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Fiscal policy volatility and capital misallocation: Evidence from China

Author

Listed:
  • Ding, Sai
  • Jiang, Wei
  • Li, Shengyu
  • Wei, Shang-Jin

Abstract

This paper investigates how domestic policy uncertainty stemming from discretionary fiscal policy disrupts efficient capital allocation across firms. While fiscal policy represents the government’s reaction to economic conditions, its volatility presents firms with considerable uncertainty about conditions affecting their future profitability and consequently disrupts decisions about investment in the presence of capital adjustment costs. Using firm-level data from Chinese manufacturing industries spanning from 1998 to 2007, we find that reducing fiscal policy volatility leads to a decrease in the dispersion of the marginal revenue product of capital, accounting for 8.3 percent of the observed improvement in capital allocation during the sample period. In addition to various fiscal reforms to curb fiscal policy volatility directly, policies contributing to lower capital adjustment costs and lower reliance of firms on government expenditure can alleviate the adverse effects of fiscal policy volatility.

Suggested Citation

  • Ding, Sai & Jiang, Wei & Li, Shengyu & Wei, Shang-Jin, 2024. "Fiscal policy volatility and capital misallocation: Evidence from China," European Economic Review, Elsevier, vol. 167(C).
    • Handle: RePEc:eee:eecrev:v:167:y:2024:i:c:s0014292124001260
    DOI: 10.1016/j.euroecorev.2024.104797
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    More about this item

    Keywords

    Fiscal volatility; Capital misallocation; MRPK dispersion; Capital adjustment costs; China;
    All these keywords.

    JEL classification:

    • D24 - Microeconomics - - Production and Organizations - - - Production; Cost; Capital; Capital, Total Factor, and Multifactor Productivity; Capacity
    • E62 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Fiscal Policy; Modern Monetary Theory
    • O23 - Economic Development, Innovation, Technological Change, and Growth - - Development Planning and Policy - - - Fiscal and Monetary Policy in Development

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