Domestic Market Integration and Subsidies Provided by Local Government to Zombie Firms: Evidence from China’s City-Level Data

Abstract

With the advancement of economic globalization, market integration has become a critical contributing factor for sustainable economic development. However, the persistence of zombie firms continues to undermine fiscal sustainability, creating a critical policy challenge. The core purpose of this article is to propose novel policy directions for emerging economies to foster domestic market integration (DMI) and sustainable development. Based on panel data from 297 cities in China from 2008 to 2020, this paper employs a two-way fixed effects model to empirically test the impact of subsidies allocated to zombie firms on DMI. The results indicate that targeted subsidies provided by local governments to zombie firms exacerbate regional market segmentation and hinder the process of DMI. The analysis reveals several key mechanisms underlying this phenomenon: on the one hand, local governments may shift expenditure burdens to enterprises located outside their jurisdiction, leading to higher institutional trade costs and lower fiscal sustainability; on the other hand, the persistence of zombie firms crowds out the resources available to healthy enterprises and distorts the allocation of factor resources, thereby impeding the ability of local products to compete effectively in intercity markets. However, enhancing the business environment and upgrading the industrial structure can effectively mitigate the market fragmentation induced by such inefficient subsidies. This research offers a novel perspective for quantifying local protectionism and provides important implications to improve DMI as well as sustainable economic development.