Local State Capacity and Uneven Taxation across Industrial Firms

• Published date: 01 May 2024
• Author: Linke Hou,Zhikuo Liu,Qi Zhang,Xiaolu Zhao
• Date: 01 May 2024
• DOI: http://doi.org/10.1111/cwe.12536

©2024 Institute of World Economics and Politics, Chinese Academy of Social Sciences

China & World Economy / 191–214, Vol. 32, No. 3, 2024 191

Local State Capacity and Uneven Taxation

across Industrial Firms

Linke Hou, Zhikuo Liu, Qi Zhang, Xiaolu Zhao*

Abstract

In this research we investigate the association between local state capacity (LSC) and

effective tax burdens (ETBs) on industrial firms within counties between 1998 and 2013.

The LSC measures a state’s capacity for policy implementation and specifically its ability to

acquire low-cost agricultural land for nonagricultural (industrial or commercial) purposes.

Based on China’s government-led development experience since the 1990s, we draw on two

unique household survey datasets to capture LSC at county level. We find robust evidence

that greater LSC was associated with much lower ETBs on large industrial firms. This

taxation pattern implies local government’s primary reliance on larger manufacturing firms,

while the ETBs for small-and-medium enterprises are not as prominently addressed. This

research highlights that LSC can affect both the amount of revenue a local government can

generate and the methods it uses to collect these revenues.

Keywords: China, ef‌f ective tax burdens, land requisition, local government, local state

capacity

JEL codes: H70, H71, H77

I. Introduction

Governments across the world are responsible for maintaining order and providing

public goods and services, including infrastructure and regulation of economic

activities. Based on an array of empirical work derived from the formation of modern

statehood from late medieval Europe (Mann, 1984; Tilly, 1990) to the economic miracle

of contemporary Asian development states (Johnson, 1982; Wade, 1991) and to the

economic challenges faced by African countries (Herbst, 2000), scholars tend to believe

*Linke Hou, Professor, the Economic Research Center, Shandong University, China. Email: abramhlk@sdu.edu.cn;

Zhikuo Liu, Professor, China Center for Economic Studies, Fudan University, China. Email: liuzhikuo@fudan.edu.cn;

Qi Zhang, Associate Professor, China Center for Economic Studies, Fudan University, China. Email:

zhangqifd@fudan.edu.cn; Xiaolu Zhao (corresponding author), Assistant Professor, School of Economics,

Ocean University of China, China. Email: zhaoxiaolu@ouc.edu.cn. Zhikuo Liu and Qi Zhang acknowledge

that the work is supported by the National Natural Science Foundation of China (Nos.72121005, 72342030,

72293565, and 72173025), Innovative Research Groups Project of the National Natural Science Foundation

of China (No. 72121002), and the Ministry of Education of Humanities and Social Science Project of China

(No. 21YJA790042).

Linke Hou et al. / 191–214, Vol. 32, No. 3, 2024

©2024 Institute of World Economics and Politics, Chinese Academy of Social Sciences

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that whether a central or local state has the capacity to fulf‌i ll these duties and functions

is vital for economic development and prosperity (Acemoglu et al., 2015).

In this paper, we associated local state capacity (LSC) with the uneven distribution

of tax burdens across firms of different sizes in China. We conceptualized LSC as the

capacity of the local government to gather ef‌f‌i ciently the required resources from local

society to implement its preferred policies. This involves a focus on minimizing costs and

optimizing administrative ef‌f‌i ciency. This def‌i nition captures both how much bureaucratic

capacity the local government has (Mann, 1984; Migdal, 1988) and the ends to which

the government uses that capacity (North, 1990; Tilly, 1990). In particular, the present

study explored how county governments in China leveraged their inf‌l uence to reallocate

resources from the countryside, with the aim of fostering local industrialization. This

included the ability of a county government to acquire agricultural land in its jurisdiction

at a low cost. Such ability ensured that the subsequent industrial enterprises could

acquire land at reduced cost, thereby stimulating manufacturing investment. This local

government practice constituted the cornerstone of the land finance (tudi caizheng)

strategy, where revenue generated from land served as the primary funding source for

urban maintenance, construction, and development in China (Zhang et al., 2017).

Aside from providing cheap land, Chinese local governments also resorted to

taxation tools to achieve policy goals. In this context, strong LSC enabled governments

to of‌f er selective tax credits and breaks, aimed at attracting and retaining manufacturing

firms within their jurisdictions. It is commonly observed that larger manufacturing

firms were prioritized in economic strategies to boost manufacturing investment.

Consequently, it seems reasonable to suggest that these larger f‌i rms were more likely to

benef‌i t from favorable tax treatment compared to small and medium-sized enterprises

(SMEs), which generally did not anticipate similar advantages. Based on this, our

hypothesis posits that greater LSC correlated with a tax collection approach that was

more benef‌i cial to large manufacturing f‌i rms than to SMEs.

We drew on two datasets to measure LSC and firm tax burdens, respectively.

One is a unique household survey dataset spanning 28 provinces from 2005 to 2016.

Households self-reported whether their land was requisitioned by the local government,

and if yes, when and how much monetary compensation they received. For those

households that experienced land requisition in a given year, we compared the actual

monetary compensation they received with the compensation that they were supposed

to receive according to the compensation standard set by the local county-level

government. The measure of a county government’s policy implementation capacity is

based on its ef‌f‌i ciency in acquiring rural land at a relatively lower cost. This is indicated

by whether a significant number of households that experienced land requisition