Digest on Embedded Power: Chinese Government and Economic Development by Lan Xiaohuan  

Summer 2023

Characteristic of Chinese Economy 1: A Market Economy System Dominated by Government-led Investment

The Chinese government is the primary investor in the Chinese economy. From industrial planning to infrastructure construction, the Chinese government not only indirectly influences economic activities through policies but also directly participates in economic activities. Through various state-owned enterprises or government funds, the Chinese government makes substantial direct investments in enterprises. This model is quite different from the private capital-dominated investment model represented by Silicon Valley in the United States. In the U.S. model, the government usually participates in economic activities as a regulator. However, in China, the government not only acts as a referee but also plays on the field.

Why can the Chinese government dominate investment?

To invest, the government first needs money.

1. Central Government’s Fiscal Power: The Tax-Sharing System Reform

Before the 1994 tax-sharing system reform, the central government’s share of total government revenue was declining yearly, leaving the central government with less money. At that time, the “contract system” was implemented nationwide. Local governments negotiated with the central government to determine the annual tax revenue that the local government would pay to the central government. The amount to be paid to the central government was fixed after negotiation, and any excess after paying this amount could be retained by the local government. This system stimulated the economic development vitality of local governments, leading to faster local economic development. The growth rate of local tax revenue was always higher than the percentage of tax revenue paid to the central government. On the other hand, local governments often implemented tax reduction policies for township enterprises to “pretend” that the local government don’t collect enough tax revenue this year so that they can have a better stand for negotiating the tax payment with the central government next year. These tax reduction policies reduced local budgetary revenue but increased extra-budgetary revenue (local governments usually compensated for some of the losses from tax reductions by increasing administrative fees, levies, and sponsorship fees, which were all extra-budgetary revenue). As a result, the local government’s share of total government revenue increased yearly, while the central government’s share of total government revenue declined yearly.

Without money, the central government could not invest in key infrastructure projects, especially those requiring cross-provincial coordination. Therefore, many “broken roads” appeared in the 1990s because local governments had no motivation to build roads in the economically marginal areas of their provinces, making it impossible to connect roads from neighboring provinces to their provinces. Such issues greatly hindered cross-provincial and cross-regional economic development and exacerbated the isolation of local economies, making it difficult to form a unified national market.

The 1994 tax-sharing system reform reversed the trend of the central government’s declining share of total government revenue. In the tax-sharing system reform, for example, with value-added tax (VAT), after the 1994 reform, the central government received 75%, and the local government received 25% (since 2016, it has been divided equally). To prevent a sharp decline in local government tax revenue, the central government implemented a “tax rebate” policy. In simple terms, it took the tax revenue of a certain year in the past as a reference point. The local government only needed to share the difference between this year’s tax revenue and the reference year’s tax revenue with the central government. This ensured that after the reform, the local government’s tax revenue would be higher than the reference year’s tax revenue, avoiding a sharp decline. However, this “tax rebate” policy also led to a surge in local tax revenue in the year before the reform (because the reference year was usually the year before the implementation of the reform policy), showing the central-local game. But overall, the tax-sharing system reform was successful. After the reform, the central government’s share of total government revenue stabilized at over 50%.

2. Local Government’s Fiscal Power: Land Finance

After the tax-sharing system reform, local governments’ fiscal power was squeezed. At the same time, the central government delegated more investment spending on local infrastructure construction to local governments. With decreasing revenue and increasing spending, local governments urgently needed new sources of income. Two things happened in 1998: first, the housing allocation system was abolished, and housing commercialization began; second, the revised Land Management Law basically locked the channel for rural collective land to be used for non-agricultural purposes. These two events established the government’s monopoly position over land as a factor of production. The era of real estate and land finance officially began. The government transformed “raw land” into “developed land” suitable for population settlement and economic development through “seven connections and one leveling” and then obtained funds by selling land use rights. These funds were then invested in industrial planning and future infrastructure construction. Urban investment companies were special products of this process. As local state-owned enterprises, urban investment companies undertook the task of transforming raw land into developed land and raising the funds needed for this task. Urban investment bonds were born accordingly.

The Pros and Cons of Government-led Investment

1. Improving Resource Allocation Efficiency

In the early stages of an imperfect market economy system, many resource allocations that the market could not complete (such as large-scale infrastructure construction and industrial planning and layout requiring substantial investment) were completed with government credit guarantees. These “heavy asset” investments have long investment cycles, low short-term returns, and unclear profitability. In an imperfect market economy system, relying entirely on private capital cannot complete such investments. The government does not seek short-term profits, so its investment is naturally more suitable for such investments. Meanwhile, with government guarantees, social capital is more willing to participate in such investments. This is what is often referred to as one of the advantages of the Chinese system: “concentrating power to do big things.”

2. Resource Misallocation

a. Overcapacity

The government is not a company. Private capital companies pursue profits, but local governments’ investment goals are often to pursue GDP and tax revenue growth. On the one hand, since value-added tax (VAT) has always been China’s largest source of tax revenue, the government naturally favors large-scale manufacturing (regardless of whether the products can be consumed by end users, as long as the products are produced and start circulating in the supply chain, the government can collect VAT). On the other hand, the excessive pursuit of GDP growth in the early stages of reform and opening up meant that local governments had no motivation to strengthen capacity regulation and adjustment for companies, leading to overcapacity.

b. Distorted Non-market Interest Rates

Debts raised in the name of government investment are usually considered “low risk.” Although the law does not explicitly guarantee that these debts will be repaid in case of default, people believe that these debts have implicit government guarantees. In fact, the default rate of urban investment bonds, for example, is indeed very low. Therefore, the market is very enthusiastic about this type of debt investment. However, the existence of such low-risk, high-yield anomalies like urban investment bonds causes excessive resources to be tilted towards them (squeezing out other debt investments). However, not all infrastructure and basic investments supported by urban investment bonds are high-quality investments, while the squeezed-out debt investments are not lacking in high-quality assets. The distorted interest rates of debts raised in the name of government investment lead to resource misallocation.

Characteristic of Chinese Economy 2: Heavy Investment, Heavy Production, Light Consumption

After living in the United States for two years, I still often feel uncomfortable with the high personal income tax and consumption tax in the United States, which are the two largest types of tax revenue for the U.S. government. However, in China, the two largest types of tax revenue for the government are value-added tax (VAT) and corporate income tax. Simply put, the U.S. government prefers to tax individuals (the U.S. doesn’t even have a VAT), while the Chinese government prefers to tax enterprises. This also reflects different focuses in economic development. The Chinese government relatively emphasizes investment and production, while it downplays consumption. The U.S. is the opposite. In fact, in 2018, U.S. household consumption accounted for 70% of GDP, while China’s only accounted for 44%.

Why Does China Emphasize Investment and Production over Consumption?

1. Tax System Design: VAT

As mentioned earlier, VAT makes the government favor large-scale manufacturing. Since VAT is collected from enterprises, as long as the product is produced and starts circulating in the supply chain, the government can collect taxes. Therefore, when the government acts as an investor in industrial planning, it naturally prefers large-scale manufacturing. These large-scale manufacturing industries usually require relatively large investments in the early stages. Therefore, as the main investor in the economy, the government tends to reduce social spending and increase such industrial investments.

Compared with consumption tax, VAT has its unique advantages—it is easy to audit. Consumption tax is collected from end consumers, and it is easy to avoid. As long as merchants do not issue invoices, consumption tax can be evaded. Merchants usually offer discounts to customers in exchange for their consent not to issue invoices. However, VAT is different. VAT is collected from producers at various stages of the production chain. Suppose there are four producers, A, B, C, and D, in the supply chain of a product, and each producer creates an added value of 1 million yuan for the product. When the semi-finished product is delivered between A, B, C, and D, VAT can only be successfully evaded if all four producers simultaneously agree not to require invoices. However, in reality, this is very difficult. Suppose producer C asks B to issue an invoice. Then B has to bear the VAT on 2 million yuan (1 million yuan from A and 1 million yuan from B), which B will definitely not agree to because it would mean B is paying VAT for A. Therefore, B will also ask A to issue an invoice to avoid paying extra VAT. Due to this chain tax characteristic, VAT is easy to audit. China is vast, with complex economic activities, and tax auditing costs are high. Especially before the advent of the Internet era, the degree of electronic tax systems was very low. VAT has shown unique advantages in China’s tax environment.

VAT is also called an indirect tax. Although this tax is collected at the production stage, the cost is ultimately indirectly passed on to the end consumer. Indirect taxes are usually fixed rates, meaning that regardless of the consumer’s income, they all pay the tax at a fixed rate. Therefore, in reality, the tax rate as a percentage of income for the wealthy is lower than for the poor. Therefore, indirect taxes are also called regressive taxes (the wealthier you are, the lower the tax rate). In contrast, personal income tax is a progressive tax rate. If a country’s main tax is regressive, it will exacerbate wealth disparity. This important issue will be discussed later.

2. National Conditions and Culture: High Household Savings Rate

Chinese people love to save money and are reluctant to spend. The reasons are complex, involving cultural and economic realities. Under East Asian culture, the strategy of raising children for old age has been impacted by the one-child policy, forcing households to increase savings to combat the risks of aging. Additionally, due to land finance, house prices have generally risen, forcing households to increase their savings rate to “get on the property ladder.”

The Impact of Emphasizing Investment and Production over Consumption

1. Developed Manufacturing Industry: The most natural result of emphasizing investment and production over consumption is that China’s manufacturing industry has received sufficient investment and development. China has become the country with the most complete manufacturing sectors. On the one hand, the manufacturing industry has absorbed a large number of employed workers and cultivated highly skilled workers; but at the same time, it has also created a greater historical burden for China’s industrial transformation and upgrading.

2. Long-term Low Social Spending Compared to Investment and Production Spending: The government’s investment in industry and production has squeezed out social spending on education, healthcare, and other social welfare. The Scientific Outlook on Development proposed in 2003, with its core concept of putting people first, has great foresight and will not be outdated even in the next few decades.

3. Long-term Trade Surplus, Over-reliance on Exports, Trade War

When products are produced, someone needs to consume them. With abundant domestic manufacturing capacity and insufficient consumption power, the only option is to export. The Chinese economy has long relied on exports. The long-term imbalance of trade surplus and deficit makes trade wars, such as the U.S.-China trade war, inevitable. All diplomacy is merely an extension of domestic affairs. The domestic economic structure’s imbalance (“emphasizing investment and production over consumption”) inevitably leads to international diplomatic imbalances. Chinese culture deeply understands the balance between yin and yang, and domestic and foreign affairs are two sides of the same coin, as are investment, production, and consumption. Solving the domestic economic imbalance fundamentally also solves the international economic and diplomatic imbalance.

Direction of Reform and Opening Up

1. Building Dual Domestic and International Circulation

The core and essence of the dual domestic and international circulation proposed in recent years is to increase domestic consumption and balance domestic and international circulation. Walking on two legs, without over-relying on exports, is the inevitable path to rebalancing domestic investment, production, and consumption.

2. Common Prosperity

After decades of reform and opening up, although the economy has made great progress, the imbalance in development has worsened, and the gap between rich and poor has further widened. The widening wealth gap is usually an important cause of debt crises. The reason is simple: if the wealthy are very wealthy, they always need to lend out their money. So, who borrows the money? It can only be the poor who lack money. Eventually, the poor will be unable to repay, triggering a debt crisis. Therefore, the widening wealth gap usually comes with an increased risk of economic crises. The central government’s efforts in recent years, such as establishing pilot projects for common prosperity, are also aimed at reducing the risk of systemic economic crises. As mentioned earlier, China’s tax system, with regressive taxes like VAT as the mainstay, needs to be reformed (because regressive taxes exacerbate wealth inequality), and further reform is needed to make direct taxes (such as personal income tax) the mainstay of the tax system.

3. Marketization of Investment Capital

At the current historical stage, the Chinese government remains the largest participant and investor in the Chinese economy. For a long time in the future, the Chinese government will still be the main player in improving resource allocation efficiency. However, as an investor, the government also needs to transform. As mentioned earlier, the biggest difference between government and private capital investors is that, for the government, investment returns are sometimes not even the primary goal. The government must also balance short- and long-term economic development, industrial planning, social welfare, and other goals. Managing the government like a business, focusing solely on profit, is unworkable. However, pursuing several goals simultaneously is extremely complex and can also lead to resource misallocation. Therefore, using market forces to help the government complete some investments has become a necessary reform path. The FOF (Fund of Funds) model developed in recent years is also a beneficial reform attempt.