What are the Consequences of the New Fiscal Rule of Korea?

Abstract

A new fiscal rule was proposed in Korea, which is unique since it imposes a ceiling on a combination of the debt-GDP and deficit-GDP ratios. This paper attempts to assess empirically how much fiscal adjustments should be made to satisfy the new fiscal rule, and what their impacts on the macroeconomy are. We establish a model-consistent accounting framework for these questions using a small open new Keynesian DSGE model and the long-term projection data by the National Assembly Budget Office (NABO). Three main findings emerge from our analyses. First, the new fiscal rule tends to be contractionary, with the effect pronounced more for the longer runs. The expected GDP loss in 2050 is more than 1\% regardless of the type of fiscal adjustments. Second, substantial adjustments in the fiscal instruments are necessary to satisfy the new fiscal rule. As of 2050, tax revenues should increase by 10\% or more than the NABO's projections, together with cuts in government spending and transfers more than 10\%. Third, the GDP loss can be mitigated by the fiscal authority's more active stance against the debt-to-GDP ratio, but comes with a cost of higher macroeconomic instability.