How do Vertical Fiscal Imbalances Impact China’s Economic Development Quality？ The Dual Effect of Local Government’s Tax Effort and Expenditure Structure Through Simultaneous Equations

Wang, Ke and Liew, Venus Khim-Sen (2025) How do Vertical Fiscal Imbalances Impact China’s Economic Development Quality？ The Dual Effect of Local Government’s Tax Effort and Expenditure Structure Through Simultaneous Equations. PhD thesis, Universiti Malaysia Sarawak.

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Abstract

China’s economy has shifted from rapid growth to high-quality development, making the improvement of economic development quality and sustainability a pressing issue for the government. The existing literature primarily focuses on the impact of vertical fiscal imbalance on the scale of economic growth, yet there is no consensus on the direct mechanisms through which it affects the quality of economic development. Moreover, there has only been limited research on the dual mediating pathways through which VFI influences economic development quality via tax effort and expenditure structure. This study uses panel data from 30 provinces in China from 2008 to 2022 and applies the Three-Stage Least Squares method to analyse how vertical fiscal imbalance, local government tax effort, and expenditure structure impact the quality of economic development at the national level and in the eastern, central, and western regions. The results indicate that increasing vertical fiscal imbalance not only directly hinders the quality of economic development but also indirectly affects it by reducing local governments’ tax efforts and improving the proportion of livelihood-related public expenditure. After standardizing the panel data, the study further quantifies the direct and indirect effects within these mechanisms. The direct effect in the tax effort model is larger than the indirect effect, while in the expenditure structure model, the direct effect is smaller than the indirect effect. Overall, the current level of vertical fiscal imbalance will help improve economic development quality in China. Additionally, regional regressions reveal that in the eastern region, as is the case nationally, the vertical fiscal imbalance directly negatively impacts the quality of economic development, while the indirect effect is positive, resulting in a negative overall effect. In the central region, the direct effect is negative, but since vertical fiscal imbalance does not significantly impact expenditure structure, there is no indirect effect through this pathway. However, the indirect effect through tax effort is positive, again leading to a negative overall effect. In the western region, conversely, the direct effect is positive, and with no indirect effect, the overall effect is also positive. In the eastern region, where fiscal revenues are relatively abundant, governments tend to optimize resource allocation by adjusting expenditure structures. In contrast, local governments in the central and western regions face greater fiscal pressures and are more reliant on central fiscal transfers, which limits their capacity to adjust tax effort and expenditure structures. Therefore, it is necessary to control vertical fiscal imbalance, tailor the policy on it to local conditions, and optimize political performance incentives to establish a clear fiscal relationship between central and local governments. This will help balance fiscal power across regions, enhance the quality of economic development, and achieve sustainable development for both local and national economies.

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