How significantly and through what mechanisms can regional economic disparity be shaped by fiscal incentives? This paper uses the exemption of the agricultural tax in 2005 across China as a natural experiment to answer this question. Using a “difference-in-differences” model, which allows us to make within-group comparisons before and after the reform, we show that the revenue loss of county governments aggravated inter-regional economic disparity. Reasons behind it lie in the different tactics that local governments employed when dealing with the financial stress. In particular, governments in lower-income regions chose a negative way including tougher tax enforcement and less production-oriented investments, while those in higher-income localities embraced positive taxation and expenditure strategies to attract more capital inflow. This paper helps shed light on how to optimize fiscal system arrangement to alleviate the broadening regional economic disparity and improve local fiscal sustainability.

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