The empirical effects of performance contracts: evidence from China

Performance contracts are widely used to reform state-owned enterprises. By June 1994, there were 565 such contracts in 32 developing countries, used prinicipally to reform large utilities and other monopolies, and roughly another 103,000 in China, where they are also used to reform state manufacturing enterprises. A performance contract is a written agreement between the manager of a state enterprise (who promises to achieve specific targets in a certain time frame) and government (which--usually--promises to award achievement with a bonus or other incentive). Performance contracts are a variant of the pay-for-performance or incentive contracts often used to motivate managers in the private sector. In the public sector, they are viewed as a device to reveal information and motivate managers to exert effort. The authors analyze China's experience with performance contracts in more than 400 state enterprises. China is a good place for such a study because no country has ever used them on such a scale or with such a variety of enterprises (mostly in the competitive sector). China also uses many different kinds of contracts, with different targets (more profit-, tax-, or output-oriented). The authors find that performance contracts: a) on average, do not improve productivity in China's state enterprises and may even reduce it; b) are ineffective in competitive firms as well as monopolies; c) do more harm when they provide only weak incentives and when they do not reduce information asymmetry. They find no connection between variables for commitment and the effects of performance contracts. Design matters. When performance contracts contain all the"good"features--profit orientation,higher wage elasticity, and lower markup ratios--the firm's productivity growth rate could increase as much as 10 percent. The Chinese government was serious about implementing performance contracts, and used measures considerably more radical than other countries used, hailing the contract system as the official national mode for reforming state enterprises. But most of the contracts have had little or no effect on growth rates and the observed frequency of contracts with"good"provisions is exceedingly low. Perhaps the political economy of incentive contracts in government settings merits further study. Political considerations may preclude the design of incentive contracts for government actors could produce the sort of productivity gains some private firms have achieved. One observer (Byrd 1991) points out that the central government gave local governments a good deal of discretion in implementing performance contracts and local governments had a tendency to adopt the lowest common denominator, a"bare-bones"performance contract.