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.?