This note is on Korea’s transition to a knowledge-based economy, the prospects and challenges ahead, and the development of its financial sector. Assessment of recent government initiatives to develop capital markets has been presented. The note discusses restrictions on Chaebol ownership of Korean banks and strategy for restructuring the small and medium-sized enterprise sector in Korea. This note describes the key fiscal challenges and discusses possible ways to address them, arguing that there is already a great need to start taking remedial action.


This note is on Korea’s transition to a knowledge-based economy, the prospects and challenges ahead, and the development of its financial sector. Assessment of recent government initiatives to develop capital markets has been presented. The note discusses restrictions on Chaebol ownership of Korean banks and strategy for restructuring the small and medium-sized enterprise sector in Korea. This note describes the key fiscal challenges and discusses possible ways to address them, arguing that there is already a great need to start taking remedial action.

V. A Family Divided—Revisited: Income Inequality and Social Polarization in Korea62

A. Introduction

1. In 2003, the Article IV consultation on Korea found that the country’s labor market was actually two markets in one, with regular workers enjoying stable jobs on one side, and a large share of non-regulars jumping from job to job on the other.63 The particular paper that studied these issues was titled: “A Family Divided: Labor Market Duality in Korea.” 64 In this paper we revisit the growing gap between the haves and the have-nots, but this time with a different focus: income inequality and social polarization.65

2. Income inequality and social polarization have become major issues in Korea. President Roh Moo Hyun’s dedicated his 2006 New Year’s address to this problem, stressing that “The issue of socio-economic disparity must be resolved.” More dramatically, presidential chief of staff Lee Byung-Wan warned that “If the polarization problem is left unsolved, South Korea could be even divided into two, resulting in three Koreas on the peninsula.” 66

3. Of course, concerns about income inequality are not new, nor are they confined to Korea. Indeed, over the past few decades the combined effects of technological change and international trade have put downward pressure on the employment and wages of lower and middle-income households in most advanced countries, with concomitant increases in inequality measures.

4. But the situation in Korea is arguably more dramatic than elsewhere. To start, income inequality is rising at a pace unseen in other OECD countries. Moreover, income inequality is rising not just because the rich are getting richer: lower incomes in Korea have fallen substantially in absolute terms despite rapid economic growth.

5. So why is Korea doing worse? The links with the labor market are clear: Korea is doing worse because the loss of regular jobs in favor of more precarious forms of employment has been more severe than elsewhere. And this happened because, in Korea, the global forces of technology and trade were met with highly rigid policies on permanent employment, as well as stifling regulations that all but killed productivity growth and job prospects in the service sector. In other words, the key to reducing inequality in Korea lies in less, not more, regulated markets.

B. Income Inequality in the World and in Korea

6. Over the last couple of decades, many advanced countries have experienced a substantial rise in income inequality. This rise has cut across all continents, occurring in countries with significant income redistribution through taxation as well as in those with less protected labor and product markets. There have been important cross-country differences in the way the process has materialized, but overall the commonalities in income inequality dynamics among developed countries outweigh these differences.67


Gini Coefficient in Selected Countries

Citation: IMF Staff Country Reports 2006, 381; 10.5089/9781451822205.002.A005

Sources: U.S. Bureau of Labor Statistics, Statistics Canada, and Statistics Norway.

7. Korea has not been immune to this global trend. Korea used to be different, in that income inequality was falling for much of the 1980s, while it was increasing most elsewhere. As some Korean scholars have noted, the gradual liberalization of union activities during the transition to democracy led to a major redistribution of wages and incomes towards the bottom and middle of the distribution (Choi, 2003). But inequality started rising mildly in the early 1990s, and then surged during the financial crisis of 1997–1998 as massive corporate layoffs disproportionately affected lower-wage employees.68,69 And real economic growth of close to 50 percent since 1998 has not been able to reverse the jump in inequality during the crisis; in fact, inequality rose further during this last period.70,71 This is in sharp contrast to past historical experience in Korea, when high growth was typically accompanied by declines in inequality.


Net Job Creation, 1997-98

(In percent of jobs in each wage decile)

Citation: IMF Staff Country Reports 2006, 381; 10.5089/9781451822205.002.A005

Sources: Korea Ministry of Labor, and staff calculations.

Gini Coefficient in Korea1

Citation: IMF Staff Country Reports 2006, 381; 10.5089/9781451822205.002.A005

Source: Professor Kyunsoo Choi, Korea Development Institute.1 Based on labor income.

8. There is consensus among academics that skill-biased technological change (SBTC) has been the main factor behind higher inequality in advanced countries.72 According to this theory, computerized equipment has replaced the jobs of many unskilled workers while boosting the productivity of highly-skilled individuals.73 Krussel et al. (2000) estimate a model where equipment capital is a complement to skilled labor and a substitute to unskilled labor, and show that growth in the stock of such capital can account for much of the rise in relative demand for skilled labor in the United States and concomitant rise in the skill premium.74 Machin and Van Reenen (1998), Goos and Manning (2006) and Spitz-Oener (2006) among many others also find strong evidence of SBTC in European countries and Japan. More recently, some authors have emphasized a slight variant of SBTC which maintains the complementarity of capital with skills/education but refines the substitutability between capital and unskilled labor. In this view, computerized equipment can easily replace humans in jobs that require non-cognitive repetitive tasks (i.e., typical office work), but cannot (yet) replace humans in jobs based on non-repetitive manual tasks such as cleaning or waitressing. This theory then predicts a polarization of the labor market, with jobs disappearing in the middle of the wage distribution and growing at the two extremes. Autor, Levy, and Murnane (2003) and Autor, Katz, and Kearney (2005) have been proponents of this “polarizing” SBTC, arguing that it can explain why in countries like the U.S. higher incomes are rising relative to middle incomes, while the latter are falling relative to lower incomes.

9. International trade and competition from low-cost countries have also played a role in fuelling inequality in most advanced countries, but a relatively minor one. There has been much worry that competition from countries like China has hollowed out traditional manufacturing, leading to the loss of many heretofore stable jobs and putting downward pressure on the wages of unskilled workers. But most studies in this literature find a relatively small effect of trade on the employment and salaries of low-skill workers in developed countries.75 At most, trade can account for 10–20 percent of the overall fall in the demand for unskilled labor, not enough to cause much widening of wage inequality. Another piece of evidence playing against international trade and in favor of SBTC is the fact that the demand for low-skill labor has fallen in non-tradable sectors and in manufacturing sectors not exposed to competition from low-cost countries by as much as they have in sectors exposed to such competition.76

10. The causes behind the increase in income inequality in Korea have not been as closely studied as in other countries, but preliminary evidence points to substantial SBTC effects. A sizeable number of papers (Cheong, 2001, Choi, 2003, Yoo, 2004, among others) have examined the increase in inequality following the 1997–98 crisis. These studies quantitatively decompose inequality trends by type—between-groups versus withingroups—or measure the contribution of different income sources—labor income, nonlabor income, etc.—in these trends. But they do not test directly for one competing theory of income inequality or another. The few that do point to SBTC effects. Kang and Yun (2003), for example, find that the rise in the college premium can explain one-third of the rise in wage dispersion in Korea between 1994 and 2000. The rise in the college premium is confirmed by IMF (2006), who also find that employment of unskilled workers has declined in absolute terms in Korea, while that of skilled workers has risen strongly.

11. There is no direct evidence on the effects of international trade on income inequality in Korea, but there is some reason to believe that they have been significant. Competition from low-cost countries, in particular China, has led to a substantial hollowing out of traditional manufacturing sectors in Korea, affecting mostly small and medium enterprises (Miniane and Kang, 2004). For example, while overall exports have grown by over 130 percent since 1995, SME exports in sectors such as textile and apparel, plastic, or rubber have been flat or falling. Employment losses in these firms account for much of the total decline in manufacturing employment—over half a million in the last ten years. This being said, whether international trade has or has not worsened inequality in Korea remains to be empirically tested. Cross-sectional studies measuring the effect of trade on inequality in Asia find that trade worsened wage dispersion, but the effect on inequality was less pronounced (IMF, 2006).77

So far, it appears that Korea fits the pattern of many other advanced countries: SBTC and international trade have led to a deterioration in income inequality. But as we will now show, Korea is different in three key regards: (i) the increase in income inequality has been more rapid than elsewhere; (ii) income inequality is not worsening just because the rich are getting richer, but also because the incomes of the poor are falling in absolute terms, despite rapid economic growth; and (iii) beyond income inequality, Korea is experiencing strong social polarization—defined as disparities across groups in terms of job and income security, and access to social insurance—as “precarious” employment is replacing permanent contracts much faster than elsewhere.

C. Things Are Tougher in Korea

12. It is hard to tell how inequality levels in Korea compare with those in other countries, but the pace of increase has been very rapid by international standards. One should be careful in making cross-country comparisons of measures of inequality such as the Gini coefficient, as these measures are very sensitive to the definitions of household and income, and which change from country to country.78 However, it is safer to compare trends in inequality, and on that measure the pace of increase in Korea since 1997 has been very rapid, arguably the fastest in the OECD (see footnote 6). The Gini coefficient has risen by more than 4 percentage points over the last eight years, compared with less than one percentage point in countries like the US or Canada.79 Even excluding the crisis years 1997 and 1998, the pace of increase has been unusually fast. Other papers such as IMF (2006) find that Korea has experienced the sharpest rise in top-to-bottom income dispersion over the last ten years of any country in Asia, developed or developing.

13. Moreover, despite an impressive economic recovery following the crisis, lower incomes have fallen in absolute terms. Real gross domestic product in Korea grew by some 50 percent between 1999 and 2005, after falling by 7 percent in 1998. Yet over the period 1998–2005 real incomes of the bottom decile fell by some 9 percent.80 The path has been quite volatile, with a sharp fall during the crisis, a sharp recovery matching the recovery of the overall economy, and a renewed fall following the bursting of the credit card bubble. Yet note that incomes at the top fell much less during the financial crisis, and did not suffer from the 2002–2005 slowdown. By and large, real wages at the top and at the bottom exhibit similar patterns to incomes.


Trends in Real Regular Income


Citation: IMF Staff Country Reports 2006, 381; 10.5089/9781451822205.002.A005

Source: Korea National Statistics Office and staff estimates.

Trends in Real Wages


Citation: IMF Staff Country Reports 2006, 381; 10.5089/9781451822205.002.A005

Source: Korea Ministry of Labor and staff estimates.

14. One reason why inequality is rising faster in Korea than elsewhere is that the country is experiencing a much sharper decline in regular employment, with a concomitant rise in non-regular employment.81 According to OECD (2002), non-regular employment accounted for 11 percent of salaried employment in the OECD as a whole in 1985, and for some 14 percent in 2000. Compare this with Korea, where over the past four years alone the share of non-regular employment has gone from 27 percent to 37 percent, as the economy lost over four hundred thousand regular jobs while creating over 1.8 million non-regular jobs.82 Similarly, some 30 percent of all new jobs created in the service sector in the past ten years have been accounted for by the self-employed, many of whom were unable to find regular employment and used their severance payments to open small, mom-and-pop shops. It is consequently not surprising that Korea has a higher share of self-employment than any country in the OECD except for Turkey, Mexico, and Greece, the former two having substantially lower income per capita levels than Korea.


Job Creation by Type of Salaried Employment

(In thousands)

Citation: IMF Staff Country Reports 2006, 381; 10.5089/9781451822205.002.A005

Source: Korea National Statistics Office and staff estimates.

Self-employed as Percent of Labor Force

Citation: IMF Staff Country Reports 2006, 381; 10.5089/9781451822205.002.A005

Source: OECD.

15. Nonregular employees are paid less than regular employees even adjusting for relevant characteristics, and the gap is particularly pronounced in Korea. One cannot simply compare wages in regular versus non-regular jobs, because both work and worker characteristics are different. However, there is mounting evidence that non-regular workers face a negative premium even after adjusting for all relevant characteristics. In Korea, this negative premium has been estimated by Jeong (2003) to range between -20 to -30 percent depending on the econometric specifications.83 In the thirteen European countries that participate in the European Commission Household Panel, the average premium is estimated at -15 percent and highly statistically significant (OECD, 2002).

16. The “precariousness” of work has implications that go beyond earnings and income inequality. For example, economic theory suggests that absent complete financial markets—a safe assumption in the real world—risk-averse individuals care about the volatility of their income. And the self-employed and non-regular workers face substantially higher income volatility than regular workers. According to OECD (2002), 58 percent of non-regular workers have been in their current job for less than a year, compared with only 13 percent of permanent workers. Non-regular workers also face a much higher risk of a return to unemployment at any point in time. Meanwhile, for the self-employed, income uncertainty is a feature of everyday life.

17. Non-regular employees are also substantially less likely to be covered by workbased social insurance. There are several reasons why this occurs: (i) minimum contribution periods are required for entitlement of benefits; (ii) the contribution records of temporary employees are fragmented across many employers; (iii) fixed-term workers are typically employed in smaller firms, which are more likely to evade taxes and contributions. And the numbers paint a bleak picture. In Korea, 47 percent of non-regular employees are covered by the National Pension, 49 percent are covered by health insurance, and 45 percent are covered by unemployment insurance. The numbers for regular employees, in contrast, are 76 percent, 76 percent, and 64 percent respectively.84

So why is regular employment disappearing so fast in Korea? Because the global forces of technical change and international trade - which put a premium on economic flexibility - were met in Korea with very rigid policies on regular employment and a highly regulated and very unproductive service sector.

D. Stemming Social Polarization in Korea

18. Policies on regular employment remain very rigid in Korea. In particular, the conditions for mass dismissal are strict, the consultation periods long, and severance payments high.85 Among other things, the Labor Standards Act (LSA) stipulates that collective dismissals are allowed only for “urgent managerial reasons”, and it requires that the employer make every effort to avoid layoffs, that it notify trade unions sixty days prior, and that it maintain discussions in good faith with trade unions on how to avoid dismissals. In some cases, approval from the Ministry of Labor is required for dismissals. Since the crisis, firms have relied on the Supreme Court’s more liberal interpretation of the conditions for dismissal attached to the LSA, but this interpretation remains narrow relative to the reality in other countries.86


Severance Payments

(Weeks of Salary, for 20 years service)

Citation: IMF Staff Country Reports 2006, 381; 10.5089/9781451822205.002.A005

Source: World Bank, Doing Business in 2004

19. Strict protection of regular contracts likely explains why Korea is rapidly losing permanent jobs.87 Studies such as Booth et al. (2002) have found that countries with stricter employment protection legislation on permanent employment tend to have higher shares of fixed-term employment; conversely, countries like the United States, the United Kingdom, and Ireland have low protection on regular employment and have high shares of regular employment—even though they have, if anything, fewer restrictions on non-regular employment.88 Moreover, non-regular employment need not be the only substitute for regular employment: rigid policies may also be pushing firms—notably the chaebol—to become more capital intensive. According to Pyo et al. (2006), the capital/labor ratio in Korea increased by 45 percent between 1996 and 2002. Finally, it is worth noting that strict regulations on regular employment are ranked by foreign CEOs as the number one deterrent to foreign direct investment in Korea (Kim and Lee, 2005).

20. Besides rigid labor market policies, the “precarization” of employment in Korea can be explained by the flow of labor from manufacturing to services. Over the last fifteen years, Korea has experienced a large flow of labor from manufacturing into services. Since 1995 manufacturing employment has declined by half a million, while service sector employment has increased by two and half million. Such a flow has happened in many countries, the result, among other things, of international trade pressures and changing social preferences as incomes rise. In the particular case of Korea, this transition from manufacturing into services was hastened by the financial crisis, which resulted in massive corporate layoffs in manufacturing, mostly of low-wage employees.


Job Creation by Sector

(In thousands)

Citation: IMF Staff Country Reports 2006, 381; 10.5089/9781451822205.002.A005

Source: Korea National Statistics Office and staff estimates.

21. Since labor migration from manufacturing to services has happened elsewhere, why did it lead to such work precarization in Korea? Because productivity levels and productivity growth in services are weaker than in other countries, both in absolute terms and relative to manufacturing. Korea’s service sector is one of the least productive in the OECD; moreover, the gap in productivity growth between manufacturing and services is higher in Korea than in any other OECD country—twice the gap in France, four times the gap in the United States, and ten times the gap in the United Kingdom (OECD, 2005). Low productivity and growth in services has limited the creation of well-paying salaried employment, failing to compensate for the destruction of regular jobs in manufacturing, and resulting in an increase in non-regular jobs and self-employment. To witness, the proportion of self-employed businesses in the service sector in Korea is about 30 percent, well above 7 percent in the US and 11 percent in Japan. To a certain extent, productivity in the service sector is low precisely because there has been an influx of labor into this sector, opening up inefficient mom-and-pop stores. But productivity in services was already low before 1998. In fact, Chapter I finds that TFP growth in services has increased since the crisis, although it remains negative.89

22. If service sector productivity is so low, it is because of a stifling regulatory burden. As Chapter I argues, low productivity in services is due to: (i) high start-up costs including costs of incorporation, which limit entry and protect incumbents; (ii) strict zoning and land law regulations, which particularly constrain growth and productivity in the distribution sector; (iii) high exit costs, due to generous public credit guarantees benefiting weak performers and an inefficient bankruptcy system90; and (iv) a host of restrictive regulations in particular areas, notably education, health, and professional services—for example, there can be no for-profit health organization in Korea.

E. Conclusions

23. Korean society is experiencing a high degree of anxiety over issues of inequality and social polarization, and it is not hard to see why. Income inequality is rising faster in Korea than elsewhere, and people at the bottom are losing out not just in relative but also in absolute terms. Growing gaps between the haves and the have-nots, be it in terms of income levels or income security, become all the more evident—and difficult to accept—in a society as ethnically homogeneous as Korea.

24. This being said, the key to reducing growing social polarization lies in less regulation, not more. Korea provides a perfect example that rigid policies, while wellmeaning, often end up protecting a dwindling pool of insiders at the detriment of a growing body of outsiders. If Korea is to tackle social polarization, it has to stimulate regular employment, and this can best be achieved by making dismissal of regular employees less costly for firms, and by deregulating the service sector to create business opportunities. This process of deregulation could be accompanied by an expansion of social insurance, on which public expenditures remain low by international standards. In other words, protect the worker, not the job. By protecting jobs, Korea has hurt a lot of its citizens.


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Prepared by Jacques Miniane. Particular thanks are due to Prof. Kyungsoo Choi of Korea Development Institute, both for his insights into the issue of income inequality in Korea and for sharing his data on Korea’s labor income Gini.


In keeping with the usual terminology in Korea, we will use the term “regular worker” to define someone under an open-ended salaried contract, and “non-regular worker” someone under a fixed-term contract.


In this paper we define social polarization as differences across individuals in terms of the precariousness of their jobs (permanent versus fixed-term contracts, full-time versus part-time, etc.), the security and predictability of their income, and their coverage under social insurance.


As quoted in Business Korea, March 2006, page 12.


Differences include the fact that the rise in inequality has been continuous in some countries (i.e., the United States), but has come in bursts in others (i.e., the United Kingdom, where inequality rose sharply in the 1980s and stabilized in the 1990s). Note that, while this paper concentrates on the trends in advanced countries, other authors have found that increases in inequality in regions such as Asia cut across countries’ income levels (see IMF, 2006).


Why this is so is not entirely clear, but one factor could be that severance payments—which on average are high in Korea—were substantially smaller for lower-wage employees. Note also that the seniority-based wage system then prevalent in Korea pushed many firms to fire older workers, for whom wage was substantially above their marginal productivity.


As IMF (2006) points out, Korea is the only Asian country where inequality rose during the financial crisis, perhaps because the other countries affected had much larger rural sectors, and the crisis predominantly hit the relatively affluent urban citizens.


Korea’s Gini coefficient computed by the National Statistics Office shows no trend increase since the crisis. The official Gini is computed based on total household income including severance payments, which are quite large in Korea. When one decomposes total income between regular labor income and others (including severance payments), a Gini based on the former shows a trend increase since the crisis, and a Gini based on the latter shows a strong trend decline. Adding the two explains why the official Gini has been relatively stable since 1998. Because severance payments are much larger in Korea than elsewhere, and because severance payments are very lumpy, a Gini based on labor income is more appropriate to compare trends in Korea with those in other countries.


It is also worth stressing that up to 2003 household income in Korea was sampled from salaried households only, thereby excluding the self-employed. This is key in a country where the self-employed account for a rising share of the labor force, a share now close to 30 percent. In this paper we generally exclude the self-employed in our calculations (unless specifically mentioned) in order to obtain longer series. Note that once the selfemployed are included the value of the Gini increases by some 15% percent.


Authors that do not subscribe to the view that SBTC has been the main driver of wage and income dispersion include Card and DiNardo (2002) and Lemieux (2006). In the particular case of the Unites States, these papers have argued in favor of institutional factors such as the real decline in the minimum wage, or changes in workforce composition, notably age and experience.


Examples of capital and skill complementarity are countless: think of the asset manager who can now track instantaneously the performance of a global portfolio with countless assets, or the top doctor who can consult in real-time on a far-away surgical procedure.


The skill premium is usually defined as the ratio of wages of college educated workers to wages of noncollege educated workers.


Freeman (1995) and Cline (1999) provide good reviews of this literature. Wood (1994) finds much larger effects of trade on inequality, but his views are not widely shared.


Skill-biased technological change and competition from low-cost countries need not be mutually exclusive explanations of the increase in inequality. To the contrary, they could be mutually reinforcing. Imagine that SBTC leads to greater polarization of work within services than within manufacturing. If so, competition from low cost countries could exacerbate the effects of SBTC by shifting labor from relatively egalitarian manufacturing into relatively polarized services. This hypothesis is only speculative, though.


This may be simply due to the fact that, in many countries in the sample, salaried employees accounted for less than 50 percent of total employment. But this is not true in Korea, and certainly not in the early to mid-1990s when inequality started rising.


The OECD has constructed harmonized measures of the Gini coefficient for most of its member countries, but unfortunately Korea is not part of the sample.


The calculation for Korea is based on the labor-income Gini, not the total income Gini.


This calculation is based on household income data from the National Statistics Office. Calculations using labor income data supplied by Prof. Kyungsoo Choi of Korea Development Institute show an 18 percent real decline for the bottom decile, and an 8 percent real decline for the second lowest decile. Bottom incomes have not fared well in the United States either, but the decline has been smaller than in Korea over this period despite lower overall economic growth.


To some extent, self-employment and part-time or fixed-term employment is the result of preferences. However, there is evidence, including for Korea, that much of it is not.


These figures are from the October supplementary survey to the monthly Economically Active Population Survey (EAPS) conducted by the National Statistics Office. The supplementary survey was first undertaken in 2002, and hence no data exists for earlier periods. The standard EAPS is longer dated, but its classification of workers between regular workers and non-regular workers can be misleading, in that workers with fixed-term contracts of one year duration or longer are classified as regular workers.


Note that, even after adjusting for relevant observable characteristics, these specifications do not control for unobservable but potentially relevant ones, nor do they easily control for the potential endogeneity of temporary work.


Not all regular employees are covered by social insurance, because many work in small enterprises that evade contributions.


OECD (2004) attributes only a moderately high value to Korea’s employment protection legislation on regular employment. But this is because, de jure, Korea has no legal provisions for monetary compensation in the case of dismissals. De facto, workers do receive severance payments. This being said, one should be careful when comparing these de facto payments with those in other countries (i.e., one should take the graph plotted above with a grain of salt). Severance payments in Korea are high because they are often in lieu of retirement benefits, which are paid to the dismissed worker in one lump sum. But the fact remains that high severance payments are a good proxy for the legal difficulty of dismissing workers discussed in the paragraph.


Some authors such as Kim (2002) have gone so far as to argue that layoffs of regular workers have become even harder after the reinterpretation of the LSA.


See He and Tressel (2004) for more detailed evidence on this issue.


The fact that Korea now has a relatively liberal regime for fixed-term employment (OECD, 2004) only accentuates the perceived cost of permanent employment.


Pyo et al. (2006) also find that TFP growth has improved in services, being slightly negative before the crisis and slightly positive after.


See Miniane and Kang (2004) for more details.

Republic of Korea: Selected Issues
Author: International Monetary Fund