[Insight & Opinion] How to Escape the Dilemma of Expansionary Fiscal Policy

Recently, the government approved a budget proposal of 728 trillion won for next year at a Cabinet meeting. This represents an 8.1% increase over this year, marking an expansionary fiscal policy. The policy direction of actively utilizing fiscal resources to revive sluggish domestic demand and secure competitiveness in new industries such as artificial intelligence (AI) is desirable. This also aligns with the technology-led growth strategy promoted by the new administration. In particular, the role of fiscal policy is crucial in a situation where monetary policy is constrained by the real estate bubble and rising household debt. However, while expansionary fiscal policy can stimulate domestic demand, it also creates the dilemma of worsening fiscal soundness due to fiscal deficits. It is urgent to devise measures to break free from the dilemma of expansionary fiscal policy.

Policymakers may consider increasing tax revenue by raising tax rates. However, even if tax rates are raised, it is not easy to increase tax revenue due to the trap of low economic growth. Moreover, if fiscal spending is expanded while simultaneously raising tax rates, it is difficult for domestic demand to recover under a neutral fiscal policy. Corporate tax, inheritance tax, gift tax, earned income tax, and capital gains tax rates are already so high that further increases could lead to tax resistance and lower public support for policy. While value-added tax could be raised, this is difficult due to concerns over price increases. Taxing capital gains from stock transactions, the only untaxed source of income, is also challenging due to opposition from small shareholders. Policymakers say they will cover fiscal deficits through the issuance of government bonds, but this raises concerns about increasing market liquidity and causing fiscal inflation.

What is the solution to escape the dilemma of expansionary fiscal policy? First, it is to raise the economic growth rate. If the current labor and tax systems, which do not meet global standards, are reformed to improve the corporate investment environment, corporate investment will increase, creating jobs and raising the growth rate. As the growth rate rises, tax revenue can increase without raising tax rates, thereby securing fiscal soundness. However, at present, while policymakers emphasize support for fostering new industries such as AI, they are also discouraging corporate investment through amendments to laws related to labor unions and small shareholders. The government and the National Assembly must implement consistent economic measures to increase corporate investment, create jobs, and raise the growth rate.

It is also important to make fiscal spending more efficient. Rather than populist fiscal expenditures, spending should be increased in areas with strong ripple effects so that the stimulus to domestic demand can be sustained. Since it is difficult to increase tax revenue at present, it is necessary to achieve the greatest effect with limited fiscal resources. Along with boosting domestic demand, the construction industry is a sector with significant ripple effects. The government should expand fiscal investment in transportation, education, and distribution infrastructure in low-income residential areas to stimulate the construction sector and simultaneously increase the income of low-income households.

Finally, various tax deductions and exemptions should be reformed to increase tax revenue. Raising nominal tax rates does not necessarily increase tax revenue because of the existence of numerous deductions and exemptions. Excessive deductions and exemptions lower the effective tax rate paid by taxpayers, reducing tax revenue. Most tax systems, including housing capital gains tax and real estate holding tax, include deductions and exemptions. The current economic team is also aware of this and is planning to reform the deduction and exemption systems. Although strong opposition from related interest groups is expected, policymakers must overcome this effectively and proceed with the reform of deductions and exemptions.

Given the trends of low growth and an aging population, tax revenue is expected to decrease while fiscal spending increases, leading to a rapid rise in fiscal deficits and national debt. In addition, as the competitiveness of key industries weakens and job losses increase, domestic demand stagnation will worsen, expanding the dilemma of expansionary fiscal policy. Policymakers must focus on raising the growth rate while simultaneously making fiscal spending more efficient and reforming deduction and exemption systems, so that the economy can break free from the dilemma of expansionary fiscal policy.

Kim Jeongsik, Professor Emeritus of Economics, Yonsei University