KDI - Korea Development Institute - RESEARCH - Research Areas

Summary

Policy Study KOR Economic Effects of Sectoral Fiscal Expenditure and Policy Implications

This study presents an agreeable standard among various criteria used for discussions in setting the upper limit on financial resource allocation by sector via economic effect analysis. A dynamic stochastic general equilibrium (DSGE) model estimates fiscal multipliers according to economic character classification. In the DSGE model, economic agents (households, businesses, government, etc.) are equipped with microeconomic foundations for making optimal choices with reasonable future expectations, and macroeconomic variables (consumption, investment, etc.) are linked to fiscal spending. Sectoral fiscal outlays sorted by economic qualities have these multipliers to calculate economic impacts over the past six years, both on average and per input unit.

To summarize the findings of this study, the economic effects range from least to greatest in order of social welfare, national defense, general & local public administration, education, health, environment, and public order & safety. However, the impact on social welfare, general & local public administration, and education is more significant because of the sheer size of the budget increase from the previous year. Accordingly, from most to least, the effect per budget unit can be listed from transportation & logistics, public order & safety, national defense, environment, and agriculture & fisheries to health. In addition, the public order & safety and defense sectors, which have a high proportion of government consumption, show a gradual decrease in economic effects over the medium term. On the other hand, transportation & logistics and environment, with a high proportion of government investment, show an increased impact in the same time frame.

Sorting by economic characteristics per consolidated fiscal balance may lead to heterogeneous economic ripple effects bundled together as one group and making decisions with social and political factors instead of economic ones. Also, even in the presence of limitations in research, like the assumption of a closed economy model, the impact of economic growth estimated in this study can be used as a sensible reference for preparing guidelines for making sectoral priorities for efficient spending or budgeting in line with economic characteristics and deciding fiscal reforms in the order of importance. That is, this study offers key implications for policymaking that, with expenditure ceilings put in force lately, earmarking more funding for budget categories with greater economic knock-on effects and restructuring ineffective budgets can ensure sound fiscal management in response to the expected economic slowdown.

Summary

Research Monograph KOR Macroeconomic Challenges and Policy Direction for the Post-COVID Era

Korea experienced changes in its economic architecture in the aftermath of two major economic recessions, the Asian Financial Crisis and the Global Financial Crisis. However, triggered by a non-economic factor of infectious disease rather than structural problems of internal and external economies, the COVID-19 crisis unfolded differently from the two previous downturns after 2020. In response, the Korean government carried out aggressive fiscal, monetary, and financial policy measures, together with the early signing of a currency swap agreement with the US. Its quick and decisive actions helped stem capital flight and swiftly stabilized the financial market. Another unique feature of the current crisis is its hugely uneven shocks among economic entities. Notably, the face-to-face service industry had a significant contraction due to its high susceptibility to contracting the virus. Still, asset prices soared even in the pandemic-induced recession thanks to abundant liquidity supplied into the market, widening the gaps in labor and asset income.

Based on the observations, this study intends to analyze the macroeconomic aspects of the ongoing situation and take lessons from it. While investigating the crisis itself, it also attempts to make projections of possible changes in the post-pandemic world and offer policy implications. It first analyzes the pandemic recession on the basis of an economic cycle and identifies what sets this incidence apart from past economic downturns. Then, it turns to the labor market to analyze the impact on jobs and forecast possible structural changes while further examining the features of firms that fared relatively well. Lastly, fiscal and monetary policy measures during the crisis are evaluated to provide implications for the future macroeconomic policy direction.

Summary

Policy Study KOR Fiscal Policy in Open Economies: Capital Accounts and the Crowding Out

We analyze the effect of fiscal policy of open economies, and examine the effect of fiscal policy on domestic corporate investment. Capital flows are important factors in determining the effect of fiscal policies in a small open economy. Fiscal expansion which tries to boost overall demand could, in principle, be restricted by various factors. So-called crowding-out could reduce the effectiveness of fiscal expansions, and thus lower the fiscal multiplier. Capital flows could play an important role in determining the effects as it determines how the revenues for fiscal expansion are financed. Here, we examine the magnitude of the fiscal multipliers with different states of capital flows. Through the structural vector auto regression (SVAR) model using the sign restriction on national panel data from 42 countries, we find that fiscal multiplier is higher when capital inflows and lower when it outflows. And the responsiveness of different states of capital flows are more notable in investment than in consumption, the other component of GDP accounts.

In the second part of the paper, we further examine the corporate investment of Korea. If the crowding-out prevails, fiscal expansions could lower the overall investment. Increased supply of government bonds will substitute corporate bonds in the loanable funds market. However, if it could partially be off-set if firms could fund their investment from international investors. That is, if individual firms could finance their investment from external funds, it could unwind the crowding-out of the fiscal expansions. We analyze Korean firm level data from 2005 to 2020, and confirm that with fiscal expansions, investment ratio decreased especially in companies with high debt-to-equity ratio. However, those negative correlation is not observed in a sample of companies which hold foreign debts or have foreign main banks.

Summary

Research Monograph KOR A Study on Public Sector Debt

This report consists of two independent and interrelated studies pertaining to the debt of state-owned enterprises (SOE).

Chapter 1 analyzes the impact of SOE debt on the financial soundness of the government. First of all, we review the current status of public sector debt by examining data and previous studies on various categories such as local government, public institutions (including SOEs), financial institutions, etc. The results reveal that Korea’s relative size of non-financial SOE debt to GDP is much higher than that of major foreign countries, and the ratio of SOE debt to sovereign debt is also very high, indicating that the role of SOEs in Korea’s public sector is significant. On the other hand, we conclude that regulations on the financial status of SOEs is relatively insufficient. Therefore, the regulating system needs to be improved for future public debt management and control of public institutions.

Based on these findings, we develop a general equilibrium model that explicitly considers SOE debt for analyzing its effects on fiscal soundness and the macroeconomy. The results vary depending on whether the debt growth of SOEs is a temporary shock or is accompanied by the economic inefficiency of SOEs. If the debt shock is merely temporary while the efficiency of SOEs is maintained, the fiscal sustainability is hardly affected. Government subsidies increase slightly, but it has little impact on the economy's fiscal soundness and macroeconomic variables. However, if both debt growth and economic inefficiency occur simultaneously, it can shrink the economy’s fiscal space and reduce private consumption and the growth rate, thereby worsening social welfare. Accordingly, it is necessary to improve management and supervision functions on debt growth and efficiency of SOEs to the extent of the regulations on the debt of central and local governments.

Taking into consideration the distinctive traits of public enterprises, Chapter 2 (Should this be Chapter 2) analyzes the problem of 'moral hazard' (in terms of economically inefficient behavior rather than illegal action) arising from the government's tacit guarantees on their debt. In general, Korean public enterprises become financially indebted through the issuance of bonds. These bonds are recognized as safe assets in the market because participants share a strong but implicit belief that when a debt defaults, the government will repay it on their behalf. In the banking sector, it has become a well-known fact since the global financial crisis that moral hazard occurs when the discrepancy between management fundamentals and funding conditions widens. However, unlike banks, public enterprises’ decisions on large-scale investments are determined not by their management executives but by the government, meaning that moral hazards may differ.

Chapter 2 examines the effect of moral hazard in implicit guarantees, using a theoretical model that takes into account situations in which the government assigns policy projects to public enterprises for operation. The analysis shows that implicit guarantees by the government on public enterprise-issued bonds incur moral hazard not only for the public enterprises themselves, but also for the government―which, in turn, boomerangs back to the public enterprises as a larger moral hazard. Once a policy project is assigned, the employees of the public enterprise are guaranteed a salary under the payment guarantee (salary guarantee effect), even when they fail. There is even less incentive to work harder as public enterprises can issue bonds at an interest rate similar to that of government bonds (low cost financing effect) without making any special efforts towards the success of the project.

Additionally, the government will be unable to meet the participation constraints of employees in public enterprises if it ignores profitability when assigning projects in order to maximize political interests. However, with implicit guarantees, the aforementioned effects of a basic salary guarantee and low-rate procurement serve to increase the utility of employees and, thereby, relax the participation constraints, resultantly making it easier for the government to force public enterprises to take on political-oriented policy projects―this is a moral hazard on the government side. Also, such a ‘forced’ policy project could damage the business environment in public enterprises, thus exacerbate the moral hazard of employees. This double moral hazard may diminish the social welfare of the general public.

Based on the analysis, this study suggests the following policy directions for the government's implicit guarantees. First, guarantees should not be provided in general situations. Second, guarantees should only provided in exceptional cases wherein sufficient funds cannot be raised from the bond market while the project is needed for its considerable social contribution.

Summary

Policy Study KOR Analysis on Macroeconomic Effects of Tax System Change: A General Equilibrium Approach

This paper analyzes macroeconomic effects of tax system change based on a calibrated dynamic stochastic general equilibrium model. Based on the IMF’s Global Integrated Monetary and Fiscal (GIMF) basic model, the model includes a pension module and considers four countries to reflect the future trend in age-related government expenditure and the trade structure of the Korean economy. Key parameters were set based on the latest statistical data and previous research results.

We examine macroeconomic effects of three types of tax system change: the temporary tax reductions to boost the economy, the permanent tax increments to finance the expected age-related or pension expenditure, and realistic tax policy changes in recent years or in the near future of home and foreign countries.

These quantitative exercises give us the following policy implications. First, the tax cut policies for stimulating the economy are less effective than the fiscal spending expansions. Temporary tax reductions may be at best complementary to other government spending policies firming up the policy direction of government in exceptional circumstances such as the economic crisis. Second, we need to start discussions on the structural change of the tax system to finance the long-term age-related spending. The consumption taxes are the most efficient policy measures minimizing the reduction in aggregate output but there is a risk of sparking political opposition because the consumption taxes tends to be regressive and the private consumption will sharply shrink at the time of tax hike. Third, the domestic spillover effects of major countries' tax policies are relatively large due to the small open economy characteristic of Korean economy, so it is necessary to consider preemptive policy responses to mitigate or reinforce the domestic ripple effects.

Summary

Policy Study KOR A Study of the Effect of NPS on Decision of Household Saving and Asset Based on Income Group and Household Debt

This study estimates the individual’s social security wealth using the Korea Labor Panel Data (KLIPS) and investigates the effect of pension wealth by income level on household savings and choice of asset composition respectively based on panel analysis. In addition, we analyze the marginal effect of pension wealth by income level according to the household debt burden level based on the mortgage recognition rate (LTV) of the household and examine the effect of pension wealth on household financial assets and non-financial assets. The results show that the pension wealth crowds out househole net worth and the crowding-out effect decreases as the income level increases. It is found both in household financial assets and non-financial assets. When the household debt burden level is taken into consideration, the households are analyzed to construct more savings and assets for consumption smoothing as the debt burden level increases. Financial assets and non-financial assets are analyzed in detail, and it is found that the pension wealth crowds out the real estate assets and the protection insurance which is a long-term saving to prepare for old age. These results suggest that current income inequality may lead to the imbalance of old-age income after retirement. At the same time, it is confirmed that the national pension plays a role of substitute for long-term savings by performing the old-income guarantee function. It means that the household’s non-financial assets can be used as a means of personal retirement.

Summary

Research Monograph KOR Assessment and Policy Recommendation for Fiscal Soundness

Due to the changes to the composition of population, the number of economically active population has been continuously declining. As a result, fiscal soundness is projected to be toppled as the demand for public spending increases while tax revenue decreases. It is all the more necessary for the public finance to be stable so as to act as insurance when the economy comes to face a crisis. The first part of this study appraises the overall status of the fiscal soundness. The second part analyzes social welfare, education, medical care, and SOC that could possibly offer a solution to restore fiscal soundness. The third part offers assessment and recommendation on fiscal revenue.

Chapter 2: Due to the pessimistic view of the future course of fiscal balance, the tax burden should be maintained at 20% of GDP along with less than 10% discretionary spending of GDP. Chapter 3: Many public-private partnership projects by local governments are exposed to a long-term fiscal risk, and therefore, should be thoroughly reviewed before being implemented. Chapter 4: In order to deal with their massive debts, excessive functions of State-Owned Enterprises (SOEs) must be reduced by introducing competition. Chapter 5: In order to stabilize long-term fiscal balance, there needs to introduce fiscal rules to curtail public expenditures. Chapter 6: As for the model for social welfare, it is ideal to strive to position ourselves somewhere in the middle between Scandinavian countries and Germany. Chapter 7: Public pension systems should be restructured so that the compensatory element of the pension should be covered by private retirement pension. Chapter 8: To stabilize the medical costs, the accountability for the payment process of medical benefits should be enhanced. Chapter 9: Expenditure on education should be adjusted in a flexible way, taking consideration of the number of students, and there needs to be a strict financial division of responsibility between the private and the public. Chapter 10: Since the marginal productivity of SOC investment is low in general, especially so for roads, SOC supply policy must redirect its investment to be more efficiency-oriented. Chapter 11: The proposed order of financing sources for the increasing social welfare costs is higher social insurance contribution, then more income tax burden followed by higher consumption tax. Chapter 12: Utilizing CPI as inflation-linked index is recommendable not only for expanding the tax base but also for better redistribution effects. Chapter 13: Value Added Tax (VAT) is not so regressive or could be even progressive if we include the indirect effect such as consumption changes of each income bracket and the redistribution effect of the higher expenditure on the social welfare based on the increased revenue.

The conclusions are as follows. First, it is of utmost importance that fiscal soundness to be maintained since it has the potential to become dangerous, especially when we consider the local governments and the SOEs. Second, it is difficult to maintain the long-term fiscal soundness only with restructuring expenditure side, so the expansion of the revenue side should also be considered. Third, there must be a strict demarcation between what the public finance is responsible for and what the private sector must take over. Fourth, since government expenditures must be economized, priority should be set among expenditures and there also needs to be flexibility in setting the right amount to spend. Fifth, financial accountability must be guaranteed in order to safeguard the future fiscal balance especially in the fields of local government, SOEs, and medical service. Sixth, institutionalization is pivotal in obtaining the fiscal soundness, and implementation of fiscal rules is no longer a choice but a necessity. It is time to lay a foundation for the long-term fiscal soundness for the sake of our next generation.

Summary

KDI Policy Forum House Prices and Monetary Policy in South Korea

□ The ex-ante responses the central bank made in the past to achieve house price stability may not be as beneficial as ex-post responses. However, this attitude has been challenged after facing enormous conomic and social expenses caused by the huge economic setbacks resulting from the global financial crisis in 2008.

- In the past, houses were generally regarded as a kind of durable asset from the perspective of monetary policy, and therefore changes in house prices, such as share price fluctuations, were not regarded as a factor requiring a monetary policy response.

- Hit by the financial crisis resulting from the US sub-prime mortgage crisis in late 2007 and by Lehman Brothers filing for bankruptcy in September 2008, the global economy experienced a 1.6 years slowdown (December 2007 to Jun 2009), the longest the world had seen since the Great Depression in the 1930s.

- The recent economic recession that occurred in relation to the housing market continued for a longer period and caused larger losses to the national economy on average than economic recessions that had nothing to do with the housing market.

□ Now that financial stability has been added as a new goal for the Bank of Korea (BOK), there is a greater need than ever for an analysis to be made concerning the linkages between house prices and monetary policy that takes into account recent economic conditions.

- During the eighth revision of the Bank of Korea Act on Sep. 16, 2011, financial stability was declared to be a new goal for the BOK. The act was revised to say, “The Bank of Korea shall pay heed to financial stability as it carries out monetary policy.”

□ Inspired by these factors, this paper uses model simulations to deduce the optimal monetary policy frontier line of central bank, and analyzes the effectiveness of monetary policy that takes house prices into account.

- The paper discovers the mutual complementarity of housing and consumption and includes this characteristic in its design of the macroeconomic model.

□ Presuming there is an expectation that house prices will go up inside an economic structure where the average loan-to-value (LTV) ratio is 50%, housing and consumption act as complementary goods, and housing demand and consumption tend to move together.

- The simulation shows that, assuming that the first priority of the central bank is decreasing inflation volatility and economic volatility, interest rate rules that respond to house prices contribute 6% more to inflation stability and 2% more to economic stabilization than interest rate rules that do not.

- The central bank needs the ability to determine the fundamental factors affecting house prices, and if economic stability is considered an important task, interest rate rules that respond to house prices will effectively carry out monetary policy goals.

□ Since the central bank needs to monitor house prices for financial stability, it is necessary to reorganize credible market indices and construct statistical models to achieve monetary policy goals.

- The most that is being done in South Korea at the present is using financial stability reports and other data that KB Kookmin Bank and Real Estate 114 available to the market to gather information about the housing market.

□ The Federal Reserve Bank of New York regularly purchases data from CoreLogic and uses it to monitor house prices. It periodically releases the results of its comprehensive analysis of the financial market in relation to house prices.

- It is necessary to reorganize market indices and devise economic models in order to monitor volatility in the housing market and to conduct an empirical analysis of the effectiveness of policies.

□ Economic contraction that is connected with the housing market has brought more attention to the important role that monetary policy should play than ever before.

- Analyzing and assessing the intrinsic value of house prices in response to an economic recession that is connected with the housing market is an important job for the central bank to do in their pursuit of new monetary policy goals.

- It might be necessary to consider expansionary monetary policy that seeks to reduce the volatility in house prices and stabilize consumer sentiment about the recovery in the real economy in current situation.

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