Putting Gini back in the bottle

Why China’s personal income tax calls for a different measure of inequality

Li Du, ZhongXiang Zhang

Economics and finance, Government and governance, Social policy | Asia, East Asia

20 June 2018

Did China’s adjustment to personal income tax in 2011 reduce inequality? Li Du and ZhongXiang Zhang write that using the Gini coefficient could conceal the positive impacts of the policy.

Rising inequality in the early 21st century has put personal income tax (PIT), a widely used redistributive instrument, on the reform agenda of many major countries.

To reform personal income tax to alleviate inequality, policymakers need good measurements of its redistributive effect – which is essentially the extent to which the tax reduces income inequality. Consequently, the underlying measure of inequality adopted by policymakers could greatly influence the assessment of personal income tax.

The Gini coefficient is a statistical measure of the income or wealth distribution of a population. Because the Gini coefficient is a widely-used inequality measure, a common practice adopted by scholars and governments is to evaluate the redistributive effect of PIT on the basis of the Gini coefficient.

However, because the Gini coefficient is more sensitive to changes at the lower tail of the income distribution, using it to compare the redistributive effects of different tax rules might be misleading. This is particularly true in countries where taxpayers have limited access to credit, and where low-income households typically don’t receive any transfer through the PIT system.

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China is one of those countries.

As part of an effort to combat rising inequality in household income distribution, in 2011 the Chinese Government revised the Personal Income Tax Law (PITL).

The main purpose of this tax adjustment was to “lower the tax burden on medium and low-income groups and strengthen the adjustment of excessively high income”.

Most notably, as of September 2011, the standard deduction for payroll income and business income was increased from CNY 2000 per month to CNY 3500 per month, and marginal tax rates were increased for top income brackets and decreased for others.

Based on the Gini coefficient, most previous studies have concluded that the 2011 PIT adjustment dampened the overall redistributive effect of China’s PIT system on the incomes of urban households.

However, it can be found that this tax adjustment has increased the tax burden of top 0.15 per cent of income earners. Hence, if all urban households are divided evenly into five groups, this tax adjustment actually reduced the income gap within the top income group. And if the measurement results say that the overall income gap was enlarged by the tax adjustment, it might be because the Gini coefficient puts a lower weight on the top part of the income distribution.

To properly examine the redistributive effect of the 2011 PIT adjustment in China, we developed a new approach. It’s based on the generalised entropy (GE) indexes, which, as a class of inequality measures developed from information theory, can better reflect the changes in the bottom, middle or top part of an income distribution and provide more reliable results.

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This new approach reveals that China’s 2011 PIT adjustment has effectively reduced the inequality within the high-income group, albeit widening the inequality between all groups at the same time.

Moreover, according to a widely cited study conducted by Xiaolu Wang, almost 30 per cent of the country’s gross domestic product is hidden from the urban household survey conducted by China’s National Bureau of Statistics – a level of hidden income too large to be ignored.

If we include the hidden income in household income data and adopt the GE index which is scale invariant or puts more weight on the inequality within the high-income group, the overall redistributive effect of this tax adjustment turns out to be positive. The new rule introduced by the reform may improve the redistributive effects by nearly 20 per cent.

For policymakers, it is important to adopt the right inequality measures to capture the structural features of income distribution and redistribution policies and to notice the positive redistributive effects of China’s PIT reform on the pre-tax household income structure.

This article is based on the authors’ paper Measuring the redistributive effects of China’s personal income taxwhich was published in Asia & the Pacific Policy Studies in May 2018. All articles in Asia & the Pacific Policy Studies are free to read and download.

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