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.