Commitment Problem, Economic Inequality and Institutional Reform in Authoritarian Regimes: A Case Study of China

Abstract

Under authoritarian rule, investors' fear that their assets will be arbitrarily confiscated by the government weakens their incentives to make an investment, unless the commitment that the authoritarian government will favor capital owners is credible. In the case of China, the reform comprising decentralized economic competition and career mobility within bureaucracy to some degree substitutes the commitment. The prospect of promotion based on the performance in economic competition induces local government officials to shelter the investors. This policy bias in a long run, however, gives rise to a new commitment problem as it triggers the economic inequality between factor owners. As inequality grows, for placating the suffering factor owners who may organize massive collective actions to overturn the regime, the government has an incentive to redistribute revenues between factor owners. Recognizing this risk, investors hold up investment, particularly in projects with significant exit costs that may result in being captured by the government. The novel mechanism proposed by the Chinese Communist Party to solve this commitment problem in order to stimulate the economy is to co-opt entrepreneurs, ensuring their stake in regime's long-term survival and development. This logic explains the dynamics of political and economic institutional reform and the development of the private sector in China.