China, Constraining the Government without Reducing Its Revenue.

6. Constraining the Government without Reducing Its Revenue

• One of the fundamental institutional obstacles to economic development, according to economic historians is the lack of institutional constraint on the powerful, discretionary state
• While the rule of law is proven to be an effective way of constraining the state in developed countries, China has not had it yet. But there are other institutional arrangements that perform the similar function of constraining the arbitrary behavior of the government in order to protect private incentives.
• When it is difficult to constrain the state power in a direct way, it may be possible to reduce the effectiveness of the state power by reducing the information available it, this has played an important role in constraining the government in China in the absence of rule of law (practices of anonymous business transactions through the use of cash and anonymous financial assets through the use of anonymous bank deposits.)
• In China there was a very tight control over the use of cash for business transactions before the reform:  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 transaction. Also the use of anonymous household bank deposits, so the state does not have the information about individual’s financial wealth, in turn sets credible limits to government taxation and thus preserves private incentives, This implies that the state cannot target particular individuals and thus can only levy a flat tax on savings deposits. As a result, he state is forced to tax the rich and the poor and needy at the same flat rate. But this credible commitment mechanism can enhance the security of private property rights that would otherwise not possible.
• The above analysis shows how reducing information available to the state improves economic efficiency. Conceivably it could be against the interests of the state if the state cannot tax anything.

> Information opaqueness, together with financial repression, achieves two goals at the same time: efficiency improvement and interest compatibility.

• Government’s fiscal revenue is only a partial story, because the government has another important “quasi-fiscal” revenue source from the state banking system. Collected revenue from both currency seigniorage and from implicit taxes on savings deposits when interest rates were set below the market rate
• Combining the fiscal and the quasi-fiscal revenues, total government revenue would be more than 22 percent of GDP in the mid-1990s. This may well be substantially less than that in the pre-reform period, but does not represent a collapse of government revenue.
• ( take a look on comparative exemple between China and Russia)
• Anonymous household bank deposits existed even before the reform, but it finds its new use in a new environment Anonymous bank deposits become an important institution to protect private interests only after the reform when the ban on private businesses was lifted and the use of cash for business transaction becomes legal

7. From Transitional Institutions to Best-Practice Institutions

• During the transition from central planning to a market economy, markets need to be created and expanded, firms needs to be developed, and the government needs to be transformed
• The previous four sections in the article  have provided four examples from China's experience showing how innovative institutional reforms improve efficiency and benefit major decision makers and also complement the existing institutions. However, the institutional forms in all the above four examples are better understood as transitional institutions. They are transitional because they incur higher costs and generate lower benefits than some alternative institutions if other complementary institutions are in place. Therefore, these institutions should not be viewed as permanent and should eventually be replaced by the more conventional, best practice institutions when the underlying environment improves. The fact that best practice institutions are more efficient than transitional institutions does not imply that the former should always prevail.
• There was an optimistic possibility in which a sequential reform strategy has important advantages of building constituencies as well as momentum at the interim stage of reform for further reform. Three factors seem to facilitate the effects of building up constituencies and momentum: the nature of early reforms, the potential gains from further reforms, and the compensation schemes for potential losers.
• The four examples above were examined :

1. On January 1, 1994, plan allocation of foreign exchange was completely abolished, and the planned track and the market track were merged into a single market track. Two direct factors have contributed to the smooth transition to a single track market.

• First, because of the fast growth of the market track, the planned track becomes less significant as compared to the market track.
• Second, when the plan track was abolished, potential losers were explicitly compensated.

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1. Privatization of TVEs accelerated in 1998 after the Chinese Constitution was amended to regard the private sector as “an important component” of the economy, and by the year 2000 over 90 percent of TVEs have been privatized. Three changes have played significant roles in increasing the gains from privatization of TVEs and/or the costs for the local government to continue to run TVEs. :

• First, an important benefit of TVE ownership is the political protection of local government against adverse environment in order to secure property rights
• Second, the cost of TVE ownership, mainly the lack of managerial incentives, became more important as the economy became increasingly marketized and both product and labor markets competition intensified.
• Third, the reforms in the monetary and banking systems made local bank branches more independent of local governments.

The potential social gains from privatization will not automatically lead to privatization unless the local governments have the incentives to do it. After privatization, the township and village governments were able to keep all the privatization revenue,

1. China’s fiscal contracting system had played a positive role of providing fiscal incentives for local governments , On January 1, 1994, China introduced major tax and fiscal reforms which is more aligned with international best practices
2. Although the new tax and fiscal institutions are more in line with the international best practice, they might potentially hurt the interests of some local governments because they kept larger marginal shares of revenue under the previous fiscal contracting system. The move from the fiscal contracting system to fiscal federalism turned out to be quite successful. On April 1, 2000, China introduced “real name” household deposits under which all the bank deposits require a depositor’s ID. This is an important step in moving from anonymous banking to real-name banking, an international practice

Conclusion :

The Chinese experience of institutional changes shows the possibility that transitional institutions can be superceded by conventional best practice institutions when more development and reform take place. Transitional institutions do not necessarily lead to a partial reform trap, and incremental reforms do not always create obstacles to block further reforms. However, China’s experience also shows that this will not arise automatically. It depends on the nature of early reforms, future gains, and especially, compensation schemes.

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