Appendix: Calibrating the GFM for Korea
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Tarhan Feyzioğlu and Murtaza Syed are with the Asia and Pacific Department, and Michael Skaarup is with the Fiscal Affairs Department of the IMF. We thank Jerald Schiff and Mark DeBroek for many helpful comments and suggestions.
In addition to the National Pension System, separate occupational pension schemes operate for government employees, private teachers and military personnel, and currently insure around 8 percent of the labor force.
There are considerable uncertainties and complications associated with making long-term age-related expenditure projections for any economy, relating to demographic factors and underlying expenditure assumptions; the evolution of non-age-related expenditures; and the growth-interest rate differential. For a further discussion of aging in the G-7 countries see Hauner, Leigh and Skaarup (2007).
The future public expenditure pressure is broadly similar in magnitude to the aggregate expenditure pressures discussed in the Vision 2030 Report of the government, although in the latter these pressures stem also from a number of factors that are non-age related.
Payment of regular old-age pensions will only begin in 2008, once the initial participants meet the minimum 20 years of contributions.
These figures are highly sensitive to a number of parameter assumptions, including average return to equity and relative wage growth, and as such should be taken as illustrating the point that significant effort is still needed to put the pension system on a sustainable track.
To limit potential concerns about political interference in the allocation of the pension system’s assets, the governance and investment policies underpinning their management would need to be carefully designed.
Base broadening cannot be distinguished from rate increases in the GFM, except in the case of payroll taxes. Hence, our simulations reflect increases in the effective tax rate, which could reflect either of the two, although the behavioral effects on the economy differ.
There may be other arguments in favor of timely action, including political economy considerations, as the elderly will soon represent the majority of the voting public, making it potentially more difficult to implement some reforms; and the possibility that capital markets may anticipate the consequences of long-term pressures and impose penalties—in the form of lower debt ratings, limited access to capital or higher borrowing costs—if they perceive that the government has not done enough to address these concerns.
While the VAT also affects the consumption-leisure decision, since accumulated savings are an implicit component of the PIT base, it is less distortionary. This order of efficiency is consistent with evidence from various international studies—see Baylor (2005) for a survey—as well as results of a general equilibrium model for the Canadian economy (Department of Finance, 2004). See Baylor and Beauséjour (2004) for a detailed discussion of the model and results.
More specifically, the scenario assumes a payroll base broadening from 60 to 80 percent of the labor force during 2008–10 followed by a pension contribution rate hike from 9 percent to 13 percent during 2010–25; an effective VAT rate increase of around 3½ percentage points during 2011–20 and an effective PIT rate increase of around 1½ percentage points during 2016–25; and a cut in total expenditure growth of 1½ percentage points of GDP during 2011–20.
The wage deduction declines progressively as earnings increase: it is 100 percent for annual earnings of less than 5 million won (equivalent to an exempt amount), and declines in four steps to 5 percent for earnings above 45 million won.
Unlike employees, self-employed workers must pay the full 9 percent contribution rate themselves, so that evasion is more attractive. With nearly two-thirds of Korea’s labor force either self-employed or working or short-term irregular employees, enforcing compliance is difficult.
Some recent work by the IMF examines 300 cases of large fiscal consolidation, many involving adjustment over prolonged periods (IMF, 2006).
Related work by Gupta et al. (2003) finds that expenditure-based adjustments are not in themselves sufficient to maintain healthy public finances over the medium-term; efforts are also needed on the revenue side.