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. A political élite is able to extract surplus from the state sector and tax the private sector, but it also needs support from suﬃciently many citizens to maintain the political power. “Divide-and-rule” strategy is implemented to guarantee such support: state workers receive high wages and become supporters of the élite, 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.
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