Much Ado about Nothing, Almost: Factor Income Distribution in China Chong-En Bai Zhenjie Qian Tsinghua University

Trend since Compensation of employee Capital income (=operating income + depreciation) Net taxes on production

Observations Capital share increased from in 1978 to in year Labor share declined from 49.8 in 1978 to in Share of taxes on production increased from in 1978 to in There is an abrupt change between : capital share increased from to 44.35, and labor share declined from to

Trend since 1978 （ net of production taxes)

Questions What is behind the recent changes in factor income distribution in China? What explains the abrupt changes between 2003 and 2004?

Why Do We Care? Factor income distribution may affect size income distribution. –What Is China Doing to Its Workers? (by Arvind Subramanian, Peterson Institute, in Business Standard, New Delhi, February 8, 2008): This might well be the mother of all redistributions. Is the dramatic decline in labor's share of the economic pie ominous? Will the decline in labor's share of the economic pie be reversed through political change? That may be China's big question.

Why Do We Care? Factor income distribution may affect size income distribution. –A workers' manifesto for China (Economics focus, Economist, Oct 11th 2007): “Many countries have seen a fall in the share of labour income in recent years, but nowhere has the drop been as huge as in China. This partly reflects China's large pool of surplus labour, which has depressed wages relative to the economy's large productivity gains.”

Why Do We Care? Factor income distribution may affect size income distribution. –Many economists in China have also talked about the rapid decline in labor share and proposed policies in response to the decline. –The government has adopted or is considering adopting policies to deal with the issue.

Why Do We Care? Return to capital –Investment rate has been increasing. (figure)figure –Capital output ratio has also been increasing. (figure)figure –How has the rate of return to capital changed? The answer depends on capital share. Kaldor’s stylized facts about the growth of advanced industrial economy: –Fact one: Real output per capita grows at more or less constant rate over fairly long periods of time –Fact two: The stock of real capital, crudely measured, grows at a more or less constant rate exceeding the rate of growth of labor input –Fact three: The rates of growth of real output and the stock of capital goods tends to be about the same, so that the ratio of capital to output shows no systematic trend –Fact four: The rate of profit on capital has a horizontal trend –Fact three and four imply that factor income share in output should be constant

Preview of Results Sources of the decrease in labor share Total decrease in labor share from , N % Change in statistical method % Structural transformation % Decrease in labor share in industry % Restructuring of SOEs-0.99 Increase in monopoly power-0.49 Remainder-0.16 Remainder0.5-5% N1: Aggregate Labor share start to decline in 1995

Preview of Results The elasticity of substitution between capital and labor in industry sector is not significantly different than 1. The change in the relative price of capital and labor is not a significant factor behind the change in labor share in industry sector.

Outline What Explains the Abrupt Changes between 2003 and 2004? Structural Transformation Change of Labor Share in Industry

What Explains the Abrupt Changes between 2003 and 2004? Before 2004, all the income of the self-employed was counted as labor income. Since 2004, income of the owners of the “individual businesses”, a major form of self-employment other than rural households, has been ascribed as capital income. In 2004 census, it’s stipulated that the operating surplus of state-owned and collective-owned farms should be counted as labor compensation and almost half of the provinces follow this method in year 2004, which explains why there is an abrupt increase in the labor share in primary industry.

What Explains the Abrupt Changes between 2003 and 2004? Adjustments made using the 2004 census data: –In table 1-26 of China Economic Census Yearbook (NBS, 2007), there are items such as operating revenue, operating expenditure including employee compensation and payable taxes, book value of fixed assets for individual businesses by industry, which can be employed to calculate value-added, operating surplus for individual businesses by industry according to the method given in DNA (2007). Depreciation = book value of fixed assets × 5% Operating surplus = operating revenue-operating expenditure-depreciation Net production taxes and labor compensation reported in NBS (2007) Value added = Depreciation + Operating surplus + Net production taxes + Employee compensation –We subtract calculated operating surplus of individual businesses from the reported total operating surplus by industry and add it to employee compensation. With this adjustment, we recalculate labor share.

What Explains the Abrupt Changes between 2003 and 2004? –We also adjust for the inconsistency between national and provincial data on individual businesses, by assuming that labor productivity of individual businesses at the provincial level is the same as that at the national level. –As we do not have enough information to judge how much operating surplus of state-owned and collective-owned farms are counted as labor compensation in 2004, we could not make adjustment to eliminate the effect of the associated change. We recalculate aggregate labor share in 2004 using the actual labor share in primary industry in year 2003.

What Explains the Abrupt Changes between 2003 and 2004? Adjustments results: Notes: N1: labor share calculated using reported data; N2: labor share adjusted using Census data; N3: labor share adjusted using Census data and provincial employment numbers in individual businesses; N4: labor share in primary industry in year 2004 is replaced by that in year 2003 Conclusion –The jump in reported labor share between 2003 and 2004 is the result of the change in the way we tally the income of the self-employed.

Structural Transformation Observation: –Labor share of the primary sector is much higher than other industries. –Labor share of the primary sector is overestimated since all the income of rural households engaged in primary industry production is counted as labor income

Structural Transformation Observation –The structural transformation resulted in the decline of the primary sector and rise of the tertiary sector. –As labor share in the primary industry is much higher than that of the tertiary industry, labor share declined with the structural transformation. –As labor share in the primary industry is overestimated, the effect of structural transformation would not have been as large if we obtain true estimate of labor share in primary industry

Structural Transformation If there’s no structural transformation between 1995 and 2004, then the labor share in 2004 would have been 57%, rather than 53.6% Structural transformation can explain 31 percentage points in the change of labor share.

Change in Industry Change in labor share in industry explains 15 percentage points in the change in aggregate labor share. What has happened?

Change in Industry: Theory Utility function Production function Firm objective: SOEs are interested in the size (output and/or employment) of the firm as well as profits. labor share: formula for labor share The elasticity of substitution between capital and labor is important.

Change in Industry: Predictions Ownership effect: labor share is higher when the firm has a stronger size preference. Monopoly power: labor share is lower when the firm has stronger monopoly power The change in the relative price between capital and labor is reflected in capital-output ratio in efficient term. Elasticity of substitution between factors determines the relationship between labor share and capital- output ratio

Change in Industry: Data Description of the data –Annual survey of industrial firms conducted by the National Bureau of Statistics of China from 1998 to Industrial survey covers all SOEs and non state-owned enterprises with annual sales over 5 million Yuan. –Capital share: ratio of operating profit and accounting depreciation to value added at factor cost –Three proxies for monopoly power: price markup; HHI; CR10 –Two groups of proxies for ownership: equity shares (req_x); control rights (D_x) – Capital-output ratio: ratio of fixed assets at book value to value added at factor cost –Capital augmenting technical parameter: controlled by year dummies –Other factors are controlled by industry dummies

Change in Industry: Methodology Description of the methodology –System GMM estimation estimates level and difference equations simultaneously, each using lags of difference term and level term of endogenous variables as GMM instruments. This deals with the problem of the endogeneity of capital-output ratio. –System GMM estimation estimate level equation so that explicit fixed effect such as region dummies and industry dummies can be estimated. –System GMM estimation uses both between group and within group information when estimating level and difference equation and hence obtain precise estimation for the difference of capital share between enterprises with different ownership structure.

Change in Industry: Empirical Results Notes: N1, base model; N2, log model ； legend: * p<.1; ** p<.05; *** p<.01

Change in Industry: Robust Checks legend: * p<.1; ** p<.05; *** p<.01

Change in Industry: Robust Checks Notes: N1, observations in sample no less than 3 years; N2: observations in sample since 1998; legend: * p<.1; ** p<.05; *** p<.01

Change in Industry: Decomposition － 81% of actual increase in capital share can be predicted by the model ； － 1/2 of the predicted capital increase is contributed by ownership restructure － 1/4 of the predicted capital increase is contributed by monopoly power change － contribution of the restructure across region and industries is trivial ；

International Comparison The potential problems with international comparison –Data compatibility: the tally of income of the self-employed differs across countries –Gollin (2002) estimated labor share by country assuming income of self-employment as capital income, comparable to that adopted by the NBS

Rate of Return to Capital: Revised

Preview of Results Sources of the decrease in labor share Total decrease in labor share from , N % Change in statistical method % Structural transformation % Decrease in labor share in industry % Restructuring of SOEs-0.99 Increase in monopoly power-0.49 Remainder-0.16 Remainder0.5-5% N1: Aggregate Labor share start to decline in 1995

Conclusion The elasticity of substitution between capital and labor is not significantly different than 1. The change in the relative price of capital and labor is not a significant factor behind the change in labor share.

Investment rate since 1978 Back

Capital-output ratio since 1978 Back

Structural Transformation Back