Korea has been hard-hit by the commodity price shock and the global financial crisis, which have slowed economic activity and pushed up inflation. The terms-of-trade loss reduced national income, thus damping domestic demand, while the slowdown in world trade has moderated Korea’s export growth. Moreover, the sharp exchange rate depreciation and the intensification of the global financial market crisis have further dimmed the outlook. Although the recent fiscal stimulus is likely to help support growth, an economic rebound depends on a recovery in the world economy. In addition to these short-term difficulties, Korea faces a number of challenges to sustaining economic growth over the medium term, notably tax reform, enhancing service sector productivity growth and reforming the labour market and education system.

The Korean economy has faced a number of shocks in 2008, including higher commodity prices, slowing world trade and the global financial crisis. The terms-of-trade shock – Korea is the world’s fifth-largest oil importer – weakened the won and heightened inflationary pressures, which have squeezed household income and corporate profits, damping private consumption and investment. In addition, housing market policies contributed to a 5% decline in residential investment over the past year, while the deceleration in world trade took a toll on Korean export growth. With weaker domestic demand and exports, output growth fell from 5% in 2006-07 to 3% in the first three quarters of 2008, at a seasonallyadjusted annual rate. Intensified financial turbulence in September 2008 has further dimmed the economic outlook by accelerating the depreciation of the won and tightening credit conditions. The timing of the rebound depends on an improvement in the world economy, which may not occur until well into 2009. In that event, economic growth is projected at around 3% on a year-average basis in 2009 before rising back to around 4% in 2010.

Korea has been adversely affected by soaring oil and commodity prices, which led to a spike in inflation and slowed the pace of economic activity. Moreover, the global financial crisis accelerated the depreciation of the won and clouded the economic outlook. Output growth is likely to remain subdued until the world economy improves, which may not happen until well into 2009. Korea faces a number of challenges, both in the short and long run. This chapter looks at four key challenges: i) setting an appropriate macroeconomic policy to cope with the severe external shocks; ii) raising additional tax revenue as rapid population ageing puts upward pressure on public spending; iii) promoting the development of services, where productivity growth and levels lag significantly behind manufacturing; and iv) reforming the labour market and the education system to address the growth and equity problems related to labour market dualism and population ageing.

Macroeconomic policy faces difficult challenges in responding to the shocks from the global financial crisis. In the near term, the monetary authorities should focus on supporting activity and financial-market stability. While inflation is well above the target zone, it is expected to slow significantly over the next year as output growth decelerates, despite the depreciation of the won. Given that the won’s fall is driven by international financial-market turbulence, foreign exchange market intervention is likely to be costly and ineffective and should therefore be limited to smoothing operations. Fiscal stimulus has a role to play in cushioning the downturn. Over the medium term, the priority should be on maintaining a strong fiscal position given future spending pressures associated with population ageing. Slowing the growth of outlays is necessary to achieve the medium-term target of a balanced budget, excluding the social security surplus.

Korea has one of the lowest tax burdens in the OECD area, reflecting its small public sector. However, rapid population ageing will put upward pressure on government spending. The challenge is to meet the long-run need for greater expenditures and tax revenue while sustaining strong economic growth. A pro-growth tax reform implies relying primarily on consumption taxes for additional revenue. There is also scope for raising personal income tax revenue from its current low level by broadening the base by reducing the exemptions for personal income. The planned cuts in the corporate tax rate should be financed at least in part by reductions in tax expenditures. The broadening of direct tax bases would also help finance an expansion of the earned income tax credit to address widening income inequality. In addition, the local tax system should be simplified and reformed to enhance the autonomy of local governments.

Labour productivity growth in the service sector has been low relative to manufacturing. This is explained in part by weak competition in services resulting from strict product market regulation and the low level of import penetration and inflows of foreign direct investment (FDI). Increasing productivity growth in the service sector, which accounts for 67% of employment and 58% of value added in Korea, is essential to sustain high potential growth. The priority is to strengthen competition by eliminating domestic entry barriers, accelerating regulatory reform, upgrading competition policy and reducing barriers to trade and inflows of FDI. Another challenge is to enhance the performance and accelerate the restructuring of small and medium-sized enterprises, which account for over 90% of service-sector employment. Furthermore, it is essential to boost productivity in service industries with high growth potential, such as telecommunications and financial and business services.

A well-functioning labour market is essential to sustain rapid economic growth in the face of population ageing. Priorities are to reverse the rising share of non-regular workers, which has negative implications for both growth and equity, and encourage greater employment of women and youth, who are under-represented in the labour force. Attracting more women to employment requires increasing the availability of childcare, strengthening maternity leave and creating more familyfriendly workplaces. Youth employment rates should be boosted by upgrading tertiary education through stronger competition and closer links to enterprises to reduce mismatches. Educational reform should be extended to elementary and secondary schools to enhance efficiency and decrease the burden of private tutoring. The age of retirement of employees should be raised by eliminating mandatory retirement and phasing out the retirement allowance. Active labour market policies should focus on policies to expand human capital rather than wage subsidies.