The Rise of Income Inequality in Urban China, 1996-2010: Increasing Returns to Education, State Sector Shrinkage, and Composition Effects

Income inequality in urban China has experienced a rapid growth over the past two decades. To account for the rise in income inequality, previous studies have provided three major explanations: widening regional gaps, increasing returns to education, and growing residual inequality. Since the mid-1990s, however, the composition of the urban labor force has been considerably reshaped by three large-scale structural changes: (1) the expansion of higher education, (2) the shrinkage of state sector employment, and (3) a surge in rural-to-urban migration. In this article, I discuss how the recent rise of income inequality can be driven by these institutional and demographic shifts. Based on data from two nationally representative surveys, I use variance function regressions to decompose the growth in income inequality from 1996 to 2010 into four components: changes in between-group income gaps, changes in within-group income variation, and two types of composition effects (distribution effect and transfer effect). The decomposition results indicate that changes in between-group income gaps explain around 40% of the rise in inequality, while more than half of the total growth can be attributed to composition effects. Using counterfactual analysis, I find that changes in between-group income gaps are almost entirely driven by increases in returns to education, while composition effects stem chiefly from changes in human capital distribution and the shrinkage of state sector employment.