Invited Lecture at Spring Meeting of the Japanese Economic Association on 7 June 2009

Poverty traps with Local Allocation Tax grants in Japan
Takero Doi(Keio University)
http://web.econ.keio.ac.jp/staff/tdoi/
1. Introduction● Economic and fiscal disparities among regions● Local Allocation Tax (LAT) grants from the central government have a function of interregional income
redistribution.
● Defects of the LAT grants¾
Flypaper effect: Nagamine (1995), Doi (1996, 2000)¾
Subsidy effect: Hayashi (2000), Doi and Bessho (2005)¾
Soft budget constraints: Akai, Sato, and Yamashita (2005)
Poverty traps in the Japanese intergovernmental system● Suggestion of the former governor of Tottori prefecture Yoshihiro Katayama(his presentation at the Decentralization Reform Committee on September 18, 2007)
In this paper,●Investigate poverty traps with the LAT grants
Explain the system of the LAT grants
Effects of the LAT grants on economic growth using a simple dynamic model
Implement Granger (non-)causality test with panel data in Japan to confirm poverty traps with theLAT grants
Micro-Allocation Rule of LAT Grants

Gini Coefficients

Calculation for the LAT grants0.22

Special LAT grant

0.2
Shortfall inrevenue source

0.18
0.16

StandardFinancial
Need

0.14
0.12
0.1
1980

Actual general revenue

1985

1990

1995

2000

GDP

Local Taxes

StandardFinancialRevenue

2005
25 percent ofthe estimated tax revenue

Ordinary
LAT grant

Local taxes andlocal transfertax

Retaind tax
revenue

Source: Doi and Ihori (2009)

2. System of Local Allocation Tax grants

Table 1 Calculation of the Standard Financial Need (Outline)_____________________________________________________________________________________________
Police expenses = unit cost of police officer * number of police officers * adjustment coefficient
Education expenses = unit cost of teacher * number of teachers * adjustment coefficient
Public works expenses = …
Agriculture, forestry, and fishery expenses = …
Commerce and industry expenses = …
Debt-service expenses = …
…
_____________________________________________________________________________________________
Sum of the above amount = the Standard Financial Need of this local government_____________________________________________________________________________________________
Note: * means ‘multiplied by’.
Source: Doi and Ihori (2009)1

3. A simple model of poverty traps with LAT grants
3.1 Basic framework
The local government of region i (in a small open economy)
max U i =s.t.

∞ui ( g t )∑ (1 + ρ )
t =1

ρ>0t

(1)

bi ,t = gi ,t + xi ,t + (1 + r )bi ,t −1 − τ L yi ,t − hi ,t(2)

bi,t: outstanding local government debt at the end of period t
hi,t : fiscal transfer from the central governmentτ L: local tax rate (constant over time), yi,t: regional income in period tgi,t: welfare-improving (but unproductive) government consumption
xi,t: productive government investmentr is the interest rate, given exogenously

whereEmploy a Solow-Swan growth model

ki ,t = (1 − δ )ki ,t −1 + si (1 − τ L − τ C ) yi ,tsi > 0, δ > 0(4)

τC: national tax rate for fiscal transfer from the central government. (τ ≡ τ L + τ C)

whereNNi =1i =1∑τ C yi,t = ∑ hi,tProduction function in this region

yi ,t = f i (ki ,t −1 , xi ,t −1 )

(3)

2
2
where ∂yi ,t > 0 , ∂ yi ,t < 0 , ∂yi ,t > 0 , ∂ yi ,t < 0 .

∂ki ,t −1∂ki ,t −12∂xi ,t −1∂xi ,t −12ki,t-1 is capital equipped by private firms at the end of period t –1
The Benchmark case: hi,t is a lump-sum transfer
max (1) subject to (2) and (3)FOCui′( gi ,t ) 1 + ρ=ui′( gi ,t −1 ) 1 + r∂yi ,t3.2

=(5)

1+ r

(6)

∂xi ,t −1 τ L
Effects of the Standard Financial Revenue in the LAT grants

The amount of the (ordinary) LAT grant:

hi ,t = η gi ,t − θτ L yi ,tthe difference between the SFN and the SFR
η > 0, 1>θ > 0(7)Substituting (7) into (2), bi ,t = (1 − η ) gi ,t + xi ,t + (1 + r )bi ,t −1 − (1 − θ )τ L yi ,t(2’)

max (1) subject to (2’) and (3)FOCui′( gi ,t ) 1 + ρ=ui′( gi ,t −1 ) 1 + r∂yi ,t∂xi ,t −1=1+ r
1+ r>(1 − θ )τ L
τL

(8)

The condition for government investment is distorted by the LAT grants (the SFR).
(8) implies the government investment xi,t decreases compared with the benchmark case.
Specify a function form
The production function is assumed to be the following AK function.
yi ,t = Ai ( xi ,t −1 )ki ,t −1
Ai(xi,t-1) is a function of xi,t-1 with Ai’(xi,t-1) >0, and Ai”(xi,t-1) < 0.

ki ,t = (1 − δ )ki ,t −1 + si (1 − τ ) Ai ( xi ,t −1 )ki ,t −1(4’)

The growth rate of capitalki , tki ,t −1= 1 − δ + si (1 − τ ) Ai ( xi ,t −1 )Ai(xi,t-1) decreases due to the LAT grants.

If 1 − δ + si (1 − τ ) Ai ( xi ,t −1 ) < 1 , ki ,t < ki ,t −1 .

Ex. when δ = 0.05, si = 0.1, τ = 0.3, Ai(xi,t-1) = 0.6, 1 − δ + si (1 − τ ) Ai ( xi ,t −1 ) < 1 .

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(8) is replaced by∂yi ,t∂xi ,t −1= Ai′( xi ,t −1 )ki ,t −1 =1+ r(1 − θ )τ Lki,t(8’)

Poverty Trap45°

If ki ,t < ki ,t −1 , Ai′( xi ,t ) > Ai′( xi ,t −1 ) from (8’).
Hence xi ,t < xi ,t −1 under this specification. It implies yi ,t < yi ,t −1 .
In this situation, the steady state of regional income is zero.
That is a kind of poverty traps due to the LAT grants
like the kleptocratic poverty trap, introduced by Azariadis (2006).

3.3

Effects of the Standard Financial Need in the LAT grants

In addition to (7), including compensation for government investment
hi ,t = η g i ,t + ω xi ,t −1 − θτ L yt
η > 0, 1>θ > 0, ω > 0 (7’)
Substituting (7’) into (2),ki,t–1

bi ,t = (1 − η ) gi ,t + xi ,t − ω xi ,t −1 + (1 + r )bi ,t −1 − (1 − θ )τ L yi ,t(2”)

max (1) subject to (2”) and (3).

ui′( gi ,t ) 1 + ρ=ui′( gi ,t −1 ) 1 + r

FOC∂yi ,t∂xi ,t −1=

1+ r − ω(1 − θ )τ L

If ω > (1+r)θ, 1 + r − ω < 1 + r .
(1 − θ )τ L
τL(9)If ω ≤ (1+r)θ, 1 + r − ω ≥ 1 + r .
(1 − θ )τ L
τL

4. Empirical analyses of poverty traps

Confirm whether the LAT grants enhance or deteriorate regional economic growth by using panel data on
the Japanese regional economy and local public finance.

4.1

Panel Granger (non-)causality test

Hurlin and Venet (2004), and Hurlin (2005, 2008)
JJj =1

j =1

Yi ,t = ∑ γ i jYi ,t − j + ∑ β i j X i ,t − j + μi + ε i ,t(10)Analogy from Im, Pesaran, and Shin (2003) to test the unit root hypothesis.
Set the following null hypothesis in (10) (the homogenous non-causality (HNC) hypothesis)∀i = 1, 2, …, N where β = β 1 , β 2 ," , β J ′H0: β = 0ii(iii)

The alternative hypothesis is
H1: βi = 0∀i = 1, 2, …, N1 (N1 < N)βi ≠ 0 ∀i = N1+1, N1+2, …, N
The average of individual Wald statistics to test the HNC hypothesis for individuals, such thatWNHnc,T =1 N
∑Wi,TN i =1where Wi,T denotes the individual Wald statistics for the ith cross section unit associated to the individual test H0: βi = 0.

For a small T sample ( T > 5 + 2J), compute the following approximated standardized statisticZ NHnc
,T =⎤
N (T − 2 J − 5) ⎡ (T − 2 J − 3) Hnc
WN ,T − J ⎥××⎢
2 J (T − J − 3) ⎣ (T − 2 J − 1)⎦dZ NHnc→ N (0,1),T ⎯⎯⎯
N →∞These causality tests are applied in Peltrault and Venet (2005), Bhaduri and Durai (2006), and Suliman(2008).

4.2

Prefectural dataSample period: from fiscal 1990 to 2006, By prefecture
GDP : real prefectural GDP per capita Cabinet Office “Annual Report on Prefectural Accounts.”
LATGP: per capita real LAT grants received by prefectures (deflated by the prefectural GDP deflator)
Ministry of Internal Affairs and Communications “Annual Statistical Report on Local Government Finance.”
LATGT: per capita real LAT grants received by prefectures and municipalities
Population
Ministry of Internal Affairs and Communications “Basic Resident Registers.”
Tokyo, Kanagawa, Aichi, and Osaka prefectures (non-receiving bodies) are excluded.

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4.3

Test results

Unit Root Tests: Im, Pesaran, and Shin (2003)
StatisticP-value
GDP-3.852
0.000
LATGP
-4.0480.000
LATGT-3.076

The panel Granger non-causality test
StatisticP-value
LATGP to GDPZ NHnc
,T

0.001

Z NHnc,TZ NHnc,TZ NHnc,T

Estimate equations based on (10)J

11.2820.000

GDP to LATGP
11.5780.000

LATGT to GDP
14.5210.000

GDP to LATGT
2.191

0.014

JGDPi ,t = ∑ α i j GDPi ,t − j + ∑ β i j LATGX i ,t − j + μiGDP + ε iGDP,tj =1j =1JJj =1j =1

LATGX i ,t = ∑ γ i j GDPi ,t − j + ∑ ζ i j LATGX i ,t − j + μiLATGX+ ε iLATGX,t,t(where LATGX means LATGP or LATGT)

Identify their lag length (Schwarz Information Criterion for Identification)
Estimated coefficients in regression LATGP to GDP

5. Concluding remarks

Examine poverty traps with the LAT grants.
Show that the LAT grants give a disincentive toincrease their estimated tax revenue and regional
income by a theoretical model.
● From the panel Granger (non-)causality tests
proposed, we find that there are poverty traps dueto the LAT grants.
● To break out of poverty traps in the Japaneserural regions, the calculation of the LAT grants
should be revised in future decentralization reform
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20-2-4-6-8-10-12

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