Industrial Policy in China: Quantification and Impact on Misallocation

This paper quantifies the size of the main industrial policy instruments in China and estimates their impact on domestic factor misallocation and aggregate productivity. The quantification of industrial policy instruments leverages data from financial reports of listed firms and the land registry. The equivalent fiscal cost of industrial policy through cash subsidies, tax benefits, subsidized credit, and subsidized land for favored sectors (including both private and state-owned firms) is estimated at about 4 percent of GDP per year, with a growing share of tax benefits over time. Next, the paper uses a structural model to estimate the relationship between industrial policies and factor misallocation for a broad sample of firms. Various industrial policy instruments are found to affect factor allocations in different ways—subsidies tend to lead to excess production, while trade and regulatory barriers limit production. Overall, factor misallocation from industrial policies is estimated to reduce domestic aggregate TFP by about 1.2 percent. The results resonate with IMF policy recommendations for China to scale back industrial policy and increase its transparency.