How Reforms Worked in China?
1. A Reform That Worked But Puzzling
In the last 20 years of the 20th century, China transformed from a poor, centrally planned economy to a lower middle-income, emerging market economy.
China's GDP grew at an average annual rate of over 9%, and per capita GDP quadrupled.
Benefits of growth were shared, with the number of people in absolute poverty decreasing from over 250 million to about 50 million.
Life expectancy increased from 64 in the 1970s to over 70 in the late 1990s.
China's growth is surprising given its initial conditions: poverty, overpopulation, lack of human capital and natural resources, and ideological opposition to markets.
China is the largest transition and developing economy, with a population three times more than all other transition economies combined.
Its economy was larger than all other transition economies combined as of 2000.
China's population is almost three times that of the eight high-performing East Asian economies.
In terms of purchasing power parity, China’s current per capita GDP is about 1/10 of that of the U.S. (roughly speaking, 3,000 vs. $30,000).
Because China has the population approximately five times as large as the U.S., China’s total GDP, in terms of purchasing power parity, is about one-half of that of the U.S. at the present time.
If China continues to grow five percentage points faster than the U.S., then China’s total GDP will be larger than that of the U.S. in 15 years.
China has managed to match the growth record of these economies during their heyday, but on a population size much larger.
In 1988, China's total GDP was less than half of Russia's, but ten years later, Russia's was less than half of China's.
Two decades ago, China and India were about equal on a per capita basis, but now China is about twice as rich as India.
Defying the perception that China has reached a plateau of growth, more and more economists start to believe that the best part of China’s growth has not come yet.
With the imminent entry into the World Trade Organization (WTO), they suspect that China’s economy is perhaps on the verge of the next boom.
According to Maddison's (1998) calculation, China might overtake the United States in total GDP in terms of “purchasing power parity” by 2015.
China would be the only economy, excluding European Union, possible of surpassing the U.S. economy in the next two decades.
Lawrence Summers speculated in the early 1990s: “It may be that when the history of the late 20th century is written in a hundred years the most significant event will be the revolutionary change in China” (Summers, 1992).
China's reform has worked based on economic growth and improving living standards, but it is puzzling.
In the early 1990s, the economics profession and policy makers reached a “surprising degree of unanimity” (Summers, 1991) on the recipe for transition form plan to market.
Simply put, it calls for stabilization, liberalization, and privatization, following political democratization.
Although China has adopted many of the policies advocated by economists, such as being open to trade and foreign investment and sensitive to macroeconomic stability, violations of the standard prescriptions are striking.
For the most part of the past two decades, China's reform succeeded without complete liberalization, without privatization, and without democratization.
One might have reasoned that coexistence of the planning mechanism with partial liberalization would only cause more distortion and become a source of disruption, not growth.
Without privatization and secure private property rights, one might conclude that there could not be genuine market incentives.
Without democracy, economic reform lacks a political basis and commitment to a market and thus is vulnerable.
China's actual performance contrasts with these expectations.
China's reform has been viewed as an anomaly and not appreciated by mainstream economists.
World Development Report 1996 on transition economies only gave China short shrift because it couldn't figure out where to put China on the various measurement parameters.
Two common misperceptions of China’s economic success are:
Regarding foreign direct investment (FDI) and exports as the driving force.
The roles of overseas Chinese and of Hong Kong and Taiwan are often emphasized.
The argument immediately loses its plausibility as soon as one considers a parallel experience in Germany.
If Hong Kong or Taiwan could play such a powerful role on mainland China, West Germany should have been even more effective on East Germany.
The role of FDI in China is vastly overstated.
For the entire 1980s, FDI in China was tiny.
FDI only started to increase substantially in 1993, and at its peak it accounted for about 10 percent of total investment.
China’s exports expanded very fast but it cannot be the main story.
The direct contribution of foreign trade and investment to large countries cannot be quantitatively as important as to those small countries.
China's growth was not just a phenomena of coastal provinces--it is across-board, both coastal and inland.
Inland provinces grow fast while coastal provinces just faster.
About 20 out of top 30 growth regions in the world in the past two decades would be provinces in China, a lot of which did not receive much foreign investment and did not depend on exports.
If focusing on FDI and foreign trade leads to a downplay of the entire reform process and of the role of indigenous institutions then the simple-minded view on trade and foreign investment would create obstacles to the understanding of growth in any country.
The effectiveness of openness has to work through the corresponding internal changes.
Russia became very open after reform, more so than China, but neither higher growth nor more FDI ensued.
Therefore, it could well not be the export that drives growth, but the same forces of domestic changes drive both export and domestic growth.
Attributing it exclusively to the agricultural reform in the early 1980s.
China’s agricultural reform was a huge success because it is pretty much a standard story of family farming plus market liberalization.
There seemed to be significant contributions from the rural R&D and infrastructure investments made in the 1970s on the agriculture productivity growth in the 1980s; and the state institutions for marketing also played important roles in rural development
Economists are generally comfortable with the Chinese agriculture reform because it fits well their models of the world.
The agriculture reform is the first reform success in China, and its bigger achievements lie elsewhere.
At the outset of reform in the late 1970s, over 70 percent of China’s labor force was employed in agricluture.
By 2000, China’s agriculture labor force already declined to below the 50 percent mark, which is impossible without successful development outside the agriculture sector.
In the late 1990s, the agricultural share of China's GDP was as 16 percent, about the same level as that in Poland and the Soviet Union in the early 1980s.
Most China’s growth came from the non-agricultural sector -- the industrial and tertiary sectors.
Successful agriculture reform provides sources of savings and labor to boost or even drives industrialization.
Reforms of the non-agriculture sector is necessary, and how China managed it went beyond the agriculture success.
The main success of China’s reform is outside the agriculture sector.
2. Perspectives on Institutions
Economists consider labor, physical capital, human capital, and productivity as the proximate determinants of growth.
Factor accumulation and productivity changes are endogenous, depending on the improvement in technology, allocative efficiency, and incentives, which in turn are shaped by institutions.
The advocates of New Institutional Economics recognize that a good market economy requires not only “getting prices right,” but also “getting property rights right” and “getting institutions right.”
Property rights and institutions set the rules to affect the behavior of economic agents.
The institutional economists regard the conventional wisdom of transition focusing on stabilization, liberalization, and privatization as inadequate, missing the important institutional dimension.
A set of institutions is critical for sustained growth, including:
Secure private property rights protected by the rule of law.
Impartial enforcement of contracts through an independent judiciary.
Appropriate government regulations to foster market competition.
Effective corporate governance.
Transparent financial systems.
These institutions can be readily found in the developed economies, especially in the U.S., implying that they are “best practice” institutions.
Economists use these institutions as a benchmark to judge transition and developing economies, often finding huge institutional gaps.
These findings serve three purposes:
Diagnosis of the deficiency of institutions.
Explain why these economies perform poorly.
Lead to recommendations for institution building.
This “menu perspective” on institutions is useful in providing a benchmark of best practice institutions with which today’s most developed economies have achieved to the development frontier.
Compare China with Russia for the last decade. Neither of them had the rule of law, secure private property rights, effective corporate governance, or strong financial system. But the two exhibited a huge performance difference.
A similar problem also arises from cross-country regressions that incorporate institutional development indices.
For example, the World Bank study Beyond Washington Consensus: Institutions Matter (Burki and Perry, 1998) gets serious on institutions.
It compiled a “composite institutional development index” for each country, and the study carried out cross-country growth regressions using this index to find out positive associations between economic growth and institutional development.
While the cross-country regressions are useful in estimating the magnitudes of the effects of explanatory variables on growth, they only do this right when the latter are correctly measured and truly exogenous.
China, together with Taiwan and Chile, is an outlier in the regression showing the relationship between institutional development and economic growth.
China is again an outlier in the more refined regression of the “true” partial coefficient between institutional development and growth, together with Thailand, Indonesia, and Korea.
In all these cross-country regressions, China’s performance is too high relative to its index value of institutional development.
This is not too surprising because the measurement of the institutional development index is simple-minded and the underlying variable is likely not exogenous.
Recognizing the importance of institutions is only a beginning.
A major problem in the study of reform in developing and transition economies is the naive perspective on institutions.
The naive perspective often confuses the goal (i.e., where to finish up) with the process (i.e., how to get there) and thus tends to ignore the intriguing issues of transition paths connecting the starting point and the goal.
It is as if one neglects the “transition equations” (or “equations of motion”) and the “initial conditions” in dynamic programming.
Although building best practice institutions is a desirable goal, getting institutions right is a process involving incessant changes interacting with initial conditions.
The difference between China and Russia lies in the institutions in transition.
To understand how reforms work in developing and transition economies, we need to broaden our perspective on institutions.
It is not enough to study the familiar forms of conventional institutions found in the most developed economies as a desirable goal; it is also essential to study the variety of unfamiliar forms of institutions in transition.
The distinction between the conventional, best practice institutions and the transitional institutions is important.
Gershenkron (1962) made a crucial point in his studies of the economic development of latecomers: the latecomers need to make special arrangements to compensate for their backwardness, and they can find ways to do so.
The broadened perspective on institutions takes a dynamic, not static, views on institutions.
It recognizes that the real challenge of reform facing transition and developing countries is not so much about knowing where to end up, but about searching for a feasible path toward the goal.
Therefore, it focuses on transitional institutions, not best practice institutions.
In the metaphor of mountain climbing, although the peak of a mountain offers the best view, mountaineers enjoy a better and better view along the path toward the peak.
For mountaineers, the most challenging job is not the study of the peak, but the search for a feasible path toward the peak.
Like Shleifer and Triesman’s (1999) study of Russian transition, our study of China’s transition is not about what is desirable, but about what is feasible.
Compared to the developed economies, the backwardness resulting from the initial institutional conditions in transition and developing economies can be both disadvantageous and advantageous for growth.
On the one hand, the immediate effects of the initial institutional conditions are generally not hospitable to growth in most transition and developing economies.
Moreover, although these countries can take advantage of being latecomers to shorten the time of change, they may not be able to make and complete all the changes in a short period of time.
This is disadvantageous for growth.
On the other hand, however, because the adverse initial institutions created myriads of distortions, these economies usually enjoy great growth potential once institutions are changed to remove these distortions.
The central question for many transition and developing countries is how to make institutional changes to realize the great growth potential when the initial condition has myriads of distortions.
Underlying China’s reform is a serial of institutional changes in the novel form of transitional institutions.
These institutions work because they achieve two objectives at the same time -- they improve economic efficiency on the one hand, and make the reform a win-win game and interest compatible for those in power on the other.
And they take into consideration of China’s specific initial conditions.
At one level, one could argue that China’s transitional institutions merely unleashed the standard forces of incentives, hard budget constraints, and competition. This is true, but such an economic rationale is not enough.
The transitional institutions are not created solely for increasing the size of a pie, they are also created to reflect the distributional concerns of how the enlarged pie is divided and the political concerns of how the interests of those in power are served.
Rudimentary political logic readily predicts the existence of inefficiency, but it has difficulties in explaining why inefficient institutions are replaced by more efficient ones.
China’s reform shows that when the growth potential is large, with intelligence and will, reformers can devise efficiency improving institutional reforms to benefit all, including and especially those in power.
There is apparently a larger room than we thought for institutional innovations to simultaneously address both the economic and political concerns, that is, to make a reform efficiency improving and interest compatible for those in power.
Successful institutional reforms usually are not a straightforward copy of best practice institutions.
They need not be because huge room exists for efficiency improvement that does not require fine-tuning at the beginning.
They should not be because many dimensions of the initial conditions are country and context specific that require special arrangements to accommodate.
Therefore, inevitably, transitional institutions display a variety of non-standard forms.
Because these institutions are often responses to the initial institutional distortions, the mechanisms of their functioning can be intricate.
Understanding these mechanisms sometimes needs to appeal to the seemingly counter- intuitive “second-best argument,” which states that removing one distortion may be counter- productive in the presence of another distortion.
Studying institutions in transition requires careful, and sometimes imaginative, analysis.
In this paper we study the general principle and the specific mechanisms underlying China’s transitional institutions through the analysis of four successful reforms and one failure.
Together, these five examples cover a broad spectrum of institutional reforms of the market, firms, and the government.
The first example is about market liberalization through the so-called “dual-track” approach under which prices were liberalized at the margin while inframarginal plan prices and quotas were maintained.
The second example concerns an innovative ownership form of firms – local government ownership in general and rural Township-Village Enterprises (TVEs) in particular.
The third example is on how to make fiscal federalism productive. China’s fiscal contracting between the central and local governments has worked to provide the incentives for local governments to pursue economic prosperity.
The fourth example is about how to constrain the government in order to protect private incentives in the absence of rule of law.
One miserable failure is the reform of large-scaled state-owned enterprises (SOEs).
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3. Creating the Market: A Dual-Track Approach to Liberalization
The simplest way to demonstrate how China's reform worked is through an illustration of the dual track approach to market liberalization (Lau, Qian, and Roland, 2000).
It highlights the general principle underlying this innovative, transitional institution in the most obvious way: making reform efficiency-improving and interest-compatible.
It also shows how the initial conditions play a role in implementing the reform, including how to use the existing institutions.
An essential building block of a market system is allocating resources according to free market prices.
An essential ingredient of any market-oriented reform involves price liberalization.
The Eastern European experience has shown two alternative approaches.
In the first approach, practiced in Hungary, for example, after its 1968 reform, bureaucrats set prices administratively, supposedly by market supply and demand.
This approach proved a failure.
After 1990, Eastern European countries have adopted a standard approach: prices are freed in one stroke and determined solely by the market.
China adopted a third, unconventional approach to market liberalization known as the dual-track approach.
Under the plan track, economic agents are assigned rights to and obligations for fixed quantities of goods at fixed planned prices as specified in the pre-existing plan.
At the same time, a market track is introduced under which economic agents participate in the market at free market prices, provided that they fulfill their obligations under the pre-existing plan.
In essence, prices were liberalized at the margin while inframarginal plan prices and quotas were maintained for some time before being phased out.
Clearly this approach differed from the two approaches experienced by the Eastern European countries: it differs from their experience prior to 1990 because real market prices and markets as a resource allocation institution were created immediately. It was also different from their experience after 1990 because of the continued plan track.
The first implication of the dual-track approach is political: it represents a mechanism for the implementation of a reform without creating losers.
The introduction of the market track provides the opportunity for economic agents who participate in it to be better off, whereas the maintenance of the plan track provides implicit transfers to compensate potential losers from the market liberalization by protecting the status quo rents under the pre-existing plan.
This can be seen easily from the special case of efficient rationing and efficient planned supply, that is, the planned output is allocated to users with the highest willingness to pay and the planned supply is delivered by suppliers with the lowest marginal costs.
Dual-track liberalization means that planned quantity continues to be delivered at plan price but any additional quantity can be sold freely in the market.
With the dual track, the surpluses of the rationed users and the planned suppliers remain exactly the same. At the same time the new users and suppliers outside the plan are together better off.
In comparison, the single track approach to liberalization in general has distributional consequences that cannot guarantee an outcome without losers.
The second implication of the dual track approach is economical: it always improves efficiency.
Moreover, as the compensatory transfers are inframarginal, the dual-track approach may achieve allocative efficiency too.
This can be seen most obviously in the special case of efficient rationing and efficient planned supply.
However, efficiency can still be achieved under full market liberalization under which market resales of plan-allocated goods and market purchases by planned suppliers for fulfilling planned delivery quotas are permitted after the fulfillment of the obligations of planned suppliers and rationed users under the plan (Lau, Qian, and Roland, 2000).
This type of transactions take many common forms in practice, for examples, subcontracting by inefficient planned suppliers to more efficient non-planned suppliers, and labor reallocation when workers in inefficient enterprises keep the housing while taking a new job in more efficient firms.
The dual track approach to market liberalization is an example of reform making best use of existing institutions.
It utilizes efficiently the existing information embedded in the original plan (i.e., existing rents distribution) and thus its implementation does not require additional information.
It also enforces the plan through the existing plan institutions and does not need additional institutions.
Agricultural market liberalization followed the dual-track approach.
The commune (and later the households) was assigned the obligation to sell a fixed quantity of output to the state procurement agency as previously mandated under the plan at predetermined plan prices and to pay a fixed tax to the government.
It also had the right to receive a fixed quantity of inputs, principally chemical fertilizers, from state-owned suppliers at predetermined plan prices.
Subject to fulfilling these conditions, the commune was free to produce and sell whatever it considered profitable, and to retain any profit.
Moreover, the commune and households could purchase grain (or other) outputs from the market for resale to the state to fulfill its responsibility.
Under the dual-track, the state procurement of domestically produced grains between 1978 and 1988 remained essentially fixed, with 47.8 million tons in 1978 and 50.5 million ton in 1988, while total domestic grain production increased from 304.8 million ton to 394.1 million ton, almost a one-third increase.
Industrial market liberalization also shows how markets could grow out of plans (Byrd, 1991; Naughton, 1995).
For coal, the planned delivery was increased somewhat from 329 million tons in 1981 to 427 million tons in 1989 (mainly because new state coal mines were opened), but the market track increased dramatically from 293 million tons to 628 million tons in the same period.
For steel, the plan track was quite stable in absolute terms, but the share of plan allocation fell from 52 percent in 1981 to 30 percent in 1990.
In the cases of both coal and steel, because the plan track was basically "frozen," the economy was able to grow out of the plan on the basis of the market track expansion by state or non-state firms.
Labor-market development follows a similar pattern.
Employment in the non-state sector increased from 48.9 million to 204.85 million in 1994.
Employment in the plan track has been virtually stationary -- it went from 74.51 million in 1978 to 83.61 million in 1994.
4. Developing Firms: Non-Conventional Ownership Form of Township-Village Enterprises
Ownership reform of firms is a central issue in transition to market.
In the earlier reforms (prior to 1990), there was a lack of development of non-state enterprises and a lack of privatization of state-owned enterprises, both were thought responsible for the reform failure.
In the post-1990 transition, mass privatization of state enterprises became the cornerstone of the reform, and in many cases, it was a political mandate.
New entry private firms, rather than privatized state firms, have been the driving force for recovery and growth.
New entry firms have been also the driving force of China’s growth.
China differs from Eastern Europe and most other developing economies: in the first fifteen years of reform between 1979 and 1993, most new entry Chinese firms were neither private firms nor state firms but local government firms.
Private enterprises played only a minor role: in 1993 they contributed to less than 15 percent of the national industrial output.
Local government firms contributed to 42 percent of the national industrial output.
The crucial feature of TVEs is the local community (i.e., township or village) government control of firms, in contrast with private or national government control.
One of the most salient institutional features in China (and in many developing countries as well) is the absence of rule of law to protect private property rights.
Combined with strong anti-private property ideology that inherited from the central planning era, private property rights, both cash flow and control over assets, are not secure.
The state has attacked private enterprises during several general political crackdowns after the reform, which include the “anti- spiritual pollution campaign” of 1983, the “anti-bourgeois liberalization campaign” of 1987, and most recently, after the Tiananmen Square of 1989.
In such an institutional environment the property rights of local government-owned firms, such as TVEs, can be more secure than those of private enterprises because of the protection of community governments.
The political support provided by the local governments makes them useful to the national government, which could the basis of power of local governments.
Their support for the national government takes a different form -- providing local public goods, such as maintaining order, building roads, providing water and irrigation system, and implementing family planning.
These local public goods have both political and economic dimensions.
Because the local community government engages in the activity of providing local public goods, the interests of the national government will potentially be more aligned with those of the local governments than with those of a private enterprise owner.
Indeed, when the local government controls TVEs, it will become more useful to the national government than private owners.
Ownership of firms provides owners with control over firms’ books and accounts, which allows the owner to hide and receive unobservable parts of the revenue.
In the case of local government ownership it is the local government who has the control rights and receives unobservable revenue.
When the local government runs a business, ownership and control rights interact with government activities and generate two effects that are absent under private ownership.
First, the local government would have higher incentives in providing local public goods because its ownership rights give it access to the future revenue in a credible way.
Second, anticipating this, the national government would leave bigger budget to the local government and thus optimally prey less on TVEs than on private enterprises. This in turn makes the local government less worried about revenue confiscation and reduces TVE revenue hiding.
Both effects improve efficiency.
TVEs not only have contributed to growth, but also served the interests of national and local governments.
The crucial linkage is the role of local government in providing local public goods.
The national government has stipulated that the TVE after- tax profits should be essentially used for two purposes: reinvestment and provision of local public goods.
From the panel data of 28 provinces between 1986 and 1993, the relationship between ownership forms and fiscal revenues of local and national governments have been estimated (Jin and Qian, 1998).
The main findings are that, in rural China, the share of TVEs relative to private enterprises in a province has a positive association with the revenue shares of the national and especially the township and village governments, after controlling for the level of per capita income and other geographic variables.
Specifically, a 10 percentage point increase in the share of TVEs relative to private enterprises in the total rural non-agriculture employment (i.e., TVEs plus private enterprises) is associated with a 1.1 percentage point increase in the revenue share to the national government.
These results indicate that local government ownership not only provides higher revenues to both the national and township and village governments, but also makes proportionally more revenue stay in rural areas rather than going to the urban areas.
One of the common institutional problems in developing and transition countries is an inadequate taxation system for generating tax revenue for the government and a good fiscal system to use the revenue.
After the liberalization of prices and ownership, profits are more equally distributed among different sectors and the government loses revenue bases, especially in enterprises it does not control (McKinnon, 1993).
Local government ownership of TVEs can work in mitigating both problems.
With the ownership and control rights over firms, the local government has a less costly way to extract revenues from these firms than from private firms because the latter control their own financial accounts.
For the same reason, when local governments control firms, it is harder for the central government to extract revenue from them, and thus revenue is more likely to stay in the local areas.
The root of TVE organization is the agricultural commune system initiated in 1958.
Commune and Brigade Enterprises were renamed as TVEs in the 1980s and became the engine of growth and the driving force for the market-oriented reform.
The same local government ownership became something phenomenal only in a particular time period under particular circumstances with complementary changes in other aspects of the economy.
The fact that TVEs are being privatized in the 1990s is another reminder that one should not take a static view on institutional reforms.
5. Reforming the Government: Productive Fiscal Federalism
Economists working on transition used to focus on the trilogy of stabilization, liberalization, and privatization.
Arguably, Russia has implemented more reforms in the areas of price and trade liberalization and privatization than China.
Nevertheless local governments in Russia are often blamed for being the obstacles to local development.
Local governments in China have been viewed as being very enthusiastic in supporting local development and helping local businesses.
The difference cannot be attributed to that China has developed better rule of law than Russia.
One plausible explanation is the local government’s fiscal incentives.
An important, innovative reform in China has been a fiscal reform concerning the central- local relations, which started as early as in 1980.
After excluding price subsidies during 1986-90 to make the data comparable to previous periods, the shares of local spending came down to about 50 percent.
China's decentralization involved more than just the devolution of government authority. It also involved changes introduced between 1980 and 1993 in the fiscal incentives for local governments through the so-called “fiscal contracting system.”
Government revenue in China falls into three categories: budgetary funds, extra-budgetary funds, and off-budget funds.
Up to 1994, all budgetary revenues except custom's duties were collected by local governments.
In 1980, reforms put into place the new fiscal system known by the nickname “eating from separate kitchens.”
Government revenue in China falls into three categories: budgetary funds, extra-budgetary funds, and off-budget funds.
The off-budget funds are not recorded, so little can be said about them.
Extra-budgetary revenue consists of tax surcharges and user fees levied by the central and local government's agencies as well as earnings from SOEs.
The extra-budgetary local revenues are not subject to sharing with the central government but the budgetary revenues are.
First, central fixed revenue was defined to include custom's duties, direct taxes or profit remittances from the central government supervised SOEs and some other taxes. All other revenue falls under the heading “local revenue.”
Second, the local revenue was divided between the central and provincial governments according to pre- determined sharing schemes.
Over time, many provincial governments retained 100 percent of the total local revenue at the margin, which effectively made them residual claimants.
The central government intended to guarantee itself a certain flow of revenue from provincial governments. Second, the central government also wants to provide provincial governments with incentives to build up local economies and their own revenue bases.
Jin, Qian, and Weingast (2001) have used the panel data of 28 provinces between 1982 and 1992 to answer these two questions.
Through the examination of the correlation between local governments' revenue generated and their expenditures one can gauge the marginal fiscal incentives of provincial governments.
The correlation coefficient between the provincial budgetary revenue and budgetary expenditure is, on average, 0.75, and that for the extra-budgetary revenue and expenditure is as high as 0.97.
These numbers imply that a one yuan increase in provincial budgetary revenue results in about three-quarters of a yuan of provincial budgetary expenditure, and the relationship becomes almost one-to-one for extra-budgetary revenue and expenditure.
Prior to the reform the central government, on average, extracted over eighty percent of any increase in provincial revenues.
The new fiscal system enhanced the fiscal incentives for local governments.
Zhuravskaya (2000) examined the fiscal incentives of city governments in the region-city fiscal relationship in post-reform Russia (city is one level below region, which in turn is one level below the federal government).
Using the data of 35 cities for the period 1992-1997, and by regressing the change in “shared revenues” between local and regional governments on the change of “own revenue,” she found that the coefficient was -0.90.
increases in a city's own revenue are almost entirely offset by decreases in shared revenues from the region to the city.
The incentive theory tells us that if the central government takes away all the locally generated revenue, the local government would have no incentives in supporting productive local businesses because it cannot benefit from such an effort.
An increase in the marginal fiscal revenue retention rate in a province by 10 percentage points is associated with an increase of 1 percentage point in the growth rate of employment by non-state enterprises in that province.
6. Constraining the Government without Reducing Its Revenue
One of the fundamental institutional obstacles to economic development, according to economic historians such as North, is the lack of institutional constraint on the powerful, discretionary state.
When the state is not constrained, it faces a fundamental commitment problem, that is, how to credibly commit not to prey on private gains or intrude on private economic activities despite the great temptation to do so.
The lack of such commitment often results in excessive discretionary marginal tax rates, which are detrimental to private incentives.
When it is difficult to constrain the state power directly, it may be possible to reduce the effectiveness of the state power by reducing the information available it.
Bai, Li, Qian, and Wang (1999) suggest that reducing information available to the state has played an important role in constraining the government in China in the absence of rule of law.
This includes the practices of anonymous business transactions through the use of cash and anonymous financial assets through the use of anonymous bank deposits.
There was a very tight control over the use of cash for business transactions before the reform. Any transaction of more than 30 yuan (about US) had to go through a state bank.
During the reform, government controls were relaxed. The ratio of cash in circulation to GDP was less than 6 percent at the eve of reform in 1978, but increased to more than 13 percent in the 1990s.
When a transaction is conducted in cash rather than going through a state bank, the state obtains no information about the actual income earned through business transactions.
In China, individuals making bank deposits need not present personal IDs or register their real names.
The use of anonymous transactions and financial assets leads to a combination of income and wealth hiding, which in turn