2001 Reports

Micro Incentives and Macro Stability

Quian, Yingyi

This essay argues that appropriate assessment of the role of decentralization in China requires careful analysis. First, it is not just that the higher share of local government expenditure in total government expenditure matters, more crucially, higher local fiscal incentives in terms of higher marginal retention rates are important for inducing local governments' support for local business development. Second, however, such high incentives may not be conducive to macroeconomic stability, in particular when local governments have considerable influence over the banking system. Third, the central government's authority in appointing provincial leaders induces a tradeoff between macro stability and development: while it is not so good for local non-state sector development, it plays a role in maintaining macro stability. Therefore, there is a complexity of the relationship between micro incentives and macro stability.