Sound health management and supportive policies helped Korea emerge swiftly from the pandemic, with economic growth boosted by strong semiconductor exports. The recovery is set to continue as pandemic-era restrictions on contact-intensive services are shelved, despite the Russia-Ukraine war raising inflation and highlighting the need for supply chain resilience. Fiscal policy support will need to be scaled back to finance rapid population ageing. Spending should focus less on supporting firm survival in an SME sector with chronically low productivity and more on supporting people and business dynamism. The productivity gap between small and large, highly productive companies is reflected in labour market dualities of income, job quality and social protection. It spurs fierce competition among young men and women to enter prestigious universities and good jobs and slows down youth’s labour market entry and family formation. Record low birth rates reflect that combining motherhood and a career is difficult, and raising children and investing in their education is expensive and time-consuming. Korea is well-placed for a green transition, with a functioning emissions trading scheme and popular support. Reforms to reduce productivity gaps and improve business dynamism would help Korea achieve ambitious cuts in greenhouse gas emissions, with a smoother and less painful structural reallocation of capital and jobs.
OECD Economic Surveys: Korea 2022
1. Key policy insights
Abstract
Korea’s capable pandemic response minimised economic damage from COVID-19, resulting in one of the smallest GDP contractions among OECD countries in 2020, followed by a strong rebound in 2021 and the first half of 2022. Growth is set to continue as people resume normal consumption and Korean products remain in high global demand. However, Russia’s invasion of Ukraine is weakening the outlook, even though Korea is less directly exposed than many OECD peers. High household debt is an increasing vulnerability in a period of high inflation and monetary policy tightening. Many small and medium-sized companies in contact-intensive services, still weak from the pandemic and sensitive to eroding purchasing power, continue to be propped up by government support, while inflationary pressures and rapid population ageing call for fiscal restraint.
Sizeable and widening productivity gaps between large and small companies underpin inequalities in pay, working conditions and social protection. Youth and their parents invest considerable amounts of time, money and effort to land regular employment in large companies and government that yield employment stability and a high level of income and welfare. As a result, young Koreans delay labour market entry and postpone family formation. Couples are discouraged from having children by labour market dualities, and by expensive education and housing. Some women have to give up a regular career for non-regular employment, which offers lower pay and less social protection, after childcare breaks. A share of older people end their working lives in low-productivity small-company jobs, and end up with low income due to short pension contribution histories and a societal preference for lump-sum severance pay over pre-funded company pensions.
Targets to reduce greenhouse gas emissions by 40% (from the 2018 level) by 2030 and reach net zero by 2050 are ambitious but within reach. Korea’s economy is emission-intensive and has a high share of coal-fuelled electricity generation. This offers sizeable opportunities to cut emissions with large co-benefits in terms of reduced air pollution and enhanced energy security, but also considerable challenges in sectors like steel production, which will need further technological development to fully decarbonise. Korea’s own emission trading scheme (K-ETS) was the first introduced in East Asia and is a potentially important tool to reach carbon neutrality. It covers three quarters of emissions, but needs to be tightened going forward. At the same time, regulations preventing the carbon price signal from passing through to electricity producers need to be loosened.
Against this background, the main messages of this Survey are:
Monetary policy should continue to move towards a less accommodative stance with a view to keep inflation expectations in check. Inflationary pressures and rapid population ageing call for fiscal consolidation.
Boosting competition by streamlining regulations and reducing and redesigning support that keeps low-productivity SMEs alive are key to reduce gaps in productivity and living standards. So are closing gaps in job security and social protection by relaxing employment protection for regular workers and expanding social protection for non-regular workers. Addressing these challenges would facilitate youth employment, reduce gender gaps, boost earnings for older workers and strengthen long-term growth.
Delivering on promises to reduce greenhouse gas emissions, ultimately to net zero, requires timely policy action to ensure the K-ETS cap aligns with the targets and that the whole spectrum of industrial and energy policies and regulations support a green transition.
The economy is recovering, but faces headwinds
Korea’s skilful management of the COVID-19 pandemic protected its people and economy, with GDP per capita surpassing the OECD average for the first time in 2020. The country was able to contain the pandemic without a national lockdown, thanks to a world-leading tracing system implemented early in spring 2020. Korea started its COVID-19 vaccination campaign relatively late, but achieved one of the highest vaccination rates in the OECD in a short period (Figure 1.1, Panel A). In early 2022, the number of newly confirmed cases per million soared to nearly three times the OECD average due to the spread of the Omicron variant (Panel B). Even so, the cumulative COVID-19-related death rates have remained relatively low (Panel C). Reassured by the lower severity of the new variant, the authorities gradually eased nationwide distancing measures (Panel D), and the focus shifted from preventing infection to treating seriously ill patients. By May, almost all social distancing measures had been lifted, except for mandatory mask wearing in public indoor and some outdoor places. The number of new daily COVID-19 cases started to rise again in late June, peaking in August (Panel B). In the face of this new COVID-19 wave, the authorities have strengthened advice for the elderly to receive booster shots, and are expanding the number of "one-stop" COVID-19 treatment centres, where people can take virus tests, get in-person medical care services and receive antiviral drugs.
Figure 1.1. Korea’s pandemic management has been highly effective
Note: In Panel D, the index is a composite measure based on nine response indicators including school closures, workplace closures, and travel bans, rescaled to a value from 0 to 100 (100 = strictest).
Unweighted averages for OECD aggregate in Panels A, B and C.
Source: Oxford Coronavirus government response tracker; OurWorldinData; and OECD calculations.
As a result of effective management of health measures and economic support policies, disruptions to domestic demand have been relatively limited. After contracting by less than 1% in 2020, GDP grew by 4.1% in 2021 (Figure 1.2, Panel A). The recovery continued into 2022, although at a slower pace. A key driver of the recovery has been exports (Panel B). The accelerated pace of digitalisation worldwide, together with a solid economic recovery in major export markets, has boosted demand for semiconductors, Korea’s largest export (Panel C). Private consumption recovered at a slower pace as contact-intensive services faced some restrictions. As restrictions are lifted, some service activities, notably accommodation and restaurants, are recovering to their pre-crisis levels (Panel D).
Figure 1.2. Exports have driven the recovery while consumption still lags
Source: OECD Economic Outlook database; and Korean Statistical Information Service.
The labour market has been recovering, with unemployment gradually normalising and employment surpassing pre-crisis levels by late 2021 (Figure 1.3, Panel A). The labour market underutilisation rate, including both unemployment and involuntary part-time workers, has also recovered its pre-crisis level (Panel B). However, the employment recovery has been uneven. Contact-intensive services such as accommodation and food services have not yet reached their pre-crisis employment levels (Panel C). Employment in health and public services have shown the fastest recovery, driven by government-led job creation programmes and increased demand for health workers in response to COVID-19 (Panel C). Construction and manufacturing have gradually recovered with improved business conditions. Unlike regular workers, the employment rates of non-regular workers fell sharply during the pandemic. This partially reflects the fate of non-regular workers, particularly in the face-to-face service sector (KLI, 2022). The number of daily workers has still not recovered to pre-crisis levels (Panel D). Also, the employment insurance enrolment rate among non-regular workers and self-employed is much lower than among regular workers, implying that on the whole they were less protected by the government employment retention scheme (Chapters 2 and 3).
Figure 1.3. Employment has recovered in most sectors
Note: Panel B: The labour force underutilisation rate is defined as the sum of the number of persons unemployed and time-related underemployment, expressed as a percentage of the economically active population.
Source: Bank of Korea; and Statistics Korea.
The authorities launched a swift and sizeable fiscal response during the pandemic. Relatively low public debt and deficits before the crisis provided the space for a significant fiscal expansion to support the economy. Discretionary fiscal support is estimated at 2.1% of GDP in 2020 and support continued into 2021, while strong revenue growth in 2021 offset the deterioration of the underlying primary balance (Figure 1.4, Panel A). Liquidity measures, including loan payment deferrals and loan guarantees, kept firm insolvencies low. Employment retention subsidies and cash transfers helped save jobs and limited household income losses. Despite the pandemic, the incomes of the bottom 20% of households grew by 14% in 2020 (Panel B). The first emergency cash transfer provided in April 2020 is estimated to have temporarily reduced the poverty rate by around 12 percentage points in 2020 (KIHASA, 2021). The National Assembly approved a supplementary budget of KRW 62 trillion (2.9% of GDP), which is to be financed mostly by excess tax revenue. This was the eighth supplementary budget since the start of the pandemic, and the largest in Korean history. On July 8, the government decided to earmark additional fiscal support estimated at KRW 0.8 trillion (0.04% of 2021 GDP) to help households shoulder higher living costs. This includes financial support to low-income households (KRW 480 billion) and the expansion of tariff exemptions on key foodstuffs (KRW 330 billion). The increased spending and reduced revenue is to be partly offset by budget cuts in some government programmes. The government plans to reduce spending from 2023, and recently presented a KRW 639 trillion budget for next year, 6% lower than this year’s total expenditures.
Figure 1.4. Fiscal stimulus has supported household disposable income
Source: Economic Outlook database; and Statistics Korea.
The Ukraine war is weighing on economic recovery
Even with limited direct exposure, the war is affecting the Korean economy through a number of channels. Korea is indirectly exposed to the extent that the crisis reduces foreign demand for its exports. The exports orders index has declined, reflecting the war in Ukraine and lockdowns in China. Terms of trade had fallen 4% compared to the 2021 average in the first quarter of 2022. They fell further and reached a record low in July. The impact of the war on inflation is already being felt in Korea like in many other countries. Even prior to the war, inflation had risen in Korea mainly because of soaring energy prices, together with pandemic-induced supply bottlenecks. The war in Ukraine pushed up energy prices and inflation further.
Like their peers abroad, Korean semiconductor producers source raw materials from Russia and Ukraine, notably rare gases essential in this sector. For instance, half of the krypton gas used in Korea came from Ukraine and Russia before the war. The price of neon gas already tripled in early 2022 compared to a year earlier. The impact has been limited so far thanks to raw material stockpiling, import diversification and the establishment of domestic neon gas production. The government is also investing in R&D to homeshore the production of other essential raw materials such as krypton and xenon. However, supply of raw materials falls short of demand, and a prolonged crisis could therefore increase the cost of Korean semiconductor production.
Direct economic consequences for Korea of the war in Ukraine and sanctions on Russia are relatively modest at least in the short term, given limited direct trade and financial links. Only 2% of Korea’s total exports were destined for Russia and Ukraine in 2021, and Russia and Ukraine accounted for only 0.4% of Korean financial institutions’ total external exposure. Russia's share of Korea's inward (outward) foreign direct investment was about 0.02% (0.8%). Dependency on Russian oil and gas is also low. Korea imported 6.4% of its oil and 6.8% of its gas from Russia in 2021. Furthermore, Korea has traditionally maintained a high level of oil and gas security (IEA, 2020), and can cover 107 days of total domestic demand from national oil reserves. In addition, stocks held under the International Joint Stockpile programme allow Korea first drawing rights to oil and gas stored in Korea by foreign oil companies in case of supply disruptions. Korea also imports one tenth of its corn and wheat from Russia and Ukraine. The government has secured grain imports from other countries in response to the crisis.
The recovery will continue at a slower pace and uncertainty is high
Real GDP is projected to grow by 2.8% in 2022 and 2.2% in 2023 (Table 1.1). The Omicron wave and supply disruptions weighed on economic activity in early 2022, while high levels of immunity and the lifting of practically all restrictions set the stage for consumption in contact-intensive services to recover from late spring. The recovery in consumption is nonetheless expected to be gradual, as inflationary pressures from commodity prices and supply chain disruptions are being passed on to consumers. Inflation is set to remain elevated, based on the assumption that global oil prices remain around current levels throughout 2023.
Table 1.1. Macroeconomic indicators and projections
Annual percentage changes unless specified, volume (2009/10 prices)
1. Contribution to changes in real GDP.
2. National Accounts basis excluding unfunded liabilities of government-employee pension funds.
Note: The projections are based on the June 2022 OECD Economic Outlook, taking into account the advance national account estimates for the second quarter released in July as well as the latest high-frequency indicators.
Source: OECD (2022), Economic Outlook 111 (database), projections revised as of 12 September 2022.
Growth will continue in 2023, although at a slower pace as global growth is weakening. Business investment is set to grow, owing to continued demand for Korean products and planned business investment in key industries such as semiconductors and batteries. KRW 6.3 trillion (USD 5.3 billion) of spending is planned to support future-generation vehicles, system semiconductors and bio-health by 2024. Goods exports will remain robust on the back of strong global demand for major items. However, various downside risks cloud the outlook, in addition to the aforementioned geopolitical risks linked to the war in Ukraine. New and dangerous COVID variants could lead to stricter lockdowns in China, negatively affecting activity. In addition, elevated household debt and housing prices pose downside risks to domestic demand, as further discussed below. On the other hand, a quicker-than-expected end of the war or stronger than expected private consumption after the lifting of pandemic restrictions pose upside risks to the outlook (Table 1.4).
Table 1.2. Low-probability events that could lead to major changes in the outlook
Financial stability risks should be monitored
Korea’s financial system has remained resilient during the pandemic, mainly thanks to corporate financial soundness backed by the economic recovery and a number of temporary measures to ensure sufficient liquidity in financial markets, support credit growth, and keep loan delinquencies low. Loans and guarantees have been provided from the government to the financial sector to secure continued funding to SMEs. Also, to ease the burden on borrowers, loan repayments for small businesses have been deferred. The share of companies with a debt-to-equity ratio exceeding 200% decreased from 15.3% at the end of 2020 to 12.3% in June 2021 (BOK, 2022). Capital ratios of financial institutions remain well above mandatory requirements, but also well below the OECD average (Figure 1.5, Panel A), the overall leverage ratio is close to the OECD average (Panel B), and the nonperforming loan ratio remains low (Panel C).
As temporary support measures are withdrawn, financial vulnerabilities may arise. Focus should be shifted from keeping the largest possible number of SMEs alive towards supporting necessary restructuring, while monitoring potential spillovers to the financial system.
Like in many other countries, housing prices surged during the pandemic, which carries macroeconomic risks as rising interest rates or a potential price correction could lead over-leveraged households to hold back non-essential consumption. New housing supply has not been enough to meet the strongly rising demand in recent years, partly driven by an increase in single-person households (Figure 1.6, Panel A). Historically low mortgage rates and expectations of higher housing prices may also have fuelled speculative behaviour. Real housing prices, which have been stable over the past decade, rose around 11% in the fourth quarter of 2021 from two years ago, reaching their highest level since the mid-1990s (Panel B). The housing price-to-income ratio in Seoul rose from 12.8 in the third quarter of 2019 to 17.8 in the first quarter of 2022, but has edged down since then. Strong mortgage credit growth has increased the exposure of banks to the real estate sector, with housing-related loans accounting for around 80% of the total loan portfolio at the end of 2020 (KDIC, 2021). Household debt has increased rapidly over the past decade, and is high in OECD comparison (Figure 1.7). Floating-rate loans have increased significantly during the pandemic (Figure 1.8 Panel A). More than 80% of total new loans were floating rate in late 2021, implying that households’ debt servicing burden is set to increase as monetary policy is tightened and interest rates rise. According to estimates by the Bank of Korea, a 0.5 percentage point increase in interest rates would increase the total annual household debt servicing burden by KRW 6.6 trillion (0.3% of GDP). Unsecured loans (e.g. credit loans) have also increased (Panel B), especially from non-bank sectors. These loans are largely related to housing, as strict macroprudential policies limit the availability of mortgages (FSC, 2021a).
Figure 1.5. The financial system has remained resilient
1. Korean data are for 2019.
2. 2021 data for Korea and 2019 data for Finland
Source: IMF Financial Soundness Indicators; and Korean Financial Supervisory Service.
To contain the rapid growth of household debt and housing prices, the government strengthened borrower-based macroprudential measures, namely the loan-to-value ratio, debt-to-income ratio on mortgage lending, and debt servicing ratio. Interest rate rises in 2021 were also partially motivated by surging house prices and household debt. Currently, the loan-to-value ratio ranges between 0% (for the most expensive homes in pressure areas) and 70%, depending on the value of the property and the region, while the LTV for first-time buyers is 80%. The debt-to-income limit ranges between 40% and 50% depending on the region. In April 2021, the government strengthened the debt servicing ratio rule, basing it on individual borrowers rather than financial institutions, so that household loans are extended based on borrowers’ total debt servicing capabilities. Under this new regulation, amortisation of bank loans above KRW 200 million (KRW 100 million from July 2022) should not exceed 40% of the borrower's annual income. In January 2022, the debt servicing ratio ceiling in the non-bank sector was strengthened by lowering it from 40% to 50%. Together with the normalisation of monetary policy, these measures seem to have helped slow the growth in household debt and housing prices since the autumn of 2021. To stabilise the housing market further, the new administration also plans to increase the housing supply.
Figure 1.6. Housing prices surged, partly reflecting strong demand
Note: Panel B: Housing supply ratio is defined as the ratio of the number of dwellings to the number of households.
Source: OECD, House Price Indicators (database); and Ministry of Land, Infrastructure and Transport.
Figure 1.7. Household debt is relatively high and has been rising
Source: OECD (2022), Household debt (indicator).
Figure 1.8. Unsecured and floating rate loans have increased during the pandemic
Source: Bank of Korea.
Further macroprudential measures may be required in the future. These could include some lender-based measures, for instance, applying higher mortgage risks weights or introducing a ceiling on the share of unsecured floating rate loans in total bank loans. Introducing a sectoral countercyclical buffer which imposes a capital buffer for household loans, should also be considered. In 2018, Korean financial authorities planned to adopt a sectoral countercyclical buffer, but it has been delayed several times due to the pandemic. The experience of Switzerland suggests that a sectoral countercyclical buffer in the household sector can contribute to lowering banks’ mortgage and related financial risks (Suh, 2021). Furthermore, authorities should consider reducing the debt servicing ratio ceiling for the non-bank sector further so that the remaining gaps in the debt servicing ratio ceiling between banks and non-banks are reduced. This would help prevent individuals from borrowing from multiple institutions to circumvent mortgage prudential requirements (IMF, 2022).
Over the past few years, the previous government gradually increased the Comprehensive Real Estate Holding Tax, progressive taxation levied on homeowners holding multiple dwellings, to contain housing demand. Capital gains taxes on the transfer of real estate were also raised to prevent short-term speculation. The higher Comprehensive Real Estate Holding Tax increased the holding costs for multiple-home owners, but the capital gains tax hike may have disincentivised multiple-home owners from selling real estate, at least in the short term (IMF, 2022). The new administration plans to reform tax policies, notably reducing comprehensive real estate holding tax and capital gain taxes, together with constructing more houses. Reducing capital gains taxes would help bring underutilised housing to the market (notably as this policy is planned to be implemented as a time-limited tax reduction). Taxes on immovable property are in general regarded as an efficient means of raising tax revenues, because the tax base is highly immobile, which limits the scope for behavioural responses to the tax such as labour supply and investment in human capital (OECD, 2022a). The Comprehensive Real Estate Holding Tax, however, has some weaknesses, including low acceptability due to the recent sharp rises in the tax rate and that the additional tax burden was passed on to tenants. Furthermore, real estate transaction statistics show decreasing housing sales and an increase in properties being given away, consistent with anecdotal evidence of tax planning as properties were gifted to relatives. The comprehensive real estate holding tax should be revised to contribute to stabilising the housing market as was initially intended, and the tax burden should be shouldered in a more sustainable way. More generally, however, frequent changes in housing-related taxes and macroprudential policies should be avoided. Frequent policy changes increase volatility, and new policies may not have the intended effect if households expect that the next administration will undo any changes.
Monetary policy should continue to keep inflation expectations anchored
Headline consumer price inflation moderated to 5.7% in August 2022 from its 6.3% peak in July, amid weaker global oil prices (Figure 1.9). However, this is still close to triple the 2% inflation target due to persistent underlying pressures, including from supply bottlenecks and recovering consumption. Core inflation reached 4% in August 2022, reflecting a broadening of price pressures to various categories of goods and services, including furnishings and restaurants. In a timely response, the Bank of Korea initiated a normalisation cycle in August 2021, raising the key policy rate in seven steps from 0.5% to 2.5%, initially partially motivated by a wish to dampen household credit growth. The pre-emptive moves have helped keep inflation expectations anchored and nominal wage increases modest so far. However, year-ahead inflation expectations have increased lately and upward pressure on nominal wages is expected to mount as the labour market tightens. Wages are accelerating, notably in conglomerates. On June 30, the Minimum Wage Commission agreed to raise the minimum wage by 5% for next year. Upstream, producer prices rose 9.2% in July 2022. Prices rose broadly across energy and non-energy products. Manufacturing product prices rose by 12.8%, utility prices by 21.4%, and food and beverages prices by 9.3%. Core producer prices excluding energy and food were up 6.6%, with services prices up by 3.5%. The war in Ukraine is likely to exacerbate the situation. Korea’s trade-weighted exchange rate weakened over the course of 2021 and 2022. In July 2022, the real effective exchange rate reached its lowest level since June 2013 (Figure 1.10), largely reflecting a relative strengthening of the US dollar. Even though fluctuations are considerably less severe than what has been seen during periods of strong currency movements in the past, the weakening will compound inflationary pressures from higher import prices going forward.
Figure 1.9. Monetary policy has been normalised in response to rising inflation
Note: In boxes, the medium-term consumer price inflation target.
Source: OECD, Economic Outlook database.
Monetary policy should continue to keep inflation expectations anchored to prevent a price-wage spiral. The Bank of Korea’s tightening cycle has been well-timed so far but it should keep a close eye on the risk of rising debt servicing burdens putting households under financial strain, holding back consumption and triggering a hard landing in the housing market.
Figure 1.10. The won has been weakening
Real effective exchange rate
Note: The real effective exchange rate is a weighted average of exchange rates adjusted by relative consumer prices. The basket consists of 60 economies and weights are based on Korea's trade flows, with the highest weights given to CNY, USD, EUR and JPY. A decline in the real effective exchange rate means that the won has depreciated.
Source: Bank for International Settlements.
Table 1.3. Past recommendations on monetary policy
Fiscal policy support should become more targeted
Fiscal policy should be scaled back to support necessary structural change. Fiscal consolidation should proceed gradually, and support should move from broad-based crisis support toward targeting households and businesses likely to be affected by such restructuring and those vulnerable to rising living costs and debt servicing burdens. Strengthening the social safety net and improving training and activation policies of those who have lost their jobs are essential policies in this respect, as further discussed in Chapters 2 and 3.
The support measures should, as far as possible, be deployed in ways that do not exacerbate ongoing price pressures, to help the central bank contain inflation. This requires delivering maximum relief to the most vulnerable at a lower cost. Concrete options to strengthen and better target the social safety net are discussed in Chapter 2 of this Survey. To relieve the burden of soaring energy prices on households, the government increased the temporary fuel tax cut on gasoline, diesel and liquefied petroleum gas to 37% and extended it until the end of 2022. Even though many OECD countries have implemented similar emergency measures, such generalised energy subsidies are costly, and benefit disproportionally higher-income households (OECD, 2022b). If extended over the long term, they lead to overconsumption and run counter to climate targets. The fuel tax cut should be phased out in due course. According to a weighted price index from the Korea Economic Research Institute, consumer price inflation as experienced by the bottom quintile of the income distribution was 1.4 times higher than that for the top quintile (KERI, 2022b). This was because the price of food, housing, and utility bills, which are the main expenditure items for low-income households, rose faster than for other items such as education. The government has expanded tariff-free import items to some key foodstuffs including beef and chicken as an effort to protect livelihoods and curb inflation.
Transfers to those most in need, while allowing domestic prices to move in tandem with international prices, would be a superior alternative to fossil fuel price support. Such transfers could for example be extended through the existing energy voucher programme put in place in 2015, distributing lump-sum payments to support low-income households with their energy bills. The programme was recently almost doubled in size to KRW 230 billion, adding 0.3 million households to the scheme. Some OECD countries transfer a lump-sum amount to vulnerable households to offset the impact of higher energy crisis. Denmark, for example, offered a DKK 3 750 (EUR 504) tax-free cheque to help around 320 000 households who earn less than DKK 550 000 (EUR 73 909) and live in an area with district heating driven primarily by gas power plants or have individual gas heating. Germany has recently approved a EUR 130 million package of one-time grants to be offered to low-income households in summer 2022, when they receive their energy bills.
Going forward, a credible fiscal framework to ensure long-term sustainability needs to be put in place, given spending pressures ahead. By early 2023, the new administration plans to establish a long-term fiscal plan with concrete actions, which is a step in the right direction. The pandemic resulted in a large deterioration in the fiscal balance, but gross government debt still remains relatively low in international comparison (Figure 1.11, Panel A and B). The population is still relatively young, but rapid population ageing, together with the ongoing challenges of improving the social safety net (Chapter 2), are expected to place higher spending pressures on Korea than on most other OECD countries in the long term. According to the OECD Long-term Model, ageing-related public expenditure will increase faster than in most other OECD countries, requiring additional revenues (or expenditure cuts) corresponding to 10% of GDP by 2060 to stabilise debt (Figure 1.12, Panel A). Narrowing employment and productivity gaps of youth, women and the elderly, increasing the pensionable age and curbing health spending growth as described later in this chapter could ease spending pressures by approximately one-third (Panel B).
Figure 1.11. Government debt remains relatively low
1. OECD projection for 2021 and 2022.
Source: OECD (2021), OECD Economic Outlook 111 (database), projections revised as of 12 September 2022.
In 2020, the previous government proposed a fiscal rule with a debt-to-GDP ratio anchor at 60%, comparable to the original EU fiscal rules, and a flexible consolidated deficit target of 3% of GDP. Concretely, the following formula was to be upheld: (government debt to GDP/60%) x (consolidated fiscal balance/-3%) ≤ 1.0. A drawback of this rule was that in the near term it allowed for large deficits and a potentially rapid build-up of debt, while demographics are still relatively benign. In early July 2022, the government announced a revision to the proposed fiscal rule, which is welcome. Previously, the deficit target (3% of GDP) was based on a consolidated fiscal balance, which includes social security funds. The rule in practice would thus have allowed deficits of about 4.5% of GDP, as social security funds are currently in a surplus (about 1.5% of GDP in 2021). Henceforth, the announced deficit target is to be based on the managed fiscal balance excluding social security funds, which implies a tightening of the rule. Moreover, the provision under the previous proposal allowing deficits over 3% of GDP when the national debt to GDP ratio is lower than 60% has been removed. Last but not least, the fiscal rule is to be laid down in law rather than in the form of a decree, so as to make it more binding. The government plans to introduce a bill to this effect in September this year, and the fiscal rule is to be put into effect as soon as the National Assembly passes it – ahead of the previously planned implementation of the rule in 2025.
Figure 1.12. Rapid ageing will put pressure on public finances
Note to Panel B: The baseline scenario is constructed by keeping government revenue constant as a share of GDP from 2022, while GDP, expenditure and interest rates are simulated in the OECD long-term model. In "female employment increases", 2/3 of the baseline gender employment gap is closed. In "youth employment increases" employment gaps to the OECD average are closed for each of the age groups 15-19, 20-24 and 25-29. The faster increase in the National Pension eligibility age implies increasing the legal pension age to 68 by 2034 and increasing it by two thirds of life expectancy gains thereafter. "Health care efficiency increases" implies reducing the baseline increase of health expenditure by around 20%. The scenarios are cumulative, so that e.g. the "youth employment scenario" also incorporates effects from improving female employment and the "health care efficiency scenario" also includes effects from the three other scenarios.
Source: OECD calculations based on the OECD Long-term model.
Besides fiscal rules, many countries have independent fiscal institutions that enhance the transparency and credibility of fiscal policy, notably by monitoring compliance with fiscal rules and reviewing legislative proposals in the fiscal area (IMF, 2021; Kopits, 2011; Shaw, 2017). The National Assembly Budget Office (NABO) has to an extent been playing this role. NABO was established by the legislature in 2003 to provide projections of economic growth and tax revenue and to analyse national fiscal management, including the annual budget proposed by the President. It also evaluates government spending programmes and estimates the cost of legislation proposed in the National Assembly. Another important task is to estimate the medium and long-term fiscal requirements for government programmes. Thanks to its analytical capabilities, NABO has become a respected and influential institution. NABO would be well-equipped to take on a formal role as an independent fiscal council with the expected adoption of the fiscal rule. This would make the rule more effective and could be combined with a ‘comply-or-explain’ principle as set in legislation in EU countries (Jankovics and Sherwood, 2017). According to this principle, budgetary authorities should react publicly to the fiscal council’s assessment, within deadlines defined by law.
Table 1.4. Past recommendations on fiscal policy and action taken
Measures are needed to bolster the resilience of essential supply chains
The war in Ukraine has exposed Korea’s structural vulnerabilities connected to its deep integration in global value chains (GVCs), particularly for electronic goods (Figure 1.13). Korea’s reliance on Russia and Ukraine for raw materials to produce semiconductors is just one manifestation of the vulnerabilities posed by the concentration of trade both geographically and in terms of products. Approximately 14.7% of imported items depend more than 80% on supply from China, according to the Korea International Trade Association. These items include some essential goods. Urea, a key raw material for the chemical and logistic industries in Korea, has been entirely imported from China. China's temporary urea export restrictions in November 2021 therefore caused domestic urea prices to skyrocket, disrupting diesel car production, transportation and certain industries such as fertilisers. Magnesium ingots used to manufacture cars are also entirely imported from China. China controls 85% of the world's supply of magnesium, without which production of major Korean exports such as cars, smartphones and batteries would be hard hit.
Ongoing efforts are underway to diversify Korea’s trade relations. In April 2022, the Korean government proposed to join the Comprehensive and Progressive Agreement for Trans-Pacific Partnership (CPTPP), a free trade agreement involving 11 Asia-Pacific nations. Member nations account for around 15% of world trade. In February 2022, Korea joined the Regional Comprehensive Economic Partnership (RCEP), a free trade agreement among 15 Asia-Pacific nations. The government participated in meetings of the Indo-Pacific Economic Framework (IPEF) for deeper cooperation with partner countries in the Asia-Pacific region on supply chains and other emerging trade issues. Besides trade diversification, the government plans to enact and revise laws on supply chain management to help ensure stable supply chains of strategically vital goods. The government also plans to better secure overseas resources, notably through expanding loans and other financial assistance to companies that invest in high-risk key industries in overseas markets. These steps are welcome and should be implemented without delay.
In the process, consideration should be given to developing consistent and evidence-based policy tools to help identify potential supply chain bottlenecks and clarify the scope of essential products (Box 1.1). These tools would also support collaboration with the private sector and improve transparency and trust (OECD, 2021a). The private sector plays an important role in managing supply chain risk. In the semiconductor sector, for example, stockpiling of raw materials by major companies has helped minimise the impact of the Ukraine crisis. Going forward, the government can provide the private sector guidelines for crisis planning based on such tools and request them to implement contingency plans to avoid or mitigate supply chain disruptions.
Box 1.1. Government measures to reduce supply chain risks
A number of measures can be considered to ensure the supply of essential goods:
Governments can mitigate supply chain risks by facilitating the development of stress tests to identify potential supply chain bottlenecks, collect and disseminate information on the concentration of production, and clarify the scope of essential products. Based on such stress tests, countries can require private suppliers of essential goods to implement contingency plans to avoid or mitigate supply chain disruptions.
Governments can facilitate stockpiling of essential goods based on risk assessment and cost/benefit analysis of investing in stockpiles. Committing to regular purchases of a minimum quantity from a supplier at a set price in exchange for a commitment by the latter to stand ready to temporarily scale up production in the case of an emergency surge in demand can be considered.
Governments can also support the development of domestic production capacity with due consideration for political economy trade-offs, including opportunity costs of public funds, and possible costs of introducing other distortions into markets.
Source: (OECD, 2021a).
Figure 1.13. Exports are concentrated geographically and in terms of products
2021
Source: Korea Customs Service.
GHG reduction targets are challenging, but the new framework helps
Korea is among the largest greenhouse gas (GHG) emitters in the OECD. Emissions have risen fast since 1990, but have fallen from the 2018 peak. Per capita emissions also increased over the same time period, largely reflecting GDP and income growth. Emission intensity per unit of GDP has improved, but remains high compared to OECD peers. In 2020, Korea pledged to achieve carbon neutrality by 2050 and in 2021, tightened its international commitment to reduce emissions (Nationally Determined Contribution, NDC) from 37% below business-as-usual to 49% below (corresponding to 40% below the 2018 level) by 2030 (Figure 1.14). These pledges were upheld by the new government. Korea’s Framework Act on Carbon Neutrality and Green Growth to Tackle the Climate Crisis was passed in 2021, and requires the government to present a first Basic Plan for Carbon Neutrality and Green Growth for a planning period of 20 years, by 25 March 2023. In order to minimise adjustment costs of reaching ambitious targets, a policy package should be concrete, efficient, comprehensive and timely.
Figure 1.14. Steep greenhouse gas emission reductions are needed
Note: LULUCF stands for land use, land use change and forestry.
Source: OECD, Air and climate statistics (database).
Concerns have been raised that such a rapid pace of emission reductions will put too high a burden on business in the emission-intensive Korean economy, as its emissions peaked later than most OECD countries, and its industry structure is tilted towards high-emission industries like iron and steel, cement and petrochemicals. Korea’s NDC implies that emissions be reduced at a 4.2% annual rate from 2018 to 2030. This is relatively fast compared to 2.0% annually for the European Union (to achieve a 55% cut from 1990), 2.9% annually for the United Kingdom (a 68% cut from 1991), 3.1% annually for the United States (a 51% cut from 2007), and 3.6% annually for Japan (a 46% cut from 2013). Emission reduction targets are challenging, but the late emission peak and high emission intensity also mean that considerable emissions remain from sources that have already been reduced in a number of OECD countries.
To reduce emissions, the new government recognises that it is necessary to incentivise businesses to invest in clean technologies (MOEF, 2022). This can be done by harnessing the potential of the emissions trading scheme to accelerate energy efficiency savings and phase out coal from electricity generation. The United Kingdom for example has largely phased out coal from electricity supply with a combination of the EU emission trading scheme (EU ETS) price and a carbon price floor of GBP 16 introduced in 2013, replaced by an auction reserve price of GBP 22 in the UK-ETS upon departure from the European Union. These price signals were in the United Kingdom complemented by “Contract for difference”, a cost-efficient renewable electricity support scheme with auctioning (OECD, 2022b). Indeed, emissions from coal-fuelled power plants (37% of electricity supply) alone equal approximately 35% of Korea’s emissions. Coal can be phased out and replaced by tested and available technologies at a moderate abatement cost which will likely be more than offset by gains from reducing excess mortality and ill health caused by particle pollution (Kim et al., 2020; Botta et al., 2022; Lanzi and Dellink, 2019). Furthermore, accelerating the replacement of coal with renewables would likely entail considerable net job creation, even in provinces currently reliant on coal (Climate Analytics, 2021). According to current plans, the share of coal in electricity generation will still be high at 22% in 2030, and there may be scope to reduce this share further.
The new administration’s policy shift towards supporting nuclear electricity generation in addition to renewables (MOEF, 2022) improves the chances of target achievement and may reduce costs compared to previous plans to phase out nuclear and coal in parallel. Korea places great emphasis on nuclear safety. A master plan for high-level radioactive waste management, set out in December 2021, describes the method and schedule for safe disposal of spent nuclear fuel in a deep geological disposal facility. But so far, like in most countries, it has proven challenging to agree on a location for such a permanent disposal facility due to local resistance.
Korea’s emissions trading scheme holds potential to reduce emissions in line with targets
Policies need to comprehensively target all sources and removals of emissions in order to facilitate cost-efficient reductions. Cross-sector policies also reduce the scope for lobbying and sectoral carve-outs. By pricing emissions, people and businesses adjust their investments, production and consumption in accordance with their own technical possibilities and circumstances. This is largely privately held information, which cannot easily be targeted by regulations or subsidies. Emission pricing also strongly incentivises research and development of low-emission solutions (D’Archangelo et al., 2022).
Korea has an emissions trading scheme (K-ETS), covering approximately 74% of Korea’s emissions, which compares favourably to the approximately 40% of EU emissions covered in the EU emission trading scheme, although prices are currently lower in the Korean ETS and many EU countries have additional explicit carbon pricing instruments in place at the national level (Figure 1.15). All companies and facilities (around 700 in total) with emissions above a certain level are included in the system. Industry has complained that laws and guidelines for the operation of K-ETS are too complicated, pointing to the need to streamline the set-up, while enhancing transparency and reliability by reducing the room for discretionary interpretation. The K-ETS could be a powerful tool for steep and efficient emission reductions, but its potential is not being harnessed. Allocations for the third trading period (2021-25) were made with the overall cap consistent with emission targets of the 2018 Nationally Determined Contribution Roadmap by 2030, which implied a 26.3% cut from the 2018 level, well below the 40% target set in 2021.
During 2021-25, 90% of ETS allowances are handed out for free, except in emission-intensive trade-exposed industries, who receive 100% for free. This is a much higher share of free allocations than the approximately 40% of the total in the EU-ETS. Furthermore, improving the institutional framework for electricity supply would allow the marginal carbon cost to pass through to electricity producers, improving the effectiveness of the ETS for a major and systemically important emitting sector (Figure 1.16, Panel A) (IEA, 2021). The new government plans to reduce the share of free allowances and assign a larger share by means of benchmarking (MOEF, 2022). This is a step in the right direction.
A mechanism intended to add the ETS price on top of the production cost estimate that determines which electricity producers are allowed to produce at any given time (“environmental dispatch mechanism”) implemented from January 2022 largely fails to incentivise emission reductions. Rather than calculating the ETS market price multiplied by actual emissions, it adds the actual expenses incurred by the power generation business to acquire ETS allowances, most of which are allocated for free. Price liberalisation may potentially facilitate full carbon cost pass-through in the future (Kuneman et al., 2021).
Figure 1.15. Emission pricing has broad coverage, but prices are not target consistent
Note: Panel A: The data in this figure only covers CO2 emissions from energy use. The Carbon Pricing Score (CPS) measures the extent to which countries have attained the goal of pricing all energy related carbon emissions at certain benchmark values for carbon costs, including explicit carbon prices and fuel excise taxes. For example, a CPS of 100% against a EUR 60 per tonne of CO2 means that all emissions are priced at a level that equals or exceeds the benchmark of EUR 60 per tonne CO2. Panel B: IEA estimates are for CO2 prices for electricity, industry and energy production in advanced economies with net zero pledges. The estimate depicted here considers the effects of other policy measures alongside CO2 pricing, such as coal phase-out plans, efficiency standards and renewable targets. These policies interact with carbon pricing; therefore, CO2 pricing is not the marginal cost of abatement as is often the case in other modelling approaches. Estimates are in 2020 prices. More information can be found in the World Energy Outlook table B.2.
Source: OECD (2021), Effective Carbon Rates 2021; International Carbon Action Partnership; International Energy Agency (2021), World Energy Outlook 2021.
Korea’s electricity price is set by Korea Electric Power Corporation (KEPCO), the state utility, subject to government approval. It has been raised by KRW 11.8 (USD 0.009) per kWh in 2022, the first substantial increase since 2013, but remains one of the lowest in the OECD, despite the “Climate Change and Environmental Charge”, which has been levied on users of electricity since 2021. The financial position of KEPCO, which will also be responsible for considerable investment in transmission, nuclear and renewable energy over the green transition, has weakened considerably due to rising global energy prices in 2021 and 2022. A mechanism to adjust prices was put in place in January 2021, but annual price adjustments are limited to maximum KRW 5 (USD 0.004) per kWh. KEPCO’s recommendation to increase prices in line with the mechanism was overruled by the previous government in March, but the price was adjusted by KRW 5 in July. In addition, prices are differentiated by six consumer categories, such as households, agriculture and industry, leading to distortive cross-subsidies between sectors. Electricity used in agriculture for example costs approximately 40% of the electricity used by households. Electricity sector reform with competition in production and retail sales of electricity ensuring full pass-through of relevant costs, including that of ETS compliance, overseen by an independent regulator as in most OECD countries, should be an urgent priority going forward (OECD, 2021d).
Liquidity in the K-ETS has been limited in the past, with high price volatility and companies hoarding allowances they were allocated for free. Important actions to solve this problem were taken by enabling financial intermediaries in the secondary market to trade allowances from 2021, and by the appointment of three new market maker institutions committing to quote both bid and ask prices (ICAP, 2022). Fundamentally, auctioning a higher share of allowances would increase the number of transactions and thereby boost liquidity.
Figure 1.16. Emissions are highly concentrated in electricity generation and manufacturing
Source: Greenhouse Gas Inventory & Research Center of Korea; Korean statistical information service.
Free allocations are usually intended to soften competitiveness concerns and avoid those emitting activities moving to laxer jurisdictions. However, evidence does not suggest that countries with stricter environmental policies lose competitiveness in general. There is, though, a risk that a select few emission-intensive, trade-exposed industries, notably within heavy manufacturing and metals sectors (Figure 1.16, Panel B), can relocate their production should the carbon price differential to trading partners increase to very high levels in the future (HMT, 2021; OECD, 2021b). Such relocation is termed carbon leakage if it results in increased global emissions. This issue is best solved by global cooperation to ensure that the most emission-intensive and globally-traded sectors face a meaningful carbon price or equivalent regulations in major producer countries. Sectoral deals on steel, road transport, aviation and shipping were agreed during COP26, in an encouraging move forward. Furthermore, the idea of better measuring and harmonising direct and indirect price signals in leakage-exposed sectors is gaining traction in international organisations and fora such as the OECD, IMF and G20 (IMF and OECD, 2021; HMT, 2021). Domestic mechanisms can help level the playing field in the absence of such global cooperation, but such mechanisms face challenges and trade-offs related to their practical implementation and effectiveness, costs, and WTO compliance. The European Union has proposed a levy on carbon-intensive imports, which is set to affect Korean exports to the European Union, notably steel. The K-ETS price will most likely be deductible from the levy payable by European importers of Korean exports.
Policies for the K-ETS going forward should focus on bringing the overall emission cap in line with annual targets derived from the 2030 target and expanding its coverage, auctioning a larger share of allowances and comprehensively reviewing the institutional framework hindering the carbon price from passing through and holding back emission reductions in the electricity sector. The United Kingdom intends to align the ETS cap with the net zero objective by January 2024, and is considering expanding ETS coverage across the economy (OECD, 2022b). The EU has for many years operated an ETS cap consistent with targets, and is also considering expanding coverage based on the German pricing system in transport and heating that became operational in January 2021 (D’Archangelo et al., 2022). Signalling a tightening of the emission cap post-2025 (K-ETS phase 4) consistent with the 2030 target would increase the carbon price immediately in expectation, and hence speed up the necessary action to reduce emissions. Early action spurred by higher prices and a liberalisation of electricity prices would imply a more gradual and less costly transition overall.
Policies complementing the emissions trading scheme should be selective and well-designed
Target-consistent policies also need to be developed outside of the ETS. Fuels for transport, construction and heating can likely be included in the ETS (or taxed) by charging refineries and importers based on the carbon content of fuels sold domestically as done in Quebec (Canada), California and Germany. Double taxation of the same emissions could be avoided with a refund mechanism for fuel consumption already covered by the ETS. Negative emissions from natural and engineered removals of carbon will over time need to offset remaining emissions. They could also be included in the ETS by crediting verified removals with ETS-eligible allowances. Engaging in international cooperation on carbon offsets or linking K-ETS to other emissions trading schemes is in principle welfare enhancing, but requires that markets are competitive and that partner countries have credible plans to also reach net zero by 2050 to avoid hollowing out Korea’s contribution to the world reaching net zero. Public sector regulations, investments and activities impact emissions, but will not always be covered by the K-ETS. Consistently applying the price of greenhouse gas emissions in public sector cost-benefit analyses would make sure policies across government are in line with emission reduction targets. The UK system of cost-benefit analyses regulated by the “Green book” is a good practice example, where target-consistent “carbon values” are systematically applied.
Regulation and subsidies should complement carbon pricing by addressing a number of market imperfections, but need to be well-designed, coordinated and selectively targeted to specific well-identified cases of market failure. Businesses that do not respond to price signals will decline, provided that they operate in competitive markets. Policies to streamline regulations and boost business dynamism described below will therefore also ease the cost of transitioning the economy to net zero by allowing industry structure to adapt quickly while effectively matching people to jobs and ensuring incentives reach across sectors. Subsidies can help, notably by boosting investments in green research, development and initial deployment of technologies (OECD, 2022b; D’Archangelo et al., 2022; Dechezleprêtre and Cervantes, 2022). Korea’s Carbon Neutral Industry and Energy R&D Strategy announced in November 2021 supports the development of core technologies in 17 key industries, and the budget for R&D related to carbon neutrality was more than doubled to KRW 1.9 trillion in 2022. Furthermore, the new government plans to intensify the link between financial support and carbon reduction performance.
The disciplining effect of markets is much less salient for households, whose greenhouse gas emitting consumption habits may resume even if cleaner alternatives are available and inexpensive. Subsidies can address liquidity constraints preventing households from investing in energy efficiency and clean heating. Regulation can help overcome coordination problems and bounded rationality for example by mandating energy efficiency and availability of electric vehicle charging points in the building code, and setting regulatory back-stops to phase out fossil fuel cars and heating systems and the use of coal in electricity generation (OECD, 2022b; D’Archangelo et al., 2022; Dechezleprêtre and Cervantes, 2022). The Korean building code has tightened energy efficiency requirements since 2009, and is set to expand the mandatory zero-energy building standard, currently applying to public buildings of more than 1 000 square meters, to encompass public buildings of more than 500 square meters and new public apartment buildings with more than 30 housing units from 2023. From 2024, the zero-energy building standard will be gradually expanded to new categories of public and private buildings. Subsidies for energy efficiency improvement of existing buildings, such as “Green Remodelling Support”, were introduced in 2013 and have been strengthened considerably since. Energy savings in existing buildings are supported locally, with for example Seoul Metropolitan Government providing interest-free loans for energy efficiency, such as replacement of insulation, lighting, and heating facilities. Vehicle emissions standards were implemented in 2008, and are being tightened according to a pre-announced schedule.
The K-ETS operates alongside a range of energy policy instruments aimed at decarbonising Korea’s electricity generation mix, such as capacity payments, renewable portfolio standards, emission performance standards, fuel taxes, phase down trajectories, and technology targets (Kuneman et al., 2021). The new government has stated its intention to adjust Korea’s Carbon-Neutral Implementation Plan based on scientific advice and in compliance with the 2030 emission reduction target. This evaluation should make sure that policies complement and improve price pass-through from the K-ETS rather than complicate performance monitoring, blur price signals and blunt economy-wide incentives (D’Archangelo et al., 2022).
Institutional arrangements can help support the drive towards net zero. A number of countries including the United Kingdom, Sweden, France and New Zealand have for example set up independent climate policy councils with tasks including advising the government on setting climate targets, monitoring progress and evaluating policy (OECD, 2022b). Korea’s 2050 Carbon Neutrality and Green Growth Commission, a permanent body established under the 2022 Framework Act on Carbon Neutrality, is set to perform similar tasks in Korea. The Commission reviews carbon-neutral policies, takes stock of the implementation and collects opinions of various stakeholders. Its membership is broad, including government, experts and civil society. The Commission is co-chaired by the Prime Minister and a representative from the private sector. Equipping the Commission with a sufficiently funded secretariat with strong analytical capabilities would be a way to ensure high quality and relevance of outputs and advice from the Commission going forward.
Central banks and financial supervisory authorities increasingly take responsibility to green the financial system. However, the financial sector does not work in isolation. It can only be a facilitator, funding climate-friendly investment in response to effective policies. Financial regulators have an important role to play in improving financial resilience by mandating better assessments and disclosure of risks from climate change and transition risks from a changing policy and investor landscape, and integrating these risks into the supervisory framework. Increasing demand for more environmentally-friendly investment portfolios combined with climate risk assessments and disclosures can on the other hand leave a vacuum and lead to counterproductive market dynamics such as blanket portfolio exclusions of firms or sectors on simple criteria including their current emission intensity. Disclosure and a taxonomy classifying activities and investments as harmful or beneficial to the climate can help alleviate these concerns. The European Union has already implemented important parts of their taxonomy, while the United Kingdom is also developing one (OECD, 2022b).
The Bank of Korea and the Financial Services Commission are both members of the Network of Central Banks and Supervisors for Greening the Financial System (NGFS), a group of financial regulators sharing best practices and contributing to the development of environment and climate risk management in the financial sector. Such cooperation is helping Korea to quickly catch up with international best practices set by frontrunners such as the United Kingdom. The Financial Supervisory Service (FSS) has introduced a guideline to manage climate risks in the financial sector, detailing areas such as business environment and strategy, governance structure, risk management and disclosure and launched a climate risk forum in May 2021 to coordinate among relevant government agencies and financial institutions. The five major trade groups in the financial industry have prepared a green finance handbook, providing best practice examples and reference information on financial institutions’ green finance strategies. In close cooperation with financial companies, the authorities plan to develop a climate scenario and conduct a pilot stress test in the financial sector in 2022 (FSC, 2021b).
The Korean people support policies to reduce emissions
Implementing policies to reduce greenhouse gas emissions also depends on support from the population. The first-order effect of policies targeting household emissions would likely be regressive in Korea (Alonso and Kilpatrick, 2022). Taxes on heating fuels and electricity are more so than those on transport fuels, as low-income households tend to use a larger share of their income for heating than high-income households. These distributional effects can be met by targeted transfers and programmes to improve residential housing energy efficiency and transition to zero-emission heating, notably heat pumps (OECD, 2022b; D’Archangelo et al., 2022).
However, compensating negatively affected households might not be sufficient to secure support for efficient policies even when, as in Korea, the objective of mitigating climate change is broadly accepted. A new OECD survey of more than 1 500 representative respondents in Korea and several other countries analyses the public acceptability of carbon pricing and other climate policies. Like in other OECD countries, an overwhelming majority of Koreans agreed in early 2022 that climate change is an important problem (94%) and that it will negatively affect their personal life (86%). Support for various concrete policy measures is nonetheless moderate, except for subsidising low carbon technologies, which 71% support. Only 46% support a tax on fossil fuels, but this is much higher than in Germany, France and the United States, and on par with the United Kingdom and Denmark (Figure 1.17, Panel A). Support increases to around 80% if carbon revenues are used to subsidise low-carbon technologies and fund environmental infrastructure (Panel B) (Dechezleprêtre et al., 2022). This indicates that expansion and improved pass-through of the price signal from K-ETS is feasible politically if combined with technology and infrastructure support. Consecutive administrations’ failure to raise electricity prices over the past nine years does point to a political cost of making decisions to raise energy prices. Broad acceptance of climate policy would also require active discussions with the business community, as well as creating or strengthening institutions and mechanisms to engage and promote opportunities for intergenerational dialogue (OECD, 2020a).
Figure 1.17. Concrete climate policies receive varying degrees of popular support
1. The question in the survey was as follows: "Governments can use the revenues from carbon taxes in different ways. Would you support or oppose introducing a carbon tax that would raise gasoline prices by 40 cents per gallon, if the government used this revenue to finance..."
Source: Dechezleprêtre et al. (2022).
Table 1.5. Past recommendations to reduce emissions and action taken
Societal divides hold back productivity, well-being and fertility
Korea’s exceptional journey from one of the poorest countries in the world in the 1950s to the 10th largest economy in 2020 saw per capita GDP rise from around 1% of the OECD average to surpassing the average in 2020. GDP growth and access to health care have pushed life expectancy well above the OECD average, and was accompanied by a transition from authoritarian rule to democracy. This rapid development was founded on an export-oriented growth strategy, sound macroeconomic policies with an investment-friendly climate and heavy investments in education. Large family-run business groups (chaebols) focused on manufacturing acted as engines of growth, supported by subsidies, favourable access to credit, tax incentives and trade protection, notably throughout the 1960s and 1970s, after which this support was scaled back (Jones, 2021).
Productivity gaps between small and large companies widen despite policy efforts
However, the very drivers of Korea’s economic miracle also gave ground to pronounced gaps in business and society. Large business groups are still dominant today in terms of national sales, and even more so in exports. These firms typically offer highly educated workers well-paid jobs, good working conditions, regular employment and social insurance coverage. Low-productivity SMEs, often in the domestic-oriented service sector, hire a larger share of non-regular workers, who earn less pay and have less protected jobs. These firms are not able to attract the skills needed to boost productivity, for example by adopting digital technologies. Indeed, firms with at least 300 employees pay young workers 50% higher wages than those with less than ten employees, and only employ 14% of their work force on non-regular contracts, compared to almost half in companies with five or less employees (Chapter 3) (OECD, 2020b; OECD, 2018).
The 2018 OECD Economic Survey of Korea found that productivity gaps between large and small companies are supported by the concentration of economic power among large companies. While these companies need to maintain high productivity to compete internationally, they often tend to use their market power domestically. SMEs that supply products to large firms complain that they are unfairly squeezed by those firms. Their sheer size and importance to the Korean economy is a macroeconomic risk, compounded by their complex ownership structures (OECD, 2018).
Owner families wield outsized voting power, which can lead to private interests taking precedence over those of other shareholders (OECD, 2018). A regulatory move away from opaque circular ownership structures has been largely successful in increasing transparency around these conflicts of interest, although considerable discrepancies between voting power and cash-flow rights remain (Chattopadhyay et al., 2021). Legislation has been passed to prevent controlling shareholders from abusing these voting rights, for example by allowing shareholders to file lawsuits against directors causing damage to subsidiaries of which they are in charge and measures to protect audit committee members’ independence from controlling shareholders’ influence. The government plans to pursue further measures to penalise unfair business practices and promote fair competition (MOEF, 2022).
Close ties between business and political elites led to a number of high-level corruption scandals in the past. Although Korea has climbed the rankings in the Corruption Perceptions Index (Figure 1.18, Panel A), from 52 in 2016 to 32 in 2021, reflecting falling low-level corruption, it scores poorly compared with most other OECD countries. It also scores relatively low in the World Bank’s Control of Corruption index (Panel B), even though it improved over time (Panel C). By sector, Korea’s score in legislature corruption is slightly worse than the OECD average (Panel D). Anti-corruption policies have been tightened considerably, and are still evolving (Box 1.2).
Figure 1.18. Control of corruption is improving
Note: Panel B shows the point estimate and the margin of error. Panel D shows sector-based subcomponents of the “Control of Corruption” indicator by the Varieties of Democracy Project.
Source: Panel A: Transparency International; Panels B & C: World Bank, Worldwide Governance Indicators; Panel D: Varieties of Democracy Project, V-Dem Dataset v12.
Box 1.2. Anti-corruption policies in Korea: recent developments
Korea’s Anti-Corruption and Civil Rights Commission (ACRC) works continuously to improve its integrity education for elected officials. In 2021 it added scholarship student selection to the list of public duties subject to the Improper Solicitation and Graft Act, Korea’s extensive law on bribery. Moreover, the ACRC has taken steps to strengthen whistle-blower protection and plans to increase compensation for those reporting irregularities. When whistle-blowing results in increased revenue, or recovery of funds, the whistle-blower can be rewarded with up to KRW 3 billion (EUR 2.2 million). The number of reports on corruption and public interest infringement that received monetary rewards has increased steadily, from 12 in 2011, when the Act on the Protection of Public Interest Whistle-blowers was passed, to 408 in 2019. The ACRC has intensified efforts to increase the transparency of companies, distributing guidelines to public institutions in June 2022 on how to comply with the Integrity and Ethics Compliance Programme. It plans to develop and implement a similar programme for companies within the year, comprehensively taking into account international standards reflected in Korean law, such as the UN Convention against Corruption.
ACRC’s own annual Anti-corruption Initiative Assessment showed that, on the whole, public institutions continued to increase anti-corruption efforts in 2021. ACRC did, however, note that public universities and health institutions could do more to minimize the risk of corruption. ACRC also carries out an “Integrity Assessment”, surveying corruption perceptions among officials and citizens. From 2022, the two assessments are combined into one.
To address corruption among high-ranking officials, an independent anti-corruption agency, the “Corruption Investigation Office”, was established in January 2021. The agency can investigate abuse of power, such as bribery and embezzlement, among high-ranking officials, including the President and prosecutors from the Supreme Prosecutors’ Office, and their families.
In May 2022, the Act on the Prevention of Conflict of Interest Related to Duties of Public Servants took effect to prohibit public officials from seeking personal gains and to secure fairness in their performance of public duties. The law, which will directly affect around 2 million civil servants including officials, lawmakers and executives at state-run companies, also stipulates that officials involved in real estate developments should declare it within two weeks if they or their family members possess real estate located in real estate development areas.
In June 2021, the OECD Working Group on Bribery noted that while 22 out of its 36 Phase 4-recommendations had been fully or partially implemented, there was still much to be done. In particular, Korea needed to increase its efforts to train and provide adequate guidance to officials working with foreign bribery investigations to improve detection and enforcement. Korea was also urged to step up promptly and significantly its level of foreign bribery enforcement and to address key unimplemented recommendations concerning, among others, the false accounting offence and its anti-money laundering reporting framework (Figure 1.19).
Figure 1.19. Tax transparency and anti-money laundering measures
Note: Panel A summarises the overall assessment on the exchange of information in practice from peer reviews by the Global Forum on Transparency and Exchange of Information for Tax Purposes. Peer reviews assess member jurisdictions' ability to ensure the transparency of their legal entities and arrangements and to co-operate with other tax administrations in accordance with the internationally agreed standard. The figure shows first-round results; a second round is ongoing. Panel B shows ratings from the FATF peer reviews of each member to assess levels of implementation of the FATF Recommendations. The ratings reflect the extent to which a country's measures are effective against 11 immediate outcomes. "Investigation and prosecution¹" refers to money laundering, and "Investigation and prosecution²" to terrorist financing.
Source: OECD Secretariat’s own calculation based on the materials from the Global Forum on Transparency and Exchange of Information for Tax Purposes; and OECD, Financial Action Task Force (FATF).
The large business groups no longer drive broader Korean prosperity as in the past. Their share of employment has fallen, even as their production became ever more internationalised, capital- and technology-intensive. By 2016, Korean SMEs – defined as firms with less than 300 employees – accounted for 80% of business sector employment, the second highest share in the OECD At the same time, their productivity has lagged increasingly behind, and is now approximately one-third of that of large companies. As illustrated in the 2020 OECD Economic Survey of Korea, increasing SME productivity to the OECD average of approximately half that of large companies would boost GDP per capita by more than 40% by 2060. Increasing service sector productivity as a share of manufacturing productivity from currently 45% to the OECD average of 85% would boost GDP per capita by almost 60% (OECD, 2020b).
Since the late 1970s, successive governments have become increasingly conscious of the imbalance between large and small companies. A large number of policies have been put in place to support SMEs, including subsidies, favourable access to public procurement, regulations differentiated by company size and whole market segments reserved for SMEs. Although many of these policies may have some justification when seen in isolation, they sum up to a system that supports the survival of low-productivity firms against a backdrop of regulatory complexity (OECD, 2018).
As recognised in the government’s “Economic policy directions” (MOEF, 2022), policy should rather focus on ensuring fair competition, simplifying and loosening unnecessary regulations across sectors and firm sizes. Policies targeted at large firms should focus on strengthening board independence, protecting minority shareholder rights, ensuring that voting rights reflect ownership shares, and striking down unfair business practices taking advantage of market power, such as those related to subcontracting. Policies that end up unduly supporting low-productivity SMEs should be phased out by systematically re-evaluating the numerous regulations affecting SMEs and service sectors, and the numerous schemes in place to protect them from competition from larger companies. Subsidies should be re-targeted towards mainly young companies in a growth phase and towards areas supporting productivity growth, such as research and development, digital adoption and on-the-job digital training, and to fill financing gaps related to intangibles which are difficult to collateralise. Support should be time limited, as continued support to companies that are not able to survive on their own wastes fiscal resources and lowers productivity at the same time (OECD, 2018; OECD, 2020b). Since 2018, the government has implemented SME graduation schemes for technology credit guarantees and SME policy loans to prevent SMEs with low performance from receiving misappropriated or repetitive support. These schemes are supported by the SMEs Integrated Management System. The new government plans to reform the SME policy evaluation system to more focus on boosting innovation and growth potential of SMEs (MOEF, 2022).
Table 1.6. Past recommendations to reduce productivity gaps and action taken
Inequalities spur an unproductive race for a golden ticket
The wide productivity gaps between small and large Korean companies is a key factor behind high income inequality in Korea. Labour income inequality mirrors firm’s productivity gaps (Figure 1.20, Panel A). It is compounded by a high incidence of non-regular workers in small companies relative to larger ones. Regular workers receive higher wages, social insurance coverage and strong employment protection, while non-regular workers receive lower wages, are less likely to be enrolled in social insurance and work in precarious jobs (Chapter 3).
Figure 1.20. Income inequality mirrors productivity gaps between firms
Note: Panel A: OECD is the unweighted average of the countries for which data are available. The country-specific data points indicate the unweighted average of within-industry labour income inequality and productivity dispersion between firms. The coverage of firms in the dataset varies across countries and is restricted to firms with at least 20 employees. The P90/P50 ratio is average labour income or labour productivity of the firm at the 90th percentile divided by the corresponding value of the firm at the median.
Source: OECD (2018), Economic Survey of Korea 2018; OECD Income Distribution (database).
A part of social protection gaps between large and small companies is due to gaps in mandatory (un-)employment insurance coverage for non-standard employees, and limited pension rights earned during unemployment and childcare-related career breaks. Another substantial part is explained by weak enforcement of social protection rights, notably employment insurance and the National Pension Scheme, reflecting the notion that SME productivity is too weak to carry additional labour costs (Chapter 2). As a result of this, and the practice of honorary retirements around the age of 50 in a country with a life expectancy of over 83 years, old-age poverty in Korea is high (Panel B). Preventing honorary retirements would require boosting life-long learning to address a large skill gap between young and old, and moving away from the combination of seniority-based wages and severance pay which creates large employer liabilities increasing sharply with the worker’s age.
SME compliance with employment standards also has room for improvement. The minimum wage reached about 63% of the median wage in 2019, after a nearly 30% increase over 2017-19. This is relatively high among the OECD countries with a minimum wage, and the rapid increase likely weighed on employment in SMEs. Subsidies were put in place to help them adjust, and the minimum wage was increased by 2.9% for 2020 and 1.5% for 2021 (OECD, 2020b). Despite these efforts, survey evidence indicates that 4.4% of workers earned less than the minimum wage in 2021, with the proportion of underpaid workers as high as 11% in agriculture and fisheries and 12.5% in hospitality (Minimum Wage Commission, 2022). Minimum wage increases can in principle boost productivity by making labour unaffordable for low-productivity firms, but would likely be more successful if competition functioned better and product- and labour-market regulations were less stringent. The Earned Income Tax Credit (EITC) can be a useful complement to the minimum wage by subsidising a match between supply and demand for low-productivity labour while reducing in-work poverty (OECD, 2020b).
Early career outcomes can have life-long consequences in terms of income, pensions and security. The potential gains of landing employment in large and productive companies or in government are so large and the alternative so unattractive that an enormous amount of time, resources and personal efforts go into maximising chances to end up on the winning side. This Korean “golden ticket syndrome” includes an excessive focus on education and entrance exams, money and time spent on after-school tutoring (hagwon), a high share of youth being neither in education, employment or training (NEET) while for example preparing to sit or re-sit exams. Notable costs of this situation are reduced youth well-being, low youth employment rates due to delayed labour market entry, delayed family formation, increased cost of having children in terms of time and money and reduced intergenerational social mobility, as discussed in Chapter 3.
Policy priorities to reduce inequalities notably include breaking down labour market dualism and expanding social insurance enrolment. Relaxing employment protection for regular workers and reducing the uncertainty associated with redundancies would make it less risky for employers to hire on regular contracts, while expanding social insurance enrolment and training for non-regular workers would reduce precariousness, improve matching and reduce skill gaps (OECD, 2018; OECD, 2020b). This would take some pressure off youth, and should be complemented by reform of the education system. Such reforms should aim to reduce the focus on admission to prestigious universities by improving other paths to success, including vocational and entrepreneurship education, in a dialogue with employers and unions. To improve the quality of universities, caps on student enrolment should be gradually phased out, combined with other measures to encourage universities to shift resources according to social demand. In particular, increased investment in universities outside of the Seoul metropolitan area would reduce the dominance of Seoul-based universities in the ranking of Korean universities (Chapter 3).
Table 1.7. Past recommendations to address inequalities and action taken
Women’s stark choice between career and family holds back employment and fertility
The notable costs to Korean youth, parents and society pursuing a golden ticket to attractive employment do not seem to carry comparable benefits in terms of a well-functioning labour market matching of workers to the firms and tasks they are best suited to perform. Literacy skills and tertiary education, objective measures of skills which are highly correlated with employment and productivity in most OECD countries, do not significantly affect the likelihood of employment in Korea (Figure 1.21). The weak link between objective skills and labour market outcomes raises questions about fairness and the intrinsic value of equal opportunities, and it represents a misallocation of human capital and likely a substantial loss of productivity.
Instead, labour market outcomes, employment in particular, overwhelmingly reflect individual demographic characteristics, notably age, gender and parental status. Low employment rates among youth of both genders yield way to rising male employment until around the age of 50, after which many workers exit their career jobs (Chapters 2 and 3). A considerable gender wage gap opens up between men and women in typical childbearing age. Fathers are considerably more likely to be employed than men without children, while mothers are considerably less likely to be employed than women without children (Figure 1.22, Panel A). The combined gender- and parenthood-related employment gap in Korea is the largest in the OECD for all but the youngest adults (Panel B). The widening gender gaps around the time of parenthood reflect two aspects of the male breadwinner model affecting men and women differently. Marriage and childbearing are typically postponed until the father is in stable employment. Women in stable employment, notably in the public sector, are also more likely to have children. However, Korean women tend to leave the labour force following childbirth at very high rates compared to the OECD average, and those who interrupted their career after the birth of their first child stopped working for three years on average over the period 2006 to 2015 (OECD, 2019).
Figure 1.21. Literacy skills and tertiary education matter little for employment in Korea
Note: The log likelihood of being employed is estimated in a logistic regression controlling for 10-year age-gender cohort, parental status (by gender), education level, literacy skills and work experience (relative to age). Literacy skills are measured in PIAAC score points on a scale from 0 to 100. Education is measured by the International Standard Classification of Education (ISCED). ISCED 5A and 6 corresponds to tertiary education at Bachelor level or above. PIAAC data are from 2014-15 for Chile, Greece, Israel, Slovenia and Turkey, and from 2011-12 for the rest. The reference category is a man aged 35-44 without young children, holding an upper secondary degree.
Source: Pareliussen (2022), “How labour market outcomes reflect age, gender and skills in Korea, evidence from PIAAC”, OECD Economics Department Working Paper, forthcoming.
Figure 1.22. Employment excessively reflects gender and parental status
Note: The log likelihood of being employed is estimated in a logistic regression controlling for 10-year age-gender cohort, parental status (by gender), education level, literacy skills and work experience (relative to age). Literacy skills are measured in PIAAC score points on a scale going from 0 to 100, while education is measured by the International Standard Classification of Education (ISCED). ISCED 5A and 6 corresponds to tertiary education at Bachelor level or above. The shaded area in panel B spans all OECD values. The reference category is a man aged 35-44 without young children, holding an upper secondary degree.
Source: Pareliussen (2022), “How labour market outcomes reflect age, gender and skills in Korea, evidence from PIAAC”, OECD Economics Department Working Paper, forthcoming.
Gender gaps are also prominent among the employed. Korea has the largest gross gender wage gap in the OECD, and the second lowest share of female managers in the OECD after Japan (OECD, 2021c). Fathers, the traditional breadwinners, get a career boost from parenthood, increasing work hours and hourly pay within their pre-parenthood career. Women tend to fall behind men in terms of earnings per hour, work hours per week, and the likelihood of being employed on an open-ended (regular) work contract or working in a large company (Figure 1.23).
In sum, women have gained opportunities to prosper in the workplace, as access to education and jobs has become increasingly equal between genders, but working life and social norms have not kept pace. The high cost of having children, in terms of going from the winning side of labour market dualities with regular and rewarding employment to a second-rate path of low-pay, non-standard work in a low-productivity SME forces women to choose between career and family. Combining career and children is often not an option because the demands from working life are tough, with a culture of long work hours and relatively little flexibility and an unequal division of unpaid care work in households rooted in traditional concepts of gender roles. Following up on their children’s education to help them win their own golden ticket costs time and money. Expensive housing and higher demands to meet material standards add to the cost. Women who have left the labour force for a few years to care for young children tend to find the return to the labour market an unattractive proposition. In general, regular employment opportunities are hard to find for “mother returners”, for whom low-paid non-regular jobs are the only opportunities available. As a result, mothers are three times more likely to be in non-regular employment than fathers (OECD, 2021c; OECD, 2019). These factors lead young women to postpone family formation and to have fewer children over their lifetime. The average age of first childbirth has increased from 26.2 to 32.3 in less than three decades (Figure 1.24, Panel A). The total fertility rate, which was at six children per woman on average in 1960, has dropped to just below one child per woman in 2019 (OECD, 2019).
Figure 1.23. Working women face considerable gender gaps
Labour market outcomes conditional on employment
Note: Log hourly earnings in PPP-adjusted USD as well as work hours per week are estimated in ordinary least squares regressions with robust standard errors. The log likelihood of being a regular employee or working in a large firm (250 employees or more) are estimated in logistic regressions. All regressions control for 10-year age-gender cohort, parental status (by gender), education level, literacy skills and work experience (relative to age). Literacy skills are measured in PIAAC score points on a scale going from 0 to 100, while education is measured by the International Standard Classification of Education (ISCED). ISCED 5A and 6 corresponds to tertiary education at Bachelor’s level or above. The reference category is a man aged 35-44 without young children, holding an upper secondary degree.
Source: Pareliussen (2022), “How labour market outcomes reflect age, gender and skills in Korea, evidence from PIAAC”, OECD Economics Department Working Paper, forthcoming.
Policy has in many ways been responsive to these challenges. Korea has developed a comprehensive system of public and private formal day care and kindergartens, raising public spending to 1% of GDP, and reaching enrolment rates on par with Nordic countries. The government pays for the tuition for all children, including in private day-care centres. To alleviate concerns over quality, all day-care centres have been obliged to go through an accreditation process since 2019, and the government implements policies to turn private day-care centres into public ones, as these are still highly preferred by parents. Korea is also rolling out a community-based care service network that will provide childcare services using school and community facilities, and link and expand current out-of-school-hours services, an area where supply is still insufficient.
Figure 1.24. Childbirth happens later in life in Korea
Source: Centres for Disease Control and Prevention, Office for National Statistics, Statistics Japan, Statistics Korea, Statistics Norway; OECD Family Database.
Paid childbirth-related leave has also been expanded, but has gaps. Paid maternity leave up to 100% of regular earnings is available for 90 days for mothers who are covered by employment insurance. The first 60 days are in general covered by the employer (there are exceptions for SMEs). One year of parental leave is available for both mothers and fathers, paid up to 80% of the monthly ordinary wage. The new government plans to extend parental leave to one and a half years. Eligibility is limited by the limited coverage of employment insurance as outlined above and in Chapter 2. A lump-sum payment of KRW 500 000 (EUR 375) per month for three months is available for those not covered by employment insurance. Due to limited eligibility, gender norms, a lack of enforcement of parental leave rights and the cost incurred by employers, the paid parental leave system is under-used (OECD, 2019). 13.4% of parents who gave birth in 2020 took up parental leave (24.3% of mothers and 2.5% of fathers). Among those parents eligible for parental leave, 24.2% exercised their right. A fairly large share (63.9%) of mothers used it, while only very few (3.4%) fathers did.
In light of these considerable investments in childcare and parental leave, difficulties in combining career and family are increasingly reflecting gender norms and an unforgiving work culture (Doepke et al, 2022; Myong et.al, 2020). Long working hours and low flexibility for parents make it difficult to combine work and family. Maximum allowed working was reduced from 68 to 52 hours per week in firms with 300 or more employees as of July 2018, and has been applied to all firms with five or more employees from July 2021. To increase flexibility, a tripartite agreement was signed on a plan to extend the period over which the flexible work hours system can be averaged from three to six months. The first phase of the reform, targeted at firms with 300 or more employees, has contributed to reducing the percentage of individuals working very long hours. This change is helpful, but a 52-hour working week is not compatible with taking active part in raising children and other domestic work. Work culture will need to change by changing norms, and by reducing the current strong emphasis on overtime pay in the total remuneration package. Norms also need to change to reduce pressures on women regarding what it means to be a good mother and wife and sharing domestic and paid work better between mothers and fathers. The public sector as an employer is already considered more family-friendly than the private sector, and can continue to lead by example and engage in constructive dialogue with unions and employers.
Going forward, any policies reducing labour market duality and dampening the intense competition facing youth would reduce the cost of motherhood in terms of foregone earnings and career opportunities. Strengthening the real incomes of young people and families by means of better labour market matching and public support could help provide a more solid basis for starting and supporting a family (Chapter 2, OECD, 2019). Financing maternal, paternal and parental leave fully by social security contributions or general taxes, as is the case in many OECD countries including all the Nordics, could help secure employers’ support, combined with enforcement of workers’ rights.
Table 1.8. Past recommendations to reduce barriers to women’s careers and action taken
Bridging gaps can boost growth
Simulations in the OECD Long-term model (Box 1.3) indicate that Korea’s GDP per capita growth potential will slow from around 3% per year in 2005-22 to around 1% per year in 2023-60. About half of the fall results from a declining working-age population. The rest reflects slower growth in the employment rate, less capital deepening and weaker multifactor productivity, despite assumed convergence towards the best-performing OECD countries (Guillemette and Turner, 2021). This steeply reduced growth potential is not inevitable. Policy recommendations in this Survey could contribute to closing gaps in employment and productivity across genders and age groups, and simulations in the Long-term model illustrate how this could improve growth, employment and public finance outcomes.
Box 1.3. The OECD Long-term model
The OECD long-term model includes 48 countries. It is built around a set of long-run projections for potential output which are extensions of the short-term potential output estimates prepared for the twice-yearly OECD Economic Outlook. Potential output is based on a Cobb-Douglas production function with constant returns to scale featuring physical capital and trend employment as production factors plus labour efficiency growth.
Labour efficiency growth converges to a steady state which depends on the particular institutional and policy environment of each country, including the stock of human capital, governance, product market regulations, trade openness, research and development and income inequality. In steady state, labour efficiency grows at an assumed exogenous rate of global technological progress of 1% per year.
Trend employment is primarily the result of three sets of dynamics: the evolving size of the working-age population; its age composition; and trends in the employment rates of different age-gender groups driven by historical employment trends and education levels.
The productive capital stock is notionally split between private and public sector capital stocks. The public sector capital stock-to-output ratio is assumed to be constant in the baseline scenario, while the business sector capital stock ensures that in steady state, the capital-to-output ratio is stable. Housing is excluded from the definition of the productive capital stock.
Source: Guillemette and Turner (2021), “The long game: fiscal outlooks to 2060 underline need for structural reform”, OECD Economic Policy Papers, No. 29.
Policies outlined above to increase women’s opportunities to combine careers and families, speed up young peoples’ labour market entry and reduce the pressure on youth and their parents from the race to secure educational credentials are likely to increase fertility. However, even a large and immediate increase in fertility will only affect output with a long lag. The GDP growth projection in the Long-term model is based on population projections from the United Nations Population Division under a “normal” fertility rate. Even the normal fertility trajectory implies that fertility rises from 0.8 children per woman today to approximately 1.5 children per woman in 2060. Fertility rates in the high-fertility trajectory equals the normal trajectory plus 0.5. Increasing fertility would increase GDP growth in volume noticeably from approximately 2040. However, the higher dependency rate would lead to lower per capita GDP growth until 2048 (Figure 1.25).
The OECD Long-term model’s baseline already assumes that the employment gap between women and men will narrow from 18 percentage points in 2020 to 6 points in 2060 based on education and societal trends. If reforms outlined in this Survey succeeded in bringing about an even more equal sharing of paid employment and unpaid work within families, further narrowing the gender employment gap to 2%, this would raise potential employment by 1.7% and GDP per capita by 1.6%. If a package of policies proposed in Chapter 3 succeeded in raising youth employment to the OECD average, this would entail even larger gains of 2.9% in employment and 2.7% in GDP. The largest gain would come from raising the pensionable age faster than planned, to 68 years by 2034, and increasing it by two-thirds of gains to life expectancy thereafter, as proposed in Chapter 2 (Table 1.9).
Figure 1.25. Potential GDP growth is set to continue falling
Note: Fertility trajectories are from the United Nations Population Division. Even the Normal fertility trajectory implies rising fertility to approximately 1.5 children per woman in 2060. Fertility rates in the High fertility trajectory equals the Normal trajectory plus 0.5.
Source: OECD calculations based on the OECD Long-term model.
Wage gaps in Korea reflect productivity gaps as outlined above, although not perfectly. Assuming that productivity gaps could be reduced corresponding to closing two-thirds of the wage gap between men and women would boost GDP per capita by 10%. Closing two-thirds of the wage gap between youth and 30-34 year-olds would yield 1.6% higher GDP per capita in 2060, while boosting old workers’ productivity corresponding to closing two-thirds of the wage gap between 50-74 year-olds and 45-49 year-olds would entail 8% higher GDP per capita. Assuming that a broad product and labour-market reform narrowed all employment and productivity gaps identified here at the same time in line with the above, potential employment would increase by 9% and GDP per capita by 29% compared to the baseline (Table 1.9).
In the baseline Long-term model projections, spending pressures are set to increase by approximately 10% of GDP by 2060. This increase is driven by ageing, notably pensions and health expenditure (Table 1.10). A broad reform narrowing employment and productivity gaps of youth, women and the elderly, increasing the pensionable age and curbing health spending growth would narrow spending pressures by approximately one-third from 9.8% of GDP to 6.6%. Speeding up youth’s labour market entry would reduce spending pressures by 0.9% of GDP compared to the baseline, while closing the gender employment gap would reduce pressures by 0.5% of GDP. Productivity increases for these groups and the elderly would slightly add to spending pressures, notably driven by health expenditure. Curbing health spending growth would reduce spending pressures by 0.6% of GDP, while the single largest saving would come from increasing the pensionable age more quickly than planned, which would reduce spending pressures by 2% of GDP by 2060 (Table 1.10).
Table 1.9. Long-term scenarios for GDP and employment
Note: Gaps between youth and the OECD average (for employment) and 30-34 year-old (for wage) are defined and closed for each of the groups age groups 15-19, 20-24 and 25-29. Gaps between 50-74-year olds and 45-49 year-olds are also defined for each individual five-year age cohort. The faster increase in the pensionable age implies increasing the National Pension eligibility age to 68 by 2034 and increasing it by two-thirds of life expectancy gains thereafter.
Source: OECD calculations based on the OECD Long-term model.
Table 1.10. Long-term scenarios for public finances
Note: Gaps between youth and the OECD average (for employment) and 30-34 year-old (for wage) are defined and closed for each of the groups age groups 15-19, 20-24 and 25-29. Gaps between 50-74-year olds and 45-49 year-olds are also defined for each individual five-year age cohort. The faster increase in the pensionable age implies increasing the National Pension eligibility age to 68 by 2034 and increasing it by two thirds of life expectancy gains thereafter.
Source: OECD calculations based on the OECD Long-term model.
Key policy insights recommendations
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Annex 1.A. Economic Cooperation with North Korea
Response to COVID-19
In response to the outbreak of COVID-19 in early 2020, and against the backdrop of gradually worsening geopolitical tensions between the two Koreas, North Korea implemented drastic measures, blocking human and material exchanges across the border and restricting domestic movement. This seems to have contributed to contain the spread of the virus for some time, but at considerable cost for the economy and citizens.
North Korea has not carried out many tests (Kim Jeongmin, 2022) and has hesitated to secure COVID-19 vaccines internationally, ending up alongside Eritrea as one of only two countries worldwide that did not start a COVID-19 vaccination campaign. North Korea rejected various vaccine offers including of Sinovac and AstraZeneca doses, reportedly owing to concerns about effectiveness and safety (Reuters, 2021; Cha, 2021). Another question pertains to the ability of the medical system to adequately distribute vaccines around the country (Byrne, 2021). By end-2021, COVID-19 Vaccine Global Access (COVAX) had allocated 8.1 million doses of early COVID-19 vaccines to North Korea, which would have allowed it to inoculate over 15% of the population. However, as the country failed to arrange any shipments, the COVAX allocation was cancelled in early Spring 2022. North Korea did begin to receive COVID-19 related medical supplies and equipment dispatched by the World Health Organisation in October 2021 (Cumming-Bruce et al., 2021). In Spring 2022, the new South Korean President indicated that his country stood ready to provide vaccines.
In May 2022, the North Korean authorities started reporting COVID-19 cases and deaths, even as strict lockdowns were imposed across the country. By late July, they had reported around 4.8 million cases of “fever” (close to 19% of the total population) and an implausibly low number of only 74 deaths (38 North, 2022). Infections likely took place much earlier, however (Jang, 2021). With an unvaccinated and largely malnourished population, the risks associated with infection are high. On the Chinese side of the border, the municipal authorities in Dandong took measures in late Spring to limit smuggling on account of contamination risks (Bremer, 2022). In August, the North Korean authorities declared victory over COVID-19 and lifted face mask mandates and other distancing rules, except in the border regions and while still recommending that those experiencing respiratory symptoms keep wearing masks (Choi, 2022).
Economic developments
Before the COVID-19 outbreak, the North Korean economy recorded two years of severe contraction in 2017-18, against the backdrop of tightened international sanctions, with barely any recovery in 2019 (Annex Figure 1.A.1). In 2020, GDP fell by an estimated 4.5%, the steepest drop since 1997, in a context of border shutdowns in the face of the pandemic, continued international sanctions and natural disasters such as floods and heavy rains. Production in agriculture, forestry and fishing decreased sharply due to bad weather and virus-related fishing restrictions. So did production in mining and light industry. The service sector experienced a recession as well, due to the suspension of foreign tourism and the contraction of retail trade. In 2021, GDP contracted further but barely, by an estimated 0.1%, with a rebound in agriculture offset by a continued decline in industry and a small drop in services. Prior to the pandemic, tourism, not targeted by UN sanctions, had been an important source of foreign currency income. Chinese tourists stopped visiting North Korea due to strict border closures, and the ambitious tourism development projects launched in recent years reportedly stalled. Meanwhile, North Korean migrant workers staying abroad despite the UN sanctions have remained an important source of foreign currency for North Korea together with the smuggling of coal and minerals, cyber hacking and the selling of fishing rights (periodic reports of the United Nations Sanctions Committee Panel of Experts; Chainalysis, 2022). The North Korean central bank also issued money coupons (tonpyo), which trade at a discount. This may have resulted from shortages of imported paper and ink (Ishimaru, 2021), but it may also be seen as deficit finance (Lim and Cho, 2022).
Annex Figure 1.A.1.. Estimated GDP level and growth rate
Note: Estimated at 2015 constant prices (using South Korea relative prices). Estimates are subject to considerable limitations (see Koen and Beom, 2020).
Source: Bank of Korea.
Accordingly, the economic gap with South Korea has widened further in recent years. Recorded foreign trade was 1 766 times smaller than South Korea’s by 2021, and gross national income per capita over 28 times smaller, down from 22 times in 2016 (Annex Table 1.A.1).
Annex Table 1.A.1.. Comparison of North and South Korea in 2021
Source: Bank of Korea.
At the Eighth Party Congress in January 2021, the failure of the elapsed five-year 2016-20 National Economic Development Strategy was officially recognized. Spending in the 2021 government budget increased only 1.1%, the lowest since 1966 (excluding the “Arduous March” period in the 1990s) and far below the 6% annual growth rate since 2012 under Kim Jong-un. A 2021-25 National Economic Development Plan was unveiled, emphasizing self-reliance and with military and economic development as the two primary goals. In contrast to the 2016-20 plan, which had aimed to make science and technology the driving force of development, the 2021-25 Plan focuses narrowly on metals and chemicals, notwithstanding the challenges associated with the international sanctions (Cho, 2021). Economic difficulties are expected to continue as long as borders remain mostly closed, be it due to COVID or because of the international sanctions, which have disrupted private markets, the main driver of economic growth. This has been accompanied by a tightening of government control of private markets. With the reduced role of international trade and private markets, coupled with measures to discourage demand for foreign currencies, the exchange rate of the North Korean won to the US dollar has displayed increased volatility since late 2020.
Shortages of fertilisers and agricultural materials, combined with recurrent natural disasters, affect food production. The Food and Agriculture Organisation (2021) estimated North Korea’s cereal shortage in 2020-21 at 1.06 million tonnes. The price of rice traded in the market, which remained stable until 2019, has become more volatile since the pandemic despite the authorities’ efforts to stabilise it via releases of stocks. The recent winter drought foreshadowed a poor harvest of wheat and barley this year.
Recorded external trade plummeted by 73% in 2020 to USD 0.86 billion, the lowest level since 1990, and shrank by another 17% in 2021 (Annex Figure 1.A.2). Overall recorded exports dropped by 70% cumulatively over those two years, with exports of mineral and textile products collapsing to only USD 20 million. According to KOTRA (2022), imports of fertilisers for agricultural production decreased by 44% (on a volume basis) over those two years, hurting food production. Since imports fell more than exports, the recorded trade deficit narrowed, from USD 2.7 billion in 2019 to about USD 0.5 billion in 2021. While trade with China decreased by almost 90% over those two years, it accounted for almost 96% of North Korea’s total external trade by 2021, followed by Vietnam (1.7%) and India (0.4%). While trade with China started to pick up in late 2021, and train traffic across the Chinese border resumed, trade flows were still only a fraction of their pre-pandemic level in early 2022 according to Chinese customs data. Moreover, train traffic with China was stopped in April 2022, as COVID-19 cases emerged in Dandong, China.
Annex Figure 1.A.2.. Recorded North Korean foreign trade
Source: Korea Trade-Investment Promotion Agency; Statistics Korea. The data shown here are based on mirror statistics produced by North Korea’s trading partners and do not capture smuggling and illegal ship-to-ship transfers of coal, oil and other materials circumventing United Nations sanctions.
Since the closure of the Gaeseong Industrial Complex in 2016, trade of goods between the two Koreas has almost vanished, and amounted to only USD 1.1 million in 2021 (Bank of Korea, 2022). In early 2022, the Unification Ministry announced financial support for South Korean businesses affected by the dormant projects in North Korea, amounting to KRW 57.4 billion (around $48 million) in the form of direct subsidies and special loans.
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