"They have an economic model that has run out of steam. They need to place much more reliance on domestic-led growth, domestic consumption," he told CNBC from Seattle, where Chinese President Xi Jinping will meet with American business leaders Tuesday.
The Chinese government has recently received criticism for its handling of a sluggish economy and erratic stock markets, including moves to ease monetary policy and devalue its currency. Paulson contended that cooperation and investment between China and the U.S. will not only help to kick-start economic activity but also address growing concerns like cyberattacks launched from Chinese soil.
"The most troublesome economic issue is corporate and commercial cybertheft. I think it's the biggest risk when you look at U.S.-China relations. Ultimately, it's very important for our two countries to come together," Paulson said.
Xi's tour of the U.S. this week—when he will meet with President Barack Obama and speak at the United Nations—comes as U.S. officials have reportedly considered economic sanctions over cyber-espionage. Some experts remain skeptical that the diplomatic trip will yield any significant progress.
Paulson stressed that cooperation is crucial to China changing its economy. He said U.S. businesses currently hold concerns about the "pace of reform" and China opening its doors to more foreign firms.
He contended more competition is needed to spur China's transition from an export-driven economy to one focused on domestic consumers.
"The only way to have real competition that's going to benefit the Chinese economy is to open up to foreign competition so you have the best businesses and the most efficient businesses competing there," Paulson said. "That is the key. That is what the U.S. businesses will be pressing for."
He believes Xi is "very serious" about economic reforms. However, Paulson noted that the process would likely "take a while" as reformers would need to overcome "strong vested interests" in pockets of the government.
—CNBC's Michelle Caruso-Cabrera contributed to this report.