@Incentive to provide local public goods, fiscal

JournalofPublicEconomics76(2000)337–368:fiscalfederalism,Russianstylea,b,*EkaterinaV.ZhuravskayaaRussianEuropeanCenterforEconomicPolicy,PotapovskyPereulok5,building4,101000Moscow,RussiabStockholmInstituteforTransitionEconomics,Stockholm,SwedenAbstractBasedonauniquedatasetonRussiancitybudgets,thispapershowsthatrevenuesharingbetweenregionalandlocalgovernmentsprovideslocalgovernmentswithnoincentivetoincreasetaxbaseorprovidepublicgoods.Anychangeinlocalgovernment’sownrevenuesisalmostentirelyoffsetbychangesinsharedrevenues.Thisleadstogovernmentalover-regulationofprivatebusinesses.Itisshownthatfiscalincentivesareadeterminantoftheformationofprivatebusinessandtheefficiencyofpublicgoodsprovision.TheRussianfederalismiscomparedtotheChinesefederalism,wherefiscalincentivesreputedlyarestrongerinmanyprovinces.2000ElsevierScienceS.A.Allrightsreserved.Keywords:Federalism;Russia;Localgovernment;TransitionJELclassification:H11;H41;H71;O57;P351.IntroductionTheperformanceoftheRussianeconomystandsinstrikingcontrasttotheperformanceofseveralothercountriesinEasternEuropeandAsiathathavealsoundertakeneconomicreforms.RealRussianGDPhadbeendecliningfor8years1andstabilizedin1997forashortperiodoftime,whereasPolandandChina,for*Tel.:[phone];fax:[phone].E-mailaddress:[e-mail](E.V.Zhuravskaya)1Source:RussianEconomicTrends(1998).0047-2727/00/$–seefrontmatter2000ElsevierScienceS.A.Allrightsreserved.PII:S0047-2727(99)00090-0338E.V.Zhuravskaya/JournalofPublicEconomics76(2000)337–368example,havebenefitedfromcontinuedhighgrowth.Thispaperarguesthatinefficientinter-governmentalrelationsareapossiblyimportantreasonwhyRussialagsbehindothercountriesineconomicgrowth.Inparticular,thispaperprovidesevidencethatthestructureofrevenuesharingbetweenregionalandlocalgovernmentsaffectsgovernments’incentivestofosterbusinessgrowthandtoprovidepublicgoodsefficiently.IuseauniquedatasetonRussiancitybudgetstoshowthatanychangeinalocalgovernment’sownrevenuesisalmostentirelyoffsetbyanoppositechangeinsharedrevenues.Localgovernmentsareunabletobenefitfromanincreaseinthelocaltaxbase,andthereforelackarevenueincentivetoexpandthetaxbase.Whataretheconsequencesofthemagnitudeoffiscalincentives?Ibuildasimplemodeltoillustratethatiffiscalincentivesarestrong,i.e.ifanincreaseinthelocaltaxbaseresultsinanearlyequalincreaseinbudgetaryrevenues,thengovernmentsbearfinancialcostsintermsofforegonetaxeswhentheyover-regulateorrestrictbusiness.Incontrast,iffiscalincentivesareweaksothatthelocalgovernment’sabilitytoincreaseitsmarginalrevenuebyincreasingitstaxbaseisclosetozero,thenbudgetrevenuesarenotaffectedbychangesingovernmentalpolicytowardsbusiness.Economicallyunjustifiedpoliticalinterventionintobusiness,suchasexcessiveregulation,adverselyinfluencesentrepreneurialactivityandlowersthe2governmentaltaxbase.Inasystemwithstrongerlocalfiscalincentives,oneshouldobservemorebenignregulation,andhighergrowthcomparedtoasystemwithweakerfiscalincentives.Inaddition,strongerfiscalincentivesshouldleadtohigherefficiencyinprovisionofpublicgoods,becauseasmallerportionofpublicexpendituresiswasted.HavingshownthatfiscalincentivesareweakinRussiaonaverage,Iempiricallyexaminetheirconsequences.Firstly,Iprovidesomeevidencethatthestrengthoffiscalincentivesaffectsprivatebusinessformation.Secondly,Ishowthattheefficiencyofpublicspendingatthelocallevelincreaseswithlocalfiscalincentives.ForeachcityandyearIgaugestrengthoffiscalincentivesbyabinomialindicatorofthepresence(orabsence)ofcrowding-outofchangesinownrevenuesbychangesinsharedrevenues.Ithenestimatehowthevariationinthestrengthoffiscalincentiveshelpstopredictvariationinoutcomesofpublicgoodsprovisionandformationofprivatebusinesses.3Myapproachrestsonthetheoryof‘market-preservingfederalism’.Thisliteraturestressestheimportanceofthegovernmentofficials’fiscalandpoliticalincentivesforeconomicgrowth.Contributorstothisliterature(e.g.Oi,1992,1994;Montinolaetal.,1995;QianandWeingast,1996,1997;Jinetal.,1999)arguethattheChinesefiscalreformoftheearly1980suntil1994gavelocalgovernmentsincentivestopursuelocaleconomicgrowthandpossiblycreateda2SeeBoyckoetal.(1995)andJohnsonetal.(1997).3Forasurveyofthisliterature,seeQianandWeingast(1997).E.V.Zhuravskaya/JournalofPublicEconomics76(2000)337–3683394basisforChina’sremarkableeconomicperformance.‘Theimportanceofthesenewfiscalarrangements[inChina]isthattheyinduceastrongpositiverelationshipbetweenlocalrevenueandlocaleconomicprosperityforallprovinces5andcities,thusprovidinglocalofficialswithincentivetofosterthatprosperity’.OtherworkonChinesefiscalrelations,however,hasshownthatsuchastrongrelationshipbetweeneconomicperformanceofalocalityandlocalbudgetrevenue6existedonlyincertainpartsofChinaandnotinothers.ThemainresultofthispapercontrastswiththeliteratureonChinesefederalismbecauseitshowsthatthesystemofintergovernmentalrelationsinRussiarepresentsamodelthatdeservestobecalled‘market-hamperingfederalism’sincelocalrevenuesareindependentof7localeconomicprosperity.Shleifer(1997)arguesthattheeconomicd