The Costs of Political Manipulation of Factor Markets in China

Abstract

China over the last forty years has undergone massive reform in output markets and experienced extraordinary economic growth. However, reforms of factor markets and city governance are much slower. In this paper, we tackle the key issue of local political manipulation of land markets and the objectives of local leaders, along with capital price favoritism of certain cities and migration frictions, using a structural general equilibrium model based on prefecture level data. In doing so, we model the political process of land misallocation within cities which drives up housing prices and estimate city-by-city local leaders’ preferences over economic performance versus resident’s welfare. Counterfactual analysis shows that equalizing capital price across cities increases national social welfare and returns to capital by 2.6% and 11%, respectively. Further correcting the distortion of local leader’s preference towards GDP would increase residents’ welfare by another 5.3%. These reforms would significantly reduce the population of cities like Tianjin and Beijing, which are currently favored in capital allocations, and raise the population of cities like Shenzhen, which leaders seem to be more incentivized to focus on GDP enhancement, rather than consumer welfare.