The trade-off between risk and incentives in fiscal federalism: Evidence from China

Bingyang Lyu, Guangrong Ma and Jingnan Zhan

Journal of Comparative Economics, 2022, vol. 50, issue 4, 1019-1035

Abstract: A central argument of the second-generation fiscal federalism literature is that allocating a considerable share of tax revenue to local governments can provide fiscal incentives for local officials to promote economic growth. However, increasing incentives will increase the costs of uncertainty if local government officials are risk averse. Building on the insights of the classic principal-agent models, we predict that the optimal share of tax revenues retained by local government will decrease as the uncertainty of total tax revenues increases. Using Chinese provincial data, we find a robust negative relationship between volatility and the tax-sharing ratio at the sub-provincial level. Our results indicate that optimal decentralization in developing countries balances the trade-off between risk and incentives.

Keywords: Risk; Incentives; Fiscal federalism (search for similar items in EconPapers)
JEL-codes: H71 R51 (search for similar items in EconPapers)
Date: 2022
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Citations: View citations in EconPapers (1)

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Persistent link: https://EconPapers.repec.org/RePEc:eee:jcecon:v:50:y:2022:i:4:p:1019-1035

DOI: 10.1016/j.jce.2022.05.004

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