Decentralization and Local Governance in China’s Economic Transition
Justin Yifu Lin
China Center for Economic Research, Peking University
Ran Tao
Institute for Chinese Studies, the University of Oxford
Center for Chinese Agriculture Policy, China Academy of Sciences
Mingxing Liu
School of Government, Peking University
Paper prepared for the conference: The Rise of Local Governments in Developing Countries, London School of Economics, May 2003.
1. Introduction
In any discussion of China’s decentralization and local governance, there are three aspects that deserve special attention. First, China is a large country with five levels of government. Below the central government are 31 provincial level units (42 million population on average), 331 prefecture level units (3.7 million people on average), 2109 counties (580,000 people on average), and 44,741 townships (27,000 people on average). Furthermore, there are about 730, 000 more or less self-governed villages in rural areas below the township level (World Bank, 2002). The multi-level nature of Chinese bureaucracy frequently causes confusion when people talk about decentralization and local governance in China, since the level can range from provincial to village level.
Second, the fact that China is still a transitional economy in a process of marketization makes the existing literature on China’s decentralization somewhat different from the general decentralization literature. Since China used to be a planned economy and most of the economic activities were under center’s control in the plan period, the reforms initiated since the late 1970s can be viewed as a process of delegating more decision-making powers in investment approval, firm entry, revenue mobilization and expenditure responsibilities to lower levels of government and granting more autonomy in production and marketing to state owned enterprises. As a result, much of the literature on China’s decentralization actually dealt with China’s economic transition and liberalization (see Qian and Weingast 1996 as an example), compared to the general literature of decentralization that focuses on the transfer of public functions to lower level governments.
Third, China is still a Party State with all levels of government officials appointed from above by the ruling Communist Party. Unlike many industrializing countries of Africa or Latin America that are often plagued by bureaucracies lacking experiences or organizational capacity, the Chinese bureaucracy is an elaborate network that extends to all levels of society, down to the neighborhood and working unit, exhibiting a high degree of discipline by international perspective (Parish and White, 1978,1984). Within each level there exists an impressive organizational apparatus that could effectively transmit the state policies down to lower level government agencies step-by-step through several layers of government bureaucracy (Oi, 1995). Only in the 1990s, grass-root elections took place extensively at village level, which is not formally a level of government. Therefore, the concepts of “constitutional decentralization” and “political decentralization” do not quite fit in the case of China since neither are there institutionalized rights of local governments in the central decision-making procedures nor are there widely accepted genuine elections at and above the township level.
This paper focuses on a limited number of topics considered essential to understand China’s decentralization and local governance by the authors. Considering the multi-level nature of Chinese bureaucracy, we will focus on the decentralization and governance issues at local level, i.e. county, township and village level, while at the same time strive to illustrateing the structure and evolution of inter-governmental arrangements at higher levels that constitute the institutional background. Since China is still a transitional economy, the Chinese state was deeply, and still is, though to a lesser and lesser extent, involved in some competitive sectors and intervenes into the social and economic lives on many fronts. The decentralization process in China has been accompanied by institutional changes such as granting more power of non-public functions (such as investment approval, entry of non-state firms) to local governments. Given decentralization of non-public functions constitutes an important element in China’s economic transition and in many cases took place simultaneously with decentralization of public functions, both dimensions will be explored. Furthermore, the centralized political system not only have largely shaped the administrative and fiscal decentralization process, but also constitute the basis for understanding major local governance issues in China such as unfunded mandates and farmer’s tax burdens, ineffectiveness in anti-poverty programs to be discussed in the paper.
The paper is structured as follows: in section 2, we review the centralization-decentralization cycles in the plan period before 1978 and the logic for such cycles. In section 3, a discussion of administrative and fiscal decentralization in China’s market-oriented reforms since the late 1970s and their impacts on economic growth, spatial inequality and poverty reduction are presented. In section 4, we describe the recentralization since 1994 and analyze how it affected local public finance and public goods provision. Based on analyses of China’s inter-governmental fiscal and political arrangement, section 5 further explores two major local governance issues in China, i.e., un-funded mandates and ineffectiveness in anti-poverty. Part VI concludes.
2 Centralization-Decentralization Cycle In the Plan Period
The founding of the People’s Republic of China in 1949 marked a new era of the Chinese history. The ambitious government leaders then believed that to defend the new socialist system, and to keep pace and even overtake western industrial countries, rapid industrial development, especially the establishment of a complete set of heavy industries was essential. Learning mainly from the Soviet experiences, the Chinese government began to formulate and implement the First Five-year Plan that gave priority to heavy industrial development since 1953.
However, development of capital-intensive industries would have been extremely costly if free market were allowed to operate in a capital-scarce economy. To mobilize resources for such a heavy industrialization, a plan system was established, which was characterized by a trinity of a macro-policy environment of distorted prices for products and essential factors of production (e.g. trained personnel, funds, technologies, resources, etc.), highly centralized planned resource allocation and a micro-management mechanism in which firms and farmers had no decision-making power (Lin et al, 2003).[i] For instance, the People’s Commune system was set up in the rural areas in the late 1950s to guarantee state monopoly of grain procurement. Besides supplying grain at depressed prices, the communes and production brigades were also responsible for mobilizing financial and human resources for local public goods provisions, such as water conservancy construction by organizing compulsory labor services of farmers.
Under the plan system, a heavily centralized fiscal system was established. Not only the accounting systems of SOEs were directly incorporated into government budget, but also major resources were controlled by the center. The State Planning Commission commanded the authority in determining local revenue and expenditure plans on an annual basis, known as "unified revenue and unified expenditure" (tongshou tongzhi). Local governments (at province, prefecture, county level and commune level) did not have independent budgets.[ii] As to expenditure assignment, the central government was responsible for national defense, economic development (capital spending, R&D, universities and research institutes), industrial policy, and administration of national institutions such as the judicial system. Responsibilities for delivering day-to-day public administration and social services such as education (except universities), public safety, health care, social security, housing, and other local/urban services was delegated to local governments.
However, in a country of the size like China, the working loads to formulate, administrate, coordinate, and monitor the central plans were extremely heavy and became more and more so as the economic system became larger and more complicated. For example, the number of state owned enterprises(SOEs) subordinated to the central government increased from 2,800 in 1953 to 9,300 in 1957, and the number of items in material allocation under central planning increased from 55 in 1952 to 231 in 1957(Qian and Weingast 1996). The classical problem of control and monitoring under information asymmetry emerged soon after the planned system was set up. As the economy grew larger with more projects initiated and enterprises started, the plan system became increasingly unmanageable. To make things worse, a highly centralized planned system inevitably undermined the incentives of local governments when local coordination in industrial development was essential.
Under this background, China initiated its first decentralization within the planned framework by delegating more powers to local governments in 1957. The policies then included: (1) delegating nearly all SOEs to local governments, such that the share of industrial output by the enterprises subordinated to the central government shrank from 40 percent to 14 percent of the national total; (2) central planning was to change from a national to a provincial basis, with decisions about fixed investment to be made by local governments rather than the central government; (3) revenue sharing schemes were fixed for five years and local governments were granted some authority over taxes. The share of central revenue decreased from 75 percent to around 50 percent within 2 years.
Indeed, local incentives responded quickly to decentralization. Local small industries such as backyard steel mills and coal mines boomed in this period. This program, however, did not succeed because of serious coordination failures caused by the radical decentralization. The soft budget constraint faced by local governments and SOEs soon led to excessive investment expansion and inefficient interregional duplication of production. Recentralization had to begin in 1959 in which all large and medium-sized industrial enterprises were again subordinated to the center. However, the centralization again brought about the incentive problem and economic stagnation in the 1960s, thus a second wave of decentralization followed in the early 1970s when local governments gained more authority over fixed investment and local revenue. Afterwards, a similar, but less serious investment boom led to yet another round of recentralization in the mid-1970s.
In retrospect, it is easy to see that the decentralization under a plan system was not able to alleviate the inefficiency problem since it could neither improve micro-efficiency through market discipline, not could it change the heavy industry development strategy inconsistent with China’s comparative advantage. Under the soft-budget constraints faced by local government and SOEs, a cycle of “ decentralization leads to disorder; disorder leads to centralization; centralization leads to stagnation; stagnation leads to decentralization” was inevitable.
3 Decentralization under Market-Oriented Reforms: 1978-1993
Low efficiency in the plan system was considered as a serious problem as early as the 1950s before the first round decentralization was initiated(Mao,1956). However, it was not until 1978 that some fundamental reforms were undertaken. What was evident to the policy makers in the late 1970s was the correlation between production inefficiency of enterprises and People’s Communes and lack of stimulus for workers and farmers. That explains why the reforms began with the micro-management system in the late 1970s in an attempt to improve work incentives. In rural areas, the Household Responsibility System (HRS) emerged in 1978. In just a few years, the system became a dominant form of microeconomic organizations in rural areas. In cities, reforms on SOEs were initiated in the early 1980s, centering on power delegation and profit sharing. Such reforms rendered rural households and SOEs de facto residual claimers of their production and thus greatly promoted work incentives.
3.1 Administrative and Fiscal Decentralization
Accompanying the micro-reforms in rural areas and SOEs was a process of administrative and fiscal decentralization, which was deemed necessary in a large country like China to induce local coordination in market-oriented reforms.
Administrative Decentralization.
From the administrative perspective, the reform period witnessed a significant strengthening of local governments’ role in local economic management, such as investment approval, entry regulation and resource allocation. A particularly striking example is the opening up policy initiated in coastal regions. Starting from 1979, many provinces were allowed to set up their own foreign trade corporations. From then on, regional experimentation of opening up began, which includes the “one step ahead ”policies implemented in Guangdong and Fujian in 1978, the establishment of four special economic zones (Shenzhen, Zhuhai, and Shantou, and Xiamen) in 1980, declaring 14 coastal cities as "coastal open cities” in 1984. Not only did these areas enjoy lower tax rates and higher share of revenues, but also, and perhaps more important, they enjoyed special institutional and policy environments and gained more authority over local economic development and the establishment of special economic zones and economic development zones.
Another dimension of administrative decentralization was delegating more state-owned enterprises to local governments at the provincial, municipality and county levels since the early 1980s. By 1985, the state-owned industrial enterprises controlled by the center accounted for only 20 percent of the total industrial output at or above the township level, while provincial and municipality governments controlled 45 percent and county governments 35 percent (Qian and Xu, 1993). With ownership shift from central to local, local governments were provided with incentives in taxes and profits to step up their effort in revenue collection. At the same time, the spending of the fixed investment for local-government-owned-enterprises naturally fell on the shoulders of local government. Since SOEs had provided a wide ranger of social services like education, health care, pension services to their employees, more local ownership implied local governments’ primary and final responsibilities for these expenditures.
Fiscal Decentralization.
The fiscal dimension of decentralization was no less dramatic. In 1980, inter-governmental fiscal system shifted from a "unified revenue and unified expenditure" into a "cooking in separate kitchens”(fenzhao chifan) that divided revenue and expenditure responsibilities between the centerl and the provincial governments.[iii] After that, the central-provincial fiscal arrangement experienced some further changes, i.e., the proportional sharing system in 1982 and the fiscal contracting system in 1988.In the 1988 fiscal contracting system, the center negotiated different contracts with each province on revenue remittances to the center, and permitted most provincial governments to retain the bulk of new revenues. There were six basic types of sharing schemes in 1988 and they continued through 1993 (Bahl and Wallich, 1992). Besides a fixed subsidies from the center (in 14 provinces), fixed quota delivery to the center (in 3 provinces), fixed sharing with the center(in 3 provinces), quota delivery with a pre-specified growth(in 2 provinces), other provinces adopted either an incremental sharing(a certain share is retained locally up to a quota and then a higher share is retained in excess of the quota in 3 provinces), or sharing up to a limit with growth adjustment (10 provinces retained a share within a specific percentage of revenue from the previous year and then retain all revenues above that quota).