As the Chinese economy has exploded to the upside over the past two decades, the country’s income gap—the difference in earnings between top earners and bottom earners—has become one of the largest in the world.

This income gap is now second only to South Africa, which is still grapping with its legacy of apartheid. It’s particularly pronounced between urban and rural Chinese, with city dwellers typically enjoying three times the disposable income of their country cousins.

That huge disparity creates the potential for social unrest, particularly in a society that should at least be nominally egalitarian given its ideology. The Chinese Communist Party (CCP) is clearly becoming worried about the potential political ramifications and the new administration has moved the issue of income inequality to the top of its list of action items.

China’s State Council, essentially the executive cabinet, recently released a set of guidelines aimed at addressing both the causes and consequences of income inequality. The broad document outlines a number of proposed reforms that focus primarily on the state sector.

The new policy calls for a 5 percent increase in the amount of profits state-owned enterprises (SEOs) pay to the central government, caps on executive salary and the requirement that SEOs that rely on the country’s natural resources for profits pay most of those profits into the public coffer.

Working in a nod to the new government’s anticorruption efforts, the plan also calls for caps on current government staffing levels, reduced spending on purely discretionary items such as government receptions and travel, pay raises for local officials, and clear rules on income disclosures by government employees.

A call for a more progressive system of taxation is also included, as well as new taxes on property, consumption and inheritance.

The proceeds from the new taxes will be used by the government to enhance the social safety net, by increasing outlays on social security and employment promotion by about 2 percent by 2015. A portion of the proceeds will also be put towards strengthening subsidies for the country’s farmers and poverty reduction in rural areas.

While the plan isn’t nearly as aggressive as it could be, it should go a long way towards reducing income disparities.

The government’s rationale is that these reforms will help drive wage increases, a process that occurred when Taiwan implemented similar reforms in the 1980s and 1990s that helped spur the transition in that country away from a classic manufacturing economy to one that specialized in electronics and other valued-added products. Taiwan’s reforms also helped fuel China’s manufacturing boom.

More room for skilled labor in China’s economy has become a critical issue. A recent study shows that of the 94 million Chinese who have or will graduate from college between 2010 and 2020, most will be forced to take blue-collar jobs due to a lack of demand for skilled labor. While a more educated workforce is usually good for an emerging market economy, it’s a moot point if there isn’t a need.

Efforts to foster greater income equality will also help drive China’s transition from an export-driven economy to one that’s more reliant on consumption. Numerous studies show that middle class consumers are much more apt to spend their earnings than their wealthier counterparts who, while purchasing more luxury items, tend to save more.

Keeping the money moving creates a virtuous cycle in any economic loop: more spending begets  job creation, which begets more spending. The economic dynamics of post-WWII America are a classic example of this virtuous cycle in action.

China’s reform package is far from a done deal and still faces several bureaucratic hurdles. Moreover, vested interests, particularly top executives with SEOs, are likely to prefer the status quo and can be counted on to fight the proposals.

But regardless of these challenges, addressing income inequality will go a long way towards helping the CCP achieve the economic evolution that remains its stated goal. The upshot could be huge investment opportunities in sectors ranging from financials and consumer goods to housing and infrastructure.

Portfolio Roundup

Shares of Tullow Oil (London: TLW) bounced recently, after analysts at both Morgan Stanley (NYSE: MS) and Bank of America Merrill Lynch (NYSE: BAC) reiterated their overweight and buy ratings, respectively, on Tuesday. Tullow hit a rough patch after a number of test wells in Africa’s French Guiana failed to produce as expected, but analysts believe Tullow’s production schedule remains on track.

Currently trading well below our buy target, Tullow remains a buy under GBP1,450 for long-term investors.