically insolvent. 52Yet this reform remained limited because the four specialized banks retained responsibility for their pre-existing debts. Shaun Breslin, “Learning to Live without the Plan: Financial Reform in China,” in Geoffrey R.D. Ravenhill and Xiaoke Zhang, eds., International Financial Governance Under Stress (London: Cambridge University Press, 2003), pp. 203-222. 53Of course not all lending to the state sector is “unproductive.” See James Laurenceson and Joseph C.H. Chai, “State Banks and Economic Development in China,” Journal of International Development, vol. 13, pp. 211-225. 54The non-state sector (i.e., the private and the collective sectors) has had access to various non-banking financial institutions such as rural credit cooperatives and urban credit cooperatives. 55People’s Bank of China, “Financial Industry’s Performance was Stable in 2003,” January 15, 2004, available on-line at http://www.pbc.gov.cn. On the potentially positive macroeconomic externalities of financial rationing in transitional economies, see Ronald McKinnon, “Financial Control in the Transition from Classical Socialism to a Market Economy,” Journal of Economic Perspectives, vol. 5, no. 4, 1991, pp. 107-122; and “Financial Growth and Macroeconomic Stability in China, 1978-1992: Implications for Russia and Other Transitional Economies,” Journal of Comparative Economics, vol. 18, no. 3, 1994, pp. 438-469. 56“Gray area of quasi-legality” means that some financing practices are sanctioned by some bureaucracies but not others; similarly, different administrative levels of government may have conflicting regulations governing substantively similar practices. Kellee S. Tsai, Back-Alley Banking: Private Entrepreneurs in China (Ithaca: Cornell University Press, 2002). 57Ibid, pp. 36-37. 58“Chinese Lawmakers Urge Crackdown on Local Protectionism in Debt Cases,” Xinhua, August 24, 2002, as reported in FBIS-CHI-2002-0824. 59Oi, “Fiscal Reform.” 60For example, William A. Byrd and Lin Qingsong, eds., China’s Rural Industry: Structure, Development and Reform (Washington DC: IBRD/The World Bank, 1990); and Christine P. W. Wong, “Interpreting Rural Industrial Growth in the Post-Mao Period,” Modern China, vol. 41, no. 1, January 1988, pp. 3-30. 61Oi, Rural China Takes Off; and Susan H. Whiting, Power and Wealth in Rural China: The Political Economy of Institutional Change (New York: Cambridge University Press, 2001). 62See, for example, articles written in 1986 by members of the Economic Research Institute of the Chinese Academy of Social Sciences, translated into English in Peter Nolan and Dong Fureng, eds., Market Forces in China: Competition and Small Business—The Wenzhou Debate (London: Zed Books, Ltd., 1989). 63Relatedly, on the increasing regional, intra-provincial, and rural-urban income disparities, see Wang and Hu, The Political Economy of Uneven Development; and The World Bank, China 2020: Sharing Rising Incomes (Washington DC: The World Bank, 1997). 64Yasheng Huang, Selling China: Foreign Direct Investment During the Reform Era (New York: Cambridge University Press, 2003); and Dali Yang, Beyond Beijing: Liberalization and the Regions in China (New York: Routledge Press, 1997). 65Lance Gore, Market Communism: The Institutional Foundation of China’s Post-Mao Hyper Growth (London: Oxford University Press, 1999); Carsten Hermann-Pillath, Feng Xinyuan, and Hu Jinhua, “Local Protectionism and Local Market Separation in China: Problems and Policy


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Recommendations,” China and World Economy, Institute of World Economics and Politics, Chinese Academy of Social Sciences, November 1, 2002. 66When the economy overheated in the late 1980s, there were “cotton wars,” “silk wars,” “tobacco wars,” “tea wars,” etc. See, for example, Andrew Watson, Christopher Findlay, and Harry X. Wu, “Who Won the ‘Wool’ War? A Case Study of Rural Product Marketing in China,” China Quarterly, vol. 118, June 1989, pp. 213-41. 67Huang, Selling China, Ch. 6; and China Business Times [Zhonghua gongshang shibao], December 17, 2002, as reported in “China Hubei official urgent talks with Shanghai on removing protectionist auto laws,” ChinaOnline, December 23, 1999. I thank Eric Thun for these references. 68This was more serious in the 1980s, but it has continued. “PRC Radio Commentary Calls for Smashing Local Blockades, Eliminating Protectionism,” February 2, 2002, as cited in FBIS-CHI-2002-0203. 69“State Council Issues Local Protectionism Ban,” People’s Daily [Renmin ribao], April 30, 2001. 70For example, at the 2002 China Development Forum, Wang Yang, the vice minister of the State Development Planning Commission emphasized, “Breaking down local protectionism and setting up a unified, fair and orderly national market are urgent and important tasks facing the government.” “Senior Chinese Official Vows to Further Curb Regional Protectionism,” China News Digest, April 1, 2002, citing Xinhua News Agency, March 26, 2002. 71Surveys of private entrepreneurs have found that excessive taxation and lack of access to official credit are among the most frequently cited challenges to running a business. See Zhongguo siying jingji nianjian 1978-1994 (China private economy yearbook) (Hong Kong: Xianggang siying jingji nianjian, August 1994); and Zhongguo siying jingji nianjian 1996 and 2000 (China private economy yearbook) (Beijing: Zhonghua gongshang lianhe chubanshe, April 1996 and January 2001). 72Weingast, et al. acknowledge that local protectionism may foster rent-seeking in China, but maintain that MPF holds in general. 73See Xiaobo Lü, Cadres and Corruption: The Organizational Involution of the Chinese Communist Party (Stanford: Stanford University Press, 2000); and Yan Sun, Corruption and Market in Contemporary China (Ithaca: Cornell University Press, 2004). 74Barry R. Weingast, “Constitutions as Governance Structures: the Political Foundations of Secure Markets,” Institutional and Theoretical Economics, vol. 11, 1993, pp. 286-7, cited in Jonathan Rodden and Susan Rose-Ackerman, “Does Federalism Preserve Markets?” Virginia Law Review, vol. 83, no. 7, October 1997, p. 1522. This point is explored more fully in Douglass C. North, Structure and Change in Economic History (New York: Cambridge University Press, 1981); and Institutions, Institutional Change, and Economic Performance (New York: Cambridge University Press, 1990). 75Sunita Parikh and Barry R. Weingast, “A Comparative Theory of Federalism: India,” Virginia Law Review, vol. 83, no. 7, October 1997, pp. 1593-1615. 76Rodden and Rose-Ackerman, “Does Federalism Preserve Markets,” pp. 1557-1562. 77Ibid, pp. 1521-1572. 78For example, Evans, Embedded Autonomy. 79Note, however, that rural surplus labor released from decollectivization, dubbed the “floating population,” has become more mobile despite barriers to acquiring urban residency. Dorothy J. Solinger, Contesting Urban Citizenship in Urban China: Peasant Migrants, the State, and the Logic of the Market (Berkeley: University of California Press, 1999). 80In using the term “market-thwarting federalism,” I do not mean to suggest that it represents a formal “model” of development in the same way that the theories of MPF and DS connote


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developmental ideal types. Instead, this article only intends to contest the applicability of the MPF and DS models to China. 81Ma, “Macroeconomic Management and Intergovernmental Relations in China,” pp. 52-7. 82Barry Naughton, “How Much Can Regional Integration Do to Unify China's Markets?” in Nicholas Hope, Dennis Yang, and Mu Yang Li, eds., How Far Across the River? Chinese Policy Reform at the Millennium (Stanford: Stanford University Press, 2003), pp. 204-232. 83In 1992, Deng Xiaoping made his now-famous “southern tour” of the coastal provinces and special economic zones. The trip indicated that economic reform would continue despite the Tiananmen Square crisis of 1989. After 1992, both external trade and domestic private sector development boomed. 84Alwyn Young, “The Razor’s Edge: Distortions and Incremental Reform in the People’s Republic of China,” The Quarterly Journal of Economics, vol. 115, no. 4, November 2000, p. 1128. 85Chong-En Bai, Yingjuan Du, Zhigang Tao, and Sarah Y. Tong, “Protectionism and Regional Specialization: Evidence from China’s Industries,” Hong Kong Institute of Economics and Business Strategy Working Paper Series, No. 1040, February 2002; Jie Li, Larry D. Qiu, and Qunyan Sun, “Interregional Protection: Implications of Fiscal Decentralization and Trade Liberalization,” China Economic Review, vol. 41, no. 3, November 2003, pp. 227-245; and Xinpeng Xu, “Have the Chinese Provinces Become Integrated Under Reform?” China Economic Review, vol. 13, no. 2-3, July 2002, pp. 116-133. 86Indeed, Clayton Gillette suggests that the conditions of MPF are more likely to hold among localities within a given state due to their relative homogeneity and frequency of interaction rather than among states in a federation. Clayton P. Gillette, “The Exercise of Trumps by Decentralized Governments,” Virginia Law Review, vol. 83, no. 7, October 1997, pp. 1347-1417. 87Wang Shaoguang and Hu Angang, Report on the State of the Nation: Strengthening the Leading Role of the Central Government During the Transition to the Market Economy (New Haven: Yale University Press, 1993), also published as Zhongguo guojia nengli baogao (Hong Kong: Oxford University Press, 1994). The authors toned down this position, however, in The Political Economy of Uneven Development, p. 202. 88Loraine A. West and Christine P.W. Wong, “Equalization Issues,” in Wong, ed., Financing Local Government, p. 286. 89Jae Ho Chung, “Studies of Central-Provincial Relations in the People’s Republic of China,” China Quarterly, vol. 142, June 1995, pp. 487-508. 90Elizabeth J. Remick, Building Local States: China During the Republican and Post-Mao Eras (Cambridge: Harvard University Asia Center, 2004). 91On local state building at the county level, see Remick, “Big Plans and Empty Pockets.”

92Gong Ting and Chen Gong, “Institutional Reorganization and its Impact on Decentralization,” in Hao and Zhimin, eds., Changing Central-Local Relations. 93Huang, Inflation and Investment Controls in China. Cf. Shirk, The Political Logic of Economic Reform in China. 94Following a similar logic, Kaja Sehrt argues that the center’s relative losses in fiscal revenue capacity have been offset by its control over bank lending, licensing and personnel appointments in the formal financial system. Kaja Sehrt, “Banks versus Budgets: Credit Allocation in the People’s Republic of China, 1984-1997,” Ph.D. diss., University of Michigan, 1998. 95Yasheng Huang, “Why China Will Not Collapse,” Foreign Policy, vol. 99, Summer 1995, pp. 54-68; and Dali L. Yang and Houkai Wei, “Rising Sectionalism in China?” Journal of International Affairs, vol. 49, no. 2, Winter 1996, pp. 456-476.

off balance: the unintended consequences of fiscal federalism in china

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