How Was Korea Successful in Protecting its Tax Base?
Korea’s tax structure was not fundamentally different from that of many other developing countries. Due to insufficient tax information and a large informal sector, its tax base was initially quite narrow. Nevertheless, Korea increased its tax-to-GDP ratio from around 12 percent in the early 1960s to nearly 25 percent—comparable to the level of advanced economies. How was this achieved?
First, Korea made extensive use of earmarking mechanisms that reduced taxpayer resistance. Linking specific revenues to specific expenditures was widely practiced throughout the budget system and proved particularly effective in mobilizing quasi-taxes such as charges, fees, levies, and contributions. Second, Korea expanded the rent-generating opportunities available to domestic conglomerates and successfully utilized the corporate income tax (CIT) as a major source of government revenue.
Tax Incentives and Tax Base Protection in Developing Countries
Joosung Jun
Draft paper prepared for Fourth High Level Dialogue on FINANCING FOR DEVELOPMENT in Asia and Pacific, United Nations ESCAP, Bangkok, April 28-29, 2017
Tax incentives have been widely used in developing countries to promote economic growth, though fiscal experts have critiqued their costeffectiveness for many years. In addition to foregone revenue, tax incentives can create distortions in resource allocation, complicate tax administration and increase the opportunities for corruption and rentseeking.
The empirical evidence on the benefits of tax incentives is very sparse and inconclusive. The question, then, is why governments have used such a seemingly ineffective and inefficient instrument, rather than offering regular budget expenditure to support a targeted activity. One immediate answer in the practical context of policymaking is that unlike budget expenditure, tax breaks do not require a new source of revenue to finance an activity. Tax revenue in developing countries is generally low and their governments operate a tight budget in financing infrastructure and public education. Instead of introducing a new spending item, governments may find it convenient to choose a tax expenditure that can even be heralded as a ‘tax cut.’
The Korean example is puzzling since the effects of tax incentives on marginal investment by local firms were estimated to be weak. If investment allowances and credits were not sufficiently effective, why did the Government keep these incentives in place? Political factors might well have worked to some extent considering the cosy relationship between large firms and the Government. On its own, this is not an adequate explanation for the continuity of tax incentives. It is hard to imagine that a country can make such remarkable economic progress while wasting valuable fiscal resources in such a way. Notably, tax revenue has steadily increased from 17 per cent of gross domestic product (GDP) in 1980 to the current 25 per cent in the Republic of Korea. This chapter suggests the possibility of an alternative route through which tax incentives may promote economic growth. That is, incentives can be used to support firms that pay more in taxes, and the increased revenue can be used to finance growth-promoting infrastructure. The Government of the Republic of Korea likely favoured local companies because they made a greater contribution to its revenue base than foreign investors.
The comparison of Singapore and the Republic of Korea implies that tax policy needs to be designed and evaluated based on country-specific factors. Among developing countries there can be large differences in economic and political structures, with different countries facing different constraints. Even among countries that pursue a growth-oriented tax policy, a tax structure that might be desirable for one could be undesirable for another. In the context of tax incentives, therefore, best practices based on optimal tax theory and the experience of advanced countries should be considered with caution for most developing countries. In countries with strong investment climates such as Hong Kong China and Singapore, investment incentives could be more effective as stressed in the literature. For most developing countries, however, it is a remote possibility to build infrastructure and human resources in a short period of time. Providing tax incentives then can be considered as a second-best option to attract foreign investment if appropriately designed around country-specific factors.
Korea’s Tax Structure: Directions for Reform
Roger Gordon (University of California, San Diego)
Joosung Jun (Ewha Womans University)
Korea Institute of Public Finance (KIPF), 2013
Considering the potential costs of reunification and the soaring retirement benefits for the rapidly aging population, Korea needs to reform its tax system with a specific aim to expand the revenue base. Since most taxes distort economic behavior and likely generate inefficiencies, any revenue raising efforts need to be undertaken carefully so as not to undermine economic growth.
This study notes that the current tax structure in Korea is very similar to that seen on average in less developed countries. Tax bases are narrow and personal income taxes play a less significant role, compared to most advanced countries. In addition, Korea has a relatively large size of the informal sector, around 26% of GDP. In such an environment, simply replicating tax systems in the advanced countries might not be the optimal choice.
While discussing various directions to reform the current tax structure in Korea, this study stresses the importance of shrinking the size of the informal sector and reducing the evasion rates in the formal sector. Such efforts could raise both revenue and efficiencies, a much needed recipe for Korea in which financing welfare expenditure without in the process hurting growth potential has become a keen policy priority. Various policy options are explored to encourage firms to shift into the formal sector and to reduce evasion in the formal sector.
Contents
1. Current Korean tax system
2. Conventional recommendations for tax reform
3. Policies that can reduce evasion and informal activity
4. Summary
How Was Korea Successful in Protecting its Tax Base?
Korea’s tax structure was not fundamentally different from that of many other developing countries. Due to insufficient tax information and a large informal sector, its tax base was initially quite narrow. Nevertheless, Korea increased its tax-to-GDP ratio from around 12 percent in the early 1960s to nearly 25 percent—comparable to the level of advanced economies. How was this achieved?
First, Korea made extensive use of earmarking mechanisms that reduced taxpayer resistance. Linking specific revenues to specific expenditures was widely practiced throughout the budget system and proved particularly effective in mobilizing quasi-taxes such as charges, fees, levies, and contributions. Second, Korea expanded the rent-generating opportunities available to domestic conglomerates and successfully utilized the corporate income tax (CIT) as a major source of government revenue.
Tax Incentives and Tax Base Protection in Developing Countries
Joosung Jun
Draft paper prepared for Fourth High Level Dialogue on FINANCING FOR DEVELOPMENT in Asia and Pacific, United Nations ESCAP, Bangkok, April 28-29, 2017
Tax incentives have been widely used in developing countries to promote economic growth, though fiscal experts have critiqued their costeffectiveness for many years. In addition to foregone revenue, tax incentives can create distortions in resource allocation, complicate tax administration and increase the opportunities for corruption and rentseeking.
The empirical evidence on the benefits of tax incentives is very sparse and inconclusive. The question, then, is why governments have used such a seemingly ineffective and inefficient instrument, rather than offering regular budget expenditure to support a targeted activity. One immediate answer in the practical context of policymaking is that unlike budget expenditure, tax breaks do not require a new source of revenue to finance an activity. Tax revenue in developing countries is generally low and their governments operate a tight budget in financing infrastructure and public education. Instead of introducing a new spending item, governments may find it convenient to choose a tax expenditure that can even be heralded as a ‘tax cut.’
The Korean example is puzzling since the effects of tax incentives on marginal investment by local firms were estimated to be weak. If investment allowances and credits were not sufficiently effective, why did the Government keep these incentives in place? Political factors might well have worked to some extent considering the cosy relationship between large firms and the Government. On its own, this is not an adequate explanation for the continuity of tax incentives. It is hard to imagine that a country can make such remarkable economic progress while wasting valuable fiscal resources in such a way. Notably, tax revenue has steadily increased from 17 per cent of gross domestic product (GDP) in 1980 to the current 25 per cent in the Republic of Korea. This chapter suggests the possibility of an alternative route through which tax incentives may promote economic growth. That is, incentives can be used to support firms that pay more in taxes, and the increased revenue can be used to finance growth-promoting infrastructure. The Government of the Republic of Korea likely favoured local companies because they made a greater contribution to its revenue base than foreign investors.
The comparison of Singapore and the Republic of Korea implies that tax policy needs to be designed and evaluated based on country-specific factors. Among developing countries there can be large differences in economic and political structures, with different countries facing different constraints. Even among countries that pursue a growth-oriented tax policy, a tax structure that might be desirable for one could be undesirable for another. In the context of tax incentives, therefore, best practices based on optimal tax theory and the experience of advanced countries should be considered with caution for most developing countries. In countries with strong investment climates such as Hong Kong China and Singapore, investment incentives could be more effective as stressed in the literature. For most developing countries, however, it is a remote possibility to build infrastructure and human resources in a short period of time. Providing tax incentives then can be considered as a second-best option to attract foreign investment if appropriately designed around country-specific factors.
Korea’s Tax Structure: Directions for Reform
Roger Gordon (University of California, San Diego)
Joosung Jun (Ewha Womans University)
Korea Institute of Public Finance (KIPF), 2013
Considering the potential costs of reunification and the soaring retirement benefits for the rapidly aging population, Korea needs to reform its tax system with a specific aim to expand the revenue base. Since most taxes distort economic behavior and likely generate inefficiencies, any revenue raising efforts need to be undertaken carefully so as not to undermine economic growth.
This study notes that the current tax structure in Korea is very similar to that seen on average in less developed countries. Tax bases are narrow and personal income taxes play a less significant role, compared to most advanced countries. In addition, Korea has a relatively large size of the informal sector, around 26% of GDP. In such an environment, simply replicating tax systems in the advanced countries might not be the optimal choice.
While discussing various directions to reform the current tax structure in Korea, this study stresses the importance of shrinking the size of the informal sector and reducing the evasion rates in the formal sector. Such efforts could raise both revenue and efficiencies, a much needed recipe for Korea in which financing welfare expenditure without in the process hurting growth potential has become a keen policy priority. Various policy options are explored to encourage firms to shift into the formal sector and to reduce evasion in the formal sector.
Contents
1. Current Korean tax system
2. Conventional recommendations for tax reform
3. Policies that can reduce evasion and informal activity
4. Summary