The Challenge for China's New Leaders: The Dangers of Allowing Inequality to Worsen

Yukon Huang, 03/07/12

When Deng Xiaoping opened up the Chinese economy three decades ago, he did so on the premise that economic liberalization would precede political liberalization. For an impoverished generation that was still coping with the excesses of the Cultural Revolution, the chance at a better material life far outweighed the need for political expression. That trade-off held for many years; as recently as 2008, China topped the list of 24 countries included in the Pew Global Attitudes survey for its citizens' satisfaction with their nation's economy.

Recently, however, talk of a political transformation in Beijing is showing signs of renewal. A growing, newly socially conscious middle class has taken to the streets to decry the government's response to the 2008 tainted milk scandal, to the 2008 Sichuan earthquake, and to the harsh working conditions for migrant laborers in factories such as the electronics manufacturing firm Foxconn, which was the subject of a globally publicized inspection just last month. These instances of unrest -- and they are but a few of many -- expose a growing discontent with three fundamental facets of China's modern rise. For one, Beijing's distinct economic management style has created vast inequality. Second, the economic system has led to almost intractable disputes over a finite resource -- land. And third, the Chinese system relies heavily on migrant workers, who are stripped of many rights and protections, and therefore all the more likely to protest.

These problems reflect the failure of Beijing's reform agenda in recent years. There were plans to strengthen the fiscal system to address social equality and distribution imbalances during a time of rapid growth. Rigid controls over the use of key resources such as land and labor have created distortions that exacerbate social tensions. And this leaves a question for the next generation of leaders to be ordained later this year: Are they willing to tackle the many vested interests that have impeded change thus far and set China on a sustainable path into the future?

Deng might have avoided this outcome. When he launched his program of economic reforms in the late 1970s, he modeled it on the growth strategies the other Asian tigers had used to so much success -- focusing on investment and exports. But he concentrated production and state resources along the coast, where only one-third of the country's population lived. At first, half of all public expenditure went to those areas, but by the mid-1980s, the figure was closer to two-thirds. The coast thrived, while the vast western majority of the country lagged.

The geographical imbalance set off an unusually sharp disparity in regional income. Before liberalization in the 1970s, income inequality, as measured by the Gini coefficient, was a low 0.25 -- then, everyone was poor. Today, China's coefficient is relatively high, at 0.47. Although that figure is in line with Singapore and Malaysia (and lower than those of Thailand and many Latin American countries), the rapid change has been astounding. In just three decades, those who took the initiative found themselves wealthy beyond what they could have imagined in the 1970s. Meanwhile, as the protections traditionally provided by state farms and cooperatives dried up, those in rural areas lost their access to health services and guaranteed minimum incomes.

Inequality could have been manageable, as South Korea showed with its efforts to ensure the same quality of social services in rural and better-off urban areas during its industrialization. That it was not is all the more surprising, given the egalitarian origins of China's communist state. There was a real failure to moderate disparity through social services. At first, such services were seen as the writ of the central government, but Beijing's weak finances (the share of revenues to GDP fell to just 12 percent by the mid-1990s) made major redistribution efforts untenable. Responsibility cascaded down to the local levels, but funding did not follow. This was not for lack of money. Beijing's revenues have been rising steadily, but that money simply does not get budgeted out for social programs, given Beijing's preoccupation with supporting infrastructure to keep growth rates high.

Beijing's tax system is also economically divisive. In a communist system, revenue collection is normally geared toward redistribution. But in China, consumption-based indirect taxes (sales and VAT taxes, for example) make up the dominant share of revenues. Far from being redistributive, indirect taxes exacerbate inequality, because the poor use a larger share of their personal income for consumption. China does have income taxes, which in principle can be designed to target the better off, but most households earn below the threshold that makes them eligible to pay such taxes. And the wealthy often find ways to avoid their obligations altogether.

The vast earnings of state-owned enterprises are a major untapped source of revenue that could go toward funding social programs. But unlike in other countries, Chinese state-owned enterprises do not pay significant dividends back to the government. As their profits soared in the last decade, so did their clout within the political system. Thus, any moves to change the business codes were quickly forestalled, and the small amounts the firms paid out in dividends were not channeled into the state budget but into other loss-making state enterprises.

Consider that if state-owned enterprises had made dividend payments of 30-50 percent of earnings to the government -- as such enterprises around the world typically do -- each year Beijing would have collected revenues equivalent to two or three percent of GDP. With those funds, it could have increased spending on social programs by least one-quarter to one-third, which would have pushed expenditures on education, health, and social welfare closer to the international norm.

Since citizens cannot depend on Beijing or the benefits that flow from a sound tax system, they have turned to selling off land rights -- mostly to well-connected developers. Local officials typically pressure villagers and urban property owners to sell their land. The officials underpay them and then charge market premiums to developers, pocketing the difference for their own needs -- whether that be balancing government budgets or self-enrichment, as it sometimes is. Because this process is prone to rent-seeking, it underpins much of the buildup in Chinese mistrust of local governments over the past decade.

Improving the transparency of land sales would go a long way toward alleviating Chinese anger about regional inequality. For one, fair compensation to rural landowners would help facilitate more internal migration, opening a pressure valve of sorts. For rural families to relocate, they need to be able to liquidate their land assets. Without cash, would-be migrants are reluctant to give up rights that have been in the family for generations to go in search of better opportunities. But if poor people were able to pick up and seek fortunes elsewhere, Chinese would be less conflicted about a political and economic system that seems to lock rural residents into poverty.

Of course, the ability to migrate would not solve the entire inequality problem. Although the rural areas are the poorest, no group feels the government's inability to provide social services more than the 250 million Chinese workers who have migrated to the megacities. That group is made up of a steady stream of people who left their rural homes beginning in the early years of Deng's reforms, optimistic that they could find work that paid well. But they were never granted formal residency rights (hukou), so they did not qualify for health insurance or for better-paying jobs.

Initially, the deprivations did not seem important, since most migrants saw their stint in the cities as temporary. Over time, however, as wages and the availability of social services in the interior did not keep up with the coast, what was seen as temporary became permanent. For migrants, life in the cities without hukou was bad, but not as bad as back in the villages. Now in the cities -- many of them for good -- migrants have started demanding more compensation and more rights.

But the central government itself is under little pressure to make fundamental changes. That is because the target of most protesters -- whether migrant workers or villagers -- is local businesses and officials. The conflict between the residents of Wukan, a fishing village in Guangdong province, and local authorities over disputed land sales is a noteworthy example.

The details are all too familiar: Under pressure from local officials, village land was transferred to developers for nominal prices. When villagers discovered what had happened, they took to the streets. Local police arrested many of the protesters, and a village representative died while in custody. The locals then appealed to senior provincial and national officials, who conceded to villagers' demands to organize more representative elections and review the land transfers. In doing so, Beijing reinforced the popular perception that it is a potential savior against the abuses of corrupt local officials.

The claim that economic liberalization begets political liberalization is an old one -- and it has proved true in many countries, from South Korea to Chile. China, too, will eventually face the same forces. Yet the country is a unique case. Its decentralized political management style and strong regional differences in attitudes and customs have fostered a sharp distinction between how most Chinese view local authorities and how they view those in Beijing. Indeed, the capital's senior leaders are still perceived as having the people's best interests at heart, while local leaders are blamed for whatever goes wrong in citizens' daily lives. Accordingly, Beijing's worries over regional protests will likely prove overblown. In China today, for better or worse, local problems beget local reform.

Real systemic change would be a long and slow process, and so far, authorities have been reluctant to provide more responsive outlets for voicing complaints. They have also been less accommodating of village-level governance experimentation as they were a decade ago, when a number of such experiments flourished. Despite China's impressive economic achievements, the next generation of senior leaders taking office this year must find a way to move on political liberalization that meets popular aspirations but is acceptable within the party system. When a country is growing so fast, it can only kick change down the road for so long before the ride gets very, very bumpy.

http://www.foreignaffairs.com/articles/137316/yukon-huang/the-challenge-for-chinas-new-leaders