State Owned Enterprises (SOEs) are often the recipients of preferential treatment from the state including bailouts in periods of financial stress, access to cheap inputs, etc. These connections between SOEs and the state thus enable unproductive SOEs to avoid restructuring (Kornai, 1990; 1992, Part III). However, Chinese reforms for restructuring SOEs announced during the Fifteenth Party Congress in 1997 have been followed by impressive gains in SOEs. profitability in the manufacturing sector during 1998-2007. We develop a new method for analyzing firm-level labor share dynamics that enables us to evaluate whether the SOEs successfully restructured. We find that the SOEs were under declining political pressure to hire excess labor, and also had increasingly preferential access to cheap capital for financing investment during 1998-2007. Because the elasticity of substitution between capital and labor is greater than one in Chinese manufacturing sectors, lower political pressure to hire excess labor in combination with subsidies for capital have enabled SOEs to become more profitable by cutting labor and drastically decreasing labor capital ratios; these gains in profitability, however, were not driven by strong improvements in total factor productivity.
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