The political economy of ratchet effect: Evidence from China's environmental regulation

The ratchet effect is a critical component in dynamic incentive designs. This paper exploits China's recent adoption of minimum performance standards in air pollution controls and variations in the frequency of target assignment, and utilizes Regression Discontinuity Design to estimate the impact of target ratcheting on Chinese local officials' incentives to reduce air pollution. We find strong evidence that (i) when local officials fail the minimum targets and try to make up for the failure to avoid severe punishment, the prospect of being ratcheted would weaken the make-up efforts, and (ii) air quality will significantly deteriorate after local officials fulfill the minimum targets ahead of schedule, regardless of whether local officials face the prospect of target ratcheting. We further discover that job rotation and the existence of comparable peers could effectively mitigate the ratchet effect.