Tuesday, December 20, 2011

Macroeconomic Policies Widen Income Gap in China

By Tianlun Jian

The economic reforms since 1978 in China have largely followed principles based on two sentences by former paramount leader Mr. Deng Xiaoping; “Open up to the outside world and invigorate the domestic economy;” and “Let some people get rich first.”

Historically, the eastern region has been richer than the western and middle regions in China. Macroeconomic policies guided by “Let some people get rich first,” however, have only acted to widen the regional income gaps as well as income gaps between urban and rural residents.

Policies to Promote Export and Investment

“To open up to the outside world, and to invigorate the domestic economy.” Under these guidelines, special economic zones (SEZs) were first established. Preferential policies were set in SEZs to attract capital investment, especially foreign direct investment, with corporate tax exemption or reduction and tariff reduction or exemption. Products manufactured in the zones were designated mainly for export.
Four SEZs were first established in 1980 in the coastal regions. Then dozens more economic development zones (EDZs) with similar policies were set up to attract capital investment and promote export. Almost all were also in the eastern coastal regions.

Such preferential policies in effect are using tax revenue from other regions in the country to subsidize the SEZs and EDZs. Consequently, capital in billions of dollars flew into these zones, accelerating growth rates there. Statistics show that the eastern region, where SEZs and EDZs are located, experienced higher growth rates over the western and middle regions. At the outset of the reform, the eastern region accounted for 59.2 percent of China’s GDP. Thirty years later, its share of GDP increased 10 percentage points to 68.9 percent in 2008.

Monetary Policy: Currency Undervaluation

Higher economic growth and investment in SEZs and EDZs set an example for China’s growth model. But how could China as a whole also enjoy such high growth and investment? The key was to promote exports. That is, to open up to the outside world, but how? With backward technology, poor management, and low quality products, how could Chinese products compete on the international market? Export subsidies, tax exemptions, and dual exchange rates were all used to promote exports with limited success.

However, it was learned that the most effective and efficient way to promote exports was through exchange rates. Undervaluing the yuan would universally promote exports and redirect resources toward the export sector. Thus, the yuan exchange rate policy was set to promote exports, guaranteeing China’s export competitiveness.

Since the mid-1980s, exchange-rate policies were set to promote exports, unifying the exchange rates by devaluing the yuan from 1.50 yuan per dollar in 1980 to 3.20 yuan in 1985, and further to 5.80 yuan in 1993. In 1994, the yuan was drastically devalued to 8.62 yuan per dollar, drifting to 8.28 in 1995 and remained there for 10 years until July 2005, when most economists believed the yuan was undervalued by about 40 percent.

The yuan's undervaluation has made Chinese exporters extremely profitable but greatly constrained domestic demand, boosting China’s export-led growth and twisting domestic income distribution. China’s exports have grown at double-digit rates since 1986, and grew at an annual rate of 25 percent between 2000 and 2005, more than doubling its GDP growth rates in the same period.

As a result, real exports as a percent of China’s GDP increased from 21 percent in 1998 to 57 percent in 2007. Foreign capital was attracted by the profitable export sector. Foreign direct investment increased from US$3.5 billion in 1990 to US$75 billion in 2007; 58 percent of FDI engaged in exports, accounting for 57 percent of China’s total exports.
Meanwhile, China’s consumption, suppressed by the undervalued exchange rate policy, has declined each year as a percent of China’s GDP, from 58 percent in 1970s to 50 percent in 1990, to only 35 percent in 2008. This is much lower than the norm of about 60 percent in major countries, even lower than India, and it was less than half of the share of the GDP used for consumption in the United States.

What has caused consumption as a share of GDP to decline? The yuan's undervaluation. The yuan's undervaluation promotes exports at the expense of non-export regions and sectors. It uses tax revenue from rural areas, interior regions, and other sectors to subsidize eastern coastal export regions. Therefore, income and consumption in rural areas and interior regions, where the majority of the population exists, have lagged behind.

The yuan's undervaluation has widened the income gap regionally, between the coastal east and the rest of China, as well as between urban and rural residents.

The ratio of an average urban resident’s disposable income over the average rural resident’s net cash income has gone up from 1.7 in 1985 to 2.2 in 1990, and further jumped to 3.3 in 2008.

As for regional inequality, let’s take as an example a comparison of Shanghai, the richest coastal export region, and Gansu, the poorest interior non-export oriented province. In 1980, an urban resident earned 1.58 times in Shanghai what an urban resident in Gansu earned. By 2008, the same person in Shanghai earned 2.43 times as much as in Gansu. For a rural resident, one earned 2.62 times in Shanghai as in Gansu in 1980, but earned 4.18 times in 2008. In fact, a rural Shanghai resident earned 11,835 yuan in 2008, better off than the 10,696 yuan an urban resident earned in Gansu. It is obvious from the table below the impoverished Gansu Province has grown at a slower rate than the national average since the reform, leaving a bigger income gap. A rural Gansu resident earned only 57 percent as much as an average Chinese farmer in 2008 and an urban Gansu resident earned only 70 percent as much as an average Chinese urban resident.
This example shows that both regional inequality and urban and rural inequality have been widened. Furthermore, the undervaluation has widened the income gap between the coastal export region and interior non-exporting oriented provinces more than the income gap between urban and rural populations.

Fiscal Policies Widen Income Gap

In addition to the favorable tax policies toward coastal and exporting oriented regions, Chinese fiscal policy on land and properties has also played a negative role in China’s income distribution—widening the income gap.
Since the 1990s, the fiscal revenues of local governments have mainly come from real estate. Most revenues come from real estate development and land sales. Especially through land development, as the local governments sell the land to developers. Such revenues account for about 40 percent-50 percent of total, local fiscal revenue. And governments do not levy property owners for holding real estate. No taxes at all for the past decades. This is completely different from the practice in western countries.

Property taxes in the United States account for about 70 percent of local government revenue. When you purchase houses and land, you own them and you use them. Space and land are resources of the country. Naturally you need to pay taxes. Governments collect taxes and use the tax revenue to provide community services, including education and social welfare. The size of the budget governments can afford and what kind of public services they can provide depend on how much tax revenue they can collect. Since about 70 percent of local government revenue comes from property taxes, communities with better public schooling are usually the ones that have high property values. High property values generate high tax revenues, which enable local governments to have a larger budget for education. This is a general phenomenon.

The case in China is totally different. Even though fiscal revenue has increased by 20 percent-30 percent each year, China has never collected annual taxes on real estate. Instead, local government revenue mainly comes from selling land and taxes on real estate transactions. Consequently, rich people who purchase houses do not have to pay any taxes for their occupation and use of land and other resources. The rich can, on the one hand, gain through property appreciation. Meanwhile they can pass their property cost through rental fees to the lessee. So the rich get richer.

Housing values have doubled or even tripled during the past years in many large cities as capital is flooding in to chase the easy export profits from yuan undervaluation. And cash from the huge export surplus has to go somewhere for investment. The rich exporters, corporate owners, and foreign investors have all contributed to the surge of China’s housing market. In places like Beijing, the cost of housing has gone up even higher than in Manhattan.

Even though housing prices have become unaffordable to most wage earners, everyone wants to catch the train, for fear that once you miss it, you will forever be unable to buy a house. As a result, everyone is trying to buy apartments. Those who are rich buy a second, third, or fourth one for the expected capital gains; those who are poor, borrow to buy. As a result, sales of property in China in 2009 were estimated to have reached 6 trillion yuan, equivalent to the total retail sales during the same period. For the poor, many have to pay over 70 percent or even 90 percent of family income in mortgage payments, greatly lowering their living standards. The bubbled property markets have crowded out Chinese private consumption.

Social Responsibilities Shift from State to Individuals

In the previous sections, we provided numbers that can be calculated to show how the income gaps have been widened. In fact, factors that are not measurable have influenced the gaps more.

In addition, since the economic reform, especially since the 1990s, education reform, health care reform, housing reform, and other welfare reforms have shifted the state’s responsibilities to individuals. Provincial and local governments have reduced or even cut out budgets on education, health care, and social services.
As result, social welfare, especially welfare for the middle-and lower-income people has declined significantly, expanding the already wide income gap. Consequently, the children of farmers and the poor drop out of school early. Many people cannot afford to go to see doctors. Even though China has started working on health care insurance, by the end of 2008, more than 1 billion Chinese people, more than 70 percent of the population, still did not have health insurance.

Unemployment benefits cover only a small portion of the population, leaving basically all farmers without coverage. Since the global recession, unemployment has increased a lot as demand for China’s exports has declined by more than 20 percent for almost a year. In Guangdong Province alone, the number of unemployed people in the first half of 2009 was estimated to be between 20 million and 40 million. At the end of 2008, only 2.6 million unemployed were able to collect unemployment benefits. This fact indicates that most of such laid-off migrant workers will not get unemployment benefits. The global recession certainly has hit the poor in China the hardest.
Tianlun Jian, who holds a doctorate in economics, writes regularly on the Chinese economy.

This article was first published on The Epoch Times on January 21, 2010.