KIPF The contemporary needs of general and earmarked grants in Korea: Assessment Hyun-A Kim Korea Institute of Public Finance 2009 Copenhagen Seminar, Sept

KIPF Political decentralization Fiscal decentralization began again in 1991 with the appointment of council members, and established in1995 by the election of local representatives in Korea Hypothetically, in an electoral process, people articulate their demands by their voting preference Local representatives has to obtain voters’ preference Some empirical results : the relationship between election and fiscal expansion Introduction 2009 Copenhagen Seminar, Sept

KIPF Fiscal decentralization… Given the political, global and fiscal trends as well as other hosts of reason, local government’s role has to be expanded alongside the increase of its fiscal size. Intergovernmental fiscal transfers has steadily grown However, fiscal power of local governments has not symmetrically grown. Introduction 2009 Copenhagen Seminar, Sept

The budget size and expenditure share of general government KIPF Increasing local expenditure by using grants 2009 Copenhagen Seminar, Sept

Transfer to total government expenditure in 2005 KIPF Increasing local expenditure by using grants 2009 Copenhagen Seminar, Sept Source: OECD (2009)

Limited local tax share and low taxing power While the majority of expenditure are done at the local level, only very limited autonomy is available in local spending decisions. Local politicians tend to avoid increasing tax rate Flexible tax rate is not activated… This tendency exacerbate soft budget problem and lower taxing power. KIPF Limited local tax share and taxing power 2009 Copenhagen Seminar, Sept.17-18

The steady share of local tax KIPF Limited local tax share and taxing power 2009 Copenhagen Seminar, Sept.17-18

Revenue assignment Local revenue is composed of own source revenue such as local tax(33%), non tax revenue (29.7%), local bonds (2.7%) Intergovernmental fiscal transfer such as revenue sharing (LST, 20.9%) and National subsidy (13.8%) in 2007 Without non-tax revenue, the share of local taxes is around 50%. General and earmarked grants are 29.5% and 19.6% respectively KIPF Limited local tax share and taxing power 2009 Copenhagen Seminar, Sept.17-18

Revenue composition of local governments KIPF An overview of intergovernmental fiscal transfer 2009 Copenhagen Seminar, Sept.17-18

Types of grants in Korea KIPF An overview of intergovernmental fiscal transfer 2009 Copenhagen Seminar, Sept Grants Non- Earmarked Mandatory General grants (LST, DRS 2010) Earmarked Mandatory (SABND, LTF ) Discretionar y (NTS) Matching Non- matching Matching Non- matching

Local taxes and grants share KIPF Steady increase in local tax 2009 Copenhagen Seminar, Sept.17-18

Local Shared Tax Major fiscal equalization system by revenue sharing  a fixed percentage (19.24%) of Domestic National Tax The objective of ordinary LST is to equalize the fiscal capacities of local governments Notably, dependence of LST to local revenue has increased significantly from 15.0% in 2002 to 20.9% in % share of LST to GDP ( Japan 4%, Northern European countries 2-4% share…) KIPF Intergovernmental fiscal transfers 2009 Copenhagen Seminar, Sept.17-18

Decentralization Revenue Sharing From the perspective of grant design, DRS is an example of changing funding system Mainly, funding source of social welfare programs has been changed from specific to general grants (0.94% of National Domestic Tax) Central  local management and operation It is scheduled to return to LST in 2010 It is easily expected that under-provision of welfare spending since money is fungible under the general grants KIPF Intergovernmental fiscal transfers 2009 Copenhagen Seminar, Sept.17-18

Decentralization Revenue Sharing DRS programs are from NTS projects such as mainly social welfare related expenditure. The rationale of the implementation of DRS was the devolution of welfare provision from central and local governments Under the lower fiscal capacity and political incentive, the reduction of social service budget will happen Now, it is evaluated that DRS failed to be operated in its real sense KIPF Intergovernmental fiscal transfers 2009 Copenhagen Seminar, Sept.17-18

Local transfer fund KIPF Intergovernmental fiscal transfers 2009 Copenhagen Seminar, Sept Local transfer fund was introduced in 1991 as a conditional block grant Contribution : around 70% of the LTF is to be used for local road maintenance. Tax-sharing: the fund was transferred directly to local govts without first being accounted for in the central budget. Qualitatively, it was almost same with the NTS This was abolished in 2005  LST Earmarked  General way

National treasury subsidy National treasury subsidies are categorical grants provided by the central government to local governments for specific projects Social welfare and the increase of fiscal needs after local autonomy are the reasons of expanding NTS from 1995 to 2002  The reform of NTS in 2005 Finally, reliance on earmarked grants has been reduced from 22% in 2002 to 13.8% in KIPF Intergovernmental fiscal transfers 2009 Copenhagen Seminar, Sept.17-18

Special Account of Balanced National Grants Implementation of new formula to distribute for provincial bases : NTS  earmarked block grant The discretionary power of the line ministries had been reduced because nearly half of the SABND grants are formula based Fiscal flexibility in local government However, the three-year implementation evaluation did not manifest local efforts to promote high quality of public delivery KIPF Intergovernmental fiscal transfers 2009 Copenhagen Seminar, Sept.17-18

Political needs : Tax-sharing or general grants? With a long debate, new ‘tax-sharing’ way of revenue increasing in local govt. are determined by the Introduction of Local Consumption Tax and Local Income Tax For example, 20% of VAT  LCT Arguments : urban concentration of tax bases, qualitatively same with LST….. Despite of many problems, political meaning of LOCAL TAXES dominate rather than GRANTS…. KIPF Intergovernmental fiscal transfers 2009 Copenhagen Seminar, Sept.17-18

Reform of the specific grants: Comparison of transfers KIPF System change of intergovernmental fiscal transfers from 2005 Determination Method of Financial Resource Distribution Method among Regions LST, DRS Constant Portion of Domestic Tax Revenue Formula Based SABND 100% of Liquor tax Specific Transfer Other Fees Formula Based NTSDetermined Every Yearat discretion 2009 Copenhagen Seminar, Sept.17-18

Contrasting figure after 2000 (among 16 regions) KIPF Intergovernmental fiscal grants 2009 Copenhagen Seminar, Sept.17-18

Recent change turns to the way of general grants …. NTS  DRS  LST, NTS  SABND, LTF  LST Tax sharing or general grants : The introduction of Local Consumption Tax and Local Income Tax ‘Federalist approach’ : simple lump-sum transfers with no conditionality would be desirable Korea is one the leading countries to expand general grants for fiscal federalism Easy money dependency is getting bigger KIPF Intergovernmental fiscal transfers 2009 Copenhagen Seminar, Sept.17-18

Would this trend be desirable in Korea? This paper tends to focus more on the effectiveness of earmarked grants in Korea as a developing economy The reasons are following : 1) Korea is not a developed country, but in an immature stage in local autonomy 2) Soft budget relations between donor and recipient 3) Welfare expenditure needs rises KIPF Discussion 2009 Copenhagen Seminar, Sept.17-18

Soft-budget problem Intergovernmental risk sharing might be fundamental issue Soft budget relations between donor and recipient may exacerbate the effectiveness of grant purpose regardless of the choice of grants To smooth soft budget problem, tight linkage between marginal increase of revenue and their works should be done Now, local governments are not main providers of education, health, social services  to be the ultimate fiscal charger, expenditure assignment should be rearranged KIPF An assessment 2009 Copenhagen Seminar, Sept

Fundamental incentive effect in LST “Tax effort problem” : Intrinsically, local gvts have incentive to enlarge local needs while reduce local revenue The process of calculating the incentive revenue is not legally binding. The ambiguity leads local gvts. to believe that efforts to boost their tax revenue reduce the amount of the LST that they receive Accountability and responsibility of general grants? KIPF An assessment 2009 Copenhagen seminar, Sept

Welfare expenditure rises… Fiscal needs  Social welfare Intergovernmental welfare arrangement in function and money is the hottest issue Asymmetric information problem between central (revenue source) and sub-central (local information) governments is growing especially in welfare service program Under-provision of public good such as politically unattractive service (disabled supports, low income people…..) would happen KIPF An assessment 2009 Copenhagen Seminar, Sept.17-18

Composition of local expenditure between OECD and Korea KIPF Enlargement of social service in local expenditure 2009 Copenhagen Seminar, Sept

Per capita social expenditure in Seoul KIPF Enlargement of social service in local expenditure 2009 Copenhagen Seminar, Sept.17-18

Findings and policy suggestion Own purpose of grants is established from 2000, especially in earmarked grants. Soft budget issue and the introduction of tax- sharing with the same source of money seem to impede the justification of the increase of general grants. My conclusion : with these observations, the function of earmarked grants in comparison with general grants might be more suggestive in Korea. KIPF Conclusion 2009 Copenhagen Seminar, Sept.17-18