International experience has shown that fiscal policy can play a leading role in promoting a shift toward a more inclusive economic model, balanced income distribution, and improved living standards. 

However, in developing economies, fiscal policy has been less effective in addressing inequality due to a high reliance on indirect taxation, and lower and less progressive tax and spending levels.

The People’s Republic of China’s (PRC) Twelfth Five-Year Plan (2011-2015), acknowledges the importance of fiscal policy and optimal taxation in its economic reform program, and the key role of fiscal policy to narrow income inequality and balance the pattern of growth. 

To achieve the Plan’s goals, however, requires comprehensive reforms to address major constraints.

First, PRC’s tax base should be broadened. Recent reforms in income taxation have reduced the number of personal income tax payers to less than 3 percent of the population. Tax evasion is high, and collection and enforcement are low. The narrow base leaves policymakers with no powerful income distribution tool. The direct income tax base can be broadened through measures to curtail tax evasion, to reduce the informal sector in the economy, and to strengthen tax administration.

Second, taxation should be more progressive. To achieve this, there should be more emphasis on direct taxation. Currently, the value-added tax is China’s single largest source of tax revenue. Indirect taxation is effective in raising revenue, however, it taxes rich and poor alike for the same transaction, and is highly regressive. Direct progressive taxation of incomes would help to shift the tax burden from low-income to high-income households. Taxing capital gains and property would also help to balance income distribution.

Third, social expenditure should be increased to curb precautionary savings and foster consumption. International experience suggests that increased public spending on healthcare directly increases private consumption. Similarly, higher provisions for education and pensions reduce life-cycle savings and free up household resources for consumption. Despite improvements in recent years, the need for broader pension reform remains urgent. Low pension levels distort consumption patterns and foster precautionary savings. 

Fourth, an overhaul of the tax revenue sharing system between the central and local governments is needed. Revenue allocation to the local level needs to be aligned with expenditure responsibilities. If this is not done, large disparities in public social spending per person will emerge and perpetuate inequality. Local governments’ low share of value-added tax revenue should be increased to allow them to fund their obligations to provide social services. Inter-provincial compensation mechanisms from richer to poorer provinces could also be adopted.

Tax reform and increased spending on healthcare, education, and pensions would reduce pressure on low-income household budgets. These measures would also reduce pressure for salary increases, which has had an impact on the PRC economy’s competitiveness. The reforms would encourage households to consume, providing the country with social stability and the economy with an important buffer against external shocks.

From the resources point of view, improved tax collection, further liberalization of energy and resource prices, green taxation, and transferring State-owned enterprises’ dividends to social expenditure would allow increased social spending to narrow the income gap, without straining public finances.