The Fiscal Burden of KoreanReunification

A Generational Accounting Approach- Alan J. Auerbach, Young Jun Chun, and Ilho Yoo,

2004.

Presentation byKatrina Schemainda, Alica Linke, Leonie Nonnast, Daniel Linden, Katarina Fröhlich

Introduction

● many koreans want North and South Korea tobe reunified again

● reunification will have many effects on thecountry and its people

● important factor: financial consequences

● costs of a reunification will be a burden forKorean future generations

2. Generational Accounting Calculation Method

reflects on taxes and socialinsurance contributions (=”taxes“)

2.1 The Standard Method calculated in 2 steps:

1) calculation of the next tax payments of current generations on the basis of current fiscal rules

2) collective payment, measured as a time present value, required of future generations determined by the governmentbudget

the lifetime net tax payments of future generations are directlycomparable with those of current newborns

the computation of the total net payment across generationsrequires information about average tax burdens and transferpayments by age and sex

assumes that the age-sex profiles of transfer payments and taxburdens do not change over time

assumes that purchases, transfer payments, and tax revenuesgrow at the same rate as GDP [=Gross Domestic Product]

2.2 Extending the Standard Method 2 sets of prospective changes:

1) present in South Korea even without reunification2) relates to changes associated with reunification

the maturation of the National Pension System (NPS) will change theage profiles and aggregate levels of benefits and contributions in South Korea

average NPS benefit per member: 70+ y/o > 55-70 y/o changes in social welfare expenditures will increase more rapidly than other components of government

expenditure the participation of North Korean residents, whose average income

is currently less than 10% of that of South Koreans, will lower the flat part of the NPS benefit

the Minimum Living Standard Security (MLSS) benefit will initiallyapply to many more North Korean residents under current rules

Calculation Procedure and UnderlyingAssumptions

• Required projections of:– population

– taxes

– transfers

– government expenditures

– initial government debt

– discount rate

– Age-sex profiles of average income of NK

Calculation Procedure and UnderlyingAssumptions

• Current fiscal policies of NK ignored

• Assumption: NK policies will be repealed

• Current fiscal policies in SK might beimplanted in NK after reunification

Current fiscal policies in SK

• Social welfare policies (public pensions (NPS), medical insurance (MI), employmentinsurance (EI), minimum living standardssecurity system (MLSS), …)

• Tax system (labor income taxes, capitalincome taxes, consumption taxes, …)

• Seigniorage

• Government consumption (expenditure on education, …)

Population Projection (NK)

• No projections of the future NK population published use information about base-year age-sex distributions, death rates and fertility rates

• Baseline year 1993 NK government reportavailable

• Assume that fertility rates (2.16>1.67(SK)) maintained until reunification

• After reunification approach those of SK followingthe same path as SK since 1983

Projection on Average Income Profile (North Korea)

• Projection of the Bank of Korea: labor productivity of NK about 11% of SK (1993)

• Labor productivity growth:

• I (1994-2001)

• II (2002-reunification): ~1% p.a. assumed

• III (stagnation 5 years)

• IV (rapid growth 45 years): up to the level of SK

• V (balanced growth): same rate as SK

• Unemployment rate:

• III: ~20% skills of many NK obsolete after reunification

• IV: gradual decrease to current rate in SK (3%)

Policy Experiments and SensitivityAnalysis

• Situation a: MLSS benefit reduction: government sets a upper limitfor North Koreans = prevent a rapid increase in MLSS expenditures substantial impact on the fiscal burden

• Situation b: EI benefit reduction: EI expenditure does not dependon the unemployment rate (unemployed are covered by the MLSS system) smaller impact than that of MLSS

• Situation c: Seperate operation of NPS: seperate NPS systems in thetwo Korean regions = prevent a decrease in the benefit levels ofSouth Koreans small impact

• Situation d: Reconstruction cost incurred by the government is 10 % of GDP for 20 years after the reunification substantially increaes fiscal burdens

Policy Experiments and SensitivityAnalysis

• Base case:

– Generational imbalance is

• Increasing in the interest rate

• Decreasing in the growth rate

– In 50 years complete convergence between thetwo Koreas (optimistic assumption) lower speed of convergence = increasegenerational imbalance and the fiscal burden

Comparison with the Case of German Reunification

• Fiscal burden: Korea (generational imbalance for the base case: 897.3%) > Germany (generational imbalance for the base case: 156.1%)

• Tax adjustment: Korea (50.5% increase) > Germany (9.5% increase)

• Difference in the reunification cost = differences in theproductivity gap (NK 8% of SK productivity level < EG 37% of WG level)+ relative population magnitudes (population ratio of NK to SK: 47% > EG to WG: 26%) Korea: longer transition period for complete convergence

• Declining fiscal situation = greater generational imbalance

Conclusion

● Result of reunification: increase in fiscal burdenfor current and future generations in South-Korea

● Korean reunification compared to German reunification: even more costs for SK due togreat differences in productivity rate etc.

● Consideration of financial aspects beforereunification important

● Reform of fiscal policies in South-Korea torestore fiscal balance

Thank you for your attention