The Visible Hand

China has transformed into a leading force in science, technology, and innovation (STI). With rapidly rising research and development (R&D) expenditure, a larger and increasingly high-quality talent pool, and impressive scientific publication and patenting statistics, the country is set to become a global STI superpower.            

The evolution of the Chinese STI sector has been widely conceptualized through a Schumpetarian perspective which emphasizes market-oriented economic development, enterprise behavior, and the enterprise-centered innovation system. The managerial and innovative capabilities of outward-looking Chinese firms have been most commonly attributed to driving China’s technological development.           

We challenge this conventional wisdom by underscoring the role of policies, politics, institutions, and the state in promoting China’s STI growth. Behind China’s innovation, we argue, is the “visible hand” of the Chinese government. Correctly conceptualizing the origins of Chinese technological development is crucial for understanding its future prospects.¹ If its present achievements are to be lasting, China must preserve the institutional capacity to achieve high-priority, national-development objectives. Above all, it must more efficiently transform R&D advancements into innovation.      

Drawing on a close inspection of China’s recent innovation policies, we identify three challenges to China’s existing STI infrastructure. First, though it has hugely increased expenditure in R&D, total investment remains insufficient and poorly allocated in internationally comparative terms. Second, recent government restructuring has weakened key agencies and obscured their decision-making power; its effectiveness remains to be seen. Finally, the structure of investment in scientific research has shifted away from government funding to enterprise-driven investment, with unpredictable results. Such challenges bear significant consequences for China’s future as a global leader in innovation.

State intervention

In pre-1978 China, the state was responsible for all scientific research funding, and the central government appropriated funds through a centralized system. Beginning in 1985, however, a profound reconstitution of China’s science and technology (S&T) system altered the mechanism of appropriations and prioritized changes to government appropriations. The State Council, or the cabinet, gave the State Science and Technology Commission (SSTC) the power to administer all operating expenses for civilian science. The SSTC and the Ministry of Science and Technology (MOST), which succeeded the SSTC in 1998, distributed funding to agencies under the State Council and affiliated research institutes. In 2000, funds became directly channeled to department budgets, while MOST managed national S&T programs.

The reform was a hallmark in China’s overall post-1978 transition from central planning to a socialist market economy. Though it coincided with the period of market reform, it was government restructuring rather than markets which encouraged the rise of China’s STI sector.

Despite its clear advantages, the new system exhibited important flaws. It suffered from the absence of unified planning, ineffective coordination, and a lack of transparency in fund distribution and spending accountability. As a result, it was reorganized once more in 2014, when central funds were directed exclusively into five streams—the National Key R&D Programs; the Mega-Science Programs; the Nation’s High-Tech R&D Program; the National Key Technology R&D Program; the Industrial Technology R&D Fund; and Special Funds for research in public sectors. The trend towards recentralization continued until 2018, when MOST was transformed into a “super” department which received allocated funding directly from the Ministry of Finance for distribution.² 

However, in 2023, the Central Committee of the Chinese Communist Party restructured China’s S&T system again, this time with major implications for central S&T and R&D funding. Under the new reform, MOST would become an office of the Central Science and Technology Commission, a new party organization responsible for formulating S&T strategy, focusing on a top-level design, unified planning, and interagency coordination. Policymaking and S&T budgeting functions related to specific sectors would be redistributed to mission-critical agencies.³

China and the US

According to the US National Science Foundation, in purchasing power parity terms, China was the world’s second largest R&D spender in 2019, accounting for about 22 percent of the global total, behind the US, whose global share was 27 percent. A 2020 report from the American Academy of Arts and Sciences observes that China “was passing the United States in research and development investment at purchasing power parity.” In May 2021, US President Joe Biden remarked: “We used to invest more in research and development than any country in the world and China was…number nine. We are now number eight and China is number one.”                

Indeed, China’s R&D investment has skyrocketed in recent decades. The central research funding reform has released the original public resources to the market, while the market-oriented reform has activated the vitality of firms and research institutes. In 2023, China’s gross expenditure on R&D (GERD) reached some RMB 3.33 trillion, three times that of ten years ago and seventy-one times that of 1995. In 2023, China’s total R&D spending as a share of GDP—or R&D intensity—reached 2.64 percent, more than triple the average of the EU member states, which together managed 2.15 percent in 2021. Although China fulfilled the R&D intensity target set for 2020 (2.5 percent) in 2022, two years later than planned, it has retained the momentum to help transform the nation’s economic structure and stimulate the next stage of STI-driven socio-economic development.

These accomplishments, however, look less promising in comparative terms. In 2019, US GERD was $657 billion, more than twice China’s $321 billion.⁴ The most recent data from the OECD show that in 2021 government-financed GDP on R&D was 0.69 percent for the US and 0.46 percent for China. America also led China in total R&D investments, which include public, private, and nonprofit investments. R&D intensity was nearly 3.4 percent for the US and about 2.44 percent for China in the same year.

Total R&D spending in the US surpassed 3 percent of GDP for the first time in 2019. In June 2021, the US Senate passed the historical Innovation and Competition Act of 2021, displaying its determination to significantly increase government spending on R&D. China’s current goal is to achieve the R&D intensity target of 2.8 percent by 2030, making it impossible for China to surpass the US in this critical statistic in the immediate future.⁵ Slow economic growth in China may also negatively affect the sustainable growth of R&D funding, despite the fact that the Chinese government has not reduced its investment in S&T.

The quality of R&D expenditure statistics itself cannot be taken for granted. In the US, the federal government’s contribution to GERD is provided by the Office of Management and Budget, and by various S&T mission-oriented agencies. Such detailed agency-level R&D expenditure statistics are unavailable in China, and estimates for central government expenditures may have major inaccuracies. 

It is also likely that measures of China’s R&D expenditure are inflated. The OECD forecast is based on the domestic purchasing power of the Chinese currency, but most research equipment, chemical reagents, basic data, and journal access are purchased on international markets. Additionally, Chinese enterprises may overstate spending on R&D to meet the “official” criterion to qualify for tax credits and other favorable policies, and to elevate their executives professionally.

 It is not just the quantity of expenditure that matters for innovation—the form that this expenditure takes is crucial as well. China has continuously spent a relatively low share of R&D expenditure on scientific research—devoting approximately 16 percent to basic and applied research and the rest to experimental development. In other words, instead of acquiring or generating new scientific or practical knowledge without any use in view, China’s R&D in the twenty-first century has been oriented towards experimental development—producing new products or processes and improving existing products or processes. From the early 2000s until 2022, anywhere from 5 to 6.57 percent of expenditure was devoted to basic research, with roughly 11 percent in applied research. This is a dramatic decline from a standard of 26 percent share applied research expenditure in 1995, and concerningly low in comparison to the US and Japan, which spent some 30 percent of respective R&D expenditure on applied research. With no new knowledge from scientific research, the generation of new products or processes depends on international technology transfers.

The sources of innovation

The sources of funding have also changed. Since 1995, the growth rate of enterprise R&D funding has significantly exceeded that of the government’s spending. Today, the proportion of the GERD contributed by enterprises has increased to 78 percent, while the share of government spending fell to about 19 percent. The trend is consciously undertaken by the Chinese government: since 2021, manufacturing enterprises have received a 100 percent tax deduction for R&D expenses, thereby increasing total tax deductions from RMB 360 billion in 2020 to RMB 440 billion in 2021. With respect to research funding, the enterprise has emerged as the primary actor of innovation. 

This high share of enterprise funding is atypical. Internationally, the proportion of government funding in GERD during industrialization was generally between 30 and 50 percent, with  enterprises accounting for 40 to 60 percent of investment. The US federal government had been the leading sponsor of the nation’s R&D for many years, funding 67 percent of all US R&D in 1964. Though this share has since significantly declined to 20.89 percent in 2021, it remains higher than China’s 18.96 percent. 

For basic and applied research, the government remains the key actor—being the sole funder of the former, and contributing 85 percent of funding for the latter. This, too, is atypical: in 2021, the US business sector was not only a substantial performer (34.62 percent) and funder (32.53 percent) of basic research, but also the largest performer (61.06 percent) and funder (56.3 percent) of applied research. While the government ought to invest more in research funding, then, firms should focus on basic research in addition to experimental development.

Given that the government constitutes the key funding source for basic and applied research, the low share of government funding in GERD has led to a relatively low share of R&D expenditure on scientific research. China’s local governments spend more on S&T than the central government, but this expenditure also includes spending on non-R&D activities. 

An additional challenge to China’s R&D sector comes in the form of organizational structure. From 2000 to 2014, reforms of the S&T budgeting system, departmental competition, and the establishment of Mega-Engineering Programs led to the diminishing role of MOST in China’s national innovation system. The 2018 reforms returned more power to MOST, and the latest 2023 reform would strengthen MOST’s role in coordination, though it may be at the expense of the ministry’s budgetary functions by moving some of its organizations to mission-oriented agencies.

Unlike the National Natural Science Foundation of China (NSFC), which funds basic research and mission-oriented research projects through competitive and peer-review processes, MOST, which until the 2023 reform administered a much larger share of the government S&T appropriation, was criticized for being non-transparent in its distribution of funds. The lack of coordination and transparency has led to redundant spending across ministries and agencies, thus wasting scarce S&T resources. Now, MOST administers over the NSFC by macro-management, coordination, supervision, and evaluation, allowing the NSFC to operate relatively independently.⁶

The future of innovation

Understanding the role of the state in promoting China’s historical advancements in STI illuminates current obstacles and carries important implications for paths forward. Key among the necessary reforms is to expand sources of R&D funding. For example, the government could create tax incentives encouraging enterprises and entrepreneurs to donate towards scientific research. Organizational reforms are also necessary—the 2023 MOST reform could make the agency and the Ministry of Finance responsible for allocating the R&D budget accordingly. While the Ministry of Finance, MOST, the National Development and Reform Commission (NDRC), the State Administration of Taxation, and the Ministry of Education have been important in the formulation of indigenous innovation policy since 2006, only MOST has played a major role in budgeting.⁷ 

In OECD countries, budgets have moved from being fiscally oriented to policy oriented. Fiscally-oriented budgeting emphasizes cost controls and ensures balance in the financial system. Policy-oriented budgeting emphasizes cost-effectiveness and cost-efficiency with evaluation geared towards the result-oriented nature and quality of budget applications. In the US, for example, every policy act has a corresponding budget plan, and the two are closely integrated. In developing countries, budget decisions are still distinct from policy decisions and national plans. China is no exception. Most Chinese STI policies do not follow with a clear budget, and it is also not clear as to whether the R&D budget corresponds to specific policy objectives.

The NDRC is responsible for important economic regulations and strategic resource allocation; its S&T role is confined to making policies related to industrial technology, and it therefore has a limited role in the S&T budgeting process. Given its prominence in the Chinese government hierarchy, the NDRC should have an expanded and integrated budgeting and policymaking function. Similarly, other agencies with a critical S&T mission and therefore a larger S&T budget also should actively participate in policymaking to harmonize S&T-related policymaking and budgeting. While there is still a long way for China to align R&D budgeting with related policies at the agency level, the scientific and political leadership understands the significant role of R&D expenditure in promoting scientific research and stimulating innovation, as well as the urgency in effectively and efficiently utilizing rising but often scarce financial resources.

Schumpeterian perspectives are valuable in providing a theoretical foundation for national innovation-driven development and policymaking. But as the Chinese state’s active creation of the market mechanism shows, Schumpeter’s ideal market is only an abstraction. Though the government has made enormous strides in advancing the STI sector, it should not lose sight of its critical role in cultivating future growth.