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China has to introduce regional solidarity if it wants to become a high-income country. Fiscal redistribution could bridge the gap between rich and poor provinces.

Uneven wealth: Nanjing Road in Shanghai.

The “middle income trap” has been a favorite buzzword in debates about China for some time now. In times of slower growth, the danger that China will fall into this trap seems more acute than ever before.

If higher wages lower the country’s competitiveness in exports of traditional unskilled labour-intensive manufacturing and if it does not move into higher value-added markets, it won’t be able to take the majority of its population beyond the “middle income threshold” of about 12,700 USD Gross National Income (GNI) per capita as defined by the World Bank.

With an estimated GNI per capita of 7,400 USD in 2014, China as a whole has made it only half way to the target of joining the high-income country club. Historic evidence suggests that changing this will be hard since very few upper-middle income countries have crossed the threshold. Almost eighty per cent of them remain trapped in the middle-income category.

But it is not useful to look at China as a whole since parts of the country have long reached the threshold to high-income economies. According to a China Business News (CBN) report, the GNI in the three mega-cities Beijing, Tianjin, and Shanghai had already approached 20,000 USD by the end of 2015. The report also stated that in 2015 Shandong became the tenth provincial region (out of 31) to exceed 10,000 USD in Gross Domestic Product (GDP) per capita. The difference between GNI and GDP in China is negligible.

Different economies within China

For the majority of Chinese regions, the picture looks quite different. The remaining 21 provincial regions are still below the 10,000-USD-threshold. With an average population of about 43 million inhabitants per province, this means that 900 million people still live below the desired income level.

A few years ago, observers were optimistic that it would only be a matter of time until all Chinese provinces catch up. As recently as 2011, the OECD estimated that by 2020 thirteen provincial regions would reach the high-income level, and that it would take until 2030 for all 33 provinces to join the club.

But given the enormous heterogeneity and structural disparities between urban and rural Chinese provinces, it is misleading to expect a linear growth path. And in light of recently decreasing growth rates, it is safe to predict that it will take longer than previously anticipated to escape the middle-income trap. By that time, however, China would already be in the stage of becoming an aging economy. This means that defending the status of a high-income country against both external crises and internal productivity slowdown would be an even tougher task than reaching it in the first place.

The unprecedented speed of urbanisation in China deprives rural provinces of the human resources they need to reach the middle-income level. With on-going rural-urban migration of the most dynamic parts of the population, the gap could get cemented, creating different economies within China. The Economist once illustrated this phenomenon by comparing the GDP of poor Bolivia with that of Qinghai Province and that of rich Finland with that of Shanghai.

Even the rich are vulnerable

These imbalances are neither good for Qinghai nor for Shanghai. Even the high average income in the three mega-cities cannot be taken for granted in a volatile global economic environment. The integration of these urban hubs into the global economy makes them vulnerable to external shocks. And the one-sided concentration of resources and capital in these regions, which were created by the uneven growth pattern, exacerbates the problem.

If they want to break this pattern, China’s leaders have a second task at their hands, in addition to the formidable challenges of maintaining high growth rates overall and fostering competitiveness and innovation. They need to create better systems for regional redistribution of the country’s uneven wealth and prevent a zero-sum game in which rich provinces gain at the expense of poor provinces suffering from the outmigration of skilled resources.

Since 1994, the central government has installed a system of vertical fiscal redistribution through a tax-sharing scheme with the provincial levels. But to create equitable living conditions throughout the entire country, the Chinese government needs to set up a horizontal fiscal redistribution mechanisms between rich and poor provinces, similar to existing systems in Austria, Australia or Germany.

This is a delicate task because it can weaken incentives in the rich provinces while fueling rent-seeking behaviour in the poor provinces. But the alternative would be much worse: China would remain trapped in the middle-income trap until its demographics crush any hope of securing a permanent place among the world’s high-income countries. Deng Xiaoping’s slogan “Let some get rich first” may have been the right motto during the beginning of the reform and opening period in the 1980s. Today’s China needs to adopt a notion of collective – and regional – solidarity if it wants to lift all boats.

Read here why China's anti-poverty fight also won't work without fiscal Redistribution.