This article provides new evidence that fiscal decentralization has supported economic development by incentiving cities to provide more sewage infrastructure. As a result of the 1994 tax reform, Chinese cities retained different shares of their value-added tax (VAT). Exploiting the persistence of this sharing system, we use the VAT share in 1995 as an instrument for the present fiscal incentives. We find that cities with higher fiscal incentives built significantly more sewage treatment capacity between 2002 and 2008. This result suggests that fiscal incentives can play a strong role in the development of city-level infrastructure.
Solution of model (2) in Section 4.1
Here, we replicate model (2) in Section 4.1. A city manager’s problem is to maximize the welfare of the city subject to the budget constraint:
The first-order condition of the above model with respect to S yields:
Differentiating this equation with respect to , we find:
Solving for :
We have assumed that the tax revenue function is strictly increasing and concave, which implies that and . The cost function is assumed to be strictly increasing and convex, which implies that , , and . Under these assumptions, . That is, a greater revenue share incentivizes infrastructure expansion.
Sewage treatment data
We have corrected some errors in the data. The sewage treatment capacity in Shanghai reported in CEY 2008 is 539,100 tons/day, an inexplicable drop from CEY 2007’s figure of 4,704,105. In CEY 2009, Shanghai reports 6,488,400. The most reasonable explanation is that a “'0” has been omitted from the 2008 figure. The empirical results are largely robust to either a correction of the CEY 2008 figure to “5,391,000” or dropping the observation altogether. Some cities shrank sewage treatment capacity or did not change over the 2002–2008 sample time frames. To incorporate these cities into our analysis, we took the biggest drop in sewage treatment capacity within a city and added this figure to the sewage capacity increase in each city. With this correction, all cities receive positive sewage treatment investment, except the city with the largest drop in sewage treatment capacity, which is excluded from the results presented. Our results are robust to this correction or to simply dropping cities that did not increase sewage treatment capacity.
|Province||Number of cities||VAT share retained by city|
|In 1995||In 2001|
|Shanxi||11||All 100%||All 100%|
|Neimenggu||8||100% (Huhehaote: 80%)||100% (Huhehaote: 79%)|
|Jiangsu||13||All 100%||All 100%|
|Zhejiang||11||All 100%||All 100%|
|Anhui||17||All 100%||All 100%|
|Fujian||9||All 100%||All 100%|
|Henan||17||All 100%||All 100%|
|Hubei||12||All 100%||All 100%|
|Guangxi||14||All 100%||All 100%|
|Hainan||2||Both 100%||One 24%, one 70%|
|Sichuan||18||All 100%||All 65%|
|Guizhou||4||All 60%||All 60%|
|Yunnan||8||All 100%||All 100%|
|Xinjiang||2||Both 100%||Both 100%|
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Under the tax system preceding the 1994 reform, provinces had different marginal revenue retention rates. After the 1994 reform, all provinces received the same, fixed share of VAT. Cities still have different VAT revenue shares after the reform.
For much of our analysis, we use the 1995 VAT sharing rate, although the tax reform in China was initiated in 1994. Wong (1997) writes that the 1994 tax reform was implemented only a few months after it was approved. She documents that neither taxpayers nor local tax officials were “prepared” for the transition. Moreover, through 1994, cities and counties were in doubt as to whether the rules of the contract system (the pre-1994 system) would govern the new tax sharing system.
We conclude from this reading that 1994 VAT sharing rates may be unreliable, since they involved a period of transition and, at best, reflect a system in place for only part of the year.
One saying, “qitong yiping,” states that, in order to attract investment, local governments must build seven forms of infrastructure: electricity, roads, water, telecommunications, cable, leveled ground, and waste treatment. We note that sewage is just one form of infrastructures that could be interesting to cities. Theoretically, each form of infrastructure should be attractive at the margin. We lack data at the city level to study the behavior of these other forms.
However, the price of water is considered a sensitive political subject in China. Cities cannot arbitrarily raise the price of water to fund the construction of new sewage treatment plants; price rises in cities are usually carefully coordinated with the central government and phased in over an extended period.
We found some occasional errors in the data of sewage treatment. This issue is discussed in “Sewage treatment data” in the Appendix in detail.
More infrastructure spending always increases the size of the tax base, since the city becomes more attractive to both businesses and consumers. Early spending can generate high returns, since important facilities such as clean water and electricity are essential to development. Later spending generates comparatively diminished marginal returns, since the highest return opportunities have already been selected.
More infrastructure always costs more to purchase and maintain. The initial units of infrastructure are comparatively cheap, while later ones are comparatively expensive.
We note that the dependent variable, change in sewage treatment capacity, is a stock variable, while the primary independent variable, a city’s VAT share, is a flow variable. Conceptually, the city’s VAT share should also affect a flow, which is the investment in sewage treatment during each year. Hence, we are answering the question of how fiscal incentives affect the aggregate set of investments in sewage treatment infrastructure.
Prior to 2002, China’s Environmental Yearbooks were not published, and the sewage treatment capacity of its cities was not known.
Sewage treatment fees are collected as a portion of the water consumption fee. These fees fund the construction and operation of treatment plants. Sewage treatment fees are widely regarded as inadequate to pay for the operating costs of sewage treatment. They fall far short of paying for the construction of sewage treatment plants (Lee 2010).
This table excludes direct-controlled municipalities.
©2013 by Walter de Gruyter Berlin / Boston