President Lee Says "Let's Revitalize the Local Economy," but 41 Trillion Won in Local Government Construction Subcontracting Remains Unchecked for 20 Years [Real Estate AtoZ]

Zero Appropriateness Reviews in 15 Regions
Only Three Penalties for Violations in Three Years
Need for Subcontract Disclosure at Bidding Stage Like in the US
Abolish Exception Clauses and Impose Fines

President Lee Jae-myung is speaking at the Local Era Committee briefing held at the Yongsan Presidential Office Building on the 8th. Photo by Presidential Office Press Photographers Group

Although the Lee Jae-myung administration has made revitalizing the local economy a core national policy task, there are criticisms that subcontracting management at construction sites-the backbone of regional economies-has been neglected for 20 years. While the scale of construction projects ordered by local governments has surpassed 40 trillion won annually, the system is failing to function properly, disrupting the virtuous cycle of the local economy that should be based on the use of local materials, equipment, and labor.

According to the construction industry on December 25, the Korea Construction Policy Research Institute recently published a report titled "Improvement Measures for the Appropriateness Evaluation System of Subcontracting Management Plans under the Local Contract Act for Revitalizing the Local Economy." The report diagnosed that "the subcontracting management system, introduced with the enactment of the Local Contract Act in 2005, is being operated only in formality, thereby hindering the revitalization of the local economy." As of last year, the scale of construction contracts ordered by local governments reached 40.8 trillion won per year, with nearly half (43.4%) of the project expenditures (procurement contracts) released by local governments being spent on construction projects.

The Lee Jae-myung administration has set "Balanced Growth through Five Regions and Three Special Zones" as a national policy task, focusing on revitalizing the local economy. President Lee stated at a meeting with governors and mayors nationwide in August that "balanced development is a survival strategy for the nation," and at the Local Era Committee work report on the 8th of this month, he said, "We will further systematize the way of providing incentives to local governments during fiscal allocation." However, no matter how much budget the government allocates to local areas, if subcontracting management to protect local companies at the field level is inadequate, the funds will leak out to non-local companies instead of benefiting local businesses.

The impact is greater in non-metropolitan regions. In Seoul, the construction industry ranks only 12th among major industries, accounting for just 2.9% of the Gross Regional Domestic Product (GRDP). In contrast, in Ulsan and Chungnam, construction is the second-largest industry, and in Gangwon, Chungbuk, Jeonnam, and Gyeongbuk, it ranks third, indicating a much higher dependency. As the reliance on construction is higher, poor subcontracting management has a greater impact on the local economy.

Over 1,800 Companies Bid on a Single Project... "Serious Paper Company Problem"

A construction worker is working at a construction site. Photo by The Asia Business Daily DB

The report first raised issues with the bidding methods used to select construction companies.

Under the Local Contract Act, local governments determine successful bidders for general construction contracts based on project size (estimated price): the Suitability Evaluation Bidding System (for projects under 30 billion won) and the Comprehensive Evaluation Bidding System (for projects over 30 billion won).

In both systems, companies are not required to disclose in advance to whom they will subcontract when they initially participate in the bid. They simply submit a price bid, and only after being selected as the preferred bidder do they submit a plan indicating which companies will receive subcontracts and at what amounts.

Because the Suitability Evaluation System requires little documentation at the bidding stage, "blind bidding" is rampant, where companies are only interested in winning the contract. This leads to a flood of fake companies that focus on winning first, regardless of their actual construction capabilities.

In fact, in the first half of this year, 1,829 companies competed for a single project worth about 10 billion won. For another project worth about 4 billion won, more than 1,200 companies submitted bids. The report pointed out, "Excessive competition in bidding is prevalent in projects subject to the Suitability Evaluation Bidding System, increasing the administrative burden on ordering agencies," and "many bidders participate through bid agencies using multiple corporations (paper companies)."

The Comprehensive Evaluation System involves more complex procedures due to the larger scale of projects, but since the subcontracting plan is also submitted only after the bidder is likely to win, the prime contractor is given time to reduce subcontract amounts or force competition among subcontractors, leading to unfair practices.

After Winning the Bid, Subcontractors Face Price Cutting... Penalties for Violations Are Minimal

Subcontract Amount Level Compared to Prime Contract Amount of Public Construction Projects in the Specialized Construction Industry Over the Past Three Years. Korea Construction Policy Research Institute

The bigger problem arises after the contract is awarded. The prime contractor, having won the bid at the lowest price, then negotiates prices with subcontractors. As subcontractors compete excessively, the unit prices are driven down.

Legally, if the subcontract amount is less than 82% of the primary contract, an "appropriateness review" must be conducted.

However, a survey of specialized construction companies found that in public construction projects, cases where the subcontracting rate was below 82% accounted for half (49.4%).

Performance of Subcontract Contract Appropriateness Review by Local Governments in the Last Three Years. Korea Construction Policy Research Institute

However, the review to determine whether the amount paid to subcontractors is appropriate is virtually meaningless.

As of last year, only two out of 17 metropolitan and provincial governments nationwide-Seoul (32 cases) and Sejong (3 cases)-conducted subcontract appropriateness reviews. The remaining 15 had zero cases.

In principle, if the construction cost is too low, the ordering agency should intervene, but there are many exceptions such as "if selected through competitive bidding, it passes" or "if contracted as per the plan, it passes."

There is hardly any punishment for violations of the system. In the past three years (2021-2023), there were only three cases nationwide where sanctions were imposed for unfair subcontracting, and only one case where a fine was imposed for failing to implement the subcontracting plan.

Audits by the Board of Audit and Inspection have uncovered cases where a subcontracting rate of 79% was falsely reported as over 82%. Decisions by the Fair Trade Commission have also revealed instances where "dual contracts" were made to avoid appropriateness reviews.

"Require Subcontracting Plans at the Bidding Stage"

The report suggested the case of California, USA, as an alternative. In California, prime contractors are required to disclose subcontractor information from the bidding stage. It is also prohibited to arbitrarily change subcontractors after winning the bid. Any changes require approval from the ordering agency, and subcontractors are given an opportunity to object.

The report also proposed imposing fines on prime contractors who do not comply with requests from ordering agencies to increase subcontract amounts that are deemed too low. Currently, if the ordering agency makes such a request and the prime contractor does not comply, there are no sanctions other than a corrective order. The report further recommended adding checks on the implementation of subcontracting plans to the "continuous illegal subcontracting inspections" currently operated by the Ministry of Land, Infrastructure and Transport and local governments, to ensure that actual construction is carried out according to the submitted plans.

Recommended Subcontracting Ratio for Local Companies by Local Governments. Korea Construction Policy Research Institute

Construction projects have a significant production-inducing effect and lead to job creation because they use local materials, equipment, and labor. In fact, research shows that a 1% increase in construction investment leads to a 1.12% increase in employment in specialized construction, which mainly handles subcontracted work. Recognizing this, local governments have enacted ordinances to promote the local construction industry, recommending that the subcontracting ratio for local companies be 60-70% or higher. However, the lack of effective management systems to support this makes the intent meaningless.

Hong Sungjin, a research fellow at the Korea Construction Policy Research Institute, said, "The subcontracting system must function properly so that capable local companies can participate in projects, which in turn ensures the use of local materials and labor, allowing money to circulate within the region," adding, "Ultimately, subcontracting management is the starting point for a virtuous cycle in the local economy."