Tax reform needed to avoid middle income trap in China

By Liu Ge Source:Global Times Published: 2017/5/23 21:48:39

Tax reform needed to avoid middle income trap

Illustration: Peter C. Espina/GT

Not long ago, Peking University economics professor Cao Heping wrote in an op-ed in the Global Times that China had avoided the threat of the middle income trap. But shortly after that, Xu Xiaonian, professor of economics and finance at the China Europe International Business School, advanced the opposite opinion, which surprised me.

From my point of view, although China's economic transformation has seen some positive signs and appears to be heading in the right direction, the arduousness of the transition has not changed at all. China does still face the risk of falling into the middle income trap. Cao was excited about the 6.9 percent growth in GDP in the first quarter and he took the rapid growth of the number of newly registered enterprises and the increased contribution of consumption to GDP growth as evidence that China's economy has transformed itself successfully. But I believe this is too optimistic.

However, as for Xu's view, I have not yet heard any international organization, research institution, business organization or economist, except for Xu, announce that China has fallen into the middle income trap. Even foreign scholars specializing in the "China collapse theory" have not made such a claim.

Xu's idea is based on China's decades of quantitative but not efficient growth. Economic development can no longer be driven by capital accumulation as it has inevitably led to diminishing marginal income, which makes investment returns close to zero, and Xu argued that the middle income trap has come about when capital gains are equal to zero.

Some of Xu's errors should be corrected. First, in the economic growth process of all developed countries, quantitative growth and efficient growth cannot be separated, and there is not a single country that has experienced merely quantitative growth. Second, all developed countries have experienced a period of zero investment returns, which is the natural cyclical fluctuation of a market economy - described as a stage of economic crisis by Karl Marx. The US suffered from the Great Depression in the 1930s, but it is still the leading economic power in the world. A child cannot be judged as mentally handicapped based on only one failure in a test.

Besides, Xu said that the investment return rate in China is zero or less. Indeed, many industries such as steel, cement, coal and light industry have experienced varying degrees of overcapacity, and numerous traditional enterprises are under great pressure. But Xu did not see China's economic transformation completely. Entrepreneurs of a new generation are using new ways of thinking, investment, operation and management to develop new industries. How can the investment return rate in these industries be zero?

Many countries have not succeeded in their economic restructuring, and they have fallen into the middle income trap. This is partly due to social conflicts and political and economic factors. But China's current political system is completely different from Latin American countries that have fallen into the trap. The political situation is relatively stable, and the amount of talent and the scale of the domestic market are both huge. As a developing country with vast territory, unbalanced development and great market potential, China can still achieve sustained growth.

However, all of these advantages lie in whether policymakers are clearly aware of the relationship between the widening wealth gap and the sustainability of China's economic growth. In the past 30 years, China basically followed Japan's economic growth model, by promoting rapid economic development under efficient and powerful government leadership. But looking at the national wealth distribution, China has also experienced the so-called "Latin American" trend like Brazil, Mexico and other countries. Therefore, a smaller gap between rich and poor is a prerequisite for avoiding the middle income trap. If China can narrow the gap in the short term, it will be able to bypass the middle income trap after experiencing some hard times. But if China misses this chance and lets the gap expand, the country will fall into the middle income trap.

If the wealth gap is not dealt with, the overall reform and opening-up will have failed. This is not an alarmist opinion. The significance of the financial and taxation system reform is also located here. China's social income inequality must be corrected, and this can be achieved through fiscal and taxation system reform and by building a new society with a proper welfare system for reducing public uncertainty and panic. In recent years, the new welfare society has grown, with the government carrying out numerous beneficial policies, but the tax reform has not made substantial progress. Reform of the tax system - including levying a property tax, inheritance tax and luxury consumption tax, and tackling illegal wealth - is the right way ahead.

The author is a senior fellow with the Chongyang Institute for Financial Studies at the Renmin University of China.
Newspaper headline: Tax reform needed to avoid middle income trap

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