The Trade-Off between Tax Incentives and Agglomeration Rents in Development Zones: Evidence from China

Abstract

Development Zones (DZs) are an important spatial carrier for the urban government to guide the allocation of industrial resources, and tax incentives are one of the important policy instruments in the DZs. This study combines Basic Tax Competition (BTC) theory, New Economic Geography (NEG) theory, and China’s DZ policy to construct an analytical framework of tax incentives in the DZs. First, this study empirically analyzes the causal relationship between the establishment of DZs and the effective tax rate of firms by applying Propensity Score Matching (PSM), time-varying Difference-in-Differences (DID), and Instrumental Variable (IV) methods to verify the existence of tax incentives in the DZs. Second, this study explores the heterogeneity of tax incentives in the DZs from the perspective of investment quantity, quality, and sustainability and finds that tax incentives are more inclined to firms with large scale, high efficiency, or high location flexibility. Finally, this study introduces agglomeration economies and tests the substitution effect of agglomeration rents for tax incentives in the DZs. Agglomeration economies can reduce the elasticity of firms to the tax rate, such that DZs can use agglomeration rents instead of tax incentives to attract investment provided that there is no comparable economic agglomeration in the neighboring areas.

Keywords: development zone, tax incentive, agglomeration rent, tax competition, China