OECD Economic Surveys: Korea 2018

Annex A2. Fiscal sustainability in the face of rapid population ageing

Korea’s population ageing, projected to be the fastest in the OECD, will have a significant fiscal impact due to increases in public pension benefits and expenditures on health and long-term care. This annex integrates long-term projections by the National Pension Research Institute (NPRI) and the National Assembly Budget Office (NABO) to illustrate the overall impact of population ageing on the general government financial balance. The conclusion is that government net debt would soar to nearly 200% of GDP by 2060 in the absence of other revenue increases.

NPRI published an actuarial analysis of the National Pension Service (NPS) in 2013 based on Population Projections for Korea (2010-2060) by Statistics Korea. NABO released a long-term fiscal projection that covers the central government and the NPS using the same demographic assumptions.

The baseline simulation below uses historical data through 2017 and OECD’s projections until 2019 (OECD, 2017c). From 2020, the underlying macroeconomic assumptions (Table A2.1) follow the NPRI’s 2013 analysis, which uses projections through 2060 made by the Long-term Financial Prediction Council of the Ministry of Strategy and Finance. The real economic growth rate is assumed to gradually slow as contributions of labour and capital fall. The real interest rate, which reflects the world interest rate, is stable around 2½ per cent while inflation converges to the Bank of Korea’s 2% target. The rate of return on the National Pension Fund is set 1.1 times higher than the nominal interest rate, based on the realised returns over 2006-11.

Table A2.1. Assumptions of the baseline projection

	2020-30	2031-40	2041-50	2051-60
Macroeconomic conditions
Real economic growth (%)	2.9	1.9	1.4	1.1
Real interest rate (%)	2.7	2.5	2.4	2.5
Inflation rate (%)	2.8	2.2	2.0	2.0
Nominal return rate of the National Pension Fund (%)	6.1	5.1	4.8	4.9
Fiscal revenues
Direct taxes on business; taxes on production and imports; capital taxes and transfer receipts; other current receipts (% of GDP)	18.7	18.7	18.7	18.7
Direct taxes on households; social security contributions less NPS contributions (% of GDP)	10.9	10.9	10.9	10.8
NPS contributions (% of GDP)	2.7	2.7	2.7	2.7
Fiscal outlays
NPS benefits (% of GDP)	2.1	3.3	4.9	6.1
Basic Old-Age Pension benefits (% of GDP)	1.0	1.7	2.0	2.2
Health and long-term care (% of GDP)	5.3	6.9	7.7	8.0
Other expenditures (% of GDP)	25.2	25.2	25.2	25.2

As for fiscal policy, contributions to the NPS and its benefits paid follow NPRI (2013). Benefits paid by the Basic Old-age Pension, which is funded by the national budget, are calculated as a ratio of NPS benefits projected by NABO (2012) through 2060. Health and long-term care benefits, which correspond to total in-kind social security benefits, are assumed to grow in proportion to NABO’s projected spending on health and long-term care insurance by the central government as a share of GDP. Direct taxes on households and other social security contributions are assumed to be proportional to NPS contributions, which remain at the current 9% throughout the simulation in the baseline. Other government expenditures and revenues remain fixed as a share of GDP over the simulation period. The simulation results are shown in Figure A2.1.

Figure A2.1. Population ageing rapidly erodes the government’s net financial position1

1. The initial net asset position is calculated as total financial assets less total financial liabilities held by the general government. Given that the authorities have not published data on government financial assets, they are estimated using flow of funds data. Financial liabilities are from the OECD Economic Outlook: Statistics and Projections (database).

Source: National Assembly Budget Office (2012); National Pension Research Institute (2013); Bank of Korea; OECD Economic Outlook: Statistics and Projections (database); OECD calculations.

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The general government is a net creditor; net financial assets are estimated at 42.0% of GDP in 2015, with the National Pension Fund holding a significant share (32.9% of GDP). However, Korea’s strong public finance position will quickly worsen as social spending rises and economic growth slows as a result of rapid population ageing. Under the existing NPS contribution rate of 9%, the National Pension Fund is projected to peak as a share of GDP in 2035. Its decline accelerates as the NPS balance moves into deficit in 2044 (Figure A2.1, Panel A). The deficit will reach 4% of GDP in 2060 when the National Pension Fund is exhausted. The government will incur budget deficits as early as 2029 (Panel B), given growing spending on the Basic Old-age Pension and health and long-term care. Growing deficits would make the government a net debtor by 2040, with net debt rising to 196% of GDP by 2060.

The 2013 NPRI study suggested several proposals to ensure the sustainability of the NPS. For example, one scenario proposed boosting the National Pension Fund to 100% of GDP and keeping it there until 2083, which would require a 16% contribution rate. Such a scenario is shown in Figure A2.1, Panel C; the NPS contribution rate rises by 1 percentage point every year from 2020 to 2026, boosting it from 9% to 16%. The gap in government net financial assets between the two scenarios (the baseline in Panel B and the 16% contribution rate scenario in Panel D) equals the National Pension Fund’s assets. However, once the Fund is exhausted in 2060 in the baseline scenario, the gap would be expected to widen because the depletion of the National Pension Fund deprives the government of an opportunity for building up assets through the higher yield on investment.

Raising the NPS contribution rate alone thus will not suffice to stabilise Korea’s debt dynamics. The government needs to find other financial sources to cope with the upward pressure on spending for the Basic Old-age Pension and health and long-term care. Moreover, this simulation assumes that the impact of ageing on other public pension plans (civil service, military, and private school teachers) will be dealt with through reforms that go beyond the 2015 changes in the civil service pension. Failure to implement such reforms would further worsen debt dynamics. The potential cost of reunification with North Korea (Annex A1) is another factor that could change Korea’s debt dynamics. On the other hand, Korea may be able to reduce spending in some areas, such as education given the falling number of children. Given Korea’s rapid population ageing, its prefunding approach – accumulating assets prior to the growth slowdown – is appropriate, but needs to be accelerated. Measures to boost revenues should not be delayed. The longer such measures are put off, the larger the revenue increase necessary to put public finance on a sustainable path.