Abstract
This Selected Issues paper on the Republic of Korea reviews near-term economic prospects and risks. Korea experiences solid growth with low inflation, and vulnerabilities to potential shocks appear low. With Korea aging at an almost unprecedented rate, spending on pensions, health, and long-term care could rise by as much as 11 percent of GDP over the long term, threatening fiscal sustainability. Although risks facing financial institutions appear quite manageable, the authorities have focused on risks to the highly indebted household sector.
I. Achieving Long-Term Fiscal Sustainability in Korea1
A. Introduction
1. Korea will confront a number of fiscal challenges in coming decades, notably accommodating spending pressures brought on by rapid population aging. As Korea undergoes a dramatic transformation from a relatively young population to one of the oldest, spending on the elderly—in the form of pensions, health care and long-term care—is, absent any adjustment, projected to increase by almost 11 percent of GDP over the next 50 years. In addition, the government’s desire to increase social safety net spending to average OECD levels by 2030 and potential cost from reunification with North Korea may also put strains on the budget.
2. This paper simulates the impact of age-related fiscal pressures on Korea’s economy and discusses options for addressing them in a sustainable manner. As the authorities are well aware, the current fiscal stance is not sustainable. The fiscal pressures will not show in the near term as the pension system continues to accumulate assets. However, in the absence of offsetting measures, as age-related spending pressures mount in the long term, both the fiscal deficit and public debt would balloon and the external current account deficit would grow rapidly. Our analysis suggests that the preferred approach to addressing these pressures would likely involve efforts on a number of fronts, including tax base broadening, improved tax administration, pension reform, and expenditure reallocation. Moreover, the earlier these measures are taken, the lower the adjustment costs.
B. Demographic Change and Related Fiscal Pressures
3. In the coming decades, the demographic structure of Korea is expected to undergo significant changes. The fertility rate—having fallen sharply from around 6 in 1960 to just over 1—is among the lowest in the world and life expectancy will increase by about 8 years over the next 45 years (UN, 2004). As a result, the working-age population is projected to decline by about 30 percent, while the elderly population is expected to expand by more than 240 percent. These changes imply an extraordinary large increase in the old-age dependency ratio from about 15 to 65 percent. Although population developments in the G7 countries show similar patterns, the magnitude of the changes is much less pronounced, with this ratio increasing on average from 25 to 45 percent.
4. Given the demographic outlook, it is estimated that—absent any adjustment—public age-related expenditures will increase by as much as 11 percent of GDP over the next half century. Aging is expected to lead to a sharp rise in pensions (including occupational pensions)2 of some 4-5 percentage points of GDP3, and a rise in health and long-term care expenditure of 6-7 percentage points of GDP (OECD, 2006; Yun, 2005). Because of the severity of population aging in Korea, the total projected increase is almost three times that in the average G7 economy.
Age-Related Expenditure Pressures
(In percent of GDP)
Citation: IMF Staff Country Reports 2007, 345; 10.5089/9781451822229.002.A001
Sources: European Commission (2005); OECD (2001); and staff calculations.5. Korea has a number of options to ensure fiscal sustainability in the face of these spending pressures. The government recently passed a limited pension reform and is also considering steps to broaden the tax base and improve tax administration. Further changes to the pension system will also be needed. In addition, reforms could be implemented in the health care sector and non-age-related expenditure growth could be restrained.
C. Applying the Global Fiscal Model to Korea
6. The GFM is a dynamic general equilibrium model designed to examine fiscal policy issues.4 The GFM analyzes the impact of fiscal policy on real activity through both aggregate demand and supply channels. Aggregate demand responses result from the absence of debt-neutrality and consumers’ impatience, and aggregate supply responses arise from the distortionary effects of taxation. The model is calibrated to reflect the macroeconomic features of Korea. Several alternative scenarios are simulated and, while the precise permutations are largely illustrative, a number of interesting results emerge.
7. The model confirms that, without adjustment, the fiscal position will not be sustainable. Under staffs baseline, in the absence of any adjustment, the fiscal deficit increases steadily, reflecting debt-financed expenditure increases and growing interest payments, and the debt-to-GDP ratio enters an unsustainable upward trend (Figure I.1) This fiscal stance leads to other imbalances, as strong private consumption and investment growth, supported by large public spending, leads to a ballooning external current account deficit. The next 15 years look deceivingly stable, as the accumulation of assets in the pension fund allows public debt to remain below 50 percent of GDP while the fiscal deficit (excluding social security funds) remains modest. Moreover, rising fiscal expenditures raise GDP growth, employment, and wages. But, these developments mask the underlying pressures stemming from demographic changes. Since sufficient assets are not accumulated to pay for future expenditure, and structural reforms are not implemented to reduce expenditure pressures, increasing pension and health care expenditures push the fiscal balance into substantial deficit over the long term, with adverse consequences for long-run growth (which would enter a downward trajectory starting around 2060, with similar declines in consumption and investment).
GFM Simulations: Basic Results 1/
Citation: IMF Staff Country Reports 2007, 345; 10.5089/9781451822229.002.A001
Sources: Fund staff estimates and projections.1/ See text for details of the scenarios.8. Another possible representation of the baseline, based on hikes in health care contributions, would lower the projected long-term debt level but still place it on a upward trajectory. Since the subsidy element of health care spending is limited to 20 percent by law, hikes in contributions could help to finance a large part of the anticipated rise in health care costs. Based on the assumption that the required increases in contributions take place, gross public debt remains lower, at around 80 percent of GDP in 2050, than the more than 200 percent under the previous scenario. However, these increases would still require discretionary action and would need to be large, rising from 3 percent of GDP now to 8 percent of GDP by 2050. Moreover, the consequences for the fiscal and current account deficits and growth in the long run, while somewhat less pronounced, would remain severe.
9. The recently passed pension reform bill delays, but does not resolve, the problem. Korea’s National Pension Fund (NPF) is very young, having been introduced in 1988, and its assets will continue to be built up over the medium term, peaking in the mid-2030s.5 However, as the number of pension recipients increases, its assets are projected to diminish rapidly. The recently passed pension reform bill will gradually reduce the pension benefit replacement rate from the current 60 percent of wages to 40 percent by 2028, but does not raise the contribution rate from its current 9 percent (Ministry of Finance, 2007). As a result, the assets of the pension fund will still be depleted, but about 15 years later than the pre-reform date of 2047. While the new replacement rate will be relatively low, Korea has, together with Australia, the lowest contribution rate among OECD countries, and the retirement age in Korea is also well below the OECD average.
Pension Fund Assets
(In percent of GDP)
Citation: IMF Staff Country Reports 2007, 345; 10.5089/9781451822229.002.A001
Sources: Korean authorities and Fund staff estimates.Pension Parameters in Selected OECD Countries
Source: OECD (2005).
Net replacement rates on average earnings in mandatory pension programmes.
Pension Parameters in Selected OECD Countries
| Contribution rate | Retirement age | Replacement rate 1/ | |
|---|---|---|---|
| Australia | 9.0 | 65 | 52.4 |
| Belgium | 16.4 | 65 | 63.1 |
| Finland | 22.9-33.0 | 65 | 78.8 |
| France | 16.4 | 60 | 68.8 |
| Germany | 19.5 | 65 | 71.8 |
| Greece | 20.0 | 65 | 99.9 |
| Italy | 32.7 | 65 | 88.8 |
| Japan | 13.6 | 65 | 59.1 |
| Korea | 9.0 | 60 | 44.3 |
| Mexico | 11.3 | 65 | 45.1 |
| Netherlands | 25.8 | 65 | 84.1 |
| Norway | 21.9 | 67 | 65.1 |
| Spain | 28.3 | 65 | 88.3 |
| Sweden | 18.5 | 65 | 68.2 |
| United Kingdom | 23.8 | 65 | 47.6 |
| United States | 12.4 | 67 | 51.0 |
| Average | 19.8 | 64.5 | 68.7 |
Source: OECD (2005).
Net replacement rates on average earnings in mandatory pension programmes.
Pension Parameters in Selected OECD Countries
| Contribution rate | Retirement age | Replacement rate 1/ | |
|---|---|---|---|
| Australia | 9.0 | 65 | 52.4 |
| Belgium | 16.4 | 65 | 63.1 |
| Finland | 22.9-33.0 | 65 | 78.8 |
| France | 16.4 | 60 | 68.8 |
| Germany | 19.5 | 65 | 71.8 |
| Greece | 20.0 | 65 | 99.9 |
| Italy | 32.7 | 65 | 88.8 |
| Japan | 13.6 | 65 | 59.1 |
| Korea | 9.0 | 60 | 44.3 |
| Mexico | 11.3 | 65 | 45.1 |
| Netherlands | 25.8 | 65 | 84.1 |
| Norway | 21.9 | 67 | 65.1 |
| Spain | 28.3 | 65 | 88.3 |
| Sweden | 18.5 | 65 | 68.2 |
| United Kingdom | 23.8 | 65 | 47.6 |
| United States | 12.4 | 67 | 51.0 |
| Average | 19.8 | 64.5 | 68.7 |
Source: OECD (2005).
Net replacement rates on average earnings in mandatory pension programmes.
10. Extending pension reform, for example by raising contribution rates, could put the pension fund on a sustainable footing. For instance, a rise in contribution rates from 9 to 18 percent over the period 2011–30 would ensure stabilization of pension fund assets at a positive level and a continuation of surpluses on the pension fund balance. Smaller increases would be required to the extent that the payroll tax base could be broadened or the return to equity enhanced.6,7 With this type of pre-funding strategy, a large part of the pension expenditure increases will be financed by the returns on the pension fund assets.8
11. In addition to a sustainable pension reform, more measures would likely be needed to address increased pressures on health and long-term care expenditure. Assuming that the pension reform is implemented in a sustainable way, rising health care costs are still projected to increase the fiscal deficit, especially after 2025. Without measures to raise revenues, reform the health sector or contain other expenditure, the fiscal deficit would likely remain on an unsustainable path.
12. One option is to raise revenue to prevent fiscal deficits from widening (Figure I.1). As discussed below, there appears to be considerable scope to raise tax revenues in Korea, in particular via base broadening. One strategy could be to start raising tax revenues—either through base broadening or by raising tax rates—only when the fiscal surplus (including the social security fund) is eliminated, which will shift costs to the next generation. To model this, the effective personal income tax (PIT) rate is assumed to increase gradually starting in 2025 to maintain fiscal balance.9 This requires the effective PIT rate to rise by a cumulative 9 percentage points in 20 years. Under these assumptions, public debt stabilizes at around 70 percent of GDP, and a positive pension fund asset position is maintained. However, higher taxes lead private consumption and investment to decline over the medium term relative to staff’s baseline.10
13. Long-term costs to the economy could be lowered by raising taxes earlier and/or faster. Early action is preferable, given the unprecedented speed at which Korea is aging and the additional long-term pressures on its public finances, notably from increased social safety net spending and potential reunification.11 As an illustration, if tax increases are brought forward and accelerated even slightly, so that the effective tax rate is allowed to increase continuously from 2021 until 2035, the effective PIT rate hike could be limited to 7½ percentage points. Relative to the previous scenario, the government maintains a comfortable overall surplus, and the current account remains in surplus due to interest returns on foreign assets. With the long-run effective tax rate lower when early action is taken, long-run GDP growth is also higher as both consumption and investment are raised.
14. The type of tax increase also matters (Figure I.2, Panel A). For instance, an effective VAT increase instead of a PIT increase would reduce distortions, and therefore lower the adverse impact of higher taxes on private consumption.12 For instance, with a gradual rise in the effective VAT rate of 9 percentage points from 2010 until 2025, the decline in private consumption is less than one-fifth, and GDP growth almost doubled, relative to the case of an increase in the effective PIT rate. However, the choice between the PIT and VAT hike is likely to depend on equity as well as efficiency considerations.
GFM Simulations: Further Results
Citation: IMF Staff Country Reports 2007, 345; 10.5089/9781451822229.002.A001
Sources: Fund staff estimates and projections.15. An alternative is to restrain expenditure growth (Figure I.2, Panel B). This could take the form of cost efficiency gains from health care reform or measures to restrain non-age-related expenditure growth. We consider a scenario where, in addition to the sustainable pension reform, total expenditure growth is reduced by 4 percentage points of GDP over the period 2011–25, offsetting about half of the baseline increase in health and long-term care expenditure under staff’s baseline. The results again show that early action makes a significant difference. Cost saving measures implemented in the next 15 years could put the fiscal stance on a sustainable path without an increase in taxes, because the return on assets accumulated early on would help pay later for the increased health care costs. The macroeconomic implications are also positive: domestic consumption and investment recover and the current account remains in surplus. However, relying solely on expenditure cuts is probably not feasible, as public spending in Korea is relatively low and additional long-term spending pressures, for higher social safety net spending and potential reunification with North Korea, are looming.
16. Finally, the government may prefer to implement a combination of more modest policies in each of the areas mentioned above (Figure I.2, Panel C). This could be particularly attractive if making large reforms in any one area would be difficult politically. A combination of higher taxes and expenditure restraint is considered, consisting of a pension contribution rate hike together with some payroll base broadening; limited hikes in the effective VAT and PIT rates; and a slowing of non-age-related expenditure growth.13 Combining these policies does not change the main conclusions: as long as the fiscal stance is put on a sustainable path at an early stage, consumption and investment recover, GDP picks up, and the current account registers a moderate surplus relative to the baseline.
D. Policy Options for Achieving the Required Fiscal Adjustment
17. While the GFM provides insights into the scope of the fiscal challenges that Korea faces and suggests broad solutions, this section discusses more concrete policy responses. Unlike most other aging economies, Korea benefits from relatively high rates of economic growth, considerable scope for increasing tax revenue, and a low level of public debt. This provides more degrees of freedom in dealing with age-related fiscal pressures, and some specific recommendations are discussed below, in addition to pension reform.
General Government Tax Revenue, 2000-03
(In percent of GDP)
Citation: IMF Staff Country Reports 2007, 345; 10.5089/9781451822229.002.A001
Source: OECD, Revenue Statistics Database.18. First, there is considerable scope to boost tax revenue collections to accommodate Korea’s future spending needs. At around 25 percent, the revenue-to-GDP ratio is low relative to most OECD countries. For all major taxes in Korea, there is considerable scope for increasing the resource envelope through base broadening, even without increases in tax rates. Key options include:
Personal income tax (PIT). While personal income tax rates are broadly in line with those in most countries, PIT yields are very low. In Korea, PIT revenue accounts for roughly 3 percent of GDP and 14 percent of total tax revenue, compared to an OECD average of 10 and 26 percent, respectively. A key reason for this divergence is that relatively few people in Korea pay PIT: in 2003, the bottom 80 percent of wage and salary employees in the tax system accounted for only 10 percent of taxable income, while the bottom half had virtually no taxable income. This partly reflects the large number of allowable deductions—including for insurance premiums, medical expenses, and education expenses—which are not subject to an overall ceiling and are estimated to have reduced the potential tax base by nearly 43 percent of wage and salary income. Capping these wage deductions would broaden the PIT tax base. Moreover, it is suspected that many employees, particularly self-employed and non-regular workers, do not file returns or understate incomes.14 In this context, improving tax administration by intensifying the auditing of the self-employed and strengthening penalties for misreporting income could also help.
Corporate income tax (CIT). Corporate income tax is a core source of revenue in Korea, accounting for 3 percent of GDP or 14 percent of total taxes, the latter the fourth largest among OECD countries. However, over coming years, global pressures to lower statutory rates of corporation tax are likely to also be felt in Korea. This makes it important to safeguard this source of revenue by limiting tax incentives. In this context, honoring sunset provisions that exist for the elimination of various CIT incentives and introducing similar clauses for other special schemes would help. In addition, publishing on a regular basis ex post estimates and projections of tax expenditures would enhance fiscal transparency and contribute to the public debate on the use of tax exemptions.
Effective Tax Rates
Citation: IMF Staff Country Reports 2007, 345; 10.5089/9781451822229.002.A001
Source: IMF, World Economic Outlook.VAT and excises. Korea makes relatively heavy use of consumption taxes, which raise over one-third of all tax revenue. However, the VAT rate of 10 percent compares to an OECD average of around 18 percent, and the VAT yield is around 4½ percent of GDP, compared with the OECD average of 7 percent. While the Korean VAT is well designed, base broadening in line with international best practice could be a potentially significant source of additional revenue. In the longer run, when gains from base broadening are exhausted, consideration could also be given to raising the VAT rate.
Standard VAT Rate
Citation: IMF Staff Country Reports 2007, 345; 10.5089/9781451822229.002.A001
sources: OECD; and IMF, World Economic Outlook.The authorities’ own preliminary plans, as described in their draft Directions for Tax Reform, are broadly in line with these recommendations.
19. Second, although the scope for expenditure-based responses appears more limited, greater efficiency and discipline with respect to non-age-related spending would also help. About 40 percent of total central government expenditure is non age-related in the median OECD country, compared to nearly 75 percent in Korea. In particular, Korea allocates a relatively large share of GDP to public investment and economic affairs.15 However, the scope for expenditure re-allocation remains limited—in particular as public spending is already relatively low in Korea and spending increases for the social safety net, and possibly for reunification with the North may eventually be required.
Government Debt, 2005
(In percent of GDP)
Citation: IMF Staff Country Reports 2007, 345; 10.5089/9781451822229.002.A001
Sources: CEIC Data Company, Ltd; and IMF, World Economic Outlook.20. There may also be some room for a limited rise in the debt-to-GDP ratio over the longer run. At around 33 percent of GDP, Korea’s public debt ratio is relatively low by OECD standards.16 The government is justifiably keen to keep debt at around its current level ahead of the onset of the full effects of aging and given other long-term expenditure pressures, such as those related to potential reunification. However, as spending pressures build, some rise in the debt-to-GDP ratio may become inevitable. While debt sustainability depends on a number of factors and needs to be carefully evaluated, international experience suggests that on average, countries with a low ratio of debt relative to GDP and revenues, a low proportion of external debt, and better-developed financial systems tend to be less susceptible to debt crises. On all these metrics, Korea currently performs well so that a modest rise in the debt level over the long term could likely be accommodated without a significant increase in vulnerabilities. At the same time, ongoing efforts to improve debt management, notably the implementation a five-year debt management plan, should continue.
Key Indicators of Public Debt, Last 10 Years
(In percent)
Citation: IMF Staff Country Reports 2007, 345; 10.5089/9781451822229.002.A001
Source: IMF, World Economic Outlook.21. Finally, publishing a regular long-term fiscal report, as in several other OECD countries, could help address long-term challenges in a comprehensive manner. A number of economies confronting population aging pressures, including Australia, New Zealand and the United Kingdom, routinely publish reports assessing risks to long-term fiscal sustainability, covering horizons of 30 to 50 years. Similarly, the European Commission publishes a comprehensive aging report for all EU member states, assessing fiscal sustainability, on an annual basis. Such reports can help to stimulate public debate and create an awareness of looming pressures that weigh on the conduct of fiscal policy, making it easier to build consensus on needed reforms.
E. Conclusion
22. A number of important policy implications emerge. First, the debt path without fiscal adjustment is unsustainable. Second, while Korea benefits from favorable initial conditions compared to other economies facing age-related fiscal pressures, the unprecedented speed of its demographic transition and the confluence of long-term fiscal pressures that it faces leave a relatively narrow window of opportunity. Third, addressing Korea’s long-term fiscal challenges will necessitate reform in a number of areas: in addition to pension reform, there is considerable scope for fiscal consolidation by increasing tax revenue, and some room for raising spending efficiency and reducing non-age-related spending as well as perhaps for some limited debt build-up, in tandem with further improvements in debt management. Building consensus for these reforms will not be easy, but the publication of a regular long-term fiscal report would help to communicate the underlying fiscal pressures to the public.
Appendix: The Global Fiscal Model
1. The GFM is a four-country dynamic general equilibrium model based on the New Open Economy Macroeconomics (NOEM) tradition.1 The GFM extends the NOEM framework by introducing non-Ricardian features via three distinct channels to allow for thorough fiscal policy analysis:
Households have finite horizons. As a result, even temporary changes in fiscal policy affect consumption patterns since any offsetting action required by the government’s intertemporal budget constraint is (perceived to be) borne by future generations and there is no bequest motive.
A fraction of households are liquidity-constrained and consume all their disposable income every period and thereby immediately respond to fiscal policy initiatives that change their disposable income.
Labor and capital taxes affect incentives to consume and invest and thus are distortionary.
2. The model has a number of other features consistent with general equilibrium models. Consumption and production are characterized by constant elasticity of substitution functions, and firms and workers have some market power so that prices and wages are above their perfectly competitive levels. Both traded and non-traded goods are modeled to allow for a bias toward domestic goods in private or government consumption. Capital and labor are the two factors of production and are used to produce traded and non-traded goods. Capital and labor can move freely between sectors, but are not mobile internationally. Investment is driven by Tobin’s Q with adjustment costs. Firms respond sluggishly to differences between the discounted value of future profits and the market value of the capital stock. There are two kinds of financial assets, government debt (traded internationally) and equity (held domestically). International trade in government debt implies the equalization of nominal interest rates across countries over time. However, real interest rates across countries could differ because of the presence of non-traded goods and home bias in consumption.
3. The GFM provides a good platform for discussing the relative merits of alternative fiscal consolidation measures and has been applied to several countries. The non-Ricardian structure of the model implies empirically plausible responses of key macroeconomic variables to changes in fiscal policy. The wide-ranging menu of taxes allows a detailed analysis of the composition of adjustment while the strong micro foundations allow consideration of the fundamental determinants of the effects of fiscal policy, such as the response of consumers and producers to changes in fiscal policy as well as the sensitivity to the structure of the economy.
4. The model is calibrated to reflect the macroeconomic features of Korea (Table I.1). In particular, the ratios of consumption, investment, government spending, wage income, and income from capital relative to GDP are set to their current values. Similarly, key fiscal variables—revenue to GDP ratios from taxation of corporate, labor, and personal income and consumption tax, as well as government debt and current government spending—have been calibrated to Korea’s fiscal structure. Also, the calibration reflects the trading patterns between Korea, the Euro Area, United States, and the rest of the world.
Korea: Key Macroeconomic Variables in the Initial Steady State
Source: IMF staff estimates.
Korea: Key Macroeconomic Variables in the Initial Steady State
| National expenditure accounts at market prices | ||||||
| Expenditure ratios | Factor Incomes | |||||
| Consumption | 55.6 | Capital | 44.1 | |||
| Government consumption | 14.8 | Labor | 55.9 | |||
| Investment | 26.7 | Government | ||||
| Exports | 41 | Net debt | 18.4 | |||
| Gross debt | 36.4 | |||||
| Tax rates and revenue | ||||||
| Payroll taxes (worker and employer) | On personal income | |||||
| Effective | 5.5 | Effective | 3.7 | |||
| As percent of GDP | 4.6 | As percent of GDP | 3.3 | |||
| On corporate income | On consumption | |||||
| Effective | 15.5 | Effective | 8.3 | |||
| As percent of GDP | 3.4 | As percent of GDP | 4.7 | |||
| Trade flow matrix | ||||||
| Korea | Euro area | United States | Rest of the world | |||
| GDP (percent share of world nominal output) | 3.0 | 27.0 | 30.0 | 40.0 | ||
| Total exports | 41.0 | 25.0 | 15.0 | 20.0 | ||
| To Korea | … | 1.0 | 0.6 | 1.0 | ||
| To Euro area | 11.4 | … | 9.0 | 2.7 | ||
| To United States | 12.2 | 10.3 | … | 0.3 | ||
| To rest of the world | 17.4 | 13.7 | 10.0 | … | ||
Source: IMF staff estimates.
Korea: Key Macroeconomic Variables in the Initial Steady State
| National expenditure accounts at market prices | ||||||
| Expenditure ratios | Factor Incomes | |||||
| Consumption | 55.6 | Capital | 44.1 | |||
| Government consumption | 14.8 | Labor | 55.9 | |||
| Investment | 26.7 | Government | ||||
| Exports | 41 | Net debt | 18.4 | |||
| Gross debt | 36.4 | |||||
| Tax rates and revenue | ||||||
| Payroll taxes (worker and employer) | On personal income | |||||
| Effective | 5.5 | Effective | 3.7 | |||
| As percent of GDP | 4.6 | As percent of GDP | 3.3 | |||
| On corporate income | On consumption | |||||
| Effective | 15.5 | Effective | 8.3 | |||
| As percent of GDP | 3.4 | As percent of GDP | 4.7 | |||
| Trade flow matrix | ||||||
| Korea | Euro area | United States | Rest of the world | |||
| GDP (percent share of world nominal output) | 3.0 | 27.0 | 30.0 | 40.0 | ||
| Total exports | 41.0 | 25.0 | 15.0 | 20.0 | ||
| To Korea | … | 1.0 | 0.6 | 1.0 | ||
| To Euro area | 11.4 | … | 9.0 | 2.7 | ||
| To United States | 12.2 | 10.3 | … | 0.3 | ||
| To rest of the world | 17.4 | 13.7 | 10.0 | … | ||
Source: IMF staff estimates.
5. The preliminary calibration of behavioral parameters is based on microeconomic evidence found in the literature (Table I.2).2 These include parameters characterizing real rigidities in investment, markups for firms and workers, the elasticity of labor supply to after-tax wages, the elasticity of substitution between labor and capital, the elasticity of intertemporal substitution, and the rate of time preference. In particular, the following calibration method was used:
The baseline value of the sensitivity of labor supply to the real after-tax wage is equal to -0.05, which is at the low-end of those found by microeconomic studies.
The elasticity of substitution between labor and capital in the production function equals -0.75.
The baseline value for the elasticity of intertemporal substitution is 0.33. This parameter describes the sensitivity of consumption to changes in the real interest rate.
The wedge between the rate of time preference and the yield on government bonds determines consumers’ degree of impatience and has not been subject to extensive microeconomic analysis. We have set the baseline value of the wedge to 4 percent (corresponding to a planning horizon of 25 years).
The baseline assumes that 40 percent of consumers are liquidity constrained (i.e., excluded from participating in financial markets). As these consumers have no wealth, these households consume a quarter of aggregate consumption.
The baseline assumes that the markup over marginal cost in the tradables sector equals 11 percent and in the nontradables sector equals 14 percent.
The baseline expenditure projections are based on the assumption that all non-age-related expenditure remains constant in percent of GDP. In addition, pension expenditure increases according to Moon (2003), and health care and long-term care expenditure gradually increases (linearly, and broadly in line with the change in old-age dependency ratio) from the current level to the level predicted by OECD (2005) by 2060.
Korea: Behavioral Assumptions and Key Parameters in the Initial Steady State
Korea: Behavioral Assumptions and Key Parameters in the Initial Steady State
| Planning horizon of consumers | 25 years | ||
| Labor disutility parameters | 0.95 | ||
| Fraction of rule-of-thumb consumers | 0.40 | ||
| Intertemporal elasticity of substitution | 0.33 | ||
| Elasticity of substitution between capital and labor | 0.75 | ||
| Depreciation rate on capital | |||
| Capital adjustment cost parameters | 0.50 | ||
| Elasticity of substitution between varieties | |||
| Tradables sector | 10.00 | ||
| Price markup over marginal cost | 1.11 | ||
| Nontradables sector | 8.00 | ||
| Price markup over marginal cost | 1.14 | ||
| Capital share in production tradables sector | 0.58 | ||
| Capital share in production nontradables sector | 0.58 | ||
| Utility from real money balances | 0.02 | ||
| Price stickiness parameters | 0.00 | ||
| Home bias in government consumption | Yes | ||
| Home bias in private consumption | No | ||
| Elasticity of substitution between traded and nontraded goods | 0.50 | ||
| Bias towards domestically produced tradable over nontradables | 0.40 | ||
Korea: Behavioral Assumptions and Key Parameters in the Initial Steady State
| Planning horizon of consumers | 25 years | ||
| Labor disutility parameters | 0.95 | ||
| Fraction of rule-of-thumb consumers | 0.40 | ||
| Intertemporal elasticity of substitution | 0.33 | ||
| Elasticity of substitution between capital and labor | 0.75 | ||
| Depreciation rate on capital | |||
| Capital adjustment cost parameters | 0.50 | ||
| Elasticity of substitution between varieties | |||
| Tradables sector | 10.00 | ||
| Price markup over marginal cost | 1.11 | ||
| Nontradables sector | 8.00 | ||
| Price markup over marginal cost | 1.14 | ||
| Capital share in production tradables sector | 0.58 | ||
| Capital share in production nontradables sector | 0.58 | ||
| Utility from real money balances | 0.02 | ||
| Price stickiness parameters | 0.00 | ||
| Home bias in government consumption | Yes | ||
| Home bias in private consumption | No | ||
| Elasticity of substitution between traded and nontraded goods | 0.50 | ||
| Bias towards domestically produced tradable over nontradables | 0.40 | ||
References
Batini, N., B. Jackson, and S. Nickell, 2005, “An Open Economy New Keynesian Phillips Curve for the UK,” Journal of Monetary Economics, Vol. 52 (6), September, pp. 1061–71.
Baylor, M., 2005, “Ranking Tax Distortions in Dynamic General Equilibrium Models: A Survey,” Working Paper 2005–06 (Ottawa: Canada Department of Finance).
Baylor, M., and L. Beauséjour, 2004, “Taxation and Economic Efficiency: Results from a Canadian CGE Model,” Working Paper 2004–10 (Ottawa: Canada Department of Finance).
Botman, D., D. Laxton, D. Muir, and A. Romanov, 2006, “A New-Open-Economy-Macro Model for Fiscal Policy Evaluation,” IMF Working Paper 06/45 (Washington: International Monetary Fund).
Canada, Department of Finance, 2004, “Tax Expenditures and Evaluations” (Ottawa). Available on the Internet at http://www.fin.gc.ca/taxexp/2004/TaxExp04_e.pdf.
Feyzioğlu, T., 2006, “Long-Term Fiscal Challenges,” in Republic of Korea: Selected Issues, IMF Country Report No. 06/381 (Washington: International Monetary Fund).
Gruenwald, P. F., 2003, “Options for Pension System Sustainability in Korea,” in Republic of Korea: Selected Issues, IMF Country Report No. 03/80 (Washington: International Monetary Fund).
Laxton, D., and P. Pesenti, 2003, “Monetary Rules for Small, Open, Emerging Economies,” Journal of Monetary Economics Vol. 50 (5), July, pp. 1109–46.
Moon, Hyungpyo, 2003, “The Korean Pension System: Current State and Tasks Ahead,” mimeo, Korea Development Institute (Seoul).
OECD, 2006, “Projecting OECD Health and Long-term Care Expenditure: What are the Main Drivers?” Economics Department Working Papers No. 477, ECO/WKP(2006)5 (Paris).
United Nations, 2004, “World Population Prospects: The 2004 Revision” (New York).
Yun, Hee Suk, 2005, Population Aging and Healthcare, eds., Korea Development Institute (Seoul).
Prepared by Tarhan Feyzioğlu, Michael Skaarup, and Murtaza Syed.
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.
Based on Feyzioğlu (2006), Gruenwald (2003) and Moon (2003), adjusted to include the effects of the recent pension reform bill, which is discussed later.
See the Appendix for a more detailed description of the model.
Payment of regular old-age pensions will only begin in 2008, once the initial participants meet the minimum 20 years of contributions.
For example, our analysis suggests that if the payroll tax base is broadened by 30 percent during 2008–20, the increase in the contribution rate needed to ensure pension sustainability could be limited to 4 percentage points (from 9 to 13 percent, phased in during 2010–25). Presently, although coverage is notionally universal, only 60 percent of the labor force contributes to the national pension system (compared to around 85 for the OECD as a whole), largely reflecting the large number of self-employed and non-regular workers.
While we only consider parametric reforms to the pension system, other options exist, such as increasing labor force participation of older workers and women, moving towards a defined contribution system, or improving the investment strategy of the system’s assets.
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.
This deterioration is not reflected in the GDP figures because increasing government expenditure raises GDP.
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.
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 description of the model and a demonstration that the conclusion is robust under alternative values for important model parameters.
More specifically, the scenario assumes a payroll base broadening of 30 percent 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 4 percentage points during 2011–20 and an effective PIT rate increase of 2 percentage points during 2016–25; and a cut in total expenditure growth of 1.5 percentage points of GDP during 2011–20.
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 as day laborers, unpaid family workers or short-term irregular employees, enforcing compliance is extremely difficult.
According to the OECD, public investment accounts for around 8 percent of GDP for the general government compared to 3 percent of GDP in the average OECD economy. Spending for economic affairs accounts for around 6 percent of GDP compared to the OECD average of about 4 percent of GDP.
In emerging market economies, the average public debt ratio is currently around 70 percent of GDP.
Other structural parameters have been calibrated using evidence from Laxton and Pesenti (2003) and Batini and others (2005).
