This Selected Issues paper evaluates the size of fiscal multipliers in Korea using the IMF’s Global Integrated Monetary and Fiscal model calibrated for Korea. The sensitivity of the results to a number of key factors is explored. Based on this, the impact of the recent fiscal stimulus packages is estimated and the appropriateness of the current mix of measures is assessed. In this context, the paper also draws on international operational experience with fiscal stimulus measures.

Abstract

This Selected Issues paper evaluates the size of fiscal multipliers in Korea using the IMF’s Global Integrated Monetary and Fiscal model calibrated for Korea. The sensitivity of the results to a number of key factors is explored. Based on this, the impact of the recent fiscal stimulus packages is estimated and the appropriateness of the current mix of measures is assessed. In this context, the paper also draws on international operational experience with fiscal stimulus measures.

I. Counter-Cyclical Fiscal Policy—Does It Work In Korea’s Open Economy?1

A. Introduction

1. The spillovers from the ongoing global financial turmoil and economic downturn have triggered fiscal policy responses in a number of countries. This has reignited the long-standing debate among economists about the ability of fiscal policy to help stabilize economic cycles.

2. Supporters of an active role for fiscal policy suggest that economies lack an efficient mechanism to return to full potential. Critics, on the other hand, argue that economic agents will offset the impact of fiscal policy on aggregate demand through changes in their saving behavior (so-called Ricardian equivalence). A middle-of-the-road view holds that fiscal policy can be effective provided certain conditions hold, including sound macroeconomic fundamentals, nominal wage and price stickiness, and/or economic agents with finite horizons and liquidity constraints.

3. The paper will evaluate the size of fiscal multipliers in Korea using the IMF’s Global Integrated Monetary and Fiscal (GIMF) model calibrated for Korea.2 The sensitivity of the results to a number of key factors is also explored. Based on this, the impact of the recent fiscal stimulus packages is estimated and the appropriateness of the current mix of measures is assessed. In this context, the paper also draws on international operational experience with fiscal stimulus measures.

4. The paper is organized as follows: Section B discusses cross-country studies on the effectiveness of counter-cyclical fiscal policy; Section C will briefly introduce the macroeconomic model used and present simulation results for Korea; Section D discusses the role for counter-cyclical fiscal policy in the current downturn; and Section E concludes.

B. Cross-Country Evidence on the Counter-Cyclical Role of Fiscal Policy

5. The question of the effectiveness of fiscal policy is ultimately empirical. There is a vast literature on this topic. Studies generally support the role for counter-cyclical measures, but evidence on the size of fiscal multipliers varies with the analytical approach:

  • Event-studies give mixed results. The 2001 income tax rebates in the United States are generally considered to have been effective in boosting domestic demand, although the impact on output was relatively small with multipliers well below 1 (Shapiro and others, 2002, 2003). The 1995 stimulus package in Japan is estimated to have been successful, but it did not have a lasting impact on economic activity (Posen, 1998 and Mühleisen, 2000). Finland’s response to the 1991 output shock, by letting automatic stabilizers operate fully, is considered to have been largely ineffective because it raised concerns about fiscal sustainability (Corsetti and Roubini, 1996). The IMF World Economic Outlook (October 2008) provides evidence that the size of public debt and composition of fiscal stimulus could be important determinants of the effect of fiscal policy.

  • Studies on advanced economies using vector autoregression (VAR) methods conclude that fiscal multipliers have declined over time and, in some cases, may even have been negative (see Perotti, 2005 for an overview). These results (Figure I.1), which differ widely across countries, likely reflect (i) increasing leakage through the trade channel due to higher openness of economies; (ii) a decline in the share of liquidity-constrained households due to better access to credit; and (iii) a sharper focus of monetary policy on price stability. Studies for Korea show that multipliers are small and short-lived (see Hur, 2005 for a review of Korean studies and Zebregs, 2003).

  • Estimates from macro models, on the other hand, show that fiscal policy can be quite effective (Figure I.1). Impact multipliers are in the range of 0.3–1.2 percent and expenditure measures appear to have a larger effect than tax measures (Hemming and others, 2002, Botman, 2006). IMF World Economic Outlook (October 2008) finds that government investment has the largest impact on economic activity and inflation. However, the size of the estimated multipliers depends on assumptions about, among others, the monetary regime, labor supply elasticities, and the pervasiveness of liquidity constraints.

Figure I.1.
Figure I.1.

Fiscal Multipliers from Structural VAR and Macroeconometric Models—Cross-Country Evidence 1/

Citation: IMF Staff Country Reports 2009, 263; 10.5089/9781451822267.002.A001

Source: Perotti (2005).1/ VAR stands for vector autoregression.

Generally, the cross-country evidence suggests that the success of fiscal policy is contingent on a number of factors. First, the fiscal response needs to be well timed. This will, in particular, reinforce the effectiveness of fiscal policy in countries with short implementation lags and/or large automatic stabilizers. Second, strong fundamentals, including macroeconomic stability and fiscal sustainability, will strengthen multiplier effects by lowering any possible offsets from precautionary savings. Finally, fiscal measures need to be well targeted to ensure the largest possible demand impact.

C. The Counter-Cyclical Role of Fiscal Policy in Korea

6. This section will assess the effectiveness of counter-cyclical fiscal policy in Korea based on simulations using a multi-country macroeconomic model. Specifically, fiscal multipliers for different revenue and expenditure measures are estimated and their sensitivity to underlying assumptions is explored. Moreover, the complementary role of monetary policy and benefits of coordinated global fiscal stimulus are also analyzed.

7. Using a macroeconomic model has the advantage that the results are underpinned by economic theory, although the results are still sensitive to the imposed restrictions and assumptions. For the purpose of this paper, the IMF’s Global Integrated Monetary and Fiscal (GIMF) model is used.

8. GIMF is an open economy general equilibrium model based on household and firm optimizing behavior in a multi-country setting. It was developed at the IMF and is documented in Kumhof and Laxton (2007). It integrates domestic supply, demand, trade, and international asset markets in a single theoretical framework. This allows for a rich set of transmission mechanisms. Households are assumed to have finite planning horizons and some are liquidity constrained. Together with other assumptions, this allows for non-Richardian effects of fiscal policy. Firms are managed in accordance with the preferences of their owners, the myopic overlapping generation households. Therefore, they also have finite planning horizons. A fiscal policy reaction function is applied and the government is assumed to target a balanced structural budget. Monetary policy is in the new-Keynesian tradition, with a number of nominal and real rigidities that allow for real effects on the economy in the short to medium run. Moreover, monetary policy is guided by a stylized Taylor-type interest rate reaction function.

9. The model is calibrated for two countries, Korea and the rest of the world, and is on an annual basis. The model is calibrated to reflect different features of the Korean economy and policy preferences, including (i) demand and supply side characteristics; (ii) trade structure; (iii) external position and composition of fiscal revenues and expenditures; (iv) fiscal and monetary reaction functions; and, finally, (v) structural parameters for household preferences and firm technology. Much of the input used for the model calibration draws on N’Diaye, Zhang, and Zhang (2008), Kumhof and Laxton (2007), and author estimates and assumptions.

Results from Fiscal Stimulus Simulations

10. A number of stimulus measures and sensitivity analyses are simulated to derive fiscal multipliers. These simulations are stylized representations of reality and do not consider some of the practical constraints that policy makers may face, including the lag structure of infrastructure investment projects and political bargaining about measures. Nevertheless, they do give a good sense of the potential growth impact of different fiscal measures, allowing for an assessment of relative effectiveness and overall impact of announced fiscal packages. Moreover, sensitivity analysis can shed light on some of the uncertainties and trade-offs that policymakers will need to consider when designing fiscal stimulus packages.

11. The simulations focus on both revenue and expenditure measures. On the revenue side, multipliers for temporary and permanent corporate income, personal income, and indirect taxes are derived. On the expenditure side, the growth impact of hikes in public investment, consumption, and transfers is considered. In each case, the fiscal stimulus is assumed at 1 percent of GDP for one year, except for the permanent cuts in corporate and personal income tax rates. To allow for an assessment of the pure discretionary impact on growth, lump-sum transfers are used to offset the impact of automatic stabilizers. In addition, in the period following the fiscal stimulus, lump-sum transfers adjust gradually to return government debt back to its steady-state value over time. The results are presented below and in Figure I.2:

  • Investment and consumption. A 1 percent of GDP temporary increase in government investment and consumption is estimated to increase growth in Korea by around 0.8 percentage points in the first year compared to the baseline without any fiscal stimulus. Over time, the impact on growth from the increase in investment will have the largest impact due to the positive spillovers on household spending as income increases (due to higher investment) and as wealth increases due to the higher productivity of the economy.

  • Income transfers. General income transfers are found to have a low immediate impact on Korea’s GDP the first year (0.1 percent) owing both to the leakage through higher imports and the poor targeting (i.e., the transfers are also given to well-off households with a low propensity to consume out of these transfers). If instead the 1 percent of GDP payout is targeted only at liquidity-constrained households, the impact triples despite the leakage, clearly demonstrating the importance of focusing transfers on low-income households.

  • Taxes. A temporary cut in either the personal income tax (PIT) or corporate income tax (CIT) would have a very small impact on growth in the crisis year (0.1–0.15 percent). Like general income transfers, this is due to the poor targeting and the large import content of any associated increase in private consumption or investment. A temporary cut in the value-added tax, on the other hand, gives rise to a much stronger impact on growth in the first year (0.33 percent) as consumers are given the incentive to bring forward consumption while the tax cut lasts. Implementing a permanent cut in the PIT or CIT results in higher multipliers than temporary cuts. This is because it gives rise to a permanent shift in income and, therefore, a stronger consumption and investment response. In the first year, a cut in the PIT has the largest impact (0.27), more than twice the impact from a CIT cut and almost matching the effect of a temporary VAT cut. This is because a cut in the PIT has an immediate positive impact through higher consumption by liquidity-constrained households. However, the CIT impact is more persistent and rising as it spurs investment. Among the fiscal measures available, government consumption and investment are clearly found to be most effective as short-term, counter-cyclical tools. However, targeted transfers and a temporary cut in the VAT are also relatively effective in spurring growth immediately.

Figure I.2.
Figure I.2.

Korea: Cumulative Fiscal Multipliers in the Base Case

(Impact on real GDP from 1 percent of GDP stimulus in year 1 unless otherwise specified)

Citation: IMF Staff Country Reports 2009, 263; 10.5089/9781451822267.002.A001

Source: IMF staff estimates.

12. The multipliers for Korea are generally smaller compared to the rest of the world. This, to a large extent, reflects the more open nature of the Korean economy and, consequently, leakages through the trade channel. However, in the event of a simultaneous stimulus in the rest of the world, the multipliers for Korea increase significantly as the fiscal stimulus abroad translates into increased Korean exports of consumption and investment goods (Figure I.2). In turn, this demonstrates the importance of coordinating counter-cyclical policy in an increasingly interconnected global economy.

13. Sensitivity analysis demonstrates the importance of complementary macroeconomic policies, household income structures, and fiscal credibility considerations (Figure I.3).

  • Complementary monetary policy. In the base case presented above, the central bank is assumed to respond to the increase in activity and inflation from the stimulus measures by raising interest rates, partly countering the initial stimulus. Assuming instead that monetary policy is accommodative during the crisis year and interest rates are left unchanged, the growth impact from the fiscal measures increases notably in the short term. This difference is, however, eliminated in the following years due to the higher level of inflation, leaving policymakers with a trade-off.

  • Degree of liquidity constraints. The share of liquidity-constrained households assumed in the base case may be too low in the event of a more severe economic downturn. As unemployment rises and banks tighten credit standards during the downturn, more households could find themselves liquidity constrained. Therefore, if the share of liquidity-constrained households in Korea instead was assumed to be 50 percent, the multipliers for all fiscal measures would be larger. In particular, the impact from income transfers or personal income tax cuts would be higher as a relatively larger share of the beneficiaries would spend the entire increase in their disposable incomes.

  • Rising risk premium. A significant fiscal stimulus could spark concerns about fiscal credibility and broader macroeconomic concerns, which could be reflected in the assignment of a higher risk premium on a country. If it assumed that the foreign exchange risk premium rises by 1 percentage point and the credit spread on private sector debt increases by 0.5 percentage points, it will reduce the impact of the temporary fiscal stimulus for Korea quite significantly, in the short and especially the medium term. Indeed, in the medium term the residual positive impact on GDP from a temporary government investment shock is more than countered by the adverse impact of the higher risk premiums, primarily through weaker investment. In turn, this underscores the importance of signaling continued commitment to fiscal prudence, as the Korean authorities have demonstrated in the past, especially during times of fiscal loosening.

Figure I.3.
Figure I.3.

Korea: Cumulative Fiscal Multiplier Sensitivity Analysis

(Impact on real GDP from 1 percent of GDP stimulus in year 1, unless otherwise specified)

Citation: IMF Staff Country Reports 2009, 263; 10.5089/9781451822267.002.A001

Source: Staff estimates.

D. Korea’s Counter-Cyclical Response to the Current Crisis

14. Korea has taken decisive steps to counter the fallout on the economy from the global economic slump. The government introduced two fiscal packages in 2009, with the original budget and the supplementary budget, totaling 3.6 percent of GDP:

  • Around a quarter of the package consists of revenue measures, primarily permanent cuts in the PIT and CIT rates. The PIT tax brackets will be cut by a cumulative 2 percentage points in 2009 and 2010 from 8–35 percent to 6–33 percent. The tax rate for the lowest tax bracket will be reduced by the full 2 percentage points in 2009. Moreover, per-person deductions were increased. Further to this, the lowest CIT rates will be reduced by 3 percentage points (13 percent to 10 percent) and the highest rates by 5 percentage points (25 percent to 20 percent) by 2010. Moreover, CIT tax brackets were doubled.

Fiscal Stimulus Packages

(In percent of GDP)

article image
Sources: Authorities and staff estimates.
  • The remainder of the stimulus measures (75 percent) comprises higher expenditure measures, consisting primarily of income support for low-income households, active-labor market policies, support for SMEs, and investment spending.

Reflecting this, the overall fiscal balance is expected to switch to a deficit of around 3 percent of GDP in 2009 and the discretionary fiscal impulse (measured as the change in the structural fiscal balance) is estimated at 2¾ percent of GDP, which is high by G-20 and Asian standards. The change in the structural balance is smaller than the size of the announced fiscal stimulus packages. This partly reflects the fact that the automatic transfers from central to local governments tied to tax collections were expected to decline in 2009 due to the slowdown and, therefore, were replaced by increased lending to local governments. The increased lending can be considered as discretionary spending and was, consequently, part of the announced fiscal stimulus packages. However, it does not effectively represent additional spending compared to the spending envelope of 2008, but rather a switch between central government spending categories.

uA01fig01

2009 Discretionary Fiscal Measures

(Change in structural fiscal balance, percent of GDP)

Citation: IMF Staff Country Reports 2009, 263; 10.5089/9781451822267.002.A001

Source: IMF staff estimates.Note: PPP-weighted average for country groupings.

15. The results from the GIMF simulations clearly show that fiscal policy in Korea can be effective as a counter-cyclical tool. This supports the authorities’ decision to rely heavily on fiscal policy as a key line of defense against the adverse economic spillovers from the global economic and financial turmoil. Moreover, Korea’s relatively favorable fiscal position provides the authorities ample room to loosen fiscal policy during this downturn.

16. Given Korea’s relatively small automatic stabilizers and the magnitude of the slowdown, a counter-cyclical response had to rely on discretionary measures.3 However, Korea benefits from relatively short fiscal implementation lags, which have allowed for a fast discretionary response to the weakening economic conditions. This was evident from the positive impetus to GDP growth from public consumption and construction investment during the first quarter of this year.

17. The authorities’ fiscal response has also fulfilled many of the prerequisites for effective discretionary policy. The fiscal stimulus was timely and it was significant in size, which was crucial given both the depth of the slowdown and considerable uncertainty surrounding the outlook. However, given the introduction of permanent tax cuts, the objective of keeping stimulus temporary was not fully achieved. In light of the protracted nature of the slowdown, the fiscal stimulus will likely have to be prolonged, so it will be important for the authorities to stand ready to do introduce more temporary measures if needed in 2010. It is also important that they clearly signal the readiness to do more to help allay uncertainties about the outlook, thereby lessening precautionary saving motives of corporates and households.

18. While there is no “magic formula” for the right mix of fiscal stimulus measures, the GIMF simulations and international operational experience suggest a number of general lessons:

  • Revenue measures: A lowering of personal and corporate income, dividend, and capital gains taxation is often effective in more normal circumstances, but may be less effective when economic conditions are weak because of the likely significant cyclical decline in the relevant tax bases. Personal income tax credits, on the other hand, can be effective through fast and targeted distribution. To foster intertemporal substitution, a possibility is to introduce a temporary tax credit on new investment. A temporary reduction in consumption taxes can also be effective by bringing forward private consumption, which was confirmed by the GIMF simulations.

  • Expenditure measures: By international experience, frontloading existing investment projects and stepping up maintenance spending tend to have a more immediate impact on demand. This was demonstrated in the GIMF simulations, which also highlighted the longer-term benefits from higher investments through secondary multipliers. Targeted cash transfers can quickly be disbursed and support the neediest with the highest propensity to consume and who are most at risk during a downturn. Taking steps to further expand social safety nets can also help lessen the precautionary savings of households. However, such measures take time to implement and could serve more as a medium term objective.

In light of this, the mix of the fiscal stimulus measures introduced in Korea in response to the current economic crisis has been broadly appropriate. The stimulus focused mostly on spending measures, including spending with a potential large near-term impact on growth, such as investment spending and transfers to liquidity constrained agents. However, the corporate and personal income tax cuts are not expected to have a large impact on growth in the short term, although they can help support the recovery once it is under way. Assuming that the change in the structural fiscal balance represents the same relative mix of measures announced in the fiscal packages, the model-generated multipliers suggest that the impact on growth in 2009 could be around 1–1½ percentage points. Nevertheless, it should be kept in mind that this assumes that the fiscal measures are fully implemented this year, with transfers in the hands of consumers, capital projects carried out, and so on.

E. Concluding Remarks

19. The analysis in this paper shows that fiscal policy can be effective as a stabilization tool for Korea, despite the openness of the economy. Simulations using a macroeconomic model calibrated for Korea point to a number of key lessons:

  • Multipliers differ across fiscal measures—they are larger for infrastructure spending, consumption, and transfers targeted at liquidity-constrained agents. These measures should, therefore, figure prominently in stimulus packages, as they have in Korea. That said, the tax cuts included in Korea’s fiscal stimulus packages are not expected to have a significant short-term impact on growth and, given their permanent nature, will make it more difficult to achieve the needed fiscal consolidation over the medium term.

  • The impact of the fiscal stimulus is relatively short-lived and an expansionary fiscal stance will need to be maintained if the recovery is weak and drawn out, as the staff expect, both for Korea’s and the global economy.

  • The effectiveness of fiscal stimulus can be strengthened if supported by complementary monetary policy, although this may involve some tradeoff between inflation and growth. The simultaneous easing of monetary policy in Korea has likely strengthened the impact of the fiscal stimulus, but not at the expense of the inflation target given the significant widening of the output gap.

  • Concerns about fiscal sustainability can impair the effectiveness of short-term fiscal stimulus by raising precautionary savings and risk-premiums. Therefore, it is important, even during a crisis, to signal commitment to fiscal sustainability, including by articulating medium-term fiscal consolidation plans.

  • Given global economic interconnectedness, a globally coordinated fiscal response helps boost fiscal multipliers, especially for an open economy such as Korea’s.

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1

Prepared by Leif Lybecker Eskesen. For more details and analysis, please see forthcoming IMF working paper “Countering the Cycle-The Effectiveness of Fiscal Policy in Korea” by the same author.

2

I would like to thank Dirk Muir for his invaluable help explaining the workings of the GIMF model.

3

Korea does not have a comprehensive unemployment benefit scheme and corporate taxes are assessed on previous year’s income.

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

    Fiscal Multipliers from Structural VAR and Macroeconometric Models—Cross-Country Evidence 1/

  • View in gallery

    Korea: Cumulative Fiscal Multipliers in the Base Case

    (Impact on real GDP from 1 percent of GDP stimulus in year 1 unless otherwise specified)

  • View in gallery

    Korea: Cumulative Fiscal Multiplier Sensitivity Analysis

    (Impact on real GDP from 1 percent of GDP stimulus in year 1, unless otherwise specified)

  • View in gallery

    2009 Discretionary Fiscal Measures

    (Change in structural fiscal balance, percent of GDP)