A Study on the Effects of Tax Reduction Policies on Fiscal Sustainability in China

Abstract

Tax reduction policies can promote economic development, employment, and social equity in the short term. Especially during economic downturns, their effects are even more pronounced. Following the massive tax cuts amounting to 4 trillion yuan in China in 2022, the government work report for 2023 has revealed that tax reduction will continue to be the central theme of fiscal policies. However, amidst a backdrop of economic growth slowdown, China is facing objective challenges such as sluggish growth in fiscal revenues, rising inflexibility in fiscal expenditures, mounting debt burdens, and fiscal imbalances among regions, which pose severe threats to fiscal sustainability. This paper selects panel data from 30 provinces in China from 2009 to 2019. Controlling for provincial and year fixed effects, FGLS method is used to empirically test the impact of tax reduction policies on fiscal sustainability. The results indicate that tax reduction significantly undermines fiscal sustainability, which exhibits a certain degree of persistence. Heterogeneity tests reveal that tax reduction policies have more pronounced inhibitory effects on fiscal sustainability in western regions, regions with lower proportions of the tertiary industry, and regions with higher levels of fiscal decentralization. Further analysis demonstrates that tax reduction primarily impacts local fiscal sustainability through two channels: stimulating enterprise production and distorting local government behavior. Based on these findings, our study proposes the need to moderate the pace of overall tax reduction policies in China, implement tax reduction policies with varying intensities tailored to regional characteristics, and promote tax reduction policy dividends as well as reduce policy costs to enhance fiscal sustainability.