Inefficient banking sector in China is actually an optimal way of taxation

It is well perceived that China's state-monopoly banking sector (with the help of capital control) is a powerful tool in channelling private sector wealth into loss-making state-owned enterprises and numerous white-elephants public infrastructure projects.

A paper written by several Chinese economists however argues that such a mechanism is actually optimal. The idea is as follows.

In developing countries, it is usually very difficult for the government to collect taxes (everyone hides their income), and official taxation is usually very inefficient (it creates a lot of distortion in the economy and a disproportionate burden on hard-working and smart people). Formal taxation thus becomes very costly and creates a lot of dead-weight costs.

But the government needs money and by whatever means the government will try to extract revenue from the private sector. Conditional on the "grabbing hand" nature of the government, an “implicit taxation” by channeling private sector wealth into low-return public projects, through the monopoly banking sector, becomes an optimal and efficient solution:  it is efficient because (1) the cost of “tax “collection is low (you can avoid it only if you completely go underground) (2) the “taxation” is relatively fair and less distorting (it is proportionate to your existing wealth).

Certainly it is even better if the government does not try to extort the private sector in the first place. But if the government does do it, it is better that it does it through the banking sector. At least you don’t need to pay the robber to rob you, and at least hard-working people don’t have higher chance of being robbed.

When a gun is pointed at you, it makes no sense to fight. Take my money but don't hurt me.

Financial Repression and Optimal Taxation (pdf file)

Chong-en Bai, David D. Li, Yingyi Qian, Yijiang Wang

Financial repression entails an implicit taxation on savings. When effective income-tax rates are very uneven, as common in developing countries, raising some government revenue through mild financial repression can be more efficient than collecting income tax only.

Comments

[China Law Blog]

Interesting idea, but still .... In China the state essentially controls loans and mostly just loans to state owned enterprises, whose productivity does not compare with the private sector. The private sector pretty much has to take out loans through the grey market (pawn shops, loan sharks, and family) at high interest rates. How can that be a good thing?

[R-Squared]

It is certainly not a good thing. When you are robbed, it is certainly not a good thing. It is "good" in the sense that you are robbed but the robber hasn't taken all of your money or killed you.
Even if banks don't lend to SOEs anymore, don't assume that SOEs will not be funded from other sources. The government needs SOEs to patrion certain segment of supporters (or to buy out dissedents). Money has to come from somewhere, and without the captured state-owned banks, the government is likely to grab money directly from your pocket, and the more hard-working you are the more they will grab from you. Plus, as tax-collection becomes more difficult, the government will hire more police and tax-collection officers. This is why I mean by "paying the robbers to rob you". I'd rather surrender my money, otherwise the robbers may need to invest in AK-47s and they will certainly want to recoup their "investments" from me, i.e., they will ask more money from me, take me to the ATM machine....