Factor Market Distortions Across Time, Space and Sectors in China

In this paper we measure the distortions in the allocation of labor and capital across provinces and sectors in China for the period 1985-2007. Most existing studies have measured factor market distortions by using some index of dispersion in individual factor returns. However, the map between these dispersion measures and the efficiency loss due to distortions is not clear, especially when there is more than one factor. In this paper, we follow Hsieh and Klenow (2009)'s strategy by measuring the factor market distortions as the reduction in aggregate TFP due to distortions. We extend their analysis by decomposing the overall distortions into between-province and within-province inter-sectoral distortions. We find: (1) For the period between 1985 and 2007, the distortions in factor allocation reduced aggregate TFP by about 31% on average, with the within-province distortions accounting for more than half of the reduction; (2) the measure of between-province distortions was relatively constant over the period; (3) the measure of within-province distortions declined between 1985 and 1997, contributing to 0.96% TFP growth per year, but then increased significantly in the last ten years, reducing the aggregate TFP growth rate by 1.41% a year; and (4) almost all of the within-province distortions can be accounted for by the misallocation of capital between the state and the non-state sectors.