A Study On The Financial Game Between Central And Local Governments In China

Finance refers to the intermediation of social funds.It is essentially a way of resource configuration. Finance is the core of modern economy.It is capable of regulating capital surplus and deficiency, optimizing resource allocation, reflecting the economic information and other functions; as a result, it can improve the economy. The allocation of financial resources has always been the content of the game between the central government and local governments.The local governments aim to attract more financial resources to promote local economic development. However, due to lack of financial management capacity and responsibility for the disposal of financial risks,the local financial risks are constantly accumulating. Although the local economic development is also the goal of the central government, it has to pay more attention to financial risks because of the negative externalities of financial sectors. The associated risks can cause systemic financial risk and regional financial risks.Therefore, there areconflicts in the division of the power to allocate financial resources between the central government and local governments.This inconsistency is the result of interaction of various factors. With the establishment and improvement of China’s market economic system, the central and local government gradually formed an independent system of interests. From the economic point of view, both of the centraland local governments are rational, and they would pursue the maximization of their own interests. The local governments have incentives to stimulate economy by using more financialresources, because local fiscal revenuesand the performance of local governments dependon their economic performance. At the same time, the deficits of local governments force them to attract more financial resourcesAfter the reform and opening up, the division of the power to allocate financialresource between the central and localgovernmentshas experienced several round of game. During this period, many problemshave been exposed, and the irrational behaviors lead to the loss of efficiency. Today, under the background of comprehensively deepen reform in our country, there will be a new game. How to make decisions more scientific, and realize the maximization of the local and the national income are the problems that central and local governments should think aboutcarefully.This paper starts fromthe changes in the financial relationship between central and local government, and classify their relationship into different stagesaccording tothe characteristics of the game. Then it explores the potential changes of the relationship between the central and local government under the new situation. After studying the history and current status of their relationship, we explain four reasons for their inconsistency, that is, conflicts of interests,unbalanced allocation of fiscal authority and powers, regional differences, and unbalanced allocation of financialresponsibility. Taking into account the characteristics of the relationship, we chose Stackelberg Model to construct the basic framework of the game between the central and local government. Through some necessary assumptions, both the central and local government can make best choices which could improve their interests. Finally, according to the game equilibrium conditions, we propose some suggestions to improve the currentfinancial relationship, in order to achieve short-term and long-term social welfare maximization. In the short term, the central and local governments should adjust their policies accordingly, but the long-term reforms are more significant.