The State as an Ensemble of Economic Actors: Some Inferences from China's Trajectory of Change
Andrew G. Walder
By the 1980s, students of communism in Eastern Europe and the Soviet Union generally agreed that these economies were unreformable. Serious reform initiatives had been blocked by political considerations since the 1950s in the Soviet Union and most other communist regimes. Even in regimes such as Janos Kadar's Hungary, which had gone the furthest in attempting to insinuate market mechanisms and free enterprise, efforts at partial reform were consistently undercut by the stubborn reality of soft budget constraints and bureaucratic bargaining inherent in state ownership of industrial assets (Kornai, 1990a). Only a decisive break with the premise of state ownership could overcome these pathologies, something that could not be successfully undertaken as long as these societies were ruled by communist parties whose privileges and very existence were based on this premise (Brus, 1989; Winiecki, 1990).
The sudden collapse of communist party rule throughout the region unexpectedly removed what was viewed as the greatest single barrier to effective economic reform. Discussions of reform strategy reflected sharp divisions over the pace of change, with some calling for a rapid leap toward a market economy (Blanchard et al., 1991; Peck and Richardson, 1992; Sachs, 1993), and others calling for a more gradual evolutionary process that would take into consideration cross-national differences and institutional legacies (Kornai, 1990a; Murrell, 1991; Stark, 1990, 1992). Yet there was broad agreement about the general direction of change: the state's assets should be privatized, state agencies should withdraw from direct economic management, and government should retreat to a role in which it would provide neutral institutions
to enforce contracts and property rights, the institutional foundations of a market economy (Blanchard et al., 1993; Comisso, 1991). Despite eloquent arguments that change is necessarily path dependent, and that capitalism cannot be made ''by design" or through "central planning," the emphasis of work on governance in the economy is still how to place constraints on government actions (e.g., to bail out firms) and how to create the proper incentives for firms.
This emphasis was encouraged by three distinct and fairly explicit models of the communist state that had gained broad currency by the mid-1980s. Each was based on long and accurate observations of the workings of these regimes, and each was coherent, clear, and at the time highly persuasive. Together they appeared to provide clear guidance, by negative example, of what must be reformed in order to restore the economies of these countries. They also appear, in light of China's rapid economic evolution under Communist party rule, to have been flawed in identifiable ways. Whether these models led to ill-advised programs for reform in Eastern Europe I am not qualified to say (and I doubt whether they did). But they did—in combination with the fall of communist party dictatorships—foreclose thinking about the reform of state structures that turns out to have been central to China's economic transformation. The purpose of this chapter is to highlight what we have learned about incentives for state agencies and officials in China's reforms, not in order to provide "lessons" for Eastern Europe, but to underline the more general point that incentives for government agencies and officials are an integral part of any program of economic transformation (see Shirk, 1993).
THREE MODELS OF THE COMMUNIST STATE
The first model highlights elite interests and political power. It has a distinguished European lineage, running from Trotsky (1937) to Djilas (1957) and Konrad and Szelenyi (1979). Communist states are in effect organizations that serve to perpetuate the advantages of a bureaucratic oligarchy or ruling class. The interests of those who rule are bound up with a system of central planning that allocates to them privileges in material distribution and in access to state property. Privilege flows from power. To use Szelenyi's language, a redistributive economy creates a class of "redistributors"—officials who have the power to allocate resources. Their privilege is founded on this power; their interests are tied to the preservation of central planning. This explains why impulses for economic reform were perennially so weak, and why regimes that did try reforms always pulled back from the brink.
Even in economies that underwent partial market reform, officials benefited disproportionately from markets because of their control of valuable assets, contracts, and licenses (Szelenyi and Manchin, 1987). In the language
of institutional economics, communist bureaucrats derived economic rents from their positions in the planning system; they would use their power to defend those rents, and if market opportunities opened up new sources of income, they would use their power to extract rent from these activities as well, stunting the development of a market economy and derailing market reform (Winiecki, 1990). It was therefore highly unlikely under communist rule that market reform would progress to the point where it could turn these economies around—the interests of the powerful militated strongly against it (Brus, 1989; see also the work reviewed in Goldstein, 1996).
The second model highlights the features of the state as a distinctive form of economic administration, and analyzes the behavior of state agencies and firms under conditions of central planning and partial reform. The premises of the system create inherent behavioral tendencies that are as predictable as they are different from the workings of market economies. By far the most influential and coherent of such analyses is that of Kornai (1980, 1991). Kornai counterposed the economic mechanisms of central planning with those of a market economy. Production proceeded according to the preferences of planners, not aggregate demand. Production in firms was therefore resource constrained, not demand constrained: firms would produce to meet production targets until they ran out of materials (which they did habitually); they did not have to worry about finding customers for their products (or improving products to maintain their sales). Firms responded to their resource constraints by stockpiling materials (the "Kornai ratio" of inventory over output was a revealing measure of this) and engaging in barter trade, and sought higher investments to produce their own parts and supplies, rather than relying on specialized suppliers. The result of such practices is wasteful investment and lack of product innovation, and an economy that excels in early stages of growth when the mobilization of capital matters, but lags in subsequent stages, when organizational and technological innovation increase productivity and drive growth (Kornai, 1980, 1991; see also Winiecki, 1987, 1988).
To Kornai and other early reformers, the only remedy for these defects of central planning was to introduce market mechanisms: evaluate managers and allocate investment according to profit criteria, not plan fulfillment; make them find their own customers and compete for sales; and allow prices for products to fluctuate so they would better reflect relative scarcities. After more than a decade of experimentation in Kadar's Hungary, however, Kornai had concluded that such partial reform was doomed to failure; a market economy could not be grafted successfully onto socialist stock (Kornai, 1990a). Kornai's explanation for this is the most memorable and persuasive: market mechanisms were defeated by the redistributive practices of public ownership. The state and the firm were locked into a position of dual dependence: the state depended on the firm to produce goods for other enterprises, maintain employment, fund social services, and contribute tax revenues. At the same
time, the firm depended on the state to set conditions that would greatly influence its success and prosperity—establishing marginal tax rates, granting investment loans and setting rates of repayment, and providing exceptions to price guidelines. Constant bargaining between the state and the firm led to countless exceptions to tax and financial regulations, resulting in a fiscal system that continued to redistribute revenue and opportunity from the more to the less profitable. Publicly owned firms facing market conditions therefore still had a soft budget constraint; bargaining undercut the incentives that were to be induced by market competition. The conclusion: public ownership is responsible for bargaining and soft budget constraints, and therefore the only feasible course of reform is to cut the ties of dependency between supplicant firms and the indulgent state by privatizing firms (Kornai, 1990b).
The third model highlights the fiscal structure of the state. From this perspective, the communist state is a formidable machine for the extraction of surplus and its mobilization for industrial investment. The state's coercive structures and monopolistic markets separate farmers from their produce at artificially low prices and keep the prices for their inputs relatively high; wages and consumption patterns are kept low, as are investment in "wasteful" consumer goods and "unproductive" investments such as housing, roads, and telecommunications (except for national defense). Savings rates are determined by central planners and are kept high; massive investment rates are biased toward heavy industry. The bias in the price structure, undervaluing raw materials, agriculture, commerce, and services in relation to manufactured products, reinforces the tendency to overinvest in manufacturing by making government revenues highly dependent on industrial production (Winiecki, 1987, 1998).
As a model of economic development, this fiscal structure reaped admirable successes in the first decades of communist rule. Its ability to enforce austerity and mobilize massive investment in key industries led to remarkable growth rates in the Soviet Union and later in China. Yet the centralized fiscal structure was behind the flaws of central planning identified by Kornai and others. It permitted the preferences of planners to reign over aggregate demand; the vast surpluses accumulated at the center were the foundation for bailouts and soft budget constraints. But for the reasons we have just seen, the fiscal structure supported a system of industrial administration that stifled innovation and productivity growth, causing these economies to fall further behind the market economies. It also put into the hands of government agencies and officials resources that were the foundation of their privileges. As long as this fiscal structure directed surpluses into the hands of government bureaucrats rather than the managers and entrepreneurs who generated them, a more market-oriented economy had little hope of succeeding.
Each of these models has clear implications for economic reform. Such reform cannot go very far, and cannot be very successful, as long as the
communist party holds a monopoly over political power. Market reform will be undermined by soft budget constraints on firms as long as public ownership is maintained. Market reform cannot succeed under a fiscal structure that concentrates capital in the hands of government bureaucrats. Despite these persuasive arguments, however, the Chinese communist party has presided over a strategy of partial reform that has produced extraordinarily rapid economic growth. Such an outcome varies widely from the predictions one would draw from the above three models of the state and leads us to wonder why our earlier understandings have proved such a poor guide to Chinese developments. Research on the role of the state in China's economic reforms has progressed to the point where we can take stock of these models by drawing inferences from the Chinese pattern of change. The models assume circumstances that were never clearly specified, and these circumstances turn out to be variables. As a result, analyses of incentives for real-world state agencies and officials have lagged far behind the analyses of incentives for firms.
The discussion that follows begins with assumptions about the state as a fiscal system, and shows how the degree to which state finances were centralized varied before reform according to both the size of the country and past institutional choices. Under certain circumstances, fiscal decentralization can alter basic arguments about the state as a fiscal system, and change both the capacities and incentives of state agencies and officials. Next, we examine how a decentralized fiscal system can alter the basic predictions of models of the state as a system of industrial administration. Finally, we look at how these changes undermine past arguments about the interests of state officials with regard to market reform. Throughout, the approach is to treat the state as a variable ensemble of economic actors, actors whose behavior is just as central to the process of reform as is the behavior of firms.
STATE FISCAL STRUCTURE AS A VARIABLE
While it is certainly true that the fiscal structure of the communist state was highly centralized and that revenue collection was focused heavily on industry by the price system, the extent of this centralization varied significantly across communist regimes. The most obvious reason for such variation is the size and scale of the economies. In small economies such as those of Hungary (and there were many such small communist nations), the central government owned and operated the vast majority of the industrial base. A relatively small number of large industrial plants contributed their revenues directly to the central budget, and received their investment and financing from the same source. It therefore makes sense to model such a state as a single centralized machine for revenue collection. On the much vaster scale of the Soviet Union, with subordinate republic and regional governments below
the center, such a high degree of fiscal decentralization was not feasible. The subordinate republics had large budgets of their own, with enterprises lodged under them and contributing to republic revenues. Nonetheless, compared with China, the Soviet Union's revenue system was more centralized, with a relatively small number of large industrial complexes providing revenues directly to the central government, and with revenues collected by republic and regional governments being turned over to the center and subsequently reallocated to them in budgets.
China differed from these Soviet-style counterparts in two ways. First, in scale of population and administrative complexity, it dwarfed not only Hungary, but the Soviet Union as well. Many of its 30 provincial governments were the size of large nations, 2 of them having populations of more than 100 million. Below these were some 340 subprovincial districts and cities, and some 2,600 counties and smaller cities. The fact that China's population was still 80 percent rural meant that a great deal of economic activity, not just agriculture, but also subsidiary production and small-scale industry closely tied to agriculture, was lodged under even lower government jurisdictions. This was especially so in the 48,000 communes, which later emerged as rural town and township governments. Each of these levels of government had its own production plans and its own revenue bases.
Second, the degree of decentralization of China's planning and fiscal system was greater than that of the systems of the Soviet Union and the smaller communist regimes, even taking into account the above differences in scale and complexity (Qian and Xu, 1993). Khrushchev's 1957 effort to decentralize the Soviet economy failed. Mao, no friend of central planning, in fact began his own decentralization drives that same year, following Khrushchev's lead, and continued to decentralize the economy into the 1970s. Far fewer industrial goods were allocated by central government planners in China than in the Soviet Union. Balances of materials were handled at each level of China's government hierarchy. Provincial and county governments had their own plans. Over two decades, this affected industrial investment decisions such that China developed toward regional autarky, with large numbers of relatively small industrial enterprises located in regions in order to promote local self-sufficiency (Granick, 1990; Wong, 1986, 1987). Hundreds of subnational governments were to a considerable extent "redistributive economies" on a scale similar to that of Hungary. By 1985, there were over 100,000 state industrial enterprises in China, only 3,835 of which were under central government planning, contributing revenues directly to the center. These central enterprises produced only 20 percent of public-sector industrial output in that year (Walder, 1995a:275). Therefore, China was not so much a centrally planned redistributive economy as it was a coordinated hierarchy of well over a thousand of such economies, each collecting its own revenues from industries under its jurisdiction.
The relationship among these redistributive economies was essentially one of bargaining over fiscal transfers between jurisdictions. Because vast numbers of industrial enterprises were located at lower levels of the government hierarchy, local governments collected the bulk of state revenues. The only question was how much of these revenues a local government was able to retain. The typical redistributive practice was to extract more from those jurisdictions that had surpluses and to subsidize those jurisdictions whose revenues fell below local needs.
In the early 1980s, these fiscal relationships changed. Fiscal contracts, or ex-ante agreements, were fixed so that the division of revenues could be predicted. Rights to revenue flows were clarified. Incentives were built in. Provinces were allowed to retain a specified proportion of revenues collected over a targeted amount. Provinces, in turn, set such agreements with districts and large cities, and these jurisdictions, in turn, set such agreements with counties and small cities, and they in turn with townships and small towns. Moreover, revenues from private industry were not to be included in the base for redivision. Government jurisdictions down to the township level now had, in theory, clearer fiscal incentives to encourage local industry. The more rapidly industry grew, the more rapidly local revenues would grow. No longer would increased revenues be seized for redistribution by higher levels (Oi, 1992; Walder, 1992; Wong, 1987, 1988).
A HIERARCHY OF REDISTRIBUTIVE ECONOMIES?
At this point one might ask, as many did, whether this kind of piecemeal reform, essentially tinkering with the old system, would have much impact. Would not the result of this fiscal decentralization simply be a hierarchy of thousands of smaller redistributive economies, each of which would replicate the fundamental problems of soft budget constraints that plague all public industry administered by economic bureaucracies? The answer to that question is a qualified, but firm, no. Why? The short answer is competition among government jurisdictions for market share and revenue; the long answer requires working through the implications of more than one "redistributive" state and the bureaucratic incentives created by decentralizing fiscal reform.
The central flaw of strategies for reform under communist party rule, as analyzed so lucidly by Kornai, is that the state has the capacity to redistribute financial resources among firms, thereby softening budget constraints and undermining the incentives of market competition among firms. Surpluses from profitable firms are skimmed off at higher rates to subsidize firms that are less profitable or operating at a loss. This weakens incentives for the profitable to perform even better and for the unprofitable to cut their losses. A "regime of bargaining" is recreated under partial reform, in which bargaining over financial terms replaces the traditional bargaining over production quo-
tas, plant capacity, tax rates, and material supplies. The fundamental flaws of the system are not overcome (Kornai, 1991).
There are two assumptions behind this analysis, neither of which receives the same kind of attention as the relationship between the state and the enterprise, which is the centerpiece of the argument. The first is that the budget constraints on the state itself are relatively weak: the state can manipulate the money supply or the price structure, run a foreign trade deficit, or borrow internationally to cover any shortfalls (this of course cannot work in the long run, as Eastern European economies found in the 1980s). The second assumption is in fact the reason why the state bothers to bargain with firms at all—why can it not just say no? The reason is structural. While some enterprises may provide crucial inputs for other national firms that would otherwise have to purchase their supplies abroad, all enterprises meet central nonfinancial needs for the state: they maintain full employment and fund housing and social services for large numbers of employees. As a result, very few firms are ever closed, and the large industrial complexes, often among the biggest money losers, are virtually never closed. To do otherwise would be to create severe social problems. The nonfinancial interests of the state in public firms prevent the imposition of hard budget constraints and therefore lead partial reforms into an impasse of constant bargaining, with concealment of financial resources as the central strategy—a reproduction of the central flaws of the system.
If we conceive of the state not as a single redistributive system (a not unreasonable assumption for Hungary), but as a hierarchy of thousands of such redistributive systems, and if we consider the effects of fiscal decentralization on revenues and bureaucratic incentives across levels of this hierarchy, we can see the possibility of different results. Instead of the system being shifted into a new yet unsatisfactory equilibrium, we see the processes that can lead to the dynamic yet gradual transformation of the behavior of bureaucrats and thereby the premises of the entire system. While systematic econometric evidence pertaining to some aspects of this transformation has only recently appeared, interview studies and field observations suggest strongly that this is precisely what has been happening in China.
First-Order Consequences of Fiscal Reform
The first step in the analysis of this dynamic transformation is to examine the impact of fiscal reforms across levels of a system in which only the small number of higher jurisdictions had the features posited by Kornai. At the pinnacle of this hierarchy in 1985 was the central government, a redistributive economy of 3,800 large industrial enterprises, each of which employed an average of 2,270 people. The revenues of the central government came directly from these large firms, which produced 20 percent of public-sector
industrial output, and from the taxes remitted by lower levels of administration. At the next lower level were 30 provinces and below them another 320 cities and districts, which together owned 83,000 public industrial enterprises (an average of 235 per jurisdiction). Together, these firms produced 52 percent of national output in 1985. Below the cities and districts were 2,000 largely rural county governments, which owned another 68,000 public enterprises (an average of only 33 per jurisdiction), producing 13 percent of national output. Below the rural counties were 91,000 townships and towns with an average of fewer than 2 public enterprises each, and below these townships were another 80,000 villages with less than 1 enterprise on average. The fiscal reforms of the 1980s gave each of the 93,000 government jurisdictions above the village level clearer residual rights to increases in revenues (Walder, 1995a:275).
It is evident that the scale of the economy, the size of its revenue base, and the degree of industrialization drop dramatically as one moves from the top of this hierarchy of redistributive systems down to the smaller cities, counties, and townships. It is less immediately evident that as a result, the centrally defining features of redistributive economies disappear as one moves down the hierarchy.1
The Intensity of Fiscal Incentives for Governments
The lower the level of the government's jurisdiction, the more its revenues rely on agriculture rather than industry, and therefore the lower its per capita revenues. Economic growth has a disproportionate impact on the revenues of less industrialized jurisdictions. Kornai's analysis of redistributive economies assumes a centralized system that itself already depends heavily on a developed national industrial base. The fiscal incentives for the smaller cities, counties, and especially townships and villages, where there is still a significant agricultural population, are much stronger than this model assumes. Additions to the industrial bases of these lower jurisdictions have a larger proportionate impact on revenues, and therefore fiscal decentralization creates more intense fiscal incentives in the lower reaches of the government hierarchy (Byrd and Gelb, 1990; Oi, 1992).
The Capacity to Redistribute Within an Industrial System
While the vast majority of China's (mainly small) industrial enterprises are held by these lower jurisdictions, the number of enterprises per jurisdiction drops dramatically as one moves down the hierarchy. While there are almost 4,000 firms at the center, there are on average only 350 at the province
and city levels (with wide variations around this mean), some 33 at the county level, and fewer than a handful in townships and villages. The lower-ranking jurisdictions therefore cannot redistribute revenues among firms with the ease assumed in the basic model. The smaller the number of enterprises, the more likely the industrial base is to be specialized in related lines of production (e.g., textiles and foodstuffs), and the more likely it is that all firms will be similarly hit by a downturn in business. In the small jurisdictions where one or two firms might contribute well over half of local revenues, there quite literally is no other source of revenue to compensate. The losses of the firm create havoc with local government finances, and government spending must be slashed immediately.
The Budget Constraint on Government Itself
If a jurisdiction below the center suffers a revenue shortfall and cannot meet its fiscal targets as set by the next higher level of government, will that government jurisdiction not have its "debt" forgiven by the higher level, and in fact receive a subsidy? Should disaster strike, this will certainly be the case; should the situation be the result of decisions for which government officials can be held accountable, it will be done only with pain and difficulty. But the temporary covering of shortfalls, or the provision of subsidies, will create severe fiscal problems, for it will cut out completely any discretionary spending in the budget and halt all capital construction and industrial investment. The opportunity costs, absent in the old revenue system when any budgetary surpluses were automatically absorbed by the higher levels, will now be very large. Yes, subsidies are possible, but just enough to cover necessary welfare expenditures; the jurisdiction will be subsidized just to the point of stagnation and poverty. The budget constraint may therefore be soft—one cannot close down a county—but the fiscal consequences will be immediate and painful.
The Nonfinancial Constraints on Government in Its Bargaining with Firms
These constraints also decline markedly as one moves to lower-level jurisdictions. Only large public firms provide a full range of benefits, housing, and other social services for employees. The smaller firms that dominate the counties, towns, townships, and villages provide few if any such benefits. In rural jurisdictions, employment does not present the same constraint as in the larger cities. Local residents who are laid off will usually still have a family farm to which they can return, or they will be able to migrate to other regions in search of wage labor. In those highly industrialized rural regions along the coast where demand for labor outstrips local supply, one can simply fire the temporary migrant workers first, and they then leave the jurisdiction. Thus
nonfinancial constraints drop dramatically in the rural jurisdictions, and local governments are much less constrained in enforcing financial discipline—or in closing down firms—than the basic model allows.
Competition Among Jurisdictions for Sales and Revenue
The implications of the above discussion for the thousands of government jurisdictions below China's center and its 30 provinces are quite profound. For the discussion implies that local government officials compete with one another for revenues by having their firms compete with one another in regional and national product markets. These thousands of local "redistributive systems" may operate in ways that echo the basic model's assumptions, but these are not the self-contained redistributive economies posited in that model. The industrial enterprises of small cities, counties, towns, townships, and villages do not constitute balanced input-output planning systems. These jurisdictions must purchase their supplies outside and sell their products far outside of their boundaries. True, public officials intervene deeply in the main business decisions of firms—to start new product lines, invest in one plant or another, or assemble capital and loans for one venture while deciding against another. But if local industry fails to thrive, local government revenues stagnate. Either local officials must actively promote local industry—by gathering information, making connections with potential customers, pulling in production subcontracts from cities, using their connections and knowledge to acquire loans in the provincial capital—or the jurisdiction will become a backwater. Under these conditions, the universal desire of officials to command larger budgets and build up local resource bases forces the local officials to become market-oriented agents who actively promote local industry. The hard reality of competition forces constant adjustments in local economic arrangements, and has transformed the orientations and interests of local officials with regard to the market economy (and, as we shall see below, the private sector as well).
Second-Order Consequences of Fiscal Reform
The second step in this analysis is to examine the fiscal pressures placed on the higher levels by competition for sales and profits between their large firms and the vast numbers of smaller firms held by lower levels of government. During the first decade of China's reforms, industrial growth has been most rapid in the lower-level government jurisdictions in rural areas—counties, townships, and villages. This growth has come at the expense of the large state-owned enterprises held by the central government, provinces, and large cities. The share of output produced by this traditional state sector shrunk from almost 80 percent to less than 50 percent over the period. As the large-
scale state sector has lost its traditional monopoly, its profit performance has suffered steady declines due to competition with the newer small firms (Naughton, 1992). As profits and sales have suffered, and as growth has shifted to the lower-level jurisdictions, the fiscal pressures on the higher-level government jurisdictions have increased in ways not apparent in the first-order impact of fiscal reform, and in ways not anticipated by the unitary models of the past.
At the same time that revenues due to the earnings of public industry have declined, the proportion of revenues received by the higher-level jurisdictions from the lower-level jurisdictions in contracting agreements has also declined. Higher proportions of national tax revenues have been retained at lower levels of government. This is due partly to the increased rights over revenue residuals enshrined in the reformed fiscal contracting system, but more importantly it is due to the rapid rise of ''extrabudgetary funds" that come from new local taxes on industry, extra-tax levies, and revenues from private industry. The center's share of total government revenue shrank from an average of 50 percent in the decade prior to 1978 to an average of only 28 percent in the decade after (Wang, 1995:104).
The growing evidence of budgetary shortfalls at the center and the steady drop in the profitability of the large state enterprises has set alarm bells ringing among conservative national politicians and has been cited by some scholars as evidence that China's strategy of partial reform is failing. But as Naughton (1995) and others have argued, it is also evidence of the systematic introduction of competition into the Chinese economy, competition that hits the formerly monopolistic large-scale state sector and the largest and most self-sufficient redistributive systems at the top of the hierarchy especially hard. It is therefore not at all clear that these central difficulties are evidence of failing reform; they may in fact be the primary evidence that reform is succeeding.
This is the argument of a number of economists who emphasize the positive effects of fiscal pressures on government and financial pressures on firms (Jefferson and Rawski, 1994; Naughton, 1995; Rawski, 1994a, 1994b). A poor central government with large numbers of money-losing firms finds it increasingly difficult to bail out losing firms, and is constantly pushed to devise strategies to sell these firms to foreign investors, use them as part of a joint venture, or begin to transfer their employees to other firms and sectors. Large state firms with falling profits, facing a government increasingly unable to bail them out, must push themselves to reorganize and innovate to a greater extent than ever before (Rawski, 1994b, 1996). Several researchers are now finding evidence that falling profits coincide with increasing factor productivity. Long stagnant in the Mao era, according to these researchers, factor productivity began a slow rise in the mid-1980s and has increased at an accelerating rate since then (Jefferson et al., 1992). Incentives for managers are increasingly being linked to performance, failing firms are more likely to
innovate, and investment is increasingly going to profitable enterprises and sectors (see the evidence reviewed in Walder, 1996). The second-order consequences of fiscal reform in a decentralized economy therefore place mounting competitive pressures and budgetary constraints on even the highest levels of government.
THE INTERESTS AND ROLES OF GOVERNMENT OFFICIALS
The impact of these changed incentives and budget constraints on the behavior of government officials has been observed and amply documented for more than a decade. Government officials, party secretaries, and government agencies have behaved in ways that contrast markedly with the behavior of the conservative rent seekers with interests tied firmly to the planned economy that have been portrayed in earlier analyses. From a growing body of descriptive field studies, a number of distinct new roles can be discerned. All of them indicate the ways in which the interests of officials and agencies have become tied to the development of a market economy. Moreover, they illustrate the ways in which government officials in this transitional economy are themselves pivotal economic actors.
Officials as Entrepreneurs
In many of the smaller rural jurisdictions in which there are only a few public enterprises in a village or township, or in which there is one that is much larger in scale than others, village heads or party secretaries will directly manage the firm that supplies them with their main source of revenue. To be sure, there are hired managers of these enterprises, but they work under the close direction and supervision of the official, who makes virtually all major business decisions, deciding on product lines, procuring contracts outside the locality, and securing investment loans. The role of government officials in these rural jurisdictions has rightly been described as entrepreneurial (Byrd, 1990; Nee, 1992; Oi, 1986, 1990).
Government Officials as a Corporate Management Team
This form of involvement has been observed in smaller cities, counties, towns, and townships, and in villages that have a large number of public industrial enterprises. In this situation there are too many firms to monitor closely, and officials cannot take the same kind of active and direct role in management that they can take in smaller and less developed local economies. Instead, local officials govern their firms in a manner analogous to that of the top management team of a diversified company or small corporation. Major business decisions are made by the village or township committee, or by a
subgroup of county officials involved in industrial administration. The hired managers of firms may originate proposals to change product lines or innovate, but the top officials make the final decisions. Once these decisions have been made, government officials on the management team are responsible for arranging finance with banks outside their jurisdiction, and making connections with state purchasing agencies, other large institutional customers, or foreign investors. In this situation, which appears to apply to a broad range of political jurisdictions from small cities down, party and government officials in effect manage a diversified portfolio of assets whose value depends on their market performance (Oi, 1992, 1996; Byrd, 1990; Nee, 1992; Walder, 1994, 1998).
Local Developmental States
In addition to this direct managerial role played by party secretaries, heads of governments, and heads of local economic commissions or departments of finance, these same officials, and other branches of local government, behave in ways analogous to the behavior of "developmental states" elsewhere in East Asia. And they do so not only with regard to local public enterprises, but increasingly with regard to household, private, and foreign firms. These latter firms also can have a major positive impact on local revenues—and have the advantage of not being burdens on the local government if they fail. After a relatively slow start, these nonpublic enterprises have grown very rapidly since 1990, often with the active encouragement and concrete assistance of local government (Walder, 1998). Local government officials travel far outside their jurisdictions to gather technical information to assist the development of local firms with regard to both manufacturing technology and especially product specifications. They assist local firms in marketing their products outside the jurisdiction. They attempt to arrange sales contracts for local firms with large state agencies in the provincial capital or along the coast. And they try to make contacts with potential foreign investors and compete with other jurisdictions to create favorable conditions that will attract such investment (Oi, 1996; Zweig, 1991).
Silent Partners in Private Enterprise
As part of an effort to secure their property by cultivating protectors in local governments, some private entrepreneurs seek to make silent partners out of government officials or agencies. Officials are hired as "consultants" or appointed to a firm' s board of directors and receive compensation for no work. They are issued share certificates in the company without having to pay for them, or their relatives are hired for important positions (Liu, 1992; Solinger, 1992; Wank, 1995). These kinds of practices are common from the center
down to the small cities and towns and are often attacked as a form of corruption. But they do open up sources of personal income that far outstrip those from official urban salaries and alter the interests of these officials regarding the private economy.
Such ties can be institutional rather than personal, and they need not involve arrangements that are corrupt. Many government agencies own assets that are potentially quite valuable in a market economy: real estate, buildings, street-front offices that can be converted to retail shops (Nee and Su, 1993). These assets can be allocated to private entrepreneurs in return for shares of the profits of the enterprise. Government agencies therefore become silent partners in a variety of real estate developments and retail and service establishments (Solinger, 1992; Wank, 1995). Land and real estate that had little value under the planned economy thereby become a windfall for local government agencies, which may retain these proceeds as "extrabudgetary funds" (and which may also decide to use some of them for personal compensation, housing, and so forth).
Government Agencies as Investors in the Private Economy
It is evident to government officials from the center down to the rural counties that the returns to private enterprise often outstrip those from the traditional state sector, large parts of which give meager returns or are in fact a drain on the budget. This fact, in combination with the fiscal pressures on government agencies described above, means agencies strapped for cash must develop alternative sources of "extrabudgetary revenue." And they do this increasingly by investing in the market economy. Examples of this are legion, and it is one of the most underresearched dimensions of China's economy. The state security agency, for example, is part owner of a luxury hotel in Beijing, having created a partnership with one of Hong Kong's wealthiest real estate tycoons. The private companies spun off from China's military establishment have become actively involved in the export of arms and in the import of sensitive military-related technology—both of which have created highly publicized strains in U.S.-Chinese relations. Ministries in Beijing create spin-off high-tech companies in the city's Haidian district—China's Silicon Valley—making state planning ministries investors in highly profitable joint stock companies (Francis, 1996). Large state enterprises facing losses or declining profits invest in other lines of business by opening up associated collective or joint venture enterprises. They can reap greater returns from these enterprises than from their core business, in large part because they face more favorable tax regulations and do not have to bear the same social welfare burdens as with their core plants (Lin and Zhang, 1996). Finally, thousands of state agencies, government jurisdictions, and state enterprises find ways to place funds overseas and bring them back into China as "foreign investment"—
again facing more favorable tax and labor regulations. Lardy (1996) estimates that this circular flow of funds rivals the magnitude of genuine "foreign" investment.
The arrangements just described would obviously not pass muster under U.S. federal antitrust regulations, and they grossly violate U.S. legal norms regarding conflict of interest. This is a far cry from government as an impartial enforcer of contracts and property rights—the kind of legal and regulatory regime that so many observers of Eastern Europe insist is a prerequisite for a thriving market economy. Reformers in Eastern Europe whose goal is to have Poland "return to Europe" (Sachs, 1993) or to create the foundations for a free society in Hungary (Kornai, 1990a) would find little to emulate in these practices—and I have no quarrel with their cultural and institutional preferences. Yet the long-observed roles of government officials as economic actors in China does demonstrate fairly conclusively that earlier models of the state in which communist elites are defined by—and unshakably tied to—their privileges in the planned economy are better as a description of Soviet realities than as defensible general model of the state. Partial reforms have created a dynamic process of change—and of rapid economic growth—that earlier models of the state would not have deemed possible (see especially Nee and Lian, 1994). Indeed, the above discussion implies that this continuing economic transformation is naturally transforming the state itself. For a state whose agents have all developed alternative sources of revenue to those provided by their superiors, and whose agents have developed strong interests in the maintenance of a market economy, is also a central state that is progressively unable to contemplate a return to the former status quo (Walder, 1995b).
China is no model for Eastern Europe. With the fall of communist party dictatorships, history there has already turned down another path of institutional development. Reform in Eastern Europe is premised on the idea that a liberal political system is to be constructed, and as part of this task the economic institutions of the past are to be dismantled as completely as possible. Reform in most of Eastern Europe aims to dismantle communist power; in China, the aim is to preserve it.
Despite this caveat, China's development over the past 15 years has shown that the models of the state on which critiques of partial reform in Eastern Europe were based—and that served as background assumptions for many programs for post-communist reform—are less general and less persuasive than was originally thought. What were supposed to be defining and stable features of state structures, relatively impervious to partial reform measures, turn out to have been variable characteristics sensitive to seemingly small initial changes in incentives for bureaucrats.
A case in point is the long-delayed process of privatization that has gained momentum in China in the past few years. Like the response to new fiscal incentives, this process is beginning at the bottom of the hierarchy and spreading upwards. Local government officials who manage a portfolio of marketoriented public enterprises have come to see the less profitable or loss-making enterprises as troublesome burdens, not worth the scarce time and resources they want to devote to their successful ventures (Kung, 1996; Ruf, 1996; Whiting, 1996; Walder, 1998). Far from wanting to preserve these public enterprises at all costs, they now actively seek to divest themselves of these dead assets by leasing them or selling them off at a discount. This long and slow process of privatization has grown naturally out of a process of fiscal change and increased competition. It did not require a preconceived and coordinated central plan or a central state-induced recession. Instead, the motivations to privatize have emerged gradually among officials themselves as a result of the altered incentives created by this evolutionary process of reform. To understand this process of change, we need to view the state as an ensemble of economic actors and to place the incentives for their actions at the center of our analyses. For it is not enough to point out that the state can play a major and important role in a transitional economy or that an evolutionary process of transformation is possible. We need to understand why, and specify the conditions under which this might be true.
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