Fiscal stress and the formation of zombie firms: Evidence from China

We investigate the causality between government fiscal stress and the formation of zombie firms. We use the province-managing-county reform recently initiated in China to exogenously identify the change in financial pressures of local governments. Matching industrial firm data and county economic data from 1999 to 2013, we carry out difference-in-differences estimation and find that the possibility of zombie firms' formation significantly decreases after the reform. Specifically, the suppression effect is more pronounced in counties with low level of initial economic development, more debt stocks, poor financial situations, and high employment pressures. Further, the mechanism analysis shows that the reform improves firms' performance, such as productivity and profitability, through the decline of tax burden, which inhibits the formation of zombie firms. Our study contributes to a profound understanding of the causes of zombie firms in a large transition economy.