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Title Structural Changes of the Korean Economy and Response Strategies (partially extracted)

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Structural Changes of the Korean Economy and Response Strategies

Published on August 7, 2020

Published by Economic Analysis Department


Ⅰ. Challenge of achieving sustainable growth in response to changes in economic structure
Since the Global Financial Crisis that led to a slowing economic growth and changing economic structure, there has been growing interest in achieving sustainable growth. Accordingly, the empirical characteristics of the relationship between changes in economic structure and economic growth were identified, and implications that could be referred to in pursuing sustainable growth in the Korean economy were reviewed. It was confirmed that a structural change occurred in the growth trend of the Korean economy that is highly dependent on external openness before and after the 2008 Global Financial Crisis. The decline in the growth contribution rate of private demand in terms of aggregate demand and the decline in the growth contribution rate of total factor productivity in terms of aggregate supply were relatively large. Amid the global value chain being restructured, due to increasing external demand-related uncertainties, there is a limit to what the Korean government can do to drive external demand. Therefore, policies should be put forth in a way that can improve Total Factor Productivity (TFP) in terms of expanding aggregate supply.
An empirical analysis was conducted for OECD member countries to identify the direction and magnitude of the impact of changes made to the economic structure of economic growth. The analysis indicates that the rate of economic growth may vary according to the changes concerned, and there are variations in the economic growth contribution for each economic structure factor. The impact of economic structure factors on the rate of economic growth illustrates that the increase in the rate of the employed, capital intensity, financial development, R&D expenditure, manufacturing industry, and external openness, etc. and the decrease in the rate of fiscal expenditure and energy basic unit have been shown to have a positive effect on economic growth. Additionally, the government debt ratio was found to have a positive effect on economic growth when it is lower than 90%. Furthermore, when whether or not economic growth factor-specific differences were found in the contribution to economic growth in the time before and after the Global Financial Crisis was ascertained, the analysis confirmed that while the contribution to growth of the rate of capital intensity, external openness, R&D expenditure, financial advancement, and manufacturing industry, as well as the government debt ratio decreased, the growth contribution of the rate of the employed and fiscal expenditure increased.
As changes to various economic structures (population structure, industrial structure, trade structure, energy structure, fiscal structure, etc.) occur simultaneously, multiple balances may exist concurrently in relation to the growth path of the Korean economy. Therefore, it is important for the government to present policy reference points that can drive the transition to a more superior growth path from the perspective of social welfare. The K-Shoring Special Zone that has taken into consideration the incentives to relocate overseas production bases of Korean companies, the Fourth Industrial Revolution Zone to help Korea become an East Asian hub of the global value chain, the Carbon-neutral Special Zone based on smart grid, and institutionalization of fiscal aggregate management mechanisms that will allow the rational allocation of limited public resources (fiscal rules, top-down budget review, strategic expenditure review, etc.) and advancement of a smart capital procurement system to help procure financial resources necessary to respond to changes in the economic structure from the private sector may be good examples for the government to consider.

Ⅱ. Strategies to respond to changes in population structure to achieve sustainable growth
Korea's rapidly declining birth rate and aging population are changing the demographic structure in a way that is different from what it was in the past. The working age population (those aged between 15 and 64) started to drop after reaching a peak of 37.65 million in 2018 as the number of births declined due to continued low fertility. Accordingly, the working age population is expected to continue to decrease in the future unless the total fertility rate rebounds to 2.1 or more, the level of the replacement fertility rate. In addition, the total population is expected to drop after reaching a peak of 51.94 million by 2028 if the current ultra-low fertility rate continues. In other words, the decline in the working age population has already begun, and the reduction in the total population is the reality and future that Korea will experience.
The decrease in the working age population has an effect on the economic structure by reducing labor, one of the factors of production, thereby reducing labor’s contribution to growth. In addition, a drop in the total population may weaken the demand base of the economy, causing a negative impact on the economy as a whole. Of course, if such a decrease in the working age population and the total population leads to productivity improvement through increased human capital investment, the negative impact could be offset by the positive impact brought about by these demographic changes. However, if the negative impact overpowers the positive impact, this could result in the decline of overall economic growth potential and chronic demand stagnation, causing the Korean economy slip into an inexorable state of secular stagnation, as its neighboring Japan did.
Next, changes in the demographic structure may have different impacts on the young and old generations. As for the younger generation whose proportion of the population in the overall population is set to decrease due to changes in the demographic structure, the social burden from taxes and sub-taxes (social security contributions) will become relatively heavy compared to that of the elderly, whose proportion of the population will increase. At the same time, however, if interest rates and asset prices fall due to a prolonged recession from changes in the demographic structure, the income of the elderly, which is mainly derived from assets, may become unstable.
In addition, the decrease in the population of the entire country has pronounced negative ripple effect on the demand base and production conditions of lower-populated regions, and thus, a “social movement” in which residents of these areas move to densely populated areas such as metropolitan areas will be witnessed. This in turn can lead to a vicious cycle where the reduced population will deteriorate the population structure and living conditions in the region.
In response to these changes in demographic structure, this report presents strategies that will help increase the working age population (improving the working age of young people and extending the retirement age, external expansion of the working age population), improve productivity (increasing investment in education, training and human capital, and expanding application of automation/robots), strengthening adaptability to changes in demographic structure (adjustment of educational infrastructure such as the number of teachers and school facilities, improvement of the military recruitment system and sophistication of military force structure), reinforcement of elderly income guarantee, improvement of intergenerational equity in shouldering financial burden, and a response to address the risk of population decrease in local areas.

Ⅲ. Strategies to respond to changes in industrial structure to achieve sustainable growth
Korea's economic growth rate declined from 8.9% in the 1970s to 9.5% in the 1980s, and fell to 3.0% in the 2010s. In the past, Korea maintained high input-driven growth with cheap labor and low-interest (policy funding) capital to promote exports, but since the 1990s, such growth has run its course and left the country’s economic expansion on the decline.
The problem is that this decline in economic growth is accelerating along with changes in the industrial structure at home and abroad. The decline by industry is as follows: while the proportion of Korea’s manufacturing industry in total real GDP (Gross Domestic Product) has increased significantly, the rate of increase in real GVA (Gross Value Added) has slowed and employment is on the decline. In particular, the domestic manufacturing base has been weakening as the international competitiveness of Korea’s main exports is losing its steam as China is swiftly catching up while its manufacturing sector, after getting hit by increased imports decreased exports, has relocated their manufacturing plants overseas. The decline in profits and investments in manufacturing coupled with heavier dependence on overseas production have elevated a risk of compromised forward/backward linkage effects, ultimately hollowing out of manufacturing sectors. 
As for the service industry, amid the share of real GVA being stagnant, the share of workers in the service industry is increasing, resulting in a labor productivity fall below that of other major countries, and it is also behind the manufacturing industry. The low labor productivity of the service industry hinders employment stability in the service industry itself, while widening the wage gap between industries, and further drives down the economic growth rate.
Meanwhile, Korea's export growth rate has been slowing since the 2008 Financial Crisis due to stagnant global trade growth, strengthened protectionist trade stances, sophistication of China's economic structure, and weakening of the vertical division of labor. In addition, not only has the global market share of major export items declined, but their concentration on specific countries and specific items is increasing. Furthermore, changes in the global value chain after COVID-19 are expected to pose both risks and opportunities for the Korean economy, which is highly dependent on foreign exports.
In this respect, the manufacturing-oriented Korean economy with a heavy focus on exports is faced with a number of difficulties. Accordingly, this report suggests measures that will help strengthen innovation capacity of the manufacturing sector, promote the advancement of the service industry, and transition to an industrial structure resistant to internal and external risks.

Ⅳ. Strategies to respond to changes in climate to achieve sustainable growth
From 2021, a new climate regime will be put in place to limit the increase of the global average temperature to 2℃ when compared to average temperatures before industrialization. The new climate regime requires all countries to participate in the reduction of greenhouse gases (GHG) regardless of the division between developed and developing countries, which signals that we have ushered in an era where not only climate change is a natural phenomenon, but also the industrial and trade strategies of trading partners to cope with climate change affect industrial structures and trade across borders.
Accordingly, major countries and industries are proactively formulating strategies to respond to climate change. European countries are setting GHG reduction targets for 2050 through the “European Green Deal” and reviewing whether or not to introduce a carbon border tax. In the private sector, an increasing number of companies are participating in the RE100 campaign to expand the use of new and renewable energy sources based on voluntary participation, and the international financial market is also reducing investment in facilities with high levels of GHG emissions. In the transportation sector, the supply of electric vehicles is increasing, and the proportion of renewable energy among recently-built new generation facilities is also increasing. In other words, after taking into consideration that under the new climate regime, the overall economic structure such as energy use, industrial production methods, and transportation methods are expected to be affected, this report investigated whether responding to the new climate regime would present an opportunity to achieve sustainable growth, and identified Korea's GHG reduction goals, and problems and strategies by sector.
First, the investigation into the relationship between economic growth and GHG emissions since the 1970s, mainly in OECD countries, has proved that GHG reductions are not a trade-off of economic growth. In the case of Europe, the United States, and Japan, which have entered the decoupling stage, national GHG emissions have been declining, although the scale of the economy is expanding. This is because they have consistently made changes to their energy consumption and economic structures. By the same token, Korea also needs to prepare measures to counteract climate change that are geared towards lowering the carbon intensity of the nation as a whole by adding high value to its manufacturing sector while keeping its manufacturing base intact. However, when examining the 2030 GHG reduction targets for industry, transportation and buildings with the recent GHG emissions performances, the 2030 targets seem quite challenging. Accordingly, it is high time that all the players in the economy make efforts to change energy consumption structures, improve energy use efficiency, and reduce GHG emissions by using alternative energy sources. This begs the need for putting in place a consistent and unified climate governance system as well as implementing GHG reduction strategies using timely statistics.
Finally, the role of finance and investment related to climate change is important to complement the externalities found in climate change and the environment. In the climate system, new products and low-carbon technologies - developed as a result of efforts to reduce GHG emissions - have the power to drive the potential growth rate in the mid- to long-term, and may realize sustainable growth of the Korean economy. However, from the standpoint of businesses, there is not enough room to invest in low-carbon green technologies at the expense of incurring immediate losses. Promoting climate finance and investment can help minimize climate change-driven economic losses caused by changes in social, economic, and trade structures and build a low-carbon economy. Accordingly, this report reviews the possible strategies necessary to achieve sustainable growth by identifying the policy trends at home and abroad to better respond to climate change, and analyzing their performance and issues by each GHG reduction sector and from individual financial and investment aspects.

Ⅴ. Fiscal strategies to respond to changes in economic growth conditions
In this report, fiscal strategy options are explored that will help respond to changes that occurred in the conditions of Korea's long-term economic growth.
First of all, it analyzed the problems and issues from a fiscal aspect following changes in economic growth conditions. In terms of fiscal income, the following scenario may be perused: decreased income tax revenue due to reduction in the working age population; reduced corporate tax revenue due to a possible drop in profit margin caused by the Fourth Industrial Revolution-induced fiercer competition; and lowered tax revenues in transportation, energy and environmental taxes due to declined fossil fuel use in relation to climate change. In terms of fiscal expenditures, the following might occur: increased welfare expenditures due to population aging; increased fiscal expenditures necessary to respond to structural unemployment caused by changes in the industrial structure; and increased fiscal support for improved energy efficiency to respond to climate change.
 The response strategies were presented by dividing them into micro-strategies that are necessary to respond to respective changes in population structure, industrial structure, and climate change, as well as macro-strategies that are necessary to respond to all these changes in a comprehensive manner. As for the latter, this report proposes a plan to change the budget review mechanism by the National Assembly to a top-down one to improve the efficiency of resource allocation. In other words, the resolution at the plenary session should determine the fiscal aggregates and limits for each sector, while the standing committee should deliberate the budget within those limits. In addition, improving flexibility of the rigid fiscal structure will be needed to enhance fiscal sustainability, and local education subsidies are a good example. Currently, the local education subsidies are fixed at 20.27% of the internal tax despite a decline in the school-age population, but if it is adjusted to reflect the actual decreasing trend, fiscal sustainability will be improved.
Strategic options to respond to changes in the demographic structure were explored with the focus on welfare and employment. Regarding the issue of deteriorating fiscal structure of the public pension, fiscal targets need to be determined with which fiscal evaluation should be conducted periodically and improvement measures should be introduced when failure to meet these targets is anticipated. As for elderly healthcare, discussions of having Health Insurance and Long-term Care Benefits included in the funds should take place to be better reviewed by the National Assembly. Furthermore, the role of primary medical institutions needs to be strengthened and role division between long-term care hospitals and long-term care facilities should be clearly articulated to improve expenditure efficiency. As for the employment situation of the elderly, to help the elderly population keep their employment, they should be provided support to reduce the gap between the wage level and productivity. In terms of the supply of foreign labor, reliable statistics should be established to implement management policies that are based on objective data.
As for the strategies to respond to changes in the industrial structure, options focused on science and technology R&D as well as labor market policies are suggested. In order to respond to what is expected in the era of the Fourth Industrial Revolution characterized by winner-take-all, it is necessary to move away from the catch-up-type R&D mechanism applied during the time of industrialization and transition to one that will lead the way in today’s realities. As interest in the quality of life is increasing due to more free time available to the general public, it is necessary to expand the government's R&D on addressing social issues related to quality of life such as health, safety and the environment. In addition, changes in industries and technologies triggered by the Fourth Industrial Revolution may lead to a reduced number of jobs in some occupations and changes to employment patterns, which is why expansion of the coverage of employment and industrial accident insurance needs to occur in order to prevent more holes from appearing in the employment safety net. When those who are in the blind spot of employment and industrial accident insurance become eligible for coverage, such as workers in special employment types, there is a greater need for protection as well as chances for pension coverage, which is why securing financial resources is needed to improve the sustainability of the insurances concerned.
Last, as fiscal strategies to better cope with climate change focus on the energy sector, since more than 90% of GHG emissions are the result of energy consumption, the corrective function of taxes needs to be strengthened because Korea’s energy taxes are lacking due to polluter-pays principle (PPP). Currently, energy tax situation features a complex tax system of special consumption, transportation, energy and environment, automobile, and regional development taxation. However, with the introduction of a carbon tax, where people are taxed based on the carbon content of an energy source, it will not only simplify the tax system, but will also regulate carbon emissions effectively. As for fiscal support for the energy sector, while recipients of tax credits for investment in energy-saving facilities are mainly large companies in the energy-intensive industries, tax credit rates are preferentially given to mid-sized businesses and SMEs. Thus, it is necessary to talk about adjusting the tax credit rates to improve this tax credit scheme. Furthermore, the Energy Efficiency Resource Standard, where energy suppliers are given energy consumption reduction targets and are required to make corresponding investments to improve efficiency, incurs various costs when the suppliers concerned make investments, which is why it is necessary to consider providing financial support upon implementation of the system.

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