Labor Market Reform, Income Disparity, and Consequences

Labor market reform has been aimed at both achieving better allocation of labor resources and providing incentives for the work force. However, for individuals, the initial result of labor market reform was to cause changes in employment status and income level. Upon a closer look, the two stages of labor market reform have had different influences on income disparity.

The first stage of labor market reform mainly resulted in a gradual adjustment of employment and income structure. Before 1997, the growth of production per capita could roughly keep pace with the growth of wages per capita. Therefore, before the labor stock underwent a radical restructuring, the benefits of economic growth were shared by most workers. At the same time, marketization reform increased the rate of return to human capital, which had been distorted under the planned economy. Many empirical studies have found that in the process of the PRC's reform and opening up, the return to education has been continuously rising (Li and Ding 2003; Li and Heckman 2004; Zhang et al. 2005). Therefore, in the first stage of labor market reform, the increase in income disparity was related mainly to the fact that the once-distorted return to human capital was being adjusted to normal. To sum up, labor market reform in the first stage caused people to “get rich together,” although some people got richer more quickly.

In the second stage, after 1996, employment restructuring became more radical. The employment status of workers was differentiated, the labor force participation rate decreased continuously, and the unemployment rate rose quickly. If we take a look at the PRC's urban unemployment rate, we can see that the registered unemployment rate of urban areas rose continuously after 1997 (Figure 12). Along with radical employment restructuring—and also because of the increase in income disparity between employed workers and laid-off workers—income disparity within cities also increased. Some of the laid-off workers fell into poverty in the cities (Meng et al. 2005). To sum up, the second stage of labor market reform brought people “structural differentiation,” in the process of which income disparity further increased.

As argued in the previous section, although the radical change in the labor market in the mid-1990s has successfully helped establish the growth pattern, based on low labor costs and high exports, labor's market position has also been weakened because of the enhanced market competition. As income inequality enlarged, labor's share of national income has been declining since 1996 (Figure 15 [ PDF 30.5KB | 1 page ]).

Being at the forefront of economic globalization, the labor market reform in the PRC has catered to the needs of globalization and led to the economy's constant utilization of the comparative advantage of low prices and the high quality of its labor force. At the same time, however, the increase in income disparity is a side effect of labor market reform. As the PRC's labor market reform takes place in an increasingly globalized and open environment, the pricing of capital and knowledge is carried out at the global level. In contrast, laborers, especially unskilled workers, cannot move freely across country borders, so they may only compete with each other within the domestic market. However, in the PRC, there is still a substantial supply of unskilled labor, and the pricing of such labor is carried out on the competitive labor market. To this day, given the institutional background of the competitiveness of the labor market, the weakness of trade unions, and competition among local governments, laborers lack protection of their rights. In the process of globalization, there is an unprecedented combination of capital and knowledge at the international level, whereas laborers are in a comparatively disadvantageous position. If the basic institutional system of the PRC's labor market does not change, it will be hard to relieve the increasing income disparity within a short period of time. Opening up the economy benefits urban areas more than their rural counterparts, and, therefore, income disparity between urban and rural areas is increased in the process of opening up (Lu and Chen 2004; 2006; Lu, Chen, and Wan 2005; Wan, Lu, and Chen 2006). Empirical studies on regional income disparity show that the opening-up process of the economy benefits coastal areas more than their inland counterparts. Globalization, with foreign direct investment and international trade as proxy variables, contributes nearly 20% of income inequality among regions, and this contribution has steadily increased (Wan, Chen, and Lu 2007).

The negative consequences of rising income inequality have been seriously ignored before the current crisis, because the PRC seemed to be so successful in terms of high economic growth. During 2003 to 2007, the PRC had five successive years with annual growth over 10%. However, when developed countries lost their purchasing power in the crisis, without other sources of demand to digest its production overcapacity, the PRC's high growth could no longer be sustained.

Furthermore, rising income disparity could harm an economy's growth potential in both short- and long-run, as an extensive literature has confirmed both theoretically and empirically. Generally speaking, there are four channels through which economic growth may be impeded by rising income disparity. First, because of imperfections in credit markets, a widening income inequality would increase the number of poor who face credit constraints, and therefore, lead to a decline in physical and human capital investment by them (see Galor and Zeira 1993; Fishman and Simhon 2002). Second, in a democratic society, a larger income disparity would create more proponents of redistributional policies which ask for higher taxes, while higher taxes provide negative incentives for economic growth. This branch of literature is represented by Alesina and Rodrik (1994), Persson and Tabellini (1994), and Benabou (1996). In addition, a larger income inequality would bring about social and political unrest, deteriorate the investment environment, and hence lead to an increased allocation of resources to property protection and a decline in the accumulation of productive physical capital (Benhabib and Rustichini 1996). Finally, low-income families generally have a higher fertility rate and lower investment in human capital. So, with the enlarging income disparity and hence an increase in the number and proportion of low-income families, the economy's total education level declines, and economic growth may be jeopardized (De la Croix and Doepke 2004).

Studies concerning the PRC have confirmed the negative influence of income inequality on growth. Using farm-household level panel data for four rural provinces in the PRC, Ravallion (1998) confirmed that initial wealth inequality had a significant negative effect on both the household consumption growth and the country's growth rate in mean consumption. Benjamin, Brandt, and Giles (2006) examine the relationship between inequality and economic growth using village-level panel data compiled from a large-scale, detailed household survey in the PRC. They also find initial inequality is negatively related to subsequent household income growth. Also, a study by Wan, Lu, and Chen (2006) finds that inequality in the PRC is quickly detrimental to investment, although inequality slightly promotes the accumulation of human capital. However, the negative effect of inequality on investment outweighs its positive effect on education. Therefore, the cumulative effect of inequality on growth is negative. It can be concluded from their empirical results that if the urban-rural per capita income ratio is lowered by one percentage point, then the growth rate would be 3.8 percentage points higher.

Apart from influences on economic growth, income disparity also has other negative effects on development. As Figure 16 [ PDF 31.7KB | 1 page ] implies, inequality may be accompanied by social unrest and crime. More concretely, the urban-rural per capita income ratio and property infringement cases have similar trends throughout the post-reform years.

The existing literature has also confirmed the relationship between poverty reduction and income inequality. Using data from Sichuan and Shaanxi provinces in the PRC, Zhang, Huang, and Rozelle (2003) find that changes in the poverty rate can be mostly explained by economic growth, and that economic growth is vital for poverty reduction. However, poverty alleviation policies in the PRC have had almost no effect. Yao, Hanmer, and Zhang (2004) find that poverty can be significantly affected by inequality. According to their estimate, for PRC urban areas, poverty would rise by about 15% or 30%, depending on whether the high or low poverty line were used, if the Gini coefficient were to increase by 10%. The corresponding increases in rural poverty would be approximately 21% and 35%, respectively, which implies that poverty ratio is more sensitive to income distribution in rural areas than it is in urban areas.

Inequality may also influence a person's health. Using individual data from the China Health and Nutrition Survey (CHNS), Li and Zhu (2006) discovered an inverse-U correlation between self-reported health status and income inequality. Their results also show that rising inequality could increase the probability of one's engaging in health-compromising behavior, such as smoking and alcohol abuse. Similarly, Feng and Yu (2007) also find an inverse-U correlation between income inequality and health in rural areas of the PRC.

Some more interesting studies relate happiness and public trust to income inequality. Using 2002 Chinese Household Income Project Survey data, Jiang, Lu, and Sato (2008) examine the effect on individual's self-reported status of happiness posed by identity related inequality. Their empirical results reveal that compared to urban residents, migrants without urban household registration (hukou) suffer more from the average income gap between groups with and without local urban household registration (hukou). Lu and Zhang (2008) show some evidence that income inequality at the village level is detrimental to public trust in rural areas of the PRC, but their finding is not robust if using different measurements of inequality.

In addition to the fact that income inequality is harmful to economic growth, income mobility also falls when income disparity increases. Using China Health and Nutrition Survey data, Ding and Wang (2005) measure the income mobility of households in the PRC from 1989 to 2000. Their findings imply that income mobility in the PRC has been maintained at a relatively high level during these eleven years, compared with the measured income mobility in Belgium, Germany, and the US reported in Kerm (2004). These positive results may explain why stability in PRC and the US is not undermined by serious social crises although income inequalities in both countries are statistically high. However, if nonmarket factors, such as social and political power, are embedded in the newly-grown market, income mobility in the PRC could decline. This unfavorable trend has already been revealed in Wang (2005) and deserves greater attention. Using data from the PRC in the period from 1989 to 1997, Wang shows that, though the overall income mobility helps to equalize the income distribution among households in all periods, this effect declined significantly in the 1990s, which implies a decrease in income mobility.

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