How a Great Power Falls Apart
Decline Is Invisible From the Inside
In China, the state controls the commanding heights of the economy—an arrangement that has fed the outside perception that Beijing poses a particular threat to the global economy.
The Chinese state limits imports, for example, and rewards foreign firms that shift production to China and voluntarily share their technology with Chinese partners. For nearly ten years, state control of the exchange rate has kept the country’s currency significantly undervalued. Generous credit to state-backed firms fuels overproduction in sector after sector, allowing Chinese companies to undercut their global competitors in important markets (notably 5G technologies). And now new state-backed investment firms are supporting companies that aim to displace many foreign imports from China’s market, such as those of advanced semiconductors.
But the pressure China puts on the global economy actually also stems from the opposite problem—namely, the limited role of its government. Far from a behemoth, the Chinese state appears relatively small in its provision of social welfare to its citizens. It may claim to be communist and to embrace the ideological legacy of Karl Marx, but the government offers relatively little support to many workers. It maintains one of the world’s most regressive tax systems while also offering relatively modest social benefits. Thanks in part to these realities, China now is one of the most unequal societies in the world. Its economic behavior on the international stage stems in large part from this domestic reality.
China has failed to tax its rich effectively, and as a result, it has been unable to fund a progressive system of social insurance. This reality shapes the way the country interacts with the global economy, and it is an underlying cause of much of the trade tension between China and the United States.
High taxes on low-wage work and the limited rights accorded to internal migrant laborers reduce the take-home pay of Chinese workers. The government has talked a lot about shifting the economy away from exports and toward domestic consumption and has highlighted the growth in its service sector. But household consumption is only 38 percent of GDP, about 20 points below the global average. That ratio has changed little in the last 20 years.
The flip side of low consumption is a rate of savings—almost 45 percent of GDP. Only Singapore saves a comparable share. But unlike China, Singapore is too small for its excess savings to have much of a global impact. China faces the perennial choice of either stimulating its economy to help absorb savings at home (at some risk to the country’s financial stability) or dumping its savings on the rest of the world and using exports to make up for a deficit in its domestic demand. Unless China exports too much or invests too much abroad, its economy sputters.
People in China are inclined to save rather than spend in part because of the limited reach of China’s social insurance. Prior to reforms that opened up the economy in the 1990s, many Chinese workers relied on a system of employer-based social insurance that guaranteed housing, a pension, and other benefits. Known as “the iron rice bowl,” that social safety net based on steady employment at a state firm has withered away. But in its absence, the Chinese government now doesn’t raise enough money through taxation to properly fund public health, unemployment insurance, or a robust system of social security.
The disparities in China’s system of taxation limit its ability to guarantee social protections for its citizens. China’s heaviest tax burden often falls on those least able to pay it. The United States doesn’t have particularly high tax rates, at least compared with those of many European countries. But relative to its economy, the United States collects about eight times as much in personal income tax as China does relative to the size of its economy—around ten percent of GDP, as opposed to China’s meager rate of 1.3 percent of GDP. Personal income tax provides only about six percent of the revenue of China’s government, compared with around 25 percent in wealthier member countries of the Organization for Economic Cooperation and Development. With limited income tax collection and no property tax, China depends on regressive taxes, notably the value-added tax (a tax on consumption) and so-called social contributions (payroll taxes). A less progressive way to drum up government funding for social benefits is hard to imagine.
A study published by the International Monetary Fund (IMF) shows that the bottom 50 percent of China’s earners are typically taxed at a higher rate than most of the top 50 percent, largely because even the poorest workers in the formal labor force have to pay a high minimum social contribution. Those taxes don’t fund an especially generous system of benefits: China’s social spending is generally lower than that of other emerging markets. In other words, taxation in China does little to reduce income inequality and may even increase it.
China invests enormously in infrastructure, but not enough in public health. The outbreak of the novel coronavirus exposed this shortfall. Patients generally pay high costs out of pocket for medical care, and the government spends only modestly on health care. Its budgeted health expenditure, according to the IMF, was under two percent of GDP in 2016. Even with projected increases, spending would rise only to around 2.5 percent of GDP. Most advanced economies spend north of eight percent of GDP on health care.
China’s limited spending on health care has almost certainly contributed to its exceptionally high savings rate. According to another IMF study, public spending on health is one of the most effective ways of reducing savings rates and raising household consumption. In the early years of the first decade of this century, China’s high savings rates reflected high levels of household, business, and government savings. Today, households account for the bulk of China’s high level of national savings, as they save at a rate that is “15 percentage points higher than the global average,” according to the IMF. It’s not just wealthy Chinese households that are guarding their wealth; low-wage workers in China also save a large share of their income, in marked contrast with their counterparts in many other countries. If China wants to encourage more domestic consumption, it needs to significantly increase spending on health care and health infrastructure, reduce out-of-pocket costs, and invest in hospitals and the training of new doctors and public health workers, so that ordinary people feel more confident that they will be taken care of when the need arises.
Chinese households also save for retirement. In most large economies, the national government provides basic retirement security. In the United States, the federal government runs Social Security and Medicare, which are financed by federal taxation. By contrast, provincial-level governments administer China’s retirement system. Shifting to a centralized, national system would offer obvious advantages—stronger and more stable financing, benefits that can be transferred around the country, and the ability to finance the provision of benefits with progressive taxes. Such a system could also help bridge the gap between workers with an urban hukou (household registration) and migrant workers, who have access to much more modest benefits.
China must increase spending on health care and social security to spur greater domestic consumption. Otherwise, the country’s high level of savings, combined with the disproportionate tax burden on low-wage workers, will continue to limit the willingness of its citizens to spend.
How China taxes its people, and the extent of its social insurance, may seem far removed from the drama of the trade war with the United States, but China’s domestic policies do in fact affect the global trading system.
In broad terms, countries with low rates of consumption have two ways of maintaining economic output. One is through exports: a large trade surplus can make up for a shortfall in domestic demand. Before the 2008 recession, China took exactly this tack while also intervening intensely in the foreign exchange market. One yuan out of every five China saved was, in effect, lent to the rest of the world to support consumption abroad and help generate demand for Chinese exports.
Alternatively, countries with low levels of household consumption can make up for the lack of domestic demand by providing a lot of credit to local companies to support investment in building infrastructure, increasing capacity in basic industries, and research and development of advanced technologies. That is what China has, by and large, done since the global financial crisis in 2008. Supplying credit on this scale has led the Chinese government to invest heavily in cutting-edge technology while continuing to invest in the often loss-making heavy industries, such as coal, steel, and aluminum production, that drove past growth.
China's domestic policies impact the global trading system.
All countries want to be among the world’s technological leaders. But the Chinese state plays a major role in guiding investment and exerts substantial control over the purchasing activities of many big companies, such as the state-run grain and oilseed importer, state-run airlines, and the state-run telecommunications firm. As a result, the heavy-handed means by which Beijing creates its national technological champions inevitably causes friction with its trading partners. The sheer scale of China’s investment is such that in sector after sector, Chinese overcapacity can flood the global market and drive other producers out of business.
China is unique in lacking any real constraints on how much the state can invest in both state-owned companies and nominally private companies. So long as China’s economy is generating more savings than it can possibly put to productive use, the state can invest inefficiently in yet more steel capacity, or supply new urban real estate in rural parts of the country, without undercutting state support for national champions in producing semiconductors or in civil aviation. The failure of one round of state-supported firms doesn’t limit China’s ability to start over and try again.
China’s trade negotiators love to talk of win-wins—their counterparts sometimes joke that China’s notion of a win-win is that China wins twice. But more social insurance financed by progressive taxation inside China really is a win-win. Such a program would raise living standards for most Chinese workers and increase Chinese demand for Chinese goods. And China wouldn’t need to pursue global market share aggressively across industries to make up for its shortfall in household demand.
But this agenda requires a conceptual shift. China does need to continue liberalizing its state-dominated economy, and it needs to allow the private market more room to operate in a number of sectors. Yet when it comes to taxing and spending, China needs a bigger, not a smaller, state—one that collects more income taxes and uses the resulting revenues to provide a stronger system of public health and social insurance.