China has weathered the Great Recession well. The world now waits to see if last year’s impressive domestic demand growth can be sustained, and if China can, in the words of Prime Minister Wen Jiabao, "give full play to the leading role of…consumer demand in driving economic growth.”

The Chinese consumer has been held back for too long, and now must be put front and center in China’s growth model. China’s government is already moving ahead on multiple fronts to attain this goal as was clear from announcements at this week’s National People’s Congress.

Of the many factors that have decreased the share of consumption in China’s economy, declining household disposable income has been central.

That, in turn, has reflected the fall in labor income as a share of the economy, owing in part to structural changes that have moved workers out of agriculture (where the labor share of income is high) and into manufacturing (where capital commands a larger share of income).

Concurrent with diminishing labor income, government-imposed ceilings on bank deposits – the primary savings vehicle for most households – have held down household capital income.

This fall in income has been magnified by rising household savings rates, driven by insufficient insurance for health care and old age, the high cost of education, growing income inequality, and demographic trends.

So what to do? Recently, I attended an IMF-organized workshop in Beijing that brought together Chinese officials, academics, international analysts, and IMF staff to discuss how best to catalyze household consumption in China.

Participants emphasized that changes would be needed in multiple areas, including improving the system of taxation and social insurance, further developing housing and the service economy, and eliminating a range of relative price distortions.

One key idea was to lighten the tax burden on labor. Taking into account the personal-income tax and various social contributions, taxation of labor income in China is too high.

To be sure, taxes are needed to finance social spending, but revenue sources other than taxes on labor income could do the job.

China could usefully explore shifting part of the burden from labor toward property, capital gains, and inheritance taxes. Larger dividends paid to the budget from the highly profitable state-enterprise sector could also provide an alternative source of funds.

Another route to improve consumption could be to offer households greater support. The global crisis has prompted China’s government to push ahead with its social-reform program.

Important improvements have been made over the past year to expand the pension system’s coverage, move toward universal health care, and provide public funding for basic education.

But more can be done to speed up the existing reform package, find ways to develop full coverage for catastrophic health events, and develop government-backed financing of tertiary education.

Fixing the housing market could also help spur consumption. Distortions in the real-estate market are a powerful motivation for saving, particularly among young people who struggle to meet the high down-payment needed to buy a first home.

Part of the high cost of housing arises from an underdeveloped financial system, which makes housing one of the few alternatives to bank deposits as a store of value.

Property or capital-gains taxes could help curb demand for housing as an investment vehicle. In addition, a comprehensive nationwide housing policy is urgently needed to ensure that housing remains affordable, particularly for those on limited incomes.

Related to this is the need for improvements in the overall financial system. By developing markets for private pensions, commercial health insurance, and annuities, China could complement expanded government provision of social insurance and weaken the incentives that underlie high precautionary saving.

Similarly, broadening the range of available savings instruments could raise household disposable income and increase consumption. A more developed financial system would provide alternatives to real estate as a store of value, thereby making home ownership more accessible.

These issues will be examined carefully during the course of this year as the Chinese government and the IMF collaborate on a Financial Sector Assessment Program for China.

Fostering a dynamic service economy will invariably boost consumption as well. In the coming years, a more fully-fledged service economy will be an essential ingredient to increase employment and lessen China’s reliance on manufacturing.

But spurring faster growth in services is a complex undertaking. Entry barriers, particularly in service industries dominated by state-owned oligopolies, need to be lowered.

Distortions in key prices that favor capital-intensive manufacturing need to be removed by raising the cost of land, energy, water, and capital. Changing the tax structure will also help.

At present, industry is the primary source of tax revenue for the government, particularly at the local level, giving the state too little incentive to foster a service economy.
Finally, a stronger renminbi ought to be an integral part of the package of reforms to boost consumption.

A stronger currency would increase household income. It would also create a powerful incentive for companies to expand into the service economy, providing more jobs and more choices for Chinese consumers.

If consumption can be successfully and sustainably boosted, I believe that China’s development will enter a new era, one in which economic growth continues at a rapid pace, generates higher employment, increases social welfare, places less demand on natural resources, and, ultimately, is of a much higher quality thereby underpinning more balanced global growth.

Anoop Singh is Director of the IMF’s Asia and Pacific Department.

Copyright: Project Syndicate, 2010.