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Definition of Middle Income Trap Essay

As the name implies, the middle income trap is an economic development situation, where a country which attains a certain income (due to given advantages) will get stuck at that level. Part of this concept was firstly discussed in the 2006 World Bank report ‘Equity and development’ as the ‘inequity trap’. But this report does not state very clearly on the definitions, classifications and measures to avoid it, etc. Then in the famous 2007 World Bank report ‘An east Asian Renaissance’, this economic phenomenon was officially addressed. According to the latest definition of The International Monetary Fund in 2013, the ‘middle-income trap’ is the phenomenon of hitherto rapidly growing economies stagnating at middle-income levels and failing to graduate into the ranks of high-income countries (2013 The International Monetary Fund Working Paper: Growth Slowdowns and the Middle Income Trap).

From the publications and journal articles, it seems there has not been universal and very concrete understanding on the details of this issue yet. For example, different researchers and even different journalist may have different classifications on it based on various standards. However, the principles applied are similar. The most recent World Bank classification with data for 2010 is as following: a country is classified as low-income if its GNI (Gross National Income) per capita is US$1,005 or less, lower-middle-income if its GNI per capita lies between US$1,006 and US$3,975, upper-middle-income if its GNI per capita lies between US$3,976 and US$12,275, and high income if its GNI per capita is US$12,276 or above. This classification was also used by The International Monetary Fund in its working paper in 2013: Growth Slowdowns and the Middle Income Trap. After the International Monetary Fund applies this classification to its sample of 138 countries in 2010, the result yields 24 low-income countries, 36 lower middleincome countries, 33 upper middle-income countries, and 45 high-income countries (2013 The International Monetary Fund Working Paper: Growth Slowdowns and the Middle Income Trap).

It’s very clear that most of the countries are still in the situation of low income or middle income. In addition, middle income countries are much more than low income countries, which ensure us that it is make sense to pay more attention to the countries in the middle income situation. In recent years the world turned to recognize the existence of a Middle Income Trap. The term Middle Income Trap is by now also being widely used in economic literature as well as businessoriented media. The Middle Income Trap occurs when the growth of an economy slows and eventually flattens after it reaches a middle income level. The problem usually arises when developing countries find themselves stuck in between high and low income levels. On the one hand, with rising wages, middle income countries are less competitive compared to lessdeveloped, low-wage countries in terms of the cheap production of manufactured goods. On the other hand, they are unable to compete with developed countries in terms of high-skill innovations. As the Asian Development Bank describes, these countries cannot “compete with

low-income, low-wage economies in manufacturing” and similarly are disadvantaged against advanced economies in high-skill innovations”. In another word, these countries cannot continue to compete on cost for cheap goods, and they cannot yet compete on quality for more sophisticated items.

Let us have a deeper look at this economic phenomenon. When low-income countries first begin to take off, they often do take the advantage of a low-wage. This allows the country’s manufacturers to offer competitive prices on the global market, since they have a lower cost base. However, as economic growth rates and productivity rise quickly, rapid wage increases tend to follow. Thus the trap is generally characterized by the fact that rising wages eventually begin to eat into the competitiveness that low-base wages originally offered. Once economies get closer to the development frontier, the growth model will become more complex. It is increasingly determined by innovation, investment in more sophisticated technologies and through the raising of the level and quality of education, notably secondary and higher education of the potential labor force. Among these factors, it must be noted that education dose matter. In addition, the second education is more important than the general education.

Lower level of education in the majority of the labor force definitely leads to insufficient qualified workers. The risks of falling into the Middle Income Trap have increasingly become a focus of discussions in terms of the long-term economic and social development of developing economies. These risks, and how to minimize them, are being discussed at the highest levels of policy making in some of the fast growing emerging economies, even while these countries may still be sources of envy to the rest of the world, such as China, Russia and India. Countries in the trap and how to avoid the middle income trap As we mentioned above, due to a variety of factors, many countries risk getting stuck in this trap.

According to the International Monetary Fund, most notably, several Latin American economies, at least until recently, would seem to belong in this category, having failed to achieve highincome levels despite attaining middle-income status several decades ago (2013 The International Monetary Fund Working Paper: Growth Slowdowns and the Middle-Income Trap). Actually it has been well accepted that countries across Latin America as well as the several Middle East economies saw catch-up growth in the 1960s and 1970s but then they hit an invisible ceiling and have mostly stuck in the “middle income trap” ever since, with per capita incomes far behind the rare “break-out” countries.

Most of the evidence on the middle-income trap comes from these economies of Latin America and the Middle East. These are regions abundant in land and natural resources. They have had growth during commodity booms, often followed by growth crashes when commodity prices drop sharply.

In Eva Paus’s article about the Latin America’s middle-income trap, she points out that the accumulation of technological capabilities is at the heart of the development process. Technological capabilities refer to the resources and organizational abilities needed to generate and manage technological change. In a changing national and global context, accumulation those

capabilities is the key to sustained productivity growth and high-end economic development. She also mentioned Policymakers should promote entrepreneurship and innovation to begin reaping the benefits of information networks and skilled labor before the gains from cheap labor and knowledge spillovers are exhausted.

Nowadays people are more studying on Asian countries with more both low income and middle income countries. Through the evidence from countries already stuck in middle income trap and the current research in Asia, people could not only forecast the future in terms of economic development, but also make the policy maker to develop the suitable measures to avoid the trap. We could take a look at the middle-income Asian economies for our further investigation. There are eight countries that stand out in East and South Asia: the ASEAN-5 (Malaysia, Thailand, Indonesia, Philippines and Vietnam), China, India and Sri Lanka. But they are at very different levels of development. They could be divided into ‘high middle-income’ and ‘low middleincome’ groups. Malaysia is at the top of the high middle-income group. Indonesia, Philippines, Vietnam, India and Sri Lanka are in the low middle-income group. China and Thailand are roughly in the middle.

As we will discuss China in every detail later, let us take Indonesia as an example. According to the Asian Development Bank, Indonesia could be the case of the country in the middle-income trap. It became a middle-income economy in 2003. It actually attained middle-income status in 1993, but fell back after the 1997-98 Asian financial crisis. It took six years to jump back to the middle income level. Now it needs to battle the “middle-income trap”. Indonesia is not unique to this problem.

Regardless the different external international economic environment, many middle-income countries are without a viable high-growth strategy. They are faced with new challenges, including social cohesion, a large pool of young people in search of jobs, as well as millions who still live in misery and poverty.

Typically, countries trapped at middle-income level have: (1) low investment ratios; (2) slow manufacturing growth; (3) limited industrial diversification; and (4) poor labor market conditions. The Asian Development Bank in its 2011 report ‘Asia 2050: Realizing the Asian Century’ raised the question that considering that the region has to face up to the daunting opportunity that lies before it, how many countries will meet this challenge? The answer is still unclear. Given this reality and uncertainties about the future the report postulates two quantitative scenarios with very different outcomes.

Most of the discussion in the report is based on the optimistic Asian Century scenario. This scenario assumes that the 11 economies (Armenia; Azerbaijan; Cambodia; P.R.China; Georgia; India; Indonesia; Kazakhstan; Malaysia; Thailand; and Viet Nam) with a demonstrated record of sustained convergence to best global practice over the past 30 years or so continue this trend over the next 40 years and that a number of modest-growth aspiring economies will become convergers by 2020. In this scenario, Asia will take its place among the ranks of the affluent on  par with those in Europe today; some3 billion additional Asians will become affluent by 2050. This is the desired or ideal scenario for Asia as a whole. The Middle Income Trap scenario assumes that these fast-growing converging economies fall into that trap in the next 5 – 10 years, without any of the slow- or modest-growth aspiring economies improving their record; in other words, Asia follows the pattern of Latin America over the past 30 years. This is the pessimistic scenario and could be taken as a wake-up call to Asian leaders.

According to this report by the Asian Development Bank, there will be a huge difference in the outcomes of the two scenarios. The economic and social costs of missing the Asian Century are staggering. If today’s fast-growing converging economies become mired in the Middle Income Trap, Asia’s GDP in 2050 would reach only $65 trillion, not $174 trillion (at market exchange rates). GDP per capita would be only $20,600, not $40,800 (PPP). Such an outcome would deprive billions of Asians of a lifetime of affluence and well-being. The possibility of a “perfect storm” cannot be ruled out in thinking about Asia through 2050. A combination of bad macro policies, finance sector exuberance with lax supervision, conflict, climate change, natural disasters, changing demography, and weak governance could jeopardize Asian growth.

In this worst case scenario, Asia could stumble into a financial meltdown, major conflict, or region wide chaos well before 2050. It is impossible to quantify this scenario, but Asia’s leaders must be aware of the potential for such a catastrophe and avoid it at all costs. By contrast, several East Asian economies have in recent decades provided a template for success to get out of the trap and continue to grow rapidly after attaining middle-income status, and thereby attaining per capita income levels comparable to advanced countries (2013 the International Monetary Fund Working Paper: Growth Slowdowns and the Middle-Income Trap). So far, five Asian countries or regions have successfully escaped the middle-income trap, which are Japan, South Korea, Taiwan, Hong Kong and Singapore. What do we need to do to follow them? There is no uniform policy solution for avoiding the middle-income trap. South Korea, Taiwan, Hong Kong and Singapore have made the transition to advanced economies.

As noted by the Economist 2013, even still little is known about why so few countries succeed in making the transition from middle-income to high-income status, however, it’s clear that their paths were different but they shared a willingness and ability to change course. To better understand this question ‘How did these east Asian countries escape the middle income trap’ and find the answer, it will be very useful for us to go back to the World Bank’s landmark report “The East Asian Miracle”, which was published in 1993. It has analyzed the catch-up growth of the several East Asian Tigers, and some of its conclusions are relevant to the middleincome trap. Its foremost conclusion was that it is vital to ‘get the basics right’: macroeconomic stability, relatively low distortions to domestic competition, openness to external trade, flexible labor markets, and investment in hard infrastructure as well as education. On the other hand, we could analyze both low-income Asian countries and high-income Asian countries to further evaluate the situation in middle-income Asian economies which include China.

For low income Asian countries like Cambodia, Nepal, etc., to get the basics right must still be the top – we may even include the less developed states in China and India. These countries and regions should be in the business of catch-up growth, which comes from maximum mobilization of capital and labor inputs, and large productivity gains from efficient resource reallocation. This is what Prof. Paul Krugman calls growth through ‘perspiration’. At the other extreme, for high income Asian economies, from Japan down to Singapore, has to rely on ‘output-led,’ productivity- and innovation-based growth. This is what Prof. Paul Krugman calls growth through ‘inspiration’. To get the basics right is still important – note that Japan is hurtling in the opposite direction with wildly profligate fiscal and monetary policies.

But this has to be complemented with more sophisticated structural and institutional reforms. These “second generation” reforms (sophisticated structural and institutional reforms) have to go beyond liberalization of product markets to encompass deregulation of factor markets (for land, labor and capital). They must also include opening up of services sectors, upgrading “soft infrastructure”, and improving the quality of public administration, regulatory agencies and judicial systems. Among them, being part of “soft infrastructure”, higher education and skills are of the most important factors.

So what about middle income countries “in between”? They need a mix of getting the basics right and second generation reforms. But the balance should differ as between high middle income and low middle income countries. For example, high middle-income countries need to crack on with structural and institutional reforms for productivity-based growth. This also applies to China (especially its coastal provinces).

Moreover, in a recent report of International Monetary Fund, economists suggest four ways to avoid that:
1. Invest in infrastructure. The International Monetary Fund analysis suggests that subpar infrastructure is a key factor that can check an emerging economy’s growth. India, the Philippines and Thailand are particularly exposed in this area and should focus on building new and upgrading existing public transit systems, freight channels, ports and energy infrastructure.

2. Guard against excessive capital inflows. Money flows from abroad can energize an economy and give domestic consumption a boost, but can send an economy south if investors retreat in a hurry. Policy makers should have macro-prudential controls in place to mitigate potential rapid outflows, according to the International Monetary Fund.

3. Boost spending on research and development and post-secondary education. Both are needed to foster the innovation that’s a hallmark of advanced economies. According to the International Monetary Fund data, Malaysia and Thailand have the highest college enrollment rates among emerging Asian countries. However, China is rapidly catching up. China far outstrips other developing Asian countries on R&D, with 2009 spending at more than 1.5% of GDP.

4. Get more women into the workforce and raise the retirement age. Aging population is a problem in a lot of Asian countries. Governments should take actions to reduce “dependency ratios” by raising the age when workers are eligible for pensions and encouraging girls to enter university and vocational training.

Anyway, avoiding the Middle Income Trap entails identifying strategies to introduce new processes and find new markets to maintain export growth. Ramping up domestic demand is also important—an expanding middle class can use its increasing purchasing power to buy highquality, innovative products and help drive growth. The biggest challenge is moving from resource-driven growth that is dependent on cheap labor and capital to growth based on high productivity and innovation. This requires investments in infrastructure and education. As the several East Asian countries has proven, building a high-quality education system which encourages creativity and supports breakthroughs in science and technology is the key.

As Asian countries have approached or are approaching the technological frontier, the role of education does matter a lot. Many Asian countries have noted for their commitment to improve the quality of their education, and already have some of the highest educational attainments in the world. Yet the fiscal and institutional challenges to lifting educational performance in the way that is needed to sustain economic growth is another thing altogether. The success or failure in that will be a major determinant of whether Asia fulfils the expectations of its long-term economic growth. Looking at China

Many observers believe China’s amazing growth is nearing its limits. A joint report by the World Bank and China’s Development Research Centre has warned that the low-hanging fruit of statedriven industrialization is largely exhausted. According to this joint report, ‘If countries cannot increase productivity through innovation, they find themselves trapped. China does not have to endure this fate’.

This report emphasized that China has reached another turning point in its development path when a second strategic, and no less fundamental, shift is called for. For China, it can no longer rely on imported technology to keep up robust growth of averaging 9.9 percent since the economy was open in 1978.

The report said China’s growth of economy will slow to 7 percent later this decade and even 5 percent by the late 2020s even if China does not perform deep reform. However, this report also point out, if everything goes smoothly, China will be a “high-income” economy by 2030 and perhaps as dominant as Britain in 1870 or the United States in 1945, or indeed as flourishing as the Qing Empire itself in 1820 before the onset of catastrophic decline. As Economists 2013 points out, for all problems of China, in the coming 10-15 years it is still likely to reach several symbolic milestones.

The International Monetary Fund predicts that in 2016 it will become the world’s largest economy on a purchasing-power-parity basis. The Economist Intelligence Unit reckons that on the basis of market exchange rates China will attain that glory in 2020. By the end of this decade, according to Daiwa Securities, GDP per person in Shanghai, China’s richest city, could be almost the same as the average for America in 2009. Now, officials and experts discuss endlessly whether China is slowly heading towards a “middleincome trap”. According to Economists 2011, China was already a lower-middle-income country in 2010, with a GDP per person of around $4,400. The fear is that it might suffer the same stagnation and turbulence as Latin American economies in the 1980s and 1990s.

Nevertheless, with trend GDP growth in China slowing to around 8% a year from as high as 11% previously, it’s no wonder economists are asking whether it and other fast-growing Asian economies will fall victim to the middle-income trap.

Income inequality
The relationship between equity and development was thoroughly illustrated in the World Bank’s World Development Report 2006: Equity and development. According to this famous report, equity means that individuals should have equal opportunities to pursue a life of their choosing and be spared from extreme deprivation in outcomes. The main message is that equity is complementary, in some fundamental respects, to the pursuit of long-term prosperity. Institutions and policies that promote a level playing field— where all members of society have similar chances to become socially active, politically influential, and economically productive— contribute to sustainable growth and development.

Greater equity is thus doubly good for poverty reduction: through potential beneficial effects on aggregate long-run development and through greater opportunities for poorer groups within any society. The complementarities between equity and prosperity arise for two broad sets of reasons. First, there are many market failures in developing countries, notably in the markets for credit, insurance, land, and human capital. As a result, resources may not flow where returns are highest. The inequality of education is taken as an example in this report. Some highly capable children from poor family may fail to complete basic education even primary schooling, while others, who are less able, may finish university.

When markets are missing or imperfect, the distributions of wealth and power affect the allocation of investment opportunities. Correcting the market failures is the ideal response; where this is not feasible, or far too costly, some forms of redistribution— of access to services, assets, or political influence—can increase economic efficiency. From the World Bank’s perspective, the second set of reasons why equity and long-term prosperity can be complementary arises from the fact that high levels of economic and political inequality tend to lead to economic institutions and social arrangements that systematically favor the interests of those with more influence. Such inequitable governments can generate economic costs.

When personal and property rights are enforced only selectively, when budgetary allocations benefit mainly the politically influential, and when the distribution of public services favors the wealthy, both middle and poorer groups end up with unexploited talent. Society, as a whole, is then likely to be more inefficient and to miss out on opportunities for innovation and investment, which will accordingly have negative impact on the economic development. At the global level, when developing countries have little or no voice in global governance, the rules can be inappropriate and costly for poorer countries.

These adverse effects of unequal opportunities and political power on development are all the more damaging because economic, political, and social inequalities tend to reproduce themselves over time and across generations.

Such phenomena was named by the economists of the World Bank as ‘“inequality traps’, as we mentioned in the very beginning. Disadvantaged children from families at the bottom of the wealth distribution do not have the same opportunities as children from wealthier families to receive quality education, which really does matter for a qualified labor force in the future. So these disadvantaged children can expect to earn less as adults. At the same time, because the poor have less voice in the political process, they—like their parents—will be less able to influence spending decisions to improve public schools for their children. And the cycle of underachievement continues.

This report documents the persistence of these inequality traps by highlighting the interaction between different forms of inequality. It presents evidence that the inequality of opportunity that arises is wasteful and inimical to sustainable development and poverty reduction. It also derives policy implications that center on the broad concept of leveling the playing field— both politically and economically and in the domestic and the global arenas. If the opportunities faced by children from the poor families are so much more limited than those faced by children from wealthier families, and if this hurts development progress in the aggregate, then public action has a legitimate role in seeking to broaden the opportunities of those who face the most limited choices.

Furthermore, this World Bank report addresses three considerations which are important at the outset.
First, while more even playing fields are likely to lead to lower observed inequalities in educational attainment, health status, and incomes, the policy aim is not equality in outcomes. Indeed, even with genuine equality of opportunities, one would always expect to observe some differences in outcomes owing to differences in preferences, talents, effort, and luck. This is consistent with the important role of income differences in providing incentives to invest in education and physical capital, to work, and to take risks. Of course outcomes matter, but we are concerned with them mainly for their influence on absolute deprivation and their role in shaping opportunities.

Second, a concern with equality of opportunity implies that public action should focus on the distributions of assets, economic opportunities, and political voice, rather than directly on inequality in incomes. Policies can contribute to the move from an “inequality trap” to a virtuous circle of equity and growth by leveling the playing field—through greater investment in the human resources of the poorest; greater and more equal access to public services and information; guarantees on property rights for all; and greater fairness in markets. But policies to level the economic playing field face big challenges. There is unequal capacity to influence the policy agenda: the interests of the disenfranchised may never be voiced or represented. And when policies challenge privileges, powerful groups may seek to block reforms. Thus, equitable policies are more likely to be successful when leveling the economic playing field is accompanied by similar efforts to level the domestic political playing field and introduce greater fairness in global governance.

Third, there may be various short-run, policy-level tradeoffs between equity and efficiency. These are well recognized and extensively documented. The point is that the (often implicit) cost-benefit calculus that policymakers use to assess the merits of various policies too often ignores the long-term, hard-to-measure but real benefits of greater equity. Greater equity implies more efficient economic functioning, reduced conflict, greater trust, and better institutions, with dynamic benefits for investment and growth. To the extent that such benefits are ignored, policymakers may end up choosing too little equity.

As emphasized by the World Bank, income inequality is not all. However, as a lot of people believe, the greatest challenge ahead is still income inequality. All attempts will fail if this greatest challenge is not tackled. As state redistributive mechanisms have been weakened in the transition toward a market-oriented economy, China has turned into one of the most unequal countries in the world. Inequality, if not reduced, will be a huge barrier of future growth as it undermines consumption, constrains development in poorer regions, and generates social tensions. Income redistribution policies and social safety nets need to be strengthened to close the inequality gap, through increased budget support and improved government’s transfers to poorer provinces and households.

In China, the gap between the rich and the poor and between cities and countryside has continued to widen. Since 2003, absolute poverty has dropped remarkably. But at the same time, the number of people in relative poverty (with 50% or less of the median income) grew from 12.2% of the population to 14.6% between 2002 and 2007, according to research by Terry Sicular of the University of Western Ontario and Li Shi and Luo Chuliang of Beijing Normal University.

In addition, in 1981, at least 77 per cent of Chinese were in absolute poverty (that is, with family incomes below $1.25 a day). By 2008 this figure had fallen to 13 per cent. But, the bank notes, a far, far smaller group of people have been able to rise above $2 a day, and hundreds of millions appear stuck in this awkward space between the end of starvation and the beginning of actual comfort and hope.

Wang Xiaolu, the economist of national economic institution of China reform foundation, thoroughly elaborated the inequality and economic development in China in his 2006 report. Wang mentioned in his report that before China’s economic reforms, the income gap between urban residents was quite small due to the unified wage policy. On the other hand, in rural areas, the income gap within one region was relatively small. But there was a very large urban rural income gap, as well as significant differences between different regions. To demonstrate the income gap, let us take a look at China’s Gini coefficient. This index is a measurement of the income distribution of a country’s residents. The number, which ranges between 0 and 1 and is based on residents’ net income, helps define the gap between the rich and the poor, with 0 representing perfect equality and 1 representing perfect inequality. According to the National Bureau of Statistics, in 1980 when was the very early stage of the economic reforms, China’s Gini coefficient stood at 0.320, which is quite low and indicates a more equal distribution of wealth. After the rural reforms in the early 1980s, farmers’ income significantly

increased which led to the reduction of the urban-rural income gap. The Gini coefficient once dropped to 0.257 in 1984, which meant China had been into the more equal income countries ranks of the world. However, in the subsequent period of China economic reforms, the income gap between urban and rural areas, different regions, and different social strata is rapidly expanding regardless the acceleration of economic growth, the rapidly increasing of per capita income. Until 2001, the Gini coefficient reached 0.447, ranking 88 in the world’s 120 countries and regions in the order from low to high. Most of the countries behind China are those in Latin America and Africa with intense social conflicts, of which a considerable part is in a long-term economic stagnation (data from the World Bank, 2004; World Institute for Development Economics, 2004). In recent yearly the situation might be worse. This index has been retreating gradually since hitting a peak of 0.491 in 2008, slightly dropping to 0.49 in 2009, 0.481 in 2010 and 0.477 in 2011, according to the National Bureau of Statistics. Most recently, the Gini index reflecting the gap between rich and poor reached 0.474 in China in 2012, which is still higher than the warning level of 0.4 set by the United Nations.

According to the data from the National Bureau of Statistics, in terms of the urban rural income gap in China, the urban per capita disposable income is 2.5 times of the rural per capita net income in 1980, 1.9 times in 1985 and
3.2 times in 2004.

With the data mentioned above, if we use the average urban per capita income of each province to measure regional income gaps, we could find out that the figure of eastern regions is 1.3 times of that of western regions in 1980 and 1.5 times in 2004.

The statistics are incomplete in terms of the income gap among different social strata, but the huge inequality is an indisputable fact. If we look at urban per capita income in 1985, the highest 10% of households in the income is 2.9 times of the lowest 10% of households in; while in 2004 the highest is 8.7 times of the lowest. If we look at rural per capita income in 1980, the highest 10% is about 7 times of the lowest 10% (rough estimate number), up to approximately 11 times in 2004 (rough estimate number). We should also take into account that household income and expenditure survey for the highest and the lowest income residents are more likely to be missed, as well as high income underreporting of cases. As a result, the actual income gap will be larger than the income gap based on surveys. More than likely the increasingly widen of income disparities between different classes has become the primary factor of income inequality. Growing gap in income distribution is seriously challenging the social justice, which easily leads to social instability and economic stagnation.

In addition, we must pay great attention to the rich caused by corruption and other non- normal channels and the poor caused by unfair distribution of wealth (such as landless farmers and laid-off workers are not properly compensated, etc. ), which are the important reasons of the widening income gap and induction of social conflict. As we mentioned above, a lot of researchers and economists further noted that the distribution of income reversely has a very important impact to economic growth and severe income inequality will hinder economic growth (e.g. Galor and Zeira 1993and Bourguignon 2003). In a situation of economic stagnation, poverty and income inequality become more difficult to resolve, which turns to be an important reason of pushing many economies into Middle-Income Trap. In several studies of the World Bank in recent years, the economist point out that economic growth plays a decisive influence in reducing poverty, but its effect varies in different.

Meanwhile, economic

growth shows no significant role in reducing income gaps. In contrast, if the income gap is too large, it will indeed lead to frequent social conflict and accordingly directly affect economic growth. Therefore, for the eradication of poverty and reduction of the huge income gap, the economic growth is a necessary, but only economic growth is not enough (The World Bank reports, 2000, 2003 and 2004).

In a research of Wang Xiaolu and Fan Gang in 2005, it was concluded that China’s urban residents’ income gap, rural residents’ income gap as well as the income gap between urban and rural areas have continued to widen with a clear trend, but data of their study does not confirm that the income gap will automatically have the tendency to shrink when per capita GDP reaches a certain level. If the income gap continues to expand, China’s Gini coefficient of income will soon break 0.5 (some articles have concluded that in fact it has exceeded 0.5), and China will become one of the world’s most unequal countries in terms of income. Generally, equality and efficiency may be alternative of each other. The increase of equality in the distribution of income will lead to a decline in economic efficiency, which in some cases exists. However, if several factors discussed below are adjusted, the economic efficiency will not be lost, and the wealth equality will continue to be improved.

First, social security is an important measure of reducing the income gap, as it can provide protection and assistance to residents to reduce their financial burden or increase their income when they are in the face of illness, unemployment, retirement and low income, etc. But this approach is constrained by the level of economic development. As Wang and Fan point out in their report, social security and transfer payments beyond the affordability will result in heavy social burden and negatively affect economic development, investment and employment initiative. At present, China’s pension insurance, basic pension insurance, unemployment insurance and minimum living security system are still running in a very low level, and only conditionally implemented in urban areas and a few rural areas. Fully implementing these social securities in all rural areas will go beyond the current financial affordability.

Even in cities and towns, the current social security system does not play an active role in reducing the income gap. On the contrary, it has the effect of widening the income gap between urban residents. This is mainly because this social security system is still with a considerable degree of coverage limitations, particularly in the low income people and the mobile labor force. More importantly, the population without coverage is precisely the low income population which is most in need of social protection by these insurance systems. On the other hand, high income residents benefit from these social security systems significantly higher than low income residents.

According to a survey of the National Economic Research Institute, the Medicare reimbursement for medical expenses in low income urban residents is much lower than that in high income urban residents. Moreover, the proportion of Medicare reimbursement for the former is lower than the latter, while the proportion of self-paid medical expense in the expenditure for the former is significantly higher than the latter. Therefore, how to ensure the current social security systems to cover urban workers not in the social security system yet as soon as possible will be a critical issue to be addressed.

At the same time, social security issues of rural residents need certainly also be placed on the agenda as soon as possible. Long-term difference in treatment between urban and rural residents is not fair. However, this issue needs a longer period of time to gradually resolve due to limited financial resources. A few wealthy rural regions have already established a unified social security system conditions. For residents of most rural areas, although the conditions of establishment of a comprehensive social security system are not mutual, some pressing issues still need to be prioritized to solve, such as the problem of farmers have no money to see a doctor. The new rural cooperative medical care system needs to be quickly spread. Experiences of some rural areas have demonstrated that cooperative medical care system is very effective to protect the low income population.

On the other hand, according to international experience, financial transfer payment is also one of the main approaches to eliminate the income gap and regional disparity. As Wang Xiaolu points out in his report in 2006, in this regard in China, in addition to financial support for agriculture, pension and social welfare and supporting underdeveloped regions expenditures, tax return from central government to local government as well as the construction investment of key projects in the less developed regions, in fact, have been performed financial transfer payment function. The total amount of financial transfer payment is quite large. However, some studies have found that financial transfer payment did not play a significant role in reducing income disparities and regional development gaps. In Wang’s opinion, this is mainly caused by the following reasons,

First, the transfer payments are lacking of a rigorous and standardized system as well as standards of implementation. Hence the transfer payments’ strongly subjective profile makes their role in reducing income disparities and regional development gaps greatly reduced.

Second, the transfer payments do not have clear objectives and their structures are not reasonable. The proportion of the transfer payments for general investment projects and government expenditures is too high while that for alleviating poverty and decreasing the bottle neck of development of backward areas (such as insufficient education and other public expenditure, weak infrastructure, etc. All of those are impediments to economic development) underfunded. It makes the transfer payments difficult to play a critical role in reducing the income gap.

Third, there are no strict and effective measures to oversee the usage as well as the effect of transfer payments. For example, in some poor areas, the government poverty alleviation and disaster relief funds were frequently misappropriated to cover office buildings, luxury cars and government staff bonuses. Due to lack of management and supervision, some of the earmarks turned into waste, and provided the chances for some rent-seeking and corrupt government officials. Therefore, for transfer payments, the main problems now seem not to be the quantity, but rather setting up clear objectives and rationalization of the system to regulate the management and to strengthen supervision. These measures will reduce the income gap. At the same time, they will not reduce economic efficiency, but improve efficiency, reduce corruption and promote development.

In addition to social security system and financial transfer payments, education and infrastructure also play the similarly important role in the relationship of equality and economic efficiency. According to Wang’s research, many domestic and foreign literatures have pointed out that education plays a crucial role in the promotion of economic development; moreover, education to the whole population helps to reduce the income gap. In 2004 the National Economic Research Institute conducted a survey on the income of mobile labor force.

Across the country, 3,000 randomly selected migrant workers and self-employed persons from rural areas were classified according to the average monthly income. The results are as following: for those not graduated from primary school the average monthly income is 769 yuan, for primary school graduated 815 yuan, for junior high school graduated 960 yuan, for high school graduated 1268 yuan, for college and above 1554 yuan. This very clearly illustrates the level of education greatly impacts on income levels. Obviously, improving education is a fundamental way to improve the employability and income levels of low income population.

On one hand, currently there are hundreds of millions of rural labor force migrates into cities and towns to work. On the other hand, there are three hundred million people who are still engaged in agriculture, with wages of a small fraction of the average urban per capita. They are waiting to continue to transfer to cities. But most of them are facing low level of education, lack of vocational skills and oversupply in the labor market. Meanwhile, a lot of city workers returned to the status of poverty due to layoffs and unemployment. It’s very difficult for them to get reemployment because of the lack of professional skills. However, the labor market needs workers with a higher level of education and professional skills but has to facing the reality of supply shortage. Therefore, in order to narrowing the income gap, it is very critical to enhance the popularity of primary and secondary education and expanding vocational education.

In Wang’s research, he found out that China’s per capita level of education exhibits unexpected negative impact on urban residents income gap. Surprisingly, higher level of education led to a widening income gap. This is a strong signal that China’s education -age population is facing unequal educational opportunities, and educational opportunities for high income groups are significantly greater than the low income population. As a result, the per capita level of education increases, while the income gap has not narrowed. Instead, the income inequality is expanding. If we look at the popularization of compulsory nine years education in China, you will find in recent years, pupils’ dropout rate in rural areas was significantly higher than that in urban areas, with many dropout of school due to poverty situation in rural areas. This point can also be reflected from the allocation of education funds. Especially a few key universities get large amount of funds, while a great number of rural primary and secondary education underfunded.

Compared the situation in 2003 with that in 1999, the state financial allocations to universities increased by 40.4 billion yuan (in another word, increase 85%), while state financial allocations to ordinary primary and junior high schools increased by 52.5 billion yuan (increase 79%) and 49.8 billion yuan (increase of 65%), respectively. Although the situation has improved to various degrees, but this increase did not exceed the revenue and expenditure growth rate (90% and 87%). Even so, in 2003 the national average education budget per 420,000 primary schools is only less than 30 million, of which the budget allocation in rural schools is far less than that of urban schools. Some individual prestigious university obtained an education funding up to ten billion. Excessively unbalanced distribution of educational resources

not only will exacerbate income inequality, but also is not helpful for efficient allocation of education resources.
Another educational problem to be solved is how to correctly handle the relationship of general education and vocational education. Although in China currently there’re more than 4million people each year go into colleges for education, but there are also more than 17 million people directly get employment without higher education. For the labor market, each year the number of demand for workers with the level of secondary education as well as specialized skills far exceeds in number of the demand for college graduates.

However, the current dominant position of general secondary education is still basically to provide students into college In another word, the main objective of general secondary schools is the examination-oriented education and does not pay attention to skills training. The dominant ideology of the entire education system is to measure the success of education by entering the university or not. Four out of five school-age youth entered the labor market as the losers of their education. This reality has incalculable negative impact on workers’ skills, work ethic and healthy psychology, according to Wang’s report.

At the same time, secondary vocational and other professional education live in a subordinate position in the education system, with very limited quantity. Compared the situation in 2003 with that in 1999, the state financial allocations to secondary vocational schools increased by 300 million yuan (an increase of 2.5%), and state financial allocations to technical schools decreased by 400 million yuan (down 16% )and vocational schools increased by 3 billion (an increase of 42% increase ). These increases are negligible compared to the funding’s growth of universities and ordinary primary and secondary. Such education dislocation makes the most of new entrants to the labor market is lacking of professional skills, and their low level knowledge on employment helps rather limited. In addition, local education and vocational education system’s exclusion for migrant workers and their children is also need to be carefully addressed.

Like South Korea, China needs to focus on creating a highly qualified workforce so that they can increase innovation. South Korea adopted a policy to intensify investments in education and innovation in preparation for this. This policy aided South Korea in developing a plan for long term growth as opposed to short term consumption driven growth. Meanwhile, the World Bank has just released its detailed report: China 2030: Building a Modern, Harmonious, and Creative High-Income Society. In this report the World Bank believes that the export-led model that has delivered the past 30-years of growth and development in China has now run its course. From the World Bank’s perspective, China can only succeed in becoming a modern, high income country if it implements a six-step series of reforms. Not surprisingly, to increase innovation and to reduce inequality are among these six reforms as following, 

Accelerate the pace of innovation and create an open innovation system in which competitive pressures encourage Chinese firms to engage in product and process innovation not only through their own research and development but also by participating in global research and development networks. Essentially, the World Bank recommends that China seek to move away from being an imitator to an innovator in its own right.

Reducing inequality by expanding opportunities and promoting social security for all by facilitating equal access to jobs, finance, quality social services, and portable social security.

With regard to infrastructure construction in recent years, transportation, communication and other conditions as well as the urban landscape have significantly improved. But we should note the imbalance in the allocation of resources. In many areas, much more emphasis and attentions were put on the facade construction, highway construction and urban centers transformation than that on rural infrastructure in remote areas. On the one hand, highways are vacant or rarely used in some less developed regions. On the other hand, there are 173 towns and more than 50,000 administrative villages still inaccessible by road, the latter accounting for 8% of the total number of administrative villages across the whole country, according to Wang’s research.

For these remote areas, the weak infrastructure is an important cause leading to poverty and backwardness. In summary, China’s development level is still at the low level. Hoping to rely on transfer payments to drastically eliminate the income gap is unrealistic. What the governments should focus on is to provide more equal opportunities and conditions in education, infrastructure and other areas. Investment in these areas will provide human resources and infrastructure supply better meeting the social and market needs. By doing them, it is entirely possible to improve residents’ economic situation.

China is facing the continually widen income gap. If this critical issue could be reasonably resolved, Chinese social justice, harmony and long term economic development will be able to be ensured. . Otherwise, China may turn into a society with huge income gap, serious social conflict, power and money collusion, corruption and plunder prevailed, which will eventually result in economic stagnation. Middle-income trap will be impossible to avoid in this case. As we mentioned above, there are several factors leading to the current expansion of the income gap or blocking reduction of the income gap. These factors include that social security system is not sound, the financial transfer payment system is with flaw, educational opportunities are not fair enough, the education system is not conducive to the promotion of employment, weak infrastructure in rural and backward areas, lack of job opportunities as well as the irrational distribution of resources and corruption and other social inequities due to the not perfect system.

To resolve these issues, it’s urgent to perform further reform and development. The following most crucial problems need to be addressed: to solve the fairness of education, to solve the disjointed issues between educations, economic development as well as employment, to create more job opportunities through economic development and urbanization, to correct government’s action, eventually eliminates the problem of corruption and unfair distribution through administrative reform. Resolving these problems not only will not affect economic efficiency, but also will ensure the impartiality of Chinese social harmony, economic efficiency and long-term sustainable development.


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