Republic of Korea: Selected Issues

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.

Abstract

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.

VI. Long-Term Fiscal Challenges91

A. Introduction

1. Since the 1980s, Korea’s prudent fiscal policies have been the lynchpin of the country’s macroeconomic stability. However, difficult fiscal challenges are looming on the horizon, and in the coming decades maintaining this prudent stance will become progressively more difficult. Population aging is the driving force behind these challenges, which are expected to have relatively swift and profound impact in the long term—more so than for most other comparable economies.

2. This chapter 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. Section B shows that Korea’s fiscal policies have been prudent for many years. Section C describes how a number of factors, including population aging, are expected to increase the fiscal burden significantly. Section D then discusses several measures—in pension system, health care system, and taxes—that can help address the long-term challenges. Section E concludes.

B. Korea has Traditionally been Fiscally Prudent

3. Over the past two decades, Korea has followed prudent fiscal policies. The fiscal deficit had ballooned in the 1970s owing to active government support for investment in heavy and chemical industries and transfers to the agricultural sector (Jun, 2004). But by the early 1980s, fiscal policy shifted fundamentally to a much more cautious stance, as the authorities aimed at “spending within revenue” and maximizing government savings to finance investment in public infrastructure and public corporations, and provide credit to targeted sectors (Zebregs, 2004). Since early 1990s, the consolidated central government balance has been in surplus, with the notable exception of 1997–99, when fiscal deficits (excluding the social security funds) on average exceeded 4 percent of GDP in response to the Asian crisis.

uA06fig43

Consolidated Central Government Balance

(In percent of GDP)

Citation: IMF Staff Country Reports 2006, 381; 10.5089/9781451822205.002.A006

Source: CEIC Data Company Ltd.

4. As a result, Korea’s public debt is small compared to the size of its economy. Total public debt was below 10 percent of GDP before the Asian crisis, and although it increased sharply afterward, by 2005 public debt, including the cost of restructuring the banking system, stood at just 36½ percent of GDP. Moreover, in net terms (including the government’s financial assets), the Korean government is actually a creditor, similar to only a handful of other OECD countries. Looking forward, the authorities aim to keep public debt, excluding the cost of restructuring the banking system (amounting to 6½ percent of GDP), around 30 percent of GDP.

5. Although the fiscal position has remained close to balance, the size of the government has increased over the past three and one-half decades. Total spending of the consolidated central government increased from 16½ percent of GDP in 1970 to 21½ percent of GDP in 2005. While official figures on the consolidated general government are not available, its size must have increased even faster, because the size of local government increased significantly during this period as fiscal decentralization efforts intensified, giving a bigger role to the local governments in providing public services.

uA06fig44

Government Debt

(In percent of GDP)

Citation: IMF Staff Country Reports 2006, 381; 10.5089/9781451822205.002.A006

Source: CEIC Data Company, Ltd.

6. Nevertheless, the general government remains small compared with other OECD countries. The OECD estimates the size of the general government to be around 31 percent of GDP in 2003 (OECD database). Since central government expenditure increased as a share of GDP in the last two years (by ½ percentage point), it is safe to assume that this figure indicates a lower bound for the current size of the general government.

uA06fig45

General Government Expenditure

(In percent of GDP)

Citation: IMF Staff Country Reports 2006, 381; 10.5089/9781451822205.002.A006

Source: IMF, World Economic Outlook.

C. The Fiscal Burden Is Set to Increase Substantially

7. By far the most important factor that will dominate public finances in the coming decades is population aging. As mentioned in Chapter I, Korea has a significant aging population problem. The fertility rate is low and is expected to decline even further. Moreover, life expectancy is projected to increase substantially in the coming years. As a result, National Statistics Office of Korea projects that total population will peak around 2025 and then decline rapidly, and the share of elderly in total population will increase sharply (National Statistics Office 2001). As a result, the dependency ratio is projected to increase above 80 percent, compared with less than 40 percent today.

uA06fig46

Dependency Ratio

(In percent)

Citation: IMF Staff Country Reports 2006, 381; 10.5089/9781451822205.002.A006

Source: Korea National Statistical Office.

8. While most of the OECD countries are facing population aging, Korea’s case is unusual in two ways. First, its dependency ratio by 2050 is projected to be one of the highest among OECD countries. Only Japan and Italy are projected to have similar dependency ratios. Second, the rate of change of the dependency ratio is the fastest among the OECD countries. For example, it will take 26 years in Korea for the proportion of elderly in total population to increase from 7 percent to 20 percent, while the same change will occur in Italy in 80 years (Young, 2005, and OECD, 2005).

9. Population aging is expected to put severe strains on the National Pension Fund (NPF). Under the current population trends and pension parameters—60 percent replacement rate and 9 percent contribution rate—the assets of the NPF are projected to peak in the mid-2030s and then rapidly decline and be exhausted around 2047 (Ministry of Planning and Budget, 2006). Without parametric reforms, funding the pension system would require additional annual funds worth 5¾ percent of GDP (Gruenwald 2003). Increasing the share of equity allocation in the pension portfolio from the current 12 percent to 16½ percent, as currently planned by the government, could marginally reduce the required additional funds to 5–5½ percent of GDP.

uA06fig47

Pension System Balance

(In percent of GDP)

Citation: IMF Staff Country Reports 2006, 381; 10.5089/9781451822205.002.A006

Sources: KDI (2002) and staff calculations.

10. Occupational schemes will also be adversely affected. The pension schemes introduced for civil servants, military personnel, and private school teachers during 1960–1975 have relatively generous benefits, with a replacement rate of 76 percent. These schemes already have a small overall deficit, which, under unchanged parameters would worsen steadily before leveling off at 2–2½ percent of GDP around 2030. Combined with the funds required to sustain the NPF, the total fiscal burden of the pension system could be around 7–8 percent of GDP per year by mid-century.

11. Population aging is also expected to increase expenditure for health and longterm care sharply. OECD (2006), in a cross-country study, estimates that aging of the population alone could increase expenditure for health and long-term care by 5½ percentage points of GDP by 2050. This projection does not take into account any (likely) efforts to contain expenditure. But at the same time it is somewhat optimistic, because it assumes that expenditure increases due to aging will come only from the increase in the share of older people in total population, and that any gains in longevity will not have any affect on health and long-term care expenditure.

12. Apart from population aging, other factors are putting pressure on health and long-term care expenditure:

  • Higher income. The range of income elasticities estimated in the literature for health care expenditure in a number of countries is wide and falls on both sides of unity. Nevertheless, the elasticity could be higher than unity in Korea, because total health expenditure is far lower than what is implied by Korea’s income level and may drift up to levels more consistent with what is observed internationally.

  • Technological change. Health expenditure could also go up with technological change, as the resulting availability of new services could create additional demand for health care services.

  • Labor force participation. Demand for long-term care may also increase because labor force participation may rise, which would reduce the availability of informal provision of long-term care.

  • Structure of the health care system. Finally, Kim (2005) argues that other Koreaspecific factors—minimum regulation of health care provision, incentives for physicians to encourage frequent office visits, and almost unconstrained freedom in terms of choosing health providers—reinforce the upward pressure on total health care costs.

13. All factors combined, under current policies, the health and long-term care expenditure of the government could increase from the current 3¼ percent of GDP to 12 percent of GDP by 2050 (OECD 2006). This 9 percentage points of GDP change is the highest among OECD countries because the rate of population aging is the highest. Sensitivity analysis suggests that under different but plausible income elasticities, the change could vary by ¾ percentage point of GDP in either direction. These results are consistent with Yun (2005) who projects that the health expenditure of the government will increase 7-fold in today’s prices by 2050.

14. Population aging also has an indirect effect on public finances, through slower growth, as discussed in Chapter I. As Korea’s annual GDP growth rate drops toward 2 percent, the ability to “grow out of the problem” of debt accumulation will be more difficult. This could be seen in the following illustration: if real GDP had grown on average 2 percent per annum during 2001–05 instead of the actual 4½ percent, while the increase in nominal debt remained the same, Korea’s public debt in percent of GDP would have increased 5¼ percentage points, instead of 1 percentage point, and total debt would have reached 41 percent of GDP by 2005.

15. Beyond pensions and health care costs, there will be additional pressures on the budget in coming years. For example, contingent liabilities, including guarantees to small-and medium-size enterprises and public-private partnership arrangements could have sizable affects on the budget. Currently, the former amounts to 5½ percent of GDP, while the latter is projected to cover investments worth close to 3 percent of GDP.

16. Public expenditure on the social safety net, excluding expenditure on health and pensions, in particular is set to increase substantially. Currently, Korea’s public expenditure on the social safety net is lower than the OECD average by a wide margin, in all categories.92 The gap is partially closed by private expenditure (e.g., voluntary social benefits many employers pay), and by family support. However, the level of family support provided by the young for the elderly and others in need will likely diminish as the share of young in the population declines. This will boost the need for higher public expenditure on the social safety net. In fact, the government’s medium-term budget plan already envisages expenditure on the social safety net (excluding expenditure on health and pensions) to increase by around 10 percent per year until 2009, significantly faster than the growth of nominal GDP. This increase entails expanding the Basic Livelihood Guarantee System and thus increasing the number of citizens that receive subsistence support and providing medical support to children under 18 in low income households (Ministry of Planning and Budget, 2006). In addition, an Emergency Welfare Support System will be introduced to help households facing difficulties from deaths or accidents. Housing support will also be boosted, both by constructing more public rental apartments and by providing financial support for housing rent.

uA06fig48

Other Social Expenditure

(In percent of GDP, 1998)

Citation: IMF Staff Country Reports 2006, 381; 10.5089/9781451822205.002.A006

Source: OECD.

17. Finally, it is worth noting the fiscal cost associated with unification could be an order of magnitude larger than any of the cost pressures mentioned so far.

18. What will all this imply for the fiscal position? Sweden, a rare example of a country that has already experienced significant population aging, provides a cautionary lesson. The Swedish population started aging relatively early, in mid 1960s. Soon after that, government expenditure begun to drift upward, mainly because of strong demographic effects, combined with a political consensus in favor of extending welfare arrangements. This upward drift in expenditure required progressively higher taxes to achieve fiscal balance. This trend continued for two decades until the early 1990s, when the expenditure ratio had reached 62 percent of GDP, 20 percentage points higher than in 1970. At that point, Sweden experienced a severe crisis. The crisis gave way to a steady fiscal retrenchment, and since then the size of the government has been shrinking in Sweden.

uA06fig49

Sweden:Revenue and Expenditure

(In percent of GDP)

Citation: IMF Staff Country Reports 2006, 381; 10.5089/9781451822205.002.A006

Source: IMF, World Economic Outlook.
uA06fig50

Sweden:Aged Dependency Ratio

(In percent)

Citation: IMF Staff Country Reports 2006, 381; 10.5089/9781451822205.002.A006

Source: United Nations.

D. How to Handle the Additional Fiscal Burden

19. Such broad and strong pressures on public expenditure requires consideration of an equally broad set of measures. This chapter focuses on three: reforming the pension system to ensure its sustainability; slowing the increase in health and long-term care expenditure; and raising taxes.

Reforming the pension system

20. The government has put forward a proposal to help bring the National Pension Fund back to financial health. The main elements of this proposal include lowering the replacement ratio from the current level of 60 percent to 40 percent, and increasing the contribution rate from the current level of 9 percent to 12–13 percent by 2020. Moreover, with a view to increasing the average return to NPF’s investments, starting in 2007, the share of the NPF assets invested in stocks would rise from 12 percent to 16½ percent. These changes will go a long way in helping NPF remain solvent for a number of additional years. Under official projections, its assets, instead of starting to decline by mid 2030s, will continue to grow until the mid 2050s.93

uA06fig51

Assets of the Pension Fund

(In trillions of won)

Citation: IMF Staff Country Reports 2006, 381; 10.5089/9781451822205.002.A006

Source: MOHW.

21. Early action is needed in changing the parameters of the NPF. Even in the current circumstances, it will take 15 years to phase in the parameter changes. If the parameter changes are delayed, say, until the assets of the NPF peak, then the assets at that time would be only 50 percent of the amount needed to maintain the NPF solvent until 2070, requiring much more drastic changes in the pension system.

22. Reforms are also needed to put the occupational pensions on a financially healthy footing. Given that the Government Employee Pension and the Military Personnel Pension are already in deficit, and that the Private School Teachers Pension Scheme is projected to begin registering deficits in about 10 years, parameter changes in these pensions are also urgent. A combination of lower replacement ratios and higher contribution rates for these pensions appear inevitable.

Containing the health and long-term care expenditure

23. The main fiscal challenge in health and long-term care is how to control the growth of public expenditure in these areas. It is difficult to argue that these costs should be shifted to the consumers, because the current system already puts a significant financial burden on them. The National Health Insurance finances only about 40 percent of total health care expenditure in Korea (Kim 2005), while consumers pay 42 percent. The rest is covered mainly by revenues from general tax and earmarked tobacco tax, and private insurance. This burden sharing is set to shift somewhat in the coming years, as the government plans to gradually expand the treatments covered by insurance from 65 percent of total treatments in 2005 to 71 percent by 2008, but the out-of-pocket payments will still remain high.

24. One option is for Korea to continue to maintain a high out-of-pocket payment system and further develop private insurance schemes. This will help reduce the projected rate of increase in government’s total health and long-term care expenditure. An additional advantage is that it would reduce the need for direct government involvement in controlling health and long-term care supply. However, in this case, the roles of private health insurance and medical savings accounts need to be enhanced to make coverage more adequate to Koreans. The potential drawback that needs to be avoided is that developing these schemes could lower consumers’ sensitivity to prices, thereby increasing demand for total health care services (OECD, 2003), and partially reversing the intended benefits to the budget. Therefore, setting up an appropriate regulatory framework for private health insurance schemes to work properly would be important.

25. Another option is to expand the public coverage of the health and long-term care services and implement strict supply-side controls. Such broad coverage would likely lead Korea’s health care system to resemble the systems of a number of high-income countries like France or Germany. These countries control among other things, the number of doctors, hospital beds, high-cost technology, and prices of pharmaceuticals. But such a system would increase the size of the government and require significantly higher contribution rates, or larger subsidies from the central budget.

26. Either one of these strategies would help control public expenditure. There are no “correct” paths; which path to choose will depend on social preferences. And these social preferences will dictate the measures to which the authorities need to give priority.

Expanding the tax base

27. To address the growing fiscal pressures, as well as to better position Korea in the global economic environment, an overall tax reform is needed. The authorities are considering a broad reform plan. They would like to expand the tax base, rather than raise rates, and most of the key elements of the package are still undecided, although some measures have been announced.94 The key elements of the tax reform pertinent to addressing the growing fiscal pressures are reviewed below.

28. The government has recently announced a set of measures to broaden the tax base also by capturing more of the transactions previously gone undetected in the informal sector. Specifically, the government will oblige business owners and professionals to accept credit cards when receiving payments for the goods and services they provide, and issue certified receipts for cash payments. Use of business bank accounts in every business transaction for the high-income self-employed will also become obligatory. Penalties will also increase to 40 percent of original taxes, for evasions and delinquencies, from the current 10–30 percent.

29. At the same time, the government has announced measures to help increase growth prospects and reduce income inequality, but would also reduce tax revenue. In particular, the government is planning to extend tax breaks to companies that invest in research and development, with a view to maintaining Korean businesses’ competitiveness in the global environment. The government will also grant larger tax cuts to households with more children starting next year, while reducing income tax deductions for single-member households and those without children (Korea Times, 2006). These measures are expected to help reverse the low fertility rate in Korea, thereby increasing the potential growth rate. Finally, to support low-income salaried workers, the government plans to phase in an earned income tax credit (EITC). The EITC is designed to provide refundable tax credit that would offset taxes paid by low-income salary workers, and qualified households could get tax refunds, if their tax credits exceed the taxes owed.

30. Apart from the measures already identified, what else could be done to reform the tax system? One potential element could be broadening the base of the personal income tax (PIT). Currently, revenue from personal income tax is low, at 3 percent of GDP, compared with 10 percent of GDP observed on average in other OECD countries. It is also low as a share of total tax revenue, even though the PIT rates are in line with rates observed in many countries. One reason for the low PIT revenue is that relatively few people pay PIT in Korea: in 2003, the bottom half of wage and salary employees in the tax system had virtually no taxable income, and the bottom 80 percent accounted for only 10 percent of the taxable income. Moreover, it is suspected (although there are no official estimates) that many workers do not even file a return. Another problem is that a large number of deductions are allowed, including for insurance premiums, medical expenses, and education expenses. Because these deductions are not subject to an overall ceiling, they benefit disproportionately employees with high income, despite their progressive abatement. These deductions are estimated to have reduced the potential tax base by nearly 43 percent of wage and salary income. Capping the wage deduction and honoring all existing related sunset clauses would help broaden the PIT tax base.

31. Another potential element of tax reform would be a revamping of consumption taxes. Korea already makes heavy use of consumption taxes, which raise over one-third of all tax revenue. These indirect taxes comprise a VAT and wide range of excises. VAT is charged at 10 percent, low compared with other OECD countries (unweighted average for OECD countries is 17¾ percent), and total revenue as a share of GDP was 4½ percent in 2003, compared with the OECD average of 7 percent. This framework could be further strengthened by expanding the base of the VAT. In particular, there is scope for reexamining some of the zero rates and exemptions (e.g., zero rates on machinery, fertilizer, and pesticides for agriculture, and exemptions on finance and insurance services, medical, health, and education services). A number of excise taxes, on the other hand, contribute little to the total revenues, and eliminating them and moving the freed tax administration resources to more productive uses could be beneficial.

32. Broadening the corporate income tax (CIT) base may also need to be considered in the near future. There are already pressures around the world to lower statutory rates of corporation tax. Over the coming years, these pressures are expected to be felt in Korea also, which has a current corporate tax rate of 25 percent (13 percent on taxable income below W100 million). Therefore, reductions in statutory corporate tax rates cannot be ruled out over the medium-term horizon. However, CIT is an important source of revenue in Korea (13½ percent of total taxes; fourth largest among OECD countries). This makes it important to safeguard this core source of revenue by preserving, and ideally expanding, the base of the CIT. This could be achieved by reducing tax incentives, with a view to eliminate them in the medium term.

E. Conclusions

33. The fiscal pressures are intense. The additional financing needed for the pension system and the cost of health and long-term care under current policies could, by themselves, exceed 15 percentage points of GDP. This will require equally intense spending discipline on non-welfare spending. The pension system should be put quickly on a sustainable path, and the health and long-term care costs need to be contained. Even then, taxes will need to be increased. While there is room to increase the tax base, in the long run, it may be necessary to increase some of the rates also. Most important, early action will help alleviate the impact of population aging, but if pressures are allowed to accumulate, the necessary measures to achieve fiscal sustainability will be much more severe, and difficult to implement.

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91

Prepared by Tarhan Feyzioğlu.

92

However, net public social expenditure (after tax) is estimated to be higher in Korea than most of the other OECD countries, because many governments tax more than provide tax advantages for social purposes (OECD 2003 and Adema 2001).

93

However, given the rapid pace of the demographic changes in Korea, even this favorable position is expected to change and the assets of the NPF, under the new parameters, are projected to be exhausted soon after 2070.

94

An FAD TA mission discussed the overall tax reform agenda in Seoul in September 2005.

Republic of Korea: Selected Issues
Author: International Monetary Fund