Decentralization, incentives, and local tax enforcement

Abstract

China recently initiated a major decentralization reform to simultaneously improve tax autonomy and fiscal transfers to county governments. We use an instrumented difference-in-differences method and a county-level panel dataset for 1995–2014 to examine the incentive effects of this reform. We find that the reform significantly reduced local tax enforcement (i.e., the degree to which county governments collect legally mandated tax obligations from companies and households); moreover, this result appears to be driven by the opposing incentive effects of increased local tax autonomy and fiscal transfers. In particular, while the reform motivated county governments to improve tax enforcement by enhancing local tax autonomy, it dampened local tax enforcement because of increased fiscal transfers. Our findings provide support to the argument in the decentralization literature that improving local tax autonomy is a more effective way than increasing fiscal transfers to finance local governments while strengthening local fiscal discipline.