Cai Fang delivers a speech at The International Academic Forum in China 2021 in Beijing on Oct. 14. Photo: Yang Chonghai/CSST

The “trickle-down effect” is an important concept in neoliberal economics. It stresses not treating poverty-stricken social strata or disadvantaged groups preferentially in the process of economic development, but instead boosting the total wealth of society through economic growth to ultimately benefit the poor.

Historical experiences reveal that this concept, grounded in a set of assumptions, is not tenable in reality. First it assumes that the “pie” can be made bigger to increase aggregate social wealth. The second assumption is that primary distribution can substantively narrow the income gap. Facts have proven that primary distribution is indeed capable of improving income distribution, but has so far failed to reduce income inequality significantly, that is, to lower the Gini coefficient which represents the wealth gap to below 0.4. A third assumption insists a middle-income group can form and grow along with economic development and the rise of per capita income, which is also not in conformity with reality.

In China, intensifying redistribution efforts is necessary for steadily advancing common prosperity, and fostering and consolidating the middle-income group.

Actual conditions in China

In the tenth meeting of the Central Commission for Financial and Economic Affairs, General Secretary of the CPC Central Committee Xi Jinping highlighted the need to uphold the people-centered philosophy to promote common prosperity while pursuing high-quality development.

To this end, to keep economic growth within a reasonable range in the upcoming 15 years, China must constantly lift the potential growth rate on the supply side, while unleashing the potential of growth on the demand side, trying its best within its capabilities.

According to the long-range objectives for 2035 set at the Fifth Plenary Session of the 19th CPC Central Committee, China will join the ranks of high-income countries around 2025, and become a moderately developed country by 2035. We have forecast that the per capita GDP can basically reach $23,000 by 2035, and household disposable income will attain a new level. This indicates that household income can basically grow in sync with GDP growth, thus enabling the people to share the fruits of development.

Nonetheless, it should be noted that the per capita GDP and per capita household disposable income are both average values; they don’t involve income distribution. To realize common prosperity, it is essential to narrow the income gap as soon as possible. Since the 18th CPC National Congress in 2012, the income gap between urban and rural residents has been hovering after a period of narrowing. Other measures are needed to bring down the Gini coefficient to lower than 0.4, thereby ensuring the substantial advancement of common prosperity.

Two hypotheses

In mainstream Western economics, there are two famous hypotheses regarding the relationship between economic growth and income inequality. The first is the Kuznets Curve [proposed by Russian-American development economist Simon Kuznets]. It argues that as the per capita income increases, the income gap widens gradually, but will begin to narrow after a peak, therefore forming an inverted U-shaped curve. A comparison of the Gini coefficient and per capita GDP of countries around the world in different periods shows that this curve is generally true.

The other is the “r > g” hypothesis put forward by [French economist] Thomas Piketty, meaning that the rate of return on capital is always higher than the growth rate of output or labor gains, in other words, economic growth rate. It suggests continuously widening income disparities, which contradicts Kuznets’s inverted U-curve.

Both hypotheses are based on certain facts. The integration of the two is a manifestation of income redistribution. Case studies of OECD countries show that the Gini coefficients of the countries mostly exceeded 0.4 following primary distribution, but income redistribution through taxation and transfer payments reduced the coefficient by 35% in general, decreasing the coefficient of most countries to lower than 0.4 and even to lower than 0.3 in some countries. Therefore, redistribution plays a key role in bridging the income gap.

Significance of redistribution

A huge middle-income group preconditions a reasonable income distribution pattern. Redistribution is equally important to fostering and expanding the middle-income group, and increasing the proportion of middle-income earners in the total population.

Liu Yulin [a professor of economics from Chongqing University] defined middle-income earners as people whose per capita disposable income falls within the range between 4,000 and 31,000 yuan per month. In light of her definition, the estimated size of the middle-income group in China is closest to the figure published by the National Bureau of Statistics. However, disposable income refers to the amount of an individual’s income that is left after basic living spending and other fixed expenses are deducted.

In 2020, the per capita monthly income of Chinese migrant workers registered 4,072 yuan. Given a lack of social security and job stability, we can hardly categorize them into the middle-income group. Therefore, the middle-income group should be defined more accurately to cover reasonable wage earnings and modest property returns under certain standards, high-quality employment, opportunities to upgrade human capital, and the access to satisfactory basic public services. These requirements cannot all be met in primary distribution. Systematic reforms can help tackle problems related to income and employment, but the issue of basic public services must be addressed through redistribution.

Redistribution also involves a series of theoretical and practical issues. A crucial theoretical issue is how to achieve fairness and efficiency in different periods, and on the practical level, the issue of where “money comes from” is outstanding. If the intention of redistribution is to realize sustainable economic growth, then it can lessen the burden of social spending based on the same theoretical logic.

According to the so-called Laffer Curve [popularized by supply-side economist Arthur Laffer], an increase in tax rates will raise tax revenue, and thus raise the GDP. However, such policies usually result in growing income disparities in reality. We can adjust the Laffer Curve properly to reflect the directly proportional relationship between the government’s social expenditures and the ratio of the expenditures to the GDP, but after a certain point in time, an increase in the GDP, the denominator, will lead to a decrease in the ratio of the public expenditures. As such, whether redistribution, apart from improving income distribution, is capable of increasing the denominator determines whether the Chinese economy can sustain its growth.

In the case of China, enhancing redistribution can “kill three birds with one stone,” or achieve trifold effects. In terms of the universal law, first, in the stage when the per capita GDP of developed nations grew from $10,000 to $25,000, the ratio of social expenditures to the GDP jumped from 26% to 37%. From now to 2035, China will also witness significant improvement of social welfare.

Second, as the Chinese population is about to peak and then decline, the demand side has increasingly become a key factor constraining economic growth. This requires the expansion of consumption to hedge against the inhibiting effect of population aging on the total demand. Boosting consumption necessitates the further improvement of income distribution, especially the solving of demand-related problems through redistribution.

The third effect is creative destruction [a seemingly paradoxical term coined by renowned economist Joseph Schumpeter, referring to the incessant product and process innovation mechanism by which new production units replace outdated ones]. Excessive governmental protection is very likely to bring about zombie enterprises, so the government should avoid undue intervention in or protection of anyone, any enterprise, any production capacity, and even any job on the fronts of corporate operation and market competition. While shoring up creative destruction, redistribution with the provision of basic public services as the primary means can ensure that the ratio of social spending is in direct proportion to productivity.

Cai Fang is former vice president of the Chinese Academy of Social Sciences (CASS), chief expert of the CASS National High-End Think Tank, and CASS Member. This is his speech from The International Academic Forum in China 2021.