KOREA FOCUS
Economic Effect of the Reunification of the Korean Peninsula
National Assembly Budget Office

Republic of Korea


I. Estimation of Economic Effect

 

1. Purpose and Necessity of Study

 

People in both South and North Korea yearn for unification. Debates on possible economic gains from reunification are actively under way these days. It is believed that a reunified Korea would enjoy higher international status thanks to its expanded economic scale.

 

Since the German unification, studies on territorial reunification in South Korea have focused mainly on its cost to the national economy. Estimates range widely from US$50 billion (Rand Corporation, 2005) to US$5 trillion (Peter Beck, 2010). This has led to concerns about the obvious tax burdens that individuals and corporations would face, generally souring public opinion on reunification. In contrast, it has not been possible to calculate the gains from reunification to society with as much clarity.

 

Yet, reunification of the divided peninsula would undoubtedly be an opportunity to re-energize the South Korean economy, which has been stuck in low growth due to structural problems. Enterprises have not found promising investment opportunities, employment is unstable and consumption is sluggish. When reunification is realized, development projects in North Korea will increase demand for all resources, leading to large-scale corporate investments and substantial job creation.

 

The first premise in preparing for unification or studying the effects of unification is that strong mutual trust will prevail. Accordingly, efforts will be mounted to form a national consensus. Unification in which one system absorbs the other will lead to unbearable political and economic burdens.

 

After the unification of Germany, which was a case of the East absorbed by the West, the economy of the eastern half rapidly shrank and unemployment soared. Some recent studies on Korean reunification suggest that keeping the North under separate economic management would be the best way of maximizing the benefits of unification while minimizing its associated costs and negative economic consequences.

 

This report analyzes the expected benefits and costs of Korean unification. Particular attention will be placed on the financial aspects, considering the favorable conditions of low wage levels and high investment efficiency that will be available in the North. The large gap in economic scales and income levels between the two sides will be a major drag on the economy of the unified Korea. North Korea’s real GDP (as of 2012) amounted to 25 trillion won, or 2.3 percent of South Korea’s 1,104 trillion won, and its per capita national income of 1,370,000 won was 5.4 percent of the South’s 25,590,000 won. The GDP of East Germany before the 1990 unification approached 30 percent of the West. The cost of unification amounted to 4 to 5 percent of the unified Germany’s gross domestic product.

 

The important task in the process of Korean unification will be to reduce the destabilizing factors stemming from the temporal difference between the large cost required in the early stage of unification and its benefits created in the long term. Government investments should be the primary catalyst for speedy normalization and economic growth in the North. But that will be a major challenge in South Korea, where a rapidly aging population will push up fiscal demand.

 

Keeping the expenditures for unification at an affordable level will be an inevitable priority as fiscal reserves will play a decisive role in managing the post-unification economy. This study examines ways to secure fiscal soundness through improved financial systems.

 

2. Parameters

 

The primary premise of this study is that the Korean peninsula is reunified peacefully. The time of unification is set for 2015 so as to use all the statistical data currently available. The more unification is delayed, the higher the cost will be because of increasing difference in the income level between the two Koreas. As such, corrections will be needed to reflect changes between the present and the time of unification.

 

Economic benefits from unification will appear gradually as a result of policies adopted by the unified government. In order to reduce the unification cost and increase benefits, policies deemed most effective at present should be explored and implemented.

 

The benefits of unification will be gleaned from different areas of unified Korea and will be reflected in a rising gross domestic product. Positive indirect factors also will materialize, such as reduction in military forces, higher economic participation by youths and lower logistics costs. However, income differences will widen and social conflicts will likely deepen. Therefore, estimates of economic benefits in monetary units may be substantially bigger or smaller.

 

Estimates for individual economic categories will help instantly understand the effect of unification. But more important for analyzing the overall fiscal picture is obtaining macroeconomic variables such as GDP, unemployment rate and prices.

 

The period of observation in this study is 45 years from 2016, the year after the supposed unification, to 2060. This much time will be needed for the normalization of the North Korean economy and a complete integration of the economies of the North and South. Analysis will be made on the impact of unification on the state debt and fiscal soundness of the unified Korea in conjunction with the long-term financial forecasts by South Korea’s National Assembly Budget Office for the period of 2014-2060. These forecasts involve the rising financial burden due to the population aging in the South.

 

Long-term observation is necessary to absorb the temporal discrepancy between the immediately required costs and the benefits to be achieved gradually. Especially in social overhead capital, large-scale investments will be needed immediately after unification but their effect will appear over a long period of time.

 

3. Economic Benefits

 

1) Method of Macroeconomic Predictions for North Korea

Macroeconomic indicators including growth rates for the North Korean area have been estimated by the growth accounting model based on the gross production function. The growth accounting model is widely used in development economics as an alternative to the DSGE (dynamic stochastic general equilibrium) or CGE (computable general equilibrium) models. Also, these methods could involve unrealistic hypothesis that the North Korean economy is a fully competitive market system.

 

To foresee economic growth in the North Korean area, it is necessary to review and compare the growth process of such development models as South Korea and Taiwan, which share some geopolitical commonalities with North Korea, as well as such systemic transition models as China and Vietnam. Also valuable is the experience of economic growth in the post-unification East German area.

 

Estimated investments from South Korea and foreign sources are based on economic growth projections. The level of labor input and the ratio of labor income distribution are linked to the overall wage scale and infrastructure investments, including education investment.

 

It is supposed that 1 percent of South Korea’s GDP is invested in the SOC development in North Korea for 20 years (2016-2035), after which the rate is cut by 0.1 percent each year until 2045, to achieve 1 percent additional productivity increase during the period. The investment will mainly go into the infrastructure and agricultural sector, with the aim of narrowing the income disparity between the North and South to the current level of domestic disparity in South Korea. An annual 1 percent increase is foreseen in productivity given such advantages as the use of the same language, free transfer of South Korean technologies and the Northern area’s adaptation to the South’s advanced socio-economic system.

 

2) Prospects

The average GDP in the Northern area will increase 9 percent annually, from 29.7 trillion won in 2016 to 1,211.3 trillion won in 2060. The North’s relative GDP size against the South will grow from 2.3 percent (against 1,268.0 trillion) to 39.0 percent (against 3,105.7 trillion won) over the period.

 

The North’s per capita GDP will climb from 1,190,000 won in 2016 to 47,020,000 won in 2060, or from 4.8 percent of the South to 66.5 percent. The disparity is comparable to the current gap between the highest and the lowest per capita GDP areas in South Korea ― Ulsan Metropolitan City with 18.31 million won and South Jeolla Province with 12.49 million won, or 68.2 percent of Ulsan (as of 2012).

 

The major macroeconomic indicators used in estimating the unification cost are:

- Employment rate rising from 54 percent in 2016 to 60 percent in 2030 and 64 percent in 2060;

- Average annual wage increasing from 1,660,000 won in 2016 to 3,080,000 won in 2020, 6,990,000 won in 2030 and 51,650,000 won in 2060; and

- The ratio of self-provided investment (from enterprises and private savings in the North Korean area) growing from 59.3 percent in 2016 to 70.3 percent in 2020, 80 percent in 2024, 90 percent in 2029 and 100 percent in 2036.

 

The unified Korea will have a GDP scale of 1,318 trillion won in 2016, which will grow by an annual average of 2.8 percent to reach 4,320 trillion won in 2060. These figure are obtained by combining the long-term prospects of the South’s GDP and the the North’s rising GDP after unification with its ripple effect on the South. Without unification, the South’s economy is forecast to grow by 2.1 percent annually during the period.

 

 

3) Ripple Effect on the South

The ripple effect of the South’s investment and fiscal assistance for the post-unification North on its own production, value added and employment has been estimated. The inter-industry relationships for the 2007-2011 period were used to pick up the average figures for the production inducement coefficient, value added inducement coefficient and employment inducement coefficient in order to minimize the variations from economic cycles.

 

This produced total production inducement effect on the South worth 3,650 trillion won (81 trillion won on average annually) and value added effect of 1,683 trillion won (37.4 trillion won on average annually) for the 45 years. In the long-term GDP prospects, about 1 percent value added effect is foreseen to be achieved (0.4 percent through investment in the North and 0.6 percent through fiscal assistance). In annual amount the value added effect will increase from 26 trillion won in 2016 to 65 trillion won in 2036, but its percentage to the long-term GDP forecasts is expected to drop slightly from 1.65 percent in 2016 to 1.5 percent in 2036 and further down to below 1 percent beginning in 2042 and eventually to 0.03 percent in 2060.

 

The employment inducement effect is estimated at an aggregate of 29,530,000 workers (656,000 in annual average) for the 45-year period; the aggregate number of wage earners will be 25,320,000 (563,000 on average annually). With the ripple effect from unification, the employment rate in the South will rise from 62.8 percent in 2016 to 66.5 percent in 2025, but the rate will slowly fall to 65.1 percent in 2036, 62.0 percent in 2045 and 60.6 percent in 2060. Overall, the number of employed people will increase by 2.4 percent and the employment rate by 1.5 percent annually.

 

4. Cost of Unification

 

1) Method of Estimating the Unification Costs

The cost of unification has been measured in five areas ― social security, public administration, education, industrial investment and other discretional expenditures. The unified Korean government will be obliged to operate the four social insurance programs ― national pension, national health insurance, employment insurance and industrial disaster insurance ― for the Northerners, subsidizing their insurance while collecting very little insurance dues. The government will also have to pay the basic pension for low-income earners.

 

Raising the administrative and educational standards in the North to those in the South will require a huge outlay in personnel costs. As observed above, investment in the social overhead capital in the Northern area will amount to 1 percent of the GDP in the South for the first 20 years after unification. The investment will be reduced by 0.1 percent annually for the next 10 years (2036-2045).

 

In a previous study, the Korea Research Institute for Human Settlement estimated that 93.5 trillion won will be needed to upgrade the North’s infrastructure during the first 10 years after unification. The Korea Rural Economic Institute expects that 26.3 trillion won will be needed for the agricultural sector over the same period of time. Investment in these and other areas will total 208 trillion won, taking up the bulk of the unification expenditures.

 

Other discretionary expenditures will include the costs for SOC maintenance and education programs aimed at easing social and cultural differences. In view of the South’s fiscal capacity and the North’s ability to absorb inputs, it is reasonable to assume that these costs will be equal to 1 percent of the South’s GDP. But this type of spending will depend largely on the policy direction of the fiscal authorities and the overall fiscal situation of the unified Korea.

 

2) Estimated Amounts

The National Assembly Budget Office estimates that the total unification cost for the 45 years from 2016 to 2060 will amount to 10,428 trillion won by the current price (4,657 trillion won in real terms), with an annual cost of 232 trillion won (103 trillion won in real terms). The first year of 2016 will demand 68.0 trillion won (53 trillion won in real terms) and the annual amount will peak in 2056 when 357.2 trillion won (127 trillion won in real terms) will have to be spent. The final year of 2060 will see the annual unification cost recede to 339.9 trillion won (115.8 trillion won in real terms).

 

The share of the unification cost against the GDP of the unified Korea will average 3.9 percent, rising from 4.2 percent in 2016 to 4.8 percent in 2035, and then steadily decline to 2.8 percent in 2060. These percentages will more realistically reflect the impact of unification cost on the overall economy than the net amounts.

 

 

By category, social security will require the largest share of the total unification cost. It will take up 47.7 percent. In order to stabilize the North Korean people’s livelihood, unified Korea will need to spend 10.8 trillion won in 2016, or 15.9 percent of the year’s unification cost. The cost of this category will rise to 154.1 trillion won, or 45.3 percent of the total expenditures for unification, in 2060, with the annual average at 28.1 trillion won over the 45-year period.

 

Expenditures in education, including teacher salaries, will balloon from 13.9 trillion won (20.4 percent of the total unification cost) in 2016 to 48.9 trillion won (14.4 percent) in 2060, with an annual average of 28.1 trillion won. In public administration, which will include payments to public servants, unified Korea will spend 11.9 trillion won (17.5 percent) for unification in 2016 and 50.4 trillion won (14.8 percent) in 2060, with an annual average of 27.7 trillion won. Total industrial investment will reach 769.6 trillion won over the 30 years following unification.

 

Other expenditures at the discretion of the unified Korean government will increase from 15.7 trillion won in 2016 to 86.5 trillion won in 2060, with an annual average of 48.4 trillion won. About 1 percent of the unified Korea’s GDP is expected to be allotted to this portion of the unification cost, which will include the money for SOC maintenance and various training/education programs for the Northerners to help them adapt to new social and economic situations.

 

 

5. Maximizing the Economic Effect of Unification

 

1) Overall Economic Effect

The combined GDP of South and North Korea in 2013 was $1.4 trillion (1,135 trillion won). Unified Korea’s GDP in 2060 is projected to reach $5.5 trillion to bring its global ranking to 10th place from 12th in 2013. Unified Korea’s per capita GDP will also swell from $29,000 in 2013 to $79,000 in 2060, rising from 19th to 7th in the world. These estimates are based on the exchange rate set at 788.9 won per dollar by the OECD’s 2005 purchasing power parity.

 

The economic benefits from unification are calculated by combining the added value of products from the South and North as a result of unification. By the real price, the net benefits will amount to 14,451 trillion won ― by subtracting the total unification cost of 4,657 trillion won from the total benefits of 19,111 trillion won. The net benefit will thus be 3.1 times larger than the estimated cost. To calculate the portion in the North Korean area’s GDP added by unification, GDP volumes by an imagined growth rate of 1.2 percent (the real growth rate between 2000 and 2013) are subtracted from the prospective North Korean GDP figures obtained through the growth accounting method.

 

2) Inter-Korean Economic Cooperation

The unification cost will be higher if the gaps in income and social and cultural standards are not narrowed. Expenditures for unification can be reduced if the income gap is closed through increased economic cooperation ahead of unification, possibly by transferring the South’s experience in developing a market economy.

 

Inter-Korean trade was insignificant at $18.7 million in 1989. But it leaped to $1,055.8 million in 2005 when the Kaesong (Gaeseong) Industrial Complex, a pilot economic cooperation project, opened in the North Korean border town of Kaesong. The bilateral trade increased to $1,970 million in 2012 and then fell to $1,135.8 million in 2013 due to disagreements over operations.

 

Bonded processing trade using the North’s low-cost labor involves relatively low investment risks. Inter-Korean cooperation in this category recorded $209 million in 2005, growing to $409 million in 2009. However, the South’s punitive measures of May 24, 2010 following the sinking of the Navy’s patrol craft Cheonan attributed to a North Korean torpedo attack kept inter-Korean trade to a minimum level.

 

The aggregate trade volume through the Kaesong Industrial Complex project recorded $8,940 million between 2004 and 2013, accounting for 46 percent of the total trade between the two Koreas during the period. The joint industrial park has more than 100 production plants established with South Korean investment. North Koreans produce goods from parts and materials brought from the South. During the nine years from 2005 through 2013, the project significantly contributed to the South Korean economy with total production inducement of 10,429 billion won and employment of 43,600 people, including 32,700 wage earners.

 

The Kaesong complex is by far the most successful international economic cooperation project that North Korea has undertaken to date. Expansion of the this complex as originally planned is desirable and similar facilities may be built elsewhere in the North. In addition to the joint industrial complex, South Korea can take part in North Korea’s special economic zones and promote its participation in multilateral economic cooperation programs.

 

The Rason Special Economic Zone, earlier called the Rajin-Sonbong Special Economic Zone, in the northeastern fringe of North Korea is seen as the most important staging point for South Korean enterprises’ cooperation with the North, considering the infrastructure and geographical factors. The Sinuiju Special Economic Zone on the northwestern border with China can be another target of South Korean investment in the North. The South can help promote North Korea’s economic reform and openness by linking its North Korean cooperation programs with its East Asian regional cooperation initiatives.

 

For the success of North Korea’s special economic zones, South Korea’s participation is essential. Inter-Korean economic projects not only assist the economic survival of North Korea but can serve as a major growth engine for the South Korean economy.

 

3) Labor Productivity in the North

The most desirable way to minimize the financial burden from unification in the mid to long term is to increase productivity in the North, thereby raising its income levels. Increase of productivity requires expansion of investment, improvement of the quality of labor, technological development and internationalization of economy.

 

While education and vocational training in the North are important, there is also a pressing need to address general malnutrition, low birthrate and the aging of population. The North’s fertility rate fell from 2.2 in 1993 to 2.0 in 2008, and it is on course to an aged society (with the 65-and-over group exceeding 14 percent of the total population) in 2033 and a hyper-aged society (with the 65-and-over group exceeding 20 percent) in 2058. The infant mortality rate in the North is reported to be 26 out of every 1,000 births, which is seven times higher than that of South Korea.

 

In order to slow down the aging of North Korean society, it is necessary to provide more food and expand assistance to improve maternal health and the general medical environment. Total grain consumption in the North amounts to 5.4 million tons a year, which is far lower than the WHO standard of 6.59 million tons. About half of the infant deaths are caused by dysentery and respiratory inflammation, which can be prevented with the adequate supply of basic medicine and clean water.

 

Among children aged below five years, 27.9 percent suffer from chronic malnutrition and 23.7 percent from anemia. Maternal mortality, amounting to 76 out of every 100,000 childbirths ― five times higher than that in South Korea ― is mostly attributed to excessive bleeding. President Park Geun-hye has said that South Korea will provide $13.3 million for the maternal health programs in North Korea via international organizations.

 

North Korea will undergo a drastic industrial transformation as unification proceeds. Therefore, it is necessary to make preparations to allow a smooth change in job categories and skill sets. Substantial vocation training will be needed as the North’s industries transition from being labor-intensive to technology-intensive. The experiences of retraining refugees from North Korea over the past years will be useful in this regard. Technical training facilities need to be opened in any joint industrial estates to be established in the North. The technical education center at the Kaesong Industrial Complex for which South Korea invested 20 billion won ($18 million) should be fully utilized to produce skilled workers.

 

Exchanges in science and technology education need to be expanded. The Pyongyang University of Science and Technology is a successful example. The institute established with money and facilities provided by private South Korean organizations started lectures for 100 undergraduate and 60 graduate students on October 25, 2010, with faculty from the United States, Canada and other countries. Future projects could include joint science and technology research institutes to study how the industrial infrastructure and systems standardization could be improved in the North.

 

Technological development and standardization/globalization of industrial systems are essential for the increase of productivity in North Korea. Particularly important is cooperation in agriculture through technology transfer and standardization of statistics, which will help accelerate economic development in the North. There also is the need for close cooperation in information and communications technology which both South and North Korea regard as the main growth engines of their economies.

 

Inter-Korean science and technology cooperation projects which began in 1999 have been suspended since May 2010. Yet it is necessary to reopen at least the joint programs for industrial standardization and statistical collaboration as soon as possible. The “South-North Industrial Standards Integration Program,” which began in 2001, also remains suspended.

 

4) Maximizing the Effect of SOC Investment

Unification will bring about larger sovereign territory, a bigger population and integration of resources and labor, which are all elements for stronger national competitiveness. To maximize their impact, it is essential to build and operate effective SOC facilities. In 2014, President Park proposed the establishment of “composite rural estates” where the two Koreas would jointly engage in agriculture, forestry and livestock projects. She also offered investment in transportation, communications and construction businesses and participation in multilateral cooperative programs with North Korea, China and Russia in the Sinuiju and Rajin-Khasan areas.

 

SOC investment involves long preparation and large-scale financing. The South Korean government should carefully study the appropriate timing of investment to ensure maximum efficiency. All of the projects for general development of the North with the construction of advanced transportation networks call for close cooperation with the international community so the North can fulfill its potential as a strategic gateway to the Northeast Asian economic sphere.

 

The Korean peninsula has the geographical advantage to play a vital role for economic and cultural exchanges in the region in coordination with China, Russia and Japan. These nations are participants of the six-party talks, which started in 2003 to deal with North Korea’s expanding nuclear arsenal. Besides the security issues, South Korea needs to get these states interested in the economic development of North Korea.

 

The South Korean government should prepare to launch SOC projects in North Korea as soon as unification is realized. Complete construction blueprints and investment plans should be on hand. Under the present state of unpreparedness for SOC investment, more than 10 years will be needed to see substantial outcomes of any infrastructure projects in North Korea. Feasibility tests and drafting of basic plans should start as soon as relations between the two Koreas begin to thaw.

 

It is necessary to open SOC projects for North Korea to domestic and foreign private investors in order to reduce the fiscal burden on the the South Korean government. In the past, the Hyundai-Asan Group invested 98 billion won in the development of Changjon Port in the North, Kookyang Shipping Co. spent 2.1 billion won for the improvement of port facilities in Nampo, and the Yanbian Xiantong Ocean Shipping Group put $2.6 million in the modernization of loading and unloading facilities at Rajin Port. These cases can be useful precedents of private investment in North Korean SOC projects in the future. The current system of the government bearing the entire land compensation cost and part of construction cost in local SOC projects can be applied to infrastructure projects in the North.

 

II. Fiscal System of Unified Korea

 

1. Government Spending

 

1) Normalization of Northern Economy and Redistribution of Income

The unified Korean government will need to help normalize the North’s economy as quickly as possible after unification to minimize the financial burden on the South. The unification cost, as observed above, is expected to amount initially to 4.3 percent of the GDP in South Korea in the first year of 2016. The proportion will grow to 5.4 percent by 2035 and will from thence go down to 3.9 percent in the target year of 2060. Despite the pressure of unification cost, the South’s economy will expand by more than 1 percent during the early years after unification thanks to broader market access and infrastructure projects in the North.

 

As the North Korean economy grows rapidly, the government of unified Korea should exercise its fiscal power to ensure fair distribution of economic benefits to people in the North. In the case of China, large businesses and capitalists took up the lion’s share of fruits from economic growth, widening income disparity. Such consequences should be avoided by implementing an effective system of income redistribution in unified Korea.

 

2) Private Investment to Ease Fiscal Burden

In the initial period after unification, the government should be ready to bear the financial burden but it should also be prepared to draw in large investment from private businesses. No one but the government can shoulder the cost of integrating two basically different economic systems. Yet, the added value from unification can be transferred to the private sector in the form of wages and profits when projects are open to private investments or borrowings from home and abroad.

 

Private capital can be utilized for SOC construction, energy and resources development and tourism industry. The government should also pre-determine the possibility of development loans from international organizations as well as foreign investment.

 

The best combination of tax increases and issuance of state bonds will need to be sought while considering the main recipients of benefits, how burdens should be fairly divided among generations, and the relative effects of supplementing revenues. Universal tax increase may be justified for welfare and other ordinary expenditures as all people will benefit from unification, but expenditures for SOC investment should be covered by state bonds since benefits will go to future generations.

 

3) Ensuring Fiscal Soundness of Unified Korea

The unified Korea will come under dual fiscal pressures from the aging of society in South Korea and the heavy unification cost. Strategic management of state debt is required not to allow fiscal disruption. Without fiscal soundness, economic growth and redistribution of income will be hard to come by amid expanding macroeconomic instability.

 

Unification will vastly expand the domestic market but external dependence will also grow. Therefore, wise fiscal management to meet short- and long-term pressures is imperative. Despite additional acquisition of natural resources from the North, the nation will continue to depend on energy imports. The unified Korea’s export-oriented economy will keep it vulnerable to external factors. If sovereign ratings fall due to soaring state debt, interest rates on government bonds will rise to raise the cost of international borrowings. That could block reissuance or replacement state bonds.

 

To ensure fiscal soundness, extra efforts will be needed to manage state debts at an appropriate level and control the issuance of bonds to cover the cost of unification. The problem is that the benefits from unification take a long time to materialize and therefore cannot meet the immediate high cost of unification, forcing the government to issue bonds in large quantities. In the case of Germany, the proportion of Bunds repayable over 10 to 30 years increased from around 40 percent of total bonds in the 1980s to over 50 percent in the 1990s after unification.

 

South Korea has been issuing 30-year bonds. The government will have to issue bonds with 40- to 50-year maturity to ensure stable debt management and stimulate purchases. In 2013, circulation of 20- to 30-year government bonds amounted to only 121 trillion won compared to 2,857 trillion won of 3-10 year bonds.

 

2. Fiscal Outlook of Unified Korea

 

Additional revenues resulting from unification have been calculated on the basis of a long-term fiscal outlook for South Korea compiled by the National Assembly Budget Office. Revenue from South Korea’s long-term economic growth specified in the NABO report was not included in the fiscal outcome of unification.

 

Supposing that the taxation rate of 19.4 percent is retained in the unified Korea, revenue increase from unification is to stand at 12.4 trillion won in 2016, going up to 175.9 trillion won in 2040 and 690.4 trillion won in 2060.

 

The ratio of state debt against the GDP is estimated at 38.7 percent in 2016, eventually rising to 163.9 percent in 2060. In NABO’s long-term outlook, South Korean government debts will be 36.8 percent of the GDP in 2016 and 168.9 percent in 2060. The percentage of the unified Korea’s government debt against the GDP in 2060 will be slightly lower than that of South Korea because the addition of North Korean residents will mean a larger tax base, which will increase the overall GDP scale.

 

Unified Korea’s state debt is calculated by adding up the fiscal liabilities arising from unification and their interests as well as fiscal deficits in the South (subtracting deficits in the four social security accounts). In 2040, the percentage of government debt against the GDP is to hit 133.6 percent, far higher than South Korea’s 85.1 percent for the year, reflecting the large proportion of unification costs in state finance up until that time.

 

 

The net debt burden, calculated by subtracting unification costs from the fiscal revenues resulting from unification, will steadily climb from 55.5 trillion won in 2016 to 116.4 trillion won in 2035 but will continuously decline thereafter until 2047, when there will be a balance between unification costs and revenues. Government debt to meet unification costs against the GDP will continue to fall from 3.4 percent in 2016 to -2.9 percent in 2060.

 

 

If the tax rate is raised by 1 percentage point from the current 19.4 percent to 20.4 percent, the ratio of government debt against the GDP will fall to 122.4 percent in 2060, or 41.5 percentage points down. The raise will add 16.4 trillion won to tax revenue in 2016, 59.5 trillion won in 2040 and 122.1 trillion won in 2060. If the tax rate is raised by 3 percentage points, the government debt to GDP ratio in 2060 will decline to 39.5 percent.

 

HigherHiA higher tax rate will allow reduction in state bond issues and improve the fiscal situation. A 1 percentage point tax raise will result in a dramatic fall in the issuance of bonds and lower total interest payments from an estimated 179.7 trillion won to 33.4 trillion won in 2060.

 

 

3. Improvement of Fiscal System

 

1) Special Accounts for Financing Unification

Money collected through government bonds or higher tax rates to cover the cost of unification should be managed in special accounts or special funds. If such revenues are delivered to general accounts, the fiscal order will be disrupted and the government could find it difficult to expend the additional revenues for unification.

 

If North Korea’s current local administration system (one city under direct control of the central government, two special cities and nine provinces) is incorporated into the unified Korea’s administrative framework, there will be a total of 29 provincial and metropolitan administrations (17 in the South and 12 in the North). It means that 12 more local administrations will share the 40 percent portion of internal tax revenues, significantly denting the amounts distributed to the local administrations in the South.

 

The incorporation of North Korean local administrative units into the nationwide administration network of unified Korea may therefore be delayed and special accounts may be introduced with fiscal resources secured through a unification surtax or unification bonds for the sole purpose of meeting fiscal needs of the North Korean area. Germany delayed incorporating the East German area into its inter-state fiscal coordination system for five years and used the special unification fund for the territory during this period. Normal fiscal system replaced the unification fund in 1995.

 

2) Sustainable Welfare System for Unified Korea

The North’s population structure may help slow down a bit the population aging in unified Korea. But the low birthrate and increase of aged people will cause serious deficits to the existing welfare systems with fewer contributors and more recipients.

 

As of 2013, the number of people aged 65 or older in South Korea accounted for 12.2 percent of the total population. The ratio will reach 14.5 percent in 2018 to push South Korea into an aged society and then in 2026 South Korea will become a super-aged society with 20.8 percent of its population in the 65-and-over group. North Korea reached “aging society” status (7.2 percent of its population aged 65 or older) in 2003 and is expected to become an “aged society” in 2033.

 

It is crucial to establish a sustainable social welfare system in South Korea, particularly various schemes related with population aging, ahead of unification so that unified Korea will be ensured financial sustainability for welfare needs. The public pension system in the South involves many problems, including grey areas, low contributions and unstable management. The National Tax Service needs to make more efforts to identify the sources of taxable income and the welfare authorities should correctly classify beneficiaries. Occupational pension schemes for teachers, soldiers and public servants also need measures to improve financial sustainability.

 

In order to ensure the stable finance of the health insurance system, collection of insurance dues should be rationalized to have richer people pay more and poorer people pay less while generally lowering medical expenses and spending on medicine.

 

3) Effective Management of Public Properties in the North

Many legal disputes could arise after unification over the ownership of properties in the North. Frequent lawsuits such as those to recover properties and get compensation for unredeemable estates will hinder economic development and social integration. If any SOC construction projects are delayed due to such disputes, investment will be delayed, causing grave consequences. In Germany, a total of 2,220,000 property claims were filed in four years after unification and the deadline for final settlements has been extended from 2010 to 2018. As of September 1994, the German government earned 65 billion marks through the sale of public properties and had to pay 350 billion marks for compensation and other expenses.

 

Unification planners in Korea need to take lessons from the German experiences regarding property claims and other aftermaths of unification. Strenuous studies should be made on timely investment in SOC construction and other industrial programs to have unification accompanied by sustained economic and social development of the entire Korean peninsula.

 

Editor’s Note: This is a summary of a report prepared by the National Assembly Budget Office.

[December 2014]