An Impact Assessment on Income Distribution-Related Policies. in China. Executive Summary. CDRF Research Team 1. June, 2012

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1 An Impact Assessment on Income Distribution-Related Policies in China Executive Summary CDRF Research Team 1 June, 2012 Since its launch of reform and opening-up policy, China has made brilliant achievement in economic growth, while it also has witnessed widening income inequality during this period. In 1978, China s Gini coefficient of household income was less than 0.3, but then exceeded 0.4 in 1993, and hit 0.48 in China s seriously unequal income distribution, together with other factors, has led to a series of economic imbalances like excessive saving and depressed consumption, which hinders Chinese endeavor of economic restructuring and transformation of growth pattern. In addition, increasing income inequality hampers social equity, destroying social cohesion and preventing formation of new consciousness on reform and development. Nowadays, income distribution has been one of the most hotly debated policy issues in China. It is since the late 1990s, in particular after 2003, Chinese government has undertaken a series of policies, mainly or partly aiming to mitigate income inequality and to promote a more balanced, coordinated, inclusive, and sustainable economic development. These policies cover a wide range of issues, including balancing regional development strategies in Western, Northeast and Central China, construction of new socialist countryside, rural poverty reduction strategy, equalization-oriented public service provision, reestablishment of social welfare system, proactive labor market policies, reform on hukou system, education reforms, taxation and fiscal transfers, etc. In light of the fairly important role that income distribution plays in Chinese socioeconomic development, the China Development Research Foundation launched this research project. Based on available representative data at macro and micro levels, this project investigates the trend of China s income distribution, and examines the 1 This is executive summary of CDRF research project An Impact Assessment on Income-related Policies in China, reflecting the key findings, discussions, and conclusions of the project. The summary is written by Yu Jiantuo, based on the commissioned reports prepared by team members. All team members have contributed to this report. Prof. Lu Mai and Prof. Li Shi have provided constructive suggestions for revision of the report. Experts from UNDP and UNICEF also provided valuable comments and suggestions. 1

2 distributional impacts of related policies over the last decade, so as to provide insights for further income distribution reforms. I. Trend of Income Distribution in China and Distributional Effects of Related Policies 1. Since the early 2000s, China s income inequality has been increasing, but at a slower pace in recent years. Decomposing Theil index shows that, urban-rural and regional income disparities, in particular the former, play a dominant role in China s income inequality. In 2007, urban-rural income disparity contributed about half of aggregate income inequality. Fortunately, these two kinds of disparities have declined more or less in recent years, indicating the hope of improving income distribution. However, income disparities within rural areas and within urban areas, in particular the latter, further push the aggregate inequality index up. 1)Urban-rural income disparity. The urban-rural income ratio rocketed from 2.78 in 2000 to 3.23 in 2003, then increased, at a relatively low pace, to 3.32 in 2007 and kept steady in the next two years. Since 2010, the ratio has been dropping continuously. In 2011, the ratio decreased to 3.13, close to the level of year ) Regional income disparity. The provincial Gini coefficient of per capita GDP, without being weighted by population share, increased from to 0.357, and then gradually declined to in 2010, lower than the level of mid 1990s. Moreover, provincial Gini of per capita GDP (constant prices at 1978) and provincial Gini of per capita consumption (current prices) also returned to the level of early 2000s. 3) Rural income inequality. Rural Gini of household income increased from 0.35 in 2000 to 0.39 in Thanks to the faster income growth of the low income group in 2010 and 2011, as compared to that of high income group, the income inequality among rural households is expected to be mitigated. 4) Urban income inequality. Urban Gini of household income rose from 0.32 in 2000 to 0.36 in 2005, and then kept constant during the period of However, this result was questioned because of systematic underestimation. Some revised results show that urban Gini coefficient has exceeded 0.4 in The widening asset income inequality resulted from soaring housing price and income gap between monopoly and competitive sectors are two main factors that push up urban income inequality. 5) Aggregate income inequality. China s national income Gini increased from about 0.45 in 2001 to 0.48 in Although there is no nation-wide representative income survey data for monitoring the trend of income inequality after 2007, the research team judges that the aggregate income inequality increases slightly over the past three or four years, maintaining a relatively steady status. However, the ubiquitous hidden income ( grey income ) and colossal black income coming from corruption and other illegal activities may exacerbates income inequality and bring uncertainties for judging the trend of income distribution. 2. China s huge income inequality largely stems from unequalizing institutions and policies. The urban-rural income and regional income inequality are 2

3 two main contributors of the aggregate income inequality. The former results from China s urban-rural dual system adopted in the pre-reform period, and the latter is closely related to the imbalanced regional development strategy undertaken during the period of 1980s-1990s. In addition, the lagged reform of factor markets and monopolies caused by unequal institutions also play important roles in widening income gaps among different social groups. Take an example of financial sector. Its average wage was 49% higher than urban average in 2003, and 87% higher in Studies show that, about two thirds of wage differences between monopoly sectors and competitive manufacturing sector should be attributed to monopoly, after controlling the impacts of human capital and other factors. Moreover, the segmentation of social welfare system also enlarges the income gap of different social groups. 3. The balancing regional development strategies launched since the late 1990s, including Western Development Strategy, Strategy on Reviving of Northeastern Old Industrial Base, and Strategy on Central China Emergency, have played significant role in mitigating provincial income inequality and regional economic disparity. Benefited from these strategies, the fixed asset investment, infrastructure construction, industrialization and opening-up in Central, Western and Northeastern China have accelerated, in particular after 2005, which lead to rapid GDP growth in these regions. Between 2006 and 2010, the average annual GDP growth rates of Central, Western, and Northeastern China reached 13.2%, 13.9% and 13.6% respectively, higher than that of Eastern China (12.3%) during the same period. The narrowing disparity of regional economic development leads to the decline of regional inequality in income and consumption. 4. Rural poverty reduction strategy undertaken in the first decade of the century has significantly reduced the gap of economic development between poor villages and ordinary villages. Between 2002 and 2009, the ratio of average income between poor villages and national rural level increased by 5 percentage points, and that between poor counties and national rural level increased by 3 percentage points. More importantly, the poverty alleviation policies significantly improved poor peasants production capacity and their access to the market while decreasing their vulnerability. Besides, in poor rural areas, households who participated in related poverty reduction projects had better economic performance that those who did not. It is noteworthy that, although low income groups in poor rural areas benefited also from infrastructural investments in their community, the higher income groups usually benefited more from these investments; hence the income ratio between top 20% and bottom 20% income groups increased from 4.6 in 2002 to 5.5 in The relaxation of hukou system and proactive labor market policies, though undertaken in a gradual manner, have stirred the mobility of labor market, and then promoted the wage convergence of migrant workers and the reduction of wage inequality in urban labor market. In the last decade, the average income ratio between top 10% and bottom 10% migrant workers declined from 5.9 in 2001 to 3.8 in 2010, down by 35.9%. The Gini coefficient of migrant workers wages has declined by 20%. After controlling the impacts of demographic factors and 3

4 working experiences, there was 11% of wage difference between migrant workers and urban workers with local hukou in 2001, which could be explained by the identity of migrant worker. This figure decreased to 5% in Since most of current household income surveys do not cover representative samples of migrant workers, this might lead to overestimate of income inequality. 6. Deregulating the price control of agricultural products increases the agricultural income of rural peasants and narrows the income gap between rural and urban residents. Based on provincial panel data between 2003 and 2009, the econometric analysis shows that, a percent increase of agricultural production price index will increase agricultural income and rural per capita pure income by 0.63% and 0.27% respectively, and will reduce urban-rural income ratio by 0.37%. Results also show that, of the producer price index of crop products has similar effects on rural income, and more significant impact on urban-rural income gap. On average, a percent increase of the producer price index of crop products will cause a 0.6% reduction of urban-rural income ratio. The analysis also indicates that during , if farmers agriculture-related income increases by 1% throughout the country, the Gini coefficient for inter-provincial rural net income will be pushed down by 0.55%-0.65%. It is obvious that increased agricultural production price index as well as the producer price index of crop products are conducive to narrowing down both rural and rural-urban disparities. However, the increase of grain retail price index has only trivial impacts on rural household income and urban-rural income gap because the index is more affected by circulation cost. The growth of this index will not drive up rural household income but the general price level. 7. Increasing circulation of arable land is favorable to reducing urban-rural income gap, while it may enlarge the income inequality within rural areas. Econometric analysis shows that, China s relative equal distribution of land equalizes income distribution of rural areas. But China launched the Law on Land Contract in Rural Areas, which encouraged the circulation of rural land. It is observed that a unit increase of arable land circulation enhances per capital agricultural income and non-agricultural income by 5% and 22% respectively. This is conducive to narrowing urban-rural income gap. However, as the increase of non-agricultural income is more unequalizing in rural areas currently, the increase of land circulation might widen disparity of rural income. 8. The free compulsory education policy is equalizing, by directly reducing education expenses of poor families in rural and poor areas and by indirectly promoting the human capital accumulation of poor children. Econometric analysis shows that the implementation of free compulsory education policy has significantly mitigated urban-rural income gap in Western China. Although the expansion of tertiary education in the last decade creates more opportunities for rural and poor students to enter colleges and universities, some case studies show that students from low social strata has fewer and fewer opportunities to study in prestigious universities. Considering the large gap of education returns between prestigious universities and ordinary ones, the tertiary education reform may exacerbate income distribution in urban labor market. It is also noted that, though the 4

5 education achievement at national level has been improved significantly, China s share of labor income in GDP keeps declining in the last decade, which is contrary to the prediction of the classical human capital theory. The temporary over-supply of well-educated labor, poor protection of labor rights, and segmentation of labor market are thought as the causes of contradiction between this theoretical prediction and Chinese reality. 9. The Central transfers to the local government are beneficial to equalizing the provincial fiscal capacity, but there is still big room for improvement. The equalizing inter-governmental transfer does not have direct impact on household income, but has indirect implications for narrowing regional income gap by equalizing public services among different provinces. The decomposition analysis shows that the tax rebates from the Central government to the local government are unequalizing. However, since the taxation reform launched in the mid 1990s, the share of tax rebates from the Central government to provincial governments has decreased from 72.9% in 1996 to 15.5% in The results also show that both general-purpose and earmarked intergovernmental transfers have significant and comparable equalizing effects. In 2009, a percent increase of earmarked transfer and general-purpose transfer reduced Gini coefficient of per capital fiscal revenue by 0.17 percentage points and 0.14 percentage points respectively. 10. Some taxation reforms, in particular those related to agricultural taxes and individual income tax, have played positive roles in increasing the disposable income of lower income groups. The exemption of agricultural taxes has reduced the tax burden of peasants (and herdsmen) by 130 billion CNY since In other words, the net income of rural households increases by 140 CNY thanks to the policy, which accounts for about 5% of their total income. In 2011, the income tax threshold was raised from 2,000 CNY/month to 3,500 CNY/month. Owing to this adjustment, the amount of people paying income tax decreased from 84 million to 24 million. In addition, China also stopped collecting interest tax, although this policy is more beneficial to the richer. The role of property tax in income redistribution is still limited, while it is expected to play a more important role in the future. 11. As China steps into the middle stage of urbanization and arrives the Lewis turning point, its income distribution has entered a turning period. Among various factors driving down income inequality in China, some are only contemporary factors, like the increase of agricultural prices, employment growth caused by economic stimulus, etc; while there are some long-term factors, like the shortage of labor supply, large scale of population migration, urbanization, etc, providing opportunities for improving income distribution. It is expected that, in the near future the income inequality will only increase at a much slower pace and sometime even decline. Note that the term turning period used here does not mean China s income inequality will turn down automatically and subsequently after reaching a peak, or so-called Kuznets Turning Point. During such a period, some factors drive down income inequality, while some others have opposite effects on income distribution, but the former keeps growing steadily. Thus the income inequality is expected to be 5

6 huge during the period until the former overwhelms the latter. The duration of the period largely depends on when and to what extent China could reform its unequalinzing institutions and policies, and on Chinese government s efforts for redistribution. II. Recommendations for Further Reforms of Income Distribution System Most of major economies experience a widening income inequality in the last two decades, while it is not the case with many Latin American countries sine the late 1990s. Among 17 countries with comparable data, 13 countries have witnessed a decline of income disparity, with their average income Gini down by 1% annually. Latin American countries, as a whole, were haunted by their extremely unequal income distribution for a long time, thus China can draw on their experiences and lessons in fighting with income inequality. Case studies of Argentina, Brazil, Mexico, and Peru show that, the decline of inequality in these four countries seems to be strongly associated with decreasing hourly wage differentials by educational level and reductions in education inequality. In addition, the integration of labor market also promotes the decline of wage inequality. It is also found that governmental transfers, in particular those conditional cash transfers to the vulnerable groups, play an important role in reducing income inequality. On the basis of impact assessment on domestic policies and international experiences, CDRF research team puts forward following policy recommendations for further reforms of income distribution system: First, to give first priority to primary distribution in the reform of income distribution system, while redistribution policies also being important. As for most households, the share of income from primary distribution in total income is much higher than that from governmental transfers. Thus equalizing primary distribution has more significant impact on narrowing income disparity. It is noteworthy that emphasizing primary distribution means that government should break institutional obstacles hampering effective market operation, promote market integration, and reduce market failure, rather than intervening the normal operation of market. The policy focus should vary for different income groups: for low income group, the government transfer schemes could play a more important role; for middle income group, labor market policies are of more significance; and for high income group, it is important to redistribute income through taxation reform. Second, to deepen reforms of state-owned enterprises and monopoly sectors. Access restrictions should be further removed for private sector to enter the markets of banking and finance, railway, electricity, and energy so as to promote the competition in these sectors. The state-owned enterprises should pay more dividends to the government so as to support a universal social welfare system, and to secure investment in other public services. Third, to accelerate hukou system reform to promote urbanization and integration of labor market. The threshold for obtaining hukou in metropolitans and large cities should be lowered substantially. Meanwhile, the reform of hukou system 6

7 should be taken step by step. Those who have steady jobs and have contributed to social insurance schemes for three years or more should be granted hukou in metropolitans and large cities. In addition, it is important to equalize access to basic public services, like housing, pension, education, and medical security, etc., among migrant workers and urban residents. Fourth, to deepen rural land reform, and undertake a more equitable compensation system for land-lost peasants. In comparision with land circulation policies, increasing land expropriation compensation to land-lost peasants has direct and more significant effect in narrowing urban-rural income gap, though compensation mechanisms could vary in line with the specific context of different regions. Fifth, to promote commodity circulation system reform. The governmental taxes and fees related to commodity circulation, in particular logistic industry, should be lowered substantially, so as to leave space for the growth of agricultural income without substantially increasing agricultural prices. Sixth, to undertake a national human capital development strategy. The Central government should formulate and launch a comprehensive Early Child Development Strategy from now on to 2020, to promote the nutrition status of children under 6 and to provide universal access to pre-school education by In addition, the subsidies for compulsory education should also be increased to equalize not only the access to school but also quality of education in schools. Furthermore, China should invest more in vocational education and promote the reform of tertiary education system, so as to lay a solid foundation for its industrial upgrading. Seventh, to optimize the intergovernmental fiscal transfer system. The general-purpose and earmarked transfers should be reclassified according to the functions of specific transfer scheme, so as to promote equalization of local governments fiscal capacity in providing basic public services. In addition, it is necessary to intensify the transfers that focus more on socially vulnerable and poor regions. Eighth, to further strengthen the reform of structural taxation reduction. The government should take further steps to cut taxes and fees collected from SMEs and wage earners. In addition, it is necessary to expand property tax pilots and to collect taxes related to resource use, on the premise that the general tax burden decreases modestly. 7