Fell by the Wayside: Trade integration and policy choices of local governments

We examine how trade integration affects the incentives and policy choices of local governments, using the construction of China’s national expressway as a natural experiment. We find that governments of peripheral counties connected to expressway “gave up” by adopting less business-friendly policies. Affected local governments changed both the level and the composition of public spending, and became less involved in inter-jurisdictional spending competition. Private firms in connected peripheral counties received fewer subsidies and faced higher effective tax rates, while state-owned firms were less likely to be privatized. These policy changes contribute significantly to the observed output decline in these regions. 

Trade integration and changes in local business environment

Trade integration between countries may lead governments to adopt different tax policy for businesses when there is competition for international capital. This research examines if trade integration within a country would similarly induce changes in the local business environment and policies, by considering intercity transport infrastructure that lowered trade cost between different regions of a country.

As connectedness between different regions increases, metropolitan areas become more economically advantageous because of agglomeration forces. By contrast, less economically vibrant areas lose out and may engage less in pro-business policies to compete for firms and businesses. This research empirically examines how the rollout of country-wide expressways in China between 1996 and 2010 may have affected the local business environment and policy choices, including effective tax rates and subsidies experienced by firms in different local regions. It finds that when the peripheral counties are connected to the national transportation network, firms experienced higher effective tax rates and received less automatic subsidies, which the local government could instead make available to businesses via discretionary measures. Business-related public spending and the degree of competition in the peripheral counties also reduced.

The research therefore suggests that trade integration by intercity transportation infrastructure could affect the provision of pro-business policies by local governments. It finds that when trade integration happens within a country, the business environment could become less favourable for firms in economically less vibrant areas as local governments change their set of policies for business.