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China is working hard to avoid falling into a Japan-style debt-deflation spiral, even introducing a $500 baby subsidy this summer. Unfortunately, all these subsidies and tax breaks might be having a pernicious effect on the economy, according to a recent IMF report.
It probably won’t be news to you that industrial policy is a pretty big deal in China. A vast and complex mix of cash payments, credit subsidies, tax breaks, land grants, regulatory barriers and direct state intervention by both local and national governments has been integral to its economic miracle since the 1970s.
But these measures aren’t costless, even when they don’t show up on local and national government accounts. Nor are they always entirely beneficial. By favouring some firms or sectors over others, they can lead to capital being allocated badly and sap the economy of some of its potential vim.
The IMF’s Daniel Garcia-Macia, Siddharth Kothari, and Yifan Tao have had a stab at estimating the fiscal cost of all these measures, and the impact they have on the aggregate productivity of China’s economy.
Unsurprisingly, the de facto expense is huge — 4.4 per cent of GDP in 2023, the last year of the period studied by the IMF’s economists:
The largest instrument is cash subsidies (at 2.0 per cent of GDP), followed by tax benefits (1.5 per cent), land subsidies (0.5 per cent), and subsidised credit (0.4 per cent). The total size of IP has been broadly stable over time, although tax subsidies have grown in importance in the aftermath of the pandemic, while the use of other instruments has slightly diminished. State-owned enterprises (SOEs) tend to benefit from lower interest rates and higher cash subsidy rates (after controlling for the sector of activity), but tax benefits are higher for private firms, and private firms are dominant in the sectors favoured by IP [industrial policy], suggesting that IP goes well beyond SOE support.
China is far from the only country to offer certain industries direct and indirect fiscal support. The OECD estimates that the 54 countries it monitors spend the equivalent of over $800bn a year on agricultural subsidies alone.
However, China is extreme in this regard, and the biggest issue is arguably the cost in terms of productivity, rather than direct cash subsidies or foregone revenues.
Estimating the impact on “total factor productivity” — basically, a measure of how much economic output is generated by the main inputs of labour and capital — is even more complex and messier than simply calculating the fiscal cost.
We’re going to skip over the methodology (here, for the econometric masochists) and jump straight to the conclusion. Alphaville’s emphasis in bold below:
The estimation results show that IP affects the allocation of production factors, but the different instruments do so in opposite ways. Subsidies are associated with excess production relative to a no-distortions benchmark, while trade and regulatory barriers limit production, possibly by increasing the market power of incumbents.
Overall, factor misallocation from IP is estimated to reduce domestic aggregate TFP by about 1.2 per cent relative to a no IP baseline, and this channel could reduce the level of GDP by up to 2 per cent. The analysis also suggests that industrial champions, or market-leading firms, owe their position to both higher productivity and policies encouraging their production relative to the average firm in the sector.
Even for an economy like China, foregoing 2 per cent of GDP a year is meaningful. Especially nowadays.
Alphaville suspects that many policymakers in Beijing agree with the IMF’s conclusions that it should unwind a lot of these industrial policies and make the remainder more transparent. But we also suspect it is another case of St Augustine’s “Lord make me chaste, but not yet”.
