Fiscal Incentives and Environmental Infrastructure in China

This paper provides evidence that China's system of tax revenue sharing is an important explanation for differences in the rate of sewage treatment plant construction among its cities. As a result of the 1994 tax reform, Chinese cities retained different shares of their value-added tax (VAT). Exploiting the persistence of this sharing system, we use the VAT share in 1995 as an instrument for the present fiscal incentives. We find that a 10 percentage point increase in the VAT sharing rate resulted in a 13.8% increase in the construction of sewage treatment capacity. This result suggests that fiscal incentives can play an important role in the provision of pollution-reducing infrastructure.

China relies considerably on surface water, but water in the majority of the country’s rivers is not fit for consumption—and the health impacts from water pollution are costly. Yet the construction of sewage treatment facilities varies dramatically throughout China. Some cities have constructed many plants, while others have not.

According to research by RFF Fellow Anthony Liu and coauthor Junjie Zhang, fiscal incentives—specifically, China’s tax sharing system—have a key role to play in the provision of sewage treatment infrastructure. In a new RFF discussion paper, “Environmental Infrastructure in China and Fiscal Incentives,” they note:

“Under China's tax sharing system, some cities are allowed to keep high shares of their value-added tax (VAT), while others keep relatively small shares. Since the VAT is levied on industrial activity, we hypothesize that cities that received relatively high shares were incentivized to direct financial resources toward activities that directly boosted the industrial tax base. One attractive form of investment is the construction of additional infrastructure in the form of sewage treatment capacity. Government officials in China widely believe that providing infrastructure is an important strategy to attract new industrial businesses and expand their tax base.”

Liu and Zhang’s method sheds new light on China’s system of city-level fiscal incentives, tying them to city-level outcomes. They find that cities react to higher value-added tax (VAT) sharing ratios by expanding sewage treatment capacity. During 2002 to 2008, a 10 percentage point increase in the VAT sharing ratio translated to 13.8 percent more growth in sewage treatment capacity.