The Viability of Fiscal Policy in South Korea, Taiwan, and Thailand

Abstract

The Asian financial crisis of 1997 led to output declines in South Korea, Taiwan, and Thailand. In response, the three countries have turned to fiscal policy to stimulate output. This study investigates the empirical evidence on the viabiltiy of fiscal policy for these three Asian countries using data starting in the 1950s. While fiscal expansion can raise output under certain theoretical conditions, deficit spending implies higher taxes that could eliminate even transitory effects. This article explores these issues, and examines the empirical relationships between government spending, taxes, and output in these three Asian tigers. The literature includes varying views on the links between fiscal policy, government spending, and output. The tax-and-spend hypothesis of Buchanan and Wagner (1978) and Friedman (1978) is that taxes lead to government spending. On the other hand, according to the spend-and-tax hypothesis of Peacock and Wiseman (1979), temporary increases in government spending lead to permanent tax increases. Meltzer and Richard (1981), describe fiscal synchronization and state that spending and taxes would adjust as the public chooses an optimal package of taxes and government spending. The related literature using Granger (1988) causality includes yon Furstenberg, Green, and Jeong (1986), Owoye (1995), Hasan and Lincoln (1997), and Darrat (1998). In addition, Koren and Stiassny (1998) consider whether taxes and spending are cointegrated. The dynamic responses of taxes, spending, and income are examined in this article using vector autoregression (VAR) analysis. Impulse response and variance decomposition are also included as in Baffes and Shah (1994) and Koren and Stiassny (1998), because coefficients of a VAR are difficult to gauge. Impulse responses trace the reaction of an endogenous variable to an innovation, capturing dynamic interactions and adjustment speeds. Variance decomposition measures the share of forecast error variance due to a shock to the system and own innovations would explain the forecast error variance of exogenous variables. This article focuses on real government spending, taxes, and gross domestic product. Fiscal policy could affect interest rates, and in turn investment spending. Interest rates could be included in the study, but it is not clear which rate to use and expected inflation clouds the issue. The empirical links between the fiscal variables and output may provide some indication of the viability of a more active fiscal policy stance in these Asian economies. The article is organized as follows. The next section briefly describes the recent history of fiscal policy in South Korea, Taiwan, and Thailand. Section II presents empirical tests of fiscal policy and output, while Section III concludes. I. The Recent History of Fiscal Policy in South Korea, Taiwan, and Thailand South Korea, Taiwan, and Thailand have achieved relatively high growth since the 1960s and in all three countries, macroeconomic policies have focused on export-led growth. Thailand's growth, in particular, was very high during the 1990s. Among the three countries, South Korea and Taiwan share many similar features in terms of economic growth, size, population, and dependency on energy imports. With regard to their characteristics, public spending patterns are also similar in these three countries. Mundle (1999) points out that public spending has been under 30 per cent of gross domestic product (GDP) in Taiwan, 25 per cent in South Korea, and 20 per cent in Thailand, relative to an average of about 50 per cent for the Organization for Economic Co-operation and Development (OECD) countries. The relatively low spending levels in these three countries has been combined with government surpluses or low deficits. Episodes of inflation have generally been followed by fiscal restraint, at least up to the financial crisis of 1997. Since the crisis, along with structural reforms, South Korea and Thailand have been pursuing expansionary fiscal policy to revive economic growth. …