Local governments subsidize enterprises directly or indirectly by various means, which may lead to the over-investment behaviors of enterprises and then induce serious overcapacity problem. How do local government behaviors affect the production and capacity decisions of the enterprises? Previous studies primarily focus on the impacts of institutional factors on overcapacity but ignore the problem of information asymmetry in the market. Moreover, only a few researchers have done the empirical studies on this topic. This paper combines Chinese unique institutional background and asymmetric information environment to build a two-period dynamic game model with incomplete information, so as to explore a new mechanism of the impact of local subsidy competition on overcapacity in China. We find that the excess capacity ratio induced by local subsidy competition is larger than the normal excess capacity ratio when the market information is asymmetric. And the more subsidies an enterprise receives, the more likely the industry has overcapacity. Based on the micro-data of enterprises from 2001 to 2007 in China, this paper uses the propensity score matching difference-in-difference method to do the empirical test. The results show that: for those enterprises who have received the subsidies, the overcapacity rate after the subsidies rises by about 1% to 3%. And compared with those non-subsidized enterprises, the overcapacity rate of subsidized enterprises rises by about 2% to 12%, which indicates that local subsidies could significantly inhibit the capacity utilization rate of enterprises and exacerbate the overcapacity. This paper provides not only empirical evidence for the impact of local subsidies on overcapacity, but also some policy implications for the governments to deal with overcapacity. Firstly, the interest distribution mechanism between central and local governments should be rationalized, such as improving Chinese financial management system, which could be an institutional method used to regulate the behavior of local governments. Secondly, it is necessary to strictly formulate and implement the local subsidy rules and the local administrative accountability system, so as to strictly inhibit the local irregular and excessive subsidies. Thirdly, an effective adjustment mechanism for the local subsidies ought to be established to adjust the local subsidy structure actively and exert the overall benefits of local subsidies. The marginal contributions of this paper are as follows: firstly, on the basis of Lin Yifu’s " wave phenomenon”, this paper pays attention to the subsidy competition of local investments. We construct a dynamic game model with incomplete information to explore the new mechanism of how local subsidy competition affects the overcapacity. Moreover, we take the lead in using the propensity score matching difference-in-difference method to empirically test the impact of local subsidy competition on overcapacity, and focus on the changes in capacity utilization of enterprises before and after local subsidies. It not only can effectively alleviate the endogenous problem, but also provides some empirical and technical reference for follow-up research.