Fiscal Policy and Income Distribution in China

Since China introduced far-reaching economic reforms in 1978, it has experienced rapid economic growth and social development that has significantly improved the overall well-being of the Chinese population and lifted an enormous number of people out of poverty. But at the same time, income inequality in China has increased dramatically over the past three decades, and there is a significant divide between urban and rural areas as well as between regions. In 2013 the government committed to reducing rising inequality and persistent pockets of poverty through taxation, the social security system, and cash transfers. It stated that it would “accelerate the improvement of the redistribution adjustment mechanism with taxation, social security and transfer payments as the main means.”

To what extent did the combination of taxes and transfers reduce income inequality and poverty? In a CGD working paper released today—“The Impact of Taxes and Transfers on Income Inequality, Poverty, and the Urban-Rural and Regional Income Gaps in China”—we address this question using fiscal incidence analysis based on the methodology proposed by the Commitment to Equity Institute and described in Lustig (2018), using the China Family Panel Studies 2014 survey data. We find that the fiscal system was effective in reducing prefiscal inequality (inequality before taxes and transfers are accounted for) in China, in both rural and urban areas, as well as in each economic region. The fiscal system also reduced inequality between regions. However, the postfiscal urban-rural gap (the gap after taxes and transfers are accounted for) rose—an undesirable outcome given the size of the income gaps between urban and rural areas. The fiscal system reduced poverty in urban areas, but it increased the poverty headcount ratio ($5.50 PPP/day) in the rural areas and all three regions included in our study.

Size of taxes and government spending

The impact of the fiscal system on inequality and poverty depends on the size and progressivity of taxes and transfers (“transfers” here include direct cash transfers, subsidies, and spending on education and health). In 2013, China’s total tax revenue as a share of GDP was 19.4 percent, of which 1.1 percent of GDP corresponded to personal income taxes; 3.9 percent to corporate income taxes; and 12.2 percent to indirect taxes (including 5.1 percent VAT, 1.4 percent consumption tax, 3.0 percent business tax, and 2.7 percent other indirect taxes). Government spending was 24.6 percent of total GDP: social assistance programs (including the rural and urban Minimum Living Standard Scheme) was 0.8 percent; social security took 4.9 percent; and in-kind education and health transfers took 4.3 percent and 1.5 percent, respectively.

Compared to other large middle-income countries, the size of the government measured by tax and spending to GDP ratios would place China above Indonesia and Mexico, and below Brazil, Russia, and South Africa.

Impact of fiscal policy on income distribution

To estimate the impact of fiscal policy on inequality and poverty, we constructed prefiscal and postfiscal income concepts. The most comprehensive postfiscal income concept is called “final income.” Final income includes the incidence of direct personal taxes and indirect taxes, as well as cash transfers, subsidies, and education and health spending.

In our study, the Gini coefficient of prefiscal income was equal to 0.54, and the postfiscal final income Gini declined by 0.08 Gini points. How does this compare with other countries? Based on the information in the CEQ Data Center on Fiscal Redistribution, China’s fiscal system reduces inequality less than Brazil (decline of 0.11) but similarly to Chile (decline of 0.08) and much less than the formerly centrally planned economies of the erstwhile “Soviet bloc,” such as Poland (decline of 0.24) and Russia (0.17).

To assess the impact of fiscal policy on the urban-rural income gap, we decomposed the Gini coefficient into the standard “between” and “within” components both for prefiscal and final income. The “between” urban-rural component accounted for 18.2 percent of overall prefiscal income Gini, while it contributed 20 percent to the final income Gini. This result indicates that fiscal policy exacerbated the urban-rural income gap. An analogous exercise for regional inequality showed the opposite: the “between” regions component fell from 17.6 percent to 15.8 percent.

The reduction of overall income inequality and inequality within each area is mainly driven by the equalizing impact of personal income tax, contributions to social security, value-added tax, direct transfers, contributory pensions, and in-kind transfers. The widened rural-urban gap is mainly driven by the fact that urban residents received significantly more income from contributory pensions than rural residents. On average, urban residents received 11 percent of prefiscal income in pensions, while rural residents received only 3 percent. This indicates that although the “basic pension insurance for rural residents” has been in place since 2009, pensions received by rural residents are still significantly lower than those received by urban residents in 2013. The reduction of inequality between regions is due to the fact that the Eastern region—the richest—paid a higher proportion of taxes (25 percent of prefiscal income) and received the least benefits (16 percent), while the poorest Western region paid the smallest proportion of taxes (21 percent) and received the largest share of prefiscal income in transfers (direct and in-kind) and subsidies (23 percent).

Regarding poverty, based on the international $5.50 PPP/day poverty line (in 2011 PPP dollars), the headcount ratio of prefiscal income poverty in China in 2013 was 32.3 percent, 26.5 percent in the urban areas, and 39.2 percent in the rural areas. The poverty rate was the highest in the Western region (26.9 percent) relative to the Central (32.7 percent) and the Eastern (41.1 percent) regions.

Using the $5.50 PPP/day poverty line, the fiscal system reduced the incidence of poverty in the urban areas but increased the incidence of poverty in the poorer rural areas and in all three regions. In other words, China’s fiscal system drove more people into income poverty than it helped to escape poverty. When we use the squared poverty gap index, however, the fiscal system is poverty-reducing throughout. This is reassuring in that it tells us that China’s fiscal system reduces poverty for the poorest of the poor, even if it nudges some other people into poverty.

The Chinese government continues to revise its fiscal system, including through personal income tax reforms and value-added tax reforms in 2019. The findings we report in our new working paper provide a benchmark for assessing the impact of these reforms, as well as future fiscal reforms.