Modern Economy, 2012, 3, 811-816
http://dx.doi.org/10.4236/me.2012.37103 Published Online November 2012 (http://www.SciRP.org/journal/me)
The Flypaper and Teflon Effects:
Evidence from China*
Lyoe Lee, Guillermo Vuletin#
Colby College, Waterville, USA
Received August 23, 2012; revised September 28, 2012; accepted October 9, 2012
In this paper, we analyze how public spending responds to income and intergovernmental fiscal transfer shocks in
China. Similar to federations around the world, we find the flypaper effect at the provincial level since the country be-
came a de facto federation in 1980. Before 1980 we find what we define as the teflon effect at the central government
level. We rationalize the latter regularity using collection costs/distortionary taxation arguments.
Keywords: Flypaper Effect; Teflon Effect; Fiscal Federalism; Fiscal Reform; China
The flypaper effect is an empirical regularity that refers
to the greater responsiveness of subnational government
spending to increases in unconditional intergovernmental
transfers (hereafter, fiscal transfers) than to increases in
private income. The catchy term “flypaper effect” aims
to visualize the idea that money sticks where it hits:
money from the private sector (i.e., from private income)
tends to be spent in the private sector rather than being
taxed away, while money from the public sector (i.e.,
from fiscal transfers) tends to be spent by the public sec-
tor rather than being rebated to citizens. This well-known
regularity is observed in many federations and at various
levels of subnational government.
We focus our analysis on China. Since its foundation
in 1949 this unitary country has witnessed an intense
process of fiscal policy transformation regarding how
competencies (i.e., expenditure) and fiscal instruments
(i.e., revenue) are allocated across different vertical lev-
els of the government. For the period 1949-1979, gov-
ernment spending was heavily centralized and an impor-
tant bulk of provincial own revenues was remitted to the
central government. Figure 1 shows that during this pe-
riod central government spending represented, on aver-
age, 72 percent of consolidated spending, and central
government revenues accounted for 59 percent of con-
solidated revenues. This gap was financed with intergov-
ernmental transfers from provinces. As Figure 2 shows,
provinces remitted 42 percent of their own revenues to
the central government.
Researchers agree that China started to shift towards a
de facto federation in the early 1980s, when the central
government initiated a wave of expenditure decentraliza-
tion, providing provinces with more discretion over their
budget [1-5]. At the same time, revenue collection be-
came increasingly centralized. Figure 1 shows that the
degree of spending centralization decreased from about
70 percent in early 1970s to 60 percent in early 1990s
and further down to 55 percent for late 2000s. On the
contrary, the degree of revenue centralization increased
from 55 percent in early 1970s to 60 percent in early
1990s and further up to about 70 percent for late 2000s.
Indeed, Figure 2 shows that provinces continuously
transformed from net remitters of fiscal transfers to net
receivers, starting in 19801.
Following the 1994 co-participation and tax reforms,
central government transfers account for about 64 per-
cent of provinces’ spending financing. This figure coin-
cides with that of federations (40 percent in Argentina
and 60 percent in South Africa and Spain).
Exploiting this intense fiscal policy transformation,
our paper analyzes how public spending responds to in-
come and fiscal transfer shocks. We analyze the behavior
of the central government’s spending for the period
1952-1979 and provinces for the period 1980-2008. In
each case, own taxation and fiscal transfers financed a
majority of public spending. While we observe the fly-
*We are grateful to Samara Gunter, Simge Tarhan, Bradley Turner,
Andreas Waldkirch, and seminar participants at the 2011 Colby-Bates-
Bowdoin Annual Economics Conference for helpful comments and
1The exact transition year from negative to positive provincial vertical
fiscal imbalance varies by province. However, with the exception o
few moderate/low income provinces, all of provinces made the defini-
tive transition after 1980.
opyright © 2012 SciRes. ME
L. LEE, G. VULETIN
1952 1956 1960 1964 1968 19721976 1980 1984 1988 1992 1996 2000 2004 2008
Spending centralizationRevenue centralization
Note: The vertical dashed lines represent years 1980 and 1994.
Figure 1. Centralization of government spending and revenues. Central government spending and revenues as percentage of
consolidated (central and provincial) spending and revenues. 1952-2008.
1952 1956 1960 1964 1968 1972 1976 19801984 1988 1992 1996 2000 2004 2008
Note: The vertical dashed lines represent years 1980 and 1994. Negative (positive) values
indicate provinces net remitting (receiving) transfers to (from) the central government.
Figure 2. Provinces vertical fiscal imbalance. Provinces fiscal transfers as percentage of own revenues. 1952-2008.
paper effect at the provincial level after 1980, before
1980 we find what we define as the teflon effect at the
central government level. We rationalize the latter regu-
larity using collection costs/distortionary taxation argu-
Our annual panel dataset consists of government revenue,
expenditure, intergovernmental net transfers, population,
and population density at both the provincial (31 provinces)
and national level for the period 1952-20082. We obtained
data from China Data Center (http://chinadataonline.org).
2The 31 provincial level division units included in our data include 22
rovinces (Anhui, Fujian, Gansu, Guangdong, Guizhou, Hainan, Hebei,
Heilongjiang, Henan, Hubei, Hunan, Jiangsu, Jiangxi, Jilin, Liaoning,
Qinghai, Shaanxi, Shandong, Shanxi, Sichuan, Yunnan, and Zhejiang),
four municipalities (Beijing, Chongqing, Shanghai, and Tianjin), and
five autonomous regions (Guangxi Zhuang, Inner Mongolia, Ningxia
Hui, Xinjiang Uighur, and Tibet).
Copyright © 2012 SciRes. ME
L. LEE, G. VULETIN 813
Extrabudgetary funds, which is capital used for specific
projects assigned by the central government, are ex-
3. Flypaper Effect Evidence (1980-2008)
Table 1 shows the regressions for Chinese provinces for
the period 1980-2008. We consider the following basic
where g, y and f represent government spending, output,
and fiscal transfers all expressed in real and per capita
terms. Column 1 reports basic Ordinary Least Squares
regressions without controls and assuming that the re-
siduals are homoscedastic and have no autocorrelation.
The marginal propensity to spend out of fiscal transfers is
clearly larger than for local output; there is a flypaper
The regression reported in Column 2 allows for het-
eroscedasticity and autocorrelation. Column 3 allows for
provincial fixed effect and Column 4 also includes year
dummies to reduce the omitted variable bias that may
occur as a consequence of the processes of decentraliza-
tion. Column 5 controls for population density, a typical
variable used to proxy for cost of provision of public
goods. This variable is expected to have a negative sign
as such cost is expected to decrease with higher popula-
tion concentrations3. Columns 6 and 7 split the sample
into before and after the 1994 co-participation and tax
reforms. In every case the flypaper effect remains a
strong empirical regularity with a size close to 0.9. This
novel finding for Chinese provinces coincides with that
4. Teflon Effect Evidence (1952-1979)
Table 2 shows the regressions for the central government
for the period 1952-1979. We find that, even after relax-
ing the assumption of homoscedasticity, the marginal
propensity to spend out of fiscal transfers is clearly
smaller than national output.
This finding is the opposite to the one of Section 3 at
the provincial level and novel in nature. No previous
study found that government spending responds less to
an increase in fiscal transfers than to an equal increase in
private income. We define this novel regularity teflon
effect. The term teflon effect aims to visualize the idea
that, contrary to the flypaper effect, money tends to slide
from where it hits: money from the private sector (i.e.,
from private income) is taxed and mostly allocated to
public spending, while money from the public sector (i.e.,
from provincial fiscal transfers) tends not to be spent and,
therefore, rebated to citizens4. In particular, while an in-
crease of $1 in national income raises central government
spending by $0.6, an equivalent increase in fiscal trans-
fers from provinces only triggers into an increase of
$0.015 in expenditures. Therefore, the size of the teflon
effect is 0.586.
5. Rationalizing the Teflon Effect
This section develops a simple optimal fiscal policy
model that rationalizes the teflon effect using the collec-
tion cost/distortionary taxation arguments developed by
Hamilton (1986) , Aragón (2009) , and Vegh and
Vuletin (2012)  to rationalize the flypaper effect.
These papers show that the flypaper effect occurs be-
cause subnational tax collection has higher collection
costs or are more distortionary than the central govern-
The endowment economy is inhabited by a benevolent
fiscal authority (FA) and a representative citizen (RC)
blessed with perfect foresight. Without the loss of gener-
ality and in order to obtain analytical solutions, we use
log preferences for RC’s utility function:
lnln ,Wg c
where c is private consumption and g is public spending.
The RC’s budget constraint is given by
where y is output and τ is lump sum tax collection.
Because the central government has two sources of fi-
nancing, own revenues and fiscal transfers, the central
FA’s budget constraint is given by
where f is total provincial fiscal transfers to the central
are the central government and
effective provincial collection cost/distortionary taxation
. Hamilton (1986)  rationalizes them
as the real costs of distortionary taxation, while Aragón
(2009)  treats them as pure collection costs.
Solving the model we get
From expression (5) we obtain
which states that the relative optimal response of public
spending to each type of shck crucially depends upon o
3The estimated coefficient for population density would become nega-
tive if year dummies were not included.
4Naturally, funds are actually not rebated via checks or financial depos-
its but they rather decrease the amount being taxed in net terms.
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L. LEE, G. VULETIN
C© 2012 SciRes. ME
Table 1. Flypaper effect evidence. 1980-2008. Dependent variable is real per capita provincial expenditure.
(1) (2) (3) (4) (5) (6) (7)
absolute size = βf – βy 0.756*** 0.756*** 0.639*** 0.851*** 0.899*** 0.77*** 0.864***
test βf = βy (p-value) 5.85 × 10−173 4.55 × 10−12 0.0002 1.48 × 10−18 4.42 × 10−19 3.41 × 10−17 1.96 × 10−16
Econometric methodology OLS OLS FE FE FE FE FE
Standard errors Standard Robust-ClusterRobust-ClusterRobust-Cluster Robust-Cluster Robust-Cluster Robust-Cluster
Year dummies No No No Yes Yes Yes Yes
Observations 736 736 736 736 736 275 445
Provinces 31 31 31 31 31 24 31
Period 1980-2008 1980-2008 1980-2008 1980-2008 1980-2008 1980-1993 1994-2008
R2 0.934 0.934 0.928 0.955 0.957 0.928 0.962
Note: f stands for real per capita provincial fiscal transfers from central government. y stands for real per capita provincial gross domestic product. Only obser-
vations where f > 0 were included in regressions. Constant term is not reported. OLS stands for Ordinary Least Squares. FE stands for panel data provincial
fixed effect. R2 correspond to within R2. *, ** and *** denote significance at 10%, 5% and 1% levels, respectively.
Table 2. Teflon effect evidence. 1952-1979. Dependent vari-
able is real per capita central government expenditure. the collection cost/distortionary taxation associated with
each of them. If
pop. density −15.030***
absolute size = βf – βy 0.586*** 0.586***
test βf = βy (p-value) 4.10 × 10−11 3.12 × 10−8
Econometric methodology OLS OLS
Standard errors Standard Robust
Observations 28 28
Period 1952-1979 1952-1979
R2 0.947 0.947
Note: f stands for real per capita central government fiscal transfers from
provincial governments. y stands for real per capita country gross domestic
product. Only observations where f > 0 were included in regressions. Con-
stant term is not reported. OLS stands for Ordinary Least Squares. R2 corre-
spond to within R2. *, ** and *** denote significance at 10%, 5% and 1%
That is to say, the optimal response supports the teflon
effect. This occurs because the central government inter-
nalizes that spending out of provincial fiscal transfers is
more costly than spending out of their own revenue. The
opposite would be true if
The public finance literature supports that
Rubinfield (1983)  argues that revenue collection
should be centralized to take full advantage of adminis-
trative economies of scale in the collection of taxes. Bu-
chanan (1950)  and Hamilton (1986)  argue that
central government taxation is less distortionary than
subnational one, among other reasons because of tax base
mobility. These are, among others, the main reasons why
most federations have leaned to centralize tax collection.
Chinese evidence points in the same direction. Figure
3 shows that collection costs, proxied by the ratio of ad-
ministrative spending over total spending, for provinces
(0.14) are almost three times higher than those of the
central government (0.06). Following, among others,
Barro (1991)  and Jin and Zou (2005)  we proxy
tax distortion using tax burden which is measured as the
ratio of revenues to GDP. Figure 4 shows that the effec-
L. LEE, G. VULETIN 815
1952 1954 1956 19581960 1962 1964 1966 1968 1970 1972 1974 1976 1978
Provincial collection costCentral gov. collection cost
Note: Provincial (central government) collection cost is calculated as the ratio of total
administrative provincial (central government) spending over total spending.
Figure 3. Provincial and central government collection costs. 1952-1979.
1952 1954 1956 1958 1960 1962 1964 1966 1968 1970 1972 1974 1976 1978
Effective provincial tax burdenCentral gov. tax burden
Note: Effective provincial tax burden is calculated as the weighted average of each province tax
burden. The weight used in each case correspond to the relative importance of each province
transfers in the total of transfers.
Figure 4. Effective provincial and central government tax burdens. 1952-1979.
tive tax distortion imposed by provinces (0.42) is, indeed,
almost two times bigger than that of central government
(0.28). To sum up, both literature consensus as well as
some empirical evidence support the rationalization of
the teflon effect through the eyes of collection cost/dis-
tortionary taxation arguments.
Exploiting the intense fiscal policy transformation wit-
nessed in China during the last six decades, our paper
unravels two novel findings. First, we observe the flypa-
per effect at the provincial level since the country be-
came a de facto federation in 1980. Second, we find what
Copyright © 2012 SciRes. ME
L. LEE, G. VULETIN
we define as the teflon effect at the central government
level prior to 1980. We rationalize the latter regularity
using collection costs/distortionary taxation arguments
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