 I'm Salvatore Bobonis, and today's lecture is The Future of Growth in China – Fiscal Solutions for Structural Constraints. I'm going to start today's lecture by locating China's rapid economic growth of the last 40 years in a long-term, comparative and historical perspective. This chart shows the economic trajectories of four major regions of the world over the last 200 years. It charts gross domestic product per capita, GDP per capita, expressed on a log scale, since 1820 up until the current day. I'm going to focus first on the western European line, this dark blue line at the top. Western Europe has been growing pretty smoothly ever since the beginning of the Industrial Revolution. There is a major disruption for World War I, the Great Depression, and World War II, but if you connect the pre-1910 line with the post-1950 line, you would find a almost perfectly linear trajectory of growth for Western Europe. A linear trajectory in a log scale is equivalent to a fixed percentage increase on a natural scale, and really what this depicts is that Western Europe has grown on average slightly less than 2% per year every year for the last 150 or 200 years. Contrast that with the Eastern Europe growth trajectory. Eastern Europe was much poorer than Western Europe in the beginning of the Industrial Revolution. It had about one-third of the income level that prevailed in Western Europe. It industrialized as Western Europe industrialized. It too had problems during World War II, and it suffered another major disruption in the 1990s with the collapse of communism, but 200 years later Eastern Europe remains in the same relative position to Western Europe, about one-third of the income level of Western Europe, and that ratio has been pretty much a fixed ratio for the last 200 years. Eastern Europe is a high income area of the world that is at the technological frontier, growing at the same rate as overall technological growth, a little under 2% per year. Eastern Europe is a much more backwards area of the world that is nonetheless growing at the same rate of just less than 2% per year as technology increases. In effect, the poor people of Western Europe live in Eastern Europe, and the fixed ratio of incomes reflects that fact. Now look at Japan. Japan was similarly poor to Eastern Europe before the Industrial Revolution. During the Industrial Revolution, Eastern Europe started to pull away from Japan, and then in the 1870s with the Meiji Restoration, Japan implemented major reforms and converged up to the Eastern European level of income. By the 1930s, Japan had roughly the same income levels as Poland, Czechoslovakia, and Hungary. Then came World War II, which was massively disruptive for Japan. There was an artificial stimulus to the economy of war production, the massive decline at the end of the war. But then look what happened. Under American occupation, Japan jolted from the Eastern European growth trajectory up to the Western European growth trajectory. In a period of 20 or 30 years, Japan went from being a middle income country to being a high income country, and it has stayed there ever since. Japan's recent economic malaise can really be interpreted simply as Japan stabilizing at Western European or rich country levels of income. Now look at China. China, Japan and Eastern Europe were all pretty much in the same place before the beginning of the Industrial Revolution. But unlike Japan and also unlike in many ways Eastern Europe, China experienced a long series of disruptions. China was defeated in the Opium Wars. It was colonized by Western European powers. China had 20 years of civil war in the Taiping Rebellion in the 1860s and 1870s. Then there was the coming of the Chinese Revolution, the coming of the Republic of China in the 1910s, overthrowing the Emperor. Civil war throughout the 1920s and 1930s, exacerbated by Japanese invasion and occupation. Then the coming of communism, the Great Leap Forward and the Cultural Revolution. China experienced nothing but a long string of calamities from the beginning of the Opium Wars to the liberalization that began in 1978. So 150 years of economic growth was lost in China. Since 1978, China of course has grown very rapidly. But it is still converging toward middle income status. It is converging with Eastern Europe, not converging with Western Europe. The big question of Chinese growth is, does it end there? Or does it continue on a Japan-like trajectory up to high income status? I've been writing for the last six years that China is likely to converge to middle income status. In fact, China's economic growth rate for 2016 is likely to be in the low single digits. Even the government only has aspirations for 7% growth. We'll see where it ends, but I've been writing for the last several years that China's dramatic period of economic growth will be long over by 2020. In fact, China still has not caught up with the classic middle income countries of Latin America. Countries like Brazil and Mexico, which have been stagnant for generations. Brazil and Mexico, like Eastern Europe, have hobbled along at about one-third the income levels that prevail in Western Europe and North America. Here you can see the last 50 years or so of economic history in Latin America contrasted with China. China still has not caught up with Brazil and Mexico. On current trends, it's likely to converge to Brazilian and Mexican levels around the year 2020. By then, China will have a GDP per capita in excess of $10,000 per year and will be on a par with Mexico and Brazil. Some Chinese provinces have already reached that point. Jiangsu and Zhejiang in the east, Guangdong in the southeast, Fujian in between them facing Taiwan. These provinces are already at global middle income status. Guangdong resembles nothing so much as Brazil. They're similar in size and population size, similar in economic structure, similar on a range of economic statistics. The problem for China is that even though these eastern coastal provinces have already caught up with Latin America, they are the slowest growing provinces in China. The two richest provincial level units in China are Shanghai and Beijing. They are the two slowest growing provincial level units in China. The other slow growth areas are precisely the provinces around Shanghai, Jiangsu and Zhejiang, and Guangdong province inland from Hong Kong. As Chinese growth slows, we're seeing the formation of massive slums in China. Now, it's hard to get a photo of a slum in China. This is a photo of a slum in Brazil. But the Chinese government itself estimates that there are around 100 million shantytown residents in China. And if you add to those shantytown residents, the people who live in informal settlements inside buildings in places like Beijing. This is a photo of Beijing's famous basement dwellers. You see patterns of urban slums that exist on the edges of Latin American cities being replicated in China, whether on the edge of the city or sometimes underground underneath the center of the city itself. China is converging with Brazil and Mexico in all sorts of demographic statistics, not just urbanization, but also the age structure of the population. So the percentage of population that's working age in China reached its peak around 2012 to 2015, is now in decline, and by 2020 will be roughly at the same level as Brazil. And it's not just the age structure of the population, its urbanization, its inequality, levels of education, all of these are still approaching levels found in Brazil and Mexico, and will soon be there. In the year 2020, China statistically will resemble nothing more than a very, very large Brazil. And China will, quote unquote, get old before it gets rich. But no country ever got rich by having fewer babies. The one-child policy was great in its own way, I mean a human rights catastrophe, but great in its own way for raising people out of poverty. But a one-child policy is not going to make China a rich country. In fact, very few countries have ever gotten rich at all, we can count them almost on one hand. I mean the early developing countries, the countries of Western Europe and North America, were never poor. They were from the beginning, at least from the beginning of the modern age, at the economic forefront of the world. For 500 years they have been among the richest areas of the world. Certainly they never existed in a world in which much richer places lorded over their existence. There are two countries in Europe that have some people say have moved from middle income status up to rich country status, Ireland and Spain, but they had geographical advantages that can hardly be replicated. Ireland is an economic structure, a suburb of London, one of the richest places on earth, and on top of that Ireland benefited from massive European Union structural adjustment funds. The European infrastructure building in Spain was even greater. Both of these countries at some points in their recent history had European structural adjustment funds accounting for 3-4% of GDP. That kind of subsidy is not available to other middle income countries. There are the Asian Tigers, but Hong Kong and Singapore are really cities. Hong Kong is certainly not a country in any sense of the word. Singapore is a city that if it were still part of Malaysia, remember Lee Kuan Yew did not want Singapore to be separated from Malaysia, if Singapore were still part of Malaysia it would merely be the richest city of Malaysia in the same way that Moscow is the richest city of Russia. If Moscow were a country, it would be among the world's rich countries, but no one is talking about the Russian bear model of development, because everybody knows that the Russian bear model depends on having lots of poor people outside Moscow to subsidize its existence. In the same way, Hong Kong has poor people working in factories and assembly lines, but Hong Kong's poor people live in Guangdong Province and are not included in Hong Kong's GDP per capita. Singapore's poor people live in Malaysia and Indonesia. There are something like 2 million Singaporean factory workers living in Bintom in Indonesia. They are not Singaporean citizens, but they are an integral part of the Singaporean economy. South Korea and Taiwan are also distinctive cases. You can see this with nighttime lights in South Korea. South Korea is essentially a city-state, the Seoul metropolitan region, which comprises something like 40 to 60%, depending on how you count, of South Korea's entire population, certainly something like two-thirds of South Korea's total GDP. And then a hinterland that was completely excluded from Korea as a result of the Korean War, this dark area that is North Korea. So would Korea be a developed country if it also had to support those 20 million people, 20 million poor peasants in North Korea? And for that matter, is Korea really a rich country or is it a rich city, Seoul, that subsidizes its countryside because its countryside is not too extensive? Taiwan is an even more distinctive case. Leave aside the issue of sovereignty, Taiwan became a rich country, you might say, on the Israel model. No one talks about Israel as being an example of amazing economic growth because everybody knows that Israel became rich as a result of rich, well not rich, skilled, talented, educated, desperately poor Jewish refugees from Europe and from the rest of the world who were then able to build a rich society in Israel. If the Jews had not returned to Israel, if there had been no Zionism, no one would think that the Palestinian territories as an independent country would be among the world's richest and most advanced societies. What made Israel rich was the massive refugee influx, and in the same way what made Taiwan rich is the massive refugee influx from China. Something like two million skilled and well-connected people from the mainland resettled in Taiwan and amazingly, right after that fact, Taiwan began to grow rapidly. I don't think anybody sitting in a statistical office in 1935 would have identified Taiwan as the future province of China that was bound to be one of the richest, most advanced places in the world. Taiwan is rich and advanced for the same reason that Israel is rich and advanced. Millions of skilled people move there from other places. Incidentally, this exodus of skilled people from China is also partly responsible for the wealth of Hong Kong and Singapore because many of those refugees also ended up in Hong Kong and Singapore. Well, if it's not a reasonable strategy to beg a rich area of Western Europe to subsidize your growth, it's not a reasonable strategy to exile all of your poor people to be part of a different country. It's not a reasonable approach to invite all the rich and skilled refugees of the world to come join your country. What is the way for a country to become rich? I mean, how does a country move from middle income to high income status? Arguably, only one country has ever done that, and that's Japan. Japan was a middle income country in 1940. It lost World War II, was occupied by the United States, and the Supreme Command Allied Pacific general, Douglas MacArthur, imposed a set of policies on Japan, mass unionization to raise ordinary workers' wages, land redistribution, which raised rural incomes by a factor of three in just four years, a tripling of rural incomes, a local government autonomy to break the inefficiency of central government control. Universal education, Japan became a highly educated country because its American occupiers insisted that everybody should get at least an eighth grade education, and then later, of course, high school education. Kanji reform to spread literacy in Japan, and not to be sneezed at, a 70% marginal income tax. The United States Occupation Authority gave the government of Japan the fiscal tools it needed to build not just all those schools and other government facilities, but to build Japan's bullet train system, to build port facilities, to build nuclear power plants. Japan's massive fiscal capacity of the 1960s and 70s was built on the high levels of marginal income tax imposed by the American occupation. Imposed despite the fact that MacArthur was a Republican. He may have been a Republican, but he was an American of his age. In the United States in 1945, the top income tax bracket was 92%. MacArthur might have thought he was giving the Japanese a break by letting them get away with just 70%. There's a great book on the transformation of Japan called Remaking Japan, the American Occupation is New Deal by Ted Cohen. Cohen was actually a member of the Occupation Administration who then stayed on in Japan, started a small business, married a Japanese woman, learned Japanese. He actually wrote this book in Japanese in the late 1970s. It was later translated into English in the early 1980s and republished in English in the United States. What Cohen details are the dramatic changes imposed on Japanese society? The United States didn't just go to Japan and change the government and get out. The United States completely remade the society of Japan and it remade it in the image of 1940s America. Having been remade as 1940s America, Japan rapidly grew towards contemporary American levels of income. Now this is all very consistent with endogenous growth theory and economics. Endogenous growth theory is a supply side theory that pretty much says, get the economy right and the economy will converge to the society. If a country has a high productivity society, the economy will ultimately converge up to the new level of society. When Zionist Jews brought a Jewish society to Palestine, the economy of that area developed to become consistent with the new society they had brought in. And in the same way when the United States remade Japan in its own image, it got rid of a neo-feudal society in which there were large landowners who had virtual peasants, uneducated masses of uneducated people working their land by hand. It got rid of a factory system in which illiterate workers had extremely low productivity and were managed essentially as slaves by their corporate owners. When the US wiped that society clean and instead imposed on Japan a society in which ordinary people were educated and empowered. And not just given the human capital, but also given the physical capital to make them productive, the roads, the railroads, the port facilities. When the Japanese government democratized its society, its economy caught up. The problem for endogenous growth theory is that human and physical infrastructure is very expensive to build. It's one thing to say if you want growth to get a better society. It's another thing to convince a government and to convince, let's face it, the rich people in a society who are going to have to pay for all this development. It's another, a whole other thing entirely to convince them to do it. And that's the problem. What we call the middle income trap is really just the fiscal crisis of the state. Most middle income countries struggle to pay for adequate infrastructure. They get trapped at middle income levels because they're not willing to build the schools. They're not willing to educate the people. They're not willing to pave the roads and build the railroads. They get stuck in the middle income trap because of the fiscal crisis of the state. Their elite citizens are not willing to pay taxes that are necessary to grow the economy. Well, China is about to have a fiscal crisis. This graph shows revenue and expenditure in China. As you can see, they're pretty commensurate over the last 15 years. Expenditures have been slightly ahead of revenues, but you notice that each new year's revenue is always higher than the last year's expenditure. So even after 2008, when China started a big deficit spending program to build infrastructure to prevent collapse during the global financial crisis, still China's 2009 revenue was way ahead of its 2008 expenditure. 2010 revenue way ahead of 2009 expenditure. So China has been maintaining a rough fiscal balance as it's grown. And you see how revenue expenditure have dramatically grown together over the years. Well, the problem is that this pattern is breaking down. In 2015, government spending jumped, but government revenue did not. The China State Council admitted as much at the end of the year, in a press release between Christmas and New Year's 2015, they said China will increase its budget deficit in 2016, gradually raise a fiscal deficit ratio, increase government debt issuance, and set a limit for newly increased local government debt. In other words, China is going to spend, spend, spend, and to finance it, it's going to borrow, borrow, borrow. The problem is that this is not a one-off crisis. This isn't like the global financial crisis in 2008, when the United States went into 12% of GDP deficit spending for one or two years just to get over the crisis. This is a structural shift in government finance. The fundamental problem is that China relies on taxes that grow with GDP. All that massive increase in government revenues over the last 15 years occurred because there was a massive increase in GDP over the last 15 years. The problem is that as China reaches middle income status, it's starting to incur expenses that grow faster than GNP. So it's one thing to have GDP increase by 6% or 7% a year. That would be very nice, but if taxes, if taxes increase by 6% or 7% a year, that doesn't help if expenses are going up by 25% per year as they jumped in 2015. Up until 2015, both government revenue and government expenses were growing at the same rate as GDP, 10%, 12% per year. Now government expenses are rising at 20% per year as government revenue only increases by 5% or 10%. That's the problem. More than 80% of China's government revenue comes from sources that rise at the same rate as GDP. The value added tax is literally a tax on value added. That is the main source of income. Well, value added tax grows as GDP grows. GDP is simply the sum total of value added in a country, plus or minus the trade balance and a few other things. If value added goes up in a year by 10%, well, GDP roughly goes up by 10%. Or put differently, if GDP only rises 7%, value added tax will only rise 7%. The one tax that would rise faster than GDP growth is the individual income tax. The reason is that as GDP grows, people get richer, incomes tend to rise faster than GDP, and as people's incomes increase, they creep into higher and higher tax brackets. So in general, if the GDP overall grows at 7%, individual income tax revenues might grow by two or three times as much as the overall economy. Unfortunately for China, individual income taxes are a very small and poorly enforced proportion of its government revenue. Contrast that with China's spending commitments. Nearly 70% of China's government spending is in categories that must rise faster than GDP growth if China is ever going to become a rich country, if it's ever going to build the high productivity society it needs. It needs rapid increases in education spending. It also needs massive increases in social spending as its population ages and people retire. Its environment is in catastrophic shape. China, of course, is building enormous amounts of transportation infrastructure. All of these budget items should be growing faster than GDP growth. The other area, the only place where China can really sacrifice in order to make these happen is defense spending and defense spending itself is now growing at double digit rates. So if all of these required social spending areas are growing at double digits and defense spending is growing at double digits, there's no chance for China to keep its overall government budget growth down in the 7% range that it projects for GDP growth. Well, as GDP growth declines, the government says 7.5% for 2016. I suspect the real number is closer to 0% for the private taxable economy. As China's growth declines, it's going to become more and more difficult for China to fund the needed investments in public infrastructure, both human infrastructure and physical infrastructure that it needs to become a rich country. And when you add to this, not just the immediate fiscal situation, the lack of revenue, add to it the falling producer prices, falling exports, declining foreign investment, exchange rate volatility, elite emigration, elite Chinese are getting foreign passports like crazy. Capital flight, which has peaked at $100 billion a month in December and January and is still running in tens of billions of dollars a month, when you put it all together, it's difficult to see how China can fund its future growth without raising taxes. Here you see taxes and spending as a percent of GDP in China. In the old communist era, whatever it means, it was around 30%, with liberalization, the size of the government declined dramatically. It hit a minimum in the 1990s. In the 1990s, China was having problems paying its bills. China dramatically improved tax collection and enforcement of taxation in the 1990s, and China's revenue growth since the 1990s has been smooth, and China's central government and local government revenues have captured an increasing proportion of GDP. Expenditures have also risen in line with or a little faster than its revenue growth. The problem is that China is still collecting only about 23% of national income in taxes. Most developed countries are in the range of 40 or 50% of national income being collected in taxes. Now, many economists like to say that this is a problem in rich countries, and the reason their growth is so slow is they collect so much in taxes. Well, I'll tell you, economic theory and empirical studies are pretty firm on this, that the sorts of things that taxes pay for, both on the human side, education and health care, but also on the physical side, infrastructure, these kind of things are what's necessary to support a developed economy. Even the United States, the low-tax country of the developed world, even the United States collects something like 34 or 35% of GDP in government revenues, and the United States doesn't offer universal health care. If you added private health care expenses to the U.S. government tax take, if you considered private health care as part of what government does, even the United States would be over 40% of national income going into taxes. Well, how can China get there? The problem is, this is a political challenge that no other middle income country has solved. No national elite has ever decided of its own volition to increase taxes on itself in order to pay for the development of the country as a whole. In fact, the only country that has ever changed its tax structure is from a middle-income country tax structure to a high-income country type of tax structure. The only country that's ever done that is Japan. And Japan did it under American occupation. But interestingly, we might say that Japan's pro-development policies, Japan's policies that made it, that gave it a developed country society that ultimately made it a developed country, those policies were put in place by an unelected technocratic elite. In Japan's case, that unelected elite was an American occupation authority led by Douglas MacArthur. But China also has an unelected technocratic elite. Perhaps the Communist Party of China will see its way by imposing policies on its own country that will lead to a developed society and ultimately to a developed economy in China. The 13th five-year plan put forward by the Communist Party is exactly the right plan. If China implemented the 13th five-year plan over the next five years, it would go a long way toward breaking China out of the middle-income trap. The question is, will China's elite be willing to pay for all of the fantastic policies contained in that plan? For that, we'll have to see. Thank you for listening. I'm Salvatore Bobonis. You can find out more about me at SalvatoreBobonis.com and I'll also sign up for my monthly newsletter on global affairs.