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The inverted-U relationship between urbanization and urban-rural inequality has been relatively widely observed and investigated. However, most are confined to the context-specific empirical evidence and a certain measure of inequality. Furthermore, the discussions concerning the mechanism involved deserve focus and extension, particularly with the goal of new-type urbanization in China. This study aims to provide an analytical framework of the distribution effect of urbanization. It includes mathematical deductions based on the Gini coefficient and Theil's index, and empirical evidence relating to both the nexus and mechanisms across Chinese provinces based on panel models and mediating effect models. The key findings are threefold. Firstly, the inverted U urbanization-inequality nexus has been substantiated both theoretically and empirically, and most Chinese provinces have experienced the 'decoupling' between urbanization and urban-rural income inequality. Secondly, such relationships are regionally heterogeneous in China, which is less significant in the northeast region but quite significant in the eastern and western regions. Finally, urbanization can play a key role in narrowing the income gap between the urban and rural areas through increasing fiscal expenditure on urban-rural affairs and reducing that on science, education, culture, and health. Nevertheless, the mediating effect of local fiscal expenditure on agricultural issues is relatively insignificant. These conclusions not only provide both theoretical and empirical support for the urbanization-inequality Kuznets curve, but also specify and expand insights into the mediating role of the local fiscal expenditure structure in the pursuit of China's new-type urbanization. • The inverted U urbanization-inequality nexus is substantiated theoretically and empirically. • Most Chinese provinces have experienced the 'decoupling' between urbanization and urban-rural income inequality. • The inverted U urbanization-inequality nexus is regionally heterogeneous. • Increasing fiscal expenditure on urban-rural affairs and reducing that on science, education, culture, and health have mediating effects involved. [ABSTRACT FROM AUTHOR]