ABSTRACT

Starting from a poor, planning, nearly bankrupt economy in the late 1970s, China has emerged as a world economic superpower over the past three decades. China's economic miracle has profoundly challenged the conventional wisdom that property rights protection, an independent legal system, and a democratic government with checks and balances are requisite to support long-term growth. By international standards, China has a low ranking in the supply of all these institutional fundamentals. However, the sustainability of China's high economic growth has been threatened by a host of attendant problems and challenges, including environmental pollution, alarming income inequality and regional disparity, under-funded social security, and bureaucratic corruption. This book analyzes the institutional sources of China's high and sustained economic growth, as well as its downsides, using a unified conceptual framework focused on the incentives of local officials and government governance.

As an introduction to the entire book, Chapter 1 links the puzzle of China's growth miracle with the critical and positive role played by China's local governments. It elaborates on the special status of local governments in the Chinese political system and their unique contributions to China's economic reforms and development. In line with the literature's clarion call for“getting incentives right”in addition to“getting prices right”, Chapter 1 highlights the importance of“getting government incentives right”in understanding China's miraculous catch-up over the past three decades.

Our analysis of Chinese local governments is based upon two important theoretical concepts. One is administrative subcontracting, which will be addressed in Chapter 2, and the other is political tournament, which will be discussed in Chapter 5. Chapter 2 demonstrates the value and significance of administrative subcontracting in characterizing China's intergovernmental relations and their evolution from ancient times. Instead of adopting a Weberian bureaucracy, Chinese intergovernmental relations have long followed a top-down subcontracting practice: the central government subcontracts virtually all administrative functions and public services to the intermediate subordinate government, and the latter further subcontracts all of these functions and services down to the next level of government, all the way down to the bottom-level local governments, such as counties or townships. By so doing, the central government specializes in major decision-making and monitoring and saves itself from routine micromanagement, and the middle-level local governments are mainly monitors of the lower-level governments. The lowest-level governments(counties and townships) are responsible for providing all essential public goods, no matter whether they are national or local in nature. In stark contrast with Weberian bureaucracy, administrative subcontracting features the de facto power of subcontractors(i.e. lower-level governments), fiscal or budget subcontracting with significant self-finance, and outcome-oriented evaluations. Chapter 2 examines in detail how the practices of“sequential administrative subcontracting”and“territory management”were established and developed in ancient times and later evolved in the era of the People's Republic of China, ranging from the planned economy regime to the post-reform regime. Some fundamental shifts in the traditional system occurred until the late 1990s in order to correct serious problems created by administrative subcontracting. We also discuss some determinants of the scope and extent of administrative subcontracting, highlighting the important role of monitoring costs, fiscal constraints, and governance risks. Finally we strive to establish administrative subcontracting as an ideal type differentiated from administrative decentralization, M-form organization, and government outsourcing.

Chapter 3 provides a historical overview of the successive waves of decentralization since 1958 and in particular the devolution of central authority since the beginning of economic reforms. This chapter seeks to describe and analyze the evolution of sequential administrative subcontracting and territorial management over the history of the People's Republic of China. Even during the planned economy regime, China maintained a much more decentralized economy than the Soviet model. Moreover, local governments played very important roles in economic planning and materials distribution, thanks to conscious and persistent efforts by Mao Zedong to weaken the control of the central ministries and empower local leaders. Since the advent of economic reforms in the late 1970s, China's decentralization has gone much further but featured a gradualist approach that started with freeing coastal areas from central control. Chapter 3 explores in detail the reasons why both Mao Zedong and Deng Xiaoping favored regional decentralization even though their economic regimes were so different, and why these reforms fared so differently in terms of their economic performances. It also elaborates on some recent developments in central-local relations and their implications, such as the vertical centralization of banking, taxation, and customs at the central level and of product quality regulation, land management, and other issues at the provincial level.

Chapter 4 focuses on the evolution of central-local fiscal sharing since 1949 and its underlying logic. In contrast to the common perception, China's central-local fiscal relations in the pre-reform period displayed a significant degree of fiscal decentralization and subcontracting. Fiscal subcontracting refers to a fiscal sharing relation whereby a higher-level government certifies and fixes the expenditure obligations of lower-level governments, and if these lower-level governments can generate more revenues than the certified budgetary expenditures, then they can keep the remainder or a large proportion of it. The popularity of fiscal subcontracting between governments at different levels in a centralized planning regime can be understood by the necessity to support top-down administrative subcontracting arrangements, and to incentivize local governments to generate revenue and minimize expenditures. The fiscal contracting reforms started in the early 1980s represented an important extension of previous fiscal subcontracting relations in the planning regime. Under the new fiscal contracting system, local governments essentially became residual claimants of locally-generated revenues, and they gained increased autonomy over budgetary expenditures. While tax-sharing reforms initiated in 1994 substantially increased the center's fiscal authority, China's intergovernmental fiscal relations still maintained some basic features of traditional fiscal sharing, especially at subnational levels. Chapter 4 also discusses the role of extra-budgetary funds in China's local public finance as well as the current situation of intergovernmental fiscal relations at subnational levels.

Chapter 5 outlines an important governance mechanism deeply rooted in China's traditional political system—“political tournaments”, that is, competition among same-ranked local leaders in different regions for promotion to a position of higher rank. China's miraculous economic take-off occurred when promotion tournaments shifted their focus from political loyalty-based competition during the Mao era to economic-performance-based competition during the Deng era. Chapter 5 lists several preconditions which make China particularly suitable for applying growth performance-based promotion tournaments as an incentive scheme, such as: the centralized personnel control system, the lock-in effect in local officials careers, the M-form organization of the economy, and the multiple layers of territorial administration. It discusses the transition in political tournaments from the Mao regime to the Deng regime in detail. The performance-based promotion tournaments provide a vital ingredient for China's growth miracle. We also discuss the limitations of political tournaments as an incentive system when promotion becomes very difficult for most bureaucrats, especially at the lower levels of the administrative hierarchy. The last section explores the implications of a tale of dual markets created by performance-based tournaments, namely the interaction and bundling between political markets for local leaders and commercial markets for firms. Given promotion tournaments, market competition among firms located in various jurisdictions affects the economic performance of local leaders, while political competition among local leaders affects their efforts to support local firms in their jurisdictions to win in market competition.

Chapters 6—8 extend the analysis of the“dual markets model”proposed in Chapter 5 to reveal the political economy logic of China's economic growth model. Chapter 6 looks at the interaction between politics and markets, Chinese style. We document the interesting phenomenon of“top-down acceleration of growth targets”appearing in China's five-year plans at both central and local levels over the past three decades. We then link this phenomenon to the simultaneous promotion tournaments at different hierarchical levels. Chapter 6 also analyzes several other interesting issues. First, it examines the incentives of local leaders in a dynamic tournament setting, where an interim ranking of GDP growth across rival regions affects the incentive of local leaders to promote the current year's GDP growth. Second, we present evidence on the presence of a political business cycle in China and find statistically significant correlations between local leaders' age and investment growth, and between local Party congresses and resource misallocation in manufacturing. Finally, we find that city leaders' age significantly affects bank lending growth and performance; the peak of this effect appears between the ages of 54 and 55 when city leaders are close to the termination of their authority.

Chapter 7 analyzes the impact of local officials' promotion incentives on interregional competition and cooperation. There is a great deal of evidence pointing to the prolonged presence of local protectionism, duplicative investments in infrastructure and key manufacturing industries, and excessive competition in attracting FDI and many other areas. The mainstream interpretation of these phenomena in interregional interactions emphasizes the fiscal incentives of local governments to protect or expand local tax bases. However, this explanation fails to capture the essence of these phenomena: why are local leaders unable to sit down and reach an agreement to gain more from trade and cooperation? The failure of political cooperation among local leaders can be better understood by their promotion incentives: there is little benefit from cooperation but much to potentially gain through competition in a zero-sum promotion game. Moreover, the tremendous difficulty of compensating losers in the political arena makes ex ante cooperative agreement virtually impossible. Chapter 7 applies this perspective to explain why so much poverty and cross-border pollution occur among the border regions in China. The massive poverty in the border regions is not a geographical phenomenon, but a result of coordination failure among local leaders in the border regions. Local leaders who are in competition for promotion fear that if their part of the border region is developed, then there will be positive spillovers to the neighboring regions whose leaders are their political rivals. This analysis provides a political economy interpretation of China's widening regional disparity over the past several decades.

Chapter 8 examines the evolution of the local government-business relationship over time. It first describes the evolving nature of the relationship between local governments and state-owned enterprises(SOEs), explaining how the subcontracting relationship between local governments and SOEs affected the path and outcomes of SOE reforms. Then it turns to explore the role of local governments in the rise and fall of township and village enterprises(TVEs). The positive role of township and village leaders in the rise of TVEs offers a canonical example of how local governments can be a helping hand to the local economy under certain conditions. As most SOEs and TVEs were privatized, the local government-business relationship entered into a new era where local governments foster strategic coalitions with private firms and joint-ventures, and local leaders and businesspeople shake hands and gain from trade to improve economic performance and profits, ultimately enhancing local leaders' chances of winning in growth-based promotion tournaments.

Chapter 9 synthesizes the theoretical constructs developed in previous chapters, administrative subcontracting and political tournaments, into a unified theoretical framework. These two institutional arrangements are complementary and mutually supporting, creating de facto regional decentralization in a system of central control, strong fiscal incentives, and career concerns for local officials. This analytical framework is used to explain the centralization-decentralization paradox in China's central-local relations. The success of China's economic reforms and development derives from the construction of a new Chinese style of local government governance, which is rooted in traditional political institutions dating back to ancient times. Top Chinese leaders, especially Deng Xiaoping, geared Chinese reforms towards activating and enabling the traditional elements of China's government governance. Since the late 1970s, state authority has devolved gradually into the hands of local governments. A system of“fiscal-sharing contracts”between the central and provincial governments were implemented and continuously revised over time. The criterion for official promotion has shifted from political loyalty during the Mao regime to local economic growth since the Deng regime. As a result, Chinese local leaders have to compete for improved economic performance in order to get a better chance of promotion than their political rivals. All of these reforms empowered local officials with authority, discretion, and fiscal resources, motivating them to seek all possible ways to boost local economies in order to secure promotion. However, current government governance has its own weakness and is responsible for local governments' soft budget constraint, bureaucratic corruption, and localism in legal enforcement. The last section of this chapter discusses the strengths and weaknesses of China's state capacity from the perspective of the complementarity between administrative subcontracting and promotion tournaments.

The book's final chapter discusses the ongoing governance transition of China's local governments. China's time-honored government governance structure is facing serious challenges and undergoing profound changes. For instance, the territorially-based administrative subcontracting system gave local governments too much authority to protect their own interests at the expense of national interests and has led to regional segmentation of national public goods provision, such as local market protectionism and localization of social security, law enforcement, and other public services suitable for central provision. Growth-based promotion tournaments have caused distorted incentives for local officials to damage natural environments and under-supply public services that are in high demand. China's traditional government governance is seriously constrained by the costs of collecting information about local officials' behavior, since a politically centralized regime only allows for vertical, hierarchical monitoring and disables the monitoring of local governments by citizens, independent media, and checks and balances from the legislature and judicial systems. China is now moving towards the rule of law, increasing the voices of public media, people's congresses and political consultative conferences in local governments, and experiments in elections and political campaigns within the Chinese Communist Party. As the information constraint facing the central government is relaxed, we observe an interesting shift in China's government governance from traditional administrative subcontracting, which stresses de facto decentralization and market-oriented incentives, towards Weberian bureaucracy, which emphasizes accountability, procedural justice, rule of law, and centralization of authority and budgetary control. This movement is in stark contrast with the“New Public Management”movement, which calls for a shift from Weberian bureaucracy to the market-incentive-based contracting system. How China's new governance will balance the trade-off between accountability and local officials' incentives remains to be seen.

The appendix provides theoretical background for the economic analysis in the book. It briefly reviews the economic theories of incentives, organizations and governance, and their applications in government organizations. It also introduces and discusses the theories of decentralization, fiscal federalism and political tournaments. These theoretical constructs both inspire and enable our analysis in this book.