Public Finance and Economic Development May 2005 Youngsun Koh Korea Development Institute

The Role of Fiscal Policy in Economic Development -1- The Role of Fiscal Policy in Economic Development Traditionally, three roles are assigned to fiscal policy: Reallocating the resources in the economy with the provision of public goods in the hope of correcting market failures. Redistributing income and wealth with the tax and benefit system and also with the public education and other services. Stabilizing the macro-economy in the short and long term. A counter-cyclical fiscal policy, if implemented appropriately, can help to smooth out the short-term business-cycle fluctuations. Fiscal policy can contribute to a stable, long-term output growth with low inflation by maintaining sound budgetary positions and limiting the growth of public debt.

Budget Surplus/Deficit Korea OECD -2- Budget Balance Fiscal consolidation in the early 1980s restored the budget balance to a sustainable path. The recent economic crisis had a severe but short-lived impact on the balance. Budget Surplus/Deficit Korea OECD Note: Consolidated central government. Note: General government. Source: Ministry of Finance and Economy. Source: OECD.

-3- Spending Growth Fiscal consolidation in the 1980s took the form of expenditure restraint rather than revenue increase. Growth of Real Expenditure and Revenue Note: Real values were obtained by deflating nominal values with GDP deflator. Source: Ministry of Finance and Economy.

Government Liabilities Korea OECD -6- Government Liabilities The debt-to-GDP ratio declined steadily since the early 1980s but increased rapidly after the crisis. When government guarantees are included, the ratio stood at 33 % at the end of 2003. Government Liabilities Korea OECD Note: Central government. Source: Ministry of Finance and Economy. Note: General government, at the end of 2003. Source: OECD.

Government Liabilities -7- Government Liabilities During the early days of government-led economic growth, foreign borrowings played a crucial role in providing the funds for public and private investment. Debt / GDP Ratio Source: 1953-90, Korea Development Institute; 1991-2003, Ministry of Planning and Budget.

-8- Size of Spending Expenditure and net lending as % of GDP declined throughout the 1980s and then rose in the 1990s. It peaked in 1998 as a result of the expansionary fiscal policy during the crisis. Expenditure and Net Lending and Revenue Source: Ministry of Finance and Economy.

-9- Size of Spending The total government spending corresponds to 23.0% of GDP, much lower than in other countries. But the difference is mostly due to smaller social benefits in Korea. General Government Expenditures Source: OECD

Tax Burden and Social Security Burden Korea OECD -10- Tax and Social Security Burden The increase in spending has been accompanied by an increase in tax and social security burdens. Tax Burden and Social Security Burden Korea OECD

Sectoral Allocation of Spending -11- Sectoral Allocation of Spending Economic affairs has taken the largest share in total spending. The spending on social protection is on the rise after the recent crisis. Trends of Expenditure and Net Lending   (% of total expenditure and net lending)   1970 1980 1990 2000 2003 General public services Defense Public order and safety Education Health Social protection Housing and Community Amenities Recreation, culture, and religion Economic affairs Other expenditures 23.1 22.7 - 16.7 1.3 4.9 0.3   1.4 27.4 2.2 4.0 30.6 4.6 14.6 1.0 5.7 2.5   0.7 26.0 10.4 4.2 20.0 4.3 17.0 1.7 8.1 10.1   0.5 20.4 13.7 5.2 11.4 4.6 15.3 0.7 5.3   0.8 25.2 16.2 6.7 11.4 5.3 15.0 0.4 13.5 5.0   0.8 28.7 12.8 Sources: Ministry of Finance and Economy.

Spending on Economic Affairs -12- Spending on Economic Affairs Spending on economic affairs corresponds to 6% of GDP, far higher than those in advanced countries. Spending on Economic Affairs Note : Central government for Korea and general government for others. Source : IMF. 1 2 3 4 5 6 7 US Germany France UK Canada Korea (% of GDP) Other economic Affairs Transportation and communication Mining, manufacturing, and construction Agriculture and fisheries Fuel and energy

Government Lending Outstanding Stock of Loans -13 Government Lending The spending on economic affairs often takes the form of lending. Government Lending Outstanding Stock of Loans Note: Net lending = new loans - repayments. Sources: Ministry of Finance and Economy.

Coping with the Crisis of 1997 -14- Coping with the Crisis of 1997 During 1998-2002, the government made loans to Korea Deposit Insurance Corporation (KDIC) and Korea Asset Management Corporation (KAMCO) in the amount of interest payment on the restructuring bonds issued by these corporations. The government also provided guarantees on these bonds. In 2002, the government announced a plan to take up the obligation on part of the bonds (49 trillion won) and transform them into treasury bonds. The rest will be repaid by KDIC and KAMCO. In 2003, 13 trillion won was spent on the transformation. The figure for 2004-2006 is 12 trillion won each year. In addition, the government expanded the welfare programs significantly to help the poor and the unemployed.

-15- Assessment Overall, fiscal policy in Korea has carried out its roles successfully: Resource allocation: The emphasis was placed on promoting the economic growth with large spending on education, infrastructure, and other public goods. Income distribution: After the crisis, spending on social protection is increasing rapidly, and is expected to increase further in coming years. Stabilization: The prudent management of fiscal policy contributed to a sound budgetary position and a low debt-to-GDP ratio. But the short-term stabilization has been limited due to the small sizes of tax revenues and welfare spending.

-16- Assessment The Korean economy recorded an average growth rate of around 8%. The inflation was reduced drastically in the early 1980s and declined further after the crisis of 1997. Output Growth and Inflation Source: Bank of Korea.

-17- Assessment Korea is also known as a country with a relatively equitable distribution of income, even though the inequality rose significantly after the crisis. Gini Coefficient Source: Hyun (2003) and Yoo (2004).

Challenges Government spending has been on a rising trend since the -18- Challenges Government spending has been on a rising trend since the mid-1990s, and the proportion of “mandatory spending” is rising, calling for a conscious effort to restrain the spending growth. Expenditure Growth Source: Ministry of Finance and Economy.

-19- Challenges The extensive government lending activity appears to be playing a substitutive, rather than complementary, role to commercial banks. Direct support to private agents, including the government lending, should be scaled down to augment the complementarity. Loans by Financial Assets Commercial Banks / GDP

Public Sector Employment -20- Challenges On the other hand, the government should increase its efforts in the provision of basic public services such as public security, judicial services, promotion of competitive business practices, statistical services, and so on. Public Sector Employment