Pollution consequences of vertical fiscal imbalance: Evidence from China

The implementation of fiscal decentralization reform and resulting vertical fiscal imbalance, which is not beneficial for local governmental administration, have been widely observed in the world. This study analyzes how vertical fiscal imbalance affects urban environmental pollution in China. To investigate this relationship, we construct a theoretical model and use prefecture-level panel data from China over the period 2003-2009. We find the emissions intensity of urban pollution to be positively associated with vertical fiscal imbalance. The empirical results hold across various econometric specifications, including instrumental variable estimation and the difference-in-differences method. We also determine that vertical fiscal imbalance increases urban environmental pollution through increased local investment and decreased local effective tax rate. The results call for the normalization of direct access mechanisms for fiscal funds, in the context of sustainable development priorities. Our study provides a theoretical foundation and practical reference for local governments in developing countries to make better decisions regarding fiscal expenditure and the environment.