Fiscal capacity and capital misallocation: the economic costs of tax evasion

This paper examines developing countries’ low administrative capacity to enforce uniform tax rates across space as a driver of capital allocation and a cause of low productivity. We rely on the Golden Tax Project, an information technology reform in China that eliminates the need for local tax-enforcing agencies to verify firm sales and purchases through onsite inspections, as a natural experiment to study the effects of fiscal capacity on firms’ location and capital allocation decisions. Exploiting the heterogeneous shocks that the reform exerts on the fiscal capacity of Chinese counties with different geographic ruggedness, we find that the Golden Tax Project significantly leveled effective tax rates across Chinese counties, which caused capital to relocate out of counties that experienced a bigger fiscal capacity boost after the reform. Such cross-county capital reallocation significantly equalized the marginal product of capital across firms and caused a rightward shift in productivities among them. • Technological innovations for electronically submitting and cross-checking invoices improve tax enforcement. • Local fiscal capacity influences firm location and capital allocation decisions. • Uneven tax enforcement across locations leads to capital misallocation across firms and reduces firm productivity.