Junxue Jia, Rong Li, Chang Liu, Jing Ning

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This paper empirically examines the role of local government fiscal policies in stabilizing local economic fluctuations, focusing on how local information and vertical fiscal imbalance (VFI) influence this role. The study contrasts two theoretical perspectives: one that argues local governments cannot effectively use conventional stabilization tools due to fiscal spillovers and beggar-thy-neighbor policies, and another that suggests local governments have an informational advantage, allowing them to make better decisions for local economic stabilization. However, VFI weakens this advantage because part of the local government's revenue comes from central government-controlled sources, limiting the flexibility of local fiscal policy.

Using county-level data from China between 1997 and 2007 and leveraging the 2002 income-tax-sharing reform as an exogenous variation in VFI, the paper finds that local government size has a stabilizing effect on economic volatility, but VFI weakens this effect. Local governments that rely heavily on intergovernmental transfers cannot adjust their fiscal policies based on local economic conditions, making their policies less effective in stabilizing the local economy.

The study further investigates the role of local information by examining the distance between counties and their provincial capitals. The findings show that the adverse effect of VFI is significant only for counties further from the provincial capital, suggesting that local information is a key determinant of fiscal policy effectiveness.

This research contributes to the literature on fiscal policy and VFI by highlighting the importance of local information and providing a natural experiment to address the endogeneity of VFI, offering new insights into the relationship between local fiscal policies and economic stabilization.