Does VAT retention rate affect firms’ capacity utilization? Evidence from China

Value-added tax (VAT) is shared between central and local governments, and is levied based on firms' production location, which provides incentives for local governments to intervene in firms' production. This paper investigates how local governments' VAT retention rate affect firms' capacity utilization theoretically and empirically. We find that the more VAT retained by local governments', the lower the firm's capacity utilization. Our findings suggest the fiscal and taxation system reform should correct local governments' improper incentives and eliminate the negative effects of the distorted intergovernmental fiscal relationships on firms.