1. Reforming the Fiscal Management System in Korea June 2005 Youngsun Koh Korea Development Institute

2. -2--2- b Traditionally, three roles are assigned to fiscal policy: Reallocating the resources in the economy by providing public goods in the hope of correcting market failures.Reallocating the resources in the economy by providing 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.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.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 cyclical fluctuations. –Fiscal policy can contribute to a stable, long-term growth and low inflation by maintaining sound budgetary positions and limiting the rise in public debt. The Role of Fiscal Policy

3. -3--3- Budget Surplus/Deficit Korea OECD Note: Consolidated central government. Note: General government. Source: Ministry of Finance and Economy. Source: OECD. Budget Balance Fiscal consolidation in the early 1980s restored the budget balance to a sustainable path.

4. -4--4- Note: Real values were obtained by deflating nominal values with GDP deflator. Source: Ministry of Finance and Economy. Growth of Real Expenditure and Revenue Spending Growth Fiscal consolidation in the 1980s took the form of expenditure restraint rather than revenue increase.

5. -5--5- Government Liabilities Government Liabilities Korea OECD Note: Central government. Note: General government, at the end of 2003. Source: Ministry of Finance and Economy. Source: OECD. The debt-to-GDP ratio declined steadily since the early 1980s but increased rapidly after the crisis.

6. -6--6- Debt / GDP Ratio Sources: 1953-90, Korea Development Institute; 1991-2003, Ministry of Planning and Budget. During the early days of government-led economic growth, foreign borrowings played a crucial role in providing the resources for public and private investment. Government Liabilities

7. -7--7- Source: Ministry of Finance and Economy. Central Government Spending and Revenue Size of Spending Expenditure and net lending as % of GDP declined throughout the 1980s and then rose in the 1990s.

8. -8--8- Source: OECD General Government Expenditures The total government spending corresponded to 23.0% of GDP, much lower than in other countries. Size of Spending

9. -9--9- 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

10. -10- Source: Ministry of Finance and Economy. 1970198019902000 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 15.3 5.3 0.8 25.2 16.2 Trends of Expenditure and Net Lending Economic affairs has taken the largest share in total spending. The spending on social protection is on the rise after the recent crisis. Sectoral Allocation of Spending (% of total expenditure and net lending) 2003 6.7 11.4 5.3 15.0 0.4 13.5 5.0 0.8 28.7 12.8

11. -11- Spending on Economic Affairs Spending on economic affairs corresponds to 6% of GDP, far higher than those in advanced countries. Note : Central government for Korea and general government for others. Source : IMF. 0 1 2 3 4 5 6 7 USGermanyFranceUKCanadaKorea (% of GDP) Other economic Affairs Transportation and communication Mining, manufacturing, and construction Agriculture and fisheries Fuel and energy Spending on Economic Affairs

12. -12- Government Lending Outstanding Stock of Loans Note: Net lending = new loans - repayments. Sources: Ministry of Finance and Economy. Government Lending The spending on economic affairs often takes the form of lending.

13. -13- Coping with the Crisis of 1997 During 1998-2002, the government made loans to the Korea Deposit Insurance Corporation (KDIC) and the 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 would be repaid by the 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.

14. -14- b Overall, fiscal policy in Korea has carried out its roles rather successfully: Resource allocation: The emphasis was placed on promoting the economic growth with large spending on education, infrastructure, and other public goods.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.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.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. Assessment

15. -15- Source: Bank of Korea. Output Growth and Inflation 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.

16. -16- Sources: National Statistical Office; Hyun (2003) and Yoo (2004). Assessment Korea is also known as a country with a relatively equitable distribution of income, even though the inequality rose significantly after the crisis. Labor Market Indicators Gini Coefficient

17. -17- b Containing the spending growth Revenue growth is expected to fall in line with output growth.Revenue growth is expected to fall in line with output growth. Spending is on a rising trend due in large part to the increasing welfare spending, especially on pension and health.Spending is on a rising trend due in large part to the increasing welfare spending, especially on pension and health. b Redefining the role of government Reducing the direct support to businesses.Reducing the direct support to businesses. Expanding basic public services such as judicial services, promotion of competitive business practices, statistical services.Expanding basic public services such as judicial services, promotion of competitive business practices, statistical services. b Enhancing the efficiency of spending Promoting the autonomy and accountability of line ministries.Promoting the autonomy and accountability of line ministries. Greater focus on outputs and outcomes.Greater focus on outputs and outcomes. Challenges

18. -18- Revenue sources: general-purpose taxes and non-tax revenues.Revenue sources: general-purpose taxes and non-tax revenues. Carry-over: not allowed in principle.Carry-over: not allowed in principle. Asset holding: not allowed.Asset holding: not allowed. Managed through the treasury single account.Managed through the treasury single account. Revenue sources: ear-marked taxes, levies, and other revenues.Revenue sources: ear-marked taxes, levies, and other revenues. Example: Transportation Infrastructure Special Account.Example: Transportation Infrastructure Special Account. Carry-over: not allowed in principle.Carry-over: not allowed in principle. Asset holding: allowed.Asset holding: allowed. Managed through the treasury single account.Managed through the treasury single account. Revenue sources: ear-marked taxes, levies, and other revenues.Revenue sources: ear-marked taxes, levies, and other revenues. Example: National Pension Fund.Example: National Pension Fund. Carry-over and asset holding: allowed.Carry-over and asset holding: allowed. Can change spending up to 30% without approval from MPB and the National Assembly.Can change spending up to 30% without approval from MPB and the National Assembly. Managed independently by line ministries.Managed independently by line ministries. Complicated Budget Structure Generalaccount(1)Generalaccount(1) Specialaccount(23)Specialaccount(23) Publicfunds(57)Publicfunds(57)

19. -19- b Public funds Previously, public funds were off-budget; they did not need to go through the approval process of the National Assembly.Previously, public funds were off-budget; they did not need to go through the approval process of the National Assembly. Now the same approval process is applied to public funds as to the general and special accounts.Now the same approval process is applied to public funds as to the general and special accounts. The revised Basic Law on Public Fund Management mandates MPB to examine the raison d’etre of individual funds every 3 years and to recommend their abolition or consolidation when needed.The revised Basic Law on Public Fund Management mandates MPB to examine the raison d’etre of individual funds every 3 years and to recommend their abolition or consolidation when needed. –The first such exercise was carried out last year. b Special accounts The government is currently preparing a plan to restructure and streamline special accounts and public funds.The government is currently preparing a plan to restructure and streamline special accounts and public funds. Reforming the Budget Structure

20. -20- b Presidential system of government b Ministry of Planning and Budget (MPB) –Prepares the budget and tables it on the National Assembly. b Ministry of Finance and Economy (MOFE) Treasury BureauTreasury Bureau –Releases cash to spending ministries. –Issues treasury bonds and manages assets and liabilities. Tax and Customs OfficeTax and Customs Office –In charge of tax policy and revenue forecasts. b Board of Audit and Inspection (BAI) –The supreme audit institution in Korea, reporting to the president. b National Assembly b Line ministries Major Players in the Budget Process

21. -21- b Strategic dominance-based approach (von Hagen and Harden, 1996) The MPB has a clear upper hand vis-à-vis line ministries in budget negotiations.The MPB has a clear upper hand vis-à-vis line ministries in budget negotiations. The National Assembly is prohibited from increasing the total spending or introducing new spending items without consent from the government.The National Assembly is prohibited from increasing the total spending or introducing new spending items without consent from the government. Strict cash limits are imposed on ministerial spending by the MOFE.Strict cash limits are imposed on ministerial spending by the MOFE. The BAI performs both financial auditing and regularity check of ministerial activities.The BAI performs both financial auditing and regularity check of ministerial activities. Highly Centralized Budget Process BudgetpreparationandfinalizationBudgetpreparationandfinalization ExecutionExecution Ex post control

22. -22- b The MPB devoid of policy coordination function (1970s and 1980s) (Early 1990s) (Late 1990s to this day) b Democratization of the Korean politics The balance of power tipping toward the legislatureThe balance of power tipping toward the legislature b Increased public demand for active fiscal policy to boost the economy More supplementary budgets introduced during a yearMore supplementary budgets introduced during a year Front-loading of annual spendingFront-loading of annual spending  Transition toward a target-based approach being called for Signs of Weakened Fiscal Discipline Economic Planning Board (EPB) Economic Planning Board (EPB) Ministry of Finance (MOF) (MOF) Ministry of Planning and Budget (MPB) Ministry of Planning and Budget (MPB) Ministry of Finance and Economy (MOFE) Ministry of Finance and Economy (MOFE) Ministry of Finance and Economy (MOFE) Ministry of Finance and Economy (MOFE)

23. -23- Introducing an MTEF PlanninghorizonPlanninghorizon Next single budget year Next single budget year 3-5 years in the future 3-5 years in the future BalancedbudgetBalancedbudget Each year On average over the business cycle On average over the business cycle BudgetallocationBudgetallocationBottom-upBottom-up Top-downTop-down Focus of control controlInputsInputs Outputs and outcomes outcomes AttentionAttentionGeneralaccountGeneralaccount All accounts and funds All accounts and funds b MTEF (medium-term expenditure framework) Preparing annual budgets with a medium-term perspective in a top-down way Introduced in Korean in 2004 with the publication of the National Fiscal Management Plan (2004-2008)

24. -24- Cons Better able to cope with the trend increase in spending, especially when annual spending ceilings are set up and observed over the medium term (a target-based approach).Better able to cope with the trend increase in spending, especially when annual spending ceilings are set up and observed over the medium term (a target-based approach). Stronger linkage between policy-making and budgeting.Stronger linkage between policy-making and budgeting. Full operation of the automatic stabilizer.Full operation of the automatic stabilizer. Greater autonomy in line ministries.Greater autonomy in line ministries. Spending projections becoming “entitlements” for line ministries.Spending projections becoming “entitlements” for line ministries. Deficit bias when macro-forecasts are overly optimistic.Deficit bias when macro-forecasts are overly optimistic. Greater room for waste, fraud, and abuse in line ministries.Greater room for waste, fraud, and abuse in line ministries. Pros and Cons of MTEF Pros

25. -25- Improving the MTEF –Performance management to be strengthened and the capacity for planning and prioritizing to be improved in line ministries. –The capacity for policy analysis and macro-forecasts to be enhanced in the MPB. –The medium-term targets in the MTEF to be clarified and the annual operational targets to be set out. –Various risk analysis to be introduced. –A mechanism for “baseline” projections to be established. –A reconciliation process to analyze the difference between projections on fiscal aggregates and outturns to be established. –Internal auditing to be strengthened. –“Program budgeting” to be introduced.

26. -26- Diverse Initiatives for Performance Management PerformanceAudit(BAI) PerformanceManagement PerformanceManagementSystem(MPB) GovernmentOperationsAssessmentSystem(OGPC) Self-Assessment of Spending Programs(MPB) Management by Objectives (MOGAHA)

27. -27- Adopting the framework in the Government Performance and Results Act (GPRA) of the U.S. federal government. Requires line ministries to set up performance goals and indicators for major spending programs, and prepare annual performance plans and reports. Has not been very successful. Assesses the performance and organizational capacity of ministries and citizen satisfaction with them. Relies mostly on the subjective assessment by outside experts and in-house staff. Assessment results are reported to the President in biannual cabinet meetings. From 2005 on,line ministries should establish performance indicators and announce target levels in annual business plans. PerformanceManagementSystem(MPB) GovernmentOperationsAssessmentSystem(OGPC)

28. -28- Designed after PART (Program Assessment Rating Tool) of the U.S. federal government. Requires line ministries to assess their own programs with spending levels above a certain threshold over a cycle of 3 years. The assessment is based on a series of questions asking the appropriateness of program design, program management, and performance assessment and feedback. MPB reviews the assessment results and takes them into account in budgeting. Sets annual performance targets for civil servants and reflects the results on their pay and promotion. Self-Assessment of Spending Programs(MPB) Management by Objectives (MOGAHA)

29. -29- –Consolidating diverse initiatives into an integrated system of performance management. –Establishing a sound system of planning and reporting. –Emphasis on program evaluation. –Introducing a program structure in budget accounts. –Greater use of performance contracts. Improving Performance Management

30. -30- b Works are underway to: Redefine the scope of “general government.”Redefine the scope of “general government.” Introduce accrual accounting in financial reports.Introduce accrual accounting in financial reports. –For now, budgeting in contrast to financial reporting will continue to be based on cash accounting in the foreseeable future. Redesign the IT system to accommodate the changes mentioned above.Redesign the IT system to accommodate the changes mentioned above. b Budget and Accounting Reinvention Office (BARO) was formed to tackle these issues in addition to the introduction of program budgeting. BARO members consist of secondees from MPB, MOFE, BAI, etc.BARO members consist of secondees from MPB, MOFE, BAI, etc. Other Reform Efforts

31. -31- b Many efforts to modernize the fiscal management system after the crisis of 1997. The government began the reform process on their own initiatives.The government began the reform process on their own initiatives. b Major points To Summarize.. Streamlining the budget structure Introducing the MTEF Strengthening performance management Redefining the scope of government Introducing accrual accounting Streamlining the budget structure Introducing the MTEF Strengthening performance management Redefining the scope of government Introducing accrual accounting Aggregate fiscal discipline Transparency Allocative and technical efficiency