The Social Cost of Fiscal Federalism and the Depletion of China’s Native Forests

Deforestation has been a major problem in China’s key northeastern forestry region, where the central government sets harvesting quotas, but local state forest enterprises have no incentives to comply with these limits. We develop a novel federalistic two-principal one-agent model to assess the social cost of state forest enterprise-driven deforestation, assuming that state managers make hidden decisions under the influence of provincial and central governments. We derive an expression of the social cost of hidden actions resulting in deforestation, and panel data are used to compute social losses and identify the main factors in these costs. We find the most important factors to be large natural forests and weak signals that the central forest administration has of harvesting. Our results collectively show that first best social cost minimizing outcomes are not possible unless policy reforms are undertaken.