Functional Income Distribution, Demand Driven Growth and the Middle Income Trap: The Case of China

Abstract

It is critical for China to develop its domestic market demand and to engage in technological innovations to escape the Middle Income Trap. However, evidence suggests that China has been experiencing rising functional income inequality, manifested in the declining labor share in national income until very recently. The paper argues that functional inequality contributes to worsening income inequality. This in turn reduces average consumption propensity and dampens the consumption share of GDP. Further, the ‘market effect’ of income inequality could be more pronounced than the ‘price effect’, disincentivizing further innovations. Therefore, to gain growth momentum and graduate from the MIT, China must address functional income inequality through policy measures.

Keywords:

• Functional income distribution
• consumption demand
• Middle Income Trap

JEL CLASSIFICATION:

• F63
• D33

Notes

1 China has several advantages that outweigh its high and rising inequality, including small informal sector, insignificant FDI presence, high investment and R&D spending and effective educational system.

2 Meanwhile, Kuijs (2006) concludes that the high capital share of income contributed to the high ratio of investment to output. Zhuang et al. (2012) also argue that because large share of capital assets in non-agriculture sectors is owned by state owned enterprises—50 percent in the industrial sector in 2008, an increasing share of capital income implies that part of household factor income is transferred to SOEs in the form of retained profits. This feeds into investment at the expense of household consumption. During 1995–2009, the share of corporate savings in GDP increased from 12 to 24%.

3 The effects are complex in the sense that wage is a cost for enterprises, rising wage could increase business cost and reduce production and employment. But on the other hand, because wage income is the basis of household consumption, rising wage income create enhance consumer demand and stimulate business sales and production.

4 Taking a broader view, the ILO data (2016) show that workers’ average output increased at a compound annual rate of 9.6% between 2000 and 2012 in China, while average real compensation increased at an annual growth rate of 8.2% during the same period. This suggests that labor compensation has not kept up pace with productivity growth.

5 According to the IMF, household debt has been rising rapidly in China. Between 2008 and 2018, household debt has gone up by 32 percentage points of GDP. At the end of 2008, China’s household debt to GDP ratio has reached 58%, higher than the emerging market average (Han et al. 2019).