How Reform Worked in China, Part 9

[nodular]

I am returning to my analysis of the document: How Reform Worked in China,
Yingyi Qian , Department of Economics, University of California, Berkeley, http://team.univ-paris1.fr/teamperso/sponcet/455/lecture%201%20introduction/Qian%20how%20reform%20worked%20in%20China%202003.pdf . In the past, I was periodically posting an analysis of this document, taking a small piece of the document at a time. I noticed a small group seemed to be periodically checking the postings, though few comments were made. Assuming almost no one remembers the earlier postings, if you find this one interesting, you will also likely be somewhat confused. However, the earlier postings are still in my journal, if you want to reference some of them.

Essentially, this paper addresses the question, how did the Chinese achieve their miracle economic reform? Earlier, I summarized in paraphrase many of the surprising findings in the paper, including the fact that businesses owned by local government were an important early factor in economic reforms. Another surprising driver of growth was that the Chinese reformed their system to allow local governments to increase their revenues as local businesses became more successful and paid more taxes. Previously, these types of tax increases were siphoned away by the federal government. This reform was one critical factor in the Chinese economic miracle.

As strange as these factors same in many ways, the one I will address the day is even more odd. First, the paper addresses a fundamental problem that potentially limits economic growth in any nation. How can the government restrain itself from taxing businesses so heavily that business growth is constricted?

One answer to this question is that constraint can come through the rule of law. This is essentially the American and Western answer. However, China does not have an effective rule of law constraining government at this time.

They have come up with a unique answer to this problem---allowing citizens to simply hide their money from the government. If the government cannot see the money, it cannot tax it. This reform apparently (you must rely on my attempts at interpretation here) depended on two factors. On the one hand, the government simply allowed more cash transactions to occur in the economy. To quote from the paper, "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." This was a result of listening restrictions on cash transactions in the economy. The second factor is allowing citizens to have bank accounts that are not listed under their real names. Chinese citizens apparently did not have to show any ID or prove their identity to open a bank account. Hence, the government has no way of knowing who owns the money and therefore is apparently less tempted to tax it. The paper does not explain how Chinese depositors prove their identity when they make a withdrawal, but I ascend these are all small town banks where the depositors are personally known by the bankers. The government apparently taxes the state banking system itself, thus drawing out needed revenue. This type of tax, however, does apparently not stifle individual initiative. Part of the idea is that progressive taxes are impossible in this system: the government cannot tax the rich because they can't tell who they are. Therefore, people are not deterred from becoming rich and economic development is stimulated.

Under this system, the government tax rate in China fell from a total real tax rate of about 40% of GDP in 1978 to 17% in 1996. However, because the economy was growing so much, the amount of taxes collected increased. During a 20 year period (which I assume is roughly coincident with the previously mentioned period discussing taxes) government revenue doubled in the economy expanded by a factor of five. Apparently, most of the reduction of the government's percentage of GDP taken in taxes was caused, not by formal rate decreases, but by the above-mentioned revenue-hiding methods.

In addition, people started putting more of their money in banks (for obvious reasons) and this benefit of the government also, as they basically took a cut from banking activity (at the top end, from the banks--- not at the bottom end from the individual savers.)

In Russia, without this type of system, people also engaged in revenue hiding--- but they did it by resorting to barter. As one can imagine, this did not work out as well as the Chinese system. Interestingly, the Chinese actually learned about private bank accounts from Russia, which had them first. In Russia, however, they were eliminated as part of the broad attempt to institute Western market reform.

[westerebus]

1. Thanks for the insight. n/t

[nodular]

2. You're welcome.