China Needs More Progressive Taxes and More Spending on Public Health

China’s tax system is far too regressive. And its system of social insurance is still underdeveloped.

China consequently needs to collect more in tax (from the upper income cohorts) and devote far more resources to social spending. And that includes far more spending on public health.

This isn’t the standard (pre-corona virus) outside prescription for China’s economy. The standard focus has been on reducing the large role of China’s state and allowing the market more room to operate. But that agenda is incomplete. It has to be combined with the creation of a new system of tax and much broader provision of social insurance.

China of course is very good at state capitalism—many big Chinese companies are either state owned, or effectively controlled by the party. Large private companies generally can only remain successful if they stay in the good graces of the party-state—and thus face pressure to comply with the state’s goals. China is filled with state backed investment funds to support strategic industries, and the state still directs an awful lot of purchasing—which allows it to favor domestic firms and domestic production.

But unlike European countries that use heavy taxation to equalize market outcomes, China effectively taxes the bottom half more heavily than the top half. The income tax only kicks in at the very top of the income distribution and it generates very little revenue. As a result, the VAT and the very regressive social contributions generate the bulk of China’s tax revenue.

Limited tax revenues in turn limit how much China is willing to spend on social insurance.

As a result, China's system of taxation and spending does very little to change what Dexter Roberts called China’s “unbalanced, deeply unequal society.”

I have a new article in the online version of Foreign Affairs on this topic too.

But it isn’t just my view. The IMF has reached the same conclusion—see this 2018 paper on China’s high savings rate, this 2018 paper on income inequality, this 2018 paper on taxation and this 2018 paper on fiscal federalism in China. They are all of course the work of the individual authors, but they collectively paint a stark picture of how China’s current system of taxation and social insurance falls short.

And, more optimistically, they also lay out a fairly comprehensive agenda for reform—

Three points seem critical.

1. Collecting more in income tax (and ideally introducing a property tax)

China collects something like 1.3 percent percent of GDP in personal income tax (see this IMF paper).* The system is fragmented (different rates for different kinds of income) and it only really kicks in at the top of the income distribution. The United States—counting states—collects around 10 percent of GDP in income tax.

China’s existing system of social insurance is funded by social contributions—and there is a high minimum contribution (the exact amount varies by province). As a result, the tax burden tends to fall most heavily on lower wage workers.

“The current tax structure is regressive, especially for the very poor. While personal income tax has a relatively high exemption threshold, the flat nominal amount of social contribution at the bottom puts a heavy burden on poor households, with an effective tax rate of over 40 percent”

The bottom 50 percent is, according to the IMF, taxed at a higher rate than all but the top 5 percent (which pays more in income tax).

China also doesn’t tax the assessed value of property—so taxes on accumulated wealth are low (China does tax property transactions).

As a result, a big IMF paper (Jain-Chandra, Khor, Mano, Schauer, Wingender; Juzhong) on income inequality in China noted that fiscal policy has played only a limited role in “moderating income inequality in China to date.”**

2. Create a national system for social security and unemployment insurance

Right now, social security and similar programs are provided by the provinces and the provincial level cities (Beijing, Shanghai, Chongqing), and only for those who have the right “hukou” (household registration system).

In most countries these programs are national (see this paper, by Philippe Wingender). That helps facilitate mobility across the country—as workers can move from province to province without losing retirement or other social benefits. It also helps to equalize funding—as revenue from richer regions can help support poorer regions.

China is obviously big, but moving toward a national system here makes enormous sense. It would be one way of reducing the current duality in the labor market created by the hukou system. Right now, many employers have a strong incentive to hire migrants in order to minimize the payment of social contributions.

3. Increasing spending on public health and other social services.

China’s health care system leaves much to be desired (see the New York Times). Public spending on health is comparatively low—budget spending on public health was under 2 percent of GDP in 2016, and it was on course to rise to 2.5 percent of GDP in 2022 according to the IMF (see p. 21). But that was far too low even before the corona virus shock.

One byproduct of China’s low spending on public health is that relatively poor Chinese wage earners still save a fair amount of their income.

“In many countries, the savings rates for the bottom 10–20 percentiles are often negative, indicating that substantial social transfers are used to support the basic consumption. In China, however, the savings rate for the poor is still positive and quite high at 20 percent. This points to inadequate social transfers, a lack of progressivity in taxation, and a limited social safety net”

This point applies more broadly: China’s overall social spending, not just its health spending, is actually quite modest relative to its peers.

Why does this matter to the world?

Well, as Michael Pettis and Matt Klein will argue in their forthcoming book, this system of taxation and limited social spending is a big part of the reason why household consumption is so low—

And that in turn is a big reason why China’s excess savings are so high.

The IMF in turn has noted “High savings are at the heart of China’s external and internal imbalances.”

I fleshed this out back in 2016:

“Excess savings in East Asia contributes to financial fragilities, both within the region and globally. Before the financial crisis, excess East Asian savings stoked the U.S. housing bubble and helped to create internal imbalances in the United States and the eurozone, which were sustained only through the accumulation of toxic risks in the U.S. and European banking systems. Since the crisis, they have contributed to bubbles and bad debts within the region, notably in China. Throughout, the need to rely on exports to offset the weakness in demand that often comes with high levels of savings has put pressure on trade-exposed manufacturing communities in other regions, with political consequences that have been underappreciated until recently.”

A healthy global economy is impossible when China’s own high savings either result in excessive domestic investment (China after the crisis generally speaking), or extremely large trade surpluses (as was the case before the global crisis).

Real reform to China’s system of domestic taxation—and a major expansion of China’s system of social insurance funded through progressive taxation—is thus a genuine win-win. China wins, both through higher living standards for the bulk of its population and a more balanced domestic economy. And the world wins, because China’s excess savings would put less strain on the global trading system.

Of course, this is a very different agenda from the usual agenda of trade talks and the like, which focus on limiting the reach of China’s state (and in Trump’s case, encouraging China’s state to buy American in the meantime). But it is to me of equal importance.

* China’s central government actually collects more revenue at the border, from tariffs and the VAT on imported goods (which all goes to the central government, unlike the VAT on domestic production which is shared with local governments), than it does from the personal income tax. Don’t tell President Trump, who at least used to like to brag about all the revenue that his tariffs were bringing in…

** The 2018 IMF paper on inequality notes in a footnote: “Zhuang and Li (2016) find that China’s post-tax Gini coefficient is only 3% lower than its pre-tax Gini coefficient, compared to average reduction of over 30% in OECD countries.”