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The Political Benefits of Soft Budget Constraints, and Then Some

While the entrepreneurship thesis emphasizes mutual benefits to local political and economic actors as an explanation for the growth of genetically private enterprises, the budget constraint thesis is mainly concerned with the issue of cost in the administration of public enterprises. In particular, it focuses on cost considerations as an explanation for the central government’s changing policies for the privatization of public enterprises. Its basic argument is that privatization was a result of the increasingly unbearable cost of continuing to finance the vast majority of these enterprises. This is indeed true. And the emphasis that the thesis places on the linkages between fiscal and banking reforms and the massive privatization of SOEs and township and village enterprises (TVEs) in the late 1990s is especially useful for understanding the triggering mechanisms for the decline of the public sector. Yet there are gaps in the analysis of the underlying forces at work. A key issue that needs closer scrutiny is why the budget constraint in many public enterprises not only continued to be soft but was actually further softened during the transition from central planning to markets, which presumably would tend to harden (e.g., with profit orientation and competition) rather than soften the budget constraint. There also remain questions as to whether the soft budget constraint problem provides a sufficient explanation for the deterioration of the financial health of the public sector, and what shaped and reshaped the calculation by local authorities of the opportunity cost for maintaining public enterprises up to the tipping point of massive privatization and beyond.

In his original formulation of the soft budget constraint problem in socialist economies, Janos Kornai (1979, 1980) attributes its cause to the need to internalize the social costs of unemployment and/ or organizational restructuring under an all-encompassing, “paternalistic” state. Broadening the use of the term to market economies, Shleifer and Vishny (1994) further point out that a soft budget constraint may result from the active pursuit of political benefits (e.g., votes in exchange for excessive employment or other unprofitable investments) that accrue to politicians in control of public enterprises. Shifting the focus from politics to information cost, Dewatripont and Maskin (1995) present a scenario of adverse selection in which the authority that softens the budget constraint does so not by choice, but by necessity. What causes this is that under a centralized structure of financing, information asymmetry renders it difficult for the fund provider to ascertain, ex ante, and devise effective deterrence against the fund user’s undertaking inefficient activities, making the continuation of financing a rational way to recoup sunk costs ex post facto.

Accounts of the soft budget constraint problem in China’s economic transition invoke both the political-benefit perspective and the information- cost perspective (e.g., Qian and Roland 1998; Bai and Wang 1998; Li 1998; Li and Liang 1998). Such analysis, however, largely stays at a theoretical level and has yet to be contextualized in regard to the concrete characteristics of China’s changing political economy. The utility of these perspectives may be enhanced if one uses them as launch pads for investigations into more probing questions on the complex forces that weakened the financial discipline and health of public enterprises in market-oriented reforms. What, for example, constituted the political benefits from softening the budget constraint in the post-Mao era ? And why did the soft budget constraint problem persist or even worsen under an increasingly decentralized structure for the supervision of public enterprises, which presumably would have alleviated information asymmetry and hence hardened the budget constraint?

Kornai’s emphasis on employment retention as a major political benefit associated with soft budget constraint offers a useful point of departure. It derives from his prototypical case of Hungary, which had a relatively stable population size and a high degree of urbanization from the 1950s to the 1980s. In contrast, the main challenge faced by post-Mao Chinese leaders was not employment retention but the need to create jobs by leaps and bounds. China had experienced fast population growth in the Mao era while accumulating large numbers of underemployed workers in the rural sector due to a capital-intensive strategy of industrialization and restrictions on the occupational and geographical mobility of the workforce. In the face of mounting pressures for nonfarm job creation after agricultural decollectivization in the late 1970s and early 1980s, government authorities relied heavily on public enterprises to expand nonfarm employment, which oftentimes eclipsed the goal of profit making despite the fact that these enterprises were moving away from central planning to markets.

The pursuit ofprofits by public enterprises during the early years of reform faced further interference from their supervising authorities. As will be discussed in chapters 3-4, although the reform of public enterprises aimed to turn them from passive takers of bureaucratic orders into market-oriented profit makers, supervising officials focused on the growth of sales as the main avenue to generating fiscal revenue. What fostered such behavior was a longstanding structural bias in the fiscal system, where government budget revenue was derived mainly from indirect taxes and levies tied to sales volume rather than direct taxes on profits and income.

As employment and revenue were often among the key criteria used in the assessment of the performance of leading officials, who typically had transient tenures, and since there was a lack of clear cost accounting and intertemporal tracking of responsibility in such assessment, softening the budget constraint to enlarge the workforce and boost sales without close links to profitability became a convenient tool to maximize the short-term political benefits of control over public enterprises. The moral hazard that led many public enterprises down this path of overexpansion and eventual implosion cannot, therefore, be fully accounted for without a close examination of the political incentives faced by supervising officials, as well as the demographic and fiscal conditions that defined the parameters of their decision-making.[1]

The moral hazard story also sheds some light on the link between budget constraint and information cost. The fast expansion of public enterprises orchestrated by local authorities for quick political benefits posed a parallel challenge to the enforcement of financial discipline. That is, when the number and scale of public enterprises outgrew the monitoring capacity of their supervising authorities, the budget constraint could be further softened due to the increased information asymmetry, which nevertheless resulted mainly from a significantly broadened span of control rather than centralization of control, as emphasized by the pertinent theory.

While a closer examination of the forces that softened the budget constraint will be useful, it may still fall short of yielding a sufficient explanation for the deteriorating financial health of public enterprises. A fuller account requires the consideration of a concurrent contributing factor, the self-seeking behavior of political actors. Examples of such behavior, as I have illustrated in an earlier study (Lin 2001) and will further discuss in chapter 4 and chapter 7, include the use of public enterprise accounts to manipulate revenue flows and finance personal expenditures, the diversion of resources to officials’ private profit centers, and outright asset stripping. These problems were particularly serious in the 1990s, when the decline and death of the vast majority of public enterprises occurred.

The fiscal system, again, provides a window into what led to the growth of opportunism in the administration of public enterprises. In particular, there are revealing clues from the changing opportunities and constraints faced by political actors during the fiscal decentralization in the 1980s and early 1990s, which saw a drastic expansion of off-budget revenue and spending as well as increasing inconsistencies (hence “gray areas”) in fiscal and financial regulation and supervision during the transition away from central planning (chapter 3).

Moreover, changes in the fiscal system also hold a key to understanding the shifting attitudes of local authorities toward public enterprises. Perhaps the most telling example, to be discussed in chapter 3 and further shown in chapter 7, was a reform in the mid-1990s to replace the fiscal contract system adopted in the preceding decade with a revenue-partitioning system. It significantly increased direct control by the central government of revenues from the industrial sector, which had been dominated by public enterprises. At the same time, local governments were forced to rely more on revenues from other sectors, especially the tertiary sector, which had long been given low priority under central planning and therefore posed relatively lower entry barriers to private enterprises during the early years of reform. In view of this fiscal restructuring, many local authorities began to refocus their economic policies from the industrial sector to other economic activities that could boost revenue. What followed was a rising and spreading wave of efforts throughout the country to promote urbanization and real estate development as the main stimulus for the expansion of local services (and hence government revenue and job creation). Weak initial presence, intense competition, and consideration of monitoring costs combined to limit the role of public enterprises in this undertaking, leaving open opportunities for private enterprises to proliferate. Given the growing importance of the private sector for local revenues of both the formal (budgetary) and the informal (off-budget) kinds, and in view of the deteriorating financial health of many public enterprises, the resolve of local authorities to hold on to these enterprises rapidly diminished. Consequently, the tempo of privatization greatly accelerated.

  • [1] Following the usage in economic analysis (Arrow 1963), I employ the term “moral hazard” to describethe tendency to be less risk-averse when one is shielded from the consequences of risk-taking. In thecontext of this study it refers to the tendency of state officials to risk without accountability the financial and organizational health of public enterprises for the pursuit of political and economic (includingprivate) benefits for themselves.
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