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KDI warns against expansionary fiscal policy

Nov 28,2017

The Korea Development Institute, a government-funded think tank, pushed back against the International Monetary Fund’s recommendation that Korea adopt more aggressive expansionary fiscal policy, warning of deficits from increased government spending in a report on Monday.

The institute noted that the country’s maximum fiscal space, or flexibility in government spending, is 225 percent of gross domestic product. That means the government would be capable of repaying its debt even if it spends double the amount of current GDP, about 1,600 trillion won ($1.5 trillion), through various means like raising taxes.

But if spending exceeds that level, the government risks defaulting on its bonds and won’t be able to pay back the interest much less the principal. Currently, Korea’s national debt is 40 percent of gross domestic product.

In 2010, the International Monetary Fund estimated Korea’s fiscal space was 203 percent of GDP, while Moody’s put it at 241 percent.

Both groups proposed that the Korean government adopt an expansionary fiscal policy, while Moody’s considered Korea among countries like Norway and Australia, which have some of the best fiscal soundness in the world.

Necmettin Tarhan Feyzioglu, the International Monetary Fund’s mission chief in Korea, said during a press conference in Seoul earlier this month after evaluating the country’s macroeconomic data for two weeks, advised a “more significantly expansionary” fiscal policy.

Feyzioglu noted that Korea’s debt-to-GDP ratio was relatively lower than other countries’ and said Korea should aggressively push forward with structural reforms in the economy.

However, the Korea Development Institute said that while Korea’s fiscal situation is relatively sound, if the national debt reaches the maximum fiscal space, the government will have no choice but to raise income taxes an additional 25 percentage points to pay off its debts.

Under the current level of national debt - 40 percent of GDP - 5 percent of collected tax revenue goes toward bond payments.

But if spending exceeds maximum fiscal space, the figure could surge to 24 percent, and as a result of higher taxation, overall production, consumption and investment will all fall, the report said.

Production will drop 22.6 percent a year after raising taxes and 29.6 percent in the long run, according to the Korea Development Institute, while consumption will shrink 19.9 percent a year after and 25 percent in the long term, while investment will fall 23.2 percent.

The Korea Development Institute also warned that demographic changes threaten to shrink the government’s fiscal space. Korea’s rapidly aging society will demand more government welfare spending, even as the economy continues to slow, according to the report.

In the government’s record-breaking 429 trillion won budget for next year, 146.2 trillion won has been set aside for health, welfare and labor benefits, making it the biggest category of spending. The amount is 13 percent higher than this year’s budget and represents the sharpest rise.

The Korea Development Institute determined that if economic growth falls 2 percentage points from the current level, fiscal space will fall to 179 percent of GDP.

And if the government’s total welfare spending, including subsidies for small businesses, multiples 1.5 times beyond the current level, fiscal space will fall further to 60 percent of GDP.

“A rapid increase in welfare spending will speed up the further decline of fiscal space,” said Lee Tae-suck, a researcher at the Korea Development Institute.

BY LEE HO-JEONG [lee.hojeong@joongang.co.kr]