In December 2024, the Central Economic Work Conference listed “vigorously boosting consumption, improving investment efficiency, and comprehensively expanding domestic demand” as the top of the nine key tasks. The expansion of residents’ consumption scale and the upgrading of consumption level can effectively promote the optimization of economic structure, tap the potential of domestic demand, and improve people’s living standards, which is the core driving force for sustained economic growth. Vertical fiscal imbalance, as a typical problem under the decentralized system, has had a profound impact on the expansion and upgrading of residents’ consumption by changing the fiscal behavior of local governments. Most of the existing studies focus on the independent effects of fiscal vertical imbalance or transfer payments, while there is insufficient systematic analysis of the interaction and transmission mechanism between the two. Based on the provincial panel data from 2014 to 2023, this paper constructs a panel simultaneous equation model and uses the three-stage least squares method (3SLS) to empirically test the relationship and mechanism between fiscal vertical imbalance, transfer payments and the expansion and upgrading of residents’ consumption. Empirical research has found that fiscal vertical imbalance can promote the expansion and upgrading of residents’ consumption by increasing transfer payments, and this conclusion still holds true after a series of robustness tests. Specifically, the vertical fiscal imbalance can have a positive impact on the expansion and upgrading of residents’ consumption indirectly by influencing transfer payments. However, this impact cannot offset the negative direct impact of vertical fiscal imbalance on the expansion of residents’ consumption. Meanwhile, the eastern region, the southern region, developed regions, and regions with high fiscal pressure exhibit heterogeneous characteristics. Further examination reveals that fiscal vertical imbalance indirectly promotes the expansion of consumption by enhancing the inclination of fiscal expenditure based on people’s livelihood. However, the overall effect remains negative, which highlights the necessity of optimizing the structure of fiscal expenditure. Compared with previous literature, the marginal contributions of this paper are as follows: First, it constructs a theoretical framework of “vertical fiscal imbalance-transfer payments-expansion and upgrading of consumption”; Second, it empirically tests the impact effects and mechanisms from the dual dimensions of the expansion and upgrading of residents’ consumption; Thirdly, the panel simultaneous equation and the three-stage least square method are used to empirically test the above transmission mechanism, reduce measurement errors, and clarify the mechanism of “people’s livelihood expenditure bias” in influencing the role of consumption expansion; fourthly, it deconstructs the heterogeneity of the transmission mechanism from multiple dimensions to provide refined basis and theoretical support for the design of differentiated policies. This study reveals the influence mechanism of fiscal vertical imbalance and transfer payment on the expansion and upgrading of residents’ consumption, providing a theoretical basis for government departments to optimize the design of the fiscal system and scientifically formulate transfer payment policies. The research conclusion is conducive to implementing differentiated policies in response to the fiscal pressure and development level of different regions under the background of regional coordinated development. These policies, which focus on optimizing the structure of fiscal expenditure and enhancing investment in people’s livelihood, can effectively unlock the consumption potential of residents. This, in turn, provides valuable policy insights for the establishment of a “unified national market” and the realization of high-quality economic development.