The Environmental Costs of Fiscal Distress: Evidence from China

Abstract

Environmental regulations often fall short of achieving their intended goals. This paper investigates whether fiscal distress contributes to such failures. Leveraging the 2002 China Income Tax Reform—which substantially reduced the share of corporate income tax revenues allocated to local governments—as a natural experiment, we find that cities facing larger revenue shortfalls were more likely to see increased pollution from firms. Specifically, our analysis reveals that a 1% decline in tax revenue led to a 1.4% increase in firm sulfur dioxide (SO2) emissions, caused by an expansion in firm production. Our results are likely driven by local governments adopting more lenient environmental regulations that promote firm expansion. The environmental cost associated solely with SO2 emissions during this period of fiscal distress is estimated to account for 10 percent of China’s total environmental protection investment in 2005.