Access to globally-sourced inputs can bring a variety of benefits to firms, from higher profit margins to product upgrading, but it comes at the expense of protectionist producers. In this paper, we study who wins the political contest in China between firms seeking cheaper inputs abroad and protectionist producers. We argue that the central government privileges firms under its direct control (yangqi) that it relies on for tax revenue. We propose a theory with firm-specific costs for tax avoidance to show the strategic decision revenue-seeking policymakers face in distributing tariff reductions when the development of fiscal capacity is slow. We test this argument using firm, product, and industry-level evidence, a novel method to detect corporate tax avoidance, as well as qualitative evidence from fieldwork on the policymaking process. We find that at both the firm and product levels, tariff reductions are concentrated on imports of these privileged and compliant producers that provide the lion’s share of the central fiscal revenue. In return, these firms are allowed exclusive preference aggregation channels to policymakers – bypassing the bureaucratic bottleneck that confronts private firms – and ultimately lower tariffs on their internationally sourced inputs.
Economic openness is typically associated with the loss of tax revenue in developing economies. In contrast, this paper illustrates that China’s thirty years of economic openness led to growth in fiscal capacity and unification of subnational taxing efforts, characterized by the centralization of taxing rights of corporate taxation and
the expansion of tax bureaucracy. Theoretically, we contend that this aligns with the compensatory explanation for public sector expansion: the trade-induced relative decline of the privileged state sector necessitates compensation funded by raising taxes from the rising private sector. Empirically, we collected original and rich data on the universe of bureaucratic recruits, firm registration, and industry-level FDI. With Bartik export and FDI shock measures resulting from China’s WTO entry, we show that economic openness leads to the expansion of the nonstate sector, centralized tax bureaucracy, government budget, and central-local transfer scheme to disburse wages for local public jobs, strengthening the state’s control over the new subnational tax sources and ultimately a transitioning society.