Income distribution is the key

Three decades of fast growth have transformed [People's Republic of] China into the world's second largest economy. They have also created an economy that is excessively reliant on investment, exports and capital-intensive industrial development, and in pressing need of rebalancing. And they have exacerbated the gap between high- and low-income groups, and between cities and rural areas.

Increasing consumption is frequently pointed out to be the key to reducing China's reliance on exports and investment. However, despite a range of government initiatives, consumption has persistently remained low. At about 37 percent of GDP, consumption in China stands well below other middle-income countries and far below developed economies, depriving the economy of a reliable domestic engine of growth.

The conventional wisdom is that low household consumption is the result of high precautionary savings, that is, people save for education and healthcare expenditure and old age and, therefore, do not spend much. However, low wages are also a major factor. In practice the average Chinese household simply does not have much money to spend.

Despite recent salary increases, total wages over GDP have declined to about 36 percent from 45 percent in the past 10 years. Income inequality is growing. China already has one of the highest levels of inequality in the world. Urban household incomes are, on average, three and a half times higher than rural household incomes. Inequality will hinder future growth, because it undermines consumption, constrains development in poorer regions and generates social tension.

The roots of inequality lie in the growth model adopted over three decades ago. As economic reforms progressed, state redistributive mechanisms weakened. In the 1990s, public services provision was decentralized to local governments without a corresponding increase in fiscal transfers.

In the transition toward a market-oriented economy, only limited taxation has been introduced, while central government transfers for education, healthcare, housing, and pensions have declined. As a result, growth in government fiscal revenues has exceeded income growth.

At the same time, there has been insufficient redistribution from enterprises to households. Soaring corporate profits have not been shared with households. Dividends are seldom paid, equity and bond markets are immature, and pension and mutual funds have not yet been developed. This has kept households' interest income low and, ultimately, repressed consumption.

The government has adopted a range of measures to address these challenges. However, so far they have had limited impact. Social spending has increased but remains low. About 30 percent of government revenue is spent on social security, education and healthcare, compared with an average of 52 percent in other middle-income countries. Moreover, reforms have focused on expanding the coverage of benefits rather than revamping the benefits themselves. Salaries have recently increased rapidly, but lag behind productivity gains and GDP growth. At the same time, higher labor costs are depressing China's competitive edge.

Income redistribution policies and strengthening of social safety are the key to reducing inequality, fostering consumption and sustaining economic growth.

What can China learn from other countries' experiences? In developed economies, fiscal policy is the key tool for reducing inequality. In the OECD countries, a broad tax base, progressive taxation and increased government transfers reduced inequality by one-third between 1985 and 2005. In developed economies, large fiscal transfers, for healthcare, education and pensions, have effectively reduced inequality. Reforms to broaden the tax base and increase the progressivity of taxation were also successful in redistributing incomes.

In developing economies, fiscal policy has been less effective in addressing inequality, because of their high reliance on indirect taxation, and lower and less progressive tax and spending levels.

Looking ahead, policymaking for China's next-generation leaders should focus on overhauling taxation and fiscal transfers to balance income distribution. The 12th Five-Year Plan (2011-15) acknowledges the role of fiscal policy in narrowing income inequalities, but comprehensive reforms have to be implemented to address major constraints.

First, China's tax base should be broadened. Recent reforms in income taxation have reduced the number of personal income tax payers to less than 3 percent of the population. Tax evasion is high, and collection and enforcement are low. The narrow base leaves policymakers with no powerful income distribution tool. The direct income tax base can be broadened through measures to curtail tax evasion, reduce the informal sector in the economy and strengthen tax administration.

Second, taxation should be more progressive. To achieve this, there should be more emphasis on direct taxation. Currently, the value-added tax is China's single largest source of tax revenue. Indirect taxation is effective in raising revenue. However, it taxes rich and poor alike for the same transaction, and is highly regressive. Direct progressive taxation of incomes would help to shift the tax burden from low-income to high-income households. Taxing capital gains and property would also help to balance income distribution.

Third, social expenditure should be increased. Social spending is preferable to tax cuts as a means of increasing consumption, because tax rebates are usually saved. Improved tax collection would allow higher social expenditure. A shift in public spending away from investment and toward social transfers would help to curb precautionary savings and foster consumption.

International experience indicates that increased public spending on healthcare directly increases private consumption. Similarly, higher provisions for education and pensions reduce life-cycle savings and free up household resources for consumption. The government has recently taken commendable action to expand the coverage of pensions, but the need for broader pension reform remains urgent. Low pension levels distort consumption patterns and foster precautionary savings. Improved tax collection, further liberalization of energy and resource prices, introduction of environmental taxes, and transferring State-owned enterprises' dividends to social expenditure would allow increased social spending without straining public finances.

Fourth, an overhaul of the tax revenue sharing system between the central and local governments is needed. Revenue allocation to the local level needs to be aligned with expenditure responsibilities. Otherwise, large disparities in public social spending per person will emerge and perpetuate inequality.

Local governments' share of value-added tax revenue could be increased from the present 25 percent, which is insufficient to fund their obligations to provide social services. Alternatively, the central government could increase its funding share while maintaining the existing decentralized scheme for providing social services. Inter-provincial compensation mechanisms from richer to poorer provinces could also be adopted.

Tax reform and increased spending on healthcare, education, and pensions would reduce pressure on low-income household budgets. These measures would also reduce pressure for salary increases, which has had an impact on the economy's competitiveness. The reforms would encourage households to consume, providing the country with social stability and the economy with an important buffer against external shocks.