Decentralization, Incentives, and Tax Enforcement

Abstract

China initiated a major decentralization reform in recent years to simultaneously improve tax autonomy and fiscal transfers toward county governments. We use an instrumental variables strategy and a county-level panel dataset for years 1995-2014 to examine the incentive effects of the reform. We find that the reform significantly reduced tax enforcement of the county governments, for which the result appears to be driven by the opposing incentive effects of the 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 the increased fiscal transfers. Our findings provide support to the argument in the decentralization literature that improving local tax autonomy, compared to increasing fiscal transfers, is a more effective way to finance local governments while strengthening local fiscal discipline.