_III.2. Empirical Evidence of Fiscal Interactions between Local Governments_

**Fiscal competition and public spending pattern in China.** China is considered to be the archetypal country for “market preserving federalism” (Weingast 2006). Administrative and fiscal decentralization in the 1980s led to the formation of local political interests and to a certain degree of regional and local autonomy with hard budget constraints for local governments (Herrmann-Pillath and Xingyuan Feng 2004). _De facto_ both tax rates and tax bases are kept under the central government control (local and upper-level of government share fiscal revenue according to a predetermined formula). However, fiscal decentralization has created scope for inter-provincial competition as local officials are appointed and assessed by higher levels of government on their ability to foster economic development (Zhang and Chen 2007). Fiscal competition across provinces takes the form of a bundle of preferential tax regime and (more recently) business-oriented public expenditure. To some extent, this is in line with a Tiebout-type “voting with your feet” hypothesis applied to business location. Businesses vote with their feet by locating in a particular province while  the mobility of individuals is restricted.

Zhang and Chen (2007) check whether fiscal competition has led to a distorted pattern of provincial public expenditure in favor of infrastructure and other productive public input at the expense of other public goods such as recreational facilities or health care (as discussed in Keen and Marchand 1997). Zhang and Chen consider a sample of 30 provinces and cities that they divide into four categories based on an index of public goods provision and a measure of provincial tax burden. They use provincial level panel data for the period 1995-2003 to analyze the impact of regional infrastructure level, public services, health care, tax burden and labour costs on the share of provincial FDI. They find that the share of FDI in a given province is negatively correlated with the level of public services, the tax burden and health care but positively related to infrastructure development.<sup>18</sup> This may suggest that tax competition has changed the pattern of provincial public expenditures in favor of infrastructure expenditures. Zhang and Chen argue that it is mainly due to the way local official are evaluated and to the fact that individuals’ mobility restrictions prevent individuals from “voting with their feet.” Zhang and Chen also show that fiscal competition among provincial governments has been shifting from tax preferential incentives to competition to improve public infrastructure.

There is a huge discrepancy in terms of size and endowments between Chinese provinces. This is likely to have an influence on fiscal setting as suggested by the theoretical literature. Yao and Zhang (2008) use panel data on 2094 rural counties and county-level municipalities for 1993 to 2005. They include as endowments the level of economic development, stock of capital, natural resource endowment and labour skills. They find that ( _i_ ) there is strong evidence for spatial clustering of tax rates for some regions and weak (or null) evidence in others; ( _ii_ ) Tax reduction is more effective to attract investment in coastal provinces than in inland regions; ( _iii_ ) in 1994-2002, a cluster of rich counties competed with each other in cutting their tax rates (“race to the bottom”) while a cluster of poor counties facing much tighter budget constraints than rich counties were engaged in a “race to the top” with their neighbors. As underlined by Yao and Zhang, poor countries may have been involved in predatory tax practices against the industrial and business sectors (in line with Cai and Treisman 2005).

> 18 The tax burden is measured as the ratio between business-based regional fiscal revenue and non agricultural regional GDP (as a proxy of the tax base).

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