Economic Survey of Korea 2008: Reforming the Tax system to promote economic growth and cope with rapid population ageing

 

Contents | Executive summary  | How to obtain this publication | Additional information

The following OECD assessment and recommendations summarise chapter 3 of the Economic Survey of Korea published on 17 December 2008.

 

Contents                                                                                                                             

…and implement a comprehensive tax reform, which would boost revenue through consumption taxes in the longer term…

Government spending, currently one of the lowest in the OECD area as a share of GDP, is likely to rise significantly over the medium term, given the long-term spending pressures, thus requiring additional tax revenue. However, such increases will impose larger economic costs, underscoring the need for a comprehensive reform that sustains Korea’s growth potential, addresses rising income inequality and relative poverty and improves the local tax system. The most efficient way to boost revenue is through consumption taxes, which impose fewer distortions than direct taxes. Korea has considerable scope to hike its value-added tax (VAT) rate of 10%, which is well below the OECD average of 18%. At the same time, the base should be broadened by scaling back the scope of exemptions and the special treatment of small and medium-sized enterprises (SMEs). The complicated system of individual consumption taxes on 20 items should be simplified, in part as an effort to reduce the role of earmarked taxes, which account for 14% of tax revenue. Excises should be limited to products with negative health or environmental effects, such as tobacco, liquor and energy. In particular, greater use of environmentally-related taxes would increase efficiency.


Value-added taxes in OECD countries
 


1. VAT Revenue Ratio = (VAT revenue) / [(consumption expenditures – VAT revenue} * standard VAT rate]. The most recent year for which complete data are available is 2005.
Source: OECD (2008), Consumption Tax Trends, OECD, Paris.

 

…and a broadening of corporate and personal income tax bases

In addition, direct tax bases should be broadened. Cutting corporate tax expenditures, which remain large at about one-fifth of corporate tax receipts, would help to offset the revenue impact of the planned rate cuts, while reducing distortions in the allocation of investment. Introducing a tax expenditure budget, as planned in 2010, and enhancing transparency would help identify tax expenditures whose costs exceed their benefits. In addition, the low rate paid by SMEs does not appear to be effective in addressing the challenges faced by small firms and should therefore be phased out. The relatively minor role of personal income taxes – among the lowest in the OECD area at 4% of GDP – reflects large exemptions and deductions for employees aimed at levelling the playing field with the self-employed. Only half of wage income is taxed, well below the OECD average of 84%, and only half of employees pay income taxes. However, the proportion of self-employed paying income tax has risen from 40% to 63% over the past decade, suggesting scope to cut the exemptions and deductions granted to wage income, while avoiding increases in marginal rates.


International comparison of wage income subject to personal income tax
At the central government level in 2007

 

Source: OECD (2007), Taxing Wages 2006 2007, OECD, Paris.

 

The earned income tax credit should be the major tool to address rising income inequality and relative poverty

Increasing the share of workers paying income taxes would have a negative effect on income distribution and relative poverty, which has trended up during the past decade. By the mid-2000s, the rate of relative poverty – defined as a disposable income below 50% of the median – had risen to 15% in Korea, the seventh highest OECD-wide. In 2008, the government introduced an earned income tax credit (EITC), which is likely to boost employment by making work pay for low-skilled persons. However, the EITC will initially cover less than 2% of households. Expanding the credit, which could be financed by broadening the personal income tax base, requires further enhancing transparency about the income of the self-employed. In addition, taxing fringe benefits as individual income would improve equity.


International comparison of relative poverty¹
 

1. Poverty rates are defined as the share of individuals with equivalised disposable income below 50% of the median for the entire population.
2. In percentage points. In Korea, taxes and transfers reduced the relative poverty rate from 17.5% to 14.6%.
Source: OECD (2008).


Local property taxes can enhance local government autonomy

The Comprehensive Property Tax (CPT), a highly progressive nationwide tax on property that is paid by 2% of households, aims at redistributing income and stabilising house prices. Its introduction in 2005 was accompanied by a scaling back of the local property tax. However, local governments’ tax powers should instead be expanded to allow them to better respond to the preferences of local citizens and help ensure fiscal discipline by making the cost of local services more visible. Property taxes are well-suited for local governments as they are visible, impose discipline on the quality of services and are relatively resistant to tax-base flight. The government should, therefore, follow through on its plan to scale back the CPT by raising the threshold at which it applies and reducing the tax rates, as a first step toward merging it with the local property tax. Greater reliance on local property holding taxes would enhance local government autonomy and facilitate a streamlining of the complicated local tax system, which includes 16 different taxes and thus raises compliance costs. In particular, the heavy reliance on property transaction taxes, which have lock-in effects that reduce the supply of housing, should be reduced.


Direct tax rates should be kept low to sustain output growth

A comprehensive tax reform, which relies primarily on consumption taxes for additional revenue, the EITC for income redistribution and property-holding taxes for local government, would limit the rates of direct taxes, thus promoting growth. OECD experience shows that taxes on personal and corporate income tend to reduce saving and investment, labour supply and demand, inflows of foreign direct investment (FDI), entrepreneurship and education. The government’s reforms to reduce direct taxes are in line with international trends and will help support competitiveness. The planned cut in the corporate tax rate should be accompanied by a reduction in quasi-taxes, which include a wide range of administrative fees and user charges, as well as a number of contributions that tend to be levied on firms in a discretionary and non-transparent manner.
 

How to obtain this publication                                                                                        

The Policy Brief (pdf format) can be downloaded in English. A Korean version is also available (pdf format). It contains the OECD assessment and recommendations.The complete edition of the Economic survey of Korea 2008 is available from:

 

Additional information                                                                                                  

 

For further information please contact the Korea Desk at the OECD Economics Department at eco.survey@oecd.org.  The OECD Secretariat's report was prepared by Randall S. Jones and Masahiko Tsutsumi under the supervision of Vincent Koen. Research assistance was provided by Lutécia Daniel.

 

 

 

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