| This paper investigates the relationship between discretionary charges, which I define to be fees and levies that are collected at the discretion of the local government, and the firm size distribution. I document that there is an inverted-U relationship between the discretionary charges paid by firms and the size of firms in China. I build a political economy model that captures interactions of firms, the local government, and the central government. These interactions explain why discretionary charges fall most heavily on medium-sized firms and, consequently, reduce the number of medium-sized firms. Using the 2002 Chinese Income Tax Reform as a natural experiment, I find that a 1 percentage-point reduction in local tax revenue increased discretionary charges on firms by approximately 2 percent on average, with medium-sized firms experiencing the largest increase of 4.7 percent. In addition, a 1 percentage-point reduction in local tax revenue resulted in a 1.2 percent decline in the number of medium-sized firms as a share of total firms. These results suggest that low local government tax revenues may help explain why there are relatively fewer medium-sized firms and why there is larger firm productivity dispersion in low-income countries. |
