Income redistribution policies and strengthening of social safety are the key to reducing inequality, fostering consumption and sustaining economic growth.

What can China learn from other countries' experiences? In developed economies, fiscal policy is the key tool for reducing inequality. In the OECD countries, a broad tax base, progressive taxation and increased government transfers reduced inequality by one-third between 1985 and 2005. In developed economies, large fiscal transfers, for healthcare, education and pensions, have effectively reduced inequality. Reforms to broaden the tax base and increase the progressivity of taxation were also successful in redistributing incomes.

In developing economies, fiscal policy has been less effective in addressing inequality, because of their high reliance on indirect taxation, and lower and less progressive tax and spending levels.

Looking ahead, policymaking for China's next-generation leaders should focus on overhauling taxation and fiscal transfers to balance income distribution. The 12th Five-Year Plan (2011-15) acknowledges the role of fiscal policy in narrowing income inequalities, but comprehensive reforms have to be implemented to address major constraints.

First, China's tax base should be broadened. Recent reforms in income taxation have reduced the number of personal income tax payers to less than 3 percent of the population. Tax evasion is high, and collection and enforcement are low. The narrow base leaves policymakers with no powerful income distribution tool. The direct income tax base can be broadened through measures to curtail tax evasion, reduce the informal sector in the economy and strengthen tax administration.

Second, taxation should be more progressive. To achieve this, there should be more emphasis on direct taxation. Currently, the value-added tax is China's single largest source of tax revenue. Indirect taxation is effective in raising revenue. However, it taxes rich and poor alike for the same transaction, and is highly regressive. Direct progressive taxation of incomes would help to shift the tax burden from low-income to high-income households. Taxing capital gains and property would also help to balance income distribution.

Third, social expenditure should be increased. Social spending is preferable to tax cuts as a means of increasing consumption, because tax rebates are usually saved. Improved tax collection would allow higher social expenditure. A shift in public spending away from investment and toward social transfers would help to curb precautionary savings and foster consumption.

International experience indicates that increased public spending on healthcare directly increases private consumption. Similarly, higher provisions for education and pensions reduce life-cycle savings and free up household resources for consumption. The government has recently taken commendable action to expand the coverage of pensions, but the need for broader pension reform remains urgent. Low pension levels distort consumption patterns and foster precautionary savings. Improved tax collection, further liberalization of energy and resource prices, introduction of environmental taxes, and transferring State-owned enterprises' dividends to social expenditure would allow increased social spending without straining public finances.

Fourth, an overhaul of the tax revenue sharing system between the central and local governments is needed. Revenue allocation to the local level needs to be aligned with expenditure responsibilities. Otherwise, large disparities in public social spending per person will emerge and perpetuate inequality.

Local governments' share of value-added tax revenue could be increased from the present 25 percent, which is insufficient to fund their obligations to provide social services. Alternatively, the central government could increase its funding share while maintaining the existing decentralized scheme for providing social services. Inter-provincial compensation mechanisms from richer to poorer provinces could also be adopted.

Tax reform and increased spending on healthcare, education, and pensions would reduce pressure on low-income household budgets. These measures would also reduce pressure for salary increases, which has had an impact on the economy's competitiveness. The reforms would encourage households to consume, providing the country with social stability and the economy with an important buffer against external shocks.

Robert Wihtol is director general of the Asian Development Bank's East Asia Department, and Yolanda Fernandez Lommen is head of the economics unit at ADB's China office.

(China Daily 10/30/2012 page9)