Banking on Taxes: Financial Expansion as Tax Policy

Do governments intentionally implement non-tax policies to expand the tax base and raise revenue? Answering this question requires plausibly exogenous fiscal shocks, a measurable non-tax intervention, and evidence of government intent. We address these requirements by studying China’s 2005 abolition of the agricultural tax, which generated differential fiscal shocks across cities because formula-based transfers incompletely offset revenue losses. In this setting, bank expansion was a feasible non-tax instrument, and annual government work reports provide statements of policy rationale. Using a difference-in-differences design, we show that cities with larger net losses opened more bank branches, particularly local banks. Firms in more exposed cities increased borrowing, expanded their tax base (output, value-added), and ultimately paid more in taxes. The resulting revenue gains exceeded the initial losses. Text analysis of government work reports supports tax revenue intent for this financial tax policy. We also document policy costs of non-tax policies, including higher pollution and greater fiscal volatility, and show that political incentives and market conditions shape the implementation of such policies.