Fiscal Decentralization, Local Protection and Market Segmentation

This chapter investigates the impact of fiscal decentralization on regional industrial specialization in China. The theoretical and empirical analyses demonstrate that fiscal decentralization incentivizes local governments to adopt protectionist policies, which hampers regional specialization. However, increased openness to external markets weakens the distortive incentives for local authorities to engage in such protectionist behaviour. In regions with lower economic openness, fiscal decentralization tends to lead to more pronounced market segmentation. As economic openness rises, local governments gradually reduce market protection efforts and shift towards reaping the benefits of regional industrial specialization. Furthermore, this chapter reveals that the effect of fiscal decentralization on regional despecialization was more pronounced before the implementation of the tax-sharing reform.