The Tax Competition Between Local Governments: Effect And Governance Of The Problem

In1994, China carried out a tax reform and established the tax-sharing system(fenshuizi), which determined the tax share of sub-central governments (SCG) in total taxrevenues. The system has then become the institutional driving-force behind the taxcompetition between SCGs. To increase the economic resources and welfare in their ownjurisdictions, SCGs have started horizontal tax competition. In the competition, SCGs havedifferentiated their tax policies and used a variety of measures to vie for the increase oftheir own taxes. This resulted in the expansion of tax competition in terms of forms andscope.The main causes of tax competition between SCGs in China include poor fiscaldecentralization and broad discretion. The causes also include such defective institutions asinconsistent distribution and poor efficacy of tax legislative power, overlappingresponsibilities and functions of tax administrations and mismatch of transfer paymentsystem. Horizontal tax competition presents itself in many forms, which keep changingwith the times. They include regional tax incentives, financial returns, reduced rates,investment lobby with preferential tax treatment and illegal tax enforcement. The taxcompetition, albeit with some positive effects, also produces some side effects, such asdisruption of the fiscal order and increase of power rent-seeking. It has been SCGs’ main goal to raise the capital inflow into their jurisdictions for thepast three decades. To attract FDI, SCGs adopted, explicitly and implicitly, variouspreferential tax policies. While these policies broadened the capital inflow gap betweenSCGS, they intensified the horizontal tax competition between SCGs. As the reformsdeepened, we found that tax incentives did not become the only important factor in FDIinflow. The truth is the impact of tax incentives on FDI is dropping. The empirical analysisand study on the correlation between tax competition between SCGS and FDI show thatthe role of attracting FDI in the tax competition between SCGs examined is fading.Tax competition between SCGs featuring tax incentives also has substantial impact onthe migration of labor. Like other countries, SCGs in China also strive to compete forquality labor. The empirical model in this paper shows that between1992and2010taxcompetition between SCGs had changed the flow and composition of labor forces,resulting in the imbalance of talents across regions.It is urgent to find out the solution to various problems caused by tax competitionbetween SCGs. Tax competition between SCGs is commonplace in the world. The bestpractices of Switzerland, USA and Brazil in addressing the tax competition are worthlearning. They include building an appropriate, standardized and coordinated model of taxcompetition between SCGs, enhancing central government’s tax legislative power,improving the level of tax legislation and building a robust intergovernmental transferpayment system.Learning from international experience and considering China’s realities, we believeit is important to move towards the following four fiscal and tax strategies as chinastandardizes the tax competition between SCGs. They are demarcating the responsibilitiesand power of SCGs at all levels, building a balanced intergovernmental fiscal relationship, building a coordination mechanism on tax interests between SCGs, and intensifyingexternal disincentives for tax competition.All in all, the tax competition between SCGs in China has both positive and negativeimpacts, with the latter growing. The fact that the tax competition has both positive andnegative impacts requires China to standardize and improve rather than denying thecompetition. The paper suggests that the central government help SCGs establish stablesource of substantial revenue, thus alleviating the mismatch between revenue andresponsibilities of SCGs and eliminating vicious tax competition, and set up standardizedtransfer payment system to address top-down the poor allocation of resources resulted fromtax competition.