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Using 1987-2006 panel data for China, we explore the dynamics of the skill premium. The present paper focuses on the skill premium as an explanation for why income differences are so large in China. Our empirics show that: the rise in the relative supply of skilled labor results in an increase, instead of a decrease, in the skill premium; domestic investment is not complementary with skill formation; the skill premium is higher in more developed provinces; economic openness facilitates an increase in the skill premium; whether foreign direct investment induces skill-based technology change or not, it drives up the skill premium. An array of policy prescriptions for reducing income differences and ensuring sustained economic growth are provided.