"The Economic Development of Taiwan: A Survey of Approaches and the Economic-Institutional Framework"

Written by P.O. Lee

polee@rocketmail.com

November 1992

Draft Only. Please Do Not Quote Without Permission.

Summary

This study approaches the study of economic development by adopting an economic-institutional framework. This framework incorporates both the institutional setting and the economics of development as its explanatory variables.

In terms of the institutional approach, this study looks at the structure of institutions existing within Taiwan and the way in which these institutions give rise to incentives that motivate rational economic behaviour which accelerates economic growth. In this connection, the important point to note is that the proper definition and enforcement of property rights and one which encourages improved productivity and residual rights would enhance economic growth.

For the economic part, this study examines the concept of "transactions efficiency" as developed in Yang (1991). In using the concept of transaction efficiency, this study also examines the extent to which transactions efficiency can be regarded as the generator of economic development. How does transactions efficiency lead to specialisation and in this regard promote economic growth?

This study argues that the Economic-Institutional Approach is an important approach as it identifies the root cause of economic development to be reliant on both the institutions prevailing, and as well as the economic forces existing in a country. It is argued that the one aspect alone cannot serve as an adequate explanatory variable for economic development: they are intertwined and are equally important for explaining the economic development of Taiwan.

Keywords:

Property Rights

Residuals

Role of the State

Transactions Efficiency

Economies of Specialisation

Market Economy/Capitalism

OUTLINE

Introduction

Economic Development of Taiwan

Literature Review and Theoretical Framework

The Institutional Economic Framework in Explaining Economic Development: Usefulness and Shortcomings.

Conclusion

What is my focus?

What do I want to explain?

What are my variables?

Introduction

The economic development of the Republic of China (Taiwan) has attracted much of attention from both academics and policy makers alike. From 1953 to 1991, the real GDP of Taiwan has averaged around 8.7 per cent.¹ What are the factors which have brought about the impressive rates of growth since the 1950s? What was the root cause of economic development in Taiwan? Is one factor alone responsible or are there a number of causal factors? This study attempts to address the above questions.

There are many factors which generate economic growth. Sometimes, it is difficult to isolate a single factor and use it as an explanatory variable for economic development. But it is important that the root cause of economic development be identified. The focus of this study is not so much on developing a model but rather on exploring the many approaches available and selecting an approach considered to be relevant for explaining economic development. This paper argues that any model used should identify the root cause of economic development; many of the approaches tend to use either too many variables to be useful as a representative model or, being too descriptive, they do not identify the root cause of development at all.

The outline of this paper is as follows. Section 1 presents a survey of studies on the economic development of Taiwan. To what extent do these approaches shed light on the economic development of Taiwan? Do they identify the root cause of economic development in Taiwan? What is the most suitable approach towards the study of economic development in Taiwan? What is the most important aspect? A brief description of the proposed framework adopted in this paper, that is, the economic-institutional approach, comes at the end of Section 1. An economic history of the development of Taiwan then follows in Section 2. In this connection, the physical setting as well as some general statistical data of Taiwan will be presented. This will serve to highlight the structural changes which have been occurring and as well as the challenges which have been faced by the Nationalists from the 1950s to the present times. The section then concentrates on applying the economic-institutional framework to Taiwan. Thereafter a conclusion will be provided in Section 3.

SECTION 1: Literature Review, Transaction Efficiency and the Economic-Institutional Approach

Approaches to the Economic Development of Taiwan: Introduction

Many approaches have been highlighted for studying the economic development of Taiwan. Some studies stress the importance of a multiple of factors approach (multi-factor approach) in influencing the developmental pattern of Taiwan (Galenson, 1982; Kawano, 1967; Kuo, 1988a; Kuznets, 1988; Liang and Liang, 1988a, 1988b; Myint, 1982; Shei, 1988), some highlight a single factor being of primary importance (Bishai; 1991; Chou, 1992; Hou, 1988; Hsu, 1981; Woo, 1991), some a political economy approach which, in some instances, also emphasise the important role played by the state (Alam, 1989; Clark, 1987; Davis and Ward, 1990; Ho, 1987; Park, 1990).

- Multi-Factor Approach

Multi-factor qualitative models have been the most common approaches towards the study of economic development in Taiwan. The common inter-related aspects identified to be important are equitable land distribution, US aid, capital investment, export-led industrialisation, efficient bureaucratic management, efficient labour utilisation, a free market economy where the private sector played a dominant role in economic development, and economic liberalisation (trade and financial)². Galenson (1982), for example, identified capital accumulation, foreign investment (aid from the United States), the role of the agricultural sector in supplying capital for industrialisation, foreign trade, efficient fiscal and monetary management, and human resource development to be important factors in Taiwan's development.³ Kuznets (1988) identified five factors: high investment ratios, small public sectors, export orientation, labour market competition, and government intervention in economic factors.⁴ In that paper, Kuznets also incidentally highlighted the important attributes which an economic model should have in explaining economic development. According to Kuznets, a model should "set forth the major economic relationships or the proximate reasons for rapid growth. Critics can then determine whether hypothesized relations prevail or even if such relations do not establish ultimate causes."⁵ Liang and Liang (1988a) stressed that a flexible, open, and pro-active government policy played a very important role in the economic development of Taiwan. In addition, they also noted the following exogenous factors to have played an important role: well-educated hardworking labour force; colonial rule from Japan; the Confucian tradition emphasising education, frugality and kinship ties; export led industrialisation; and pressure from the United States to open the Taiwan market.⁶ Some models have identified two interactive elements. For example, Myint (1982) identified Taiwan's success to lie in a comparative advantage situation where there was a labour surplus, and also the institutional setting which favoured the use of labour intensive techniques in both agriculture and industry.⁷ These factors, according to Myint, promoted economic development in Taiwan. Shei (1988), on the other hand, emphasised the important role played by the agricultural sector in providing the resources for industrialisation and the concurrent institutional setting which allowed for this transfer of resources.

- Single Factor Approach

For the single factor models, Bishai (1991) has identified the legal framework of Taiwan's land policies as the important element for economic development.⁸ The legal framework for economic development has been succinctly summed up by Bishai as such:

This unique instrument of state intervention, while perhaps less readily visible than measures such as price subsidies, tax breaks, and state ownership of key industries, has surely played a role in Taiwan's smooth and rapid transition to a remarkably prosperous industrial economy.⁹

Chou (1992) identified US pressure as a major determinant of the early trade liberalisation measures adopted by Taiwan which in turn promoted efficiency and competitiveness. Chou argued that this external relationship with the US was a major determinant of "tension and economic leverage, and an instrument that [lessened] a society's ability to govern its own affairs".¹⁰ In short, US pressure to an extent influenced Taiwan's pattern of economic development. Hsu (1981) explained Taiwan's economic development via export promotion strategy. Export promotion had improved allocative efficiency which in turn promoted higher rates of economic growth by encouraging a higher rate of capital formation, technical progress and "learning effects" from foreign technology. Woo (1991) stressed that education has been instrumental in generating a successful economic development in Taiwan. Three features were identified: basic educational infrastructure, migration of a highly educated labour force from mainland China, and an educational system which adapted to the changing requirements of the economy. Citing growth accounting models used by various authors, Woo concluded that there has been a positive and strong correlation between education and economic growth.¹¹

- Political Economy Approach

A political-economy approach also adds light to the ever complex problem of economic development. Clark (1987), for example, posed five elements for a political-economy model of Taiwan: social structure and distribution of wealth and resources, the structure and performance of the economy, the role of the state in directing society and the economy, the nature of the political and economic elites, and finally the external economic and political relations.¹² In the paper, Clark also sketched the interactive causal relationship between the five elements. In their political-economy model, Davis and Ward (1990) studied, in a quantitative manner, the contribution of state entrepreneurship in facilitating and promoting economic growth. Alam (1989) regarded the role of the state as that being of a "critical variable in the management of economic policies".¹³ According to Alam, the state subordinated political objectives to economic objectives. This took the form of the state sustaining market determined wages, maintaining effective economic bureaucracies, lowering public consumption expenditures, shortening completion time for public projects, reducing official corruption, increasing the efficiency of public enterprises, provision of marketing, managerial and technical services.¹⁴ Park (1990), on the other hand, discussed "government failure"¹⁵ in affecting the economic development of Taiwan and Korea. Ho (1987) attributed the economic success of Taiwan to many factors but highlighted the importance of Taiwan's economic bureaucracy in the land reform, and the financial and trade liberalisation which were important factors for promoting economic growth.

Summary of Approaches

The above approaches have to some extent highlighted very important aspects in the economic development of Taiwan. Most have tended to be macroeconomic in their approach and some institutional in their focus. In analysing the development of Taiwan, some of the approaches have tended to be rather descriptive. But has the root cause of economic development been identified? What basic factor is the most important aspect for explaining economic development? This paper, in turn, will argue that the concept of "transactions efficiency" developed and discussed in Yang (1991) is relevant for identifying the root cause of economic development on a policy level¹⁶ and will be applied to examine the pattern of economic development in Taiwan. This interrelationship will be explored in a qualitative manner. As such, the following question are useful: How is the concept of transaction efficiency operationalised to explain the economic development of a country? In other words, how can the concept of transaction efficiency be used to explain the transformation of Taiwan or any other country for that matter? To what extent is the concept of transaction efficiency applicable to the case of Taiwan? Do alternative approaches presented by other authors pose a challenge to the concept of transaction efficiency in the Yang model?

This study will also argue that although economic development does hinge on the "transaction efficiency" existing in a country, it is also important to examine the country's underlying institutional set-up which defines clear property rights from which individuals can operate from. In this connection, the role of government in allowing competitive market forces to operate is also deemed important. However, it must be noted that it is not the government but the institutional framework and the competitive economic forces operating that generates economic development. The government merely provides a conducive environment via a favourable institutional framework and political stability for economic development. In summary, the conceptual framework adopted to explain economic development is interactive: that is, economic forces interact with the institutions and vice versa in influencing economic development. Hence, an economic-institutional approach. The following two sections will elaborate on this.

Transaction Efficiency and the Yang Model

The Yang Model, a microeconomic equilibrium model, formalised the theory of production proposed by Adam Smith and Allyn Young. The model represented a departure from conventional neo-classical microeconomics in that it assumed that producers and consumers are non-separate entities. Instead, it assumed that there is neither a pure producer nor a pure consumer.¹⁷ Basically the assumptions of the Yang model are as follows:

1. Each individual is a producer/consumer. The division of labour is a result of an increase in the proportion of an individual's production that is not consumed by that individual and an increase in the proportion of the consumption that is not produced by that individual. Productivity depends on the level of specialisation and the aggregate transformation curve depends on the level of the division of labour. Contrary to conventional microeconomics where pure consumers cannot decide on their level of specialisation as they must buy all the goods from the firm, the individual in this model can decide how many goods would be self provided and his/her level of specialisation. Therefore the level of specialisation is an endogenous factor.

2. A Cobb-Douglas utility function is specified for each producer-consumer. Therefore, each individual as a consumer prefers diverse consumption and each producer prefers specialisation. There is a trade-off here as the division of labour entailed in specialisation will incur higher transaction costs (a trade-off between economies of specialisation and transaction costs). An increase in productivity entails specialisation and the division of labour but this requires a high level of transactions efficiency or low transaction costs. Hence, according to Yang, a "natural conjecture is that a competitive equilibrium will balance the trade-off between the economies of specialization and transaction costs, and that improvements of transaction efficiency will move the equilibrium closer to the PPF (production possibility frontier), resulting in an increase in the division of labor."¹⁸ This, Yang proves through a mathematical approach using a model with three goods.¹⁹

In essence, the Yang Model states that productivity is related to the level of division of labour and this in turn depended on the transaction efficiency existing in the economy; the root cause of productivity boiling down to the fact that transaction efficiency plays a very important role in economic growth. A high transaction efficiency allows for a high level of the division of labour. This high level of division of labour also allows for a high level of productivity. A high level of transaction efficiency implies a low level of transaction costs. Also, Yang stated that transaction efficiency is affected by the institutional arrangement, urbanisation and government policies.

Institutions and Property Rights

Rabushka (1987) highlighted the importance of property rights in the following manner:

The key rules include the definition and enforcement of property rights, which encourage improved productivity and the expectation that individuals will be able to reap the rewards of their own work or investments.²⁰

In terms of property rights, the work by Alchian and Demsetz (1972) is also important. They discussed the idea of metering input productivity and metering rewards: an incentive system that rewards individuals in a fair manner. According to Alchian and Demsetz:

If the economic organization meters poorly, with rewards and productivity only loosely correlated, then productivity will be smaller; but if the economic organization meters well productivity will be greater.²¹

How can an organisation or country meter correctly? This is found in the concept of the "monitor" developed by Alchian and Demsetz. With the existence of the monitor, each economic agent will be rewarded according to their input or efforts and the monitor, in turn, will be rewarded by his/her claim to the residual²². The residual in effect serves as a check-and-balance system on the efficiency of the monitor. The helps to engender a system of property rights which would provide incentives for individuals to work hard and thus benefit the economic development of a country.

Not only are property rights important, but also the institutions (legal framework) which exist within a country. This was highlighted in the above work by Bishai (1991).

The Economic-Institutional Framework

The economic-institutional framework, as its name implies, considers two aspects which are important for explaining the economic development of a country: the economics of development (transaction efficiency) and the institutions which allow for economic forces to operate efficiently and effectively. It should be noted that one aspect cannot operate without the other. Efficiency can only be fully achieved when the institutional framework is conducive to productivity, that is, private property rights are well defined. Productivity, in turn, depends on the level of transaction efficiency.

A low level of transaction costs (a high level of transaction efficiency) could result in the following observations:

1. A low level of transaction cost (low tariffs/barriers) together with market forces will provide a conducive atmosphere for options to be explored in the economy; for example in the development of the export market (export oriented development). Also, witness the development of the export processing zone in Taiwan.

2. A low level of transaction costs (low taxes) also provides a conducive atmosphere for industries to be established which in turn would promote the industrialisation of a country. With industrialisation, also comes specialisation and further growth. On the side of the individual, a low level of taxes would provide the individual with a greater incentive for him/her to maximise his/her productivity would then be in proportion to the level of effort.

3. A low level of transaction costs (low transportation/communication costs) also implies that the level of infrastructure (communication and transport) is efficient. This in turn allows for strong trade and information linkages within and outside the economy and also cheaper costs in production and/or business links. Hence, the flow of goods/information would be enhanced creating a conducive environment for economic development.

4. There is a positive correlation between the free market, transaction efficiency, and economic growth. In economic and financial liberalisation, competitive forces are set free. This would mean that the most efficient level of all economic activities could be determined; in terms of trading, capital investments, production of goods, allocation of labour inputs etc.. By finding the most efficient level, transaction costs will be reduced and transaction efficiency enhanced. This would in turn also generate economic growth.

5. However, transaction efficiency can only be fully beneficial in an environment which provides the proper incentive framework. This is where the system of laws and private property rights play a conducive atmosphere in encouraging economic agents to fully exploit their potential to achieve allocative efficiency and X-efficiency²³. A stable legal system works hand in hand with high transaction efficiency to spur economic growth. The stable legal system lowers the uncertainty which would otherwise exist when economic agents are making decisions in regards to investment and other economic activities. Where private ownership does not exist, individuals in the economy would not be motivated to exploit their full potential. A study by Yang, Wang, and Wills (1990), although not on Taiwan, supported the hypothesis that where property rights are well specified and enforced, resulted in an increase in the division of labour and consequently productivity and output.

The free market allows for the most efficient level of economic activity to take place. In this connection, the free market helps to determine the highest level of transaction efficiency. Of course, transaction efficiency can only be maintained when the institutions provide the proper setting and institutions are often the outcome of market forces.

In summary, transaction efficiency with the proper institutional framework is hence the key to understanding the economic development of a country. It must be remembered that this study is qualitative and exploratory in nature. With this in mind, the following question can be asked. Did transaction efficiency and the institutional setting provide a conducive atmosphere for economic development?

SECTION 2: The Economic History and Development of Taiwan: 1950 - 1991

Introduction

The economic development of Taiwan has indeed been spectacular.²⁴ Rabushka (1987) provides a succinct but excellent account of the history and the physical characteristics of Taiwan. In brief, the geographical landscape of Taiwan consists of mountains: two thirds of its area is mountainous and only about a quarter of its land arable. Taiwan also has very few natural resources: inferior quality coal, marble, natural gas, limited amounts of gold, sulphur, copper and petroleum, and salt.²⁵ Ho (1987) also notes similar characteristics. For example, Ho notes that in the 1950s, Taiwan's output consisted predominantly of agricultural produce (over one third of total output). Also, its population density relative to cultivable land was one of the highest in the world.²⁶ All in all, Taiwan's chief strength initially lay in its agriculture with little natural resources.

Times have changed. The structure of the economy has evolved from that of a predominantly agricultural base to that of an industrial based economy. Recent macroeconomic indicators²⁷ show the following as at end 1991: real GDP for Taiwan was 7.3 percent and consumer price inflation at 3.6 percent. The largest share of GDP came from manufacturing (34.2 percent), followed by banking and insurance (19.3 percent) and then by whole sale and retail trade (15.6 percent).²⁸ The principal exports are manufactures and the principal imports are producer goods. Appendix 2 provides some information pertaining to the structure of the Taiwanese economy in 1991. Appendix 3 shows the increasing predominance of manufactures as a component of total exports and also the increasing share of manufactures and decreasing share of agriculture in Net Domestic Product (NDP).

The development of Taiwan can be divided into two phases.²⁹ The first phase began from 1949 - 1958. The central features during this period were a

comprehensive land reform programme,³⁰ control of inflation and the development of industries with import substitution in mind. This phase was also characterised by large amounts of US aid which was dispensed from 1949 to mid 1960s: totalling up to US$ 4.1 billion.³¹ The second phase was marked by commercial, industrial, investment and tax reforms that were implemented from 1958 to 1962 and augmented through to 1985. This phase also saw the transition of the Taiwanese economy from a closed economy to that of an open predominantly private free enterprise economy. Appendix 4 shows the extent to which private ownership dominates industrial production. As pointed out by Rabushka:

Beginning in 1958, government leaders in Taiwan switched their development strategy from an import-substitution policy for a limited domestic market to the development of labour-intensive, manufactures goods for export to the world market. International price competition replaced domestic subsidies and tariffs. Financial authorities reformed the exchange rate system to ensure correct valuation of the currency. They granted tax incentives to encourage foreign and domestic investment, including the establishment of special industrial estates or free-trade zones to expedite the production of goods for export. They also minimized costly labor regulations.³²

Yet as Ho notes:

Economic development depends ultimately on the ability and willingness of the local population to mobilize domestic resources for development and exploit economic opportunities, and this, in turn, depends very much on the domestic economic environment.³³

In this connection, what influenced this willingness? The view adopted by Ho was that Taiwan's economic success came from government policies of land reform, and economic and financial liberalisation. This was partly true. As noted earlier, it was not the government but the policies that were adopted that provided the impetus for economic development. However, more importantly, on an essential level, these policies had increased the transaction efficiency in the economy which in turn provided a conducive atmosphere for economic growth. The concept of transaction efficiency will now be examined in relation to the following aspects: tariffs, taxes, and the infrastructure. After that, the institutional setting will then be discussed.

- Tariffs, Transaction Efficiency and International Trade

Initially, Taiwan's tax and tariff system, designed for the mainland economy, imposed high transaction costs on imports and in general trading. It should be noted that this period (the 1950s) was one where import substitution was promoted in Taiwan. Commodities were taxed in excess of ten percent of their value, and imports were subjected to both commodity tax and high import duties. Also, the prices of imported goods were further increased by import quotas.³⁴ Furthermore, as the exchange rate was overvalued, exporters found it extremely difficult to export. Hence, the transaction efficiency was extremely low, there was a low level of division of labour, and a low level of specialisation. The atmosphere was not conducive for the growth of the export market as most of the raw materials and commodities imported for production was subject to high tariffs and taxes. However, two factors worked against import substitution and favoured export orientation. First, the

domestic market was already exhausted or over-saturated. Second, there was a need for foreign exchange inflow in the light of the US announcement that aid would be phased out in the 1960s.³⁵

Hence, price distortions caused by tariffs were reduced in the 1958-60 price reform; the aim of this reform was to promote exports.³⁶ Among the policies adopted were a tax rebate on exports, relaxation of import quotas, and simplification of the exchange rate system which allowed manufacturer to acquire raw materials and components at competitive world prices³⁷. However, the administrative costs imposed by the policies were high. The introduction of export processing zones were attempts to reduce these costs. The first zone was created in Kaohsiung in 1965 with no import duties imposed on imports;³⁸ this allowed for the development of a high level of transaction efficiency. Two other zones were later created in Nantze and Taichung. By 1970, these three zones provided seven percent of all manufacturing jobs and one tenth of all exports;³⁹ a manifestation of the benefits that a high level of transaction efficiency can provide for the economy. Export promotion was therefore one of the development strategies of the Taiwanese economy; this being aided by a high level of transaction efficiency. Export orientation in turn has promoted the allocative efficiency of Taiwan industries and reduced the distortions present in the economy (Hsu, 1981). This is also supported by Ho who stated that trade liberalisation (which in term of the Yang Model meant a reduction of tariffs and an increase in transaction efficiency) has provided for sustained industrial growth because it reduces the unit costs of production.⁴⁰ The effects of trade liberalisation and the attendant effects of transaction efficiency is best summed by Liang and Liang (although the concept of transaction efficiency was not discussed in their paper):

Trade liberalization will lower the cost of exports by reducing prices of imported machinery and raw materials, provide a spur for improvements in productivity, trigger accelerated adjustment among industries that compete with imports... .⁴¹

Tariffs are still present in the Taiwan economy and they cover a wide range of commodities even after considerable liberalisation in the 1980s. For example, the surcharge on imports still exist, although it has been reduced from 20 percent to 5 percent; and the maximum tariff reduced from 100 percent to 57.5 percent. The government had also promised to cut the average rate of tariffs from 5.7 percent to 3.7 percent by 1992.⁴² Nevertheless, on the whole, it has been proven in a quantitative manner that export expansion has been the most important factor contributing to economic growth (Chou, 1985); this export expansion being due to an increase in transaction efficiency.

- Taxes and Transaction Efficiency

By 1958, the investment climate was very gloomy in Taiwan. To counteract this pessimism, one of the government's third four-year plan (1961-1964) was to reduce taxes and improve the investment climate. As noted earlier, a reduction in taxes would decrease transaction costs, improve the transaction efficiency in the economy, increase the division of labour and productivity -in short, provide a stimulus for economic growth.

The move to reduce taxes was contained in the Nineteen-Point Economic Financial Reform.⁴³ The key points of this reform in relation to taxation were as follows:⁴⁴

1. giving private businesses preferential treatment in the areas of taxes, foreign exchange and financing;

2. reforming the tax system and tax administration to enhance capital formation

These aims were solidified in the pursuant Statute for Encouragement for Investment. The main aim of this Statute was to encourage investments by facilitating the acquisition of plant sites, providing tax exemptions and tax deductions. These measures in effect lowered the transaction costs of investments, increased transaction efficiency and hence promoted economic development. The Statute took the following form:⁴⁵

1. Income tax holiday: A "five year tax holiday" was given to productive enterprises which conformed to the Statute's criteria. This meant that the approved enterprise would be exempted from income taxes for a period of five consecutive years.

2. Business income tax: the maximum rate of business tax was reduced from 32.5 percent to 18 percent.

3. Stamp tax: Stamp tax was abolished or reduced in many instances.

4. Losses caused by possible exchange rate revision could be covered up to 7 percent of pre tax profits.

5. Tax exemption for undistributed profits: the amount of profits reinvested for productive purposes were deductible from taxable income.

6. Taxable deduction of exports: A deduction from taxable income of 2 percent of annual export proceeds was allowed within certain constraints.

In the early 1960s, the response of industry was still slow. This resulted in the further expansion of the scope contained in the above Statute periodically⁴⁶ and also the establishment of the export processing zones. The expanded scope of the Statute included overseas investors being given the same incentives and privileges as Chinese nationals, including 100 percent equity ownership, remission of profits, repatriation of investment capital after two years and protection against nationalisation for a period of twenty years. Also, new investments in machinery and equipment were given a further four years of tax exemption or accelerated depreciation. In addition, capital-intensive or technology-intensive industries were allowed to defer the commencement of their tax holidays for up to four years. Also, specifically designated industries were exempted when they imported machinery and equipment; or on inputs not available domestically. Tax rates were limited to 22 percent for technology-intensive industries and 25 percent for the other enterprises designated as productive enterprises.

All these served to reduce transaction costs and increase transaction efficiency in Taiwan; thus improving the investment climate. As a result, the Taiwanese manufacturing enterprises

grew rapidly in terms of share in NDP and also as a percentage of exports as seen in Appendix 4. Manufacturing enterprises as a share in NDP increased from 16.83 percent in 1960 to 26.43 percent in 1970 and 40.74 per cent in 1985. For manufactures as a share of total exports a more significant change occurred: in 1960, manufactured exports as a percentage of total exports was only 28.2 percent. This increased dramatically to 76.7 percent in 1970 and 90.7 percent in 1985. Hence, the lowering of taxes increased investments in productive enterprises and expanded output. This had a positive impact on the production of manufactured goods which in turn oriented Taiwan's production towards manufactures.

It was noted that in the Yang Model that institutional arrangements cause changes in transaction efficiency which increases the division of labour which in turn increases productivity and specialisation in the economy. Indeed, the level of productivity has been very impressive in Taiwan. For 1952 to 1980, Ho estimated that labour productivity increased at an annual rate of 6 percent

per annum.⁴⁷ Appendix 5 provides a breakdown of labour productivity into various years.

A study by Chou (1985), revealed that there has been increasing specialisation in manufacturing.⁴⁸ Chou classified the manufacturing industry into four groups: (1) food, beverages, and tobacco; (2) nondurable consumer goods⁴⁹; (3) intermediate goods industries⁵⁰; and (4) metal and machinery⁵¹. Using a comparative approach with data collected from other countries by another author, and obtaining the concentration ratios of the various groups, Chou's research suggests that specialisation has been emerging from the export-oriented industries where the growth rate has been the greatest.⁵² It should be noted that the growth in the export oriented sector can be attributed to the high level of transaction efficiency present there. This supports the hypothesis that transaction efficiency has led to the growth of the export oriented sector which in turn led to increased specialisation in export-oriented manufacturing.

- Transportation and Transaction Costs

The transportation network in Taiwan has been dictated by geography and the

uneven distribution of the population.⁵³ The commitment towards a well functioning infrastructure dates back to the 1950s. Accordingly, the public sector during that time used quite a significant proportion of the US aid for the expansion of infrastructure, including electricity, transportation and communication.⁵⁴ As a result, Taiwan is well served in terms of air and water routes and well connected internally by an excellent road and rail network system. These networks would mean that linkages within and without the country would be strong and the efficient transportation network would not impose high transaction costs on the movement of goods and information which would in turn be conducive to trade and economic growth.

For railways, the total length was 4,500 km in 1990; and electrification was completed in 1979. However, the two main routes, the east and the west line are not connected and are not compatible because of the different gauges used. The government approved a project in 1983 to finish the South Link which would complete the railway link around the island. However, freight transport through railway has decreased because of the efficient road network. There were 19,479 km of roads in 1990, of which 85.9 percent were paved. International air services operate through two airports; the Kaohsiung Airport in the south and the Chiang Kai-shek International Airport, 40 km outside Taipei, which was opened in 1979. There are five major shipping ports inn Taiwan. Kaohsiung accounted for 63.4 percent of freight handling in 1990 and it is the world' tenth largest port and third largest container port. Plans

are underway to make Kaohsiung the largest container port in the world. Taiwan also has the third largest container fleet in the world. In the 1970s, Taiwan's telecommunications expanded at a rapid rate. The number of telephone subscribers have increased from a meager 24,609 in 1952 to 6.3 million in 1990.

- Transaction Efficiency and the Free Market System

Was the free market system allowed to work in Taiwan? On a cursory level, it would appear that the government played a very important role in influencing the developmental pattern of Taiwan. However, on a deeper examination, the government very much allowed free market forces to dominate. It only intervened to provide a stable legal and property rights system, to reduce transaction costs in the economy, to provide infrastructure, and also to provide for public works. Appendix 4 highlights this fact by revealing that the private sector took the major initiative in industrial production. From the 1970s, the private sector, on average, owned at least 70 percent of industrial production. In reducing transaction costs, the government was also in effect removing distortions and allowing competitive market forces to operate freely. The role of government was best summed by Rabushka:

Economic planning in Taiwan remained largely indicative, with the government setting major targets for output, investment, foreign trade, the balance of payments, social development, urban and regional development, infrastructure, public investment in several key heavy industries, and the overall structure of the economy. ... Apart from infrastructure and the major development projects, primary responsibility for wealth and job creation was left to the private sector. Setting broad objectives in Taiwan bore nor resemblance to mainland China's central planning regime, which tried to allocate inputs and outputs.⁵⁵

The government has, at times, tried to intervene in economic matters. Nevertheless, it is well known that if the intervention worked against market forces, it was bound to fail. Witness the import substitution strategy in the 1950s in Taiwan. Also, the recent flow of Taiwanese investment into mainland China (estimated at US$ 4 billion)⁵⁶ in spite of government prohibition of contact and which, in turn, has led to the government seriously reconsidering its approach towards these trade flows.⁵⁷ The reason: with prohibition of contact, trade flows was still occurring via Hong Kong or Korea and this being more expensive than if Taiwan had dealt directly with mainland China. Also, Taiwan by prohibiting contact is losing a source of cheap labour in mainland China which could be tapped. These two factors increase transaction costs and is not conducive to economic efficiency.

Hence, free market forces work competitively to determine the level of transaction efficiency and this in turn promoted economic development.

The Institutional Setting

The institutional framework plays a very important role in influencing transaction efficiency. Has the institutional and political environment in Taiwan provided a conducive atmosphere where transaction efficiency can be fully exploited? How do institutions interact with transaction efficiency?

The study by Bishai (1991) shows that Taiwan has had a very stable legal framework from which economic policies could operate efficiently. The establishment of Taiwan's industrial estates was based, in part, on the ability of Taiwan's land-use laws to promote industrialisation.

According to Bishai:

Taiwan's use of written laws as a framework for its land policy has given that policy a functional legitimacy and stability often absent in the public polices of other developing countries.⁵⁸

The three major written laws were as follows: the Land Law, the Constitution of the Republic of China, and the Statute for Encouragement of Investment. These laws provided a conducive and stable incentive structure to motivate economic agents in the economy to pursue industrialisation and economic development. Also, these laws gave the right of ownership of land and capital to individuals and put the economic system of Taiwan on the basis of private ownership. With private ownership rights existing, individuals would have strong incentives to motivate themselves to achieve their best potential. Also, with the "residuals" would accrue to the entrepreneurs. As stated by Kuo:

The economic system of Taiwan is based on private ownership. Particularly, the institutional environment after the late fifties was such that it allows entrepreneurs free to seek their own profits and workers free to seek their own wages. This free economic system founded an essential dynamic force which led the economy to rapidly grow.⁵⁹

The Statute for Encouragement of Investment improved the business climate in Taiwan by having a written code which specifically provided incentives for the setting up of enterprises - local or foreign - in Taiwan. This institutional framework set out to reduce transaction costs (tariffs and taxes) for enterprises and hence provided a positive inducement for industrialisation. It also limited the powers of the government in nationalising enterprises and set out clear guidelines from which enterprises could operate from. With such clear guidelines in a stable legal framework, transaction costs involved in settling disputes of ownership, rights of private ownership, residual rights, and claim to profits would be significantly lessened.

Labour regulations in Taiwan allowed for the operation of competitive market forces. The supply and demand for labour determined wage rates. Also, trade unions have very little impact on wage increases. The labour situation is well described by Rabushka:

Apart from a modest list of labour regulations - the government limited overtime work, stipulated rest days and annual holidays, banned night work for women and those under 16 years of age, required full leave pay for short-time military training, guaranteed eight weeks maternity leave with pay, and imposed mandatory insurance on all workers over 14 financed by a premium of 7 percent of workers' salaries - wage levels and fringe benefits were set in the market. Job placement were largely private, wages reflected prevailing rates in the area, merit dominated wage increases, and dismissals were extremely rare.⁶⁰

In short, free market forces were allowed to operate in the labour market and this would result in labour resources being efficiently allocated and the greatest amount of transaction efficiency being generated.

SECTION 3: Conclusion

Transaction costs or transaction efficiency plays a very important role in economic development. It was shown that a high level of transaction efficiency promoted the economic development of Taiwan. Sometimes, the effects were direct in that a reduction in tariffs directly reduced unit costs of production and gave a spur to production. In other instances, the removal of tariffs removed distortions in the market, allowed free market forces to operate and this in turn improved the allocational efficiency in the economy and promoted economic development. Also, transaction efficiency was important in allowing specialisation to evolve. However, transaction efficiency would not have been effective without the proper institutional setting which provided the right incentives to motivate productivity and growth. This study being qualitative in nature could be extended by quantitative studies to determine in a precise manner the various observations expressed above.

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Appendix 1

Gross National Product of Taiwan, 1952 - 1985

* The exchange rate was severely overvalued in the early 1950s.

Source: Cited in Rabushka (1987), p. 217.

Appendix 2

Macroeconomic Indicators
Year	'87	'88	'89	'90	'91
Real GDP Growth %	11.9	7.8	7.6	4.9	7.3
Consumer Price Inflation %	0.5	1.3	4.4	4.1	3.6
Population million (av)	19.7	19.9	20.1	20.2	20.4
Exports fob US$ bn	53.7	60.7	66.3	67.2	76.2
Imports cif US$ bn	35	49.7	52.2	54.7	62.9
Exchange Rate (av) NT$ per US$	31.85	28.59	26.4	26.89	26.8

Origins of GDP 1991	% of total	Components of GDP 1991	% of total
Agriculture, forestry and fishing	3.7	Private consumption	53.9
Mining	0.4	Public consumption	17.9
Manufacturing	34.2	Gross fixed investment	22.3
Utilities	2.8	Stockbuilding	0.6
Construction	4.9	Exports of gds and services	48.3
Transport, storage and communications	6.1	Imports of gds and services	-43
Wholesale and retail trade	15.6	Total	100
Banking and Insurance	19.3
Total incl others	100

Principal Exports 1991		Principal Imports 1991
	US $bn		US $bn
Textiles and Clothing	12	Machinery and Electrical Equipment	18.6
Electronic Products	8.2	Basic Metals	8.1
Information Technology	5.7	Chemicals	7.1
Plastic and Rubber Articles	5.2	Transport Equipment	4
Footwear	3.8	Crude Petroleum	3.2
Toys, Game, Etc.	3	Food and Beverage	2.6

Main Destinations of Exports 1991	% of total	Main Origins of Imports 1991	% of total
USA	29.3	Japan	30
Hong Kong	16.3	USA	22.5
Japan	12	Germany	4.8
Germany	5.1	Australia	3.2
Singapore	3.2	Hong Kong	3.1
Netherlands	2.9	South Korea	2.8
UK	2.7	Singapore	2.3
Canada	2.1	Malaysia	2.2
		Indonesia	2

Source: Taiwan: Country Report No. 3 1992, London: The Economist Intelligence Unit, 1992.

Appendix 3

Structural Change as Indicated by Percentage Shares in NDP, Exports as a Percentage of GNP, and Percentage Share of Manufactured Exports as Compared to Total Exports.

Percentage shares in NDP (current prices) at factor cost by industrial origin Primary Production Manufacturing Social Overhead Services	1952 38.01 10.84 8.90 42.25	1955 34.61 13.80 9.64 41.95	1960 35.10 16.83 9.86 38.21	1965 29.26 20.14 11.34 39.26	1970 19.41 26.43 12.68 41.48	1975 16.18 29.28 14.57 39.97	1980 10.26 34.23 15.82 39.69	1985 6.59 40.74 14.49 38.18
Exports as a Percentage of GNP	8.07	8.28	11.3	18.73	29.72	39.5	52.97	55.17
Manufactured Exports as a Percentage of Total Exports	-	7.6	28.2	42.6	76.7	81.3	88.2	90.7

Source: Cited in Liang and Liang, (1988a), pp. S94 and S95.

Appendix 4

Distribution of Industrial Production by Ownership in Taiwan (%): 1952 - 1985.

Source: Cited in Rabushka (1987), p. 219.

Appendix 5

Labour Productivity: 1952 - 1985

Period	1952 - 1955	1955 - 1960	1960 - 1965	1965 - 1970	1970 - 1975	1975 - 1980	1980 - 1985
Labour Productivity	11.51	6.26	9.89	10.37	2.73	8.25	3.5

Source: Cited in Liang and Liang, (1988a), p. S98.

¹ Taiwan: Country Profile 1992-93. London: The Economist Intelligence Unit, 1992, p. 10.

² For liberalisation measures, see Liang and Liang (1988a), pp. S81- S92; and also Chou (1992). Both papers highlight the important role played by the United States in pressurising trade liberalisation which in turn provided a competitive and efficient environment for Taiwan's development. In addition, Liang and Liang also discuss the broad financial and foreign exchange liberalisation which have been occurring in Taiwan.

³ Galenson, W., "How to Develop Successfully: the Taiwan Model", in Li, K. and T. Yu, eds., Experiences and Lessons of Economic Development in Taiwan. Taiwan: Academia Sinica, 1982, pp. 38-55.

⁴ Kuznets, P.W., "An East Asian Model of Economic Development: Japan, Taiwan, and South Korea", Economic Development and Cultural Change (Supplement) 36, No. 3 (1988), p. S17.

⁵ Kuznets, op. cit., p. S10.

⁶ Liang, K., and C.H. Liang, "Development Policy Formation and Future Policy Priorities in the Republic of China", Economic Development and Cultural Change (Supplement) 36, No. 3 (1988a), p. S92-S93.

⁷ Myint, H., "Comparative Analysis of Taiwan's Economic Development with Other Countries", in Li, K. and T. Yu, eds., Experiences and Lessons of Economic Development in Taiwan. Taiwan: Academia Sinica, 1982, p. 74.

⁸ Bishai, M.F., "The Development of Industrial Land in Taiwan: A Legal Framework for State Control", The Journal of Developing Areas 26, No. 1, (1991), p. 53.

⁹ Bishai, op. cit., p. 62.

¹⁰ Chou, Y., "Economic Dependence and Changes in Taiwan's Trade Policy, 1984-89", Issues and Studies 28, No. 1, (1992), p. 98. [brackets mine]

¹¹ Woo, J.H., "Education and Economic Growth in Taiwan: A Case of Successful Planning", World Development 19, No. 8 (1991), p. 1040-1041.

¹² Clark, C., "Economic Development in Taiwan: A Model of Political Economy", Journal of Asian and African Studies XXII, Nos. 1-2 (1987), p. 12.

¹³ Alam, M.S., Governments and Markets in Economic Development Strategies: Lessons from Korea, Taiwan, and Japan. New York: Praeger Publisher, 1989, p. 87.

¹⁴ ibid., p. 86.

¹⁵ The failure of the government to adjust to the changing economic environment.

¹⁶ It should be noted that the approach adopted in this paper is qualitative rather than quantitative so the mathematics used in Yang's paper will not be discussed in this paper.

¹⁷ X. Yang, "Development, Structural Changes and Urbanization", Journal of Development Economics 34, (1991), p. 199.

¹⁸ Yang, op. cit., p. 200. (brackets mine)

¹⁹ ibid., pp. 202 - 222.

²⁰ Rabushka, A., The New China: Comparative Economic Development in Mainland China, Taiwan, and Hong Kong. Boulder, Colorado: Westview Press, 1987, p. 5.

²¹ Alchian, A.A., and Demsetz, H., "Production, Information Costs, and Economic Organization", The American Economic Review LXIII, No. 5 (1972), p. 779.

²² The residual is the amount accruing to the monitor less the amount of wages/costs paid to all other inputs in the production process.

²³ X-efficiency refers to a situation where the technological frontiers of production in a production possibility frontier has been fully exploited.

²⁴ See Appendix 1 for the annual growth rates of Taiwan.

²⁵ Rabushka, op. cit., p. 105.

²⁶ Ho, S.P.S., "Economics, Economic Bureaucracy, and Taiwan's Economic Development", Pacific Affairs 60, No. 2 (1987), p. 232.

²⁷ See Appendix 2 for macroeconomic indicators from 1987 to 1991, origins of GDP 1991, components of GDP 1991, principal exports/imports 1991 and main destinations for exports 1991, and main origins of imports 1991.

²⁸ See Appendix 3 for the composition of manufactures as a percentage of total exports.

²⁹ Rabushka, op. cit., pp. 109-121. See also Kuo, Ranis and Fei (1981); Kuo (1988a, 1988b); and Gregor, Chang, and Zimmerman (1981).

³⁰ The Land Reform between 1948-1953 is arguably one of the most significant aspects of Taiwanese history. It was carried out in three stages: rent reduction, the sale of public land, and a "Land to the Tiller" programme. See Rabushka (1987), pp. 109-112; Kuo, Ranis, and Fei (1981), pp. 48-55; and Kuo (1988b), p. 110. Kuo, Ranis, and Fei (1981) provides a systematic statistical account of the land reform as well.

³¹ Ho, op. cit., p. 232.

³² Rabushka, op. cit., p. 125.

³³ Ho, op. cit., p. 233.

³⁴ Ho, op. cit., p. 238.

³⁵ Rabushka, op. cit. p. 125.

³⁶ ibid., p. 238.

³⁷ Kuo, S.W.Y., The Taiwan Economy in Transition. Boulder, Colorado: Westview Press, 1983, pp. 298, provides some information on the cumbersome exchange rate system which existed initially. Foreign exchange was given partly in cash and partly in exchange settlement certificates (ESCs). This resulted in an overvaluation of the Taiwanese currency. However, this was abolished in the early 1960s and therefore removed the exchange rate distortion that affected exports.

³⁸ Rabushka, op. cit., p. 128.

³⁹ ibid., p. 128.

⁴⁰ Ho, op. cit., p. 239.

⁴¹ Liang and Liang, op. cit., p. S90.

⁴² Taiwan: Country Profile 1992-93, op. cit., p.44.

⁴³ Kuo, 1983, op. cit., pp. 300-303.

⁴⁴ ibid. p. 300.

⁴⁵ ibid, p. 301; and Rabushka, op. cit., p. 128-129.

⁴⁶ Rabushka, op. cit., p. 128.

⁴⁷ Ho, op. cit., p. 229; and see Appendix 5 for a breakdown of labour productivity into various years.

⁴⁸ Chou, T., "The Pattern and Strategy of Industrialization in Taiwan: Specialization and Offsetting Policy", The Developing Economies XXIII, No. 2 (1985), pp. 140-141.

⁴⁹ This group consists of textiles, clothing and footwear, furniture, printing and publishing and miscellaneous manufactures.

⁵⁰ This group consists of wood products, paper and paper products, leather and leather products, rubber products, chemicals, petroleum and petroleum products, and nonmetallic mineral products.

⁵¹ This group consists of metal products, basic metals, non-electrical machinery, electrical machinery, and transport equipment.

⁵² Chou, T., op. cit., p. 142.

⁵³ Statistical information of this section is drawn from Taiwan: Country Profile 1992-93. London: The Economist Intelligence Unit, 1992, pp. 32-33.

⁵⁴ Kuo, S.W.Y., "Development of the Taiwan Economy", Conference on Successful Economic Development Strategies of the Pacific Rim Nations, November 14-18, 1988, Conference Series No. 10, Taiwan: Chung-Hua Institution for Economic Research, 1988a, p. 51.

⁵⁵ Rabushka, op. cit., p. 126.

⁵⁶ Goldstein, C., "The Bottom Line: Taiwan Capital, Factories Pour Into China", Far Eastern Economic Review 155, No. 37 (17 September 1992), p. 23.

⁵⁷ Baum, J., "Flags Follow Trade", Far Eastern Economic Review 155, No. 37 (17 Sept. 1992), 20-21.

⁵⁸ Bishai, op. cit., p. 55.

⁵⁹ Kuo, S.W.Y., "The Achievement of Growth with Equity", Conference on Economic Development Experiences and Its New Role in An Emerging Asia-Pacific Area, June 10-18, 1988, Taiwan: The Institute of Economics, Academia Sinica, 1988b, p. 109.

⁶⁰ Rabushka, op. cit., p. 129.