Government as a Discriminating Monopolist in the Financial Market: The Case of China

Abstract

To date, China has maintained a variety of restrictions on its financial markets. In addition to imposing capital controls and regulating interest rates, the government controls both the set of firms that can sell equity on the domestic or foreign stock markets, and the amount they can sell. China is unique in that foreigners pay much less than domestic investors for intrinsically identical shares. In this paper, we show that these characteristics of the Chinese financial market are consistent with a government choosing regulations to maximize a standard type of social welfare function. The observed policy of charging much higher prices for equity sold to domestic than to foreign investors can simply reflect the more inelastic demand for equity by domestic investors. Under certain conditions, these regulations are equivalent to income taxes on business and interest income. The pattern of tax rates is not qualitatively different from those commonly observed elsewhere, particularly in other countries with capital controls. Given the ease with which firms and individuals can evade income taxes, however, indirect taxation through restrictions on the financial market may serve as an effective alternative.