Misallocation of factors of production has been recently viewed as a promising explanation accounting for the large difference in total factor productivity (TFP) across countries. This paper differs from previous studies by concentrating on interregional capital misallocation and by focusing on the role of fiscal decentralization in shaping misallocation. Using a city-level panel data set, we measure intra-provincial and inter-municipal capital misallocation in China over 2003-18. The empirical results based on provincial-level panel data suggest that fiscal decentralization can lower inter-municipal capital misallocation while revenue decentralization performs better than expenditure decentralization. We further find that this positive effect is more significant and much larger when the market rather than government intervention is driving the flow of capital. The results are robust to subsample regressions, IV estimations, spatial autoregressions and alternative measurement of interregional misallocation. Our study complements the literature on the causes of misallocation and enriches the understanding of the consequences of fiscal decentralization, especially in terms of economic growth and interregional inequality.