Regional Inequality and Fiscal Decentralization in Korea: Evaluationand Policy Implications

Hyungpyo Moon
Senior Fellow, Korea Development Institute

This paper attempted to examine from various angles the shifts in regional inequality in Korea during the 1990s, and to identify how the recent efforts of fiscal decentralization affected the local government's fiscal capacity, and thereby regional disparity, across different jurisdictions. The empirical findings and their policy implications can be summarized as follows.
First, we found that the regional inequality in terms of per capita GRDP and per capita regional consumption expenditure exhibited distinctly different patterns with respect to the degree of inequality as well as their dynamic movements. The rising regional inequality of per capita GRDP is mainly attributable to the regional concentration of manufacturing industries in the areas where aggloremation economies are already established. On the other hand, the market-induced changes seemed to be made toward the direction that the level of per capita consumption expenditure was equalized across regions during the 1990s.
Second, it seems that spatial disparity, rather than regional per capita income inequality, especially between the Seoul Metropolitan area and other regions poses more serious challenges in pursuing regional balanced development. Accordingly, greater emphasis should be placed on regional development policies promoting the geographical decentralization of population and economic powers. Additional investments in social infrastructure as well as economic infrastructure in lagging regions is required, so that market-induced changes in the regional distribution of population and economic powers can occur gradually.
Third, we found that intergovernmental transfers are allocated among regions so that the level of per capita fiscal expenditure is higher for the low income regions in terms of per capita consumption expenditure. Furthermore, this equity-enhancing role of intergovernmental transfers was strengthened when fiscal and political decentralization initiatives were being actively pursued. We also found that the equity-enhancing role of Local Share Tax, general grants, was more effective than other conditional grants.  This finding derives an important policy implication; inthat, increasing the shares of Local Share Tax in total intergovernmental transfers by shifting part of the conditional grants would not only improve efficiency by providing more fiscal autonomy to local governments, but it would also have a positive impact on enhancing regional equity.
Lastly, the regressivity analysis on the sub-categories of per capita regional fiscal expenditure revealed that the degree of regressivity in social development expenditure is much weaker than economic development expenditure. The likely reason is that the central government and/or local governments has placed more priority on investments for economic development, compared to social development, in lagging regions to achieve the policy objective of balanced regional development. However, our analysis indicates that more priority should be placed on polices that narrow the social development gaps across regions to alleviate regional disparity in terms of welfare and spatial concentration of population.

Expenditure Assignment in Korea: Does It Spur Regional Concentration?

Junghun Kim
Korea Institute of Public Finance

Fiscal decentralization and balanced regional development are major reform policies currently undergoing in Korea. The nature of the policies, however, is not clearly understood in the political debate, and sometimes even in the academic debate: the main question is whether fiscal decentralization and balanced regional development can go together. In this paper, it is argued that the design of expenditure assignment in Korea is such that it offers a great incentive for fiscally induced in-migration into a large city such as Seoul. This is because, unlike other countries such as Japan, United Kingdom, and Spain that are surveyed in this paper, local governments in Korea do not provide important publicly provided private goods such as education, police, and welfare programs. For the consistency and success of the two policies, we need to strengthen the link between the fiscal capacity and expenditure responsibilities of local governments. If we focus on transfer of fiscal resources on the one hand, and pursue rigorously market-intervening balanced regional development policies on the other hand, we will end up with having less efficient local public finance system with more regional disparity.

Intergovernmental Allocation of Tax Bases in Korea

Seok-Kyun Hur
Fellow, Korea Development Institute

Our paper, as a part of a trial to explore the issue of decentralization, focuses on the reallocation of tax bases within a hierarchy of multi-tier governments, aiming to suggest timely policy recommendations for the future tax reform in Korea. For this purpose, we analyze the current situation by providing summary statistics from tax revenues, expenditures and gross regional domestic product data during 1992~2001. In addition we provide a few simulation results, to measure the impact of possible changes in the intergovernmental tax allocation on the local fiscal self-reliance.
By and large, the current local fiscal system of Korea characterized by the high proportion of national tax revenues with respect to the local tax revenues and the huge size of local fiscal transfer system, exposes several problems, such as huge regional disparities coming from concentration of population in Seoul metro areas and the low fiscal independence of local governments from the central government.
Considering the situation, intergovernmental allocation of tax bases should be balanced with fiscal functional devolution and mitigate regional disparities. Specifically, these principles are put into practice by:
First, the introduction of local income tax is appropriate from the standpoint of benefit principle and the income tax portion of the current inhabitant tax takes the role. However, considering severe regional concentration of the inhabitant tax revenue on Seoul metro area, it is considerable to transfer non-labor income and corporation income portions of inhabitant tax to the central government in order to adjust regional differences.
Second, Japanese type local consumption tax should be introduced. This will avoids worsening the regional inequality of tax revenues.
Third, considering 1 trilllion won of its revenue size and relatively low regional differences, transportation tax can also be considered as an alternative to local consumption tax.
Fourth, acquisition, registration, property, and aggregate land taxes should be transferred to the central government due to the bug regional differences. Especially, property and aggregate land taxes can be shared by both the central government and the local governments

Local Share Tax in Korea

Yong-Seong Kim
Fellow, Korea Development Institute

The success of fiscal decentralization depends on an effective intergovernmental transfer system. A transfer system had better to be simple, accountable, and predictable. This paper focuses on the Local Share Tax (LST), the primary intergovernmental fiscal transfer in Korea. A simple model for net fiscal benefit is presented and is tested empirically. The result shows that the current Local Share Tax system seems to be fairly successful in terms of equalizing net fiscal benefits. A problem with the LST is that many refinements turn a simple formula into obscure and ambiguous one. Introducing time series dimension by utilizing a panel data prevents miscalculation of fiscal needs and greatly improve the stability and the predictability of the system. It is advisable that the current Local Share Tax excludes the variables such as the number of local government officials, and number of administrative districts because these variables are typically under the control of local governments. In stead, the distributive formula for LST can be based onpopulation, dependence ratio, size of area, and geographical distance of a local government from the nearest populated area. Using these variables will improve the transparency and accountability of the LST system.

Reforming the Local Debt Issuance System

Moon-Soo Kang
Senior Fellow, Korea Development Institute

Currently, local debt is issued through a bond floatation approval system where local debt can be issued only after the central government's approval is granted. The local governments have to issue local debt with the approval of the minister from the Ministry of Government Administration and Home Affairs(MOGAHA).
The budget size for the issuance of local debt decreased in 2001, and totaled 3.86 trillion in 2002. The size of localdebt accounted for 6~10% of the local government's revenue in the 1990's, though has been on a decline accounting 4% of the local government's revenue as of June 2002. Also, the balance of local debt now totals 17.6 trillion.
The bond floatationapproval system has been assessed to bring about a passive fiscal management in the local governments. Under an approval system for issuing local debt, the fiscal flexibility of the local governments can be reduced which in turn weakens the fiscal conditions at the local governments. Since local debt is mostly issued at a lower interest rate than the market rate, the localdebt market has not been fully developed due to a lack of marketability and liquidity of local debt. The proportion of local debt traded in the financial markets was only 0.4% of the total bond market as of March 2003.

1. Short-term recommendations
Municipalities do not yet have the autonomy to determine local tax rates and tax sources, and merely expanding tax revenues is not sufficient.  Therefore, introducing limits on the issuance of local debt would contribute to maintaining sound fiscal management, increase fiscal autonomy, and restrain excessive issuance of local debts by municipalities with low credit quality. The central government shouldset limits on the issuance of local debt by assessing the local fiscal capacity, condition and credit quality of municipalities. Allowing municipalities to issue their own local debt within established limitations would contribute to improving the autonomy of municipalities and flexibility of fiscal management.
To enhance financing of municipalities by issuing local debts, the competitiveness of local debts as financial instruments should be heightened by raising the after-tax rate of return on local debt by allowing interest-income tax reductions and exemptions similar to those of the U.S. and other advanced countries. This would facilitate the participation of institutional investors such as pension funds and other government related funds in the local debt market.
It would be difficult to expect that the local debt market can be fully developed in the short-term considering the condition of Korea's current bond market. Many of the advanced countries other than the U.S. manage municipal development funds through debt financing from local governments.
A plan must be established to set up "common municipal development funds" that can take on a considerable amount of local debt issued by local governments within issuance limitations set by the central government, following the cases established by the U.S. and other advanced countries.

2. Mid-and long-term Recommendations
When ensuring the tax autonomy and the fiscal responsibility of local governments in the future, market rules-based should be set for mid-and long-term improvement to enhance the effectiveness of fiscal expenditures. First, the central government (MOGAHA) must require municipalities to reach a standard above than the specifiedcriteria when local fiscal analyses are carried out on municipalities in order to be able to issue local debt in the capital markets on their own credit worthiness. Furthermore, a credit rating system for local debt of municipalities must be introduced.
The issuance rate should be set at the market rate and local debt should be issued through public offerings to induce the voluntary participation of institutional investors including various pension funds like the national pension fund in the local debt market.
A self-regulated organization should be established and operated in order to regulate general matters related to the issuance of local debt autonomously similar to the Municipal Securities Rulemaking Board (MSRB) for supporting the mid-and long-term development of the local debt market.  Focusing on information disclosure, the self-regulated organization for local debt can make issuers and investors flexibly decide and adopt among related regulations, procedures and types of local debt.

Promoting Transpareency And Accountability of Local Public Finance in Korea

Ilho Yoo
Senior Research Fellow, KDl School of Public Policy and Management

With very short history of local autonomy, her local fiscal system leaves much to be desired. In this paper, it is attempted to give policy suggestions to promote transparency and accountability of local governments.
Suggestions are as follows: First, use of the performance based budget should be expanded.  For this, proper measure for the performance and the technique to analyze it should be developed. Besides, double entry bookkeeping system should be used and the accrual accounting is to be used in the long run.  Second,  monitoring system on local governments should be reformed. More emphasis of the government audit should be on the performance audit and redundancy of it should be avoided. Monitoring by citizens should be expanded with better access to information. Third, taxing and revenue mobilization power of local governments should be enhanced including the introduction of local VAT. Proper but not too strict control over local government bonds should be exercisedand the regular review and evaluation of the fiscal soundness of local governments is necessary. Finally, reform of the intergovernmental transfer system should be done.  Particularly, special grant should be abolished, computing formula for the standard fiscal needs should be simplified.