Price Indexation for Earned Income Tax? It Must Be Viewed Within the Entire Tax Law Framework [Tax Reform, Let's Change This]

It Is Not a Simple Matter of Just Linking the Tax Base
Sharp Value Judgments Needed to Decide Scope of Indexation
Low Income Tax Burden Also an Obstacle

During the last presidential election, there was a growing call within the political sphere for the introduction of a "price indexation system," which would automatically link the income tax base brackets to the inflation rate. This was in response to criticism that, as inflation pushed up nominal wages while the tax base brackets remained unchanged, a "silent tax increase" had been occurring. However, both government officials and academics largely agree that introducing such a system is not easy under Korea's current tax structure. There are complex issues surrounding the scope of taxes to be indexed to inflation, which would require sharp value judgments and a comprehensive overhaul of the tax law system if implemented. Additionally, Korea's income tax burden is still considered low compared to major countries.

According to political sources on July 11, the price indexation system for income tax, which was proposed by candidates Lee Jaemyung and Kim Moonsu during the presidential election, is not currently being pursued. The final campaign pledge book of President Lee Jaemyung omitted this proposal. The government is also not considering including the system in its tax law amendments.

The price indexation system is a method that automatically links tax base brackets and various deduction schemes to the inflation rate to mitigate the increase in real tax burden caused by rising prices. From the taxpayer's perspective, this reduces the uncertainty of changes in real tax burden due to inflation, which could increase public acceptance.

22 OECD Countries Have Introduced Price Indexation; 17 Also Apply It to Deduction Schemes

As of 2022, 22 out of 38 OECD member countries have introduced price indexation in their income tax systems. However, the method of indexation varies from country to country. In 20 countries, excluding New Zealand and Mexico, the income tax base brackets are adjusted according to the inflation rate, and in many of these countries, at least one deduction item is also indexed. In particular, 17 countries?excluding New Zealand, Mexico, Slovenia, and Turkiye?operate systems that adjust not only the tax base brackets but also deduction schemes in line with inflation.

If Korea were to introduce a price indexation system, it would first need to determine the scope of its application. Policymakers would have to decide whether to adjust only the tax base brackets according to the consumer price index, or to also include basic deductions, personal deductions, and tax credits. They would also need to determine whether indexation should be triggered only when inflation exceeds a certain level, or if it should be automatically linked to both inflation and income. An official from the Ministry of Economy and Finance explained, “Since Korea’s system allows for a large number of deductions for earned income, indexing only the tax base brackets would not constitute a true price indexation system.”

The problem is that determining the scope of indexed deductions is not a simple matter. If multiple deductions are indexed to inflation, there could be issues of fairness between business income tax and earned income tax. While Korea has actively applied deductions to earned income, business income earners are allowed to deduct necessary expenses, resulting in relatively fewer deduction items. If the indexation standard is expanded to detailed deduction items, a social consensus would be required on the scope that does not undermine fairness. Since income tax in Korea is classified into types such as interest, dividends, business, earned, pension, other income, as well as capital gains and retirement income, the decision on the scope of indexation would require a comprehensive overhaul of the entire tax law. An official from the Ministry of Economy and Finance stated, “In the case of price indexation, simply linking the tax base brackets to the price index is not a simple fix?it is a sensitive issue that would require amending the entire tax law.”

Contribution of Income Tax to Tax Revenue Remains Low... Still Premature

The relatively low maturity of Korea’s income tax contribution to tax revenue is also an obstacle. Professor Sung Myungjae of Hongik University explained, “Implementing a price indexation system is characterized by maintaining the effective tax rate as is, which presupposes that the current income tax system has reached an ideal level.” He added, “An ideal level means that the fiscal contribution of income tax and the relative ratio of tax burdens by income class are appropriate, ensuring a fair system.”

As of 2022, Korea’s income tax revenue stood at 6.6% of GDP, lower than the OECD average of 8.2%. The proportion of wage earners who pay no earned income tax has steadily declined from 48.1% in 2014 to 33.0% in 2023, but remains high. This is higher than in major countries such as the United States (31.5% in 2019), Japan (15.1% in 2020), and Australia (15.5% in 2018). This is due to the wide application of income and tax credits in the income tax calculation process. Therefore, before introducing a price indexation system, it is necessary to first streamline various deduction and exemption schemes and raise the effective tax rate and tax burden ratio. Professor Sung stated, “The introduction of a price indexation system can never be achieved in the short term, nor should it be. At least five to six years would be required at a minimum.”