Industrial Policy: Proactive and Effective

Abstract

Despite a lack of consensus on its effects, industrial policy has existed for a considerable period of time and is now back in the spotlight amid the changing global landscape. In the 19^th century, Germany used industrial policies to cope with international competition. After the Second World War, Japan also actively employed industrial policies. Vertically, the US and Japan both used industrial policies to promote industrialization when they were at the stage of catching up with other economies. After becoming leading economies, they shifted the focus of their industrial policies to promoting innovation. Horizontally, the US as a leading economy often used industrial policies to compete with latecomer economies if the competitiveness of the latter improved substantially. The world today is undergoing profound changes (e.g., green transition, the COVID-19 pandemic, competition between large countries, and the growing gap between the rich and poor) which not only affect market efficiency, but also affect security in a broad sense. Therefore, US and European governments have stepped up efforts to intervene, and industrial policy is back in the spotlight.

Profound changes call for a new mindset. The theoretical basis for industrial policies is shifting from neoclassical economics, which took center stage in recent decades, to political economy, and governments need to take proactive measures rather than occasionally intervene in the market when necessary. According to traditional views, the goal of industrial policy is mainly to solve problems related to market failures, including monopolies and externalities. However, in an era of profound changes, industrial policies should not only focus on efficiency, but also pay more attention to security. After analyzing policy targets, policy tools, income distribution modes, competition, and innovation from the perspective of the government’s role, we believe the principles that industrial policies follow will change considerably. Industrial policies should shape and create new markets and be more comprehensive, focusing not only on manufacturing but also on service industries. Income distribution modes should also be improved as government investment increases. Industrial policies should not hurt competition while improving and strengthening industries and achieving economies of scale. Otherwise, they could be detrimental to innovation.

In an era of profound changes, China’s industrial policy is multifaceted, but promoting innovation remains crucial. Industrial policies have played an important role in China’s economic development, but they have also led to various problems. In the future, industrial policies should not only continue to improve efficiency, but also focus on social governance. For China’s industrial policies, we think promoting innovation remains crucial, whether from the perspective of coping with profound changes or from the perspective of catching up with other countries. To promote innovation, we suggest increasing support for R&D. We believe government-guided funds are a good effort, but the market-oriented operations of such funds need to be improved. In an era of deglobalization, economies of scale are an advantage for China, but efforts should be made to avoid exacerbating monopolies, and to avoid improving security at the cost of lowering efficiency. We think expanding opening-up and attracting foreign investment are of far-reaching significance.

Authors of this chapter: ZHANG Wenlang, HUANG Yadong, ZHOU Peng, ZHENG Yuchi. Translator: WANG Wendong. Editors: Kenneth HO, Jude ABEYERATNE, HUANG Yadong, LIU Xinran.

7.1 Industrial Policy Back in the Spotlight Amid Profound Changes in the World

The world’s economic development has entered a new stage and is facing profound changes and grand challenges. Such changes and challenges include but are not limited to geopolitical conflicts, competition between large countries, trade policies that support domestic industries, the COVID-19 pandemic, supply chain disruptions, climate change, green transition, the gap between the rich and poor, etc. These changes and challenges not only affect efficiency, but also affect security. “Security” here refers to security in a broad sense, including security related to social stability, energy security, and supply chain security.

• 1) Competition between large countries is not only an economic issue but also a political one, and it is related to national security. Amid impacts from deglobalization, global cooperation is facing challenges, affecting supply, demand, and the operation of supply chains. Trade frictions and technology disputes are both manifestations of the imbalance in global governance against the backdrop of deglobalization.

• 2) The COVID-19 pandemic has had significant impacts, and governments proactively undertook emergency measures to protect the health of the public. From an economic perspective, public policies should not only ensure supply and demand, but also promote the transformation of the economic structure.

• 3) Maintaining the stability of supply chains implies that supply chain management should strike a balance between risks and rewards.¹ On the one hand, the private sector pursues efficiency, while the public sector attaches great importance to security. For society as a whole, the optimal combination of risks and rewards may be somewhere between the respective optimal combinations of the private and the government sectors. On the other hand, supply chains are highly complicated, and information asymmetry is a serious problem. Both governments and individuals may underestimate risks, and actual risks could be greater than the perceived risks. In such a context, if supply chains are hit, losses may be much larger than expected.

• 4) Climate change could increase the frequency and intensity of natural disasters, and a green transition is necessary. Carbon emissions have negative externalities. The rewards of economic activities generating carbon emissions belong to individuals, but the damage caused by carbon emissions is global. The green transition, however, will bring positive externalities as individuals may have to bear the cost of carbon emission reductions, but it will bring global benefits. As such, the private sector’s investment in green technologies is insufficient. The green transition also raises questions about fairness. For example, regions that rely on fossil fuels for production may suffer more losses—should they be compensated for the losses incurred for the green transition? How should developing countries and developed countries play different roles in the process?

• 5) The growing gap between the rich and poor across the world affects not only economic growth but also social stability, and is both an efficiency issue and a security issue.

In response to these profound changes and grand challenges, the US and Europe have stepped up efforts to implement industrial policies. Against the backdrop of the COVID-19 pandemic and geopolitical changes, the US and EU have both proposed to enhance the resilience of local supply chains, and their common focus is mainly on five fundamental areas: Raw materials, active pharmaceutical ingredients, semiconductors, batteries, and renewable energy. In addition, the US also pays significant attention to the defense and transportation industries, while Europe pays close attention to cybersecurity and cloud computing. China has become a focus of attention and a keyword in the industrial policies of the US and Europe. This is not only because China’s economic strength has improved and the country has become an important market in the world, but also due to increased economic and trade frictions between the US, Europe, and China.²

On August 9, 2022, US President Joe Biden signed the CHIPS and Science Act with a total investment US$280bn, with US$52bn earmarked for supporting chip and semiconductor technologies with a focus on supporting the manufacturing of high-end chips. The major goals of the CHIPS and Science Act are to bring semiconductor manufacturing back to the US and to create new jobs in the country. With the signing of the bill, investments will be made to “poise US workers, communities, and businesses to win the race for the twenty-first century” according to President Biden.³ During the Obama administration, the US introduced the American Recovery and Reinvestment Act of 2009 (ARRA) and the Manufacturing Enhancement Act of 2010 to promote the development of domestic manufacturing industries in the US. During the Trump administration, the US implemented “America First” policies, introduced the Strategy for American Leadership in Advanced Manufacturing, and strived to bring manufacturing back to the US. After the outbreak of the COVID-19 pandemic, manufacturing jobs were brought back to the US at an accelerated pace. Statistics from the Reshoring Initiative in the US indicate that about 260,000 manufacturing jobs were brought back to the US in 2021, mainly from countries such as China, Mexico, India, and Japan.⁴

This means that despite a lack of consensus on its effects, industrial policies are back in the spotlight. Did Western countries eschew industrial policies in the past? Do arguments over industrial policies still make sense? How are industrial policies in an era of profound changes in the world different from those in the past? What are the lessons learned from China’s industrial policies in the past, and what kind of industrial policies should be implemented in the future? What are the implications of industrial policies implemented by other economies? These are the questions we try to answer in this chapter.

7.2 Industrial Policies Have Been Adopted by Various Countries in the Past

7.2.1 Japan and the US Have Adopted Industrial Policies in the Past, but in Different Ways

In the past, industrial policies were mainly used to promote industrialization. Later, the focus of industrial policies expanded from the industrial sector to all sectors of the economy. In a narrow sense, industrial policy takes the form of government intervention in specific industries. Broadly speaking, industrial policy is “any type of intervention or government policy that attempts to improve the business environment or to alter the structure of economic activity toward sectors, technologies, or tasks that are expected to offer better prospects for economic growth or societal welfare than would occur in the absence of such intervention”.⁵ The broad definition has been increasingly adopted in research on industrial policies, which in essence is about how to define the boundaries of government and market in the late twentieth century. We adopt the broad definition in this chapter.

In the 19^th century, the German-born economist Friedrich List discussed the necessity of adopting trade protection policies to develop domestic industries in his work The National System of Political Economy. Meanwhile, Japan and the US have been continuously adopting industrial policies, albeit for different purposes, and in different ways and at different stages of development.

Industrial policies played a significant role in Japan’s economic development after the Second World War, and the focus of the country’s industrial policies shifted from a wartime economy to promoting innovation. (1) From 1945 to the 1960s, Japan’s industrial policies still retained characteristics of a wartime economy. Direct regulation of private-sector economic activities through measures such as price controls, rationing, and prioritizing coal and steel production facilitated Japan’s post-war economic recovery.

(2) From the 1960s to 1973, Japan’s industrial policies adopted “hard measures” (e.g., tax incentives, subsidies, preferential financing, and trade protection) to support strategic industries. In 1960, Japan formulated the “income-doubling plan”, focusing on developing heavy industries such as steel, petrochemicals, and machinery manufacturing.

(3) From 1973 to the 1990s, Japan’s industrial policies adopted “soft measures” (e.g., administrative guidance, state-driven industry associations, and structural adjustments and assistance for supply and foreign exchange shocks) to support strategic industries. Industrial policies focused on areas of market failure, and took the form of providing public services, developing new industries, and adjusting declining industries.

(4) After the 1990s, the focus of Japan’s industrial policies shifted to promoting innovation. In 1994, Japan’s Ministry of International Trade and Industry released a report on industrial structure in the twenty-first century, identifying Japan’s 14 major industries of the future, including information and telecommunications, energy, and high-tech manufacturing industries. In 2000, the Japanese government introduced a law on information technology, codifying the country’s national strategy for information technology into law.

Since the US was founded, the country’s industrial policies have undergone a transformation from industrial policies for industrialization to industrial policies for innovation, and from industrial policies for direct intervention to industrial policies for indirect intervention. The US adopted trade policies that support domestic industries prior to the Second World War. After its declaration of independence, the US was faced with an influx of industrial products from the UK and difficulties in the development of domestic industrial sectors. Alexander Hamilton, the first US Secretary of the Treasury, delivered a report on manufacturing industries to US Congress in 1791, stressing that the country was unable to develop an independent industrial system in the face of fierce competition from abroad. He proposed eleven basic principles for industrial policies, including tariff protection, import restrictions, direct government subsidies for target industries, tax exemptions for manufacturing inputs, and provision of public infrastructure. The average import tariff rate of the US rose from 8.5% in 1789 to 30% after the War of 1812. In 1930, the US announced the Smoot-Hawley Tariff Act, bringing the country’s average import tariff rate to 65%.

The US government increasingly focused on technological innovation policies after the Second World War, in two stages. In the first stage, the US strived to promote breakthrough innovation in the context of the Cold War (1945–1980). The government increased public R&D investment and government procurement to improve national security and basic research. In 1958, the Defense Advanced Research Projects Agency (DARPA) was established to engage in advanced defense technology R&D. Technologies such as the internet, semiconductors, laser, and GPS technologies all originated from this government department.

In the second stage, the US strived to promote application innovation amid globalization (1980–2008). Faced with threats related to manufacturing and technology from the rise of Japan and Germany, it began to promote the commercialization of basic research. In 1992, the US launched the Small Business Technology Transfer (STTR) program to strengthen cooperation on innovation between small businesses and non-profit research institutes to improve the efficiency of commercialization of basic research. Mariana Mazzucato, a professor at University College London, believes that without the massive amount of public investment behind the computer and internet revolutions, Steve Jobs, co-founder of Apple, might have invented a new toy instead of cutting-edge revolutionary products like the iPad and iPhone which have transformed the way that people work and communicate. She also points out the success of Genzyme, an American biotechnology company which benefited from early research by public sector scientists.⁶

While focusing on technological innovation after the Second World War, the US continued to use industrial policies to compete with rivals. Japan’s semiconductor industry grew rapidly in the 1970s and the 1980s, pushing US semiconductor companies such as Intel and AMD to the brink of bankruptcy. In 1985, the US launched a “Section 301” investigation into Japan’s semiconductor products. In 1986, the two countries signed a semiconductor trade agreement, and Japan had to open up its domestic semiconductor market and ensure that foreign companies’ products would gain at least a 20% market share in Japan within five years. Since then, the glory days of Japan’s semiconductor industry have come to an end, and its market share in the global market has continued to decline.

By analyzing the history of industrial policies in major economies, we come to two solutions. First, the content and purpose of industrial policies vary in different stages of economic development. For example, the US and Japan both used industrial policies to promote industrialization when they were in the stage of catching up with other economies, including policies that protected their infant industries and promoted exports. After becoming leading economies, the US and Japan gradually shifted the focus of their industrial policies to promoting innovation. Second, if the competitiveness of latecomer economies improves substantially, the US as a leading economy tends to use industrial policies to maintain its advantage and compete with latecomers.

7.2.2 Should the Government Adopt Industrial Policies? How Should the Government Use Industrial Policies?

Various countries have adopted industrial policies in the past, but criticism of industrial policies remains. Proponents of industrial policies argue that industrial policies address the problems of market failures. Generally speaking, market failures come from monopolies, externalities, information asymmetry, and shortage of public goods. Traditional industrial policies mainly address the problems of monopolies and externalities. For example, environmental pollution is a typical market failure phenomenon with externalities, and environmental protection policies are needed to restrict pollutant discharges.

Opponents of industrial policies argue that the existence of market failures does not justify government intervention in the market because government failures may also occur.⁷ If a government failure is more serious than market failure, industrial policies could lead to greater losses.⁸ Nobel laureate Gary Becker believes that “the best industrial policy is none at all”.⁹ There are two main sources of government failures: Information asymmetry and rent-seeking.¹⁰ Information asymmetry means that the government often lacks information to select truly effective industries or companies. The problem of rent-seeking occurs when interest groups seek to obtain government support and protection through rent-seeking behavior. Politically connected businesses tend to have more resources for rent-seeking, which could be unfair to other businesses.

In order to correct market failures and avoid government failures, policymakers and scholars increasingly believe that industrial policy should play a role of indirect intervention and should reduce direct intervention. Direct intervention industrial policy tools include subsidies, credit, government procurement, and trade protection. Governments could use direct intervention industrial policy tools to provide resources to specific industries or enterprises in a targeted manner. The advantage of direct intervention industrial policy tools is that they are quick to take effect and can rapidly boost employment and economic growth. The disadvantage of direct intervention industrial policy tools is that they could lead to government failure.

Governments could use indirect intervention industrial policy tools to establish rules, standards, and mechanisms that do not target specific industries or enterprises. For example, governments could either directly boost the production of goods in a specific industry through subsidies, or indirectly improve the competitiveness of the industry through anti-monopoly policies designed to increase production across the industry. The advantage of indirect intervention industrial policies is that they reduce the likelihood of government failure and problems such as information asymmetry and rent-seeking. The disadvantage of indirect intervention industrial policies is that they require long-term efforts and are unlikely to produce significant impacts in the short term.

A mainstream view is that direct intervention policies may be more effective if an economy is in the stage of catching up with other economies as the direction of economic development is clear in this stage and there is less information asymmetry between the government and market. However, indirect intervention policies may be more effective when an economy has passed the stage of catching up with other economies and is at the forefront of technology. In this stage, the government is no more aware of the direction of economic development than the market, and direct intervention is likely to be counterproductive. Based on a report released by the International Monetary Fund, truly effective industrial policies tend to be technology and innovation policies that intervene indirectly.¹¹ To develop technology and achieve innovation, the government should have its own goals. Industrial policies should not be limited to supporting industries with comparative advantages, but should also play an active role in creating markets and providing resources and taking responsibility for developing new industries. Industrial policies should focus on supporting industries with high complexity and be export-oriented rather than import-oriented. Industrial policies should also strive to maintain intense market competition.

7.3 Profound Changes Call for a New Mindset

7.3.1 New Mindset Amid Profound Changes in the World

Neoclassical economics is the theoretical basis for traditional industrial policies, and such industrial policies place emphasis on improving efficiency, but it is difficult for them to address the grand challenges that the global economy faces. Therefore, industrial policies need to be reimagined. Against the backdrop of profound changes in the world, new industrial policies introduced by the US and the EU indicate that industrial policies no longer focus solely on efficiency, but also attach great importance to issues such as supply chain security, geopolitics, cybersecurity, and the gap between the rich and poor. For example, the “reindustrialization” of the US aims to both improve domestic fairness and reduce the possibility of transferring technologies to competitors, which has gone beyond the scope of neoclassical economics thinking.

Neoclassical economics is somewhat out of touch with reality, and the liberalization it has advocated over the past few decades has led to some of the grand challenges the global economy now faces. Therefore, we can no longer abide by the thinking of the past. For example, globalization has enabled multinational companies to establish a global presence, which has improved efficiency but weakened security and led to substantially elongated supply chains. Financial liberalization has also led to a growing gap between the rich and poor, threatening social stability. Neoclassical economics pays little attention to the issue of distribution. Pareto optimality holds a particularly strong political view of accepting the existing pattern of wealth distribution without addressing why a gap exists in the first place. However, from the perspective of political economy, market behavior must be subject to political and social ethics and values, and policies in reality must pay attention to issues of fairness and social stability. We think the new mindset amid profound changes in the world is that industrial policies should not only place emphasis on efficiency but also on security, and the theoretical basis for industrial policies is shifting from neoclassical economics in recent decades to political economy.

Some scholars have rethought industrial policies from the perspective of political economy. Nobel laureate Joseph Stiglitz believes that the current challenges stem from the failure of neoliberalism and the policy framework it supports, and that neoliberalism should be replaced by a new economic vision.¹² One example is mission-oriented industrial policy from a political economy perspective. Mariana Mazzucato believes that mission-oriented industrial policies in an era of profound changes should have more inspirational goals and focus on the public interest rather than just economic benefits.¹³ In other words, we think industrial policies should address social problems in addition to economic problems. From the perspective of the government’s role, industrial policies should not only passively solve the problems ignored by the market, but also take proactive measures and even play a role of leading the way.

Traditional methods for the evaluation of industrial policies are static and ex ante cost-benefit analysis, while the new mindset for industrial policies requires dynamic and systematic evaluation methods. In terms of attitude towards risk, failure is inevitable in the process of learning and thus policies should tolerate a certain degree of failure and improve risk tolerance. Overall, although mission-oriented industrial policies also have shortcomings (e.g., failure to consider issues such as government failure, inequality, and international cooperation), we believe the concept remains useful in thinking about industrial policies in an era of profound changes.

7.3.2 Five Basic Principles for Industrial Policies in an Era of Profound Changes

Based on the new mindset on industrial policies and drawing on existing research, we summarize some basic principles that industrial policies should follow in an era of profound changes in the world. These principles may not be comprehensive, but we think they indicate how industrial policies should change from different perspectives.¹⁴

1. The role of government: In the past few decades, the government mainly played the role of fixing market failure. In an era of profound changes in the world, the government not only needs to correct market failures, but also needs to take proactive measures to improve security and fairness. The government is becoming increasingly important as a market creator, i.e., shaping and creating new markets and guiding the direction of technological progress. Although the government has occasionally played the role of market creator in the past few decades, this role has become more important amid profound changes in the world. For example, addressing pollution is a case of correcting market failure, while the Apollo and Manhattan projects of the US government created new markets. In recent years, China, the EU, and the US have established carbon trading markets, and the US passed the Inflation Reduction Act in 2022 to promote energy transition and cope with climate change, which we think also reflects the government’s role as a market creator.

2. Targets of policies: Industrial policies should focus on manufacturing industries as well as service industries, especially given the accelerated development of the digital economy. From the perspective of efficiency, industrial policies mainly promoted the development of manufacturing industries in the past. However, from the perspective of fairness, service industries now account for an increasingly large share of employment, and such industries cannot be ignored in order to narrow the gap between the rich and poor. We think industrial policies should pay attention to the development of service industries in the future. Dani Rodrik, an economics professor at Harvard University, proposed that the traditional focus of industrial policies on manufacturing industries needs to be broadened to service industries. The policies should place more emphasis on service industries, improve the productivity and labor income of workers in service industries, and create more jobs in service industries to address the current gap between the rich and poor.¹⁵

From the perspective of efficiency, the traditional view is that service industries are characterized by non-tradability, slow technological progress, and small spillover effect. In the era of the digital economy, the level of tradability of service industries has increased, and service industries are giving a stronger boost to the industrial sector and becoming an important source of productivity improvement amid improving tradability in service industries. Therefore, industrial policies should pay more attention to service industries. China released Development Plan for Digital Economy during the 14th Five-Year Plan Period in 2022, proposing that the proportion of key industries of digital economy in GDP should increase from 7.8% in 2020 to 10% in 2025. China’s digital economy is growing rapidly, and we believe the size of a large country, as discussed in Chapter 5 Digital innovations reshaping industry chains, provides innate advantages for the development of the digital economy.

3. In the face of profound changes and grand challenges, industrial policies should be more comprehensive. (1) Traditional industrial policies often consider the development of one or two individual industries, and are often formulated by an individual government department and industry experts. In an era of profound changes in the world, industrial policies should expand beyond this scope and pay attention to multiple factors such as fair income distribution among industries, regional disparities, and competition between large countries. Therefore, industrial policies must be coordinated with various other policies. Taking the solar industry as an example, traditional industrial policies mainly consider how to promote the development of the solar industry alone. Against the backdrop of achieving the goal of carbon neutrality, the development of the solar industry could reduce carbon emissions and thus is related to all carbon-emitting industries.

(2) New industrial policies impose higher comprehensive requirements on the government’s capabilities. In the face of major social challenges, market information provided by the private sector may be biased in terms of social value, and the government must be able to conduct independent and comprehensive information collection and analysis (e.g., individual companies are usually unable to collect supply chain information, and such information must be collected and shared by the government).

(3) Traditional industrial policies generally assume that technology is neutral (i.e., technological progress only improves efficiency without changing the proportions of income distribution among different groups of people) and that industrial policies should not proactively intervene in the path of technological development. In reality, technology is non-neutral and has different impacts on different groups of people, which could cause social problems. Therefore, industrial policies can proactively guide the development of technology. For example, technological development may lead to polarization in employment,¹⁶ and technological development supported by subsidies for fossil energy may increase pollution. Therefore, industrial policies need to comprehensively consider the efficiency and fairness issues of technological advances.

4. Income distribution modes: The government should place emphasis on developing rules to promote fair distribution of income. Industrial policy thinking in an era of profound changes implies that government investment may increase, and that this should be matched by suitable modes of income distribution. Otherwise, industrial policies may become unsustainable and widen the gap between the rich and poor. For example, the government should play an active role in technological innovation as innovation has positive externalities and may bring much uncertainty.

(1) Innovations and breakthroughs in fundamental technologies often produce substantial spillover effects, and it is difficult for innovators to enjoy the rewards of all the spillover effects. (2) Compared with risk, uncertainty in innovation is a factor that is more likely to result in inaction on the part of companies. Risk is characterized by probability distribution, and companies could take action based on expectations for risk. However, uncertainty has no characteristics of probability distribution, and companies tend to wait and see in the face of uncertainty as they have no experience to draw on.

Innovation of fundamental technologies is often accompanied by uncertainties. There is no probability distribution for which path of technologies may succeed and which may fail. The private sector cannot bear the cost of such large uncertainties. Therefore, the government needs to actively participate in the innovation of fundamental technologies. The government’s heavy investment in innovation should be rewarded accordingly. Under the current market system, it is common for the risks and costs of government investment in innovation to be borne by the public but for the benefits to go to relatively few. Policies should change this situation to ensure the fairness and sustainability of innovation.

5. Industrial policies should not hurt competition while improving and strengthening industries and achieving economies of scale. Otherwise, they could be detrimental to innovation. Security and efficiency are negatively correlated from a static perspective or in the short term, but they are positively correlated from a dynamic perspective or in the long term. For example, emphasis on bringing back manufacturing to a country and strengthening its domestic manufacturing for supply chain security could reduce risks in the short term. However, in the long term, if the country’s international competitiveness declines as a result, this would weaken its efficiency and security.

7.4 Promoting Innovation is Crucial Amid Multifaceted Industrial Policy in China

7.4.1 Historical Experience and Lessons for China’s Industrial Policy

Since China introduced the reform and opening-up policy, the focus of the country’s industrial policy shifted from promoting exports and the development of basic industries in the early stage to improving urbanization, then to promoting innovation and sustainable development (Fig. 7.1). In 1989, China’s State Council released a policy document about the government’s decisions on key points of industrial policies and it is the very first policy document named after industrial policies. In the policy document, the country laid out plans for the development of the country’s industries at the time, focusing on developing basic industries such as agriculture, energy, transportation, and raw material industries.

Fig. 7.1

Source Wind, Gov.cn, CICC Research

Changes in China’s industrial policies.

In 1994, China released a policy document about the country’s industrial policies for the 1990s, proposing that industrial policies should match the socialist market economy with Chinese characteristics and strengthen the role of the market in allocating resources. These industrial policies broke through the planned economy management model at that time, and gradually transformed planned management-oriented policy measures into policy tools such as investment approval, industry access, fiscal, taxation, and financial policy tools, which promoted the transformation of China’s economy from a planned economy to a market economy.

After joining the World Trade Organization (WTO) in 2001, the focus of China’s industrial policies shifted to the structural adjustment of industries. In 2005, the State Council introduced rules on promoting structural adjustment of the country’s industries, proposing categories of industries to be encouraged, restricted, and eliminated. In 2012, the State Council released a policy document on plans for the development of strategic emerging industries during the 12th Five-Year Plan period to support the development of industries such as the information technology, biotech, and high-end equipment manufacturing industries.

Industrial policy has played an important role in China’s economic development. In the past, China’s industrial policies mainly focused on direct intervention and promoted the development of industries through subsidies, tax incentives, and government procurement. In recent years, the emergence of equity investment has reduced the direct intervention of industrial policies, resulting in a gradual shift to indirect intervention. We analyze China’s industrial policy tools based on the country’s industrial policies for the new energy vehicle, solar, and semiconductor industries.

1) Subsidies: For the solar industry, the State Council released a policy document in August 2013 on promoting the healthy development of the industry and introduced on-grid solar electricity price policies for different regions and standards on subsidies for distributed solar photovoltaic systems. China implemented a policy to provide subsidies of Rmb0.42/kWh for the electricity generation of distributed solar photovoltaic systems.

2) Tax incentives: In 2012, China’s Ministry of Finance and the country’s State Taxation Administration released a policy document on the corporate income tax of companies in the software industry and the integrated circuit industry to further encourage the development of these two industries, and introduced various tax incentive policies (e.g., tax exemptions and halving of tax payments).

3) Government procurement: In 2013, China released a policy document on continuing to promote the use of new energy vehicles, stipulating that government agencies and public institutions should favor new energy vehicles when purchasing vehicles. For public transportation vehicles, government vehicles, logistics service vehicles, and sanitation vehicles, the proportion of new energy vehicles in newly-added vehicles or vehicles used to replace old ones should be at least 30%.¹⁷

4) Equity investment: In June 2014, the State Council released a policy document to promote the development of China’s integrated circuit industry, making the development of the industry a national strategy. In September, a national integrated circuit industry investment fund was established in China, raising funds of more than Rmb100bn for equity investment in companies in the integrated circuit industry chain.

Overall, these policies have produced positive effects and boosted the development of the new energy vehicle industry, the solar industry, and the semiconductor industry. (1) The new energy vehicle industry has become a strong industry in China. Based on statistics from the China Association of Automobile Manufacturers, the sales volume of new energy vehicles in China increased by more than 430 times in the past decade from 8,159 units in 2011 to 3.52 mn units in 2021. (2) The solar industry in China has gradually overtaken that in Europe as the world’s largest market for installed solar photovoltaic electricity-generation capacity. As of 2021, China’s cumulative installed solar photovoltaic electricity-generation capacity was 306,403 MW and accounted for 36.3% of the global total, while that of the EU and the US accounted for 18.7% and 11.1% of the global total. (3) Thanks to policy support and tax incentives, significant progress has also been made in China’s semiconductor industry. However, some problems have also emerged during the implementation of industrial policies. Taking the three aforementioned industries as examples, we can gain some experience and lessons from industrial policies for these industries:

1. Experience from success stories. (1) Industrial policies could expand economies of scale, reduce production costs, and enhance the competitiveness of industries through economies of scale. For example, the cost of solar electricity generation is high in its early stages of development and is uncompetitive compared to electricity generated by thermal power plants. Thanks to government subsidies, the cost of solar electricity generation has approached or even fallen below that of electricity generated by thermal power plants amid the expanding scale of solar electricity generation and cost reduction and efficiency improvement in various segments of the solar industry chain.

(2) Industrial policies could be used to increase competition, which has been reflected in the development of the new energy vehicle industry. First, industrial policies could be used to break regional monopolies. In 2013, China released a policy document on continuing to encourage the use of new energy vehicles, stipulating that the number of new energy vehicle brands from outside a given region should account for at least 30% of new energy vehicle brands whose vehicles are encouraged to be used in the region, and no obstacles shall be created to restrict purchases of vehicles of brands from outside the region. Second, industrial policies could be used to attract foreign automakers and make competition in the new energy vehicle industry more market-oriented. Third, industrial policies could be used to encourage the adoption of the contract manufacturing business model for new energy vehicles and lower barriers to entry for new energy vehicle production. Under the contract manufacturing business model, new energy vehicle producers such as NIO, XPeng, and Li Auto have emerged, increasing competition in the market.

(3) Industrial policy subsidies should be withdrawn at the appropriate time. In May 2018, China released a policy document on solar electricity generation in 2018 calling for accelerating the reduction of subsidies for solar electricity generation to achieve market-driven growth as early as possible. Lessons from the solar industry show that the competitiveness of China’s solar industry has been strengthened rather than weakened through market-oriented competition mechanisms after industrial policy subsidies were removed.

2. Lessons from inadequacies. (1) Overall, China’s industrial policies have been successful and promoted the progress of industries. However, some problems (e.g., excessive investment) also emerged during the implementation of industrial policies. It should be noted that having problems do not mean that industrial policies have failed, but that room for improvement remains. (2) Some industrial policies have exacerbated environmental pollution and widened the gap between the rich and poor, and industrial policies under the new mindset should focus on solving these problems. While promoting the development of manufacturing industries, some industrial policies did not pay enough attention to the problem of environmental pollution, resulting in environmental damage. However, this problem has been addressed in recent years. In terms of the income gap, the simultaneous expansion of the real estate and financial service industries may widen the gap between the rich and poor.

To cope with these problems, we think two points merit attention. First, the implementation of industrial policies could be refined. The effect of industrial policy implementation is positively correlated with the government’s capabilities in governance. Improving the government’s ability to formulate, implement, and supervise policies could help to reduce failures. Second, industrial policies should focus on economic issues as well as social issues. Industrial policies in the past paid little attention to social issues (e.g., environmental pollution and the gap between the rich and poor), which should be one of the differences between industrial policies in the era of profound changes and traditional industrial policies, and is a topic of our discussion below.

7.4.2 Industrial Policy Should Play a Role in Multiple Aspects in an Era of Profound Changes

In an era of profound changes in the world, China’s industrial policy should play its role in multiple aspects and not only promote economic development but also actively participate in social governance, including facilitating the green transition, narrowing the gap between the rich and poor, and improving supply chain security. China’s industrial policies have stepped up efforts to cope with these issues, but still have much room for improvement.

1. Facilitating the green transition. (1) Raising carbon prices to internalize external costs; promoting technological innovation in energy conservation and emissions reduction. A large number of studies have found that a clearer carbon price signal could play a stronger role in driving innovations in low-carbon technologies and improving companies’ willingness to develop and adopt low-carbon technologies. China’s carbon market has been in operation since July 2021, and the cumulative number of companies participating in carbon trading has exceeded more than half of the total number of major carbon emitters in the country up to July 2022.¹⁸

(2) Accelerating innovation; fundamentally changing production methods. Developing new emissions reduction technologies and carbon capture technologies could reduce carbon emissions per unit of energy, and using clean energy could reduce energy consumption per unit of GDP. To achieve the goal of carbon neutrality, efforts must also be made to improve social governance. Efforts should be made to formulate corporate governance standards suitable for a low-carbon society, build an environmentally friendly financial system, improve carbon tax and carbon market systems, encourage low-carbon lifestyle habits, and advocate new consumption concepts. In the process of achieving the goal of carbon neutrality, attention must also be paid to the issue of fairness, and it is necessary to consider using fiscal measures to distribute the cost of carbon neutrality as fairly as possible, such as reducing the use of carbon taxes, increasing tax rebates, or using the collected carbon taxes to subsidize low-income earners.

2. Making use of digital technologies. In Chapter 5, we note that emerging technologies and new ways of organizing production and trade (e.g., digital platforms) are driving changes in factors of production, and service trade is likely to become a new growth driver. Industrial policies should focus not only on manufacturing but also on service industries. In the aforementioned chapter, we also note that attention should be paid to digital and data security, and building digital markets and a digital economy system.

3. Narrowing the gap between the rich and poor. The excessive expansion of the financial and real estate industries is an important reason behind the growing gap between the rich and poor, and the policy of “housing is for living in, not for speculation” has played a positive role in narrowing the gap in recent years. Meanwhile, the government has made other efforts to narrow the gap between the rich and poor:

(1) Introducing inclusive finance policies to encourage financial institutions to benefit the real economy. At end-July 2022, outstanding agriculture-related loans of domestic financial institutions stood at Rmb47.2trn, an increase of 1.6 times since 2017. As of end-July 2022, domestic financial institutions’ inclusive loans to small and micro enterprises have maintained a growth rate of more than 20% for 39 consecutive months.

(2) Alleviating poverty through development of industries. Since 2017, China’s new modern agricultural industrial park projects have covered 58 poverty-stricken counties, the country’s advantageous and characteristic industrial cluster projects have covered 261 poverty-stricken counties, and its projects aiming to build towns with strong agricultural industries have covered 400 towns in 370 poverty-stricken counties.

However, we think it is necessary to further improve rules for financial markets and build a dual-pillar financial system. The efforts to build the so-called dual-pillar financial system are mainly efforts to build a financial system in which a guaranteed banking system and unguaranteed capital markets develop in parallel based on the premise that industries and finance should be separated and operate separately. In particular, the main mission of capital markets should be to offer equal opportunities and support innovation and development. The banking system needs to weaken its unreasonable competitive advantage from market-driven profits and government guarantees through a “non-profit-maximizing transformation”, and vigorously promote the development of inclusive finance. It is also necessary to advance supply-side reforms for the real estate industry to narrow income disparities caused by housing. Efforts should be made to focus on the housing needs of new city dwellers and young people, and actively increase the supply of land for rental housing. Meanwhile, legislation should be accelerated to ensure that tenants and homebuyers have equal rights to basic public services, and to protect tenants in terms of rent increases and the setting of lease terms.

4. Improving economies of scale. In Chapter 3 New advantages in economies of scale amid deglobalization, we note that more attention needs to be paid to the role of economies of scale in promoting economic growth, and China has the potential to make the most of its advantage in economies of scale as a large country. On the demand side, industrial policies could narrow the gap between the rich and poor and improve equal access to public services. For industries, industrial policies could help to facilitate the circulation of goods and factors of production, build a unified domestic market, promote cooperation and development among industry chains, and eliminate monopolies. In terms of trade, strengthening international cooperation could play an important role in China’s economic development and economies of scale.

5. Improving supply chain security. (1) Industrial policies could proactively improve information asymmetry between manufacturing and service industries. Traditional industrial policies mainly focus on individual industries, but industrial policies in an era of profound changes in the world should optimize the structure and coordination of production among various industries in the upstream and downstream segments of industry chains. In recent years, some local governments have begun to implement a “industry chain chief” system (appointing officials as chiefs of industry chains) and use industrial policies to facilitate connections between the upstream and downstream segments of supply chains. (2) Industrial policies could help to establish security measures for key agricultural products, which is of special significance to China and is part of supply chain security. China’s grain reserves have long been above 70% of its annual consumption. The country’s arable land area remained at 1.92bn mu (1,280bn sqm) in 2021 and its grain sown area was 1.76bn mu (1,173bn sqm). China’s grain self-sufficiency rate has remained above 95%. (3) Industrial policies could be used to ensure China’s energy security. Energy security issues have become increasingly prominent amid the green transition and geopolitical changes. At present, China still relies on fossil energy. In 2020, fossil energy sources accounted for 84.1% of the total energy consumption in China and non-fossil energy sources accounted for 15.9%. Meanwhile, China also relies heavily on imports of some energy sources, and the degree of the country’s dependence on crude oil imports (net imports of crude oil divided by total domestic crude oil consumption) was higher than 70% in 2021. Therefore, industrial policies need to promote low-carbon transformation on the one hand and improve China’s independent energy supply on the other.

7.4.3 Promoting Innovation Remains Crucial

In the past, China was mainly an economy catching up with other economies, but it is now beginning to take a leading position in some areas. The history of development of the US and Japan shows that the focus of industrial policies should be shifted from protecting infant industries and promoting exports in the stage of catching up with other economies to improving innovation in the stage of becoming leading economies. For China, innovation policies are particularly important. We think technological innovation could play an indispensable role in maintaining industry chain security and energy security, advancing the green transition, and narrowing the gap between the rich and poor. We believe efficiency improvement and economic development is the best way to fundamentally solve the current problems the world faces.

Since the 18th National Congress of the Communist Party of China, China has shifted the focus of industrial policies to technological innovation, including technological innovations in information technology, semiconductors, high-end equipment, alternative energy, and pharmaceuticals. In 2022, the 20th National Congress of the Communist Party of China proposed that China should achieve high-level technological independence and become a leading innovative country by 2035. Meanwhile, China should promote high-quality development, accelerate the establishment of a modern economic system, strive to improve total factor productivity, and improve the resilience and security of industry and supply chains. In The Rise of China’s Innovation Economy, we discussed how to improve China’s innovation capabilities from three perspectives: Supply (R&D investment and human resources), demand (domestic and overseas demand), and ecosystem (regional and national innovation systems). Here, we discuss how to promote innovation from the perspective of industrial policies.

7.4.3.1 The Government Should Actively Participate in Innovation and Improve Income Distribution Mechanisms

Innovation has characteristics of positive externalities and considerable uncertainties, and thus requires government intervention to let industrial policy play its role. As innovation requires a large amount of government investment, the government should also enjoy the benefits of innovation. The system of income distribution in the market needs to be improved to increase fairness for the distribution of income from innovation. How should the government be rewarded for its investment in innovation? We think letting the government hold a stake in innovation projects could be a direction to consider. Government-guided funding is a good practice, but some problems remain at present.

7.4.3.2 R&D Policies Could Be More Effective in Promoting Innovation Than Direct Subsidies

Different industrial policies could play different roles in promoting innovation. Innovation activities are characterized by high risks and high returns, and it is difficult to predict which technology and which enterprise will succeed in innovation. Therefore, direct subsidies could face serious risks of information asymmetry, making it difficult to select potential “winners” in innovation. Compared with industrial policies that directly intervene (e.g., trade protection policies and subsidies for specific companies), R&D policies have a lower degree of direct intervention. Experience from the US over the past five decades shows that R&D policies appear to be more useful in promoting innovation, while trade protection policies and subsidies for specific companies result in mediocre outcomes.¹⁹

In areas where it has a leading position, China should strengthen supportive policies for R&D to promote innovation. From the perspective of economic development, the US and Japan gradually shifted the focus of their industrial policies from industrialization to innovation. China now has a complete industrial system, and the value added of the secondary sector as a percentage of GDP has fallen from 47% in 2010 to 39% in 2021. The US experience shows that government support and tax incentives for R&D have an advantage in supporting the innovation of small enterprises and breakthrough innovation, while Japan has shown that bank credit has an advantage in supporting the innovation of large enterprises and incremental innovation. The advantage of government investment funds may lie somewhere between them. China needs both incremental innovation and breakthrough innovation. Therefore, we think the country should balance the allocation of resources for various policy tools and increase the proportion of tax incentives to support R&D. Data from the Center for Strategic and International Studies indicates that the proportion of R&D policies (including R&D tax incentives and government support for R&D) in industrial policies remains relatively low in China compared with that in the US, while the proportion of direct subsidies and credit incentives is relatively high in China.²⁰ We believe there is still inconsistency between the structure of spending for China’s industrial policies and the country’s efforts to innovate and transform. In the future, to promote innovation, we think China should increase the proportion of R&D policies in the country’s industrial policies.

7.4.3.3 Efforts Should Be Made to Improve Market-Oriented Operation of Government-Guided Funds

Although industrial policy in the era of profound changes requires the government to play a greater role, this does not mean that innovation should be funded solely by the government. The government is only one contributor of funds for innovation, and the private sector should also play an important part.²¹ Through cooperation between the government and enterprises, government-guided funds could help the government better identify truly efficient enterprises, which not only avoids the problem of information asymmetry, but also improves the efficiency of industrial policies. Compared with direct subsidies for enterprises, cooperation between the government and enterprises is a more effective form of industrial policy.²² China’s government-guided funds have grown rapidly in the past decade. By late 2021, China had established 1,988 government-guided funds with a target size of about Rmb12.45trn and about Rmb6.16trn of funds already in place.

However, some problems remain in the operation of government-guided funds in China, and there is room for further improvement. (1) The problem of objectives. Government-guided funds are sometimes involved in addressing the investment needs of local governments, and they may have to invest in some inefficient companies, which is not in line with the direction of technological innovation. (2) The problem of management. Some managers of government-guided funds are not selected on a market-oriented basis, and they may lack experience in the market-oriented operation of government-guided funds. (3) The problem of investment. Government-guided funds have relatively strict rules on regions where they invest, and they often impose restrictions to direct investments in local enterprises, which could result in a tendency towards local economic preferences and lead to repeated competition among local enterprises. (4) The problem of performance evaluation. As it is difficult for government-guided funds to tolerate large losses, managers do not dare to invest funds in seed-stage or innovative start-up companies and entrepreneurs. Many government-guided funds invest in late-stage innovation projects (e.g., projects in the mature stage) or directly purchase wealth management products. Some funds are not sufficiently used, failing to meet the policy goals of promoting innovation and guiding structural upgrades of industries. Therefore, we think the efficiency of government-guided funds can be improved through methods of market-oriented operation, such as focusing the goal of government-guided funds on promoting innovation, selecting suitable fund managers on a market-oriented basis and reducing intervention as appropriate, relaxing restrictions on investments of government-guided funds and reducing local protectionism, and improving government-guided funds’ tolerance of investment losses to enable investments in early-stage high-risk innovative companies.

7.4.3.4 Efforts Should Be Made to Avoid Improving Security at the Cost of Hurting Efficiency

Economies of scale should be an advantage of large countries in the context of deglobalization. Large-scale markets could help to spread the substantial R&D costs. Meanwhile, technology will continue to advance as the scale of production of products expands. However, we should be wary of exploiting economies of scale at the cost of exacerbating monopolies, thus impairing competition, hurting innovation, and lowering efficiency. Although monopolies could be conducive to innovation in the early stage, economies of scale would be substantially reduced over the long term in a monopolistic market rather than a competitive market. The behavior of enterprises is affected by the structure of market. A prolonged monopoly could weaken enterprises’ motivation to pursue technological advances, and may even prompt them to maintain their monopolistic positions through rent-seeking. Balancing the relationship between competition and improving and strengthening industries is a challenge.

In the process of upgrading industries, China needs to rely on strong external competitors to motivate Chinese enterprises to some extent. Losing access to external markets or reducing imports of foreign products may weaken the competition faced by Chinese enterprises. Under the premise of opening-up, protective industrial policies are still necessary for some industries. However, historical experience shows that a certain degree of protection for industries could be conducive to the development of infant industries in their early stage, but foreign competition will become more important after such industries grow strong enough. China should not only support domestic companies to go global, but also strive to attract foreign companies to China. In the global value chain system, supporting domestic companies to go global could improve their innovation capabilities through competition. In terms of attracting foreign companies to China, we think it is necessary to expand market access to attract more foreign direct investment (FDI). According to AmCham China’s China Business Climate Survey Report (2022), 69% of surveyed companies reported unfair treatment with regard to market access. If China expands market access, 61% of surveyed companies would consider increasing investment in China, especially in the technology and consumer sectors. In a survey conducted in 2022, 22% of surveyed manufacturing companies plan to adopt a “China-plus-one” strategy and relocate some factories and suppliers to other Asian countries. Amid global geopolitical and industrial competition, China should adopt corresponding fiscal support measures such as subsidies, government purchases, and tax cuts to slow the transfer of FDI and maintain domestic competitiveness.