Decentralizing in Transition Economies: A Tragedy of the Commons?

China began its gradual economic reform in the late 1970s; Russia initiated radical reform in the early 1990s. During the course of reform, China has enjoyed rapid growth while Russia has contracted. This paper argues that an important explanation for the striking performance difference in China and Russia is that, during the course of reform, Chinese local governments have gained much more clearly defined tax rights than their counterparts in Russia. When tax rights are sharply defined, a local government has the exclusive right to tax enterprises located within its territory. These rights become fuzzier as the number of agencies which independently tax enterprises increases. The implications of these differences in government tax rights are analyzed using a model of a local economy which predicts that: 1) investment is higher when tax rights are more clearly defined- 2) local tax collections and local provision of public goods and infrastructure are higher when tax rights are more sharply defined; 3) the effective tax rate for investors increases as tax rights become fuzzier; 4) tax evasion is higher when tax rights are fuzzier. It is argued that these four points capture important differences in the performance of local Chinese and Russian economies. The model also predicts that capital mobility tends to encourage local and regional governments to limit cross-border capital flows. This prediction is consistent with local and regional government policies observed in both China and Russia.