## wp1891

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### I. Introduction — Fiscal position and challenges
- Fiscal and demographic context:
  - General government debt at around 40 percent.
  - Average fiscal surplus of the consolidated central government of 1.2 percent of GDP since 2010.
  - Old-age dependency ratio expected to rise by 50 percentage points in the next 50 years.
  - Projected increase in pension and health-related public spending: 10-16 percent of GDP by 2060.
  - Personal saving rate has increased by 8 percentage points since the early 2000s.
  - Share of private consumption to GDP has fallen by 6 percentage points.
- Structural headwinds:
  - Lagging productivity (especially in services).
  - Labor and product market distortions.
  - Insufficient social protection: public social spending is less than half the OECD average; benefits and pensions less generous than in many OECD economies.
- Research question and approach:
  - Can fiscal policy preserve sustainability amid rising age-related spending while supporting higher, inclusive, more balanced long-term growth?
  - Paper presents long-run fiscal projections incorporating healthcare and pension spending and new potential growth estimates from a novel multivariate filter, and analyzes policy options via model simulations.

### II. Assessing Korea’s potential output with an extended multivariate filter
- Methodology:
  - Standard multivariate filter augmented with a Cobb-Douglas production function; observable variables: employment, capital stock, and total-factor productivity (TFP).
  - Equilibrium TFP projected by assuming productivity catch-up vis-à-vis the United States.
  - Equilibrium employment estimated from UN population projections, equilibrium participation rate, and NAIRU.
- Advantages over univariate (HP) filters:
  - Multivariate system incorporates production function structure and links between variables; addresses end-of-sample problems and real-time uncertainty of HP filter estimates.
- Main projection and drivers:
  - Korea’s potential growth projected to steadily fall until 2058.
  - Declining employment growth (and levels after 2030) driven by shrinking labor force explains most of the downward trend.
  - Contribution from capital to potential growth expected to fall over time to reach a constant capital-output ratio after an earlier period of rapid rise.
  - Current TFP about 60 percent of the U.S.; long-run steady-state Korea-U.S. productivity ratio projected at 68 percent (assumptions: continued convergence to frontier; speed somewhat slower than past two decades).
- Potential growth estimates (Average Annual Potential Growth, in percent):
  - Authors’ estimates based on an extended multivariate filter:
    - 2020-30: 2.2
    - 2030-40: 1.9
    - 2040-50: 1.5
    - 2050-60: 1.2
  - MOSF (2015):
    - 2020-30: 2.6
    - 2030-40: 1.9
    - 2040-50: 1.4
    - 2050-60: 1.1
- Caveats:
  - Significant uncertainty due to capital stock data quality and susceptibility of cross-country productivity convergence to structural shocks.
- Policy implication:
  - Potential growth is not policy invariant; can be raised through structural reforms to boost productivity and labor force participation, complemented by fiscal policy.

### III. The fiscal impact of aging: implications for debt sustainability
- Pension and healthcare spending projections (percent of GDP and changes 2015/16 to 2060):
  - Pension projections:
    - MOSF (2015): from 3.0 to 10.6 (Change: 7.5)
    - National Pension Research Institute (2013): from 1.2 to 6.9 (Change: 5.7)
    - National Assembly Budget Office (2012): from 2.4 to 8.9 (Change: 6.5)
  - Health projections:
    - MOSF (2015) (health insurance spending, including long-term care insurance): 2015/16: 0.6; 2030: 0.9; 2040: 0.9; 2050: 0.8; 2060: 0.2
    - OECD (2015) (health-care and long-term care; De la Maisonneuve and Martins (2015)): Change 2015/16 to 2060: 8.6-13.2 (range); Change amount reported: 4.6-9.2
    - IMF (2016) (health-care and long-term care): 2015/16: 4.4; 2030: 6.1; 2040: 7.6; 2050: 9.0; 2060: 10.0 (Change: 5.6)
- Baseline fiscal projection assumptions:
  - GDP growth consistent with October 2017 WEO forecast until 2022; from 2023 onward output grows at potential estimated in Section II.
  - Annual primary expenditure as a share of GDP assumed to increase by about 0.3 percentage point per year on average from 2023 through 2060, implying a cumulative increase of around 13 percentage points by 2060.
- Interest rate and inflation assumptions:
  - Nominal interest rate on government debt assumed to increase gradually to 4.5 percent in 2060.
  - Inflation assumed at the 2 percent target; real interest rate on government bonds increases above real GDP growth starting in 2035.
  - The 4.5 percent long-run interest rate embodies an approximately 50 bps country-risk premium relative to the United States.
- No-revenue-increase scenario:
  - Keeping total revenue fixed as a share of GDP results in explosive debt dynamics.
  - Consolidated fiscal balance would turn negative in 2024 and reach a deficit of about 14 percent of GDP in 2050.
  - Debt level over 100 percent of GDP by 2050.
  - NABO (2016) projects consolidated central government deficit of about 8 percent of GDP and debt-to-GDP ratio of 111 percent in 2050 assuming no change in policies.
- Sensitivity examples:
  - Adding NHIS insurance premiums to government revenues (NHIS insurance premium income was 3.1 percent of GDP in 2016) projects debt-to-GDP ratio nearly 150 percent in 2060 and rapidly growing afterwards.
  - If potential growth followed MOSF (2015) projections, debt ratio differences in the long run are marginal (less than 1 percentage of GDP difference in 2075).

### IV. Paths to long-term fiscal sustainability — scenarios and policy instruments
- Policy instruments and reforms to preserve sustainability and support growth:
  - Increase retirement ages in both private and public sectors to contain pension spending.
    - Pension age currently 61 with at least ten years of contributions; reduced early pension available from age 56.
    - Normal pension age being increased to reach 65 in 2033; early pension age will increase to 60.
    - An additional hike in the retirement age by 3 years by 2035 would reduce pension spending by an estimated 1 percentage point of GDP in 2050.
  - Broaden the tax base with both efficiency and equity gains.
    - Korea’s average effective personal income tax rate is one of the lowest in OECD; for the median wage earner it is close to zero.
    - Base could be broadened by gradually eliminating wage and other deductions.
    - Corporate income tax is a source of multiple distortions that could be streamlined.
  - Increase payroll contribution rates that are currently at 9 percent, compared to a 20 percent average in advanced economies.
  - Increase selected tax rates, for example the VAT rate, currently at 10 percent.
- Debt capacity and illustrative targets:
  - Korea can safely sustain public debt levels above 40 percent of GDP; IMF (2013) signal-approach estimate for advanced economies’ debt ceiling is 85 percent of GDP.
  - Allowing debt-to-GDP to reach 45 percent in the long run would leave space for policies to enhance social protection and support growth.
- Illustrative scenario dynamics:
  - Revenues kept constant for 10 years: fiscal surplus declines gradually, deficit arises in 2024, peaking at about 1.5 percent of GDP in 2027; debt-to-GDP declines until 2027 to about 30 percent.
  - After 2027 revenues start to increase. In a “permanent deficit” scenario with deficit stabilizing at 1.5 percent of GDP, debt reaches 40 percent of GDP in 2077 and achieves a steady state of 45 percent of GDP thereafter.

### V. Key takeaways and policy recommendations
- Core messages:
  - Rising age-related spending (10–16 percent of GDP by 2060) requires sizable revenue increases in the long run to stabilize debt if borrowing is constrained.
  - Given Korea’s low public debt and a low global interest rate environment, a combination of higher revenues (partly via base broadening) and additional borrowing can finance increased age-related spending while preserving fiscal sustainability.
  - Small revenue changes can have large impacts on long-term debt dynamics.
- Recommended fiscal and structural priorities:
  - Higher targeted transfers to the most vulnerable.
  - Fiscal measures to support female labor force participation and employment.
  - Comprehensive product and labor market reforms to raise potential growth.
  - Growth-friendly fiscal policies during periods of low long-term interest rates to help raise potential growth ahead of eventual higher rates.

### 2100 / Scenario: Revenues increase from 22 to 33 percent of GDP in 2060 — “temporary deficit”
- Fiscal projections and debt scenarios:
  - Revenues increase from 22 to 33 percent of GDP in 2060.
  - In the “temporary deficit” scenario:
    - Revenues increase to nearly 34 percent of GDP in 2060.
    - The deficit declines to zero in 2084.
    - The primary balance turns into a surplus in 2040.
    - Public debt-to-GDP ratio peaks at 30 percent in 2036 and declines afterwards.
  - Debt declines during periods of overall balance positivity are driven by the increase in nominal GDP and the assumption that fiscal surpluses are saved.

### Permanent increase in social safety net spending: design and impacts
- Policy simulated:
  - Permanent increase in targeted transfers (transfers to liquidity-constrained consumers) of 0.75 percent of baseline GDP.
- Financing variants:
  - Gradual increase in consumption taxes.
  - Gradual increase in labor income taxes.
  - Gradual increase in capital income taxes.
  - A rise in deficit by 0.8 percentage points of GDP (in scenarios with increased deficit).
- Key simulation findings:
  - The consumption tax is the least harmful revenue source in macroeconomic impact and allocative distortions.
  - Increase in capital taxation reduces investment; increase in labor income tax lowers employment.
  - In all three tax-financed cases, government-debt-to-GDP ratio increases by 15 percentage points above the baseline in the very long run and stabilizes there.
- Effects on private saving and external balances:
  - OECD (2011) finding cited: an increase in public health care spending by 1 percent of GDP is associated with a decline in the saving rate by 1.9 percentage points.
  - In the FSGM simulation, private saving as a share of GDP declines by 1 percentage point in the long run due to permanently higher transfers.
  - Stronger private consumption and investment boost GDP growth and reduce Korea’s current account surplus.
  - Real exchange rate appreciates, consistent with stronger imports.

### Structural reforms and fiscal measures to boost labor supply
- Reform package components (implemented over 10 years):
  - Ease product market regulation and employment protection legislation (75 percent of the reforms needed to converge to the average of three OECD frontier economies).
  - Increase the share of consumption and property taxes in total tax revenues by 1.1 percentage points, accompanied by a decline in the share of labor income tax.
  - Expand childcare spending by 0.25 percent of GDP.
  - Increase active labor market policies (ALMP) spending by 0.5 percent of GDP.
  - Financing: combination of higher VAT revenues and higher deficit.
- Simulation results:
  - Korea’s potential output could rise by more than 6 percent in the long run.
  - Potential growth would increase by over 0.6 percentage point a year on average for a decade.
  - The additional spending on childcare and ALMP would result in a rise in public debt in the very long run of 15 percentage points of GDP.
  - Model caveat: impact of ALMP spending may be underestimated because it is assumed to affect equilibrium employment but not participation rate.

### Combined policy package: outcomes and fiscal costs
- Package components: stronger social safety nets, structural reforms, increased fiscal spending to boost labor supply.
- Macroeconomic outcomes (deviations from baseline):
  - Output increases by about 6 percent in 10 years.
  - Real consumption increases by about 9 percent in 10 years.
  - Current account surplus declines by nearly 2 percent of GDP in 10 years.
- Fiscal outcomes:
  - The policy package would imply a 30 percentage points increase in the debt ratio relative to the baseline scenario.
  - Deficit would increase by 1.5 percentage points of GDP relative to the baselines.
  - Example trajectory under “temporary deficit” path plus additional measures:
    - Public debt-to-GDP would peak at 51 percent in 2061 and decline afterwards.
    - Deficit would peak at 3 percent of GDP in 2027 and decline afterwards.
  - Example trajectory under “permanent deficit” path plus additional measures:
    - Public debt would reach 70 percent of GDP in 2080 and stabilize 75 percent past beyond 2100.
    - The deficit would stabilize at around 3 percent.

### Policy implications and recommendations (detailed)
- Fiscal instruments and tax design:
  - Financing through a mix of higher borrowing and additional revenues obtained by broadening the tax base and selected tax increases is preferable given Korea’s low public debt and low interest rates.
  - VAT extensions could include:
    - All new real estate supplies, including the value of land.
    - Insurance and financial services.
    - Suppliers to exporters.
  - Move toward neutrality in taxing various sources of capital income.
- Fiscal policy objectives:
  - Strengthen social safety nets to reduce poverty and boost private consumption.
  - Increase fiscal spending on childcare and ALMP to boost labor supply and potential growth.
  - Support structural reforms that raise productivity growth and efficiency (e.g., easing product and labor market regulations; encourage R&D).
  - Maintaining government debt at elevated but sustainable levels would provide buffers to deal with the fiscal costs of possible reunification.

### Appendix I. A Summary of the IMF’s G20MOD Module of FSGM
- Model overview:
  - G20MOD is an annual, multi-economy, forward-looking model combining micro-founded and reduced-form formulations.
  - Contains individual blocks for G-20 countries and 5 additional regions.
  - Each economy structurally identical except for commodities; distinguished by unique parameterizations.
- Key model blocks:
  - Consumption: overlapping-generations households and liquidity-constrained households.
  - Investment: Tobin’s Q model; firms are net borrowers with risk premia varying with the output gap.
  - Trade: reduced-form functions of a competitiveness indicator and domestic/foreign demand; competitiveness improves one-for-one with domestic prices.
  - Potential output: endogenous via Cobb-Douglas production with exogenous trend TFP and endogenous capital and labor.
  - Inflation and wages: reduced-form Phillips’ curves with lags/leads of inflation, output gap, real effective exchange rate, and second-round effects.
  - Monetary policy: interest rate reaction function, typically inflation-forecast-based.
  - Commodities: three commodities (oil, metals, food) with relatively price-inelastic short-run supply and demand.
- Cross-country distinctions:
  - Differ via parameter values and steady-state ratios rather than structural differences (except commodity treatment).

### Appendix II. Composition and Cost of Illustrative Structural Reforms
- Product Market Regulation Reform:
  - OECD Typical Historical Reform Size: 20% Reduction in the OECD PMR Index.
  - OECD Illustrative Supply-Side Impact after 5 Years: 2.4% Level Gain in MFP for Advanced Economies; 3.4% Level Gain in MFP for Emerging Markets.
  - Assumed Korean Reform Size: 22.5% Reduction in the OECD PMR Index.
  - Assumed Fiscal Cost Effects in Model: None.
  - Resulting Impact: 2.7% Level Gain in MFP.
- Employment Protection Legislation Reform:
  - OECD Typical Historical Reform Size: 20% Reduction in the OECD EPL Index.
  - OECD Illustrative Supply-Side Impact after 5 Years: 0.44% Level Gain in LP for Advanced Economies; 0.48% Level Gain in LP for Emerging Markets.
  - Assumed Korean Reform Size: 30% Reduction in the OECD EPL Index.
  - Assumed Fiscal Cost Effects in Model: None.
  - Resulting Impact: 0.66% Level Gain in LP.
- Tax Structure Reform:
  - OECD Typical Historical Reform Size: 3 Percentage Point Rise in the Share of Consumption and Property Taxes in Total Tax Revenues.
  - OECD Illustrative Supply-Side Impact after 5 Years: 0.75% Level Increase in LP.
  - Assumed Korean Reform Size: 1.125 Percentage Point Rise in the Share of Consumption and Property Taxes in Total Tax Revenues.
  - Assumed Fiscal Cost Effects in Model: None.
  - Resulting Impact: 0.28% Level Gain in LP.
- Spending on Childcare:
  - OECD Typical Historical Reform Size: 1 Dollar Increase in Spending per Child (in US$ PPP).
  - OECD Illustrative Supply-Side Impact after 5 Years: 0.002 Percentage Point Increase in the Employment Rate of Women.
  - Assumed Korean Reform Size: 0.25% of GDP, or Approximately 2000 Dollar Increase in Spending per Child (in US$ PPP).
  - Assumed Fiscal Cost Effects in Model: Targeted Transfers of 0.25% of GDP Permanently, Financed by VAT, Resulting in a Rise in Debt of 5 Percent of GDP in the Long Run.
  - Resulting Impact: 0.75 Percentage Point Increase in the Total Labor Participation Rate.
- Spending on Active Labor Market Policies:
  - OECD Typical Historical Reform Size: 12.5 Increase in Spending per Unemployed, as a Percent of GDP over Population.
  - OECD Illustrative Supply-Side Impact after 5 Years: 0.25 Percentage Point Decline in the Structural Unemployment Rate (NAIRU).
  - Assumed Korean Reform Size: 0.50% of GDP, or Approximately an Increase of 28 in Spending per Unemployment, as a Percent of GDP over Population.
  - Assumed Fiscal Cost Effects in Model: Government Consumption of 0.50% of GDP Permanently, Financed by VAT, Resulting in a Rise in Debt of 10 Percent of GDP in the Long Run.
  - Resulting Impact: 0.56 Percentage Point Decline in the NAIRU.

*Source: Authors’ estimates and analysis in the provided content.*

### References .............................................................................................................

### References

### I. Introduction — Fiscal position and challenges
- Korea has general government debt at around 40 percent and an average fiscal surplus of the consolidated central government of 1.2 percent of GDP since 2010.
- Rapid population aging: the old-age dependency ratio is expected to rise by 50 percentage points in the next 50 years.
- Projected increase in pension and health-related public spending: 10-16 percent of GDP by 2060.
- Decline in labor force growth will slow potential growth and worsen long-term public debt dynamics.
- Structural headwinds: lagging productivity (especially in services) and several labor and product market distortions.
- Insufficient social protection: public social spending is less than half the OECD average; benefits and pensions are less generous than in many other OECD economies.
- Private saving and consumption trends:
  - Personal saving rate has increased by 8 percentage points since the early 2000s.
  - Share of private consumption to GDP has fallen by 6 percentage points.
- Research questions and approach:
  - Can fiscal policy preserve sustainability amid rising age-related spending while supporting higher, inclusive, more balanced long-term growth?
  - Paper presents long-run fiscal projections incorporating healthcare and pension spending and new potential growth estimates from a novel multivariate filter, and analyzes policy options via model simulations.

### II. Assessing Korea’s potential output with an extended multivariate filter
- Methodology:
  - Standard multivariate filter augmented with a Cobb-Douglas production function; observable variables include employment, capital stock, and total-factor productivity (TFP).
  - Equilibrium TFP projected by assuming productivity catch-up vis-à-vis the United States.
  - Equilibrium employment estimated from UN population projections, equilibrium participation rate, and NAIRU.
- Advantages over univariate (HP) filters:
  - Multivariate system incorporates production function structure and links between variables, addressing end-of-sample problems and real-time uncertainty issues found with HP filter estimates.
- Main projection and drivers:
  - Korea’s potential growth projected to steadily fall until 2058.
  - Declining employment growth (and levels after 2030) driven by shrinking labor force explains most of the downward trend.
  - Contribution from capital to potential growth expected to fall over time to reach a constant capital-output ratio after an earlier period of rapid rise (capital deepening).
  - Current TFP about 60 percent of the U.S.; long-run steady-state Korea-U.S. productivity ratio projected at 68 percent (assumptions: continued convergence to frontier; speed somewhat slower than past two decades).
- Potential growth estimates (Table 1: Average Annual Potential Growth, in percent)
  - Authors’ estimates based on an extended multivariate filter:
    - 2020-30: 2.2
    - 2030-40: 1.9
    - 2040-50: 1.5
    - 2050-60: 1.2
  - MOSF (2015):
    - 2020-30: 2.6
    - 2030-40: 1.9
    - 2040-50: 1.4
    - 2050-60: 1.1
- Caveats:
  - Significant uncertainty due to capital stock data quality and susceptibility of cross-country productivity convergence to structural shocks.
- Policy implication:
  - Potential growth is not policy invariant; can be raised through structural reforms to boost productivity and labor force participation, complemented by fiscal policy.

### III. The fiscal impact of aging: implications for debt sustainability
- Projected increase in pension and healthcare spending (Table 2: Pension and Healthcare Spending Projections, in percent of GDP)
  - Pension projections (change 2015/16 to 2060):
    - MOSF (2015): from 3.0 to 10.6 (Change: 7.5)
    - National Pension Research Institute (2013): from 1.2 to 6.9 (Change: 5.7)
    - National Assembly Budget Office (2012): from 2.4 to 8.9 (Change: 6.5)
  - Health projections:
    - MOSF (2015) (health insurance spending, including long-term care insurance): 2015/16: 0.6; 2030: 0.9; 2040: 0.9; 2050: 0.8; 2060: 0.2
    - OECD (2015) (health-care and long-term care; De la Maisonneuve and Martins (2015)): Change 2015/16 to 2060: 8.6-13.2 (range); Change amount reported: 4.6-9.2
    - IMF (2016) (health-care and long-term care): 2015/16: 4.4; 2030: 6.1; 2040: 7.6; 2050: 9.0; 2060: 10.0 (Change: 5.6)
- Baseline fiscal projection assumptions:
  - GDP growth consistent with October 2017 WEO forecast until 2022; from 2023 onward output grows at potential estimated in Section II.
  - Annual primary expenditure as a share of GDP assumed to increase by about 0.3 percentage point per year on average from 2023 through 2060, implying a cumulative increase of around 13 percentage points by 2060.
- Real interest rate assumptions (Figure 5 context):
  - Nominal interest rate on government debt assumed to increase gradually to 4.5 percent in 2060.
  - Inflation assumed at the 2 percent target; real interest rate on government bonds increases above real GDP growth starting in 2035.
  - The 4.5 percent long-run interest rate embodies an approximately 50 bps country-risk premium relative to the United States.
- No-revenue-increase scenario results:
  - Keeping total revenue fixed as a share of GDP results in explosive debt dynamics.
  - Consolidated fiscal balance would turn negative in 2024 and reach a deficit of about 14 percent of GDP in 2050.
  - Debt level over 100 percent of GDP by 2050.
  - NABO (2016) projects consolidated central government deficit of about 8 percent of GDP and debt-to-GDP ratio of 111 percent in 2050 assuming no change in policies.
- Sensitivity examples:
  - Adding NHIS insurance premiums to government revenues (NHIS insurance premium income was 3.1 percent of GDP in 2016) projects debt-to-GDP ratio nearly 150 percent in 2060 and rapidly growing afterwards.
  - If potential growth followed MOSF (2015) projections, debt ratio differences in the long run are marginal (less than 1 percentage of GDP difference in 2075).

### IV. Paths to long-term fiscal sustainability — scenarios and policy instruments
- Policy instruments and reforms to consider to preserve sustainability and support growth:
  - Contain long-term pension spending pressures by increasing retirement ages in both private and public sectors.
    - Context: Pension age currently 61 with at least ten years of contributions; reduced early pension available from age 56. Normal pension age is being increased to reach 65 in 2033 and early pension age will increase to 60. An additional hike in the retirement age by 3 years by 2035 would reduce pension spending by an estimated 1 percentage point of GDP in 2050.
  - Increase revenues by broadening the tax base with both efficiency and equity gains (NABO, 2012; IMF, 2014a).
    - Context: Korea’s average effective personal income tax rate is one of the lowest in OECD; for the median wage earner it is close to zero. The base could be broadened by gradually eliminating wage and other deductions.
    - Corporate income tax is a source of multiple distortions that could be streamlined.
  - Increase payroll contribution rates that are currently very low, at 9 percent, compared to a 20 percent average in advanced economies.
  - Increase selected tax rates, for example the VAT rate, currently at 10 percent.
- Debt capacity and illustrative financing paths:
  - Korea can safely sustain public debt levels above 40 percent of GDP; IMF (2013) signal-approach estimate for advanced economies’ debt ceiling is 85 percent of GDP.
  - Multiple paths can keep debt well below that threshold; allowing debt-to-GDP to reach 45 percent in the long run would leave space for policies to enhance social protection and support growth.
- Illustrative scenario dynamics (Figure 7 context):
  - Revenues kept constant for 10 years; fiscal surplus declines gradually, deficit arises in 2024, peaking at about 1.5 percent of GDP in 2027; debt-to-GDP declines until 2027 to about 30 percent.
  - After 2027 revenues start to increase. In a “permanent deficit” scenario with deficit stabilizing at 1.5 percent of GDP, debt reaches 40 percent of GDP in 2077 and achieves a steady state of 45 percent of GDP thereafter.

### V. Key takeaways and policy recommendations
- Rising age-related spending (10–16 percent of GDP by 2060) requires sizable revenue increases in the long run to stabilize debt if borrowing is constrained.
- Given Korea’s low public debt and a low global interest rate environment, a combination of higher revenues (partly via base broadening) and additional borrowing can finance increased age-related spending while preserving fiscal sustainability.
- Small revenue changes can have large impacts on long-term debt dynamics.
- Fiscal space exists to implement measures that boost potential output and social protection, including:
  - Higher targeted transfers to the most vulnerable.
  - Fiscal measures to support female labor force participation and employment.
  - Comprehensive product and labor market reforms to raise potential growth.
- Growth-friendly fiscal policies during periods of low long-term interest rates can help raise potential growth to prepare for eventual higher rates.

*Source: Authors’ estimates and referenced IMF, MOSF, NABO, National Pension Research Institute, OECD projections as presented in the supplied content.*

### 2100. Revenues increase from 22 to 33 percent of GDP in 2060. In the “temporary deficit”

### wp1891 - 2100. Revenues increase from 22 to 33 percent of GDP in 2060. In the “temporary deficit”

### Fiscal projections and debt scenarios
- Revenues increase from 22 to 33 percent of GDP in 2060.
- In the “temporary deficit” scenario:
  - Revenues increase to nearly 34 percent of GDP in 2060.
  - The deficit declines to zero in 2084.
  - The primary balance turns into a surplus in 2040.
  - Public debt-to-GDP ratio peaks at 30 percent in 2036 and declines afterwards.
- The debt dynamics reflect the assumption that fiscal surpluses are saved; declines in the debt-to-GDP ratio during periods of overall balance positivity are driven by the increase in nominal GDP.

### Permanent increase in social safety net spending: design and impacts
- Policy simulated: permanent increase in targeted transfers (transfers to liquidity-constrained consumers) of 0.75 percent of baseline GDP.
- Financing variants:
  - Gradual increase in consumption taxes.
  - Gradual increase in labor income taxes.
  - Gradual increase in capital income taxes.
  - A rise in deficit by 0.8 percentage points of GDP (in scenarios with increased deficit).
- Key simulation findings:
  - The consumption tax is the least harmful revenue source in macroeconomic impact and allocative distortions.
  - Increase in capital taxation reduces investment; increase in labor income tax lowers employment.
  - In all three tax-financed cases, government-debt-to-GDP ratio increases by 15 percentage points above the baseline in the very long run and stabilizes there.
- Effects on private saving and external balances:
  - OECD (2011) finding cited: an increase in public health care spending by 1 percent of GDP is associated with a decline in the saving rate by 1.9 percentage points.
  - In the FSGM simulation, private saving as a share of GDP declines by 1 percentage point in the long run due to permanently higher transfers.
  - Stronger private consumption and investment boost GDP growth and reduce Korea’s current account surplus.
  - Real exchange rate appreciates, consistent with stronger imports.

### Structural reforms and fiscal measures to boost labor supply
- Reform package components (implemented over 10 years):
  - Ease product market regulation and employment protection legislation (75 percent of the reforms needed to converge to the average of three OECD frontier economies).
  - Increase the share of consumption and property taxes in total tax revenues by 1.1 percentage points, accompanied by a decline in the share of labor income tax.
  - Expand childcare spending by 0.25 percent of GDP.
  - Increase active labor market policies (ALMP) spending by 0.5 percent of GDP.
  - Financing: combination of higher VAT revenues and higher deficit.
- Simulation results:
  - Korea’s potential output could rise by more than 6 percent in the long run.
  - Potential growth would increase by over 0.6 percentage point a year on average for a decade.
  - The additional spending on childcare and ALMP would result in a rise in public debt in the very long run of 15 percentage points of GDP.
  - Note: model caveat — impact of ALMP spending may be underestimated because it is assumed to affect equilibrium employment but not participation rate.

### Combined policy package: outcomes and fiscal costs
- Components combined: stronger social safety nets, structural reforms, increased fiscal spending to boost labor supply.
- Macroeconomic outcomes (deviations from baseline):
  - Output increases by about 6 percent in 10 years.
  - Real consumption increases by about 9 percent in 10 years.
  - Current account surplus declines by nearly 2 percent of GDP in 10 years.
- Fiscal outcomes:
  - The policy package would imply a 30 percentage points increase in the debt ratio relative to the baseline scenario.
  - Deficit would increase by 1.5 percentage points of GDP relative to the baselines.
  - Example trajectory under “temporary deficit” path plus additional measures:
    - Public debt-to-GDP would peak at 51 percent in 2061 and decline afterwards.
    - Deficit would peak at 3 percent of GDP in 2027 and decline afterwards.
  - Example trajectory under “permanent deficit” path plus additional measures:
    - Public debt would reach 70 percent of GDP in 2080 and stabilize 75 percent past beyond 2100.
    - The deficit would stabilize at around 3 percent.

### Policy implications and recommendations
- Given rising age-related fiscal spending, financing through a mix of higher borrowing and additional revenues obtained by broadening the tax base and selected tax increases is preferable given Korea’s low public debt and low interest rates.
- VAT could be extended to:
  - All new real estate supplies, including the value of land.
  - Insurance and financial services.
  - Suppliers to exporters.
- Move toward neutrality in taxing various sources of capital income.
- Fiscal policy should be used to:
  - Strengthen social safety nets to reduce poverty and boost private consumption.
  - Increase fiscal spending on childcare and ALMP to boost labor supply and potential growth.
  - Support structural reforms that raise productivity growth and efficiency (e.g., easing product and labor market regulations; encourage R&D).
- Maintaining government debt at elevated but sustainable levels would provide buffers to deal with the fiscal costs of possible reunification.

*Source: Authors' estimates and analysis in the provided content.*

### Appendix I. A Summary of the IMF’s G20MOD Module of FSGM

### Appendix I. A Summary of the IMF’s G20MOD Module of FSGM

### Overview
- G20MOD is an annual, multi-economy, forward-looking, model of the global economy combining both micro-founded and reduced-form formulations of economic sectors.
- The model contains individual blocks for the G-20 countries, and 5 additional regions to cover the remaining countries in the world.
- Each economy in the model is structurally identical (except for commodities) but distinguished by unique parameterizations: different key steady-state ratios and different behavioral parameters.

### Consumption and Investment
- Consumption:
  - Features overlapping-generations households that can save and smooth consumption.
  - Includes liquidity-constrained households that must consume all of their current income every period.
- Investment:
  - Determined by a Tobin’s Q model.
  - Firms are net borrowers; their risk premia rise during periods of excess capacity (when the output gap is negative) and fall during booms (when the output gap is positive).
  - The risk-premia mechanism mimics effects such as falling/rising real debt burdens.

### Trade
- Trade equations are reduced-form and are functions of:
  - A competitiveness indicator, and
  - Domestic or foreign demand.
- The competitiveness indicator improves one-for-one with domestic prices—there is no local-market pricing.

### Potential Output
- Potential output is endogenous.
- Modeled by a Cobb-Douglas production function with:
  - Exogenous trend total factor productivity (TFP), and
  - Endogenous capital and labor.

### Inflation and Wages
- Consumer price and wage inflation are modeled by reduced-form Phillips’ curves.
- Phillips’ curves include:
  - Weights on a lag and a lead of inflation,
  - A weight on the output gap.
- Consumer price inflation also includes:
  - A weight on the real effective exchange rate, and
  - Second-round effects from food and oil prices.

### Monetary Policy
- Monetary policy is governed by an interest rate reaction function.
- For most countries, it is an inflation-forecast-based rule working to achieve a long-run inflation target.

### Commodities
- The model includes three commodities: oil, metals, and food.
- Purpose:
  - Distinction between headline and core consumer price inflation.
  - Richer analysis of macroeconomic differences between commodity-exporting and importing regions.
- Demand and supply characteristics:
  - Demand for commodities is driven by world demand and is relatively price inelastic in the short run due to limited substitutability of the commodity classes.
  - Supply of commodities is price inelastic in the short run.
- Households consume food and oil explicitly; countries can trade in commodities.
- Global real commodity prices are determined by:
  - A global output gap (only a short-run effect),
  - The overall level of global demand, and
  - Global production of the commodity in question.
- Commodities as business-cycle moderators:
  - In times of excess aggregate demand, upward pressure on commodity prices from sluggish supply adjustment will put some downward pressure on demand.
  - If there is excess supply, falling commodity prices will ameliorate the deterioration.

### Cross-country Distinctions
- Countries differ mainly via parameter values and steady-state ratios rather than structural model differences (except for commodity treatment).

### Appendix II. Composition and Cost of Illustrative Structural Reforms

- Product Market Regulation Reform
  - OECD Typical Historical Reform Size: 20% Reduction in the OECD Product Market Regulation (PMR) Index
  - OECD Illustrative Supply-Side Impact after 5 Years: 2.4% Level Gain in Multi-Factor Productivity (MFP) for Advanced Economies; 3.4% Level Gain in MFP for Emerging Markets
  - Assumed Korean Reform Size: 22.5% Reduction in the OECD PMR Index
  - Assumed Fiscal Cost Effects as Implemented in the Model: None
  - Resulting Impact: 2.7% Level Gain in MFP

- Employment Protection Legislation Reform
  - OECD Typical Historical Reform Size: 20% Reduction in the OECD Employment Protection Legislation (EPL) Index
  - OECD Illustrative Supply-Side Impact after 5 Years: 0.44% Level Gain in Labor Productivity (LP) for Advanced Economies; 0.48% Level Gain in LP for Emerging Markets
  - Assumed Korean Reform Size: 30% Reduction in the OECD EPL Index
  - Assumed Fiscal Cost Effects as Implemented in the Model: None
  - Resulting Impact: 0.66% Level Gain in LP

- Tax Structure Reform
  - OECD Typical Historical Reform Size: 3 Percentage Point Rise in the Share of Consumption and Property Taxes in Total Tax Revenues
  - OECD Illustrative Supply-Side Impact after 5 Years: 0.75% Level Increase in LP
  - Assumed Korean Reform Size: 1.125 Percentage Point Rise in the Share of Consumption and Property Taxes in Total Tax Revenues
  - Assumed Fiscal Cost Effects as Implemented in the Model: None
  - Resulting Impact: 0.28% Level Gain in LP

- Spending on Childcare
  - OECD Typical Historical Reform Size: 1 Dollar Increase in Spending per Child (in US$ PPP)
  - OECD Illustrative Supply-Side Impact after 5 Years: 0.002 Percentage Point Increase in the Employment Rate of Women
  - Assumed Korean Reform Size: 0.25% of GDP, or Approximately 2000 Dollar Increase in Spending per Child (in US$ PPP)
  - Assumed Fiscal Cost Effects as Implemented in the Model: Targeted Transfers of 0.25% of GDP Permanently, Financed by VAT, Resulting in a Rise in Debt of 5 Percent of GDP in the Long Run
  - Resulting Impact: 0.75 Percentage Point Increase in the Total Labor Participation Rate

- Spending on Active Labor Market Policies
  - OECD Typical Historical Reform Size: 12.5 Increase in Spending per Unemployed, as a Percent of GDP over Population
  - OECD Illustrative Supply-Side Impact after 5 Years: 0.25 Percentage Point Decline in the Structural Unemployment Rate (NAIRU)
  - Assumed Korean Reform Size: 0.50% of GDP, or Approximately an Increase of 28 in Spending per Unemployment, as a Percent of GDP over Population
  - Assumed Fiscal Cost Effects as Implemented in the Model: Government Consumption of 0.50% of GDP Permanently, Financed by VAT, Resulting in a Rise in Debt of 10 Percent of GDP in the Long Run
  - Resulting Impact: 0.56 Percentage Point Decline in the NAIRU

*Source: Appendix I and Appendix II of the provided content.*

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_Source: https://www.imf.org/-/media/files/publications/wp/2018/wp1891.pdf_