An institutional change from the communal system to the household responsibility system in rural China brought about an increase in productivity during 1979-1984, but it has also opened up a set of new problems, including decreased investment. I argue that the new responsibility system is effective in providing work incentives to peasants by rendering residual claims, but not so in internalizing positive externalities of investment, resulting in underinvestment. Remedies such as agricultural investment subsidies, investment tax credits, the roles of such institutions as township and village enterprises in undertaking investment in agricultural infrastructure, and most fundamentally, well-defined property rights are discussed. J. Comp. Econom., June 1996, 22(3), pp. 242-266. La Trobe University, Bundoora, Victoria 3083, Australia.