Authorities’ Views

37. The authorities viewed fiscal policy in 2019 as expansionary. They emphasized that the expenditure increase this year would be the highest since 2000. Moreover, to support the economy they plan to frontload spending in the first half of the year. The authorities did not expect significant revenue over-performance in 2019 as stronger-than-expected corporate income would be unlikely this year. Moreover, the Earned Income Tax Credit has been expanded. Considering weak economic data thus far in 2019, the authorities committed to take necessary measures to achieve their growth target of 2.6–2.7 percent, including introducing a substantial supplementary budget to boost job creation, further enhance social safety nets, and address fine dust pollution. Moreover, part of the 2018 revenue overperformance will be transferred to local governments in 2019 for additional spending. The major public institutions will increase their investment by KRW 9.5 trillion (0.5 percent of GDP) in 2019. In addition, government dividends from investment in corporations in the amount of KRW 1.5 trillion won (0.1 percent of GDP) will be reinvested. Private-public partnership will be strengthened further. The authorities agreed that the fiscal stimulus should be efficiently spent and aimed at enhancing potential growth.

38. BOK regarded the current monetary policy stance as still accommodative. They agreed that the neutral real interest rate in Korea has declined as in other advanced economies, but underscored the high uncertainty in estimating the neutral rate. They stressed that their monetary policy stance has continued to be accommodative when judged against the range of their own neutral rate estimates. They also presented a broad set of information, including their own financial conditions index to support their view. Given their assessment of an accommodating stance, they noted that current macroeconomic trends and financial stability risks should be considered in a balanced manner. The BOK also pointed out that cutting the policy rate would further reduce policy space to address possible future severe negative shocks needs to be considered.

39. BOK viewed inflation expectations as well anchored. They stressed that Korea’s undershooting of the inflation target for the past five years was primarily due to supply-side shocks, including the fall in oil prices, and institutional factors, such as the government’s stronger welfare policies which affected administered prices. The BOK’s underlying inflation indicators excluding these factors rose close to the 2 percent target last year. The BOK also mentioned that recent signs of decline in consumers’ inflation expectations were modest and partly reflected a restructuring of the sample of consumer survey respondents in September 2018, and the aforementioned supply side factors which were expected to reverse.

40. BOK stressed that their mandate included financial stability. They emphasized that while macroprudential measures were effective in specific markets, the build-up of financial imbalances including the increase in general risk-taking behavior across the economy should be contained with a policy mix including monetary policy. In their view, using a mix of macroprudential and monetary policies, is more effective in addressing financial stability risks.

41. The authorities were of the view that borrower-based macroprudential policies have been effective in reducing and containing household debt growth. However, they noted that household debt continues to rise more than income. Their target is for it to grow in line with nominal GDP in the mid-to-long-term . The authorities considered the cap on banks’ foreign exchange derivative positions necessary. They saw it crucial to contain any excessive increase in short-term foreign debts.

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Yields on Personal Income Tax in Selected OECD Economies

(2017 or Latest, Percent)

Citation: IMF Staff Country Reports 2019, 132; 10.5089/9781498314794.002.A001

Sources: OECD and IMF Staff Calculations.Note: Yields are calculated as tax revenues from personal income tax in percent of GDP divided by the maximum statutory rate.

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42. The authorities stressed that they adhere to the principle that the exchange rate is determined by the market. They clarified that intervention policy in foreign exchange market was limited to episodes of disorderly market conditions. They noted that exchange rate flexibility would continue.

Fiscal Policy

43. Fiscal policy should maintain an expansionary stance over the medium term to support inclusive growth and reduce excessive external imbalances. The authorities plan to raise government expenditure in the medium-term, which will be accompanied by a decline in the fiscal surplus. The 2018–22 National Fiscal Management Plan envisages an increase in fiscal expenditure by about 7 percent per year, on average. Revenues are projected by staff to increase by 4.7 percent, on average, per year. Assuming a supplementary budget of 0.3 percent of GDP in 2019, the structural balance is expected to decline from 2.9 percent of GDP in 2018 to 0.9 percent of GDP in 2022. Staff recommend that the government further reduce the structural balance toward zero in the coming years.

44. The additional fiscal spending should focus on fostering social protection, boosting long-term growth and supporting growth-enhancing structural reforms. The authorities plan to strengthen social safety nets, buttress job creation, and foster innovation. Staff support increasing spending on targeted transfers to the vulnerable. Fiscal spending should also focus on training and job services to prop employment, as well as childcare and child benefits to buttress female labor force participation and fertility. Fiscal measures can also play an important role in facilitating the implementation of reforms to make the labor and product markets more flexible (see below). Staff simulations indicate that, for example, an expansion in childcare spending by 0.25 percent of GDP, and an increase in Active Labor Market Policies spending by 0.5 percent of GDP, accompanied by labor and product market reforms would boost output by more than 6 percent in 10 years. Staff caution against using transfers to SMEs to preserve jobs indefinitely. Given the large number of fiscal programs in support of SMEs, it would be important to regularly monitor and periodically review their impact. Rather than providing subsidies based only on firm size, focus should be on firms that are more likely to experience improvements in productivity and long-term profitability and produce long-lasting employment gains, such as young and innovative firms.⁶

45. Tax reforms could help support long-term growth. Increasing the neutrality of corporate income taxation with respect to financing sources would enhance resource allocation. Currently, the effective marginal tax rate on equity financing in Korea is estimated to be 40 percentage points higher than that on debt financing. This is a disadvantage for innovative firms—especially start-ups—that tend to rely on equity, rather than debt, for R&D investment. Options to eliminate the distortions arising from corporate debt bias include allowance for corporate equity system or a cash flow tax. Consideration should also be given to adjusting the progressive corporate income tax rate schedule to avoid tax-induced fragmentation of integrated business activities and under-reporting of income.

46. Fiscal challenges from the aging population will require greater revenue mobilization in the longer term. Outlays for pensions and healthcare are set to rise by 10–16 percent of GDP by 2060. While future spending could be partly lowered through an increase in the retirement age and possibly other expenditure cutting measures, the debt-to-GDP ratio will move on an unsustainable trajectory with unchanged revenues. Korea’s tax revenue-to-GDP ratio is one of the lowest in the OECD, providing ample room for expansion. Higher revenues could be achieved in the longer term by broadening the tax base. Yields on the personal income tax are low in international comparison, due to significant tax deductions. Tax expenditure on personal income tax increased by more than 40 percent from 2012 to 2017 and was more than 25 percent of personal income tax revenues in 2017. While personal income tax deductions aim to achieve important policy objectives, there will be a need to reassess their effectiveness and costs in the longer term. Tax expenditure on industry, including SMEs, which represented about 30 percent of total tax expenditure in 2017, will also need to be reviewed. The VAT base could also be broadened to cover all new real estate supplies (including the value of land) and fee-based financial services. Depending on the comprehensiveness of these base-broadening measures, it may still be necessary to raise some tax rates, notably the VAT which is relatively low at only 10 percent.

Labor Markets Reforms

47. “Flexicurity” should be adopted as the basis for labor market policies to boost employment and reduce labor market duality. Flexicurity involves three pillars: (i) more flexibility for regular workers; (ii) a strong and inclusive safety net for the unemployed; and (iii) Active Labor Market Policies. The fundamental principle of “flexicurity” is that it protects workers rather than jobs. The authorities are developing policies that cover some of the pillars, notably an expansion in unemployment insurance. Only by eventually implementing all three pillars can an adequate balance between incentives, support, and protection be assured.

48. Measures should be geared toward more flexibility in employment protection regulation for regular workers. For this category regulation is stricter than the OECD average. Korea has particularly tight restrictions on dismissal of regular workers. To strengthen job creation, the ability to dismiss regular workers for performance and other economic reasons should be eased. Staff analysis also suggests that rigid labor market regulations are particularly harmful to female employment Increased flexibility will have to be accompanied by adequate unemployment benefits to provide sufficient safety nets. Active Labor Market Policies should also be enhanced. Currently, the focus is on creating jobs directly through subsidies, while spending on training and employment services is relatively low. Active Labor Market Policies should also support labor reallocation from ailing corporate sectors toward more productive ones, while ensuring sufficient incentives to job search. Active Labor Market Policies would need to be carefully monitored and evaluated to ensure effectiveness.

49. Efforts to encourage the participation and leadership of women in the labor market should continue. Korea’s female labor force participation is one of the lowest in advanced economies—20 percentage points below the best performers. The gender pay gap in Korea is one of the highest in the OECD, with women earning only 63 percent of what men earn. Women take up just 10.5 percent of management positions, compared to the OECD average of 31 percent. Significant growth gains would be obtained by boosting Korea’s FLFP rate further. If FLFP were to rise to close the gap with Korea’s male labor force participation by 2035, women work would boost real GDP by more than 7 percent, in spite of the significant decline in working age population (Box 4). There is scope to further increase spending on early childhood education and care. Additional measures could include promoting shared parental leave, implementing the reduction in working hours, and fostering a working culture supportive of flexible-working arrangements.

50. Boosting youth employment is another priority. Korea’s youth employment is about 10 percentage points below the OECD average. To support youth employment, existing measures such as specialized vocational schools (Meister schools), the work-study dual system, and internships could be strengthened. This entails a more active collaboration with businesses and ensuring the quality of placements, to guarantee accumulation of on-the-job skills and enhance career prospects.

51. The government should be cautious about expanding public employment to create jobs. The government is planning to expand public sector jobs by 810,000 by 2022, partly by converting non-regular public-sector workers into regular employment. Public sector job creation should be linked to developing services that cannot be provided by the private sector. Moreover, in creating public jobs the impact on public sector productivity should be considered. The authorities should also conduct an analysis of public-private sector wage differential to inform hiring conditions in the public sector to minimize the risk of crowding out private jobs.

Box 4.

Output Gains from Increasing Female Labor Force Participation in Korea

With fast aging population and declining productivity growth, Korea faces key challenges in raising long-term growth. To what extent can increased female participation in the labor market contribute to Korea’s growth?

The growth impact of female labor force participation (FLFP) can be assessed in a growth accounting framework. This decomposes a country’s growth rate into the contributions of labor input, human capital, physical capital, and the efficiency with which various factors are combined. Typically, growth accounting does not make a distinction between male and female labor in the production function, implicitly assuming that the elasticity of substitution (ES) between the two is infinity. However, recent estimates by Ostry and others (2018) indicate strong complementarities between women and men in production, with the ES ranging between 0.2 and 3.8. Hence, departing from the literature, we develop a growth accounting framework where labor and human capital are disaggregated by gender, assuming a CES production function.

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Contribution to Yearly GDP Growth

(Yearly Averages, Percentage Points)

Citation: IMF Staff Country Reports 2019, 132; 10.5089/9781498314794.002.A001

Sources: Barro and Lee, UN, WDI and IMF Staff Calculations.1/Populationaged 15–64.2/Employment rate is here defined as the share of workforce that is employed.3/ Labour force participation.

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Female contribution to Korea’s growth has risen over the past decades, thanks to women’s higher participation in the labor market and increases in their human capital. The growth decomposition indicates that in the last decade the female contribution to growth has slightly exceeded that of men, even though the population of males in their working age increased more than that of women. This result is even stronger if the ES is assumed to be low.

Despite recent progress, though, Korea’s FLFP rate remains relatively low. It was around 58.6 percent in 2017, almost 20 percentage points below that of men, and 11 percentage points below the average of other advanced economies. On the bright side, though, Korea’s human capital of women, based on average years of education from the Barro and Lee database, was estimated to be very close to that of men in 2017, and above the average of other advanced economies.

Significant growth gains would be obtained by boosting Korea’s FLFP rate further. Under a baseline scenario in which FLFP increases at the same rate as the average of the past 10 years, between 2017 and 2035 the output generated by females would fall, as the impact of the expected decline in the female population of working age more than offsets the rise in FLFP.¹ Instead, if Korea’s FLFP rate were to reach the average rate of other advanced economies by 2035, women’s work would add nearly 4 percent to GDP over the period, in spite of the decline in female working age population. If FLFP were to rise to close the gap with Korea’s male labor force participation by 2035, women work would boost real GDP by more than 7 percent.

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Female Contributions to Real GDP Growth, 2017–2035

(Cumulative, Percentage Points)

Citation: IMF Staff Country Reports 2019, 132; 10.5089/9781498314794.002.A001

Sources: Barro and Lee database, Unted Nations, WDI, and IMF Staff Calculations.1/ FLFP stands for female labor force participation.2/ AEs stands for advanced economies.3/ LFP stands for labor force participation.

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¹ Projections for the female population are from the UN, and projections for female human capital are based on the Barro-Lee database.

52. Future large increases in the minimum wage will likely have adverse side effects on employment. As part of the government strategy to support income, the minimum wage was raised by 10.9 percent for 2019, following a 16.4 percent increase in 2018. The hike for 2019 is significantly larger than the expected labor productivity increase. This will likely bring the ratio of minimum to average wage to around 46 percent, well above the OECD average of 41 percent (in 2017), likely hurting employment of low-skilled labor (Figure 5). The government set up a Job Stabilization Fund to subsidize eligible SMEs to dampen the impact of the minimum wage increase and preserve some jobs, with a fiscal cost of about KRW 2.5 trillion (0.1 percent of GDP) in 2018, and KRW 2.8 trillion (0.1 percent of GDP) expected for 2019. A new minimum wage determination mechanism is being designed to ensure better representation of labor market groups and better reflect economic circumstances. Staff welcome this initiative and look forward to its implementation. Next year the minimum wage increase should be set below labor productivity growth to partially mitigate the adverse effects on employment. Targeted fiscal instruments (such as in-work tax credits) would be more appropriate measures for addressing in-work poverty while not adversely affecting employment. Subsidies to the SMEs facing increased labor costs should be phased out.

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Korea: Minimum Wage Increase

Citation: IMF Staff Country Reports 2019, 132; 10.5089/9781498314794.002.A001

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53. The new regulation on maximum working hours will be beneficial. In 2018, Korea amended the Labor Standards Act to lower maximum weekly working hours from 68 to 52.⁷ The objective is to improve work-life balance, as Korea’s average hours worked per employee are the second highest in the OECD and about 19 percent above the OECD average. The reduction in working hours could support workers’ well-being and possibly contribute to higher productivity, employment and fertility. It will be important to monitor implementation to ensure an effective and widespread decline in hours worked across sectors and assess the implications for firms and productivity.

Product Market Reforms

54. Policy efforts to diversify the manufacturing sector should be expedited. Korea’s manufacturing sector is highly concentrated, particularly compared to peers. The electrical and electronic equipment industry has contributed almost half of the growth in the manufacturing sector since early 2000s.⁸ The dominant industries are highly interconnected with other domestic industries via upstream/downstream linkages, and with foreign markets via export/import linkages. Moreover, these industries are dominated by few large firms. Staff analysis suggests that tighter vertical and trade linkages have increased the vulnerability of the economy to domestic and external shocks.⁹ The authorities’ ongoing efforts to promote fair competition between large corporations and smaller firms and foster innovation especially in SMEs are welcome initiatives, which should help reduce these vulnerabilities.

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Industrial Decomposition of GDP Growth: Manufacturing

(In percent)

Citation: IMF Staff Country Reports 2019, 132; 10.5089/9781498314794.002.A001

Sources: Bank of Korea; IMF staff calculations.

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55. Deregulating the non-manufacturing sector could help boost long term growth, spur domestic demand, and help reduce external imbalances in the short run. Product market regulations are more restrictive relative to most other OECD economies, even though Korea has undertaken substantial product market deregulation in the past (Box 5). ¹⁰ Some incumbents are protected through legal barriers to entry and antitrust exemptions, while startups face relatively high entry costs and some administrative burden. Explicit barriers to trade and foreign investments are also high relative to peers, which could act to further close the business environment off from competition. Staff analysis indicates that additional reforms could significantly boost GDP and productivity, (Box 5) as well as the contribution of the non-manufacturing sector to growth, increasing diversification . Such reforms could also help reduce the current account surplus through higher investments. The government initiative to create regulatory sandboxes (i.e. speeding up the process of obtaining approval to launch new products) is a useful move in this regard. In addition, competition could be promoted by reducing the tax costs of firm entry as well as remaining administrative burdens and legal barriers for entry in some industries. Consideration could also be given to enhancing foreign competition by reducing tariffs and domestic co-financing requirements for foreign investments.

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Labor Productivity: Service Sector Relative to Manufacturing

(2017, Manufacturing = 100)

Citation: IMF Staff Country Reports 2019, 132; 10.5089/9781498314794.002.A001

Sources: OECD.

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56. Corporate restructuring is necessary to support long-term growth. Rapid implementation of the strategy for financial and operational restructuring of distressed firms is critical to allow the reallocation of resources toward more productive and profitable sectors. Social spending should be used to cushion the impact on affected workers and help reallocate them to other activities. Subsidies and tax expenditures to SMEs should be reviewed and focused on spurring innovation rather than protecting jobs with very low productivity. Subsidies should not be given based on firm size, but rather on firm age and scope for long-run productivity increases.

57. Staff encourage the authorities to enhance some aspects of data reporting. Over the medium term they could consider moving to SDDS Plus, which is the highest tier of the IMF Data Standards Initiatives, aimed particularly at economies with systematically important financial sectors. Also, the authorities should improve the timeliness of financial soundness indicators and general government operations data reporting.

Box 5.

Advancing Growth Through Product Market Reforms¹

Product market regulations in Korea remain among the strictest compared to OECD peers despite recent liberalizations. There are barriers to international trade and foreign investment, given relatively high tariffs, restrictions on foreign startups, and regulation. State control is high as the government has strong control over state owned enterprises (SOEs), remain involved in business operations through regulation, and Korea is among the OECD countries with the highest degree of price controls. There are also remaining barriers to entrepreneurship given administrative procedures, a complex licensing and permit system, and relatively high startup costs.

Selected Product Market Regulation Components for Korea

^1/Rank is among OECD countries.

Source: OECD, Product Market Regulation Database (Assessed November 2018).

Selected Product Market Regulation Components for Korea

Korea’s rank from 1 (most strict) to 35 (least strict) 1/
Overall score		8
State control	Governance of state-owned enterprises	4
	Price controls	2
Overall score		10
Barriers to Entreprenuer-ship	Licence and permits	10
	Administrative burdens for corporations	8
	Legal barriers to entry	12
	Antitrust exemptions	10
	Barriers in network sectors	4
Overall score		2
Barriers to trade & investment	Barriers to FDI	6
	Tariff barriers	1
	Barriers to trade facilitation	7
Overall score		4

^1/Rank is among OECD countries.

Source: OECD, Product Market Regulation Database (Assessed November 2018).

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Selected Product Market Regulation Components for Korea

Korea’s rank from 1 (most strict) to 35 (least strict) 1/
Overall score		8
State control	Governance of state-owned enterprises	4
	Price controls	2
Overall score		10
Barriers to Entreprenuer-ship	Licence and permits	10
	Administrative burdens for corporations	8
	Legal barriers to entry	12
	Antitrust exemptions	10
	Barriers in network sectors	4
Overall score		2
Barriers to trade & investment	Barriers to FDI	6
	Tariff barriers	1
	Barriers to trade facilitation	7
Overall score		4

^1/Rank is among OECD countries.

Source: OECD, Product Market Regulation Database (Assessed November 2018).

The literature suggests that product market reforms can increase productivity through more competition:

• First, reforms can improve allocative efficiency between firms in the economy. More competition will better align output prices with the marginal costs of inputs, which in turn will improve the allocative efficiency of resources.

• Second, reforms can improve resource efficiency within existing firms. More competition in a certain market segment can induce firms to reduce slack, inter alia as cost reduction will also be more profitable in a market with a high price sensitivity.

• Third, reforms can spur innovation. Intensified competition can induce firms to speed up their innovation, and adoption of recent technologies, to avoid being pushed out of the market by new entrants.

Firm level evidence suggests that past product market reforms in Korea have improved productivity and innovation. Analysis of firm level data in Korea finds that past product market liberalizations have been associated with (i) higher employment, (ii) higher labor productivity, and (ii) higher spending on Research and Development.

A modelling exercise suggests that Korea could gain significantly from further product market liberalizations. A Dynamic Stochastic General Equilibrium (DSGE) model with product market frictions (Cacciatore et al, 2016) is calibrated to Ko rea. This model is used to analyze the impact of a 50 percent decline in barriers to entry bringing the level in line with the OECD average (see Table). In the model, the reform decreases unemployment by 0.5 percent, and boosts output per worker by 7 percent in the long run as high productive firms enter and low productive firm exits. Consumption also increases by 6.6 percent in the long run, reflecting higher employment and wages, but in the short run consumption falls as higher firm profitability induces more investment in capital. Higher firm profitability also attracts foreign capital, in the short run leading to a weaker current account of up to 1.5 percent of GDP.

Long Run Effect of a 50 percent Decline in Barriers to Entry

Source: Staff calculations.

Long Run Effect of a 50 percent Decline in Barriers to Entry

Output (in percent)	Consumption (in percent)	Real Wage (in percent)	Unemployment (in pct points)
6.8	6.6	6.3	-0.5

Source: Staff calculations.

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Long Run Effect of a 50 percent Decline in Barriers to Entry

Output (in percent)	Consumption (in percent)	Real Wage (in percent)	Unemployment (in pct points)
6.8	6.6	6.3	-0.5

Source: Staff calculations.

¹ See the Working Paper “Advancing Growth through Product Market Reforms in Korea” (forthcoming).

Authorities’ Views

58. The authorities agreed that medium-term fiscal expansions should focus on enhancing social protection and labor productivity. They stressed that the 2018–22 National Fiscal Management plan envisages a 10.3 percent annual increase in welfare, health and employment spending. This involves large expansions in spending on basic livelihood security (17.3 percent annual increase), vulnerable groups (15.8 percent increase), the elderly (15.4 percent increase), and women, family and youth (11.2 percent increase). The authorities agreed that the programs to support SMEs should be regularly reviewed to ensure a positive effect on productivity. Current programs have been recalibrated based on regular assessment. Additional measures are being designed to promote productivity growth in SMEs.

59. The authorities recognized the need to reform the tax system and increase revenues in the longer term. They agreed on the need to increase neutrality of corporate income taxation, but were concerned about the feasibility of staff’s suggestions, including introducing an allowance for corporate equity system. They also had concerns that reducing the number of corporate income tax rates would aggravate the burden for SMEs. Instead, they would be in favor of streamlining existing tax reductions and exemptions to avoid distortions in corporate resource allocations. They cautioned against additional tax cuts as they did not see convincing evidence of their effectiveness. The authorities shared staff’s concerns on long term fiscal sustainability due to the aging population. They planned to broaden the tax base very gradually.

60. The authorities viewed the proposed expansion of public employment as necessary to improve living standards and service the aging population. They emphasized that Korea’s public employment is only 9 percent of total employment, far behind the OECD average of 21.3 percent. As the population ages, more public service would be needed to improve citizens’ welfare.

61. The authorities agreed with the need to move in the direction of “flexicurity” on the labor market. They noted that introduction of further Active Labor Market Policies are a high priority for the government. They argued that the general direction of the recent minimum wage increases was correct, and pointed out that they are monitoring their impact. A bill has been submitted to parliament aimed at improving the minimum wage setting framework. The new mechanism will ensure appropriate representation of workers, employers, and government and better reflect economic conditions. The authorities also sympathized with the idea that the compensation of small businesses for minimum wage increases should be temporary.

62. The authorities agreed on the need to ease the regulatory burden for firms. They pointed to the recent introduction of regulatory sandboxes for selected sectors as a first important step in this direction. They also emphasized the need to boost innovation in start-ups.