This paper investigates a question central to the long-standing debates on federalism and decentralization: how does decentralized decision-making distort the governments’ incentives to internalize border spillovers, and what are the associated economic and welfare consequences? We exploit the fact that in the event of a township merger, a polluting firm adjacent to the original “merging border” suddenly becomes at the center of the newly merged township, changing it from “polluting your neighboring township” to “polluting your own township,” which should lead to an abrupt increase in the township government’s incentive to internalize its negative environmental externalities. Collecting novel firm-level geocoded emission and production panel datasets, and exploiting more than 3000 cases of township mergers happened in China between 2002 and 2008, we find that when a polluting firm suddenly switches from “border” to “center,” it receives lower government subsidies, faces higher de facto tax rates, which would lead to reduced pollutant emissions and decreased productivity. Utilizing another transaction-level dataset containing the universe of land auctions in China, we observe that both land prices and new developments of residential buildings increase near the merging borders with polluting firms, indicating that household welfare increases with the internalization of border pollution.

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