## 4. Complementary fiscal and monetary policies ## Source details **Canonical URL:** [4. Complementary fiscal and monetary policies](https://www.imf.org/-/media/files/publications/wp/2024/english/wpiea2024183.pdf) ## Other formats - [Markdown version](/-/media/files/publications/wp/2024/english/wpiea2024183.pdf.md) - [Structured JSON version](/-/media/files/publications/wp/2024/english/wpiea2024183.pdf.json) --- ### Complementary policies: main findings - EPL reforms produce higher gains when implemented alongside complementary fiscal or monetary policies relative to baseline outcomes. - EPL reforms on regular workers yield a more positive and significant impact on output and labor productivity over the medium term under expansionary fiscal policies. - Results are not statistically significant for EPL reforms on regular workers under expansionary monetary policies. - Supportive policies can help mitigate the short-term adverse effect of EPL reforms by facilitating efficient reallocations of labor, in addition to their direct impact on the economy. - The stronger effects of expansionary fiscal policies are probably attributed to complementary targeted support to those affected groups, while monetary policy can only work on aggregate demand. - Note: t=0 is the year of reform. Shaded areas in the underlying figures show 90 percent confidence bands. ### EPL reform impacts under different policy stances (descriptive) - Fiscal policy scenarios assessed: - Fiscal contraction - Fiscal expansion - Monetary policy scenarios assessed: - Monetary contraction - Monetary expansion - Outcomes examined: - Output (percent) - Employment (percent) - Labor productivity (percent) - Impulse response functions (IRFs) computed for time horizon from zero to five years after reform. ### Robustness checks - Cross-checking with alternative data sources: repeated analysis using the OECD index on the strictness of employment legislation and the IMF structural reform database instead of the EPL reform shock variables by Duval et al. (2008). - Controlling for additional variables: included other potential control variables that capture important characteristics of labor markets, such as annual work hours and trade union density. Country and time fixed effects included to largely mitigate omitted variable risks. - Alternative specifications: tested different lags of reform variables and other control variables. - All extended regressions point to similar results as shown in the baseline specifications. ### Caveats and micro-data evidence - Macro-data based empirical approach limits scope; there could be significant heterogeneity in reform effects across industries and firms. - Some reform areas critical for Korea (working hours reform and switch to performance-based pay) are not captured by cross-country macro data; micro-data evidence would complement macro findings. - Working hours reforms - Countries with long hours of work are often associated with low unit labor productivity, measured as GDP per hour worked. - Literature evidence: reductions in long working hours could increase productivity by improving employee morale, physical health, and operational efficiency (Bosch and Lehndorff, 2001; Golden, 2012). - Flexible work time arrangements reported to benefit employees and employers (Williams et al. 2000; Koekemoer and Downes, 2011), with higher productivity gains for firms with more flexible working time arrangements. - ILO (2019) highlights desirable working time arrangements should balance health, family, gender equality, productivity, and worker choice. - Empirical chart: "Working Hours and Labor Productivity" based on a sample of 38 OECD countries during 1980-2021 (sources: OECD and IMF staff estimates). Regression line: y = -0.0598x + 148.91; R² = 0.5074. Units: X-ray in hours; Y-ray in USD, constant prices, 2015 PPPs. Annual Working Hours per Worker vs GDP/Hour. - Performance-based pay reforms - Firm-level data in the US (Lazear, 2000) shows higher productivity gains associated with the shift to performance pay reform. - Preconditions matter: Japanese firm study (Miyamoto and Higuchi, 2007) shows reforms should be complemented with a fair procedure for performance evaluation. - Industrial differences: performance-based pay more effective in core manufacturing industries where tasks are standardized and performance measurable; seniority-based pay more effective in services where employee commitment and loyalty are important (Meulenaere, 2016). ### Implications for Korea’s reform plans - Labor market characteristics in Korea: - Employment protection is stricter than the OECD average, with more restrictive regulations on individual dismissals. - Non-regular workers account for a significant share of total employment, among the highest in the OECD, with lower wages, fewer benefits, and less job security compared to regular workers (high labor market duality). - Public spending on social protection as share of GDP is among the lowest in the OECD, notably on pensions, labor markets, and support for vulnerable groups. - Wage system is largely seniority-based rather than performance-based; flexibility of wage determination relatively lower than in other advanced economies. - Korean workers face long working hours and inflexible working hour arrangements. - Authorities’ intended reforms focus on bottlenecks where Korea lags relative to OECD peers; implementation plans are still being formulated. Design considerations: - Work hours reform should balance needs of workers and enterprises, ensure sufficient dialogue with stakeholders, and be carefully communicated. - More balanced working-time arrangements could improve work-life balance, encourage female labor participation, and meet fast-evolving industrial demands. - Switch to performance-based pay should incentivize private sector participation while accounting for cross-industry differences regarding productivity impacts. - Reforms to tackle labor market duality should prioritize easing employment protection for regular workers while ensuring protection of vulnerable groups through strengthened social safety nets and active labor market policies. - Sequencing and policy context: - Sequence and prioritization of reforms should be carefully designed based on economic and policy conditions. - Under the current disinflationary policy stance, prioritize reforms that are not associated with a strong contractionary or inflationary impact. The authorities’ focus on working hours reforms is aligned with this guidance. - With growth recovering, deregulations to reduce employment protection for regular workers can be considered, combined with a stronger social safety net and targeted support to protect vulnerable groups during the transition. - Switch to performance-based pay with an effective merit evaluation system could further increase productivity gains. - In cases of adverse shocks that increase economic slack, more spending on labor markets could help support growth, including through ALMP and further enhancement of the social safety net. - Recommendation: government should aim for a holistic plan laying out near-term and medium-term reform measures, contingent on economic and policy conditions. ### Empirical approach (Annex I) - Methodology - Follow approach in Duval and Furceri (2018) using local projection method (Jordà, 2005) to capture nonlinearities in dynamic response to reform shocks; estimation at each horizon up to 5 years after reform. - Basic function form (equation (1)): - Left-hand side variables: output growth, employment growth, labor productivity growth. c = country, t = year of reform, k = number of years after reform. - Right-hand side: 훼c (country fixed effect), 훼t (time fixed effect), 푅푐,푡 is the reform variable which includes one of: - employment protection legislative reform dummies for regular workers (1, 0, -1), - employment protection legislative reform dummies for temporary workers (1, 0, -1), - changes in active labor market policy spending (AMLP) in percent of GDP, - changes in labor tax wedges (taxes paid by an average worker compared to total labor cost for the employer, in percent of GDP). - 푋푐,푡푚 denotes vector of m control variables: two lags of the reform variable, one lag of GDP growth, and a recession dummy (1 or 0) following Drazen and Easterly (2001). - Extended function form (equation (2)) includes a smooth transition function F(푧푐,푡) following Auerbach and Gorodnichenko (2012) and Granger and Teravistra (1993): - F(푧푐,푡) = exp(−훾 푧푐,푡) / (1 + exp(−훾 푧푐,푡)) - 푧푐,푡 is an indicator of the state of the economy or the stance of monetary or fiscal policy. - State of economy measured by real output growth. - Stances of monetary and fiscal policy measured by exogenous monetary or fiscal policy shocks. - Measurement of policy shocks - Fiscal policy shocks: estimated by actual fiscal spending compared to forecast fiscal spending of the OECD Economic Outlook. - Monetary policy shocks: estimated by forecast error of interest rates orthogonal to unexpected shocks in output and inflation; specifically, residuals of a pooled OLS regression of inflation and output shocks on interest rate shocks. - Forecast variables obtained from Consensus Forecast and compared against actual outcomes from the World Economic Outlook. These are proxies for unexpected changes in fiscal and monetary policies that are not related to growth, inflation, and other economic conditions. - Estimation - IRFs computed by running a matrix of OLS regressions. Estimated 훽k and variance used to construct impulse response graphs for horizons zero to five years after reform. ### Dataset and features - Major variables sourced from OECD data: real GDP, expected GDP, employment, labor productivity (or total factor productivity in robustness tests), active labor market policy spending, labor tax wedges, share of temporary workers. - Coverage: 26 OECD countries including Korea; time span between 1970 to 2020. - Employment protection legislation reform shock variables created and updated based on Duval et al. (2008); regulatory actions examined through text analysis from OECD economic surveys supplemented by IMF country economists’ judgment. - Indicator compared against OECD’s strictness of employment protection indicator in robustness checks. ### Key dataset statistics (Appendix Table 1: selected entries) - Output: Annual real GDP growth, Percent, 1971-2020, OECD mean 2.7, STD 3.1, Min -15, Max 21, Korea 6.5. - Employment: Annual employment growth, Percent, 1971-2020, OECD mean 1.0, STD 2.3, Min -13, Max 22, Korea 1.6. - Productivity: Annual labor productivity growth, Percent, 1971-2020, OECD mean 1.6, STD 2.7, Min -23, Max 18, Korea 3.9. - EPL: Dummy (0,1,-1), 1970-2020, OECD mean 0.13, STD 0.19, Min -1, Max 1, Korea 0.2. - Tax wedge: Percent, 2000-2020, OECD mean 36.1, STD 10.7, Min 7.0, Max 57.1, Korea 19.7. - Active labor market policy: Average government ALMP spending, Percent of GDP, 1998-2020, OECD mean 0.56, STD 0.41, Min 0, Max 2.3, Korea 0.33. *International Monetary Fund — IMF Working Paper section 4, “Complementary fiscal and monetary policies” (content unit: wpiea2024183).* ### 1. Introduction ........................................................................................................ ### 1. Introduction ### Overview - Potential output and productivity growth in Korea have slowed down significantly in recent decades. - Part of the slowdown may reflect convergence dynamics, but the relatively fast pace of declines may also reflect structural bottlenecks that hold back potential output and productivity growth in Korea. - The paper aims to shed light on how to advance labor market reforms in Korea. Section 2 illustrates stylized facts on key structural challenges. Section 3 presents empirical analysis on the impact of key labor market reforms on output, employment, and productivity. Section 4 concludes with policy discussions. ### Government reform priorities (announced three-pillar plan) - More flexible working hours. - Switching to a performance-based pay system. - Tackling labor market duality. - March 2023 working hour reform (revising restrictive regulations on weekly working hours while limiting overtime over longer time intervals) faced pushback from younger workers; authorities are working on a revised proposal and formed a committee to design plans to reduce duality and a roadmap for wage system reform. ### Literature context - Long-run gains from labor market deregulations documented, but careful reform design is critical (Blanchard and Giavazzi, 2003; Blanchard et al., 2013). - Duval and Furceri (2018) emphasize role of macroeconomic conditions and policies in determining reform gains. - Recent studies highlight need for reforms in Korea to tackle duality and promote inclusive growth (Schauer, 2018; Jones and Urasawa, 2013; Jones and Fukawa, 2016). - A comprehensive assessment that accounts for labor market rigidities, economic and policy conditions, and government priorities is lacking—this paper addresses that gap. --- ### 2. Structural Challenges in the Korean Labor Market – Stylized Facts ### Labor market duality - High labor market duality: labor market fragmented into regular and non-regular workers. - Regular workers: lifelong employment norms, strong restrictions on dismissals (lengthy legal process), very high severance cost to fire. - Non-regular / temporary workers: much higher separation and layoff rates; receive much lower wages (on average just over half of those of regular workers); lower social benefits coverage (pension, health, employment insurance). - The share of non-regular workers has been relatively stable and ranks among the highest in the OECD; the share of temporary workers is the highest in OECD. - Note on terminology: employment status generally classifies workers as “regular” and “non-regular” worker; in the Labor Force Survey at Establishments, “temporary worker” is used instead of “non-regular worker”. ### Low social spending - Public spending on social protection is relatively low in Korea; social spending-to-GDP ratio is among the lowest in OECD. - Three areas with particularly large gaps relative to OECD average: public spending on pensions, labor markets, and incapacity. - Spending levels in unemployment, family benefits, and other social spending are closer to OECD average. - Labor tax wedge in Korea is not high (labor tax wedge defined as the gap between net take-home pay and total employer labor cost). ### Long working hours and limited flexibility - Average annual hours worked in Korea are among the highest in the OECD. - Progress has been made to reduce long working hours, but there is still a large gap of about 200 hours per year relative to the OECD average. - Share of workers who can work under flexible working time arrangements is the lowest in the OECD: only 7 percent of total, compared to the OECD average of nearly 30 percent. - By gender, a higher share of Korean women work under flexible arrangements than men, but both are significantly below OECD averages. ### Seniority-based pay and low wage flexibility - Wage system is strongly linked to seniority rather than productivity; flexibility of wage determination is relatively low. - According to a World Economic Forum survey-based score (2020), Korea is below the predicted level of wage flexibility based on per-capita income. - OECD (2019) finding: for a typical worker aged 50-60, predicted wage growth from 10th to 20th year of tenure is the highest in Korea among all OECD countries. --- ### 3. Impact of Labor Market Reforms – Empirical Analysis ### Empirical framework - Follows Duval and Furceri (2018) approach using an updated panel dataset and a local projection method to capture dynamic response of macro variables up to 4 years after reform (see Appendix). - Two empirical settings: - Baseline: controls for key reform shocks and economic fundamentals. - Extended: additionally accounts for economic and policy conditions during reform implementation. - Focus variables: (1) economic output, (2) employment, (3) labor productivity. - Key reform types analyzed: - Employment protection legislation (EPL) reform for regular workers (narrative reform database by Duval et al., 2016). - Changes in active labor market policy (ALMP) spending (OECD data, percent of GDP). - Changes in labor tax wedges (OECD data). ### Key results — Employment Protection Legislation (EPL) reforms for regular workers - Major EPL reforms to ease employment protection for regular workers have a significant impact on medium-term output and employment after controlling for economic conditions. - Empirical estimates: major EPL reforms for regular workers during economic expansions increases both output and employment by about 5 percent on average over the medium term. - Asymmetric effect by business cycle: - Positive effects in periods of high economic growth. - Could become contractionary in periods of slack; reforms may worsen economic situation in recessions by allowing easier layoffs and delaying recovery. - Under the baseline regression (without conditioning on cyclical conditions), major EPL reforms for regular workers are not found to have, on average, a statistically significant impact on output, employment, or labor productivity—highlighting importance of considering cyclical conditions when implementing EPL reforms. ### Key results — Active Labor Market Policy (ALMP) reforms - ALMP reforms show a statistically significant and positive impact on medium-term output and productivity on average. - Result is robust after controlling for fiscal stimulus effects. - The positive effect is more pronounced during recessions: - A 10 percent increase in ALMP spending raises output by around 1 percent and employment by around 0.2 percent on average over the medium term. - Output effects turn negative during times of high economic growth, though not statistically significant—possibly due to inflationary impacts of ALMP during upturns prompting countercyclical policy responses. ### Key results — Tax Wedge reforms - Reducing labor tax wedges yields a statistically significant and positive impact on output and employment on average in the baseline; results are not significant for productivity. - Impacts are more pronounced during periods of low growth: - A one percentage point reduction in the labor tax wedge could raise output and employment by 0.6 percent on average during recessions. - Tax wedge cuts tend to have bigger effects in bad times, as these reforms often involve fiscal stimulus that is generally more effective during recessions. --- *Source: IMF Working Paper — Advancing Labor Market Reforms in Korea (sections 1–3).* ### 4. Complementary fiscal and monetary policies ### 4. Complementary fiscal and monetary policies ### Complementary policies: main findings - EPL reforms produce higher gains when implemented alongside complementary fiscal or monetary policies relative to baseline outcomes. - EPL reforms on regular workers yield a more positive and significant impact on output and labor productivity over the medium term under expansionary fiscal policies. - Results are not statistically significant for EPL reforms on regular workers under expansionary monetary policies. - Supportive policies can help mitigate the short-term adverse effect of EPL reforms by facilitating efficient reallocations of labor, in addition to their direct impact on the economy. - The stronger effects of expansionary fiscal policies are probably attributed to complementary targeted support to those affected groups, while monetary policy can only work on aggregate demand. - Note: t=0 is the year of reform. Shaded areas in the underlying figures show 90 percent confidence bands. ### EPL reform impacts under different policy stances (descriptive) - Fiscal policy scenarios assessed: Fiscal contraction; Fiscal expansion. - Monetary policy scenarios assessed: Monetary contraction; Monetary expansion. - Outcomes examined: Output (percent), Employment (percent), Labor productivity (percent). - Impulse response functions (IRFs) computed for time horizon from zero to five years after reform. ### Robustness checks - (1) Cross-checking with alternative data sources: repeated analysis using the OECD index on the strictness of employment legislation and the IMF structural reform database instead of the EPL reform shock variables by Duval et al. (2008). - (2) Controlling for additional variables: included other potential control variables that capture important characteristics of labor markets, such as annual work hours and trade union density. Country and time fixed effects included to largely mitigate omitted variable risks. - (3) Alternative specifications: tested different lags of reform variables and other control variables. - All extended regressions point to similar results as shown in the baseline specifications. ### Caveats and micro-data evidence - Macro-data based empirical approach limits scope; there could be significant heterogeneity in reform effects across industries and firms. - Some reform areas critical for Korea (working hours reform and switch to performance-based pay) are not captured by cross-country macro data; micro-data evidence would complement macro findings. - Working hours reforms - Countries with long hours of work are often associated with low unit labor productivity, measured as GDP per hour worked. - Literature evidence: reductions in long working hours could increase productivity by improving employee morale, physical health, and operational efficiency (Bosch and Lehndorff, 2001; Golden, 2012). - Flexible work time arrangements reported to benefit employees and employers (Williams et al. 2000; Koekemoer and Downes, 2011), with higher productivity gains for firms with more flexible working time arrangements. - ILO (2019) highlights desirable working time arrangements should balance health, family, gender equality, productivity, and worker choice. - Empirical chart: "Working Hours and Labor Productivity" based on a sample of 38 OECD countries during 1980-2021 (sources: OECD and IMF staff estimates). Regression line: y = -0.0598x + 148.91; R² = 0.5074. Units: X-ray in hours; Y-ray in USD, constant prices, 2015 PPPs. Annual Working Hours per Worker vs GDP/Hour. - Performance-based pay reforms - Firm-level data in the US (Lazear, 2000) shows higher productivity gains associated with the shift to performance pay reform. - Preconditions matter: Japanese firm study (Miyamoto and Higuchi, 2007) shows reforms should be complemented with a fair procedure for performance evaluation. - Industrial differences: performance-based pay more effective in core manufacturing industries where tasks are standardized and performance measurable; seniority-based pay more effective in services where employee commitment and loyalty are important (Meulenaere, 2016). ### 4. Implications for Korea’s Reform Plans - Labor market characteristics in Korea: - Employment protection is stricter than the OECD average, with more restrictive regulations on individual dismissals. - Non-regular workers account for a significant share of total employment, among the highest in the OECD, with lower wages, fewer benefits, and less job security compared to regular workers (high labor market duality). - Public spending on social protection as share of GDP is among the lowest in the OECD, notably on pensions, labor markets, and support for vulnerable groups. - Wage system is largely seniority-based rather than performance-based; flexibility of wage determination relatively lower than in other advanced economies. - Korean workers face long working hours and inflexible working hour arrangements. - Authorities’ intended reforms focus on bottlenecks where Korea lags relative to OECD peers; implementation plans are still being formulated. Design considerations: - Work hours reform should balance needs of workers and enterprises, ensure sufficient dialogue with stakeholders, and be carefully communicated. - More balanced working-time arrangements could improve work-life balance, encourage female labor participation, and meet fast-evolving industrial demands. - Switch to performance-based pay should incentivize private sector participation while accounting for cross-industry differences regarding productivity impacts. - Reforms to tackle labor market duality should prioritize easing employment protection for regular workers while ensuring protection of vulnerable groups through strengthened social safety nets and active labor market policies. - Sequencing and policy context: - Sequence and prioritization of reforms should be carefully designed based on economic and policy conditions. - Under the current disinflationary policy stance, prioritize reforms that are not associated with a strong contractionary or inflationary impact. The authorities’ focus on working hours reforms is aligned with this guidance. - With growth recovering, deregulations to reduce employment protection for regular workers can be considered, combined with a stronger social safety net and targeted support to protect vulnerable groups during the transition. - Switch to performance-based pay with an effective merit evaluation system could further increase productivity gains. - In cases of adverse shocks that increase economic slack, more spending on labor markets could help support growth, including through ALMP and further enhancement of the social safety net. - Recommendation: government should aim for a holistic plan laying out near-term and medium-term reform measures, contingent on economic and policy conditions. ### Empirical approach (Annex I) - Methodology - Follow approach in Duval and Furceri (2018) using local projection method (Jordà, 2005) to capture nonlinearities in dynamic response to reform shocks; estimation at each horizon up to 5 years after reform. - Basic function form (equation (1)): - Left-hand side variables: output growth, employment growth, labor productivity growth. c = country, t = year of reform, k = number of years after reform. - Right-hand side: 훼c (country fixed effect), 훼t (time fixed effect), 푅푐,푡 is the reform variable which includes one of: - employment protection legislative reform dummies for regular workers (1, 0, -1), - employment protection legislative reform dummies for temporary workers (1, 0, -1), - changes in active labor market policy spending (AMLP) in percent of GDP, - changes in labor tax wedges (taxes paid by an average worker compared to total labor cost for the employer, in percent of GDP). - 푋푐,푡푚 denotes vector of m control variables: two lags of the reform variable, one lag of GDP growth, and a recession dummy (1 or 0) following Drazen and Easterly (2001). - Extended function form (equation (2)) includes a smooth transition function F(푧푐,푡) following Auerbach and Gorodnichenko (2012) and Granger and Teravistra (1993): - F(푧푐,푡) = exp(−훾 푧푐,푡) / (1 + exp(−훾 푧푐,푡)) - 푧푐,푡 is an indicator of the state of the economy or the stance of monetary or fiscal policy. - State of economy measured by real output growth. - Stances of monetary and fiscal policy measured by exogenous monetary or fiscal policy shocks. - Measurement of policy shocks - Fiscal policy shocks: estimated by actual fiscal spending compared to forecast fiscal spending of the OECD Economic Outlook. - Monetary policy shocks: estimated by forecast error of interest rates orthogonal to unexpected shocks in output and inflation; specifically, residuals of a pooled OLS regression of inflation and output shocks on interest rate shocks. - Forecast variables obtained from Consensus Forecast and compared against actual outcomes from the World Economic Outlook. These are proxies for unexpected changes in fiscal and monetary policies that are not related to growth, inflation, and other economic conditions. - Estimation - IRFs computed by running a matrix of OLS regressions. Estimated 훽k and variance used to construct impulse response graphs for horizons zero to five years after reform. ### Dataset and features - Major variables sourced from OECD data: real GDP, expected GDP, employment, labor productivity (or total factor productivity in robustness tests), active labor market policy spending, labor tax wedges, share of temporary workers. - Coverage: 26 OECD countries including Korea; time span between 1970 to 2020. - Employment protection legislation reform shock variables created and updated based on Duval et al. (2008); regulatory actions examined through text analysis from OECD economic surveys supplemented by IMF country economists’ judgment. - Indicator compared against OECD’s strictness of employment protection indicator in robustness checks. ### Key dataset statistics (Appendix Table 1: selected entries) - Output: Annual real GDP growth, Percent, 1971-2020, OECD mean 2.7, STD 3.1, Min -15, Max 21, Korea 6.5. - Employment: Annual employment growth, Percent, 1971-2020, OECD mean 1.0, STD 2.3, Min -13, Max 22, Korea 1.6. - Productivity: Annual labor productivity growth, Percent, 1971-2020, OECD mean 1.6, STD 2.7, Min -23, Max 18, Korea 3.9. - EPL: Dummy (0,1,-1), 1970-2020, OECD mean 0.13, STD 0.19, Min -1, Max 1, Korea 0.2. - Tax wedge: Percent, 2000-2020, OECD mean 36.1, STD 10.7, Min 7.0, Max 57.1, Korea 19.7. - Active labor market policy: Average government ALMP spending, Percent of GDP, 1998-2020, OECD mean 0.56, STD 0.41, Min 0, Max 2.3, Korea 0.33. _International Monetary Fund — IMF Working Paper section 4, “Complementary fiscal and monetary policies” (content unit: wpiea2024183)._ --- _Source: https://www.imf.org/-/media/files/publications/wp/2024/english/wpiea2024183.pdf_