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Local Government Financial Constraint and Spending Multiplier in China

I estimate the present value of local GDP increases by about 11.4 RMB for 1 RMB increase of government spending during 2001-2019 at the prefecture city level in China, where the local governments play an active role in increasing economic growth. To achieve identification, I construct a novel instrument for local government spending: the fraction of unoccupied raw land in the downtown area in 2000. After 2000, as the local governments increasingly rely on land sales to finance expenditures, a higher fraction of unoccupied raw land is associated with less compensation expense to occupants removed from the land and hence higher net profits from land sales for local governments. Moreover, the fraction of raw land is orthogonal to a rich set of city fundamentals in 2000 and major confounding shocks after 2000. The high multiplier can be explained by the local government financial constraint because it is found to be significantly lower if the local governments have better access to debt financing or face less investment opportunities. The mechanism is consistent with models where government spending is investment. Higher government spending is found to increase employment and private investment, and the total output effect of the increased inputs can explain almost all the increase of local output. The paper highlights the macroeconomic importance of the financial constraint of governments that actively invest to promote economic growth.