Feb. 2017 Byeongho Choe and Keunjae Lee Dept. of Economics, Pusan National University

1. Change in Marginal Effect of Local Population on Local Share Tax Allocationand Its Implication to Jurisdictional Merge Feb. 2017 ByeonghoChoe and Keunjae Lee Dept. of Economics, Pusan National University

2. Contents • Motivations and Research Purpose • An Overview of Korean Fiscal Equalization System • Change in Jurisdictional Population and OLST Allocation • Discussions and Implication to Jurisdictional Merge

3. Motivation and Research Purpose • Fiscal Equalization Grants (FEG) • Equity concern • Usually, fiscal equalization through filling the gap between revenue-raising capacity and expenditure needs for local governments • Access to similar fiscal resources while imposing similar tax burdens on local residents • Efficiency concern • Reduce inefficiency caused by different net fiscal benefit and resulting fiscally-induced migration • Incentive problems in FEG • Typically, transfers are inversely related to the tax base or some other measure of fiscal capacity, and thus compensate jurisdictions for the adverse impact of higher tax efforts on the tax base • Distort incentives of local governments because their taxes and expenditures can affect the parameters of the transfer formula, thereby affecting the size of transfer

4. Motivation and Research Purpose • Literatures on the distortionary effect of FEG • Baretti, et al (2002) • Study the case of German states with no tax authority • FEG has a significant adverse effect on revenue collection efforts of German states • Dahlby (2002) • Theoretically analyzes the Canadian grant formula and investigate possible distortionary effect • Grant formulas create an incentive for a recipient government to modify its tax and fiscal policies in ways that allow it to collect larger equalization grants • Buettner (2005) • Incentive effect of FEG on taxing efforts of German local jurisdictions • High marginal contribution rates, i. e., the rate at which an increase in tax base reduces FEG, induce the jurisdictions to raise their business tax rates significantly • Dahlberg, et al (2008) • The effects of federal grants on the behavior of local jurisdictions in Sweden • Federal grants are shifted to more local spending, but do not to reduced local • Liu and Zhao (2011) • Incentive effect of total central fiscal transfers and its components (tax rebates and FEG) on provincial tax effort in China • Negative impacts om provincial tax effects of both total fiscal transfers and FEG

5. Motivation and Research Purpose • Korean case: Ordinary Local Share Tax as a FEG • The structure and revenue source of LST • Popular research questions • How to resolve the negative effects of OLST on jurisdiction’s tax efforts and expenditure saving efforts resulting from the gap-filling allocation formula? • Searching for an appropriate level of equalization to achieve overall cost-efficiency in local expenditures in the presence of excessive equalization in favor of poor jurisdictions Tariff Special LST3% Ear-marked tax 19.24% National tax Ordinary LST (OLST) 97% Internal tax LST 20% Fire protection &Public Safety LST Excise tax on tobacco 100% Aggregate real-estate tax Real-estate LST

6. Motivation and Research Purpose • Background • Slowdown of population increase with lower birth rate and rapid aging • The explicit tendency of smalls become smaller, warning of “extinction of jurisdictions” • For overall cost-efficiency of local finance, is it desirable to let small and poor jurisdictions fiscally maintaining by advantageous OLST allocation? • Purpose • Investigate the change in the marginal effect of population on OLST allocation to figure out the evidence of maintaining small jurisdictions with favorable OLST allocation • Find the implication for jurisdictional merge to achieve overall efficiency of local fiscal resources under growing fiscal pressure

7. The Overview of Korean FEG System • The structure of Korean inter-governmental transfer system • Consolidated Budget in FY 2016 (trillion Won) ∙ Local Share Tax (Special, Real-estate) ∙ National Disbursement Fund ∙ FAG ∙ CDF Central → Local Auto. districts Metro Cities ∙ Legal transfers - local edu. tax - tobacco tax - local tax Higher → Lower ∙ Local Educational Share Fund ∙ Nat’l Disbursement Fund Central → Edu. Local Education Local → Edu. Central ∙ FAG ∙ PDF Cities, counties Provinces ∙ discretional transfers ∙ Local Share Tax ∙ National Disbursement Fund

8. The Overview of Korean FEG System • Allocation formula of Local Share Tax (LST) • Gap-filling grant: filling the gap between standard fiscal needs and standard fiscal revenue • Allocation formula: • Calculation of SFN and SFR

9. The Overview of Korean FEG System • Negative effect of OLST on local tax efforts • Marginal effect of a change in local tax revenue on total revenue is smaller than 1 • Excessive equalization? • Excessive estimation of per capita SFN for smaller jurisdictions? Population vs. per-capita SFN and SFR Population vs. per-capita OLST allocation

10. The Overview of Korean FEG System • Change in jurisdictional population and aging rate Population in 2000 vs. annual growth rate (2000-2015) Population growth rate vs. change in aging rate(2000-2015)

11. Change in Jurisdictional Population and OLST Allocation • Questions: • Population growth rate vs. OLST allocation? • OLST as a fiscally sustaining force for small and poor jurisdictions? • Method: • Estimate OLST allocation as a function of jurisdictional population in the period of 2000 to 2015 • Figure out the marginal effects of population on OLST allocation, and compare the effects year by year • Find either SFN or SFR is the main source of the change in the marginal effect

12. Change in Jurisdictional Population and OLST Allocation • Model • SFN and SFR as functions of population • Normalize total amount of OLST • Estimation equation

13. Change in Jurisdictional Population and OLST Allocation • Estimation result (1): and population

14. Change in Jurisdictional Population and OLST Allocation • Estimation result (1): • Marginal effect of population on OLST allocation • Marginal effect of population on OLST allocation decreases as time passed, implying more favorable OLST allocation for smaller jurisdictions population population population

15. Change in Jurisdictional Population and OLST Allocation • Estimation result (2): and population

16. Change in Jurisdictional Population and OLST Allocation • Estimation result (2): • Marginal effect of population on SFR • Marginal effect of population on SFR decreases as time passed, implying greater own revenues and inter-jurisdictional grants for smaller jurisdictions • Other things being equal, resulting less OLST allocation for smaller jurisdictions? population population

17. Change in Jurisdictional Population and OLST Allocation • Estimation result (3): and population

18. Change in Jurisdictional Population and OLST Allocation • Estimation result (3): • Marginal effect of population on SFN • Marginal effect of population on SFN decreases as time passed, implying greater assessment of fiscal needs for smaller jurisdictions Population Population

19. Discussion and Implication to jurisdictional Merge • Summary of findings • The advantage of being small in OLST allocation resulting from greater assessment of fiscal needs for smalls, which possibly making small jurisdictions fiscally sustainable with descending population • The OLST allocation formula, especially the estimation of SFN, can be greatly simplified • Discussions: The problems of small jurisdictions • Greater per capita expenditure with less own revenues • Overlapped and excessive fiscal equalization in favor of smalls • Lower fiscal multiplier, implying less efficiency in local public spending • Higher estimation error of local tax revenue • No debt issue, fiscally extremely sustainable • Opportunism and soft budget problem …

20. Discussion and Implication to jurisdictional Merge • Discussions: Population, per capita own revenue and per capita budget • Korea • Germany • Source: Buettnerand Holm-Hadulla(2008)

21. Discussion and Implication to jurisdictional Merge • Discussions: Increase in tax revenue and increase in local spending (2008-2015)

22. Discussion and Implication to jurisdictional Merge • Discussions: The fiscal soundness of jurisdictions Fiscal power index(=SFR/SFN) and debt issue (2015) Subnational debt of OECD countries

23. Discussion and Implication to jurisdictional Merge • Implications • Reform of OLST allocation formula based on a new definition of fiscal equality - Need to cut back the advantage to small jurisdiction in SFN calculation - However, hardly accepted politically • Need to resolve the fiscal-related problems of small jurisdictions to overcome the overall inefficiency in the allocation of local fiscal resources - Actively inducing jurisdictional merge while allowing more autonomy and accountability