Unfunded mandates and taxation

In mid‐2006, the Chinese central government increased the salaries and pensions of civil servants in the form of an unfunded mandate to local governments in its coastal areas but a funded mandate in others. On the basis of this policy distinction, we use the difference‐in‐difference (DiD) approach and find that this mid‐2006 unfunded mandate to coastal areas triggered their local governments to raise additional budgetary revenue to balance the increase of their budgetary expenditure. This result is robust under other approaches, such as propensity score matching and the combination of DiD with regression discontinuity, as well as with the inclusion of confounding reforms. We also find that the rule of law helped restrict unfunded counties from passing on their financial burdens to the market. Moreover, following this mid‐2006 unfunded mandate, Chinese coastal local governments increased their budgetary revenue by reducing corporate tax non‐compliance and increasing the de facto corporate income tax rate. In addition, we find some evidence that the mid‐2006 unfunded mandate in Chinese coastal areas inhibited production activities in these areas.