Hongbin Cai

State Corroding Federalism

Competition among local governments in a decentralized political system is often thought to discipline lazy or corrupt officials, improving public good provision and increasing welfare. Some scholars note possible distortions due to spillovers or a ‘race-to-the-bottom’, but suggest that central transfers or regulations can remedy these. Both arguments take for granted a framework of constitutional order in which the central government can collect taxes, allocate transfers, and enforce regulations autonomously. But what if it can’t? We show that if central enforcement capacity is endogenous, interjurisdictional competition may itself erode the center’s ability to channel competition in welfare-enhancing directions. Regional governments may compete for capital by shielding firms from central tax collectors, bankruptcy courts, or regulators. The equilibrium result is weaker central law enforcement and usually lower welfare: interjurisdictional competition corrodes the state. We illustrate with three examples—from Russia, China, and the US—of cases in which such competition apparently encouraged subnational politicians to help firms evade central taxes or regulations.

Does Competition for Capital Discipline Governments? Decentralization, Globalization, and Public Policy

Competition among countries—or regions within them—to attract mobile capital is often thought to discipline their governments, motivating them to invest more in infrastructure, reduce waste and corruption, and spend less on non-productive public goods. The result should be convergence on business-friendly policies. We argue that this requires an assumption—units start out very similar—that is often unrealistic. If units are heterogeneous (in natural resources, geographical location, inherited human capital or infrastructure), capital mobility often weakens discipline on the poorlyendowed units. This may help explain disappointing results of liberalizing capital flows within Russia and sub-Saharan Africa. (JEL F36, H73, H87)

Did Government Decentralization Cause China's Economic Miracle?

Many scholars attribute Chinas market reforms and the remarkable economic performance they have fostered in part to the countrys political and fiscal decentralization. Political decentralization is said to have stimulated local policy experiments and restrained predatory central interventions. Fiscal decentralization is thought to have motivated local officials to promote development and harden enterprises budget constraints. The locally diversified structure of the prereform economy is said to have facilitated liberalization. Reexamining these arguments, the authors find that none establishes a convincing link between political or fiscal decentralization and Chinas successes. They suggest an alternative view of the reform process in which growth-enhancing policies emerged from competition between promarket and conservative factions in Beijing.

Capital budgeting and compensation with asymmetric information and moral hazard

We consider optimal capital allocation and managerial compensation mechanisms for decentralized firms when division managers have an incentive to misrepresent project quality and to minimize privately costly but value-enhancing effort. We show that in the optimal mechanism firms always under invest in capital relative to a naive application of the net present value (NPV) rule. We make a number of novel cross-sectional predictions about the severity of the under investment problem and the composition of managerial compensation contracts. We also find that firms will optimally give greater performance-based pay (at the expense of fixed wages) to managers of higher quality projects to mitigate the incentive for managers to overstate project quality. Thus, managers may receive greater performance-based pay because they manage higher-quality projects, not that greater performance-based pay causes firm value to increase.

Eat, Drink, Firms, Government: An Investigation of Corruption from the Entertainment and Travel Costs of Chinese Firms

We propose entertainment and travel costs (ETC) expenditures as a measure of corruption in Chinese firms. These expenses are publicly reported in firms’ accounting books, and on average they amount to about 3 percent of a firm’s total value added. We find that ETC is a mix that includes grease money to obtain better government services, protection money to lower tax rates, managerial excesses, and normal business expenditures to build relational capital with suppliers and clients. Entertainment and travel costs overall have a significantly negative effect on firm productivity, but we also find that some components of ETC have substantial positive returns to firms.

Delay in Multilateral Bargaining under Complete Information

Abstract This paper analyzes a complete-information, infinite-horizon, multilateral bargaining model in which one player bargains with each of the other players one at a time and binding cash-offer contracts are used to govern transactions. Under a weak stationarity condition on equilibrium strategies, we characterize the set of equilibria for the game. We show that when players are sufficiently patient, significant delay in reaching agreements may emerge and this delay can become longer quickly as the number of involved parties rises. Indeed, when the number of bargainers is large, perpetual disagreement can occur in equilibrium. Journal of Economic Literature Classification Numbers: C78, D23, D62.

Microinsurance, Trust and Economic Development: Evidence from a Randomized Natural Field Experiment

We report results from a large randomized natural field experiment conducted in southwestern China in the context of insurance for sows. Our study sheds light on two important questions about microinsurance. First, how does access to formal insurance affect farmers production decisions? Second, what explains the low takeup rate of formal insurance, despite substantial premium subsidy from the government? We find that providing access to formal insurance significantly increases farmers tendency to raise sows. We argue that this finding also suggests that farmers are not previously insured efficiently through informal mechanisms. We also provide several pieces of evidence suggesting that trust, or lack thereof, for government-sponsored insurance products is a significant barrier for farmers willingness to participate in the insurance program.

China's Land Market Auctions: Evidence of Corruption?

This paper studies the urban land market in China in 2003-2007. In China, all urban land is owned by the state. Leasehold use rights for land for (re)development are sold by city governments and are a key source of city revenue. Leasehold sales are viewed as a major venue for corruption, prompting a number of reforms over the years. Reforms now require all leasehold rights be sold at public auction. There are two main types of auction: regular English auction and an unusual type which we call a two stage auction. The latter type of auction seems more subject to corruption, and to side deals between potential bidders and the auctioneer. Absent corruption, theory suggests that two stage auctions would most likely maximize sales revenue for properties which are likely to have relatively few bidders, or are cold, which would suggest negative selection on property unobservables into such auctions. However, if such auctions are more corruptible, that could involve positive selection as city officials divert hotter properties to a more corruptible auction form. The paper finds that, overall, sales prices are lower for two stage auctions, and there is strong evidence of positive selection. The price difference is explained primarily by the fact that two stage auctions typically have just one bidder, or no competition despite the vibrant land market in Chinese cities.

A Theory of Joint Asset Ownership

I offer a theory of joint ownership by extending the standard property right theory of the firm to situations where parties can endogenously choose the degree of specificity of their investments (i.e., both the type of investment--specific and general--and the level of each). When specific and general investments are complements, the standard GHM results are obtained and joint ownership is suboptimal. When specific and general investments are substitutes, joint ownership is optimal as long as trade takes place within the relationship. Joint ownership provides stronger incentives to make specific investments than any other forms of ownership by discouraging general investments. Copyright 2003 by the RAND Corporation.

Income and Consumption Inequality in Urban China: 1992–2003

Using the nationally representative Urban Household Income and Expenditure Survey (UHIES) conducted by the National Bureau of Statistics (NBS) of China, we document a steadily rising trend in income and consumption inequality during the period from 1992 to 2003 in urban China. Despite the rising urban inequality over time, the social welfare of urban residents unambiguously improved because every income group saw their income and consumption increase over this period (higher income groups experienced faster increases). Moreover, consumption inequality follows income inequality very closely. Labor income inequality accounts for about two‐thirds of total income inequality quite consistently over time. We find that only about one‐third of urban inequality can be attributed to observable individual choices and characteristics, of which education has increasing explanatory power, while regional differences become less important over time. We also find that restructuring of the SOE sector, urbanization, and globalization are important contributing factors to rising overall urban inequality and the within‐group inequality not accounted for by observable individual choices and characteristics.