Optimizing the “Lucas Paradox”: The Mechanism of Local Government Debt Governance on Regional Capital Allocation Efficiency

ABSTRACT Efficient capital allocation is central to balanced regional development, yet actual capital flows often contradict classical economic predictions, a discrepancy known as the “Lucas Paradox.” This paradox is also evident in China: despite a centralized political system and unified market, persistent regional disparities and distorted capital flows remain salient. This study investigates how local government debt governance influences interregional capital flows, integrating transaction cost economics with institutional theory to develop a comprehensive analytical framework. Using data on cross‐regional investments by nonfinancial listed firms across 285 prefecture‐level cities from 2011 to 2022, we find that effective debt governance significantly promotes capital mobility and allocation efficiency by easing financing constraints, curbing opportunistic government behavior, and enhancing policy credibility. Heterogeneity analyses show that the effects are more pronounced for profitable and labor‐intensive firms, while capital‐intensive firms respond less strongly. Regionally, capital inflows into central and western areas benefit most from improved debt governance. These findings underscore the critical role of institutional arrangements in shaping interregional capital flows and contributing to more balanced regional development within transitional economies.