income opportunities for raising income.60 According to a study by Knight and Song, non-farm activities in China are more rewarding than farm activities, both on average and at the margin.61 Dealing with all these challenges and a huge labor force with a size of that in China requires a much more flexible labor market.

Currently, the labor market in China is highly fragmented because of tough restrictions on migration, as well as other constraints on mobility such as geographically segmented and outmoded systems for social insurance and public services provision.62 The labor market segmentation exists not only between urban-rural, but also within the urban and rural labor markets, and between the migrant and non-migrant. The biggest constraint on labor mobility is the household registration or _hukou_ system. Under such a system, legal residence in a village, town or city is initially defined at birth and determines entitlements to local jobs, housing, schooling, healthcare and social security, and, in rural areas, to farming land as well. Unapproved migration can be extremely costly in terms of lost entitlements, and even approved movement can involve substantial losses, for example loss of claims on agricultural land without compensation.63 This makes it very difficult to migrate between the rural and urban, between rural areas, between cities and between provinces (particularly workers with low qualifications), thus exacerbating the unemployment problem. Furthermore, the restrictions on labor mobility widen the income disparity between the coastal areas and the rest of China, and inflate the numbers entering illegal professions, such as prostitution, drug dealing, and smuggling. Instead, allowing labor moving out of agriculture and informal labor moving into formal activities, could result in substantially higher average marginal productivity, which is the source of the additional welfare gain. 64 Another important barrier to off-farm labor mobility is the absence of well-defined property rights for agricultural land. This leads to the retention of additional labor in the farm sector, because farm households have to consider the returns to land in their decision to work on- or off-arm, since leaving the farm means losing the land.

In addition, there is more room for flexibility in employment policies. The introduction of contract employment in industry from 1986, which was intended to apply to all new entrants to the workforce, has contributed to firms’ greater flexibility and efficiency, however, it’s scope is still limited. In the state sector, poorly performing managers are

> 60 Kung, James L. S. and Y. Lee, “So What If There is Income Inequality? The Distributive Consequence of Nonfarm Employment in Rural China”, _Economic Development and Cultural Exchange_ , V50, No.1, October 2001.

> 61 Knight, J. and L. Song, “Chinese Peasant Choices: Migration, Rural Industry or Farming”, _Oxford Development Studies_ , V31, No.2, June 2003. Similar patterns have been obtained in other studies of rural household income functions. For instance, Zhao (1996) estimated the marginal income for an additional farm worker, local non-farm worker and migrant worker to be 5, 19 and 55%, respectively, in Sichuan. See Zhao, Y., “Labor Migration and Education in Rural Sichuan Province: A Special Pattern”, _International Conference on the Flow of Rural Labor in China_ , Beijing, 25-27, June 1996.

62 Fox, L. and Y. Zhao, “China’s Labor Market Reform: Performance and Prospects,” a background study for the World Bank, 2002.

> 63 OECD: _China in the World Economy: the Domestic Policy Challenges_ , Paris, 2002.

64 See a simulation study by Gilbert, John and T. Wahl (2003), using applied general equilibrium techniques, in “Labor Market Distortions and China’s WTO Accession Package: An Applied General Equilibrium Assessment”, _Journal of Comparative Economics_ , No. 31, pp. 774-794.

27