China's economic growth model, characterized by high input, high consumption, low added value, and low efficiency, relied on low wages for decades. This strategy facilitated rapid industrialization and fostered a competitive advantage in the international manufacturing landscape. However, the hourly labor cost in China's manufacturing sector increased fivefold from 2000 to 2012, significantly outpacing growth in other countries, including emerging markets. This paper addresses the unique phenomenon of rising labor costs in China's manufacturing industry, focusing on the significant role of government investment. Existing literature examines factors like minimum wage regulations, social security contributions, urbanization, and demographic changes as drivers of labor cost increases. This study argues that government investment, particularly in infrastructure, plays a crucial and distinct role. Local governments in China are deeply involved in economic development, often deploying massive infrastructure projects, as seen in the 2008 CNY 4 trillion investment program. This paper explores two key mechanisms: (1) Infrastructure investment creates direct labor demand, increasing labor costs. (2) Infrastructure improvements reduce transaction costs for firms, expanding production scales and leading to further increases in labor costs. This research aims to extend existing literature by focusing on the direct influence of government investment and its mechanisms on labor costs, offering valuable insights for China and other developing countries.

The literature review is divided into two parts: (1) the economic and social effects of changes in labor costs, and (2) factors influencing labor costs. Studies on the economic and social effects highlight how rising unit labor costs impact export performance, negatively affecting both the initiation and continuation of export activities. The literature also explores the relationship between rising labor costs and technological change, showing that in some contexts, higher labor costs can induce innovation and R&D spending, particularly in labor-intensive industries. However, a loss of competitiveness can also result from higher labor costs. Regarding the factors influencing labor costs, studies examine various elements including payroll tax rates, social security contributions, minimum wage regulations, urbanization, population aging, and immigration. However, the existing literature lacks a focus on the influence of government economic behavior, particularly in the context of countries where the government plays a dominant role in economic development, such as China. This paper fills this gap by exploring the unique relationship between government investment and labor costs in China.

The study employs a panel regression model using data from 31 Chinese provinces from 2000 to 2018. The dependent variables are unit labor cost (ULC) and nominal labor cost (average labor compensation). The core explanatory variable is the logarithm of government investment (GI), specifically fixed asset investment in the state-owned economy. Control variables include GDP per capita (and its square), the industrialization level, the number of employed persons in the secondary industry, and the proportion of the working-age population. Regional and year fixed effects are included to control for unobserved regional heterogeneity and macroeconomic shocks. The authors utilize a fixed-effects regression model to estimate the marginal effect of government investment on labor costs. ULC is calculated as hourly labor compensation divided by hourly labor output. Hourly labor compensation is derived from annual average compensation data, considering adjustments for rural/urban wage differences and non-wage costs. Hourly labor output is calculated from annual value-added data. The study conducts robustness checks by using alternative measures for government investment (investment in fixed assets within the state budget) and by analyzing regional subsamples (eastern, central, and western regions). Furthermore, analysis is conducted using different quantiles of government investment to explore the impact of varying scales of investment on labor costs. Finally, a mechanism analysis explores the impact of infrastructure investment through two channels. First, direct demand increases from infrastructure investment driving labor costs. Second, the reductions in transaction costs from infrastructure development creating expansion and rising labor costs. This is tested through regression and regional samples.

The core findings show a significant positive relationship between government investment and labor costs. The basic regression results (Table 2) indicate that a 1% increase in government investment is associated with a 0.013-unit increase in ULC. Similar results hold when using nominal labor cost as the dependent variable (Table 3), showing a 1.443-unit increase for every unit increase in government investment. Robustness tests (Table 6), using an alternative measure of government investment and regional subsamples, confirm these findings. The regional analysis (Table 5) reveals variations in the effects, with a stronger impact in the eastern region (0.065) compared to the central (0.015) and western (0.014) regions. Analysis by quantiles of government investment (Table 6) demonstrates a decreasing marginal effect of investment on labor costs as the scale of investment increases. The mechanism analysis (Table 7) reveals a significant positive impact of government investment on infrastructure development, particularly in the eastern and western regions, suggesting that infrastructure investment is a key channel through which government investment affects labor costs.

The findings provide strong support for the hypothesis that government investment significantly contributes to the increase in China's manufacturing labor costs. The two mechanisms identified—direct labor demand from infrastructure projects and reduced transaction costs from improved infrastructure leading to production expansion—are both supported by the empirical evidence. The variations in the regional effects suggest that the impact of government investment on labor costs depends on the existing level of economic development and infrastructure. The decreasing marginal effect of investment size implies that beyond a certain point, additional government investment might yield diminishing returns regarding increased labor costs. The study highlights the critical need for China to balance economic growth with sustainable labor cost management. The findings have important implications for policymakers in developing economies, suggesting a careful consideration of the potential trade-offs between government-led infrastructure investment and the cost of labor.

This study demonstrates a strong positive relationship between government investment and rising labor costs in China's manufacturing sector. The findings highlight the crucial role of government investment, particularly through infrastructure development, in driving up both unit and nominal labor costs. The research emphasizes the need for policy adjustments in China to manage government investment strategically, preventing excessively rapid increases in labor costs that could harm the competitiveness of the manufacturing sector. Future research might focus on analyzing the relationship between government investment, firm innovation, and labor productivity, exploring the micro-level mechanisms underlying the macroeconomic effects observed in this study. Further investigation into the optimal balance between government investment and private sector growth is also warranted.

The study acknowledges potential limitations. First, data on hourly labor compensation and output were derived from annual data, introducing potential measurement error. Second, the analysis focuses on government investment in the state-owned economy and might not fully capture the impact of all government investment. Third, omitted variables not included in the analysis could influence the results. Finally, the study's focus on China might limit the generalizability of the findings to other contexts with differing levels of government involvement in the economy.