Will China Escape the Middle-income Trap? A Politico-economic Theory of Growth and State Capitalism

Is China's rapid growth sustainable if the labor and capital market distortions persist? Will democratization occur given that Chinese middle-class are supportive of the regime? To answer the above questions, this paper proposes a politico-economic theory, as follows. In oligarchy, a political elite extracts surplus from the state sector and taxes the private sector, but it also needs political support from sufficiently many citizens to maintain its power. “Divide-and-rule†strategy is implemented to guarantee such support: state workers receive high wages and become supporters of the elite, while wages of private workers are reduced due to the policy distortion. In the short-run, the low wages in the private sector lead to rapid growth of the private firms and total output. However, long-run growth is harmed by capital market distortions favoring the state firms. The theory suggests that the economy develops along a three-stage transition: “rapid growth†, “state capitalism†, and two cases in the third stage: “middle-income trap†or “sustained growth†, depending on whether democratization occurs endogenously. The theory is consistent with salient aspects of China's recent development and gives predictions on China's future development path.