April 13, 2017

News in Charts: China needs fiscal reform to rebalance

by Fathom Consulting

China has very high levels of inequality, in comparison with its own past and with its peers. Reducing income inequality would help to boost private consumption and contribute towards rebalancing. In this article we assess whether China’s current fiscal system raises or lowers the chances of China achieving that much-needed rebalancing. We find that China’s fiscal system could be reformed to become far more progressive than it is. But we see little prospect of such reform in the short-term, so any rebalancing will be slow at best.

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Is the failure of China’s fiscal system to reduce income inequality a consequence of its political regime?

Part of any government’s role is to redistribute income and wealth across society where that is appropriate, via the fiscal system. Redistribution from rich to poor, where that is achieved, typically helps to boost private consumption. The reason for this is that the marginal propensity to consume (MPC) tends to decline as people get richer: poor people need to spend virtually all their income on essentials, while richer people have options to buy inessentials or to save. So transferring income from the rich to the poor should (all else the same) help to push up average consumption per capita. In 2012 – the latest data available – the MPC for the lowest 10% of urban earners was 0.93 compared to 0.59 for the top 10%.

The Standardised World Income Inequality Database (SWIID) provides a Gini coefficient – a measurement of income distribution with 0 representing perfect equality and 100 representing perfect inequality – for just over 170 countries. According to the theory of ‘Kuznets waves’, inequality starts out low at a country’s early stage of development because everyone is poor. Once it starts to industralise, inequality rises with it. Then it falls again. At the turn of the century, China’s Gini coefficient leapt up as GDP growth entered double-digits. Since then, it has remained around 50. That is high by the standards of most of China’s peers – ironically, for an ostensibly communist country, inequality in China is very high.

According to the SWIID, the extent to which the fiscal structure changes inequality – either to increase it or decrease it – is captured in the difference between the gross and net Gini coefficients. The gross is based on the market income of citizens, while the net measure is calculated after taxes and transfers. During the past 80 years, the Chinese government has had no success in using its fiscal system to reduce income inequality. This is in stark contrast to the US – although the gross measure for the US was above that of China, at 50.8 in 2013, its net measure lay significantly below, at 37.7. The US fiscal structure is strongly progressive. The Chinese fiscal structure is neutral in terms of its impact on inequality.

Typically, richer, more developed economies have more progressive, redistributive fiscal systems. However, although China’s GDP per capita was higher than a third of the 74[1] countries included in the chart below, its government tax and transfer system ranked bottom place in its ability to reduce income inequality.

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China’s one-party state will have been in place for 96 years in July. Its reading of -1.5 for the ‘voice and accountability’ World Bank Governance Indicator — measuring the extent to which a country’s citizens can participate in selecting the government — reflects its strict authoritarian political regime. Using this indicator as a measure of democracy, a strong positive correlation is found between a country’s level of democracy, and the extent to which the fiscal system plays a part in reducing inequality.

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Indirect taxation should play a smaller role

China’s state cabinet released a document in October 2016 on income distribution reform, noting that it would use taxation to narrow the income gap between different groups. In order to do this, the proportion of revenue that came from direct as opposed to indirect taxation needed to be increased dramatically. Consumption taxes, such as VAT, are regressive because they are applied at a rate that is independent of income, and poorer people tend to consume a greater proportion of their income.

Personal income tax revenues made up the smallest chunk of total government tax revenues at just 6.9% in 2015. The principal reason for this is that the basic personal allowance of RMB 42,000 is significantly higher than both average urban and rural income per capita. Using 2012 income data, all rural earners and the bottom 60% of urban earners would have been excluded from paying income tax in that year. To use the Chinese taxation system as a tool to reduce income inequality, the personal allowance must be lowered in order greatly to broaden the income tax base.

Provincial variation in public services

If citizens are unable to rely on the state to provide basic social services such as easily accessible health and education, the proportion of their income allocated to precautionary savings will be much higher. The World Bank categorises countries into low, lower-middle, middle, upper-middle and high income according to their GNI per capita. Based on this measure China has been classed as an ‘upper-middle income’ country since 2010. However, in that year, Chinese government spending on both health and education as a share of GDP was below the average achieved in other economies classed as ‘upper-middle’ income.

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Not only is total expenditure on public social services low in China for its stage of development, the provision of it is almost solely the responsibility of the 31 independent local governments. This results in a large variation across provinces in the average per capita government expenditure on social services . In 2015, the government spent just over RMB 20,000 per capita in Beijing, over three times more than what was spent on citizens in Hebei.

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In some provinces, citizens can rely on the state to provide good quality and easily accessible services such as doctors, hospitals, education and housing security. In those provinces, the average amount consumed per resident is higher. Therefore part of the strategy to boost domestic demand in China should include not only increasing the aggregate amount spent on social services in China, but reducing the variation in the provision and quality of public services across provinces.

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In 2013, China’s state cabinet released a document noting that it would use taxation to narrow the income gap between different groups. There has been no progress on this front since then. In order to reduce income inequality, and give China a real hope of rebalancing its growth towards private consumption, it is imperative that Chinese policymakers significantly adapt the fiscal structure to make it much more progressive. We see little prospect of this happening in the short-term. More than ever, ahead of the Autumn conference, China’s policymakers are focused on achieving the official growth target.

[1] Only 74 out of 175 countries in the SWIID are included due to restricted data availability.


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