[The Editors' Verdict] The Role of Fiscal Policy Is More Crucial Than Ever

Jae-Hyung Jeong Economic Finance Editor

The government announced a massive second supplementary budget of about 60 trillion won on the 12th. To get straight to the point, this large-scale supplementary budget is highly welcome. This is because the role of fiscal policy is more crucial now than ever before.

When the government formulated the 2022 budget last September, it had already planned for a fiscal deficit of 54 trillion won. However, new adverse factors such as soaring prices due to the Russia-Ukraine war and the restructuring of global supply chains have emerged. With the United States expected to implement several more big rate hikes ("big steps," raising the base interest rate by 0.5 percentage points each time) to stabilize prices, the Bank of Korea has no choice but to follow suit and raise its base interest rate. Moreover, if the interest rate gap between Korea and the U.S. narrows or reverses, there is a high possibility of foreign investor capital outflows. This would cause the won-dollar exchange rate to rise, which could further trigger capital outflows. Therefore, the Bank of Korea must continue to raise the base interest rate.

Macroeconomic policy is broadly divided into fiscal policy and monetary policy. In a situation where monetary policy must significantly raise interest rates, if fiscal policy remains neutral or passive, a tightening effect is inevitable. Therefore, fiscal policy must be expanded further, even if it means accepting additional fiscal deficits.

The government stated that there is no problem with fiscal soundness, expecting excess tax revenue of 53 trillion won this year following last year's 52 trillion won. However, given the significant failure in tax revenue forecasts last year, it is uncertain whether such a discrepancy will occur again this year.

Since the Yoon Seok-yeol administration has emphasized fiscal soundness so much, it might have overestimated excess tax revenue and falsely claimed that the supplementary budget would not increase the fiscal deficit. Alternatively, it is possible that corporate taxes and capital gains taxes have been collected in such large amounts that excess tax revenue of 53 trillion won actually occurs.

In any case, this large-scale supplementary budget is justified. In the current crisis, we must accept additional fiscal deficits and are willing to see the national debt ratio rise above 50.1% (based on the completion of the first supplementary budget this year). The government’s slight overestimation of excess tax revenue to justify the supplementary budget is a tolerable indulgence.

If tax revenue is indeed excessively high, then fiscal expansion is even more necessary. There is a term called the "automatic stabilizer of fiscal policy." Even if the government does not intentionally change government spending or tax rates during economic recessions or booms, tax revenues automatically fluctuate, mitigating the severity of recessions or booms. In a situation like now, where economic slowdown is expected, tax revenue naturally decreases. Since the government collects less tax, this has an effect similar to expansionary policy. However, if tax revenue is excessively high, as is expected now, the government should naturally expand fiscal spending, as it is doing. This will make fiscal policy neutral.

Looking at the recent domestic and international economic environment, there are many adverse factors. Global inflation caused by the Russia-Ukraine war, the possibility of economic recession due to China’s COVID-19 lockdowns, the risk of currency depreciation, capital outflows, and economic crises in emerging markets due to U.S. interest rate hikes, and so on. Inflation in Korea is expected to continue, and economic slowdown is becoming a foregone conclusion.

In the financial market, the won-dollar exchange rate has approached the 1,300 won per dollar mark, reaching its highest level in 13 years. Foreign investor capital, which saw a net inflow of 6.6 billion dollars in stocks and bonds from January to February this year, turned to a net outflow of about 600 million dollars from January to April.

The current base interest rates are 0.75?1% in the U.S. and 1.5% in Korea. Even if the Bank of Korea raises rates twice consecutively by 0.25 percentage points, if the U.S. takes two more "big steps," the effective interest rates will be at the same level.

Among macroeconomic policies, monetary policy should respond by raising the base interest rate to curb inflation expectations, suppress the rise in the exchange rate, and maintain the interest rate gap between Korea and the U.S. to restore external balance. The Bank of Korea should also consider big steps. The tightening effect caused by raising the base interest rate must be offset by expansionary fiscal policy. Once again, the role of fiscal policy is more important now than ever before.