Does Fiscal Decentralization Increase the Investment Rate? Evidence from Chinese Dynamic Panel Data

It is puzzling why China has one of the highest investment rates in the world. In 1994 China introduced a new fiscal system. Using this natural experiment and the dynamic provincial panel data during the following period 1995-2002, we find that fiscal decentralization has a significant, positive effect on the physical capital investment rate in both LSDV (Least squares dummy variables) and system GMM (Generalized method of moments) estimations. The results are robust to controlling for other variables, and province and time effects. China's political centralization has been maintained during its economic decentralization. The provincial officials are not elected by the local constituents, but appointed by the central government. The central government disciplines them by linking their promotion with the performance of the local economy. Therefore, it is rational for provincial officials to raise investment rates to maximize local growth and thereby their chance of promotion, explaining our findings.