After three decades of spectacular economic successes, China is facing a significant challenge. The string of recent scandals – environmental degradation, melamine-tainted milk powder, fake drugs and chemicals – have all pointed to government weakness in protecting public safety, exposing an enormous gap between China's growing economic prowess and its capacity to govern. With the leadership now focused on improving the regulatory regime, will China “catch up” and build the public institutions needed? This article argues that the reactive, incremental retrenchment of government in the 1980s and 1990s, combined with inadequate finance, had broken the intergovernmental fiscal system and created large distortions in the incentive structure facing government agencies and public institutions (shiye danwei 事业单位). Until the intergovernmental fiscal system is repaired and incentives are fundamentally reformed for the public sector, the top-down programme to redirect China's development and build a service-oriented government will have limited effect.
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