Income inequality plan a test of will to reform

The release later this month of government proposals to reduce income inequality will provide early evidence of whether a change of leadership in China has given new momentum to economic reform. The plan has had a slow journey to this point: it has been eight years in the drafting.

That is not to say that the previous leadership did nothing to address income inequality. Many of the signature policies of the last few years were explicitly directed at improving the lives of China's poorest families. Agricultural taxes paid by farmers were eliminated. Rural residents were brought under the umbrella of a basic pension scheme and rudimentary health insurance was expanded to cover virtually all of China's population. At the same time, significant investment was focused on the poorest provinces to make up some of their deficits in infrastructure.

Nonetheless, most estimates show that inequality widened over the past decade and that the disparity between rich and poor today is the greatest it has been in the post-reform era. The richest 10 percent of households in China own 85 percent of its wealth, according to a recent survey, whereas more than the 75 percent of wealth is held by the richest tenth of households in the US. Despite the margin of error in such surveys, the wealth gap in China is really as alarming as in the US.

The significant improvements in the social safety net of the last few years failed to reduce inequality because they sought only to reduce the stress faced by the poorest households. They did not address the reasons why strong economic growth was failing to deliver strong increases in the income of poorer households in the first place. A large part of the problem, as the Development Research Center of the State Council noted in its "China 2030" report, published jointly with the World Bank earlier this year, is that wages have accounted for a shrinking share of national income.

An economic model that has prioritized capital-intensive industry and, in recent years, given many advantages to State-owned enterprises, has failed to generate as many jobs as other economies at a similar stage of development. Heavy industry has boomed. Large enterprises have prospered. But the service sector and smaller companies that tend to generate most new jobs have not kept pace.

The government, on its part, has paid for increases in its spending by raising taxes. The tax burden faced by China's workers is much higher than in most other emerging economies.

The fact that the government acknowledges the need to do something to redress these imbalances reflects its recognition of the fact that widening inequality is not just a major social concern. It is also a threat to China's ability to maintain rapid economic growth. Widening inequality has gone hand-in-hand with rising saving because the major beneficiaries of the last few years' growth, company owners and their senior managers, tend to save more than they spend. The latest China Household Finance Survey shows that the top 5 percent of households by income saved 69 percent of their income and accounted for 62 percent of total household savings. The shift to a consumption-led growth model, which is at the heart of the 12th Five-Year Plan (2011-15), will happen only if ordinary households have more money to spend.

What might an effective plan to reduce inequality look like? At its core would be efforts to steer more of China's income toward average families.

The most effective steps would focus on boosting competition, job creation and after-tax wages. Protected parts of the economy should be opened up to the private sector. Dominant SOEs should be exposed to more competition from private competitors. The banking system and the wider financial sector should be liberalized so that smaller companies can easily access the capital they need to invest. Subsidies to large companies, in particular the provision of cheap loans, should be withdrawn to level the playing field. And the tax burden should be reduced.

These would be bold steps and not easy to implement. Indeed, they would involve wrenching changes for many protected parts of the economy, which presumably explains why the government has struggled for so long to agree on how to proceed.

But sticking with the status quo is not an option. Widening inequality has welfare costs and will undercut any effort to put the economy on a more sustainable path. In contrast, successful reform would have a transformative effect on China's prospects, setting the stage for another decade of strong economic growth.

The author is chief Asia economist at Capital Economics, a London-based independent macroeconomic research consultancy.

(China Daily 12/13/2012 page9)