A Study on the Efficacy of Fiscal Spending: Analyzing from Perspectives of Fiscal Decentralization, Hand-to-Mouth Consumers and Interregional Expenditure


Student thesis: Doctoral Thesis

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Award date6 Jul 2021


China is experiencing decentralization reforms in recent years. One of their aims is to improve the fiscal efficacy. Fiscal decentralization (FD) affects fiscal efficacy due to many reasons, among which two are important. First, either central or local fiscal policies may have stronger inter-personal redistribution effects. Second, intergovernmental transfers may lead to distortion. For the first reason, inter-personal redistribution gives more liquidity to the poor, who are generally liquidity constrained. The liquidity-constrained households have a higher marginal propensity to consume (MPC) than average. Accordingly, fiscal stimuli would be more effective if they have stronger inter-personal redistribution effects. However, the poor may also be subject to saving constraints, leading to a lower-than-average MPC. Together, liquidity and saving constraints make the nexus between inter-personal redistribution and fiscal efficacy ambiguous. For the second reason, intergovernmental transfers lead to the "common-pool problem" and hence less effective fiscal policies. The ineffectiveness may be spilled over into neighboring jurisdictions. Limited research sheds light on this topic in the context of China and it yields inconsistent results.

Against this backdrop, the thesis addresses three issues: (I) whether FD enhances fiscal efficacy; (II) whether fiscal stimuli targeting the low-income group yields higher efficacy; (III) the magnitude of interregional fiscal spillovers in China. Researching these issues offers new insights into factors affecting fiscal efficacy, and gives unambiguous suggestions to the decentralization reforms. Four innovations (contributions) of the thesis and associated findings are introduced below.

First, the research induces fiscal decentralization into factors that may affect fiscal multipliers, offering new options for policymakers to improve fiscal efficacy. Also, the research reconciles the dispute on the nexus between FD and fiscal efficacy and offers unambiguous policy suggestions.

Previous literature focuses on the nexus between FD and economic growth, while little is known about the nexus between FD and fiscal efficacy. Examining the latter is important since it gives new insights into the decentralization reforms in China. The results of the thesis show that fiscal expenditure decentralization decreases fiscal efficacy, while fiscal revenue decentralization increases fiscal efficacy. Moreover, the divergence of fiscal expenditure and revenue decentralization decreases fiscal efficacy. The opposite effects of fiscal expenditure and revenue decentralization are due to the distortion induced by central-local transfers. The FD divergence to some extent captures the distortion, which has unambiguous effects on fiscal efficacy.

Second, the research reconciles the mixed results on the HtM – multiplier nexus based on theories of liquidity and saving constraints. Also, the research adds to understandings of the heterogeneous effects of wealthy and poor HtM households on fiscal spending and tax multipliers.

The liquidity-constraint theory argues that liquidity constraints may increase the MPC of households, while the saving-constraint theory argues that saving constraints may attenuate the MPC of households. Households with higher-than-average MPC are deemed to respond stronger to income increase induced by fiscal shocks, leading to higher fiscal efficacy. Hand-to-Mouth (HtM) households are subject to both of the two types of constraints, leading to their ambiguous effects on fiscal efficacy. By classifying HtM consumers per their consumption levels, the research shows that the HtM consumers have unambiguous but heterogeneous effects on fiscal efficacy across the classifications. Specifically, Type-I consumers (under liquidity constraints) have substantial effects on fiscal efficacy, while type-II (under liquidity, saving, and credit constraints) have none since the effects of the constraints cancel out. Also, the research shows that wealthy HtM consumers have more prominent effects on tax multipliers while poor HtM consumers have more prominent effects on spending multipliers. This adds to understandings of the nexus between HtM households and fiscal efficacy, rather than merely indicating a positive or negative relationship.

Third, the research adds fresh county-level evidence to the literature on fiscal spillovers in China, which to some extent reconciles the disputes on the sign and the magnitude of fiscal spillovers in literature. Also, the research detects spillovers via different transfer channels. Finally, by constructing the compatibility index, the research makes the fiscal spillover effect comparable across different research contexts.

Literature on fiscal spillovers mainly focuses on the United States and European countries. A limited number of papers focus on interregional fiscal spillovers in China but get inconsistent results. The research here finds positive county-level fiscal spillovers in China, adding to understandings of interregional fiscal spillovers in China. Also, the research interprets the difference in the magnitude of fiscal spillovers at provincial, city, and county levels from two perspectives: the degree of fiscal coordination and the degree of balance in economic development. Moreover, the research examines fiscal spillovers via different transfer channels – namely, the trade channel, the capital-flow channel, and the employment channel. Finally, I construct a compatibility index to compare the degree of fiscal compatibility across different research contexts.

Fourth, by extending the classical model in literature, the research justifies that the divergence of revenue and expenditure decentralization indicates the efficiency of resource allocation among governments, and hence affects fiscal efficacy. Policymakers could follow this logic to detect more factors in improving fiscal efficacy.

Literature indicates that the relationship between FD and fiscal efficacy is an inverted-U-shaped curve. The research here further shows that the inverted-U-shaped curve also captures the nexus of FD and fiscal efficacy. Moreover, the theory of the thesis shows that fiscal expenditure decentralization and fiscal revenue decentralization are the optimal solutions to one another when optimizing fiscal efficacy. This is because, by matching fiscal expenditure and revenue decentralization, more resources are allocated to the most efficient public sectors.

    Research areas

  • Fiscal efficacy, Fiscal decentralization, Hand-to-Mouth consumers, Fiscal spillovers, Local Projection