Revenue pressure of local governments and firm productivity: Evidence from a natural experiment in China

Abstract

This study investigates how the revenue pressure of local governments affects firm total factor productivity (TFP). To establish causality, we exploit a policy shock in China, that is, the cancellation of agricultural tax in 2005. Specifically, we document that governments suffering from sudden tax reduction substantially increase local firms' productivity in the subsequent periods. Furthermore, we use the difference-in-differences-in-differences approach to explore the potential channels through which the local fiscal squeeze improves firm productivity. Local firms increase capital and employment and adopt a higher capital-to-labour substitution for a higher TFP in response to the local governments' fiscal squeeze. We find that the effects of revenue pressure incentives on productivity are prominent in firms with low resource misallocation and high labour quality. Our finding suggests that local governments could improve firm productivity in response to fiscal revenue pressure by enhancing resource allocation efficiency and labour quality.