Social Sciences in China (Chinese Edition)

No.12, 2014

A Market Distortion Angle on Government Expansion: A Finance View

(Abstract)

Lü Bingyang

It is generally believed that government expansion leads to market distortion. Conversely, however, market distortion may drive government expansion. This is because government expenditure has the dual role of supplementation and replacement of private capital. In the former case, government productive expenditure enters the enterprise production function and, when increased, enhances the marginal output of private capital. In the latter case, government expenditure is used for direct subsidies to state-owned enterprises and may increase their output. From the viewpoint of growth, such expenditure functions to replace private sector production. Although the government’s use of commodity tax financing curbs consumption and has a detrimental effect on residents’ welfare, it can reach its economic growth target by increasing expenditure. Thus market distortion will boost the growth of commodity taxes, government productive expenditure and expenditure on subsidies for state-owned enterprises. The reason inappropriate government intervention in the market causes market distortion may be that the government prioritizes organizational efficiency over economic efficiency. To some extent, this view complements theoretical explanations for government expansion and provides theoretical grounds for deepening the reform of China’s market economy system.