Chapter 1. Economic Implications of Unifying the Korean Peninsula

1. Purpose and Rationale of the Research
❑ As the unification of the Korean Peninsula, our national aspiration, is regarded as an opportunity to strengthen our global position with a bigger economy, the economic benefits of bringing together the North and the South are actively being discussed. 
    ◦ In the aftermath of the German unification, research on the potential unification of two Koreas focused mainly on its cost implications, which ended up spreading negative perceptions among the public. 
    ◦ But unification can actually revitalize the South Korean economy which is suffering from a protracted low growth stemming from structural reasons. 
❑ As a preliminary step toward unification, it is necessary to change the public perception and build consensus on unifying the Korean peninsula by highlighting the benefits that we can get from a peaceful unification backed by a solid trust between the North and the South.
    ◦ Unification by absorption can invite not just political problems but also a huge economic burden which is hard to bear.
    ◦ As a way to minimize the economic and fiscal impact while maximizing the benefits of unification, it is suggested to manage the northern region separately after unification.  
❑ Under the assumption that we make the best use of  the low cost labor and the high efficiency on investment in North Korea, this report analyzes the cost and benefits of unification from an economic perspective and assesses its impact on public finances.
    ◦ Due to the economic and income gap between the North and the South, unification would put pressure on the economy and public finances of a unified Korea.
    ◦ The report analyzes the impact on public finances such as the debt level of the government by estimating the tax revenue based on the cost-benefit analysis of the unification. 

2. Assumptions of the Analysis
❑ Under the assumption that the two Koreas are united peacefully in 2015, the report forecasts key macroeconomic indicators such as GDP (which shows a consolidated impact of the unification on the economy), estimates the unification cost by item and analyzes its impact on public finances.
    ◦ The reason why the report chose 2015 as the year of unification is because it wanted to use currently available data to estimate the economic costs and benefits of unification. 
    ◦ As the benefits of unification will be broad-based and diverse, the report used and estimated GDP as an indicator of the ultimate impact of unification.
❑ The analysis targets 45 years from 2016 to 2060.
    ◦ It is important to analyze the fiscal conditions of South Korea as it has to provide a substantial amount of economic resources until the North Korean economy is normalized, let alone the long-term fiscal aspect of the unified Korea.
    ◦ The reason why the analysis looks into a long horizon is to mitigate the impact from timing differences between the economic benefits and the cost of unification.

3. Economic Benefits of Unification
A. North Korea Macroeconomic Forecast Methodology & Assumptions
❑ The report estimated  economic growth and major macroeconomic indicators of the North with a growth accounting model which is based on the aggregate production function.
    ◦ The growth accounting model is widely used in development economics as an alternative to DSGE or CGE which are based on simple and unrealistic assumptions (e.g. they assume perfect competition even when they analyze the North Korean market) and may end up producing random results.
    ◦ To analyze the growth path of North Korea, it also referred to other countries such as: South Korea and Taiwan (East Asian countries which have experienced rapid growth and share some characteristics with North Korea); China and Vietnam (those that have experienced a regime change); and post-unification eastern Germany.
    ◦ By calculating the ratio of gross saving to gross domestic investment based on the growth forecast derived above, the report estimated investment demand from outside of North Korea (e.g. South Korea, overseas borrowing and FDI).
❑ It assumed that 1% of South Korean GDP will be invested to build and develop social infrastructure in North Korea and that there will be a 1% gain in productivity after unification.  
    ◦ For the first twenty years after unification (2016-2035), South Korea would invest 1% of GDP in the North each year and then phase out its investment at an annual rate of 0.1% for the following ten years (2036-2045).
    ◦ It assumed 1% growth in productivity each year thanks to the use of a common language and the transfer of technology and socioeconomic systems from the South to the North.

B. Results of the Forecast
❑ GDP of the northern Korea is expected to grow at an average annual rate of 9.0% from KRW 29.7 trn in 2016 to KRW 1,211.3 trn in 2060.
    ◦ The ratio of the northern GDP vs. the southern GDP will surge from 2.3% in 2016 (GDP of the South: KRW 1,268.0 trn) to 39.0% in 2060 (GDP of the South: KRW 3,107.5 trn).
❑ Between 2016 and 2060, per capital GDP will increase from KRW 1.19 mn to KRW 47.02 mn and the ratio against southern Korea will surge from 4.8% to 66.55%. This gap between the North and the South in 2060 is at a similar level to the one observed in 2012 among the different regions of South Korea.
    ◦ In 2012, Jeonnam showed the lowest per capital income (or KRW 12.49 mn), which is around 68.2% of Ulsan (KRW 18.31 mn).
❑ Macroeconomic indicators, used to estimate unification cost, are forecast to have the following values.
    ◦ Employment to grow from 54% in 2016 to 60% in 2030 and 64% in 2060
    ◦ Average annual salary to grow from KRW 1.66 mn in 2016 to KRW 3.08 mn in 2020, KRW 6.99 mn in 2030 and KRW 51.65 mn in 2060.
    ◦ The ratio of gross saving to gross domestic investment of the North to increase from 59.3% in 2016, to 70.3% in 2020, 80% in 2024 and 90% in 2029 and finally reach 100% in 2036.

❑ GDP of a unified Korea is expected to grow at 2.8% annually from KRW 1,318 trn in 2016 to KRW 4,320 trn in 2060
    ◦ The figures above were derived based on the combination of the long-term trend line of the South, post-unification GDP of northern Korea and its impact on the South.

C. Post-Unification Development of the North & Its Impact on the South
❑ Based on an input-output model, the report analyzed the effects of post-unification fiscal support and investment in the North by the South on its production, added value and employment.
    ◦ It used an input-output table at current price for the 2007-2011 period.
❑ It is forecast to boost production in South Korea by KRW 3,650 trn (KRW 81 trn annually) and create added value worth KRW 1,683 trn (KRW 37.4 trn annually).
    ◦ It means creating an additional 1% added value annually compared to the long-term GDP trend line (0.4% by investment in the North & 0.6% by fiscal support).
    ◦ Although it is estimated to grow from KRW 26 trn in 2016 to KRW 65 trn in 2036, the ratio against the long-term GDP trend line would shrink from 1.65% in 2016 to 1.5% in 2036 and to less than 1% in 2042 and 0.03% in 2060.
❑ It is estimated to create 29.53 million jobs (656,000 annually), or 25.32 million (563,000 annually) if only salaried employees are counted.
    ◦ On annual average, the number of workers would be 2.4% higher than the long-term trend line and the employment rate would be 1.5% higher. 

4. Unification Cost
A. Unification Cost Estimation Methodology
❑ Unification cost is classified under five categories (social security, administration, education, investment and discretionary) and is estimated as either mandatory or discretionary depending on its nature.
    ◦ Social Security: mandatory cost to pay for the national basic livelihood security, four major social insurance plans (i.e. national pension scheme, national health insurance, employment insurance and worker’s compensation insurance), basic pension, etc.
    ◦ Administration and Education: labor cost for central and local government officials and teachers.
    ◦ Investment: capital spending to build social infrastructure and other facilities that are necessary to develop the northern region.
    ◦ Other Discretionary Spending: SOC repair & maintenance expense, cost of education to resolve social and cultural differences, and other discretionary spending which is either impossible to estimate or excluded from estimation.

B. Results of the Estimation
❑ Over the period from 2016 to 2060, unification is estimated to cost KRW 10.428 quadrillion at nominal price (KRW 4,657 trn in real terms), or KRW 232 trillion annually (KRW 103 trn in real terms).
    ◦ It would take KRW 68 trn (KRW 53 trn in real terms) in 2016 and peak at KRW 357.2 trn (KRW 127 trn in real terms) in 2056 and then decrease to KRW 339.9 trn (KRW 115.8 trn in real terms) in 2060.
❑ Unification cost as % of the annual GDP would average 3.9%. By year, it is estimated to climb for the first twenty years from 4.2% in 2016 to 4.8% in 2035 and then start a steady decline down to 2.8% in 2060.
    ◦ Unification cost as % of GDP is a better indicator of its impact on the economy than its absolute value. 
❑ By category, social security expense explains the largest portion, or 47.7%, of the unification cost.
    ◦ Social security spending to stabilize the livelihood of North Korean people would increase from KRW 10.8 trn (15.9%) in 2016 to KRW 154.1 trn (45.3%) in 2060, averaging KRW 110.5 trn per annum. 
    ◦ Education spending including teachers’ salaries is estimated to be around KRW 13.9 trn (20.4%) in 2016 and KRW 48.9 trn (14.4%) in 2060, averaging KRW 28.1 trn per annum. 
    ◦ Administrative expense to operate central and local government agencies, including labor cost, would be around KRW 11.9 trn (17.5%) in 2016 and KRW 50.4 trn (14.8%) in 2060, averaging KRW 27.7 trn per annum.
    ◦ Capital spending, assumed to be incurred for the first thirty years since reunification, would total KRW 769.6 trn, averaging KRW 26.5 trn per annum. 
    ◦ Other discretionary spending would grow from KRW 15.7 trn in 2016 to KRW 86.5 trn in 2060, averaging KRW 48.4 trn per annum.

5. Challenges to Maximize Economic Benefits of Unification
A. Summary of Economic Benefits of Unification
❑ Once unified, Korea would see its GDP grow from USD 1.4 trn (KRW 1,135 trn) in 2013 to USD 5.5 trn (KRW 4,320 trn) in 2060, moving up two notches from 12th in 2013 to the 10th largest economy in 2060.
❑ In real terms, the net benefit as calculated by deducting the unification cost (KRW 4,657 trn) from the economic benefit (KRW 19,111 trn) is estimated at KRW 14,451 trn, which 3.1 times larger than the cost.
    ◦ The economic benefit of unification is the sum of additional GDP generated in the North and the South after the two are reunited.

B. Revitalize North-South Economic Cooperation 
❑ Since unification cost tends to rise in line with social and cultural differences, it is recommended to reduce the north and south income gap through more active economic cooperation and give the North some exposure to the market economy.
    ◦ The inter-Korean trade volume, which stood at a meager USD 18.7 mn in 1989, grew to USD 1.0558 bn when the Kaesong Industrial Complex was made up and running in 2005, and then to USD 1.97 bn in 2012 and USD 1.1358 bn in 2013.
    ◦ Processing trade, in particular, is quite attractive as it can tap into the low-cost labor in the North and the investment risk is relatively low.
❑ The Kaesong Industrial Complex is a flagship investment project that South Korea conducted in the North and it had huge ramifications in South Korea as well.
    ◦ The Kaesong Industrial Complex explains 46% (or USD 8.9408 bn) of the 2004-2013 inter-Korean trade volume.
    ◦ Over nine years from 2005 to 2013, the demand for work-in-progress for production activities in Kaesong also boosted production in South Korea by KRW 10.4295 trn while creating KRW 2.9275 trn in added value and generating 43,600 jobs (or 32,700 if only salaried workers are counted).
❑ It is necessary to proceed as originally planned with the Kaesong project, which is the most successful and stable initiative that North Korea has attempted thus far for external economic cooperation, and support the project to set an example for successful inter-Korean economic cooperation while expanding it to other regions and businesses.
    ◦ For more vibrant inter-Korean economic cooperation, it is necessary to expand the Kaesong project, actively participate in the development of special economic zones in North Korea and encouraging the North to join multi-lateral initiatives for economic cooperation.
❑ The cooperation of South Korea is integral to a successful development of special economic zones in the North. Economic cooperation should be regarded not just as a way to help normalize the North Korean economy but also as an alternative to identify new growth engines and boost economic growth of South Korea. 


C. Boost Labor Productivity in North Korea
❑ The best way to improve the income of North Korean people and minimize fiscal burden caused by unification is to increase productivity within North Korea.
    ◦ It can be achieved through increased investment, improvement of labor quality, technological development and internationalization.
❑ To slow the aging of the North Korean population, which undermines the long-term growth, it’s necessary to ensure a stable supply of food and expand support to improve the maternal and child health care as well as the wider medical environment.
    ◦ The grain consumed in North Korea is around 540 tons, well below the WHO recommendation (659 tons annually) necessary to provide enough calories.
    ◦ Many people are dying from diarrhea and respiratory infection which can be prevented by providing clean water and basic medicine; death within one month from the birth also explains 50% of mortality; 27.9% of children under the age of five are suffering from chronic malnutrition; and 23.7% of children have anemia.
    ◦ Recently in the Dresden Declaration, the Government pledged USD 13.3 mn to improve the maternal and child health care environment in North Korea through international organizations.
❑ As North Korea is expected to experience a huge structural change in its industry during the unification process, it is necessary to prepare for a smooth transition toward a newly structured labor market and job transfers.
    ◦ Utilize the past experience of South Korea gained from its own transition from the labor-intensive to the technology-intensive industry as well as the experience of training defectors from North Korea.
    ◦ Make sure to install a technology training center when expanding industrial complexes like Kaesong to help make North Korean industry more tech-intensive and high-value added. 
    ◦ Promote exchange in science and technology education as in the case of Pyongyang University of Science & Technology.
❑ Technological development, standardization and internationalization are critical to boost productivity. If technological transfer in various sectors, especially agriculture, as well as the internationalization and standardization of various statistics are addressed before the actual unification happens, North Korea will be able to grow more rapidly across various industries.  
    ◦ As for ICT and other tech sectors, there is a lot of room for inter-Korean cooperation (in terms of standardization and the designing of infrastructure) since as both North and South Koreas are nurturing them as a future growth engine. 
    ◦ It is necessary to resume the inter-Korean exchange and cooperation for industrial standardization and modernization of statistics. 

D. Maximize the Benefits of Investment in Infrastructures
❑ Efficient infrastructure should be built to help unified Korea strengthen its national competitiveness by making the best use of new economic conditions such as a larger territory, a greater population and the right combination of economic resources and workforce. 
    ◦ In the Dresden Declaration, the Government proposed to: build multi-agricultural complexes in North Korea encompassing farming, livestock and forestry; invest in the infrastructures for transportation and telecommunication; develop underground resources together with North Korea; and work on trilateral projects among the two Koreas and Russia (e.g. Rajin-Hasan logistics project) and also among the two Koreas and China (e.g. Shinuiju development).
    ◦ Need to explore ways to maximize efficiency of fiscal investment and make sure that the investment is made in a timely manner, keeping in mind that both preparation and actual construction of the infrastructure take long and require a large volume of funds.
❑ To maximize its potential as a strategic hub of northeast Asian economies, Korea should thoroughly prepare for a comprehensive plan for the development of the northern territory as well as a plan for intermodal transportation and other projects for development cooperation on the Korean Peninsula, based on the support from the international community. 
    ◦ For mutual prosperity based on cooperation with China, Japan and Russia, it is important to develop the Korean Peninsula as the hub of Northeast Asia for economic and cultural exchange.
    ◦ Collective cooperation with members of six-party talks (Japan, China, Russia and the US) is of first and foremost importance and the Government should also find ways to collaborate with individual countries where possible.
❑ To start building the infrastructure right after the unification, it is necessary to develop a preliminary design and finish preparations for private investment in advance.
    ◦ Under the current plan for infrastructure investment, it would take as long as 10 years to see actual benefits from the investment. So it is important to finish necessary procedures wherever possible before the Korean peninsula is unified. 
    ◦ This kind of investment should be executed in three steps such as feasibility study, preliminary design and detailed design. Once the inter-Korean relations improve, creating the right environment for cooperation, it would be possible to conduct the feasibility study and preliminary design beforehand.
❑ Need to relieve fiscal burden caused by the construction of infrastructure by allowing a certain degree of private investment and overseas funding.
    ◦ Learn from past examples of attracting private investment for infrastructure construction in North Korea (Hyundai Asan invested KRW 98 bn to develop the port of Changjon; Kookyang Shipping invested KRW 2.1 bn to modernize loading facilities at the port of Nampo; and Hyuntong invested USD 2.6 mn to modernize loading facilities at the port of Rajin).
    ◦ The Korean government currently subsidizes the full amount of land compensation and some of the construction cost for private investment projects. This scheme can also be applied to private investment in North Korea to build the infrastructure.


 
Chapter 2. National Finance of Unified Korea

1. The Roles of National Finance of Unified Korea
A. Normalize the North Korean Economy & Strengthen the Redistribution of Income
❑ Make sure that the unification cost does not put excessive pressure on the South Korean economy but is enough to support a rapid normalization and growth of the North Korean economy.
    ◦ The amount of fiscal spending for the North should be determined at a level that can minimize negative effects on the Southern economy and prevent excessive investment which can lead to a waste of public funds.
❑ To enjoy tangible economic benefits of unification, national finance should better play its role of redistributing income
    ◦ Need to ensure that the North Korean people enjoy the benefits of unification amid a rapid growth of the Northern economy.
    ◦ Need to improve the income distribution mechanism to prevent the income gap from widening amid economic growth. 

B. Relieve Fiscal Burden through Private Investment
❑ Although public funding should serve as the primary vehicle to finance a huge amount of unification cost at the beginning stage, it is also necessary to think about how to attract private investment to minimize the fiscal burden. 
    ◦ The Government would have to fund the cost of integrating two different economic regimes with its national finance.
    ◦ But it is also necessary to actively consider funding or borrowing from the private sector or overseas markets so that the value added from the unification can be shared with the private sector in the form of wage and profit.
❑ The Government should determine an optimal combination of tax increases and government bonds to be issued in light of the principle of payment by the beneficiary, inter-generational equity and efficiency. 
    ◦ Under the principle of payment by the beneficiary, it is appropriate to finance unification-related spending with tax increases because it is the entire public who will benefit from unification. And then any shortfall can be funded by issuing public debts.
    ◦ Welfare and other current spending should be funded by tax revenues. But capital spending should be financed through public debts as it is the future generation who will enjoy the benefits from such spending. 

C. Secure Fiscal Soundness of Unified Korea
❑ Strategic management of government debt is critical to keep the fiscal health of united Korea safe from additional spending resulting from the aging population of South Korea as well as the unification.
    ◦ Without fiscal soundness, the Government cannot grow the economy or redistribute income and the macroeconomic instability would only grow. 
❑ To secure fiscal soundness, the national debt should be kept at an appropriate level and the financial risk of government bonds that are issued to fund the unification cost should be properly managed as well. 
    ◦ Government bond issuance would spike in the initial stage of unification due to the time lag between the substantial cost that is incurred over a short span of time and the economic benefits that are gained over a long period of time.
    ◦ To facilitate debt issuance to fund the cost of unification, it is necessary to vitalize the secondary market for government bonds and incentivize the trading of long-term bonds.
    ◦ Fiscal soundness is a must to attract private and foreign investment which can reduce the fiscal burden on the Government.

2. Fiscal Outlook of Unified Korea
❑ The fiscal outlook of unified Korea was derived by incorporating additional revenues and costs that are brought to North and South Koreas by unification into a long-term fiscal forecast developed by NABO.
    ◦ It aims to assess a comprehensive impact of unification on the national finance by considering the fiscal impact of the aging South Korean population and the cost and benefits of the unification.
❑ If the tax wedge is assumed to remain at the same 19.4% as in 2013 and only the additional economic growth achieved by unification is taken into account, the fiscal revenue of unified Korea will expand from KRW 12.4 trn in 2016 to KRW 175.9 trn in 2040 and KRW 690.4 trn in 2060.
    ◦ Although fiscal revenue is composed of tax revenue, non-tax revenue and charges, the estimation only focuses on tax revenue due to the data availability issue.
❑ National debt as % of GDP of unified Korea is estimated to increase from 38.7% in 2016 to 163.9% in 2060.
    ◦ The long-term fiscal outlook shows that the debt ratio of southern Korea will climb up from 36.8% in 2016 to 168.9% in 2060.
    ◦ The national debt of unified Korea was calculated by adding the debt issued for unification as well as its interest to the operational budget deficit of the southern Korea. 
    ◦ Although the ratio of national debt to long-term GDP of unified Korea is projected to improve, the short-term spike in unification cost would increase the fiscal risk.
❑ The net debt burden, calculated by subtracting the cost of unification from the additional fiscal revenue earned through unification, would rise from KRW 55.5 trn in 2016 to KRW 116.4 trn in 2035 when it would then start declining. From 2047, fiscal revenue would offset the cost of unification.
    ◦ The debt burden caused by unification as % of the GDP of unified Korea is projected to reduce steadily from 3.4% in 2016 to –2.9% in 2060.
❑ If the tax wedge were raised by 1%p (19.4% → 20.4%), the debt ratio in 2060 would improve by 41.5%p to 122.4%.
    ◦ The 1%p increase in tax wedge would translate into KRW 16.4 trn in 2016, KRW 59.4 trn in 2040 and KRW 122.1 trn in 2060.
    ◦ Need to finance some of the unification cost through tax increases in order to restore the fiscal soundness compromised by the unification-driven national debt growth.
    ◦ The 1%p increase in tax wedge would reduce the issuance of government bonds and ultimately save the interest expense. (The interest expense for 2060 would be cut from KRW 179.7 trn to KRW 33.4 trn.)

3. Overhaul the Fiscal System for Efficient Fiscal Operations
A. Overhaul the Fiscal System for Accounting & Fund Management
❑ Ensure that the unification funds sourced by issuing government bonds and raising taxes are used for the intended purpose through an efficient budget and fund system.  
    ◦ Create a new tax code (e.g. unification tax) or manage the proceeds from the issuance of unification bonds with a special account or a separate fund.
❑ If the northern Korea were incorporated in the “local finance coordination system,” 40% of the internal tax (19.24% in local subsidy and 20.27% in local education subsidy) would have to be transferred to local governments, aggravating their financial difficulties.
    ◦ If the current administrative divisions of North Korea (one directly governed city, two special administrative cities and nine provinces) were kept intact, united Korea would have twenty-nine tier 1 local governments. 
❑ Need to temporarily delay the inclusion of the North Korean local governments in the “local finance coordination system” and instead consider managing the funds collected from a special purpose tax or unification bonds by establishing a special account or a fund to finance the fiscal spending in the northern Korea.
    ◦ Germany did not incorporate eastern Germany in its inter-governmental fiscal coordination scheme but instead established the German Unify Fund in 1990, which was separately managed for the next five years.

B. Overhaul the Social Welfare System for Sustainable Welfare Spending
❑ Although the aging of the population in Korea would be moderated by the demographics of North Korea, the combination of low fertility and population aging would result in a rapid growth in the number of recipients of social security payments (e.g. pension and health care) while bringing down the number of subscribers, posing a threat to a stable welfare finance.   
    ◦ In 2013, those aged 65 or above represented 12.2% of the population of South Korea, which is projected to become an aged society (14.5%) in 2018 and a super-aged society (20.8%) in 2026.
    ◦ North Korea has already become an aging society in 2003 (those aged 65 or above: 7.2%) and is expected to turn into an aged society (14.5%) in 2033, 15 years later than South Korea.
❑ For the sustainable welfare finance of united Korea, it is critical to build a social welfare system that can minimize the side effects of unification before the Korean peninsula is actually unified. 
    ◦ Prior to unification, it is necessary to overhaul various systems that are closely related to the aging population.
❑ Key challenges facing the national pension scheme of South Korea include: the blind spots not captured by the scheme, low take-up rates and the instable funding status.
    ◦ To get rid of blind spots, it is necessary to operate pension credits and social insurance subsidies more effectively and engage the National Tax Service to better determine the income of regional subscribers by upgrading the income assessment infrastructure.
    ◦ To ensure a sustainable funding of the national pension scheme and enhance inter-generational equity, it is necessary to extend the starting age for pension payment, increase pension premiums and adjust the payment amounts, if necessary, based on the changing life expectancy.  
    ◦ It is also important to find ways to secure the fiscal stability of occupational pensions (the teachers’ pension, the military pension and the government employees’ pension).
❑ To secure the fiscal stability of the national health insurance, it is recommended to improve the payment scheme for medical service, streamline the expenditure by saving medicine cost and increase revenues by revamping the insurance contribution pricing scheme. 
    ◦ Need to review various policies such as moving toward the DRG (diagnosis-related group) system, granting incentives for medicine cost savings and increasing the portion of non-reimbursable medical cost if the patient chooses an expensive drug over a cheap generic one.
    ◦ For a fair and equitable insurance scheme, it is necessary to establish a system to determine insurance contributions commensurate to the financial capability of subscribers. By doing so, the scheme will be better received by the public and become more sustainable and beneficial.

C. Efficient Management of State Properties in Northern Korea
❑ Legal disputes that may arise while disposing of state properties in the North after unification, such as a lawsuit to claim the return of a property or the one to receive compensation if the property cannot be returned, would hamper economic growth and social integration. 
    ◦ If construction of the infrastructure, which plays a key role in normalizing the northern economy and driving the growth, is delayed due to the disputes over property ownership, it would be difficult to secure the timeliness of the investment.
❑ Need to learn from the German experience and explore ways to ensure timely investment and economic growth by identifying and reviewing potential property ownership issues that may arise after unification and developing measures to resolve them.