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Lessons from Southern Europe
The administration’s strategies to head off sovereign debt crises raise questions
Lessons from Southern Europe
  • By matthew
  • August 13, 2010, 14:39
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Top Korean policymakers gathered for a meeting on financial strategy that took place on May 9, to discuss the soundness of the nation’s currently expansive fiscal policy instituted after the global financial crisis. At the meeting, President Lee Myung-bak made it clear that sound fiscal policy is high on his agenda. “We must pay attention to fiscal health,” he emphasized repeatedly.

The focus of this meeting was state policy concerning the ratio of state debt to its gross domestic product (GDP), the main index for fiscal health. The key point of the policy is to take this ratio, which stood at 33.8 percent at the end of last year, and passing through a transitional period of 35 percent (2010 to 2012) eventually reducing it to 33 percent by 2013. Moreover, the ratio of budget deficit to GDP is also slated to be lowered an additional 0.2 percent each year, thereby turning the tide into a surplus after 2014. Last year’s national budget balance clocked at 17.6 trillion won in the red, or 1.7 percent in proportion to GDP.

There are many ways to achieve fiscal health - in the meeting, reasonable increases in tax revenue were chosen over excessive tax reduction, provided that the administration operates within the basic framework of increasing tax revenue and managing moderate levels of expenditure. There was also a decision to adopt a ‘fiscal bottom line,’ where levels of acceptable sovereign debt and budget deficits would be assigned beforehand. The pivotal point of this decision is keeping the rate of increase for government spending about 2 to 3 percent below that of import costs. This is a definite change of pace from the past four years, in which the national debt grew at breakneck speed in part because of large-scale public works intended to stimulate the economy.

To achieve this, the government has resolved to cut discretionary expenditures, such as short-term and redundant public works, plus unnecessary tax exemption policies. “Short-term governmental projects, initially adopted to overcome the global financial crisis, will be drastically reduced this year,” said Lee Yong-gul, a senior official of the Ministry of Finance and Economy. “Extensive restructuring of discretionary expenditures is needed.”

Because the administration has decided that the need for welfare expansion leaves cutting expenditure out of the question, it will focus on securing more tax revenues. Some strategies include the development of hidden tax sources, such as mandatory issuing of electronic tax invoices between corporations at the production or distribution stage.

In addition, rigorous, compulsory tax audits for specialized professions or those of high income plus the wholesale eradication of short-term policies such as temporary investment tax credits are being considered.

However, whether such policy changes will strengthen fiscal health is in dispute. There is general consensus on the need for sound fiscal health, but none on how to achieve it. The biggest conundrum, many experts agree, is in the alarming rate of increase in budget deficit. “The problem is not the ratio of national debt to GDP or that of fiscal deficit - it’s the fact that the rate of debt increase is so steep,” said Hong Gi-taek, professor of economics at Joongang University. “The existing structure is such that if there are no new sources of tax revenue, the fiscal health will succumb to rising debt and deteriorate.”

Another opinion is that the tax reduction stance of the current government must change in order to reinforce fiscal health. “It might fit the bill of ‘small government,’ but as long as areas such as service reform, R&D and welfare gain importance, expanding taxation is inevitable,” said Lee Young, professor of economics and finance at Hanyang University.