those who are already relatively rich, in which case the policy may end up widening gaps. Similarly, certain types of taxes that require the rich to pay more (relative to their income) can reduce inequality while, conversely, taxes that fall heavier on the poorer parts of the distribution, can contribute to widening gaps. Thus, how governments spend and raise their revenue directly influences the amount of redistribution the fiscal system achieves, which in turn influences inequality.

There has been relatively little enquiry on the role the _overall_ fiscal system can play in reducing inequality in China. One notable exception is Lustig and Yang (2020) which used the Commitment to Equity approach (Lustig, 2018 and 2022) to describe the fiscal redistribution in China using data from the 2014 China Family Panel Studies survey.<sup>2 3</sup> The main finding of that paper was that while the fiscal system reduced inequality overall, it also widened rural-urban gaps. The study attributed the latter to the differences in contributory pensions between urban and rural areas. These results were consistent with findings from several other studies (Li, Zhu and Zhan 2017 and Xie 2018), and somewhat contrary to Wang and Lou (2017) who found that the VAT had inequality-increasing impacts that were sizeable enough to make the overall fiscal system inequality-increasing.

Against this backdrop, this paper revisits this question using more recent representative data of Chinese households, the 2018 round of the China Family Panel Survey (CFPS). The motivation for the paper is two-fold. First, inequality has continued to remain high even as the emphasis on common prosperity has intensified. As such, continuing to highlight the role fiscal policy has been playing and could play in addressing this challenge using fresh data and evidence is important. Second, since 2014 there have been several policy changes whose impacts can be picked up in the updated analysis, though in some cases this will be confounded by the fact that this paper also introduces some methodological upgrades. For example, Lustig and Yang (2020) treated all income from pensions as government transfers. This paper will depart from this assumption and attempt to treat contributory pensions which have characteristics of deferred income differently than pensions through the resident’s system, which are more transfer-like.

Following standard practices of fiscal incidence analysis, the study combines information from administrative sources on government revenues and spending with household survey data. This allows us to identify how much households pay in taxes and receive in transfers and subsidies, across the income distribution. The analysis includes fiscal elements such as personal income tax, contributions to social insurance, value-added tax, consumption tax, cash transfers, contributory pensions, and spending on education and health and accounts for 63 percent of total revenues and around 43 percent of total government spending. Several potentially important components of taxes and spending are not included in the analysis. These include, for example, corporate income taxes and non-tax elements on the revenue side and spending on infrastructure on the spending side. Both instruments can have sizeable redistributive impacts both in the short and medium run, but there is no satisfactory way of determining the incidence of these taxes on individual households. This practice is standard in fiscal analysis exercises and acknowledged as a caveat of the methodology.

First, consistent with previous studies, this paper finds that fiscal policy achieves a sizeable inequality reduction (10.3 Gini points) in China. However, China places around the median of upper-middle-income country peers on

> 2 Lustig, Nora and Yang Wang 2020. "The Impact of Taxes and Transfers on Income Inequality, Poverty, and the Urban-Rural and Regional Income Gaps in China," Commitment to Equity (CEQ) Working Paper Series 93, Tulane University, Department of Economics.

> 3 The Commitment to Equity approach refers to the methodology developed by the <u>Commitment to Equity Institute at Tulane University.</u> For specifics, consult chapters 1-8 in Lustig (2018 and 2022).

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