[Insight & Opinion] The Political Economy of Interest Rates and Taxes

There is growing attention on whether the Bank of Korea will lower interest rates this month. It is also the season for taxes such as the comprehensive real estate tax, value-added tax, and comprehensive income tax. Few things are as important to our daily lives as interest rates and taxes. For those with loans, higher interest rates mean a heavier interest burden, and when taxes are raised, disposable income decreases. As a result, most people are not in favor of increases in interest rates or taxes. This is especially true for those who have invested in financial and real assets such as stocks, virtual assets, and real estate, since higher taxes reduce after-tax investment returns. Recently, when a bill was introduced to tax capital gains on single stock holdings exceeding 1 billion won, stock investors strongly opposed it.

Taxes are closely linked to politics. Niccolo Machiavelli, known as the father of modern political science, wrote in his book "The Prince" that a ruler should not become an object of hatred, and that the rulers most hated by their people are those who take away their wealth-in other words, those who raise taxes. Many wars and revolutions throughout history have been triggered by taxes. The Boston Tea Party, which sparked the American Revolutionary War, was related to taxes, and the French Revolution was also driven by excessive taxation.

Interest rate hikes are also closely tied to politics. Governments that raise interest rates often lose popularity with the public and are defeated in elections. In 1979, when inflation surged due to the second oil shock, then-Chairman of the U.S. Federal Reserve Paul Volcker sharply raised interest rates to curb inflation. As the economy rapidly contracted and corporate bankruptcies increased, President Jimmy Carter lost to Ronald Reagan and failed to win re-election. Similarly, President Donald Trump significantly raised interest rates during the first half of his term and failed to secure re-election. In Korea, the administration of President Roh Moo-hyun introduced the comprehensive real estate tax and raised interest rates, while the administration of President Moon Jae-in raised taxes, and the administration of President Yoon Suk-yeol raised interest rates by the largest margin among all previous governments.

Politicians who understand the political influence of interest rates and taxes tend to favor low interest rates and low taxes. Experienced politician Donald Trump, during his second term, has emphasized low interest rates and attempted to lower taxes for both economic and political reasons, fully aware that high interest rates and high taxes are unpopular with the public.

Korea's political environment is undergoing significant change. As the politicization of the economy progresses, political factors are having a greater impact on the formulation of economic policy. In mainstream economics, as taught by Adam Smith, a professor of moral philosophy at the University of Glasgow, consumers and businesses pursue their own interests, while politicians and bureaucrats who set economic policy are assumed to act in the national interest. However, in reality, the public choice theory-which assumes that politicians and bureaucrats also prioritize their own interests-is gaining traction. While economic factors play a role in interest rate and tax policy over the long term, political influence cannot be ignored in the short term.

This political economy approach is also useful for predicting economic policies such as interest rates and taxes. From a purely economic perspective, one would expect interest rates to rise when inflation worsens and taxes to increase when fiscal deficits grow. The rational expectations school also believes in Ricardian equivalence, which holds that larger fiscal deficits will lead to higher future taxes. However, politically, taxes may not be raised now or even in the future, despite fiscal deficits. This is the backdrop for concerns about fiscal inflation.

The Korean economy is experiencing rising living costs due to higher import prices and expanding fiscal deficits due to low growth. Nevertheless, in the short term, there is a strong possibility of low interest rate and low tax policies, as the politicization of the economy is increasing political influence.

Kim Jeongsik, Professor Emeritus of Economics, Yonsei University