How Does Tax Structure Affect The Governance Capacity Of Local Governments In China?

The third plenary session of the 18 th Central Committee of the Communist Party of China(CPC)addressed the fundamental role of the fiscal system in achieving the goal of promoting the modernization of the national governance system and governance capacity.Thus,it is necessary to consider the tax system’s impact on local governments’ governance capacity as an integral part of the fiscal system.Firstly,optimizing the tax system is important to clarify the boundary between the government and the market,enhancing local governments’ governance capacity.Secondly,taxation is fundamental to relations between governments and citizens.Despite significant attention paid to tax structure,previous studies usually focus on its economic effect,failing to examine the potential effect of tax structure on governance.Moreover,they mainly focus on the national or provincial levels,neglecting the importance of the governance capacity of grassroots governments.Thus,this study seeks to use 13 prefecture-level cities for 2008-2019 in Hunan Province as an example,constructing a governance capacity index(GCI)and calculating the value of each city each year using the Entropy method.Based on the GCI,this study examined the impact of tax structure on local governments’ governance capacity.Given the dynamic nature and high persistence of governance capacity,this study also used the system generalized method of moments(GMM)estimators.The results highlight that both indirect tax and direct taxes can significantly improve local governments’ governance capacity by increasing local governments’ revenue.Thus,increasing indirect tax revenues can provide a good financial basis for improving the government’s governance capacity,especially for developing regions.Compared to VAT and corporate income tax,personal income tax has the most significant impact on the government’s governance capacity by increasing government revenues and citizens’ motivation to monitor government actions.The findings suggest that for developing regions like Hunan province,governments’ revenue is still the key factor for improving their governance capacity.