The Effect of a Fiscal Squeexe on Tax Enforcement: Evidence From a Natural Experiment in China

How significantly, and through what mechanisms, can taxation be constrained by political incentives? vVhich factors can shape the local political incentives in institu­tions with multi-level governments? This paper uses the abolition of the agricultural tax in 2005 across China as a natural 'fiscal squeeze' experiment to address these questions. I show that the revenue loss of county governments were largely and quickly offset by tougher tax enforcement. In particular, counties increased effective VAT rates without substantial changes in statutory VAT rates and changes in the reported tax base. This suggests that taxation capacity is not necessarily binding and constrained by access to information on tax base, as has been highlighted in many studies. There is a potentially large role for governments to endogeneously determine on how aggressively to enforce the statutory taxes. The incentive for VAT enforcement can be weakened, however, if the county: (1) receives a lower proportion of total VAT revenues after sharing with prefectural and provincial governments; (2) has a broader VAT tax base; or, (3) has more abundant sources of revenue from land sales. These findings are consistent with a model of endogeneous tax enforcement in presence of politicians' personal interests and tax competition in an institution of multi-level governments.