percent in 2010 (see detailed calculation in Appendix Table A.3), this apparent improvement comes with caveats and should be interpreted with caution appropriate to use of administrative data voluntarily provided by firms. The shortfall in social insurance contributions due to evasion is calculated as the difference between what registered firms should contribute, given their reported wage bill, less the total of their actual contributions divided by required contribution levels.

The decline in outright evasion among formal sector firms is consistent with micro-evidence suggesting rising levels of the social insurance coverage, but the decline in evasion calculated from official yearbook data suggests higher participation rates than observed in micro data. There are two sources of exclusion: firms may hire some workers informally without contracts and the NBS yearbook data may exclude many smaller firms that are less likely to participate.

As suggested above, one disincentive for participation by both employers and employees lies with China’s high social insurance contribution rate, which leads to a “labor tax wedge” that is among the highest found in both developing and developed countries (Figure 5).<sup>26</sup> Moreover the design of the social insurance system includes minimum payments that imply significantly higher contribution rates for low income workers, primarily part-time workers, migrants and lower income self-employed. More specifically, the urban social insurance contribution, based on average wages, requires a minimum payment for workers equal to that which would be paid by a worker earning 60 percent of the local average wage and a maximum payment of 300 percent. If a worker earns less than 60 percent of the local average annual wage, for example, the worker and employer must make the same contribution as a worker earning exactly 60 percent of the average wage. This non-linearity at low income levels introduces a significant disincentive for low wage workers to participate in social insurance (DRC and World Bank, 2012).

# **3.3 Consequences of a Fragmented System: Benefit Disparity and Limited Portability**

Urban China’s social insurance system is fragmented across geographic jurisdictions. Differences in basic program features across localities are reinforced by low levels of pooling and differences in the financial capacity of local governments. As a result, workers face differences across provinces, and even localities

> 26The _labor tax wedge_ is calculated as (total labor cost – net take home pay)/total labor cost.  For example, assume a wage of 100 RMB, then total labor cost (100 + 42) is 142, net take home pay (100 – 22) is 78, and tax wedge is calculated as (142-78)/142, or 45.1 percent. For many countries, one would also calculate the personal income tax (PIT) levied after deduction of SI contribution, and OECD also allows for transfers from the state (e.g. income tax credits).  In China, neither of these is included in the calculation because the average urban worker falls below the payable income tax threshold.  Figure 5 shows cross country comparisons using OECD data. Part of the reason for the relatively high cost rests with legacy costs from the previous pension system. The high employer contribution is the primary source of social pooling used to cover the pensions of retirees who retired before establishment of the retirement system.

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