What's behind the Chinese boom?

Bret Swanson
Gilder Technology Report
March 26, 2004
Print ArticleThe 25-year Chinese boom is no longer a secret. But the reasons for that boom are still poorly understood. Most observers point to a general "opening up," meaning free trade, low-cost labor, and the emergence of a non-state business sector. These factors are correct as far as they go, but their vagueness shows that Western economists and business leaders still do not understand quite how China is doing it. Most of the world population has endured "low wages" for most of history, yet low wages do not a boom economy make. Likewise, free trade is the foundation of any strong economy, but as Nobel prize winner Robert Lucas has shown, free trade explains only a very small percentage of the 50-year cascade of Asian miracle economies, from Japan to Korea to China .

The buzz on Wall Street several weeks ago was a note on globalization from Morgan Stanley's Stephen Roach, which identifies another key factor in China 's success: education. Roach was updating his formulation, first offered last fall, of "global labor arbitrage." Among Roach's other big themes--notably, that this labor arbitrage is so pronounced that a major political backlash in high-wage nations like the U.S. is now likely--he highlights the " narrowing of the educational attainment gap between the developed and developing worlds ." Using what I think are very conservative numbers, Roach believes Greater Asia, which has 10 times the U.S. population, now produces some 10 times more engineers and scientists than the U.S. By my count, however, China alone now produces annually some three times the engineers and scientists per capita as the U.S. Nevertheless, whichever numbers you believe, Asia 's focus on technology and high-volume manufacturing, where learning curves are steep and productivity growth is rapid, is central to the boom.

All of this still ignores the bedrock of the China story, however. Many educated societies, from the Soviet Union to the India of ten years ago, have produced economic depression. Moreover, without capital and risk-taking there can be no technological or manufacturing miracles. At its core, China is the greatest and most explicit demonstration of supply-side economics in history.

It is well known that China closed for business some 500 years ago. After a long history as a leader in technology and discovery, new rulers inexplicably burned their world-beating 3,500-ship navy and turned inward. Some 450 years later things were little better, as industry and intellect were still being crushed under Mao Zedong, and living standards actually retreated to levels not seen since the year 1280.

With Mao's death in 1976 came Deng Xiaoping, who finally took the reins in 1978. About this time, political dynamics were also undergoing a major shift in the U.S. and U.K. Ronald Reagan and Margaret Thatcher were ascendant, Britain was on the cusp of deregulation, California was cutting property taxes with Proposition 13, and Washington took the first supply-side step with a cut in capital gains rates, championed by Rep. Bill Steiger. A few years later, the U.S. and U.K. would take even bigger steps, cutting marginal income tax rates across the board, launching a 20-year boom.

By far the largest tax cut of the era, however--indeed probably the largest tax cut in world history--happened in China, when in 1979 Deng freed hundreds of millions of peasants to keep all of their agricultural output beyond a small quota. Deng had eliminated marginal taxes on 16 percent of the world population. Almost immediately the perpetual "famines" of Mao's time were over, and farm output and farm income soared 18 percent per year through the early 1980s. Today, more than 99 percent of all agricultural output comes from private farms, and China produces more cotton, more wheat, and more total grains than the U.S.

China has now moved far beyond farming. So what explains its uninterrupted, seemingly unstoppable growth?

Some on the political left blame China 's "slave labor" or alternatively praise it as an example of an enlightened "socialist market economy." Many conservatives, accepting this characterization, are perplexed that "communists" running a "socialist market economy" like China's--ranked 129 th in the Heritage Foundation- Wall Street Journal Index of Economic Freedom, earning it the label "mostly unfree"--could produce such robust and sustained growth. Citing all reliable economic histories, where freedom and prosperity are indeed highly correlated, many in this group conclude China must therefore be a bubble. The Communist Party must be juicing the economy with Keynesian spending and bad loans, or "stealing" growth from the First World by manipulating its currency, the yuan. But neither can go on forever. The party must end.

A deeper examination of the Chinese economy, though, will surprise conservatives and teach them much about the very nature of capitalism. The simple fact is that after Deng's initial agricultural emancipation, the nation never really stopped cutting tax rates and freeing enterprises to experiment.

Looking across the narrow straight on the south coast of China , Deng could see low-tax Hong Kong , but unlike the Communists who saw enemy decadence, he saw an example of what China could be. In 1980, in a swamp within sight of the British protectorate, Deng, with help from an unknown middle-aged bureaucrat named Jiang Zemin, established the first of four Special Economic Zones in Shenzhen. The SEZs were low-tax, low-regulation havens, and within just a few years became the most thriving places on the mainland.

Taking seriously Deng's admonition to "let things go," the zones were highly autonomous and often almost anarchical. They charged no tax on foreign investors for the first two years of profitability, a rate of just 7.5 percent for the next few years, and only after 5 or 7 years of profitability did the rate rise to the SEZ standard of 15 percent, at the time the lowest in the world save Switzerland, and today only rivaled by the Swiss and Irish. The zones could also trade with the outside world, and even the few official trade barriers that remained were often ignored.

The four special zones were such a success, the rest of the nation begged Beijing for more. Deng obliged, and by 1993, some 8,000 zones of all types--foreign export zones, high-tech development zones, open coastal cities--had emerged, all with various but substantial tax, tariff, and regulatory incentives, most with autonomous and entrepreneurial leadership. Most of the Chinese economy had moved to the zones. Many of its people had, too, as 200 million peasants relocated from the countryside to the coast, despite official migration laws. Foreign investment poured into the country. But what surprised Beijing even more was that domestic capital flooded the zones as well.

By the early nineties, Deng's zone strategy had transformed Shenzhen from a backwater into China 's richest city in terms of per capita income. Shenzhen's per capita performance was made all the more impressive given its population surge, which saw the number of Shenzhen inhabitants grow 114-fold between 1981 and 1996. Some 98 percent of its residents are from outside the city, and the average age is 29. Between 1980 and 1993, Shenzhen's economic output grew at a compound annual rate of 40 percent, and by 1993, Shenzhen had overtaken Shanghai as the nation's number one exporter. Shenzhen by 2000 had also lured investments from 27,000 foreign companies, many of whom based their Chinese operations and employees there. This mass migration, surely the largest in history, tends to confirm Adam Smith's thesis that the surest sign of economic vitality is rapid population growth. Although China's one-child policy works to keep population growth moderate for the nation as a whole, the coastal zones and cities, which comprise a truly unique entity that might be termed New China, are the fastest growing spots on earth in terms of both economic output and people. In the 1990s it would be the Pudongs and Suzhous (near Shanghai) and numerous newer zones that experienced Shenzhen-like hypergrowth, and by 2003, the mayor of Shenzhen, citing competition from within and without China, was lobbying Beijing for the authority to conduct further "experiments" in the nation's key economic "laboratory."

The Heritage Foundation- Wall Street Journal Index of Economic Freedom can say China is "unfree," less free in fact than Rwanda, Azerbaijan, Cameroon, and other economic wastelands, because many of its criteria are official tax rates and regulations, not on-the-ground realities. China 's official corporate tax rate of 33 percent (still lower than the U.S. ) and stacks of regulations, for example, apply to very little of the economy. Beijing has created an alternative but legitimate system in which most of the economy now flourishes.

The zone strategy was as brilliant politically as it was economically. Unlike the disastrous "shock therapy" in the new Russia , Deng and Jiang had pacified the Beijing hardliners and People's Liberation Army brass. By allowing experimentation in out-of-the-way rice paddies, far away from Beijing and Shanghai , the true Communists thought they were still in charge. As "zone fever" swept the nation, however, it was not Deng and Jiang imposing capitalism on a suspicious population, it was an eager Chinese citizenry, locked up for 500 years, now bursting with entrepreneurial energy and demanding more capitalism. The decentralized approach shifted most major decisions out of Beijing , where gridlock would have killed real reform as entrenched interests saw their power slipping away. As economic power devolved, so did political power, albeit not in the Western sense of democracy.

The zone strategy, however, was not the end of China 's tax-cutting ways. In all there were at least five major eliminations of marginal taxes--the Township & Village Enterprises being both the most important and least understood. Along with stable money--embodied in China 's explicitly "strong and stable" monetary policy, with the yuan-dollar link inaugurated by Zhu Rongji in 1994--tax policy, as much as low wages or education, has fueled China 's rise.

But now that we are two generations removed from Deng's revolution, will the supply-side policies continue? Beijing appears to be holding steady on the yuan, despite Western calls to float the currency. On taxes, major reforms are in the offing. In keeping with WTO wishes and a desire to be "more fair" to poorer and less internationally connected inland and western provinces, China is said to contemplate a harmonization of its corporate income tax rates for foreign and domestic firms. Several sources suggest the 15% (foreign) and 33% (domestic) rates could be harmonized at 20%, which would still be low by international standards. Individual income taxes are also set for an overhaul--with some rumoring a low, flat tax could replace the highly graduated current system that so far has not been an impediment to growth but is now starting to hit the growing middle class.

Too much harmonization, however, could threaten a key source of China 's success: its decentralized competition and experimentation among the thousands of zones and sometimes autonomous towns and provinces. The European Union is fighting these battles right now, as uncompetitive, high-cost nations seek to impose continent wide taxes and regulations on upstarts like Ireland and multiple innovators in Eastern Europe .

Unrestrained by the class struggles inherent in democracy, Beijing so far has, in Deng's famous words, "allowed some to get rich before others," and in so doing massively improved the lives of the vast majority of Chinese citizens. There is reason to believe Beijing will continue its low-tax ways. (It is eliminating, for instance, some taxes and fees that have crept back into the agricultural sector.) But centralized power, undisciplined by competition, tends to erode economic freedom over time.

If Beijing can resist such temptations, America's former communist enemies--Russia and China--could within the next few years be enjoying flat taxes, even as U.S. companies and American workers remain trapped in a Third World tax code.
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Bret Swanson is executive editor of the Gilder Technology Report and a senior fellow at the Discovery Institute. He is writing, with George Gilder, the forthcoming book, The Crossroads of Capitalism: The Ascent of Asia and the New Global Race for Economic and High-tech Hegemony.