The Social Cost of Fiscal Federalism and the Depletion of China's Native Forests

China's key forested region is located in the northeast and consists of state forest enterprises which manage forest harvesting and reforestation. Deforestation is a major problem there and has resulted in several central government reforms. We develop a framework for assessing the social cost of state forest enterprise deforestation. We first develop a two-principal, one-agent model that fits the federalistic organization of state forests, in that state forest managers make (potentially hidden) decisions under influence of provincial and central government policies. This model is used to derive an expression of the social cost of these hidden actions. We then use panel data from a survey conducted by Peking University to compute social welfare losses and to formally identify the main factors in these costs. A sensitivity analysis shows that, interestingly, command and control through lower harvesting limits and a more accurate monitoring system are more important to lowering social welfare losses than conventional incentives targeting wages of forest managers. Through regression analysis we also find that the more remote areas with a higher percentage of mature natural forests are the ones that will always have the highest social welfare losses