Is Income Inequality Slowing China’s Economy?

March 9, 2012

If income inequality is of interest to you, I strongly recommend an intriguing New York Times Op/Ed by HSBC’s Frederic Neumann. I’ve written on this subject many times, and I now realize that I’ve glossed over a couple of important questions: what are the causes of income inequality and how will such an imbalance negatively effect a country? Although the answers to these questions call for a great deal of speculation, Neumann provides some nice food for thought.

Here are his basic points:

Over the last few decades Asia has enjoyed relatively low levels of inequality. This is changing: Income disparities are now rising faster than before and increasing more sharply than elsewhere. Questions over political tensions aside, this matters for growth. First, it’s a drag on productivity. Second, it makes harmful populist policies very tempting.

Pardon my ignorance, but I’ve been so focused on this problem with respect to China, that I did not realize that this was, with the exception of Thailand, an Asian phenomenon. Neumann links periods of rapid growth with income inequality, so this makes sense; certainly Asia has seen a great deal of that over the past couple of decades, not just in China.

What accounts for the income inequality that we’ve seen alongside this growth? The picture is murky, but Neumann does give us a few possibilities:

What exactly is driving this is unclear. It may simply reflect the nature of growth, which has been dominated by manufacturing, while services, an industry of more equal rewards, is not yet fully developed. Demographics may also play a role, with a rapid increase in working-age populations having swelled the ranks of job seekers and thus depressed the rise in wages.

I think I buy some of that, but not all of it. Growth economics is more of an art than a science. My very limited background in the subject (a single class in grad school) taught me that some of the theories espoused by the major schools of thought are built upon some seriously questionable assumptions.

I would be interested to know more about manufacturing versus services. Seems to me like this has changed over time. I know that in the U.S., for example, manufacturing wages are not what they used to be. To my knowledge, this wasn’t a factor of demographics. I guess I’m more inclined to go along with that assertion with respect to Asia though.

With respect to demographics, the aging of Asia’s populations is a familiar story, but of course the picture in China is a bit more complicated. Moreover, there isn’t agreement on whether, or to what extent, China has utilized its surplus labor — the dreaded Lewis turning point debate.

So I hope you’ll excuse me for not trying to explain income inequality before. Way above my paygrade.

Next, what happens when income inequality rises in a country? Of the two questions, this is the more important one to me. If the answer is that really bad things can happen, then this is a vote for stronger policy solutions. Then we can worry about causes and ways to counteract them.

Neumann first says that historical evidence is on his side (unfortunately he doesn’t give examples):

What is clear, however, is that as income inequality sharpens, even if more and more people cross the threshold from poverty to relative prosperity, growth may begin to suffer. History, after all, shows that prolonged spells of rapid growth often come to an end when income inequality rises rapidly.

When I talk about this subject, I usually consider the political effects. In a country like China, pointing to something that can lead to political instability is generally a good way to get some movement on policy. However, an argument based on economic growth? That’s even better. If there’s been one guiding principle here in China since 1978, it’s sustained economic growth.

Neumann points to two ways that income inequality negatively effects growth:

First, growing disparities constrict economic participation of the less well-off. The full potential of an economy unfolds only if the gifted can apply their talents with equal opportunity. Income inequality reduces access.

Methinks one could expand that argument from economics to politics, but that would get us off topic. The basic point here is that the “Have Nots” are underutilized drones. Aggregate all that out, I suppose, and you could get a significant gap between actual and potential GDP growth — sounds rather Keynesian, doesn’t it?

Second, and equally important, rising income inequality tempts populist policies. This, over time, may undermine fiscal probity and distorts the allocation of resources. Politicians, feeling sudden pressure, may resort to subsidies and other quick fixes to provide temporary relief.

Latin America anyone? How about American China bashing? Yeah, I’m on board with this one.

If you’re buying any of this, you might be wondering what the end game is. If Neumann can back this up, and the conclusion is that income inequality is so pernicious that it must be addressed, what are the policy solutions? This part is probably familiar — I’ve certainly addressed each of these before:

First, tax systems need to aim for a more active redistribution of income, with more generous exemptions at the lower end of the scale and higher contributions at the upper end. Second, quality education and health care must again be made affordable and accessible for everyone. Third, governments need to tame inflation pressures that, more often than not, hurt the poor the most.

The good news, in China, is that the government has already implemented policies in all three of these categories. The results, however, have been a mixed bag. You may have noticed that the inflation numbers announced today were pretty good, so perhaps that’s one less thing to worry about. And certainly a lot of progress has been made on the social insurance front, although it’s going to take quite a long time to really kick that into high gear.

How about using taxes to redistribute income? Should be easy in a socialist country like China, right? Think again. High tax rates only work if enforcement is effective, and in China, where a great deal of tax evasion and avoidance goes on, this is a very tall order indeed.

Regardless of these details, Neumann’s argument is most welcome. Any attempt to push this dialogue forward and provide impetus for additional policy making should be encouraged. And by the way, Asia is not the only place with income equality problems. Perhaps he could expand his analysis to include the U.S.?

9 thoughts on “Is Income Inequality Slowing China’s Economy?

  1. Kai

    When I read “It may simply reflect the nature of growth, which has been dominated by manufacturing, while services, an industry of more equal rewards, is not yet fully developed”, what I immediately thought of was not regular workers but the owners and employers (bosses).

    I thought he was saying that a manufacturing heavy economy tends to create more income inequality than in a services heavy economy. I thought this made sense, as manufacturing is capital intensive and then rewards handsomely. So you get manufacturing heads getting richer more easily than the rank and file laborers working for them, thus inequality. Services, by contrast, require less capital and have less volume potential (regardless of profit margins). The risk and reward is more spread out, so you have less instances of people getting extremely rich relative to another.

    Does this make sense or did I misread him?

    1. Stan Post author

      Sounds reasonable to me. The big drawback to Op/Eds is that you can’t say much in 700 words, and we’re always guessing “what did that mean?” {sigh}

    2. PakG1

      I actually was thinking about this recently. Enough to blog about it! :D http://www.pakg1.net/2012/02/reality-of-pareto.html

      I think with technology, we’re seriously looking at automating a lot of services too, so that becomes more capital-intensive, like how manufacturing is. Various supermarkets in Canada now have self-checkout cashiers. New tech is being developed now using tablets for self-ordering food and notifying pick-up readiness in restaurants (no more waiters!). Heck, if IBM’s Watson keeps piling up the sales, we’ll automate a lot of information/analyst jobs too.

      In the long run, I don’t think services will reliably keep the paradigm espoused in the op/ed.

  2. Mohammad

    I agree with you Stan. No part of the world can see itself as completely equal in any way, regardless of what some countries my claim on their own account. In this sense I would just like to state that I last year was in contact with a company named CWIIL GROUP which has several initiatives for equality not just on income, but in the workplace as a whole, educational etc, which overall helps to heighten the social equality. As mentioned the company is named CWIIL GROUP (their logo is in capital letters ;) ) and I would just like to inform people in Asia and developing countries as a whole that there is place they can turn and the above stated company is one such partner. The even do legal cases pro bono, so for all those who feel they are being bullied by higher classes can go there. All contact details are on their website : http://www.cwiilgrop.asia

  3. Steve Barru

    Neumann’s analysis (and 700 words is indeed limiting when it comes to analysis!) already extends to the United States. The US tax system needs to redistribute income more aggressively and we need to make education and health care affordable and accessible to all. There are other things we could do in the US to tackle sluggish growth, create jobs, and in the process redistribute some the nation’s wealth to the people who get those jobs. But reforming our tax system so that the people with the most individual wealth contribute more to the commonwealth and dealing with education and health care costs and accessibility would have an enormous impact on income inequality in the US.

      1. Steve Barru

        It is too bad, not to mention discouraging. I got curious and took a look at a Gini index ranking (http://www.mongabay.com/reference/stats/rankings/2172.html). The US Gini is in the mid 40s roughly equivalent to China’s and the US is heading in the direction of more, not less, inequality. China is probably headed in that direction too. All of the EU economies are under 40, and Germany and the northern European states come in under 30. Some of the ratings are based on guesstimates and some are from 10 or 15 years old while others are more recent. Still, food for thought.

        Rapid growth may have an impact on inequality as Neuman says, but I think political decisions probably play a bigger role. To what extent is a political system willing to tolerate income inequality, and to what extent do policy decisions either support or discourage the growth of inequality. Or taking a step back from policy making, is a country’s political system independent enough of special interests in the polity to do anything, one way or the other, about income inequality? Does the ideology that informs a country’s political culture believe a relatively egalitarian distribution of national wealth is a good thing? In other words, economic developments of one kind or another may tend towards a more or less equal distribution of income, but it is finally political will and policy decisions that determine how those developments play out in the real world.

        1. Stan Post author

          I think ideology is acting as a barrier in the U.S., but not so much in China. Although this is a generalization, China has tolerated inequality for the sake of overall growth and is now trying to ameliorate that situation — and finding it very difficult to do so. I don’t think the U.S. is even trying, or even talking about trying.

  4. Hua Qiao

    The Gini coefficient for the US is high. On the surface, the US and China are about equal based on 2008. But if you add in the grey income in China and I bet the Gini goes sky high. Also Gini does not measure quality of life. A person living and traveling in the US and China would conclude that Americans Joe Sixpack live better than the lao bai xing.
    I think Stan is a little more negative than I am regarding the US ability to fix things. First, the tax system needs to be simplified. This was done in the mid 1980s under Reagan. But Congress jumped right back in the swimming pool passing tax bill after tax bill. People seem to forget that today’s tax incentive (for clean energy, capital investment, job creation, you name it) will be tomorrow’s tax loophole.
    The core issue in any economy is how do you create a system that incents the gifted ones to use their genius to create commercial ventures that benefit all society while at the same time redistributing a portion of the wealth in the economy to all players so that they have the basic necessities in order to take advantage of opportunities at hand?
    China has not done nearly enough. The US has spent a lot of money on trying to create the safety net but the net is full of holes.