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Openness and Inequality:
Can China Compensate the Losers of Its WTO Deal?
Shaoguang WangDepartment of Government & Public Administration
The Chinese University of Hong KongShatin, NT
HONG KONGTel. +852-2609-7515Fax +852-2603-5229
Email: [email protected]
August 9, 2001
[Please don’t quote without my permission]
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Openness and Inequality:
Can China Compensate the Losers of Its WTO Deal?
Abstract
No doubt the aggregate gains China has derived from its open strategy outweigh the
aggregate costs. But such gains and costs are not evenly distributed. This article examines
whether the government is capable of compensating the losers through taxing the
winners. While not denying the constraining impact of openness on domestic
policymakers’ choice set, the case of China shows that the state is by no means helpless
in the face of the forces of globalization.
Key words: WTO, globalization, state capacity
Word count: 10,423 words
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Introduction
From the very beginning, outward-looking, export-led strategy has been an integral
part of China’s reform program. In the last 20 years, China has transformed itself from a
near-autarkic economy into an open economy. By 2001, China has become the 7th largest
trading nation in the world and the second largest recipient of foreign direct investment
(FDI) only after the United States.
There is no doubt that China has derived a great deal of benefit from its open
strategy. The prevailing opinion among Chinese economists indeed favors greater
openness. They show little concern about the social impact of greater openness, or more
specifically, the impact on employment, poverty, and income distribution. In their view,
openness is not only a way to promote economic growth but also a vehicle to further
mass well-being. It is believed that economic growth by itself is capable of reducing
poverty and advancing human development.
This article does not question the rationale of China’s open policy. Nor it challenges
the premise that, all in all, the aggregate gains from openness outweigh its aggregate
costs. But it assumes that the gains and costs generated by openness will not be evenly
distributed automatically. If increased integration with the world economy does result in
growing inequality, then its distributional implications deserve more attention than it has
drawn from Chinese economists.
My main concern in conducting this research is with the impact of openness on
income distribution in China. In looking at distributional outcomes, it is necessary to
make a clear distinction between the impact of primary incomes and that of secondary
incomes. Primary incomes refer to those people earn directly from their work and from
their investment (e.g., wages or dividends), while secondary incomes consist of
deductions from, and additions to, individuals’ primary income through taxation and
government expenditure.1 Greater openness may affect the distribution of primary as well
as secondary incomes. This paper examines who wins and who loses in terms of both
1 In addition to the state, families and nonprofit organizations are also sources of
secondary incomes. But transfers through them are generally small and thereby negligible
in aggregate terms (Steward 2000).
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primary as well as secondary distributions, with a focus on whether the government is
capable of compensating the losers through taxing the winners.
Before looking at the Chinese experience with economic openness, section 2
presents a brief theoretic discussion on what changes in the distribution of primary and
secondary incomes one would expect from greater openness. Section 3 reviews China’s
actual progress in economic openness and changing patterns of income distribution over
the last twenty years. Section 4 looks for association if any between openness on the one
hand and employment and the distribution of primary incomes on the other. Even if
openness may create growing polarity in primary incomes, the overall pattern of income
distribution will not necessarily worsen as long as there is an effective mechanism for the
government to transfer incomes from the winners to the losers. Section 5 then turns to
China’s public finance system, examining the extent to which openness affects China’s
tax structure and expenditure structure. It is found that fiscal squeeze resulted from
openness has exacerbated rather than alleviated inequality of primary income
distribution. The concluding section speculates whether China is capable of
compensating the losers of its WTO deal.
Openness and Inequality
The term “openness” refers to a country’s receptivity to free movement of goods,
services, capital, labor, technologies, and information across national borders. It is
important to bear in mind, however, that, even if a country were willing to fully integrate
its economy with world markets, the degree of international mobility would still vary
greatly among the factors of production. In general, capital is more mobile than labor.
Financial capital (portfolio investment) has perhaps the highest mobility. With the help of
modern communications, financial investors now operate 24 hours a day and they can
move money around the global almost instantaneously. Foreign direct physical
investment is less mobile but it has also become increasingly more “footloose”. Labor
used to be very mobile. Prior to the 19th century, international borders were only
approximately known and rarely policed. As late as the early 20th century, passports
were unnecessary and people could travel freely from one country to another. But the era
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of free immigration has long gone. Today, unskilled labor is largely immobile, while
professional and technical human resources are more mobile, but subject to the regulation
of the receipting country. Unfair perhaps, this international economic order is a reality all
individual countries have to face.
Characterized by such stratified mobility, globalization in its present form increases
supply elasticity for mobile factors such as capital and skilled labor, and demand
elasticity for immobile factors such as land and unskilled labor. In political terms,
globalization enhances the power of those who own capital and human capital, while
undercutting the power of those who do not. What are its implications for income
distribution? More specifically, what are the channels through which openness and
inequality may be linked? Two channels appear to be crucial: the employment channel
and the fiscal channel. The former affects the distribution of primary incomes, whereas
the latter affects the distribution of secondary incomes (Rao 1998).
The Employment ChannelLet’s look at the employment channel first. The impact of trade on the levels and
structure of employment and wage is the direct route for openness to influence
distributional outcomes. According to the standard Hechscher-Ohlin-Samuelson model of
trade (which can be adapted to capital mobility), openness should help reduce inequality
within developing countries, because free trade is supposed to increase incomes for the
abundant factor and reduce incomes for the scarce factor. In developing countries, capital
and skilled labor are scarce, while less-skilled labor is abundant. As those countries shift
from capital-intensive toward unskilled-labor-intensive production, unskilled wages will
rise relative to skilled wages and returns on property. Has this been true?
Not necessarily so. There are several reasons. First, it is possible that what is labor-
intensive in the product mix of the world turns out to be capital-intensive or skill-
intensive in the product mix of a developing country. The less developed a country, the
more likely this is the case. Wherever this happens, rather than reducing wage inequality,
openness may increase wage inequality (Xu 1999). Second, if openness is predated by a
period in which the state restricted labor mobility or created underemployment, removal
of such restrictions will enable managers, professionals, and skilled labor to enter
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international markets, and turn hidden underemployment into open unemployment, both
of which tend to worsen income differentials. Third, in former socialist countries, pre-
openness restrictions generally depressed returns to the well off (managers, professionals,
and skilled labor) and raised rewards to unskilled labor. Removal of the restrictions
would make income distribution more unequal. Fourth, in large developing countries,
export sectors tend to concentrate in relatively industrialized regions. Trade opening will
increase profits for producers of exported goods. But, with poor infrastructure and low
level of human development, less developed regions may lack the capabilities to benefit
from openness. What is worse, import-competing sectors tend to concentrate in those
regions, which make them extremely vulnerable to the costs of globalization without
being able to benefit from it. Consequently, the existing regional income gaps may
widen. Fifth, in large developing countries with diversified economic structure, the
internal mobility of skilled labor may still be higher than that of unskilled labor.
Differences in supply and demand elasticity will privilege the skilled and the mobile at
the expense of the unskilled. Finally, openness is likely to lead to shrinking capital-
intensive formal sectors and expanding labor-intensive informal sectors. The
informalization of the labor force has potentially serious consequences for wages, job
security, and income distribution, because it undermines the labor’s collective power vis-
à-vis the capital’s. (Butt & Rao 2000)
The above discussion suggests that openness is most likely to worse income
distribution in three types of countries: least-developed countries, transition countries,
and large developing countries. Recent assessment of the globalization and inequality
connection in developing countries seems to have confirmed this hypothesis. While
observing no general pattern, those studies did find that openness has been associated
with rising inequality in the world’s poorest nations (Garrett 2001), giant countries (such
as China, India, Indonesia, and Russia) (Lindert & Williamson 2001), and countries in
market transition (Steward 2000).
The Fiscal ChannelThe fiscal channel is also important for distributional outcome because both taxes
and public expenditures can be devised to remedy income inequality. On the revenue
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side, progressive taxes can reduce inequality by imposing a heavier tax burden on those
who have larger primary incomes. On the expenditure side, public spending can reduce
inequality by providing the poor with health, education, housing, social services,
subsidies for daily necessities, safety nets, other transfer incomes, and even job
opportunities. If a government is able to do both, income distribution in the country is
expected to improve. The question is what the fiscal consequences we would expect from
the reduction in barriers to international factor mobility.
The Structural Power of Capital: Threat of ExitThe dominant economic view emphasizes the structural power of capital, by which
it means the ability of capital owners to move production and money around the world in
search of higher rates of return. Whenever necessary, capital will not hesitate to move to
relatively low tax nations. The threat of exit is believed to have severely limited the
state’s room to maneuver. If governments chooses to alter the distribution of primary
income in favor of the poor through tax policies and transfers, they potentially undercut
the confidence of business in a profitable rate of return on investment and, by doing so,
reduce growth. In order to prevent capital exercising exit options offered by openness,
governments are likely to engage in “tax competition”, namely, bidding with one another
to lower tax burdens on business progressively to a “lowest common denominator”. As it
becomes more difficult to tax capital and people with high human capital, tax burdens are
likely to be shifted to immobile labor. Such a move will not only decrease the
progressiveness of the tax system, but also reduce the total share of taxation in GDP.
When tax revenues go down, public spending will eventually follow. Cumulatively,
greater openness may undermine the ability of governments to provide public services
(e.g., health and education) and social insurance expenditure, thus rolling back of the
state’s redistributive functions. In summary, this view holds that openness constrains the
freedom of governments to act autonomously and makes it inevitable the reduction of
taxation and expenditure, which is expected to worsen the distribution of secondary
incomes and exacerbate overall inequality. (Steward 2000)
The structural power theory is right in pointing out the restraining effects of global
economy on domestic political choices, but it is too deterministic so as to leave little
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room for states to adapt (Higgott 1999). Recent empirical studies reveal that, facing the
same structural pressures from the global market economy, not all states respond
similarly (Steinmo 1994; Swank 1998; Steinmo 1999; Garrett 1999; Rao 1999). If the
economic logic alone cannot explain the different national reactions to openness, there
must exist countervailing pressures that can modify the structural impact of capital
mobility and offset the ensuing inegalitarian tendencies. Where do such pressures come
from?
The Political Power of the People: Threat of VoiceWhile governments face the exit threat of mobile asset holders, they also have to
deal with market dislocations generated by openness (Garret 1999). Opening is a process
that generates losers as well as winners. As the scope of market increases in a country,
some social groups may find their income falling relative to others’ and their future less
secure. Rising income inequality and pervasive sense of insecurity could spark a political
backlash against open policy in general and free trade in particular. If the losers of open
policy happen to be powerful political forces, they may wage fervent fight against
government that imposes the openness agenda. To secure domestic political support for
continued openness to the global economy and to maintain social cohesion, the
government, as the socializer of risk of last resort, may be forced to compensate the
losers and ensure that the fruits of openness are broadly distributed. (Garrett 2001)
The key assumption of this political power argument is that constituencies in favor
of openness must continuously and consciously be built (Rajan 1999). Unless the
potential losers are adequately compensated, they may threat to block or disrupt policies
that are socially beneficial in aggregate sense. Compensation means income transfer from
those who flourish in an open economy to those who have been adversely affected under
market competition. To generate sufficient tax revenue for redistribution, the top deciles
would have to be taxed significantly more proportionally than the low deciles. Of course,
governments may or may not choose to do so, because richer taxpayers may have
economic and political power to prevent reforms that would affect them negatively.
Economically, they possess mobile assets such as capital and skills that enable them to
vote by feet; politically, they have resources and access to influence policy-making either
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directly or indirectly. But the rich has one vital disadvantage: they are small in number.
Where politicians are constrained to respond to changes in societal preferences, they may
have incentive to take the threat of social dislocations more seriously.
In summary, openness sets in motion two threats on the part of national
governments: the exit threat from the owners of mobile assets and the voice threat from
all others. Neither can dictate government behavior. In that sense, there is, and will
continue to be, considerable “room for maneuver” for governments. Numerous studies
reveal that, up to now the voice threat has overweighed the exit threat, although there are
exceptions (Steinmo 1994; Swank1996; Garrett 1999; Higgott 1999; Rajan 1999;
Kapstein 2000; Lindert & Williamson 2001; Garrett 2001;). For instance, in a recent
study of 125 countries, Rodrik (1998) identifies a positive correlation between an
economy’s exposure to international trade and the size of its government. Apparently, in
many economies exposed to significant amount of external risk, their governments tried
to mitigate risk by taking command of a larger share of the economy's resources and
institutionalizing social security, welfare spending, income-transfer programs, and other
types of compensatory programs.
Openness and Inequality in China, 1980-2000
Increased opennessThis and following sections are to look for broad association between openness on
the one hand and inequality on the other. Our intent is not to explore causality in any
rigorous sense. Rather, we simply examine trends after the onset of the openness. Of
course, this method is problematic since the government not only embarked on external
liberalization but also on reforms of domestic institutions and policies. Given that the
distributional outcomes are affected by all of these changes, it would seem impossible to
attribute the trend in income distribution solely to policy changes affecting external
economic relations. We do not intend to isolate the effects of external policy changes
because of the close relationship between external and domestic policy changes (Butt &
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Rao 2000). As long as trends in openness and inequality have coincided, at least we can
conclude that openness cannot reduce inequality.
From the very beginning, outward-looking, export-led strategy has been an integral
part of China’s reform program. Characterized by self-reliance, the Chinese economy
during the Mao’s era was basically one of autarky. Starting from 1978, various reform
policies have been implemented to promote external transactions. Those measures
included gradual reduction in import tariffs, the removal of most non-tariff restrictions on
imports of capital and intermediate goods, the broadening and simplification of export
incentives, the elimination of state trading monopolies, and active encouragement of
foreign investment and technology imports. Consequently, by 2001, China has emerged
as a fairly open economy with significant exposure to international competition.
The degree of openness can be measured by trade flows and FDI flows. China’s
foreign trade has increased substantially in the post-reform period. Foreign trade as a
fraction of GDP grew from barely 10% in the 1978 to over 40% in 1993-94. Although the
ratio has declined somewhat after the peak, it still exceeds 35% (see Figure 1).
Comparative studies show that large country size and low income level normally make
for lower trade and export ratios (Rao 1999). Taking that into consideration, one has to
conclude that China’s trade dependence is unusually high. In terms of growth, the dollar
value of China’s foreign trade increased by 17.45 times between 1978-99, while its GDP
grew only by 6.84 time in consistent price. Now, measured by trade/GDP ratio, China is
more "open" than the United States and Japan, not to mention average low-income
countries (Khan 1996).
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Figure 1: Two Measures of Openness, 1978-99
Source: Author’s databank.
FDI flows constitute another indicator of China’s external orientation. China had
little inflow of foreign investment prior to the early 1980s. In 1983, foreign direct
investment accounted for only 0.3% of GDP, which was almost negligible. The FDI/GDP
ratio peaked at 6.2% in 1993. Afterward, it began to drop. By 1999, the ratio of FDI to
GDP stayed at 4.1%, which was high even compared to large OECD countries such as
the United States, Japan, Germany, France, and Italy. In fact, China has been the largest
recipient of FDI among all developing countries, and the second largest recipient in the
whole world since 1993.
China has no doubt derived a great deal of benefit from openness. The principal
advantages of openness are three-fold: (1) by trading with foreign nations, China as a
whole can specialize according to its comparative advantage, thus improving its overall
allocative efficiency; (2) by interacting with foreign counterparts and attracting FDI,
Chinese industries can gain from knowledge spillover, thus helping overcome production
bottlenecks and improve their technical efficiency; (3) by competing with foreign firms,
Chinese firms are forced to upgrade their product quality and adopt new management
methods, thus improving their productive efficiency. (Khan 1996)
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Growing Inequality
In retrospect, it can be said that the Chinese reform has benefited everyone. There
are hardly any households whose welfare has not improved since 1978. However, a
careful review of the recent history reveals that the Chinese reform has actually gone
through two distinct phases. The first phase started in 1978 and ended around 1993.
During this period, the game of reform was truly a win-win one. All social groups gained.
The only difference was that some social groups might have gained relatively more than
others.2 Starting from around 1994, the Chinese reform entered the second phase, which
was characterized by worsening unemployment and growing inequality. To be sure, there
were still social groups that profited from the latest round of reforms. However, for the
first time, some segments of the society became net losers, losers not only in relative
sense, but also in absolute sense. Their welfare suffered real decline. To the extent that
some gained at the expense of others, the new game of reform has become a zero-sum
one. It is revealing that the second phase happened to be a period in which the degree of
openness was soaring, especially in terms of FDI.
The overall inequality in China can be usefully discomposed into four portions:
inequality within the rural sector, within the urban sector, between rural and urban
sectors, and between regions. First of all, the gaps between low-income and high-income
groups within rural China have been widening since the early 1980s (Fan 2000). The
trend was already unmistakable before 1990, but has become more visible after 1990. In
1990, the average income of the top quintile was only 6.3 times higher than that of the
bottom quintile in rural China. By 1998, the ratio had jumped to 1:9.5 (Figure 2).
2 During this period, there were moments when the game looked like a zero-sum one. For
instance, it was reported that in 1988 more than one third of the urban households
experienced declines in their real income. That was one of the reasons why millions of
Chinese took to the street in the early summer of 1989 (Wang 1992).
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Figure 2: Inequality in Rural China, 1990-2000 (The Bottom Quintile as 1)
Source: Guo Jianjun (2001): 6.
For urban China, there had been a significant increase in inequality prior to 1990
(Khan & Riskin 1998). Afterward, the situation became even worse. Due to
unemployment and other factors, many urban households experienced declines in their
real income in the second phase of reform.3 It was the poor who were hit hardest. When
the poor became poorer and the rich became richer, the gaps between them of course
widened. In 1990, the average income for the top quintile of urban households was only
4.2 times higher than that of the bottom quintile. By 1998, the ratio had jumped to 9.6
times, which was an unmistakable sign of polarization. Indeed, the richest 10 percent of
households were the biggest winners of recent reform. Their share of total income
increased from 23.6 percent in 1990 to 38.4 percent in 1998. On the other hand, the
bottom quintile was losers big time: their share of total income declined from 9 percent in
1990 to 5.5 percent in 1998 (Table 1).
3 In 1996, about 40 percent of urban households suffered such a bitter experience. The
next year was no better: those with reduced incomes constituted 39 percent of total urban
households, hardly any change from a year before.
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Table 1: Growing Inequality in Urban China, 1990-1998
Year
Income of Top 20%/
Income of Bottom 20%
Bottom 20%'s Share
of Total Income
Top 20%'s Share
of Total Income
Top 10%'s Share
of Total Income
1990 4.2 Times 9.0% 38.1% 23.6%
1993 6.9 Times 6.3% 43.5% 29.3%
1998 9.6 Times 5.5% 52.3% 38.4%
Source: Xu Xinxin & Li Peilin (1999).
Like other third world countries, China has a dual economy. When China launched
its reform initiative in 1978, the urban-rural divide was already rather deep: The per
capita income of the urban resident was 2.6 times higher than that of the rural resident
(see Figure 3). In the early years of reform, the urban-rural gap shrunk. Starting from
1984, however, the gap began to widen again. Nevertheless, before 1992, the gap was
still somewhat smaller than that of 1978. The second phase of reform was characterized
by the polarization of growth between China’s modern and traditional sectors. Thanks to
price increases of state procurement of grains, the polarization was temporarily arrested
in 1996 and 1997. But, given that China’s grain prices were already higher than those in
international markets, it is not realistic for the government to support the agricultural
sector by handing out subsidies on a regular basis. Therefore, after 1998, the urban-rural
gap began to widen once again. By 2000, the urban-rural split reached its peak, slightly
higher than that in 1994. All the gains of earlier reform years had been lost.
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Figure 3: Gaps in Per Capita Income Between Urban and Rural Residents
Source: Author’s databank.
Neoclassic economists predict that, coupled with economic growth, the operation of
market, left to itself, tends to bring convergence of regional income. But China’s
experience of the last two decades shows that convergence is by no means automatic.
Indeed the Chinese economy converged briefly in the early years of reforms, but the
trend was soon reversed. Disparity in per capita GDP between China's coastal and
interior provinces has been on the rise since 1983. And what is worse, the divergent trend
has accelerated after 1990.4 Figure 4 displays a set of coefficients of variation (CV) of per
capita GDP in constant prices, which are used to measure relative inequality between
provinces. The curve shows an U-shaped time path, with inequality declining from 1978
to 1991 and then reversing course (Wang & Hu 1999).
4 The World Bank arrives in an essentially similar conclusion (World Bank, 1997).
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Figure 4: Trend of Regional Disparities (CV), 1978-99
Source: Author’s databank.
Figure 5: Overall Inequality in China (Gini coefficient) 5
Source: http://www.stats.gov.cn/gqgl/gqglwz/200104240017.htm
From the above discussion, it is clear that the second phase of reforms has widened
the income gaps between regions, between urban and rural populations, and between rich
and poor households in both urban and rural China. These inequalities are overlapping
5 Gini coefficient is a measure of relative inequality ranging from 0, absolute equality, to
1, absolute inequality.
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and interrelated. Together, the growing inter-regional, inter-personal, and rural-urban
income differentials make China's overall income distribution much more unequal today
than ever before in the history of the People's Republic. Even the most conservative
official estimate admits that (see Figure 5).
During the Mao’s era, coupled with public ownership, strong state control over
prices and incomes was able to keep inequality at a very low level. When reform started
in the late 1970s, China was an egalitarian society with income inequality well below the
world average. By the mid-1990s, although the degree of income inequality in China was
still lower than that in most Latin American and Sub-Saharan African countries, "there is
no room for complacency" any more (World Bank 1997). China's income distribution has
already exceeded the inequality found in most transition economies in Eastern Europe
and many high-income countries in Western Europe as well as in some of its large Asian
neighbors, such as India, Pakistan and Indonesia, countries that had often been treated in
the development literature as classic cases of large income inequality. The World Bank
reports that the increase in China's overall inequality was "by far the largest of all
countries for which comparably data are available" (World Bank 1997: 7-8). Such a steep
rise in inequality in a short period of time is highly unusual in both historical and
comparative perspectives. Looking ahead, unless the trend of increasing polarization
could be somehow halted or reversed, the glaring inequalities prevailing in Latin America
and Sub-Saharan Africa are likely to emerge in China soon.
Causes of Growing Inequality of Primary Incomes
According to a World Bank study, China's export structure has moved in the
direction of greater labor-intensity (Khan 1996). Apparently, openness has facilitated
China to restructure its economy in line with its comparative advantages. The question is
why such a shift has resulted in increasing rather than decreasing inequality?
Inequality in China can be largely explained by two factors: urban-rural inequality
and inter-provincial inequality (Yao 1999), both of which seem to have been widened by
greater openness. For one thing, whether or not openness has brought about more job
opportunities for unskilled workers, the benefits mainly go to those residing in the urban
sector, not those living in the countryside. Moreover, openness tends to increase the ratio
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between manufacturing wages and agricultural wages, which is bound to enlarge the
urban-rural income gap (Khan 1996). As for the regional disparities, it needs to be noted
that a overwhelming proportion of China's exports (about 80%) originate in 11 coastal
provinces where only about 40 per cent of China's population live. These provinces had
been richer than the average to begin with. During the last two decades of reform and
openness, their growth rates of per capita GDP were generally much higher than those of
inland provinces. Khan is right in pointing out, “the export-orientation of China's growth
has by and large disproportionately benefited the richest provinces” (Khan 1996; Wang &
Hu 1999).
In addition, two factors can explain growing inequality within the urban sector. One
is raising income gaps between working employees and the employees sent home and
people with no job. Since China entered the second phase of reform, economic growth
has increasingly become a sort of “jobless growth”. This trend is vividly demonstrated in
Figure 6. In the 1980s, every additional percentage of GDP growth brought about 0.32
percent increase of employment opportunities. At that time, growth might be called a job-
creation one. By the mid-1990s, the mode of growth had changed. Then, when GDP grew
by an additional percentage point, employment opportunities increased only 0.14 percent.
The late 1990s saw the employment elasticity of output growth keeping falling. In 1999,
GDP grew 7.1 percent, while employment increased barely 0.36 percent, which meant
that every additional percentage of GDP growth brought about only 0.05 percent increase
of employment. As a result, millions of workers have already lost their jobs, and China
finds it increasingly more difficult to create job opportunities for those who newly enter
labor market (about 10 million every year).
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Figure 6: Employment Elasticity of Output Growth
Source: Hu Angang (1999).
How might one explain the paradox that growth based upon the expansion of labor-
intensive export industries resulted in such rapidly declining growth in employment? One
explanation is that during the pre-reform period and early years of reform, Chinese
industries had probably absorbed labor far in excess of requirement. So, the declining
employment elasticity perhaps reflects an attempt on the part of China's state and
collective industries to get rid of the enormous underemployment that the previous
decades have built up. Otherwise, they would not be able to respond to global
competition. In terms of efficiency, the reduction of the hidden underemployment
appears to be a wise move. It nevertheless increases the number of people whose incomes
either disappear or substantially decline (Khan 1996). Another possibility is that China’s
exportables may appear to be labor-intensive in the product mix of the world, but they are
capital-intensive or skill-intensive in the product mix of China. If that is the case, freer
trade may not be able to create sufficient job opportunities for unskilled workers in
China, which will increase rather than offset the rise in wage inequality (Xu 1999).
The other factor that explains growing inequality in urban China is increasing
returns to education. Even before the reform, returns to all educational levels were
already significant. Market reform and international competition make it imperative to
adequately reward those with high human capital. Consequently, returns to formal
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education have greatly increased during the reform era, especially during its second phase
(Zhou 2000).
Of course, the rapid growth of inequality in China is by no means an inevitable
result of the march toward an open market economy. To a large extent, government
policies are responsible for all the above-mentioned factors that have contributed to rising
inequality. Up to 1996-7, China’s policy environment had been pretty much pro-
efficiency and anti-equality. Policy barriers to rural-urban migration, for instance,
aggravated the widening gaps between urban and rural earnings. The policy of
concentrating tax and fiscal incentives as well as investment in China’s coastal growth
poles explains why the benefits of export-led growth did not spread widely to the interior
provinces. Had China chosen to adopt a set of more enlightened policies, the
distributional outcome would have been significant different (Khan & Riskin 1998).
Causes of Worsening Secondary Distribution
In theory, even if market reform and openness raise inequality of primary incomes
in a country, its government can use the gains generated by the change to compensate
those who are bypassed in its normal market operation, while still enhancing aggregate
welfare overall. If the compensatory mechanism is well designed and implemented, no
one would be worse off and everyone could be better off (Grunberg 1998). In practice,
however, the government may or may not be willing and able to deliver adequate
compensation packages to those who lose their jobs or face a relative decline in income
as a result of such economic changes (Kapstein 2000). What about China? This section
examines China’s system of public finance. It concludes that China does not have an
adequate compensatory mechanism.
Important issues in any discussion of compensatory mechanism involve two sides
of public finance: the revenue side and the expenditure side. On the revenue side, we
must, first of all, ask whether the existing overall tax level (usually expressed as a ratio of
tax revenue to GDP) is appropriate? If the government does not have sufficient revenue at
its disposal, redistribution is simply out of question. Even if the tax level is adequate, we
need to probe whether the existing composition of tax revenue is desirable in terms of its
distributional effects. Taxes can be broken into three major categories: income tax that
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comprises mainly taxes on personal income and corporate profits; domestic indirect (or
consumption) taxes that represents primarily sales tax, turnover tax, value added tax and
excises; and trade taxes, the bulk of which consists of import duties (Zee 1996).
Generally speaking, based on the principle of “ability to pay,” taxes on income are more
progressive than domestic indirect taxes on consumption, because administratively it is
almost infeasible to effectively implement, on a broad scale, graduated tax rates on
consumption.6 Compared to domestic indirect taxes, trade taxes (also a kind of indirect
taxes) are more sensitive to shocks, especially external shocks. Their proclivity to
fluctuation makes them even less desirable.
On the expenditure side, the degree of redistribution can be measured by two
general types of spending: social spending (e.g., education and health) and transfers, both
of which are supposed to benefit the poor and thereby reduce inequality.
Figure 7 provides basic information on China’s fiscal revenue, which is further
disaggregated into four categories: corporate income tax (CIT), personal income tax
(PIT); domestic indirect tax (DIT); and customs duties. Five observations can be made
from the figure. First, China’s level of tax revenue as a fraction of GDP suffered a sharp
decline between 1985 and 1996. It rebounded afterward. But the level of 1999 was still
10% below the level of 1985. Second, throughout the years, domestic indirect taxes
dominated and its share in GDP dropped but not much. Third, the decline of the
importance of corporate income tax was most drastic, falling from nearly 8% of GDP to
barely 1.6%. Fourth, customs duties’ share also fell substantially. And finally, the
proportion of personal income tax was very small but it nevertheless was the only
category that increased.
6 “In theory consumption can be taxed on the same graduated basis as income, by
allowing unlimited deductions from income of savings. But such a tax is likely to pose
tremendous administrative difficulties in most developing countries, as net savings during
a tax period eligible for deduction must be tracked and reported to the tax authorities”
(Tanzi & Zee 2000). Two countries that experimented with this tax about 40 years ago
(India and Sri Lanka) abandoned it soon after its introduction.
21
Figure 7: Structure of Tax Revenue in China, 1985-99 (% of GDP)
Source: Author's data bank.
To put China’s case in comparative perspective, Table 2 brings out the salient
differences between China and other countries. Most conspicuously, China’s overall level
of fiscal revenue was extremely low, only accounting for 11.4% of GDP, which was 20-
25 percentage point lower than those of the OECD countries and 6-8 percentage point
lower than those of developing countries. In particular, China’s revenue from income
taxes was too small, which, to a large extent, explains the low level of overall taxation.
With so little resources in its hands, the Chinese government did not have much for
redistribution. Another difference is also worth of noting. Normally, trade taxation plays
a very important role in developing countries (see Table 2). Interestingly, however, the
share of trade taxes in China resembled the OECD countries’ rather than developing
countries’, which was another factor that contributed China’s low overall level of fiscal
revenue.
Both Figure 7 and Table 2 suggest that income taxes and customs constitute the key
to explain the Chinese government’s weak and declining extractive capacity, because
their proportions in the total dropped radically and showed peculiar patterns deviating
from those of other countries. To what extent were such declines related to openness?
How exactly did openness affect the bases and rates of those taxes? We now turn to
answering those questions.
22
Table 2: China's Level and Composition of Tax Revenue in Comparative Perspective, 1995-97 (In Percentage of GDP) 7
IncomeTaxes
TradeTaxes
ConsumptionTaxes
Level ofRevenue
China (1994-98) 2.0 0.6 8.1 11.4
OECD Countries 14.2 0.3 11.1 37.9America 15.4 0.3 6.7 32.6Pacific 16.3 0.6 7.8 31.6Europe 13.7 0.3 12.1 39.4
Developing Countries 5.2 3.5 7.0 18.2
Africa 6.9 5.1 6.5 19.8Asia 6.2 2.7 7.0 17.4
Middle East 5.0 4.3 6.0 18.1Western Hemisphere 3.7 2.6 8.0 18.0
Source: Author’s data bank and Vito Tanzi & Howell H. Zee (2000).
Like other developing countries, China relied more on corporate than personal
income taxes. Personal income tax contributed very little to total tax revenue. This is so
mainly due to two factors: a large role played by informal activities8 and poor tax
administration. Again like many developing countries, China attempted to maintain some
degree of nominal progrssivity for personal income tax. But, as Figure 8 shows, the
effective rates were regressive rather than progressive. Here the effective tax rate is
calculated by dividing taxes paid by comprehensive income. Contrary to our expectation,
tax actually paid as a proportion of comprehensive income fell steadily as income raised,
which means that the poor born heavier tax burden than their rich counterparts did.
Widespread tax evasion was an obvious cause for this anomalous pattern. For instance,
7 Revenue includes income from non-tax sources. Revenues from the three major taxes
comprised over 90% of the total tax revenue of the non-OECD countries, while for the
OECD countries they comprised only about 70%. The rest was derived from social
security taxes, compared to about 5% in Africa, 7% in the Middle East, and 15% in the
Western Hemisphere. Social security taxes were inconsequential in Asia (Zee, 1662)8 It was estimated that the size of China’s informal sector is equivalent to about 25-30%
of its GDP.
23
the incomes of some of China’s newly rich came from such illegal practices as abusing
their political power to obtain bribery from domestic and foreign investors or using
insider information in the financial market to make a fortune. Such transactions
constituted a major source of base erosion. In addition, most taxable incomes in the
informal sectors simply escaped the tax net. Corrupted tax collectors might make the
situation even worse. They often relaxed enforcement in order to pocket bribes from
taxpayers.
Figure 8: Effective Rates of Personal Income Tax, 1997-99 (%)
Source: Author's data bank.
Yet, global integration was also a factor that contributed to the regressive shift.
According to the Chinese law, the legal personal exemption was RMB 800.00 per month
for Chinese citizens and RMB 4000.00 for foreigners. Although small in number,
foreigners in China typically belonged to the group with the highest income. RMB
4000.00 per month amounted to more than 10 times the country’s per capita income. In
order to make foreigners living in China happy, the Chinese government could not lower
the threshold of those people’s exemption. This in turn built up a pressure to lower the
legal personal exemption for Chinese citizens as well, which could further dampen the
share of personal income tax in the overall tax revenue.
24
When the burdens of personal income tax fall overwhelmingly on low- to moderate-
wage workers, it can be seen as a transfer from the poor to the rich, which obviously
violate the principle of horizontal equity.
As for corporate income tax, the impact of openness is more visible. Before 1994,
there had been separate laws governing corporate income taxes for domestic and foreign
enterprises respectively, which provided foreign firms with very generous tax
preferences. In 1994, China undertook major tax reform that unified tax laws for both
types of enterprise. The business tax rate on domestic enterprises was reduced from 55%
to 33%, which was supposed to be a universal rate. But legal and illegal tax preferences
for foreign investments still existed. Typically, legal preferences include generous tax
holidays, reduced tax rates, tax refunds, and various allowances such as depreciation
allowances, loss carry-backs and carry-forwards, and other allowable deductions (Lin
1999). In addition, in order to attract foreign investment to their administrative
jurisdictions, local governments often competed with one another by offering extra
preferential tax treatment to foreign investors in violating national laws. Such practice
was widespread in China.
This strategy proved to be a very expensive way to attract foreign investment (Lin
1999). Available surveys estimated that the effective rates of corporate income tax were
around 25-28% for domestic firms and 7-14% for foreign firms over the past few years
(International Taxation Research Council 2000). In other words, on average the tax
burden for domestic enterprises was 2-3.5 times heavier than that of foreign enterprises.
In 1999, the foreign corporate income tax yielded RMB 21.8 billion Yuan, which meant
that revenue lost from this source alone amounted to 22-50 billion Yuan, not an
inconsequential number.
Turning to the issue of taxes on imports, the relative importance of this revenue
source is normally much more pronounced in developing countries than in industrial
countries (Zee 1996). But China appears to be an exception. At first glance, this seems
very surprising since China’s nominal tariff has been relatively high. Prior to 1992, the
un-weighed average nominal tariff was 47.2%. It has been falling steadily afterward. By
year 2000, it dropped to 15.3% (see Figure 9). However, the nominal tariff was
misleading, because, as Table 3 shows, most of imports to China were either fully exempt
25
from customs duties (e.g., the imports for processing trade and the import of equipment
for technological transformation for foreign invested firms) or taxed at reduced rates
(e.g., those imports given preferential tariff treatment by various levels of government
legally or illegally). As late as in 2000, only less than 40% of China’s imports were
subject to customs duties in full. Consequently, the effective tariff (measured by the ratio
of imports duties to the total value of import) was only a small fraction of the nominal
tariff and it fell progressively in much of the reform era, from a peak of 16.2% in 1984 to
2.69% in 1998. In 1999 and 2000, the effective tariff recovered a little to around 4%,
which was largely due to a massive crackdown on smuggling in those two years. The
falling of both nominal and effective tariffs reflected a powerful tendency toward trade
liberalization in China. One of its consequences, however, was a significant loss in
budgetary revenue. Had the effective tariff remained at the level of 1984, China’s
revenue from customs duties in 2000 would have been over 300 billion Yuan rather than
75 billion Yuan as it actually obtained.
Figure 9: Nominal and Effective Tariff in China, 1970-2000
Source: Author's data bank.
Table 3: Proportion of Taxes ImportsYear Imports
(Billion Taxed
ImportsImports for Processing
Imports Exempted or
Other Imports
26
US$) (%) Trade (%) Taxed at Reduced
Rates (%)
(%)
1990 53.4 15.0 40.5 44.5 01995 132.1 15.4 44.2 30.7 9.71996 138.8 22.2 44.9 26.3 9.61997 142.3 23.4 49.3 16.1 11.21998 140.2 27.6 48.9 17.3 6.21999 165.8 37.8 44.4 14.6 3.22000 225.1 38.8
Source: International Taxation Research Council (2000): 78.
Clearly, under the pressure of openness, China’s tax structure has moved in a
regressive direction. This is reflected in the shift from income taxes and trade taxes
toward domestic indirect taxes. And even income taxes (personal and corporate) have
become regressive themselves. This drastic change may be considered “premature,”
because it has entailed substantial revenue losses that exacerbate the fiscal constraint
(Rao 1999). This change may also be considered “unjust” because the burden of tax have
fallen primarily on low- to moderate-wage workers.
If China’s system of taxation played no redistributive function, what about its
public spending?
Comparative studies find that openness tends to induce public sector expansion
rather than contraction as the structural power theories predict. This pattern had been
initially observed among developed countries (Cameron 1978; Katzenstein 1985). More
recently, it was established that the correlation held for developing countries as well
(Quinn 1997; Rodrik 1998; Garrett 2001). An explanation for such a correlation is that, in
countries exposed to significant amount of external risk, their governments have to find
ways to mitigate distributive conflicts generated by openness. Unless the governments
possess risk-reducing instruments and the requisite extractive capability, the ensuring
distributive conflicts may eventually derail the opening process itself.
Openness might have also increased the need and demand for government-led
redistribution of wealth and risk in China. Was the Chinese government ready to
respond? Figure 10 suggests an answer “no” to this question. In the era of reform and
openness, fiscal revenue’s share in GDP fell sharply, so did expenditure. Apparently, the
decline of fiscal revenue severely limited the government’s ability to serve as an effective
27
redistributor. By 2000, fiscal expenditure in China accounted for only 17.8% of GDP,
which was smaller than the corresponding figures in most countries, developed or
otherwise.
Figure 10: Fiscal Revenue and Expenditure in China, 1978-2000
Source: Author's data bank.
With so little at its disposal, the Chinese government simply could not afford the
luxury of institutionalizing welfare spending and income-transfer programs. Figure 11
provides information about China’s social expenditure and transfer payments. The former
refers to expenditures on education and health, while the latter covers spending on social
safety nets,9 both of which are supposed to benefit the poor and reduce income inequality.
It is noticeable that the GDP shares of the two types of expenditure were consistently
low. By 1999, China’s social expenditure barely reached 3% of GDP and its transfer
payments less than 1%. Such a low level of spending could hardly mitigate the
dislocations generated by domestic and international market forces. Moreover, the two
9 Specifically, it covers three broad expenditure categories in the Chinese budget, namely,
“expenditure on pensions and social welfare,” “supplementary expenditure on social
security,” and “special central funds on social security.”
28
categories of expenditure relative to GDP dropped substantially before the mid-1990s.
The declining proportion of GDP used for redistribution reduced the secondary incomes
of lower-income groups more than of upper-income groups. In terms of net effects of
public expenditure on income distribution, one can argue that the changing spending
patterns of the Chinese government might have aggravated rather than alleviated
inequality (Xu & Zou 2000).
Figure 11: Social Expenditure and Transfers, 1986-99 (% of GDP)
Source: Author's data bank.
Opportunities and Challenges
This paper is concerned primarily with the distributional consequences of openness.
One of its principal conclusions is that, as the Chinese economy becomes increasingly
integrated with the world economy, the distribution of primary income has worsened in
the country. Although the government’s policies, especially its regional policies, are to
some extent responsible for having aggravated the trend, the widening inequality of
primary incomes is perhaps inevitable anyway. Whatever aggregate gains openness may
engender, they are unlikely to trickle down to the poorer segments of society simply via
29
the operation of markets. Only the government can correct the rising inequality through
redistribution. The key issue then is whether the government is willing and able to extend
effective remedies to those who are penalized by the structural change.
At first glance, this study seems to confirm the structural power theory. As the
theory predicts, economic integration appears to have forced China to restructure its
system of public finance. Customs duties have been falling, so have taxes on mobile
factors. This change has led to two consequences, both of which are detrimental to
redistribution in favor of the poor. First, as the importance of trade taxes and income
taxes declines, domestic indirect taxation on consumption becomes dominant, which
shifts the whole structure of taxation toward the regressive direction. Second, overall tax
revenues plunge, which eventually results in the reduction of public spending in general
and social expenditure and transfer payments in particular. In the end, the regressive
transition in tax structure and the fall in the ratio of tax and expenditure to GDP impair
secondary income distribution.
A closer examination of the data presented in this paper, however, may lead us to a
different conclusion. Take a look at Figures 7, 10, and 11 again. Something significant
seems to have occurred around 1995-6. Indeed, in September 1995, the Fifth Plenary
Session of the Central Committee of the Communist Party of China reversed its biased
regional policy of favoring the costal growth poles, deciding to give more support to
economic development in central and western areas (Khan 1996). This was an
unmistakable sign that the government was moving away from its previous pro-
efficiency/anti-equality stance. Once the general policy orientation changed, the
government could always find instruments to pursue its newly set goals. This was
reflected in the following major adjustments. First, government revenue as a percentage
of GDP had fallen incessantly before 1995, but the declining trend was finally halted.
Between 1996 and 2000, it increased more than 4%, largely recovering lost ground in the
1990s. Second, as revenue went up, so did expenditure. The difference was that the latter
increased at much faster pace. Within the five short years from 1996 to 2000, government
expenditure as a percentage of GDP grew by 6%. By 2000, it reached 17.8%, the highest
level ever since 1988. Third, the revenue from personal income tax soared, from
negligible 8.3 billion Yuan in 1994 (the year when a unified personal income tax was
30
introduced) to over 50 billion Yuan in 2000, which represented an annual growth rate of
36%. Finally, social expenditure and transfer payments moved upward, especially the
latter. In 1998, the government added a new category of expenditure, “supplementary
expenditure on social security,” to its budget, which amounted 15 billion Yuan. The next
year saw that outlay being more than doubled (reaching the level of 34.4 billion) and the
emergence of yet another new category of expenditure, “Central fund for social security.”
The amount of the two outlays came to more than 62 billion Yuan in 1999, or 4.7% of
total government expenditure in that year.
Those recent changes were by no means accidental coincidences. Rather, they were
the results of deliberate choices. More important, there is no sign that they will come to
an end any time soon. Obviously, the Chinese government now realizes the danger of
growing inequality. In the first phase of reform and openness when everyone benefited, it
was easy to become obsessed with the neo-liberal doctrine or what some call
“Washington consensus.” Indeed, from the beginning of the 1980s to the mid-1990s, little
attention was paid to issues of distributive justice. As China entered the second phase of
reform, however, the harsh reality of zero-sum game served as a wake-up call. It becomes
apparent to everyone that growing inequality and unemployment have turned into a major
cause of political instability. Even though China is not a democratic country in the
Western sense, its government still has to respond to changes in societal preferences.
After all, this is a regime that, in spite of everything, professes to uphold the socialist
principle of equity. If it faces increasing inequality with indifference, the system itself
might be in danger of losing legitimacy. To maintain social cohesion, just like
governments elsewhere, the Chinese government now regards it imperative to provide the
most vulnerable in society with basic social insurance. Of course, this is no easy task.
Much of new transfer programs are financed by debts. It may take some more years for
the Chinese government to restore its capacity to affect the distribution of wealth and
income in society.
So, instead of confirming the prevailing structural power theory, the case of China
shows that states are by no means helpless in the face of the forces of globalization.
While it may be true that significantly increase of factor mobility has produced pressure
for national governments to “race to the bottom,” that does not have to be their only
31
choice. More likely, facing countervailing pressures from societal forces, governments
may be motivated to raise more taxes and spend more to build broader safety nets. This is
not to deny the constraining impact of openness on domestic policymakers’ choice set,
but to recognize the “transformative capacity” of states (Weiss 1998).
In this era of globalization, governments have to make two sets of choices: whether
to open their economies and whether to compensate the losers of their open policies (see
Table 4). It is certainly unwise for a country either to go back to protectionism or resign
itself too easily to the “structural power” of capital. With the “transformative capacity,”
the government can reinvent its role as the insurer of last resort without undermining the
strength of markets as economic growth generators (Higgott 33). Countries that open
themselves to the outside world while establishing institutions to ameliorate its adverse
affects are more likely to grow and prosper than those where openness simply promotes
income inequality, without any possibility for the “losers” to be compensated (Kapstein,
2000).
Table 4: Four Possible Routes to Globalization
Openness Closed DoorWith Compensation Growth with Equality Equality but stagnationWithout Compensation Growth with Inequality Stagnation and Inequality
By now, we can answer the question posed by the subtitle of this article: Is China
capable of compensating the losers of its WTO deal?10 It is certainly capable if the
Chinese government chooses to do so. However, if the Chinese government capitulates to
the “structural power” of global capital, and turns a blind eye to hardship caused by its
WTO membership, then the uneven distribution of the gains and costs of greater
openness will trigger and exacerbate distributive conflicts between the winners and
losers, and eventually derail China’s market reform and imperil its future growth (Wang
2000).
10 For an analysis of the possible impact of the WTO membership on China, see (Wang
2000).
32
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