Discretionary Charges as Firm Output Distortions: Evidence from China⇤

This paper studies discretionary charges, which I define to be fees and levies that are collected at the discretion of local officials, as firm output distortions. I document that there is an inverted-U relationship between size of firms and discretionary charges paid by firms in China. I build a simple political economy model that captures interactions between firms and local officials. 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. This decline was most likely driven by slower growth rates of existing small firms. These results suggest that low tax revenues and lack of legal protection of firms may help explain why there are more small firms and why there is larger firm productivity dispersion in low-income countries.