The economic role of Chinese central and local governments : challenges and opportunities from the state and non-state industrial enterprises

RESEARCH PAPER SERIES OC. /q9/ ENTERPRISE BEHAVIOR AND ECONOMIC REFORMS: A COMPARATIVE STUDY IN CENTRAL AND EASTERN EUROPE AND INDUSTRIAL REFORM AND PRODUCTIVITY IN CHINESE ENTERPRISES RESEARCH PROJECTS OF THE WORLD BANK CHINA NUMBER CH-RPS #12 OCrOBER 1991 The Economic Role of Chinese Central and Local Governments: Challenges and Opportunities from the State and Non-State Industrial Enterprises Geng Xiao The World Bank Transition and Macro Adjustment Division Policy Research Department World Bank Washington, D.C. CONTENTS ACKNOWLEDGEM ENT ....................................................... i A BSTRACT................................................................T I. INTRODUCTION....................................................... II. A PROPERTY RIGHTS ANALYSIS OF CHINESE ENTERPRISES ..................... 3 M. PERFORMANCE OF STATE AND COLLECTIVE ENTERPRISES ..................... 4 IV. SOURCES OF REGIONAL PRODUCTIVITY GAPS ............................... 6 V. GOVERNMENT FISCAL DECLINE: ROOTS, CONSEQUENCES AND SOLUTIONS ........ 8 V I. CONCLUSION ....................................................... 11 REFERENCES AND RELATED LITERATURE ....................................... 13 TABLES AND FIGURES TABLE 1. Regional ProductivityIndex ............................. 17 TABLE 2. Regressions Explaining Regional Productivity Gaps in China ......... 18 FIGURE 1. Sources of Provincial Productivity Gaps The Impact of Non-State Sector during 1985-1987 ............... 19 FIGURE 2. Regional Total Factor Productivity ......................... 20 FIGURE 3. Size of Fiscal Income: Contributions by Sectors 1952-1987 .......... 21 FIGURE 4. Fiscal and Extra-Budgetary Income from the State Sector 1952-1986 . . . . 22 FIGURE 5. Extra-Budgetary Income from the State Sector 1952-1986 ........... 23 FIGURE 6. Industrial and Non-Industrial Basic Construction The Role of Budget & Extra-Budget Investment 1953-1986 .......... 24 FIGURE 7. Sources of Fiscal Income: The State and Non-State Sectors 1950-1985 . .. 25 ACKNOWLEDGEMENT . The research projects on "Enterprise Behavior and Economic Reforms: A Comparative Study in Central and Eastern Europe", and "Industrial Reforms and Productivity in Chinese Enterprises" are research initiatives of the Transition and Macro Adjustment Division (PRDTM) of the World Bank's Policy Research Department and managed by I.J. Singh, Lead Economist. These projects are being undertaken in collaboration with the following institutions: for the project in China, The Institute of Economics of the Chinese Academy of Social Sciences (IE of CASS), The Research Center for Rural Development of the State Council (RCRD), and The Economic Systems Reform Institute (ESRI), all in Beijing; and for the projects in Central and Eastern Europe The London Business School (LBS); R6forme et Ouvertures des Syst6mes Economiques (post) Socialistes (ROSES) at the University of Paris; Centro de Estudos Aplicados da Universidade Cat6lica Portuguesa (UCP) in Lisbon; The Czech Management Center (CMC) at teldkovice, Czech Republic; The Research Institute of Industrial Economics of the Janus Pannonius University, Peds (RIE) in Budapest, Hungary; and the Department of Economics at the University of L6di, in Poland. The research projects are supported with funds generously provided by: The World Bank Research Committee; The Japanese Grant Facility; The Portuguese Ministry of Industry and Energy; The Ministry of Research and Space; The Ministry of Industry and Foreign Trade, and General Office of Planning in France; and the United States Agency for International Development. The Research Paper Series disseminates preliminary findings of work in progress and promotes the exchange of ideas among researchers and others interested in the area. The papers contain the views, conclusions, and interpretations of the author(s) and should not be attributed to the World Bank, its Board of Directors, its management or any of its member countries, or the sponsoring institutions or their affiliated agencies. Due to the informality of this series and to make the publication available with the least possible delay, the papers have not been fully edited, and the World Bank accepts no responsibility for errors. The authors welcome any comments and suggestions. Request for permission to quote their contents should be addressed directly to the author(s). For additional copies, please contact the Transition and Macro Adjustment Division, room N-1 1065, World Bank, 1818 H Street, N.W., Washington, D.C. 20043, telephone (202) 473-1442, fax (202) 676-0083 or 676-0439. The series is also possible thanks to the contributions of Donna Schaller, Vesna Petrovic, Cecilia Guido-Spano and the leadership of Alan Gelb. ABSTRACT Since 1978, the Chinese Government has devolved significant economic control to local governments and enterprises. Two stylized facts have emerged and aroused enormous debates on the economic role of the central and local governments: First, there was a rapid decline of the central government fiscal revenue. Second, there were large gaps in regional productivity. It has been suggested that the higher productivity in the coastal region of China may be a result of higher local government autonomy granted by the central government. According to this theory, more local autonomy in other regions may improve their productivity as well. In contrast, it has been argued that the recent decentralization has weakened the economic capacity of the central government and may hinder future economic development of the nation. This paper contributes to the above debates by examining the sources of Chinese regional productivity gaps and the root of the central government fiscal decline. It is found that the ownership structure of the local economies correlated strongly with the local industrial productivity. The impact of non-state sector on provincial productivity was so important that there would have been no significant differences in productivity among the coastal, inland, and western provinces, if the contribution of the non-state sector on the provincial productivity had been separated. Also, the decline of the central government fiscal revenue largely resulted from a rising extra-budgetary income primarily of the state-owned enterprises. The state-owned enterprises were able to use extra-budgetary incomes to carry out non-industrial projects, which would not yield future revenues for the Government but nevertheless represented rational investment from the perspective of the managers and workers. According to this paper, a policy of encouraging development of the non-state sector is more important than reforms in the central-local relations. Also, the central government fiscal decline should not be overemphasized as a serious economic problem. The central government should shift its attention to new challenges and opportunities arising from the rapid growth of the non-state sector. An encouraging sign is that both the share and the size of the fiscal income originated from the non-state sector has been increasing since the recent reforms. Prepared for the CSPSIS conference and book on: CHANGING CENTRAL-LOCAL RELATIONS IN CHINA This paper draws from the author's Ph.D. dissertation The Impact of Property Rights on Productivity and Equity in Post-Mao Chinese Industrial Enterprises completed at the University of Calfornia-Los Angeles in June 1991. The author has recently joined the Socialist Economies Reform Unit of the World Bank as a consultant. A previous version of the paper has been presented to the Chinese Central-Local Relations Workshops at the George Washington University in March 1991 and at the University of California-San Diego in August 1991. 1 acknowledge financial support for this work from the UCLA Program in Applied Econometrics. The author thanks Alan GeIb, LJ. Singh, and Lin Zhimin for helpful comments. This paper represents the individual views of the author and not those of the sponsoring agencies or institutions or their affiliated agencies. ii I. INTRODUCTION When China adopted the Soviet model of central planning for its industrialization program in early 1950s, the central government became the most important actor in the economy. Large industrial factories were built and controlled directly through the ministries of various sectors. The central government also set up national committees to coordinate the national plans and the flow of resources across sectors and regions. However, because of the sheer size of the Chinese economy, the central government also relied on the provincial governments to carry out its industrial plans and policies. During the late 1950s and the Cultural Revolution period there were waves of administrative decentralization, which shifted administrative control from the national ministries to provincial governments. The administrative decentralization before 1978 changed the mechanism of central planning in the industrial sector quite significantly by expanding the role of provincial governments in industrial management. However, the administrative decentralization did not encourage any significant move toward a market economy. There were little managerial autonomy for the industrial enterprises. The managers and workers played very limited and passive role in a fragmented but planned economy. The central and local governments as the dominant players directed the industrial investment and production (See Lardy 1975). Since 1978, the Chinese Government has devolved significant economic control to local governments and enterprises. Two stylized facts have emerged and aroused enormous debates on the economic role of the central and local governments: First, there was a rapid decline of the central government fiscal revenue. Second, there were large gaps in regional industrial productivity. It has been suggested that the higher productivity in the coastal region of China may be a result of higher local government autonomy granted by the central government. According to this theory, more local autonomy in other regions may improve their productivity as well. The changing central-local relationships have often been seen as a result of political games among central and provincial leaders of various factions (See Shirk 1991). The central government and its ministries have sometimes been identified with conservative forces favoring central planning while the local governments of the coastal regions have been regarded as leaders of market-oriented reforms. The rapid growth of the coastal regions gives rise to many bold suggestions on reforming central-local relationships. It is suggested that the local governments may initiate better reform measures than the central government because of the increasing regional gaps in industrial development. In contrast, it has been argued that the recent decentralization has weakened the economic capacity of the central government and may hinder future economic development of the nation. Some scholars also warn that the increasing regional gaps and the expanding economic power of local governments may lead to local protectionism and other regional conflicts that could also endanger economic and political stability in China. 1 2 The Economic Role: Challenges and Opportunities This paper contributes to the above debates by examining the sources of Chinese regional productivity gaps and the root of the central government fiscal decline. It is found that the ownership structure of the local economies correlated strongly with the local industrial productivity. The impact of non-state sector on provincial productivity was so important that there would have been no significant differences in productivity among the coastal, inland, and western provinces, if the contribution of the non-state sector on the provincial productivity had been separated. Also, the decline of the central government fiscal revenue largely resulted from a rising extra-budgetary income primarily of the state-owned enterprises. The state-owned enterprises were able to use extra-budgetary incomes to carry out non-industrial projects, which would not yield future revenues for the Government but nevertheless represented rational investment from the perspective of the managers and workers. In this paper, I bring enterprise behavior into a study on the economic role of the central and local governments in the post-Mao era. Most of the recent research has not examined closely the behavior of the Chinese enterprises and its effects on the role of central and local governments. During the decade of economic reforms since 1978, Chinese enterprises have acquired significant managerial autonomy and controlled more economic resources. The behavior of the managers and workers in the state and non-state enterprises have created important constraints and opportunities for both the central and local governments. As central planning becomes less important after recent economic reforms, the economic role of the central and local governments should change from primary initiators and managers of industrial projects to regulators of markets and enterprises. In exploring the role of the central and local governments, it is crucial to study the impact of specific government regulations and policies on the performance of enterprises. If the sources of rapid industrial growth in the coastal regions come from greater private, semi-private and foreign ownership of enterprises, then, it is the policy of encouraging private enterprises that should be advocated. Increasing the power of local governments may or may not facilitate a free enterprise policy. According to this paper, a policy of encouraging development of the non-state sector is more important than reforms in the central-local relations. Also, the central government fiscal decline should not be overemphasized as a serious economic problem. The central government should shift its attention to new challenges and opportunities arising from the rapid growth of the non-state sector. An encouraging sign is that both the share and the size of the fiscal income originated from the non-state sector has been increasing since the recent reforms. In this paper, I emphasize economic incentives and their effects on the behavior of the enterprises and of the central and local governments. In particular, I use results from an on- going study on the new institutions of profit-sharing, managerial autonomy and fringe benefits provision in the post-Mao Chinese industrial enterprises. The effects of new incentive structure on performance and behavior of the state and collective enterprises are The Economic Role: Challenges and Opportunities 3 examined briefly. The pattern of enterprise behavior provides important base for the discussion about the new economic role of the central and local governments. Section II provides a brief property rights analysis of the Contract Responsibility System in the Chinese industrial enterprises. Section III summarizes some empirical findings about the performance of the state and collective enterprises during the reform period. Section IV examines the sources of provincial productivity gaps and contributes to the policy debates on increasing local autonomy. Section V discusses challenges of the state enterprise reform to the financial strength of the central and local governments and opportunities provided by the rapid development of the non-state sector. This section also discusses briefly future economic role of the central and local governments. Section VI contains a brief conclusion. II. A PROPERTY RIGHTS ANALYSIS OF CHiNESE ENTERPRISES Since 1978 the Chinese government has transferred some important dimensions of property rights from the State to managers and workers. It has allowed the state and collective enterprises to retain a portion of profits for bonuses, welfare benefits such as housing, and industrial investment. The new structure of property rights can be summarized as the following (see Xiao, Spring and June 1991 for more details): First, the profit-sharing arrangements, set up between the government and the enterprises, explicitly define the formal and contractual ownership structure of the enterprises. The right to profits is the most important form of property rights over the Chinese enterprises. This right is widely recognized by the central and local governments, enterprises, as well as the scholars. Second, fringe benefits are informally controlled and "owned" by managers and workers. Unlike fringe benefits in the Western countries, which are part of a competitively determined package of employee compensation, the fringe benefits in Chinese enterprises are more like welfare benefits. The amount and even the kind of the fringe benefits are unspecified and may vary among enterprises. That is, they are not determined by explicit agreements but, instead, are a "consensual" sharing of enterprise resources. These fringe benefits can not be written into a contract and can not be un-bundled and traded with other benefits because of the government ownership of non-industrial fixed capital, which is used to provide fringe benefits services. Moreover, some of the fringe benefits, such as residential housing, involve large amount of fixed capital investment, and become an important channel for employees to accumulate quasi-private property, since it is practically impossible for enterprises to take back apartments that have been distributed to their employees, although the apartments are officially state property. The implicitly recognized claim to fringe benefits is largely ignored by scholars in China and abroad. Xiao (1991) reveals the importance of incorporating them into the formal analysis of Chinese enterprise behavior. 4 The Economic Role: Challenges and Opportunities Third, price-controls, wage-ceilings, production-quotas, and other administrative regulations specifically define restrictions on the managerial autonomy of the enterprises. Although these administrative regulations may create some distortions and inefficiency, their role in Chinese industrial activities are declining. At the margin, more and more inputs and outputs are allocated according to market prices. Some of the regulations exist for reasons relating to income distribution across industries. Also, these regulations often involve very specific products, such as steel, coal and electricity, and are implemented more effectively than the regulations on fringe benefits provision. Finally, while the central and local governments still influence enterprises through arrangements of loans, subsidies and appointments, a significant part of control over resources in the enterprises has been implicitly and non-contractually delegated to the managers. As the Chinese economy becomes more decentralized, and as economic resources are controlled to a greater extent by enterprise managers, it becomes important to study the behavior of managers under the new institutional system. Xiao (1991) formalizes the new structure of property rights described above in a dynamic model of the Contract Responsibility System. Several important theoretical results are derived: The Contract Responsibility System, which consists mainly of profit-sharing between the government and the enterprises, managerial autonomy, and the provision of in-kind fringe benefits, is more efficient than the pre-reform planning institution, but less efficient than the private property institution. Under the Contract Responsibility System, the managers and workers receive full marginal return from fringe benefits production but only a fraction of marginal return from industrial production. Since it is costly for the government to monitor effort, regulate fringe, benefits and distinguish industrial and non-industrial investment, the new system create incentives for Chinese workers to divert effort and capital away from industrial to fringe benefits production. The workers, behaving rationally, equate private returns on the margin, but this leaves social marginal returns from production of industrial profits unequal. Greater government claims lead to reduced use of resources in industrial production and inefficiency. Hence, the state enterprises should be less productive industrially than the collective enterprises. II. PERFORMANCE OF STATE AND COLLECTIVE ENTERPRISES Using firn and city-level data during 1980-1987 and econometric techniques, Xiao (1991) examines empirically the behavior and performance of Chinese state and collective enterprises. The evidence shows forcefully that the post-Mao Chinese industrial reforms have successfully stimulated individual incentives and started a promising process of evolution toward a private market economy. This section summarizes some major findings The Economic Role: Challenges and Opportunities 5 from Xiao (1991) and their implications. Economic reforms in the 1980s have increased productivity growth of both the state and collective enterprises. But, the growth rate of productivity in the collective enterprises is much higher than that in the state enterprises. During 1980-1985, the estimated annual total factor productivity growth from the firm sample of this study is 3.9% for the state enterprises and 8.8% for the collective enterprises. The productivity improvement is also reflected in the increase of output elasticity of capital in both state and collective enterprises during the reform period. However, according to the city-level data of 1985-1987, the state sector has a stagnant productivity growth in the later period of the decade-long reforms. The collective sector have maintained high productivity growth of 4.4% per year during 1985- 1987. These findings confirm the analysis in the last section. Although the productivity gap between the state and collective enterprises decreases when the non-industrial activities are taken into account properly, the decreased gap is still significant. The state enterprises are less efficient than the collective enterprises in using labor and capital. The estimated gaps of total factor productivity between the two sectors after controlling for economies of scale are 23.7% in 1985 and 34.8% in 1987 according to the city-level data. From the firm sample, the measured gap of total factor productivity between the state and collective enterprises is about 60% during 1980-85, if fringe benefits are ignored. However, the gap decreases to about 30% if the fringe benefits services are counted as output. The evidence shows clearly the effects of ownership structure on productivity. The state enterprises have much higher fringe benefits than the collective enterprises. The level of fringe benefits is positively correlated with the level of government investment in the Chinese enterprises. According to the firm sample, during 1980-1985, controlling for industrial capital and other variables, the fringe benefits capital has grown about 30% for the state enterprises and about 80% for the collective enterprises. The more rapid growth of fringe benefits capital in collective enterprises does not change the basic pattern of fringe benefits capital stock. In the firm sample, controlling for industrial capital and other variables, the state enterprises have about 100% more fringe benefits capital than the collective enterprises in 1980. This gap narrows to about 50% in 1985. It is found that fringe benefits capital is positively correlated with industrial capital. So, the capital-intensive firms have also significantly higher levels of fringe benefits capital for their workers in addition to higher wages than the labor-intensive firms. One explanation for the pattern is that Chinese managers and workers are able to divert more industrial capital for non-industrial uses when they control more government property. Hence, the managers and workers in large state enterprises have captured some of the monopoly rents which would have gone to the government in the pre- reform system. 6 The Economic Role: Challenges and Opportunities IV. SOURCES OF REGIONAL PRODUCTIVITY GAPS According to the theoretical and empirical analyses in section III and IV, Chinese industrial reforms in the Most-Mao era have increased productivity of both the state and collective enterprises through changes in incentive structures and property rights. It is also shown that in the same region or industry, the collective enterprises are more efficient than the state enterprises. This section examines the impact of non-state sector on the productivity of a region and the sources of regional productivity gaps. The industrial productivity during the reform period has been uneven across the regions. Xiao (1991) has estimates of total factor productivity index for Chinese provinces (see table 1) from city-level industrial data. The eastern (coastal) provinces have achieved the highest level of productivity and the western provinces the lowest. The average TFP indexes for the eastern, inland, and western regions are respectively 114.5, 94.2, and 87.4. These indexes mean that given a certain amount of input such as capital and labor, if the western region produces $87.4 output, the inland and eastern regions would produce respectively $94.2 and $114.5. There are many reasons for the productivity gaps. Historically, industrialization started from coastal cities such as Shanghai and Tianjing. Recent reforms with the open-door policy also benefit the coastal provinces such as Guangdong and Fujiang, which have close business contacts with Hong Kong and Taiwan. The exceptionally rapid development of the eastern region is also accompanied by a rise of local government autonomy during the reform period in that region. Guangdong, Fujiang and Jiangsu, which have productivity exceeding the national average respectively by 26%, 19% and 23%, also enjoy very favorable profit-sharing arrangements between the central and local governments. The Special Economic Zones developed in the recent reforms are all located in the coastal cities. Hence, the higher productivity in the coastal region may reflect some achievements of local government autonomy in that region. This theory would suggest that the central government should give further autonomy to the local governments since they are more able to initiate better reform measures for their own regions. Recent decentralization of economic control from the central to provincial and lower levels of governments may have contributed positively to productivity growth. However, local governments do not always produce good economic policies. In addition to local protectionism, the provincial governments potentially have all the weakness the central government has. Hence, it is important to identify which local policies have contributed to better local economic development. Sections II and III have suggested that the collective enterprises are more efficient than the state enterprises. Hence, if a region has more non-state enterprises, it should have higher regional productivity. In addition to its own high productivity, the non-state sector competes directly with the state sector. As a result of competitive pressure, the state The Economic Role: Challenges and Opportunities 7 enterprises in that region should also have higher productivity than those in the other regions. The above analyses are all consistent with the general pattern of regional productivity gaps, which ranks the coastal region on the top and the western provinces at the bottom. In this section, regression analysis is used to find out which factor is more important than others in explaining the productivity gaps. The regression analysis is based on the data in table 1. In table 1, the provinces are grouped into three regions of different concentration of the non-state sector. The region with 15 %-23 % non-state sector share of Gross Value of Industrial Output (GVIO) has a TFP index 14% lower than the national average while the region with 45 % -67% share has a TFP 20% higher than the average. Clearly, Productivity is positively correlated with the concentration of non-state enterprises in a region. This pattern is shown in figure 1 and 2. The two figures present the same underlying data in table I but provide complementary information. In figure 1, the significantly positive correlation between the provincial TFP index and the share of non-state industrial output is illustrated through a trend line. Figure 2 reveals the names of each province along a hidden trend. In table 2, weighted OLS regressions are used to explain the total factor productivity gaps across the provinces. The explanatory variables are the Non-State Share of GVIO in the provinces and dummy variables for the Western Provinces, Eastern Provinces, and City under direct control by the central government.' Regression (2) in table 2 shows that the TFP correlates with the Non-State Sector Share of GVIO. Regression (3) confirms that the TFP also correlates with the dummy variable for the coastal (eastern) provinces. Regression (1), however, is used to find out whether the TFP is still significantly correlated with regional variables after controlling for the concentration of the non-state enterprises. According to regression (1) in table 2, the regional dummy variables are not statistically significant except for the city dummy. Hence, if the impact of the non-state sector is separated from other factors, the eastern provinces did not perform significantly better while the western provinces did not have significantly lower productivity than the inland provinces during 1985-87. It should be emphasized that the above surprising result does not contradict with the theory that the increased local government power in the coastal region may have contributed to productivity growth through policies which have encouraged the development of private, semi-private, and foreign businesses in that region. In that case, the degree of local autonomy correlates with the concentration of non-state enterprises. Hence, the explanatory variable of Non-State Sector Share of GVIO may pick up the effects of both local autonomy I From figure 2, Shanghai has exceptionally higher productivity with its low share of non-state industrial output. Beijing and Tianjing have also low shares of non-state industrial output. Since, these three cities are controlled directly and tightly by the central government, it is natural to use a City dummy to separate their special circumstance. 8 The Economic Role: Challenges and Opportunities and non-state sector on productivity. The above evidence shows forcefully that other than the concentration of the non-state sector, geographical location does not have important impact on regional productivity gaps.2 Regression (4) to (6) explore further the impact of non-state sector on provincial productivity gaps by dividing the national sample into three regional sample. It is found that the correlation between the productivity and the non-state sector share of GVIO is also significant within the coastal or inland region, but is not significant within the western region. This can be illustrated by examples from figure 2. Both Zhejiang and Guangdong are coastal provinces. The productivity of Zhejiang is higher than that of Guangdong since Zhejiang has higher concentration of non-state enterprises. V. GOVERNmENT FISCAL DECLINE: ROOTS, CONSEQUENCES AND SOLUTIONS Section IV examines the contribution of non-state sector to industrial productivity and identifies the sources of regional productivity gaps. However, most of the industrial reforms in the last decade were aimed at the state sector. The central and local governments have delegated much of the economic control to managers and workers in the state enterprises. As discussed in section II and m, the increased enterprise autonomy has improved productivity in the state enterprises. However, the central government has been unable to benefit from the increased productivity through its fiscal income. Figure 3 shows the contributions of the state and non-state sector to the central government fiscal income during 1952-1987.3 It is clear that the contribution by non-state sector has been stable and increasing, although the non-state sector provided fiscal revenues at a level less than 10% of the national income. The government fiscal decline is primarily due to the fall of fiscal income originated from the state sector. In 1978, the state sector contribution to the fiscal income was more than 30% of national income, but the contribution declined to less than 20% in 1987. However, this fall of fiscal income from the state sector does not imply productivity decline or profit reduction for the state sector. As is shown in figure 4, the fall of fiscal (or budgetary) income has been accompanied by an increase in the extra-budgetary income in the state sector. In 1978, the fiscal income exceeded extra-budgetary income by about 20% of national income. However, in 1986, the extra-budgetary income suppressed the fiscal income by a few percentage of the national income while the sum of the fiscal income and extra-budgetary income was quite stable at a level about 40% of national income during 1978-1986. 2 Shanghai, Beijing and Tianjing are the exceptions. 3 All statistics for figure 3 to 7 are from Statistical Yearbook of China, 1989. The Economic Role: Challenges and Opportunities 9 Hence, the government fiscal decline during the reform era has been characterized by a decentralization of control on incomes and profits away from the central government. Nevertheless, the local governments had not increased much of their extra-budgetary income. This can be seen from figure 5, which presents the division of extra-budgetary income among the local government, administrative units, and enterprises in the state sector. The extra- budgetary income for the local government had been actually declining since 1978. Most of the increase in the extra-budgetary income were in the enterprises and the administrative work units. The above pattern of decentralization was closely related with the enterprise reforms or the Contract Responsibility System. As discussed in section II and III, the profit-sharing, managerial autonomy, and fringe benefits provision, which were key elements of the Contract Responsibility System, provided incentives for enterprises to use resources more efficiently. However, because of the limitation of the state ownership and information costs, the increased efficiency have not contributed to fiscal income. The sources of fiscal income (taxes and profit remittances) are from sales of industrial products. However, the Chinese state enterprises produce not only industrial products but also non-industrial services or fringe benefits within the enterprises. The fringe benefits raise the income of the managers and workers in the state enterprises but do not contribute to government fiscal income. As the enterprises control more resources, they tend to bias investment toward the non-industrial instead of industrial projects since the government (not the workers) would claim most of industrial profits in the state enterprises. The behavior of the state enterprises have very strong impact on the pattern of the fiscal (budgetary) and extra-budgetary investment. In figure 6, industrial and non-industrial investment on basic construction in the state sector during 1953-1986 is shown together with the budgetary and extra-budgetary investment. Before 1978, the fiscal investment largely exceeded the industrial basic construction. After 1978, the fiscal income was not enough to cover industrial basic construction. However, the extra-budgetary income were able to cover both industrial and non-industrial basic construction during the recent reforms. The increase of non-industrial basic construction after the reforms was very significant and correlated with the rise of extra-budgetary investment. A trend of decentralization has characterized Chinese economic reforms since 1978. However, the central government seldom initiated the decentralization. More often, the farmers, enterprises or local governments first demanded "policies", which gave them some autonomy, and the central government then yielded to them. After ten years of reforms, the central government now controls less economic resources and has become weaker financially. On the other hand, private business, rural enterprises, and urban collective enterprises have grown rapidly competing with the state enterprises. The state enterprises, though less efficient than the non-state enterprises, have also improved their productivity. However, the state enterprises have failed to provide enough revenue for the government because of low industrial productivity and an expansion of fringe benefits. Even the profit-losing state 10 The Economic Role: Challenges and Opportunities enterprises have not given up efforts to continue the expansion of fringe benefits projects. The reforms in the state sector produced a dilemma for the central government. If they continue the current reforms of decentralization, the state enterprises may maintain their productivity and fringe benefits expansion but contribute little to the fiscal income. Re- centralization, however, may drive down productivity and yield no profits for the central government. The solution lies in privatization and changes in the economic role of the government. The rapid development of non-state sector provides the government with new opportunities. Private firms not only have high productivity but are also a potential source of tax revenues.' The Chinese government is used to the concept that the government has invested in the state enterprises and so it should share some of the profits as fiscal income. As the government invests less in the state enterprises, it seems necessary for the government to tap new sources of tax revenues. It is true that there is difficulty in collecting taxes from small private business. But, that is also true for other countries. If the property rights of large private firms or corporations are effectively protected by the Chinese government, they may be more than happy to pay the taxes and still get enough profits for themselves. However, at present, government regulations do not intend to protect the growth of private enterprises and in many cases discriminate against them. The future uncertainty of government policy toward private business severely restricted the type and the size of private firms. Since it is only efficient for government to monitor business accounts and tax files of large firms, the financial benefits of promoting private business for the government will come later when large private and semi-private firms have earned significant profits. In table 7, the state and non-state sectoral shares of fiscal income are related to the sectoral share of gross value of industrial output. During the recent reforms, the non-state sector share of fiscal income has been increasing with its share of gross value of industrial output as the leader. Since the non-state sector share of GVIO may continue to increase in the future, the central and local governments should be able to benefit from the rise of non- state industrial enterprises. To tap fiscal income from the private sector, the economic role of the central and local governments has to change. It is not necessary for the government to initiate investment projects since the private firms have incentives to do that if societies demand those projects. However, it is important for the central government to enforce free contracting and protect private property rights. The central government has monopoly on making and enforcing laws and regulations about markets and economic organizations. If these laws and regulations are effective in facilitating efficient productions and exchange, 4 As shown in Xiao (1991b), there are significant economies of scale for the state enterprises. The economies of scale are currently unavailable to private firms because of their limited size. Large private firms should be able to reap both the economies of scale and the efficiency of private ownership. The Economic Role: Challenges and Opportunities 11 there are tremendous economies of scales for the central government to provide those public services. Also, the central government is in a better position to design and maintain an effective social security system for all Chinese citizens. Currently, employees of private sector have be discriminated with respect to social security protection. Since the private businesses do not provide extensive fringe benefits such as housing, medical care, public transportation and education. It is important for local governments to organize these community services to attract profitable businesses into their regions. The central government do not have enough information and capacity to provide these public goods. In some places such as Wenzhou, the private sector has very sophisticated transportation services. But, in most of the regions in China the local governments have to take some of the responsibilities which have been taken by the enterprise management in the state sector. The new economic role of the central and local governments should service the growth of the private sector and the growth of the private sector should be able to provide the necessary fiscal income for better functioning of the central and local governments. VI. CONCLUSION Since 1978, the Chinese Government has devolved significant economic control to local governments and enterprises. Two stylized facts have emerged and aroused enormous debates on the economic role of the central and local governments: First, there was a rapid decline of the central government fiscal revenue. Second, there were large gaps in regional productivity. It has been suggested that the higher productivity in the coastal region of China may be a result of higher local government autonomy granted by the central government. According to this theory, more local autonomy in other regions may improve their productivity as well. In contrast, it has been argued that the recent decentralization has weakened the economic capacity of the central government and may hinder future economic development of the nation. This paper contributes to the above debates by examining the sources of Chinese regional productivity gaps and the root of the central government fiscal decline. It is found that the ownership structure of the local economies correlated strongly with the local industrial productivity. The impact of non-state sector on provincial productivity was so important that there would have been no significant differences in productivity among the coastal, inland, and western provinces, if the contribution of the non-state sector on the provincial productivity had been separated. Also, the decline of the central government fiscal revenue largely resulted from a rising extra-budgetary income primarily of the state-owned enterprises. The state-owned 12 The Economic Role: Challenges and Opportunities enterprises were able to use extra-budgetary incomes to carry out non-industrial projects, which would not yield future revenues for the Government but nevertheless represented rational investment from the perspective of the managers and workers. According to this paper, a policy of encouraging development of the non-state sector is more important than reforms in the central-local relations. Also, the central government fiscal decline should not be overemphasized as a serious economic problem. The central government should shift its attention to new challenges and opportunities arising from the rapid growth of the non-state sector. An encouraging sign is that both the share and the size of the fiscal income originated from the non-state sector has been increasing since the recent reforms. The Economic Role: Challenges and Opportunities 13 REFERENCES AND RELATED LITERATURE Alchian, Armen A. and Demsetz, Harold, "Production, Information Costs, and Economic Organization," American Economic Review, December 1972, 777-795. Byrd, William A., "The Impact of the Two-Tier Plan/Market System in Chinese Industry," Journal of Comparative Economics, September 1987, 11, 295-308. ------ and Tidrick, Gene, "Factor Allocation and Enterprise Incentives," in Tidrick, Gene and Chen, Jiyuan Eds., China's Industrial Reform, New York: Oxford University Press 1987. Chen, Kuan; Wang, Hongchang; Zheng, Yuxin; Jefferson, Gary H. and Rawski, Thomas, "Productivity Change in Chinese Industry: 1953 - 1985," Journal of Comparative Economics, December 1988, 12, 570-591. Chen, Yizi and Wang, Xiaoqian, "Reform: Results and Lessons from the 1985 CESRRI Survey," Journal of Comparative Economics, September 1987, 11, 462-478. Demsetz, Harold, "The Structure of Ownership and the Theory of the Firm, "Journal of Law andEconomics, June 1983, 26, 375-390. ------, The Organization of Economic Activity, Volume I & II, Cambridge, Massachusetts: Basil Blackwell, 1988 & 1989. ------ and Lehn, Kenneth, "The Structure of Corporate Ownership: Causes and Consequences," Journal of Political Economy, December 1985, 93(6), 1155-1177. Dollar, David, " Economic Reform and Allocative Efficiency in China's State-owned Industry," Economic Development and Cultural Change, 39(1), 1990. Eggertsson, Thrainn, Economic Behavior and Institutions, Cambridge: Cambridge University Press, 1990. Fama, E. F., and Jensen, M. C., "Separation of Ownership and Control," Journal ofLaw and Economics, June 1983, 26, 301-326. Gao, Shang-quan, Nine Years of Chinese Economic System Reforms, [in Chinese], Beijing: People's Publishing House, 1987. Grossman, Sanford J., and Hart, Oliver D., "The Costs and Benefits of Ownership: A Theory of Vertical and Lateral Integration, " Journal of Political Economy, August 1986, 94(4), 691-719. Hart, Oliver D., "Incomplete Contracts and the Theory of the firm," Journal of Law, Economics, and Organization, Spring 1988, 4(1) 119-139. 14 The Economic Role: Challenges and Opportunities Jefferson, Gary H., "Allocative Efficiency and the Sources of Productivity Growth Within Chinese Industry," World Development, (forthcoming),January 1989a. .----, ."Book Review: Bruce Reynolds ed., Reform in China: Challenges and Choices, " Journal of Comparative Economics, 1989b,13, 354-356. Jensen, M. C. and Meckling, W. H., "Theory of the firm: Managerial Behavior, Agency Costs and Ownership Structure," Journal of Financial Economics 1976, 3, 305-360. Johnson, D.G., "Resource Allocation Under Share Contracts," Journal of Political Economy 58(1), February 1950. Klein, Benjamin, "Contracting Costs and Residual Claims: The Separation of Ownership and Control, " Journal ofLaw and Economics, October 1983, 26(2), 367-374. -----, ."Vertical Integration as Organizational Ownership: The Fisher Body-General Motors Relationship Revisited," Journal of Law, Economics, & Organization, Volume 4, No. 1, 199-213, Spring, 1988. ------; Crawford, R. G. and Alchian, A. A., "Vertical Integration, Appropriable Rents, and the Competitive Contracting Process," Journal of Law and Economics, October 1978, 297-326. Kornai, Janos, Economics of Shortage, New York: North-Holland, 1980. -----, "The Soft Budget Constraint," Kyklos, 1986a, 39, 3-30. ------, Contradictions and Dilemmas: Studies on the Socialist Economy and Society, Cambridge, Mass.: The MIT Press, 1986b. ------, "The Affinity Between Ownership Forms and Coordination Mechanisms: The Common Experience of Reform in Socialist Countries," The Journal of Economic Perspectives, 4(3) Summer 1990. ------, The Road to a Free Economy, Shtling from a Socialist System: The Example of Hungary, New York: W.W. Norton and Company, 1990. Lardy, Nicholas R., "Economic Planning in China's Central-Provincial Fiscal Relations," in Joint Economic Committee, U.U. Congress, China: A Reassessment of the Economy, Washington D.C.: U.S. Government Printing Office, 1975, pp 94-115. Lin, Justin Y., "The Household Responsibility System Reform in China: A Peasant's Institutional Choice," American Journal of Agricultural Economics, May 1987, 69(2), 410-415. Lin, Zhili, Shehui Zhuyi Jingii Run, [On Socialist Economy], Volume 1 and 2, Beijing: Economic Science Publishing House, 1985. The Economic Role: Challenges and Opportunities 15 Liu, Guoguang, Zhongguo Jingji Tizhi Gaige de Moshi Yanjiu, [A Study on Models of Chinese Economic System Reform], Beijing: China Social Sciences Publishing House, 1988. Lockett, Martin, "The Urban Collective Economy," in Feuchtwang et al eds., Transforming China's Economy in the Eighties, Boulder: Westview Press, 1988. Ma, Hong, Zhongguo Gongyie Jingii Wenti Yanjiu, [A Study on China's Industrial Economic Problems], Beijing, China Social Sciences Publishing House, 1983. McMillan, John; Whalley, John and Zhu, Lijing, "The Impact of China's Economic Reforms on Agricultural Productivity Growth, " Journal of Political Economy, August 1989, 97(4), 781-807. Nolan, Peter and Dong, Fureng, Market Forces in China, London: Zed Books Ltd, 1990. Otsuka, Keijiro and Hayami, Yujiro, "Theories of Share Tenancy: A Critical Survey," Economic Development and Cultural Change, 37(1), 1989. Perkins, Dwight H., "Reform China's Economic System," Journal of Economic Literature, June 1988, 26(2), 601-645. Office of National Task Force for Industrial Census, People 's Republic of China: 1985 Industrial Census, [in Chinese and with 12 volumes], Beijing: Chinese Statistical Publishing House, 1987 and 1988. Reynolds, Bruce, ed., Reform in China: Challenges and Choices, Armonk, NY: M.E.Sharpe, 1987. Riskin, Carl, China's Political Economy, New York: Oxford University Press, 1987. Shirk, Susan L., "Playing to the Provinces: Deng Xaioping's Political Strategy of Economic Reform, " mimeo, Department of Political Science, University of California at San Diego, 1991. Solow, R.M., "Technical Change and the Aggregate Production Function," The Review of Economics and Statistics, August 1957, 39, 312-320. State Statistical Bureau (SSB), Statistical Year Book of China, [in Chinese] 1987,1988 & 1989. Stiglitz, Joseph E. et al., The Economic Role of the State, Cambridge: Basil Blackwell Inc., 1989. Tidrick, Gene and Chen, Jiyuan, eds., China's Industrial Reform, Published for the World Bank, New York: Oxford University Press, 1987. Williamson, Oliver E., The Economic Institutions of Capitalism, New York: Free Press, 1985. 16 The Economic Role: Challenges and Opportunities Wong, Christine P. W., "The Economics of Shortage and Problems of Reform in Chinese Industry," Journal of Comparative Economics, December 1986, 10(4), 363-387. .----, ."Between Plan and Market: The Role of the Local Sector in Post-Mao China, " Journal of Comparative Economics, September 1987, 11, 385-398. ------, "Central-Local Relations in an Era of Fiscal Decline: The Paradox of Fiscal Decentralization in Post-Mao China," mimeo, Department of Economics, University of California at Santa Cruz, 1990. Wu, Jinglian and Zhao, Renwei, "The Dual Pricing System in China's Industry," Journal of Comparative Economics, September 1987, 11, 309-318. Xiao, Geng, "The Impact of Property Rights Structure on Productivity, Capital Allocation, and Labor Income in Chinese State and Collective Enterprises, " Program in Applied Econometrics Discussion Paper, No. 32, Department of Economics, UCLA, October 1990. ------, "Managerial Autonomy, Fringe Benefits and Ownership Structure," China Economic Review, 2(1), 47-73, Spring 1991. ------, The Impact of Property Rights on Productivity and Equity in Post-Mao Chinese Industrial Enterprises, Ph.D. Dissertation, University of California at Los Angeles, 218 pages, June 1991. -----, "Property Rights Arrangements and Industrial Productivity in China," Research Paper Series, Number 21, the Socialist Economies Reform Unit, The World Bank, October 1991. -----, ."What Is Special about China's Reforms?" Research Paper Series, Number 23, the Socialist Economies Reform Unit, The World Bank, October 1991. Yuan, Shouqi, Chengbao Jingying Zerenzhi, [Contracted Management Responsibility System], Beijing: China Economic Publishing House, 1988. Zhang, Shaojie and Zhang, Amei, "The Present Management Environment in China's Industrial Enterprises, " In Reynolds, Bruce, ed., Reform in China: Challenges and Choices, Armonk, NY: M.E.Sharpe, 1987. The Economic Role: Challenges and Opportunities 17 Table 1. Regional Productivity Index Non-State Sector Provincial Sahre Share of Gross Total Factor of National Province Name Region Classification Value of Producitivty Gross Value of Industrial Index Industrial Output Output ALL PROVINCES 40.3% 100 100.0% Provinces with 15%-23% Non-State Sector Share of GVIO 86 9.9% GANSHU West 15.3% 85 1.2% QINGHAI West 16.6% 85 0.2% XINJIANG West 17.1% 92 0.8% HEILONGJANG Inland 19.4% 84 4.1% NEI MONGGOL Inland 20.8% 75 1.1% GUIZHOU West 21.1% 83 0.9% XIZANG West 21.8% 85 0.01% NINXIA West 22.2% 85 0.2% YUNNAN West 22.8% 97 1.3% Provinces with 25%-41% Non-State Sector Share of GVIO 100 51.9% GUANGXI East 25.5% 99 1.5% SHANGHAI East, City 25.9% 123 7.7% JILIN Inland 28.2% 100 2.6% SHAANXI West 28.3% 84 1.9% JIANGXI Inland 28.9% 104 1.9% BEIJING East, City 30.0% 108 3.2% TIANJING East, City 30.6% 108 2.9% SICHUAN West 32.5% 91 5.2% HUBEL Inland 34.0% 91 4.8% HUNAN Inland 34.6% 103 3.3% SHANXI Inland 35.1% 79 2.2% LIAONING East 36.0% 99 7.6% ANHUI Inland 38.7% 110 2.9% HENAN Inland 40.9% 102 4.3% Provinces with 45%-67% Non-State Sector Share of GVIO 120 38.2% HEBEI East 46.8% 108 4.6% FUJIANG East 47.5% 119 1.9% SHANDONG East 49.5% 107 7.5% GUANGDONG East 50.6% 126 6.5% JIANGSU East 63.4% 123 11.5% ZHEJIANG East 66.7% 139 6.2% Source: Total Factor Productivity Index from Xiao (1991); Other statistics from Statistical Yearbook of China, 18 The Economic Role: Challenges and OpportunitieThe Economic Role: Challenges and Opportunities 18 Table 2. Regressions Explaining Regional Productivity Gaps in China Coefficients for each variable Sample and R-Square (t-statistics) Regression Number of (Adjusted Rberatiof (Adjusted Constant Non-State Western Eastern City Dummy Sector Share of Province Province GVIO Dummy Dummy (1) 29 provinces 0.774 66.97 88.28 -1.29 3.85 20.98 (0.736) (10.72) (5.14) (-0.237) (0.77) (3.35) (2) 29 provinces 0.516 75.82 78.96 (0.498) (12.03) (5.36) (3) 29 provinces 0.525 95.32 -6.16 21.42 -0.37 (0.468) (22.82) (-0.81) (4.09) (-0.06) (4) 11 eastern 0.621 67.66 94.35 22.44 provinces (0.526) (4.87) (3.62) (2.53) (5) 9 inland 0.360 67.54 67.54 provinces (0.268) (4.71) (4.71) (6) 9 western 0.06 84.83 16.30 provinces (-0.08) (12.62) (0.66) Source: See Table 1. Note: Dependent variables for all regressions are TFP. All regressions are Weighted OLS with Provincial Share of National Gross Value of Industrial Output as weights. Sources of Provincial Productivity Gaps The Impact of Non-State Sector during 1985-87 Index of Total Factor Productivity 150 140 --.-- - - 130~~~~~~~ ~ ~ ~S ---- --- ------ ------------ -- National:Average 9 0 - - - - --- - - - - --- 5 7 0 - - - --4 . . . g. - - - - - - - -- --- -- - - .e . . .- - - - - - - - - - - - - - - - - - - - - - 5 *- - - - - * * * 6 0 .liiii 10% 15% 20% 25% 30% 35% 40% 45% 50% 55% 60% 65% 70% Share c>f No>n-State incdusrtrial O)utput Figure I Reginal Total Factor Productivity The Impact of Non-State Sector 1985-87 Index of Total Factor Productivity 150 140 - Zhejiang 130- 120 - Guangdong 110 Shanghai Jiangsu Fujiang 100 90 Beijing Tianjing Anhui Hebei 80 Jiangxi Hunan Shandong 70 - Yunnan Guangxi Jiling Liaoning Henan 60 - xinjiang 50 u inh. Sichuan Hubsi 50ashu Qinghai 40 -Heilongiiang Xizhang Ninxia S haanxi 30- Guizhou Shanxi 20- Nei Monggol 10 0 10% 15% 20% 25% 30% 35% 40% 45% 50% 55% 60% 65% 70% Share of Non-State Industrial Output Figure 2 Size of Fiscal Income Contributions by Sectors 1952 -1987 Percentage of National Income 50% --- 40% i rniMII 3 -- - ----- -- * I I I I I I I I I 111I 1 1 1 11 nu 20% 0. i/ i i i i i i i i i i i 495153555759616365676971737577798183858789 Year from State-Sector --m from Non-State -Total Figure 3 Fiscal and Extra-Budgetary Income from the State Sector 1952 - 1986 Percentage of National Income 60% . 50% 40% 30% - -:------ 3 0 % . . . . ' *. . . . .. . . ..-. . ..- - . . . . . . . . .. 20%_ 49515355575961636567697173757779818385 89 Year - FI: State Sector EBI: State Sector - Fl+EBI: State Sector Figure 4 Extra-Budgetary Income from the State Sector 1952 - 1986 Percentage of National Income 25% 20% ----------- 15% 1 5 % - - - - - - - - - - - --- - - - - - - - - - - - 10% - 5% - 495153555759616365676971 7375777981838587 Year * State Enterprise EBI M Administration EBI U Local EBI Figure 5 Indus. and Non-Indus. Basic Construction Role of Budget & Extra Budget Investment 1953-1986 Percentage of National Income 2 5% 1 p5% S- -- 0% 4951535557596163656769717375777981838587 Year Budgetary Investment U Indus Construction Extra-Budget.Invest. Non-Indus Construct. Figure 6 2 5 - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - Sources of Fiscal Income The State and Non-State Sectors 1950-1985 The State Sector Share 1 0 0 % I I I I I I . I I I I I I I . . . Indstia Otpt FscI lncomp1eRi 80% igr 7 6 0 % -- - ------ - - - - - - - - 40%- 20% 0%.' 495153555759616365676971737577798183858789 Year Industrial Output -Fiscal Income Figure 7