Unintended Distortion of Regulating Water Use : Evidence from China

The Chinese government has been using the water efficiency target to manage commercial, institutional, and industrial water use across the country. This paper argues that the water efficiency target may unintentionally influence provincial administrators’ preferences in tightening water regulation in productive cities to satisfy the targets enforced by the central government. I develop a city-level production model with water regulation preference correlated with a city’s economic output and show that the unintended distortion of water regulation in response to the efficiency target leads to efficiency loss of resource allocation, thereby lowering regional output and productivity, especially for productive cities. Using a sample of city-level water data in China during 2006-2016, this paper empirically investigates the impact of the water efficiency target in China, the Three Red Lines policy, on provincial administrators’ preferences in water use regulation. The results indicate that the elasticity of water regulation in response to the policy is approximately -0.05, suggesting that the enforcement of the efficiency target resulted in a tightening water regulation on cities with higher economic output. Quantitatively, eliminating water distortions would slightly decrease the dispersion of the marginal revenue product of water across cities, reshape the water use across cities, and increase the aggregate output of productive cities by up to 7%. The results imply that possible consequences of the political consideration of provincial administrators in satisfying the water efficiency target cause inefficiency and inequality of water allocation