metadata: authors: 0: author: Li, Feiyue
1: author: Lin, Justin Yifu
count: World
docna: 0: docna: Development strategy, viability, and
            economic distortions in developing countries
docty: Policy Research Working Paper
subtopic: Macro-Fiscal Policy,Economic Theory & Research,Taxation & Subsidies,Economic Adjustment and Lending,Industrial Economics,Public Sector Economics,State Owned Enterprise Reform,Public Sector Administrative & Civil
            Service Reform,Food Security,Economic Growth,Macroeconomic Management,Public Finance Decentralization and
            Poverty Reduction,Democratic Government,Economics and Finance of Public
            Institution Development,Public Sector Administrative and Civil
            Service Reform,De Facto Governments
teratopic: Private Sector Development,Public Sector Development,Macroeconomics and Economic Growth,Finance and Financial Sector Development
abstracts: cdata!: This paper presents a three-sector
            static model to explore the rationale for a series of
            institutional distortions in developing countries. The
            authors argue that, after World War II, motivated by a
            belief in the development of state-of-the-art industries as
            a means for nation building, the majority of developing
            country governments attempted to accelerate the growth of
            advanced capital-intensive industries. However, since
            developing countries are relatively rich in labor or natural
            resource endowments but not in capital endowment, advanced
            capital-intensive industries were not adapted to the
            endowment structures of these developing countries at the
            time. Enterprises in those industries were non-viable in
            open, competitive markets and could not survive without
            government subsidization or protection. The model shows
            that, in order to mobilize resources into the
            capital-intensive, advanced sectors, it is necessary for
            governments to use distortionary policies such as taxes and
            subsidies, distortions of factor prices, directive
            allocation of resources, and nationalization of enterprises.
            Such distortions enable developing countries to set up
            advanced, capital-intensive industries in the early stage of
            their development. However, they also tend to suppress
            incentives, misallocate resources, and make the economy inefficient.
repnme: repnme: Development strategy, viability, and
            economic distortions in developing countries
display_title: Development strategy, viability, and
            economic distortions in developing countries
listing_relative_url: /research/2009/04/10456736/development-strategy-viability-economic-distortions-developing-countries
topicv3: Agriculture and Food Security m1326205 435,Economic Growth m1326241 471,State Owned Enterprises m1326323 721,Taxation m1327615 1121,Current Account Deficit m1582987 4544
publishtoextweb_dt: 2010-07-01T00:00:00Z
historic_topic: Private Sector Development,Public Sector Development,Macroeconomics and Economic Growth,Finance and Financial Sector Development
no_of_pages: 26
model_extractions: WPS4906 Policy ReseaRch WoRking PaPeR 4906 Development Strategy, Viability, and Economic Distortions in Developing Countries _Justin Yifu Lin Feiyue Li_ The World Bank Development Economics Vice Presidency April 2009
Policy ReseaRch WoRking PaPeR 4906

# **Abstract**

This paper presents a three-sector static model to explore the rationale for a series of institutional distortions in developing countries. The authors argue that, after World War II, motivated by a belief in the development of stateof-the-art industries as a means for nation building, the majority of developing country governments attempted to accelerate the growth of advanced capital-intensive industries. However, since developing countries are relatively rich in labor or natural resource endowments but not in capital endowment, advanced capitalintensive industries were not adapted to the endowment structures of these developing countries at the time. Enterprises in those industries were non-viable in open, competitive markets and could not survive without government subsidization or protection. The model shows that, in order to mobilize resources into the capital-intensive, advanced sectors, it is necessary for governments to use distortionary policies such as taxes and subsidies, distortions of factor prices, directive allocation of resources, and nationalization of enterprises. Such distortions enable developing countries to set up advanced, capital-intensive industries in the early stage of their development. However, they also tend to suppress incentives, misallocate resources, and make the economy inefficient.

This paper—a product of the Development Economics Vice Presidency—is part of a larger effort in the World Bank to contribute to a better understanding of the economic and social development process. Policy Research Working Papers are also posted on the Web at http://econ.worldbank.org. The author may be contacted at research@worldbank.org.

_The Policy Research Working Paper Series disseminates the findings of work in progress to encourage the exchange of ideas about development issues. An objective of the series is to get the findings out quickly, even if the presentations are less than fully polished. The papers carry the names of the authors and should be cited accordingly. The findings, interpretations, and conclusions expressed in this paper are entirely those of the authors. They do not necessarily represent the views of the International Bank for Reconstruction and Development/World Bank and its affiliated organizations, or those of the Executive Directors of the World Bank or the governments they represent._ Produced by the Research Support Team
**Development Strategy, Viability, and Economic Distortions in Developing Countries**<sup></sup>

# **Justin Yifu Lin**

# **Feiyue Li**

**Key words:** viability, development strategy, endowment structure, institutions, taxation, regulation

**JEL classification** : D02, O17, O20, P41.

>  Justin Yifu Lin is with the Word Bank. Feiyue Li is with the China Center for Economic Research (CCER) at Peking University.

> The authors thank Deh-Ming Huo, Ho-Mou Wu, Qiang Gong, Pengfei Zhang, Xifang Sun, Chaoyang Xu, Binkai Chen, Gao Xu, Mouhua Liao, Hua Chai, Rong Hai, and other seminar participants at the CCER for useful remarks and advice.
# **1. Introduction**

Many distortions exist simultaneously in developing countries—such as preferential taxes and subsidies to certain industries, financial repression, over-valuation of domestic currencies, rationing of capital and foreign exchange, administration-created monopolies, and state ownership. These distortions often lead to poor economic performance, low living standards, and even frequent crises in developing countries. There is, however, no consensus about their origins.

Some economists have provided an “interest group” explanation (Grossman and Helpman, 1994; Sokoloff and Engerman, 2000; Acemoglu, 2007). This view emphasizes the economic or political benefits to particular interest groups from the distortions, and these groups have enough political influence to force the government to adopt distortional arrangements that are favorable to them. This view is insightful because powerful interest groups in developing countries are associated largely with capital-intensive, advanced sectors, which gain the most government protection. However, the view is inconsistent with the fact that at the time when the protections were first introduced, the most powerful interest group in many developing countries was the landed class. The protections hurt the landed class. Moreover, although the powerful industrial group gains from the protections, it loses from other distortions, for example, the widely observed state ownership in advanced industries in developing countries. Gordon and Li (2005a, 2005b) provide an alternative, “public finance” explanation that suggests that developing country governments’ regulation and distortions were designed to alleviate problems with tax collection. The authors argue that since there is a large un-taxable underground economy in developing countries, it is desirable for governments to mobilize resources to support the development of sectors that are easier to tax in order to increase government revenue. According to Gordon and Li, the observed protection of formal, advanced sectors is instituted for this purpose. They did not, however, explain why the government wanted to collect the taxes and how the tax revenue was used. In fact, in many developing countries, the taxes collected from the advanced, modern sectors often amount to less than the subsidies provided to them. In addition, Gordon and Li do not provide an explanation for the existence of other types of regulations and distortions in developing countries, such as distortions in factor markets and state ownership of large-scale modern enterprises.

Lin et al. (1995, 1996, 1999, 2003, 2009) propose an alternative explanation for the complicated regulations and distortions in developing countries. After World War II, a large number of colonial or semi-colonial countries won political independence. Compared with developed countries, these developing countries lagged far behind economically. It was high on every developing country government’s agenda to develop the economy as quickly as possible to achieve rapid economic take-off and eliminate poverty. At that time, national leaders and social elites in socialist and non-socialist developing countries shared a common belief in the development of 2
state-of-the-art technologies and industries as the best means of modernization. They aimed to catch up with and avoid exploitation by developed countries and to become economically and politically independent of developed countries. They therefore pursued the development of advanced heavy industries—the state-of-the-art industries at that time—and implemented development strategies that attempted to accelerate their development. However, advanced, capital-intensive industries were not consistent with the comparative advantages determined by their endowment structures—characterized either by labor abundance or resource abundance. Such a comparative advantage-defying (CAD) strategy<sup>1</sup> made enterprises in the government’s CAD industries non-viable in open, competitive markets.<sup>2</sup> Because of the CAD strategy, developing country governments were obliged to provide the non-viable firms with various subsidies and protection.

Theoretically, a developing country government could subsidize non-viable enterprises in the CAD industries by fiscal transfers with explicit taxes collected from other economic sectors. The required amount of taxation or subsidization would depend, however, on the size of the CAD industries: if they were small, subsidization through fiscal transfer would suffice.<sup>3</sup> In reality, the capital level in the endowment structure of a developing country will be too small, the size of the CAD industries is often too large, and fiscal transfers alone will not be enough to compensate for the likely losses of the non-viable enterprises in the CAD industries. Facing this constraint, a government will have to make other institutional arrangements to implement this strategy.

One often-observed measure undertaken in a developing country is the distortion of factor prices—such as suppression of interest rates and over-valuation of domestic currencies—in order to reduce the costs of investment and imports of technology and equipment for non-viable enterprises. Such distortions result, however, in excess demand for those factors whose prices are suppressed. As a result, the government needs to use planned, administrative measures to guarantee allocation of those factors to the non-viable enterprises in the CAD industries (Lin, 2003, 2009).

When factor prices are distorted, the non-CAD industries—such as light industry and agriculture—will yield higher returns to the factors than the CAD industries and it will be profitable to reallocate resources from the CAD industries to other industries. If enterprises are owned and run by private agents, such arbitrage is likely. To avoid

> 1 Similar to the definition in Rodrick (2005), the development strategy here refers to economic policies and institutional arrangements aimed at achieving the government’s development goals.

> 2 As defined by Lin (2003), a normally managed firm is viable if it earns a socially acceptable expected profit without external subsidization or protection in a competitive market. According to Lin, the viability of a firm is determined by whether its choice of technology/product/industry is consistent with the specific characteristics of the economy’s endowment structure.

> 3 Agricultural subsidies in developed countries are an example of this case.

3
this, developing country governments often nationalize the enterprises in the CAD industries in order to strengthen their control over the use of resources.

The major hypothesis in this paper is that there is a positive relationship between the degree of economic distortions and the degree of deviation of the CAD strategy from the optimal industrial structure determined by the country's endowment structure. The larger the CAD industry, the more distortions will be needed—and loss of efficiency and social welfare will be greater.

Compared with former works, this paper makes two contributions: 1) it provides an alternative, consistent explanation for the existence of a series of distortions in developing countries; and 2) it shows how those distortions work together to achieve the developing country governments’ goal of developing CAD industries. Lin and Zhang (2007) is a pioneering work modeling this idea; our paper is different in basic assumptions and in the emphasis on the interaction of various distortions.

In the next section, we set the economic environment of developing countries in which the government pursues a CAD strategy. Section 3 shows how economic distortions are combined to build an environment that supports the development of nonviable industry. Section 4 shows that institutional distortions are a function of the government’s CAD strategy. Section 5 provides some other implications of the CAD strategy for institutional distortions. Section 6 concludes the paper with some remarks.

# **2. Baseline Model**

## **2.1 Environment**

Consider a small, open economy with three sectors: agriculture (Sector 1), light industry (Sector 2), and heavy industry (Sector 3). The production of each type of good requires inputs of both capital and labor. Total capital , where is capital input in the agriculture, is capital input in light industry, and is capital input in heavy industry. Similarly, we have total labor . Factors cannot flow internationally. We define the level of endowment structure in the economy by per capita capital, . That is, the higher per capita capital, the higher the development structure in the economy. The goods prices are given by the international market.

The production functions are Cobb-Douglas functions: (1) where , and is the level of productivity in sector in the economy. The key difference among these sectors is in capital intensity. The production of heavy industry is more capital intensive than that of light industry, and the production of light industry is more capital intensive than that of agriculture. The Cobb-Douglas form is adopted for simplicity.

4
The indirect utility function of the representative agent is (2) where is the price vector, and is the total output value of the economy. is non-increasing and strictly convex. This quasi-linear utility function form is adopted for simplicity.

On the policy side, there are activity-specific tax rate , and subsidy rate on production, which are constrained to be nonnegative. Let the set of protected sectors be denoted by and unprotected sectors by 4. The tax and subsidy make the producer prices deviate from as follows: and There are no other fiscal instruments (in particular, no lump-sum non-distortional taxes).

In addition, for protected sectors, factor price regulation depresses factor prices from market-clearing levels by a rate of , and a corresponding directive allocation system directly mobilizes resources into protected sectors at lower prices.

These activities are financed by the government’s tax revenue. The costs of these activities mainly consist of two parts: one arises from mobilizing resources into protected sectors and the other arises from supervising the utilization of resources in protected sectors. While factor prices are suppressed, it is profitable for a producer in a protected sector to take the opportunity of arbitrage by transferring resources to unprotected sectors, since these resources are directly allocated to them at prices lower than the market levels. So in addition to simply mobilizing resources, one of the most important functions of the directive allocation system is to prevent producers in protected sectors from taking this arbitrage opportunity. The government has to supervise the producers in protected sectors to make sure the resources directly allocated to them are used in protected sectors, and punish those who transfer resources.

The former part of the costs is increasing in the amount of resources to be allocated directly. The latter part of the costs is increasing in . The reason for this is that the larger is, the larger the incentive for arbitrage is, so the government has to increase the intensity of supervision as increases. Let denote the output of protected

> 4

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<u>Li > L3#</u> (eg) _ *\ 1 _ 1 m!(79) — m(r*) — (1+ (1+ 28) Fe Fe nos ~wTMTM tteJor9Jor9 <u>(+(1(1</u> _ 1)va)va) _ <u><055</u> <!-- Start of picture text --> (eg) _ *\ 1 _ 1<br>m!(79) — m(r*) — (1+ (1+ 28) Fe Fe nos<br>~wTMTM tteJor9Jor9 (+(1(1 _ 1)va)va) _ <055<br><!-- End of picture text --> <!-- Start of picture text --> 0 > ——___t____ (1+#)(1- pases) t +m(t*)’<br><!-- End of picture text --> <!-- Start of picture text --> 0yy > HEl—r9 (=(lL 1“)<br><!-- End of picture text -->
# **6. Conclusion**

In this paper, we show that if the government wants to develop an industry that is not consistent with the comparative advantages of its economy, enterprises in the CAD industry will be non-viable and the government will be obliged to provide them with subsidies and protection. If the size of the targeted CAD industry is small, the use of taxation and subsidization will suffice to achieve the government’s goal. However, if the industry is large, other policy distortions will be necessary. There is therefore a positive relationship between the degree of economic distortions and the degree of deviation of the CAD strategy from the optimal industrial structure determined by the country’s endowment structure. The logic in this paper provides a consistent explanation for the origin of various institutional distortions observed in many developing countries that adopted the import-substitution, capital-intensive, heavy-industry-oriented development strategy, which went against the comparative advantage of their economies.

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