Hundreds of millions of Chinese live in China’s biggest cities as second-class citizens, with no access to social benefits and limited ties to the locales in which they work. Their situation leads to unhappiness, lower consumption, and lost productivity.

The culprit: China’s household registration—or hukou—system. The hukou, a small red passbook, contains key information on every family, including marriages, divorces, births, and deaths, as well as the city or village to which each person belongs. What comes attached to the hukou are benefits including health care, a pension, and free education for one’s children. These benefits are only available if a Chinese citizen lives where he or she is registered. Not having a hukou for where one lives makes it more difficult to get a driver’s license, buy a house, or purchase a car.

As China strives for a more balanced economy, top policy-makers are realizing that the hukou system is a liability. Late last month, China’s cabinet announced plans to make it easier for rural migrants to obtain a city hukou (pronounced hoo-ko). On March 5, Premier Wen Jiabao told the National People’s Congress that migrant workers will become “permanent urban residents in an orderly manner” as China eases restrictions. “The hukou system is morally indefensible in today’s China. It’s also due for an overhaul because the system impedes economic growth and urbanization,” wrote Hu Shuli, editor-in-chief of China’s reformist Caixin Century Magazine, on March 8. This doesn’t mean the hukou system will be swiftly dismantled: Authorities fear that would trigger a nationwide flood of migrants into the biggest cities and raise the prospect of mass unrest. Providing social welfare benefits to new urban residents will also be costly.

Although Chinese family registries have been around for centuries, today’s hukou system began in 1958 as a version of the Soviet Union’s internal passport regime. The hukou forced farmers to stay put and produce cheap food to sustain industrialization. With the economic opening, it evolved to allow massive migration from the country to urban enterprises and export factories. The qualifier: A worker’s residency did not transfer to the city. Neither did his right to health benefits and free education.

While China had a city population of 690 million last year, more than 200 million lack an urban hukou, estimates Kam Wing Chan, a professor at the University of Washington in Seattle. Separated from their families, unable to tap into the urban network of government benefits, often living in company dorms or cheap housing, these migrant workers don’t know what the future holds and fear the outcome of a crippling work accident or lost job. In reaction to all this uncertainty, they save instead of spend and never form the solid urban households that are the backbone of any middle class. “The hukou system is holding up full urbanization, one of the most obvious ways to achieve more consumption,” says Kuijs. Because of the persistence of the hukou system, says Washington’s Chan, “the assumption that China’s urbanization will create a very large middle class is proving not accurate.”

The plight of Deng Zongwei illustrates the problem. A lighting engineer with a good job in Dongguan in the Pearl River Delta, he had to move his wife and 5-year-old son back to his hometown of Yongzhou, Hunan, last July, and has been taking the 10-hour-long bus ride home every month. If his family had stayed with him, they would have had to pay for public school in Dongguan. “School here would have cost ¥12,000 ($1,900) a year. In Hunan, it doesn’t cost us a penny,” he says, adding that his wife had to quit her job to live with their son. “This is a huge problem for all migrant workers in China. It makes our lives painful and difficult.”