This Selected Issues paper discusses the fiscal policy in the Korean business cycle, and examines the usefulness of the equations for inflation forecasting at horizons consistent with the Bank of Korea 's inflation-targeting framework. It analyzes the causes and macroeconomic consequences of Korea's dual labor market; discusses the government's reform proposals; and the nonbank financial sector restructuring to date.

Abstract

This Selected Issues paper discusses the fiscal policy in the Korean business cycle, and examines the usefulness of the equations for inflation forecasting at horizons consistent with the Bank of Korea 's inflation-targeting framework. It analyzes the causes and macroeconomic consequences of Korea's dual labor market; discusses the government's reform proposals; and the nonbank financial sector restructuring to date.

I. Fiscal Policy in the Korean Business Cycle1

A. Introduction

1. Korea’s economy has grown very rapidly over the past three decades, but as in many other emerging market economies, growth has been relatively volatile. Average annual GDP growth was 7.1 percent in Korea in 1970–2002, compared to an OECD average of 3.0 percent, while volatility of detrended GDP was 2.4 percent in Korea compared to 1.7 percent in the OECD area.2 Although Korea has established a conservative fiscal tradition since the early 1980s, there have been episodes of pro-cyclical fiscal policy, such as in the early 1990s, when the government ran fiscal deficits while the economy was overheating. This chapter investigates the impact of discretionary fiscal policy on the Korean business cycle and assesses its usefulness for smoothing economic fluctuations.

2. Fiscal policy plays a dual role in the business cycle. It has the potential for smoothing business cycle fluctuations, but it can also harm macroeconomic stability. Talvi and Vegh (2000) show empirically and theoretically that fiscal policy in countries with a volatile tax base is more pro-cyclical—and, hence, destabilizing to economic activity—than in countries with less volatile tax bases, such as the G-7. Fatás and Mihov (2003) found that discretionary fiscal policy—unexpected changes in taxes or spending that are not directly related to changes in the business cycle—contributes to business cycle volatility and is harmful to GDP growth. This chapter, therefore, addresses two questions: first, how much has fiscal policy in Korea contributed to business cycle fluctuations; and second, what is the scope for using fiscal policy as a tool to smooth business cycle fluctuations in the Korean economy? The answers to these questions are relevant in determining to what extent discretionary fiscal policy can be expected to contribute to minimizing GDP volatility and maximizing GDP growth in Korea,

3. The role of fiscal policy in the Korean business cycle will be analyzed in a VAR framework. This approach allows for the distinction between discretionary fiscal policy measures and automatic responses of government spending and revenue to fluctuations in the business cycle, i.e., the automatic stabilizers. This distinction is necessary to assess the impact of active fiscal policy on business cycle fluctuations. In a slightly different setup, Hoffmaister and Roldos (2001) found that real domestic shocks are a major source of macroeconomic fluctuations in Korea. Although they did not include separate fiscal variables in their VAR analysis, the real domestic shocks in their study can be interpreted to include changes in the tax system and fiscal expansions. This chapter focuses explicitly on the role of fiscal policy in the Korean business cycle and quantifies the impact of changes in public expenditure and tax revenue on GDP.

4. The results suggest that automatic fiscal stabilizers have contributed somewhat to greater macroeconomic stability, but that discretionary fiscal policy has not. The potential counter-cyclical role of fiscal policy is limited by the relatively small size of Korea’s government. In addition, weaknesses in budget implementation have hampered the effectiveness of discretionary fiscal policy in smoothing business cycle fluctuations. Some of the implementation problems are common to other countries, but others are specific to Korea, including a fragmented budget structure and a tendency of line departments to underspend. The implication is that a simple fiscal rule, such as balancing the budget over the business cycle, may contribute most to smoothing economic fluctuations in Korea.

5. This paper is organized as follows. Section B discusses the key characteristics of fiscal policy in Korea since 1970, and analyzes trends and fluctuations in public spending and revenue. Section C estimates the impact of fiscal policy on GDP through the use of VAR analysis. Section D concludes and draws policy implications.

B. Main Characteristics of Fiscal Policy During 1970–2002

6. After the 1970s, Korea established a tradition of fiscal conservatism. In response the acceleration of inflation and economic stagnation in the aftermath of the second oil price shock and political turmoil in 1979, the government began to rein in the fiscal deficit that had ballooned in the 1970s due to active government support for investment in heavy and chemical industries and transfers to the agricultural sector (Jun, 2004). Since the 1980s, fiscal policy in Korea has aimed at promoting macroeconomic stability and maximizing government savings to finance investment in public infrastructure and public corporations and provide credit to targeted sectors (Nam and Jones, 2003). As a result, over the past two decades, the fiscal balance was mostly in surplus and deficits were usually small, except at the time of the Asian financial crisis when the fiscal deficit exceeded 4 percent of GDP. Keeping “spending within revenue” has become a touchstone of fiscal policy and has helped to contain the accumulation of public debt to just over 20 percent of GDP, which is very low compared to the average of 74 percent among OECD countries.3

7. The size of the Korean budget has increased since the early 1970s but remains small compared to most other OECD countries. Total revenue and grants as a share of GDP increased from 16 percent in 1970 to 27 percent in 2002, while total expenditure and net lending as a share of GDP increased from 17 percent to 24 percent over the same period (Figure I.1). Tax revenue as a share of GDP rose from 14 percent in 1970 to 22 percent in 2002 (Figure I.2). Although the relatively small size of Korea’s budget is in part a reflection of its level of economic development, it is also low in comparison with many other countries that are at a similar stage of economic development, such as Greece and Portugal. Of all the OECD countries only Mexico has a smaller budget in percent of GDP than Korea. According to Nam and Jones (2003) three factors in particular contribute to the relatively low level of public spending in Korea. First, the modest social safety net limits income transfers; second, public consumption is only 10 percent of GDP, compared to an average of 17 percent for the OECD area; and third, interest payments are low due to Korea’s low level of public debt.

Figure I.1.
Figure I.1.

Korea: Fiscal indicators

(in percent of GDP)

Citation: IMF Staff Country Reports 2004, 045; 10.5089/9781451822144.002.A001

Source: CEIC.
Figure I.2.
Figure I.2.

Korea: Tax revenue

(In percent of GDP)

Citation: IMF Staff Country Reports 2004, 045; 10.5089/9781451822144.002.A001

Source: CEIC.

8. There seems to be a tendency toward a pro-cyclical fiscal policy in Korea (Figure I.3). The correlation between the fiscal impulse and the output gap during 1971–2002 was close to zero, but rolling correlations with a four-year window indicate that fiscal policy was indeed pro-cyclical in many years, that is the output gap and the fiscal impulse were positively correlated (Figure I.4).4 For example, in the early 1990s, the fiscal impulse and the output gap were both positive, whereas counter-cyclical fiscal policy would suggest opposite signs. Similarly in the first year of the Asian financial crisis fiscal policy was pro-cyclical, although in the aftermath of the crisis fiscal policy took on a more stabilizing role.5,6

Figure I.3.
Figure I.3.

Korea: Output gap and fiscal impulse1

(In percent of GDP)

Citation: IMF Staff Country Reports 2004, 045; 10.5089/9781451822144.002.A001

1 Fiscal impulse is the defined as the change in the cyclically adjusted fiscal balance.
Figure I.4.
Figure I.4.

Korea: Correlation between output gap and fiscal impulse

(4-year moving windows)

Citation: IMF Staff Country Reports 2004, 045; 10.5089/9781451822144.002.A001

9. Two well-known factors that complicate counter-cyclical fiscal policy in many countries are implementation lags and uncertainty about the economic outlook. The latter is exceptionally high in Korea, compared to many other OECD countries. For countercyclical fiscal policy to be most effective the government should be able to inject fiscal stimulus at the beginning of recessions and then withdraw stimulus during expansions. However, it remains a great challenge to predict the start of a new phase in the business cycle and therefore to initiate fiscal measures at the right time. Another problem is that once a government decides to take counter-cyclical measures it takes time for these measures to get passed through parliament and to be implemented. After implementation, depending on the type of fiscal measure, more time may expire before the economy starts to respond. Because of these difficulties in the conduct of discretionary fiscal policy, some economists believe that governments should refrain from activist policies altogether.

10. In Korea, the effectiveness of counter-cyclical fiscal policy is further hindered by a fragmented budget, and weaknesses in budget implementation (He, 2003). Expenditure shortfalls of more than 2 percent of budgeted expenditure have been common in Korea and there has also been frequent over-performance of revenues. As He (2003) notes, there appears to be a belief in Korea that the larger the surplus the better. This approach has fostered a tendency to underestimate revenues and overstate planned expenditures. In addition, strict adherence to the principle of spending within revenue is not always consistent with counter-cyclical fiscal policy, as it can deepen troughs in the business cycle when public expenditure is reined in following declining revenues.

C. The Impact of Fiscal Policy Shocks on GDP

11. The empirical evaluation of the effects of fiscal policy is carried out in a vector autoregression (VAR) framework.7 This approach allows for the identification of independent fiscal policy shocks, that is changes in fiscal policy that are not a response to changes in other economic variables, such as GDP. By abstracting from these automatic feedback effects, it is possible to estimate the direct impact of fiscal policy on GDP. As is well known in empirical monetary policy analysis, successful identification of independent policy shocks depends on a correct specification of the VAR. The identification of fiscal shocks is even more difficult, because unlike most monetary policy changes fiscal policy changes are often announced well before they are implemented. This issue will be addressed by testing several specification strategies.

Methodology

12. First, a basic VAR is estimated including real public spending, G, real GDP, Y, the GDP deflator, P, real tax revenue, T, and a short-term real interest rate, R. All data are quarterly, seasonally adjusted and expressed in logarithms. The sample period for all VARs in this chapter is 1979 Q4–2000 Q3. This is the maximum sample size given the limitations imposed by the data, including a break in the time series of fiscal data. The VAR framework for this analysis is summarized by the following equation:

Zt= A0Zt+Σi=1kAiZt1+ut,(I.1)

where Zt = (Gt Yt Pt Tt Rt) is a vector of the five aforementioned economic variables and ut is a vector of serially uncorrelated independent disturbances, all at time t. A0 is a coefficient matrix for contemporaneous effects and Ai, for i = 1, …, k, is a coefficient matrix for lagged effects. The maximum lag, k, is set at 4. This choice is a compromise as different lag length criteria suggested different lags ranging from 1 to 12 quarters. The latter would be too demanding because the available number of observations is somewhat limited for this type of analysis. A lag length of 1, on the other hand, seems too short to capture the dynamics of quarterly data. Fatás and Mihov (2000) also use 4 lags in their VAR analysis of fiscal policy in the United States. The reduced form equation of the above framework is given by:

Zt=Σi=14BiZti+ei,(I.2)

where Bi is a coefficient matrix and et is a vector of error terms which are serially uncorrelated but not independent. This is the equation that will be estimated.

13. The next step is to identify the independent fiscal policy shocks. This is achieved through the identification of the independent disturbances ut. One identification approach is to put restrictions on the short-term relations between the variables in the VAR (Sims, 1986; Bernanke and Blinder, 1992; Fatás and Mihov, 2000).8 This means setting some of the coefficients in the contemporaneous coefficient matrix A0 equal to zero. There are several ways to impose short-term restrictions. Two are explored here. The first approach, which is often referred to as Cholesky decomposition, is to assume a recursive structure among the variables in the VAR. In this approach, the first variable in the VAR is exogenous, that is, in the current quarter it is only affected by its own shocks and not by shocks in the other variables. The second variable in the VAR is affected by its own shocks and those of the first variable in the current quarter, but not by the shocks of subsequent variables, and so on. The last variable in the VAR is affected by its own shocks and by those of all other variables in the current quarter. Cholesky decomposition does not impose restriction on the long-run relations between the variables. The ordering of the variables in this study follows Fatás and Mihov (2002): Z = (G Y P T R). Under the second identification approach, often referred to as structural VAR analysis, the short-term restrictions are determined by a country’s institutions or economic theory.

Empirical Results

14. The empirical results for Korea, based on Cholesky decomposition, are qualitatively similar to those estimated for the United States.9 The impulse-response functions in Figure I.5 show the response of each of the variables to a one standard deviation increase in real public spending. The direction of these responses is similar to the responses estimated by Fatás and Mihov (2000) for the United States, but the magnitudes of the responses are different. The results suggest that discretionary spending shocks are not very persistent, dying out after about three-quarters. Moreover, the impact of government spending on GDP is rather small with an increase in real spending of about 10 percent,10 equivalent to about 2 percent of GDP, resulting in a 0.5 percent increase in real GDP in the same quarter. After about five quarters the effect has faded and GDP returns to its trend. The GDP deflator declines on impact, but then quickly returns to its trend. Real tax revenue increases on impact, but by less than the increase in real public expenditure. It then quickly drops and bounces up again. This pattern is difficult to explain and may be the result of imprecise estimates due to the relatively small sample size. The real interest rate rises after a positive spending shock, in line with the predictions of most theoretical models.

Figure I.5.
Figure I.5.

Korea: Responses to Public Spending Shock

(Impulse response functions with one standard deviation error bands)

Citation: IMF Staff Country Reports 2004, 045; 10.5089/9781451822144.002.A001

Source: Staff calculations1Time horizon is 24 quarters.

15. The estimates suggest that a real tax shock has a bigger impact on the economy than a real public spending shock (Figure I.6). Tax shocks are even less persistent than expenditure shock, as they die out after two quarters, but they generate bigger responses in the other macroeconomic variables in the VAR. A 6 percent increase in real tax revenue, equivalent to about 1.5 percent of GDP, has its maximum impact on real GDP after about 4 quarters, pushing it about 0.8 percent below its trend. Real tax shocks also have a strong impact on real public spending, which supports the notion that spending is bounded by revenue in Korea. The real interest rate falls sharply and reaches a minimum after about five quarters. It then slowly increases, but remains below its trend. The response of the GDP deflator is weak and is estimated with little precision.

Figure I.6.
Figure I.6.

Korea: Responses to Tax Revenue Shock

(Impulse response functions with one standard deviation error bands)

Citation: IMF Staff Country Reports 2004, 045; 10.5089/9781451822144.002.A001

Source: Staff calculations.

16. Permanent fiscal shocks have a small short-run impact on GDP, but no long-run impact. Analysis of the cumulative impulse response functions, not reported here, reveals that the short-run elasticity of a permanent public expenditure shock, as opposed to the transitory shocks discussed above, is 0.19.11 The short-run elasticity of a permanent tax shock is -0.29. The long-run elasticities of permanent fiscal shocks were estimated to be zero.

17. To test the robustness of the empirical results alternative specification strategies were employed, but these yielded similar results. First, the interest rate was replaced with the real effective exchange rate. It could be argued that the short-term real interest rate is not as important for the allocation of resources in the Korean economy as it is in industrial economies, because the short-term debt market in Korea is not very liquid and, at least until the early 1990s, the government actively influenced the allocation of credit in the economy. Given the openness of the Korean economy, movements in the real effective exchange rate possibly contain more information than changes in the real short-term interest rate. A new VAR was estimated with Z = (G Y P T REER). The impulse-response functions of the new VAR are very similar to those of the baseline VAR with the short-term real interest rate (Figure I.7). Another alternative specification that was estimated is a structural VAR, which allows nonrecursive short-term restrictions. Again the impulse responses were similar to those of the baseline VAR. Gracia (2003) estimated the effects of discretionary fiscal policy shocks in Korea on a range of macroeconomic variables using the approach in Blanchard and Perotti (2002), which relies on institutional information about the tax system. The results in this chapter are broadly in line with those found by Gracia (2003).

Figure I.7.
Figure I.7.

Korea: Responses to Public Spending Shock

(Impulse response functions with one standard deviation error bands)

Citation: IMF Staff Country Reports 2004, 045; 10.5089/9781451822144.002.A001

Source: Staff calculations.

18. Fiscal policy shocks are found to have the biggest impact on GDP through private consumption and facilities investment. To estimate the channels through which fiscal policy shocks affect GDP an augmented baseline VAR was estimated with Z = (G X Y P T R), where X is either real private consumption, real facilities investment, or real construction investment. Figure I.8 presents the impulse-response functions of each of the three GDP components for fiscal policy shocks. All three GDP components increase after a spending shock and decrease after a tax shock with the latter having the biggest impact on all three. For example, a 6 percent increase in real tax revenue reduces real private consumption by about 1.5 percent after eight quarters, whereas a 10 percent increase in real public spending raises real private consumption by only 0.4 percent after four-quarters. Weighing the individual responses of the GDP components by their share in GDP, a fiscal spending shock has the biggest impact on GDP through facility investment and private consumption, whereas a tax shock has the biggest impact through private consumption.

Figure I.8.
Figure I.8.

Korea: Responses of GDP Components to Public Expenditure and Tax Shocks

(Impulse response functions with one standard deviation error bands)

Citation: IMF Staff Country Reports 2004, 045; 10.5089/9781451822144.002.A001

Source: Staff calculations

19. The estimated discretionary fiscal policy shocks have not helped to reduce GDP volatility during the sample period 1979 Q4–2000 Q3. The empirical results suggest that fiscal policy measures have a small but significant impact on GDP. Given the, at times, procyclical policy stance, this raises the question to what extent fiscal policy has contributed to GDP volatility instead of reducing it. Variance decomposition shows that the identified fiscal shocks, in particular tax shocks, explain a significant part of the variation in real GDP (Table I.1). This does not imply, however, that GDP would have been less volatile in the absence of these shocks. In fact, the opposite would be the case if the identified fiscal shocks have offset other shocks to GDP. To see whether the identified fiscal policy shocks contributed to GDP volatility, GDP was simulated with the estimated reduced-form VAR in equation (I.2) under the assumption that the independent disturbances in public spending and tax revenue are zero over the sample period. This simulation produced a new path for real GDP that was then detrended and compared to actual detrended GDP. It turns out that discretionary fiscal policy has neither significantly increased nor reduced business cycle fluctuations over the sample period. Both public spending shocks and tax revenue shocks appear to have slightly raised GDP volatility by respectively 2.5 percent and 3.5 percent of the standard deviation of detrended GDP. The standard deviation of actual GDP around its trend was 2.7 percent over the sample period, whereas without fiscal policy shocks the standard deviation is 2.6 percent. This result suggests that the outcome of discretionary fiscal policy measures has been uncertain and that they have reduced volatility in some periods but increased it others. In addition, the simulated GDP series have an average annual trend growth rate that is about 0.2 percentage points higher than the actual trend growth rate. It appears that active discretionary fiscal policy in Korean during 1979 Q4–2000 Q3 has neither promoted macroeconomic stability nor GDP growth.

Table I.1.

Korea: Variance Decomposition of Real GDP, in percent1

article image
Source: Author’s calculations.

Based on baseline VAR with Cholesky decomposition.

20. The functioning of fiscal automatic stabilizers is probably limited by the small size of the budget compared to the economy. Figure I.9 shows the responses of real public spending and real tax revenue to a positive GDP shock. The responses suggest that both public expenditure and tax revenue have acted as fiscal stabilizers with expenditure falling and tax revenue increasing. However, the fiscal stabilizers do not appear to have had a large impact, because the GDP shock is fairly persistent.

Figure I.9.
Figure I.9.

Korea: Responses of Public Spending and Tax Revenue to GDP Shock

(Impulse-response functions with one standard deviation error bands)

Citation: IMF Staff Country Reports 2004, 045; 10.5089/9781451822144.002.A001

Source: Staff calculations

D. Conclusion

21. The contribution of fiscal policy to macroeconomic stability has been limited. Korea’s budget in percent of GDP is small compared to that of other OECD countries with the exception of Mexico. The potential impact of fiscal policy is therefore small, but not insignificant in the short-run. An unexpected 10 percent increase in real public spending raises GDP by 0.5 percent in the short-run, but has no discernable long-run effect. An unexpected 6 percent increase in tax revenue reduces GDP by 0.8 percent in the short-run and also has no significant long-run effect. The empirical results suggest that discretionary fiscal policy has not helped to reduce GDP volatility and may have had a small negative impact on trend GDP. It might be useful, therefore, to limit discretionary fiscal policy changes, by following a simple rule such as balancing the budget over the business cycle.

22. Meanwhile, automatic fiscal stabilizers are working, but they do not appear to be large enough to provide very effective smoothing of GDP fluctuations. In principle, the functioning of fiscal stabilizers could be strengthened through an increase in transfer payments and tax revenues, which are currently low compared to most other OECD countries. Indeed, Gali (1994), Fatás and Mihov (2001), and Silgoner et al. (2003) have shown that in countries with larger budgets the automatic fiscal stabilizers tend to be more effective. It seems likely that the size of Korea’s government will increase, including due to the rapid ageing of the population. This could contribute to strengthening of the functioning of automatic stabilizers. However, a bigger government may also introduce new costs into the economy.

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1

This paper was prepared by Harm Zebregs (APD). The author has benefited from excellent research by Borja Gracia who was a summer intern in APD in 2003.

2

In this chapter volatility is measured as the standard deviation of a detrended time series. Another way to measure volatility is to calculate the standard deviation of the growth rate of a time series. In that case, GDP volatility is 3.8 percent in Korea and 2.7 percent in the OECD area in 1970–2002.

3

Including government guaranteed bonds for financial sector restructuring, public debt in Korea is 35 percent of GDP.

4

The fiscal impulse is defined as the change in the cyclically adjusted fiscal balance.

5

See Chopra et al. (2002) for a discussion of Korea’s macroeconomic policies in the wake of the financial crisis.

6

A potential problem with using the fiscal impulse measure is that it assumes identical revenue and expenditure multipliers, an issue that will be explored further in Section C.

7

Blanchard and Perotti (2002) and Fatás and Mihov (2000) have used the VAR framework to study the effects of fiscal policy in the United States.

8

Long-term restrictions are an other option. See, for example, Blanchard and Quah (1989). Hoffmaister and Roldos (2001) impose long-run restrictions and leave the short-run unrestricted.

9

Fatás and Mihov (2000) estimate a semi-structural VAR.

10

The magnitude of this spending shock (and other shocks discussed below) is one standard deviation, as is the common practice in VAR analysis.

11

Short-run elasticities are defined here as the percentage change in real GDP after four quarters in response to a permanent one percent increase in either tax revenue or public spending. The time horizon of long-run elasticities is set at 40 quarters.

Republic of Korea: Selected Issues
Author: International Monetary Fund
  • View in gallery

    Korea: Fiscal indicators

    (in percent of GDP)

  • View in gallery

    Korea: Tax revenue

    (In percent of GDP)

  • View in gallery

    Korea: Output gap and fiscal impulse1

    (In percent of GDP)

  • View in gallery

    Korea: Correlation between output gap and fiscal impulse

    (4-year moving windows)

  • View in gallery

    Korea: Responses to Public Spending Shock

    (Impulse response functions with one standard deviation error bands)

  • View in gallery

    Korea: Responses to Tax Revenue Shock

    (Impulse response functions with one standard deviation error bands)

  • View in gallery

    Korea: Responses to Public Spending Shock

    (Impulse response functions with one standard deviation error bands)

  • View in gallery

    Korea: Responses of GDP Components to Public Expenditure and Tax Shocks

    (Impulse response functions with one standard deviation error bands)

  • View in gallery

    Korea: Responses of Public Spending and Tax Revenue to GDP Shock

    (Impulse-response functions with one standard deviation error bands)