China has changed dramatically since the nation embarked on opening and reform in the late 1970s. The nation now has an annual GDP growth of around 10 per cent, an abundant supply of rural labour, a reasonably good education system, adequate capital and social stability.

However, China is also beset by numerous problems  a remarkable regional disparity, a growing income gap, an inadequate social welfare system, a poorly funded education system and worsening environmental pollution.

Similar situations have occurred in many developed countries as a result of rapid economic development. Many of these nations tackled such problems through an increased use of public finances.

Through enhanced labour protection, caps on working hours, healthcare, pensions, free compulsory education and other measures, these countries reshaped their public finance and ensured sustained development.

Public finances could play a major role in reducing such threats to China's social and economic development. Well used, they could offer an almost instant remedy to some of the nation's greatest challenges.

One of the most important functions of a country's public finance system is the redistribution of wealth. Investing in welfare and social security is a good way for the government to tackle the growing income gap between different social groups and different parts of the country.

Such investment is badly needed in China today.

China's income gap makes its presence felt in a number of ways  between rural and urban residents, between those living in coastal and inland areas, and between well-off urbanites and their poor neighbours.

Admittedly, the income gap usually widens when a market economy replaces a planned one. Moreover, China did encourage part of the population to get rich first, in the hope that they would help the rest.

However, the widening income gap is now one of our biggest social problems.

The Gini coefficient, an index used to measure income equality, has reached 0.45 for China, which means that inequality has reached a level higher than most other countries.

This stark income disparity poses major social and economic threats.

As the Ministry of Labour and Social Security warned last year, the nation may witness social turmoil after 2010 unless effective measures are taken to tackle the growing gap between rich and poor.

The most effective way to achieve a redistribution of wealth is to tailor measures to suit the needs of different social groups. This could include housing subsidies for low-income earners, old-age pensions and scholarships for students from poverty-stricken families.

Redistribution of wealth could also play a major role in tackling regional disparities.

All of the country's provincial governments have suffered financial deficits, especially those in less-developed regions, since the country changed its tax policies in 1994.

The central government attempted to subsidize localities through tax rebates. But the rebate system was designed in such a way that the more taxes a province hands in, the higher its refund.

As a result, the provinces enjoying the highest refunds are those with the strongest economies.

The gap could be narrowed by either reforming the tax rebate system or by the State finding other ways to transfer finances.

Besides making better use of transfer payments, the government should invest more in public services. The benefits of this would be twofold  easing families' financial burdens and generally making people feel more confident about their future prospects.

Public services include urban transport facilities, rubbish and sewage processing, pollution prevention and treatment, community parks, public healthcare and education.

Demand for public services has increased markedly as a result of the nation's accelerated urbanization. Many social problems are the result of inadequate State investment in public services.

It is no secret that the government has failed to invest enough in compulsory education in recent years. The government's annual investment in education is less than 3 per cent of the nation's GDP, lower than the global average.

Most families therefore have to pay quite a lot to make up for this inadequate State input. Education expenditure for children is the heaviest financial burden for low-income families.

The same situation occurs in other fields, including healthcare and pensions.

With the social security system only covering urban dwellers, farmers who move to cities to find work are exposed to various risks without any substantial protection. Meanwhile, senior citizens in rural areas have become the most disadvantaged group.

The natural environment has deteriorated greatly due to the country's rapid industrialization. Numerous species die out, forests disappear, deserts cover more land, rivers are polluted and sandstorms ravage cities.

Environmental protection is another area where, financially speaking, the State is failing to pull its weight.

The government should try to spend more on public services. This is the most effective way to improve people's lives, as well as the most effective way to show the people the benefits of being taxpayers.

The central government should offer a uniform social welfare system to all of its citizens regardless of their residence, employment and identity. This would facilitate labour mobility across the country and improve the efficiency of resource allocation.

However, the greatest challenge for the government is tax reform.

The country's tax policies have only seen minor changes since 1994. In the context of the nation's rapid economic development, many of these policies are now fairly outdated. As an important area of public finances, tax reform would have far-reaching social and economic consequences.

However, the first target of the tax reform is to cut taxes. Less tax means less income, hence fewer resources as the leverage for promoting the reform.

Cutting tax has been a global trend over the past two decades and China does have an average tax rate higher than many countries.

Calls have been made for several years for a uniform tax rate for domestic and foreign-invested companies. Foreign-invested companies currently enjoy a tax burden that is about half of that of domestic companies.

A uniform business tax rate would see most domestic companies paying fewer taxes. This, in turn, would bring down the total tax income.

On another front, the authorities are considering an adjustment to value-added tax (VAT) in a bid to stimulate investment. Such an adjustment would also cause a sharp decline in the government's earning from VAT, which currently account for 40 per cent of the State's total tax income.

Another mission of the tax reform is to establish a tax system which equally favours economic growth and social equality.

The tax policy could also be used to encourage more people to make charitable donations. Charitable donations should be tax deductible. In this way, individual donations supplement the services the government provides to the public.

Given limited resources, the government also needs to cut down its own running costs. Running costs have accounted for a larger and larger proportion of total government expenditure in recent years.

Without a considerable cut in the government's running costs, it would be hard for the State to invest more in public services with a shrinking tax yield.

When the authorities conduct tax reform, they must understand the close relationship between taxes and government costs. Heavy government expenditure, including on social welfare, must be based on heavy taxes. Lower taxes also means lower social security benefits.

The author Lin Shuanglin is chair of the Department of Public Finance, Peking University.