Local information and the stabilization role of local government: Evidence from a natural experiment in China

Oates, (1972) argues that local governments cannot use conventional policies to stabilize economies, due to fiscal spillovers and beggar-thy-neighbor policies. Hayek's theory implies it is efficient for a central government to devolve decision-making authority to local governments that have informational advantages. This paper tests the different theoretical implications by examining a natural experiment caused by the income-tax-sharing reform in China. Our analysis reveals that local government size does have a stabilization effect, but vertical fiscal imbalance (VFI) substantially weakens this stabilizing effect; lack of local information is the key factor leading to this influence of VFI.