Intergovernmental Transfers and Pollution Abatement: Revisiting the Costs of Fiscal Decentralization

Environmental degradation is one of the key costs of decentralization in developing economies. This article examines the role of fiscal transfers in pollution control through the lens of China's central–local fiscal relations. We develop a simple theoretical framework and empirically test its implications using matched panel data from the fiscal and economic statistics of China's prefecture‐level cities and the China National Tax Survey Database for 2014–2018. We find that a 1% increase in per capita fiscal transfers from higher‐level governments reduces pollution emissions from heavily polluting enterprises by 0.99%. The pollution abatement effect is more pronounced in regions with weaker initial environmental regulation, higher baseline pollution levels, greater public environmental engagement, and among firms with higher initial pollution intensity. Mechanism analysis suggests that fiscal transfers ease local fiscal constraints, strengthen local governments' environmental enforcement, and in turn induce heavily polluting firms to reduce emissions through both production cuts and technological upgrading. Further analysis reveals that increases in tax rebates and general‐purpose transfers significantly reduce corporate emissions, whereas earmarked transfers show no discernible abatement effect. By linking decentralization to environmental governance outcomes, this article provides new evidence on how intergovernmental fiscal design can reconcile local incentives with national environmental objectives.