Institutional reform in a transition economy, which aims to enhance long run economic growth by
liberalising factor market, can actually worsen inequality and poverty at least in the short run.
Evidence suggests that a pro-growth state-owned enterprises (SOEs) reform, which allows market
forces to determine workers’ pay according to their ability and improve the efficiency of the
Chinese economy, appears to have been joined with a decline in economic growth and an increase
in urban income inequality and poverty. Meng (2004), for example, observed that there are
increasing income gains at the top end of the urban income distribution and reductions at the lower
end in China since 1995 (the year when SOEs reform started). This is a great contrast to the
previous period (1988-1995) when income grew by 53% for the top 3% of household and 20% for
the bottom 20% despite the income gap between them widens (Zhao and Li 1999). The traditional
‘equity vs. efficiency’ trade-off exists in a market economy seems to be taking shape rapidly in
urban China particularly since the initiation of SOEs reform. This paper investigates the effects of
pro-growth state-owned enterprises (SOEs) reform on China’s urban inequality and poverty during
the period of rapid SOEs restructuring by testing two models of transition by Aghion et al (1994,
1997), using Urban Household Survey data. Main findings show that the speed and manner in
which layoff of redundant workers is implemented is pivotal in determining the extent of inequality
and poverty. The gradualist approach by which the reform was experimented locally then promoted
nation-wide helped to reduce poverty incidence. However, the inequality is worsening as
fundamentally, a reward system of ‘pay according to ability’ in the labour market for higher
productivity has been introduced which allows wage differential between the skilled and unskilled
to widen. This wage differential exists more prominently among SOEs (within sector) than between
SOEs and private enterprises (between sectors), because the wage has been allowed to be
determined freely and not fixed which enables the efficient SOEs to restructure without
privatisation, hence becoming more profitable and able to reward its workers who have
higher efficiency a higher wage. The social welfare functions of the SOEs are now shifted
towards the private individuals. This substantially worsened the welfare of the SOEs
workers at least in the short run as a well-functioned social security system for the billions
take time to be established.