The Fiscal-Administrative Integration: Institutional Reform of Local Governments and Economic Inequality

【Authors】

YANG Jusheng，LAN Yuxiao & LIANG Fengbo

【WorkUnit】

【Abstract】

Economic inequality not only hampers wealth accumulation but also undermines social justice, democratic governance, and overall societal welfare. Governments worldwide have adopted various policies to address inequality, with fiscal policy playing a pivotal role. In China, however, a paradox persists within its fiscal system: despite sustained annual growth in fiscal transfers （average 9.2% from 2003 to 2020）, the national Gini coefficient has remained stubbornly high （0.46-0.48）. This paper investigates this puzzle through the lens of the Province-Managing-County （PMC） reform—China’s largest decentralization effort since 1949, implemented across 24 provinces covering 54% of counties. The PMC reform uniquely combines fiscal decentralization and administrative flattening, offering a natural experiment to examine how fiscal incentives and administrative constraints jointly shape inequality outcomes.
To overcome inherent inaccuracies in traditional Gini coefficient measurement, we introduced an innovative county-level inequality estimation method using multi-source satellite remote sensing data. Specifically, we developed a dual-validation model combining nighttime luminosity （NASA-VIIRS and DMSP-OLS data） with electricity consumption metrics, calibrated against WorldPop population grids. This approach corrects systematic biases in household income surveys and provides robust inequality estimates verified against household-level data. Additionally, we designed replicable spatial equity metrics using kernel density functions to operationalize resource distribution fairness, offering a novel tool for assessing economic geography and policy impacts globally.
The empirical analysis results are as follows. First, the PMC reform has aggravated economic inequality in pilot areas by an average of 0.5%. Second, the reform effect displays regional heterogeneity: in the eastern developed regions, economic inequality decreased, while in the western and northeastern underdeveloped regions, inequality worsened. Third, the effect shows temporal variation: reforms before 2007 intensified economic inequality, while reforms after 2012 have reduced economic inequality, and the effects of reforms between 2007 and 2012 were unstable.
Further mechanism analysis shows that the PMC reform has expanded the scale of transfer payments in pilot areas and the span of control of its superior governments. The lack of supervision has greatly increased the possibility of lower governments misappropriating general transfer payments, while information asymmetry has led to misjudgment of the intention of special transfer payments. Finally, the transfer payments that maintain the fairness of regional development failed. The PMC reform has increased the proportion of tax sharing in pilot areas and encouraged local development efficiency. Within the framework of local government competition, the promotion of tax sharing proportion makes local governments practice the development strategy of advantage agglomeration, which will aggravate economic inequality. The above mechanisms lead to the aggravation of economic inequality jointly.
Our findings highlight critical tensions in China’s intergovernmental fiscal relations. （1） Resolving the “transfer paradox” requires enhanced vertical supervision mechanisms and technical controls to correct incentive distortions that neutralize the poverty-alleviating potential of fiscal transfers. （2） Optimizing fiscal responsibility assignment necessitates matching tax-sharing ratios with regional development stages—lowering shares in developed regions and cautiously adjusting in developing regions—to prevent efficiency-focused approaches from exacerbating inequality. （3） Improving fiscal resilience through differentiated reforms tailored to regional conditions—promoting direct administrative supervision in affluent eastern regions while prioritizing provincial coordination in less-developed western regions—helps mitigate adverse impacts of decentralization.
This study moves beyond the traditional dualism of fiscal decentralization theory—“helping hand” vs. “grabbing hand”—by introducing administrative factors into the analysis. Specifically, we developed a “Fiscal-Administrative Integration” framework that yields two novel insights. First, horizontal competition intensifies fiscal incentives. By raising local governments’ share of value-added taxes, the reform intensified inter-locality competition for economic growth, causing resources to concentrate in affluent areas. Second, weakened vertical supervision diminishes the equalizing role of fiscal transfers. Administrative flattening reduced provincial oversight, enabling increased misuse of earmarked transfers and misallocation of general transfers due to local officials’ biased performance preferences. Our evidence highlights that the outcomes of fiscal decentralization crucially depend on the administrative structure, contributing empirical substance to the second-generation fiscal decentralization theories.
Future research may further these findings by exploring intra-county urban-rural inequalities—another crucial dimension of economic disparity, heterogeneous bureaucratic incentives and associated policy outcomes, and private-sector responses, such as firms’ location and investment decisions under decentralized fiscal conditions, to reveal whether fiscal incentives trigger arbitrage-based agglomeration behaviors.

JEL: R51, H11

【KeyWords】

Province-Managing-County Reform, Tax Sharing, Fiscal Transfers, Government Institutional Reform, Economic Inequality