Three major changes are noteworthy in connection with the reforms of the local fiscal equalization scheme prior to the introduction of the local autonomy system. First, the rate of the local grant tax was determined by law. The legal rate for the local grant tax was abolished with the imposition of the August 3 measure of 1973 and the amount of the local grant tax was determined each year in the budgeting process. The Local Grant Tax Act was revised as Act No. 3557 on April 3, 1982, and legal rate was reintroduced and set to be 13.27%
of the domestic tax revenue. Then, 10/11 of the local grant tax was distributed as a general grant, according to a formula, and 1/11 was allocated to organizations with special fiscal demands that were not covered by the allocation framework for the general grant. The additional grant provision scheme was newly put in place to provide grants, other than those subject to legal rate, in cases where special demands needed to be met. The imposition of the legal grant rate, which was 13.27% of the domestic tax revenue, reduced the size of local grant tax, which was 17.6% of the domestic tax revenue, but it is meaningful in that it enhanced autonomy and the stability of local finance.19)
The second change is the introduction of the local transfer fund. There was a growing consensus over the need for balanced regional development and for tax sharing between the central and local governments to strengthen local finances, ahead of the implementation of local autonomy. The local transfer fund was introduced in 1991 as an attempt to meet these two purposes simultaneously.
19) Oh(1991)
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Part of national tax revenue was transferred to local governments to support projects conducive to balanced regional development. Initially, 50% of revenue from land excess profits tax, 15% of liquor tax receipts, and the entire amount of telephone tax revenue were distributed to local governments so that the fund were used for road construction projects. Sources of local grants were steadily expanded to include the entire amount of liquor tax and telephone tax receipts, and 19/150 of the farming and fishing villages special tax revenue in 1997.
Projects financed by the local transfer fund were also expanded to farming and fishing village development projects, water contamination prevention projects, youth training projects, and regional development projects in addition to road construction projects. The local transfer fund is viewed as having made a profound impact on balanced regional development, and particularly on road construction projects.
However, as the scope of eligible projects was expanded, projects that had elements of the local grant tax were mixed in. And the local transfer fund was under increasing criticism because road construction had reached close to the target level. Local governments also complained that they were asked to shoulder part of the financial burden under manipulated rules in the process of the fund management. In addition, there was no clear cause-and-effect link between funds and uses of the funds. Eventually, the local transfer fund was abolished in 2005 and parts of the funds were integrated into the local grant tax and into the special account for balanced national development, a new form of block grant.20)
The third change that in connection with the local fiscal equalization scheme prior to the reinstating of local autonomy pertains to subsidies from the national treasury or central government subsidies. The most critical change is restructuring of Subsidy Management Act into the Act on Subsidy Budget and Management at the end of 1986. The purpose of the restructuring was to eliminate elements of inefficiency in the management of central government subsidies and to reflect the opinions of local governments in the operation of subsidies ahead of the implementation of local autonomy.
Previously, subsidies were provided without prior consultation with local
20) An(1997)
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governments and without considering the business plans and fiscal conditions of local governments. Under the new Act, subsidies were provided upon application and no subsidy was granted unless there was an application filed by the candidate local government, except when it was deemed inevitably necessary to give a subsidy, even without an application, in order to meet a national policy goal. In addition, the base subsidy rates were determined within the legal framework instead of setting and operating the rates as part of the annual budgeting process. This is considered as an effective measure that improved the stability and predictability of central subsidy programs for local governments.21)
B. Abolishing the Local Transfer Fund and Introducing the Decentralization Grant
After local autonomy began to be implemented, the old local tax system remained in effect until local consumption tax was introduced in 2010. On the other hand, the local fiscal equalization scheme experienced a few major changes in the 2000s. The legal rate for local subsidies increased from 13.27% to 15%
in 2000, the first increase in 20 years since the legal subsidy rate was first set in 1980s. Because the telephone tax, which provided a revenue source for local grants, was abolished in 2001, part of transportation tax was included in the revenue source for local grants and 23/150 of farming and fishing villages special tax was used to finance local grants in 2002, up from the previous 19/150.
In 2005, local grants were discarded and decentralization and real estate subsidies were created, bringing about major changes to the basic framework of the local fiscal equalization scheme. Previously, subsidies that the central government provided to local governments consisted of four types including local subsidies, central government subsidies, local grants and other subsidies. As [Figure III-2] shows, local grants were abolished and the sources were transferred to either local subsidies or to the special account for balanced national development, according to the nature of the source. The composition of subsidies from the national treasury was much changed. Part of the sources was transferred
21) Oh(1991)
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to the special account for balanced national development that functioned as a comprehensive subsidy in nature. Some of the functions that focused on welfare projects were transferred to local governments and, as a result, sources of the related central government subsidies reverted to the local treasury and, thus, served as decentralization subsidies. Decentralization subsidies, combined, represented 0.94% of the domestic tax revenue and were scheduled to exist until 2009 before they were to be consolidated into ordinary subsidies. The special account for balanced national development is a new special account that combined all sources related to regional development out of local grants, central government subsidies, and other subsidies. The account was a comprehensive subsidy in its nature.
[Figure III-2] Changes to the Local Fiscal Equalization Scheme (2005)
Note: 1) Decentralization subsidy rate included
Sources: Replicated from Choi & Jung(2007) and Ahn(2010).
The additional subsidy provision scheme that functioned as a central government subsidy was abolished and the special subsidy rate was lowered.
Partial transfer of local grants and introduction of decentralization subsidies increased the size of sources to 15% of the domestic tax revenue to 19.24%.
A real estate subsidy was added. The real estate subsidy newly introduced with
Changes in Local Tax and Local Public Finance Systems
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the introduction of aggregate land tax, was used primarily to make up for reductions in revenue caused by the 2005 tax reform. Other subsidies were allocated in consideration of fiscal conditions, social welfare, educational needs, the size of holding taxes, and so on.
As a result of these changes, the fiscal equalization scheme was restructured around the three pillars of local subsidies, central government subsidies, and the special account for balanced national development. From a broader perspective, local grants were abolished to simplify the subsidy system, but a closer look reveals that multiple elements including ordinary subsidies, decentralization subsidies, and real estate subsidies with disparate purposes and different allocation formulas co-exist within the wider category of local subsidies, and make the system far more complicated than before. Each individual subsidy program should have a clear purpose and the allocation formula that fits the purposes should be chosen. In this sense, the 2005 tax reform fails to garner positive reviews.22)
22) Ahn(2008)
Ⅳ
Evaluation of Local Tax and Intergovernmental Transfer System
1 The Frame of Evaluation
The evaluation frame of local tax policy is summarized in <Table IV-1>.
First, the evaluation frame can be classified into three sections. The first frame is decentralization of government finance. The second frame is distribution of fund between regions. The third frame is tax policy. These frames are factors that should be considered when dealing with local tax.
Though there might be arguments about whether decentralization of government finance is needed and about the level of decentralization, this research assumes that decentralization of government finance is needed and the local tax policies should be directed at maximizing the advantages of decentralization and minimizing the problems from decentralization. In order for local tax to maximize the advantages and minimize the problems of decentralization, the local tax revenue ought to be big enough to work as a local government’s own source of revenue, and the local government should be able to influence the local tax policies and take political responsibility for it.
The problem most worrying while undergoing decentralization is the economic disparity between regions. Under decentralization, the economic disparity between regions results in the disparity of public service provided by local governments, which cause residents to move from one region to another, widening the disparity further. This phenomenon is harmful for the country,
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so the economic disparity between regions should be mediated. This problem has the possibility of colliding with the fiscal decentralization mentioned earlier.
However, because the economic disparity is a serious problem that cannot be overlooked, harmony between decentralization and disparity between regions is necessary.
Frame of
evaluation Evaluation factors Key points of evaluation
Fiscal The relationship between local
economy and local tax revenue
- Whether local tax revenue increase when local economy flourishes
Principles of Tax Policy
Efficiency - The influence of economic activities on migration between regions
Income-redistribution - Whether income-redistribution function is excessive
Beneficiary taxation rule - Consistency with beneficiary taxation rule Simplicity - Simplification of taxation system and
administration
〈Table IV-1〉Summary of evaluation framework
Finally, the local taxation policy should consider basic factors for a taxation policy, including efficiency, income-redistribution, beneficiary taxation, and simplicity. For each factor, national tax and local tax differ in terms of necessary functions. Efficiency means minimizing the influence of tax on resource allocation. In the case of local tax, the inefficiency due to the movement of source of taxation between regions is a big issue. The income-redistribution function is best when central government takes charge, so that the redistribution by local tax should be minimized. Beneficiary taxation is rather more important
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in local tax than national tax. In local tax, the beneficiary of local public goods should be the taxpayer. Simplicity is also more important in local tax because the local government lacks experts who can deal with complex administration.
2 Evaluation Results
In An (2015), the local tax and the intergovernmental transfer system were evaluated using the frame shown in <Table IV-1>. <Table IV-2> and <Table IV-3> summarize the evaluation results. <Table IV-2> is the evaluation result of fiscal decentralization and wealth distribution between regions, and <Table IV-3> is the evaluation result of whether the basic factors of local tax are fulfilled from a tax-policy perspective. The grounds of evaluation are summarized as graphs and tables in the appendix.23)
From a perspective of fiscal decentralization, there are indicators that partially showed downward movements, and there were no big improvements. With regard to resource adequacy, not only local tax, but also the local grant tax should be taken into consideration. When considering the local grant tax, it is difficult to find evidence that local finance is short of resources. It appears that the sum of standard financial income and the local grant tax is not far from 100% of standard amount of financial demand (<Appendix IV-7>, <Appendix IV-10>).
The importance of local tax in the local government revenue, or the importance of the sum of local tax and non-tax revenue in local government revenue (an index for local finance independence) has decreased since the introduction of local autonomy system. The (local tax/local government revenue) ratio is low in Korea compared to other countries. (<Appendix IV-1>, <Appendix IV-2>). However, this ratio does not matter much. The notion of local tax is so wide that taxes the local government have no discretion on are also included in local tax. Sometimes, a very similar tax is classified as local tax and also as a national tax. Thus, taxation autonomy, that is, local tax that the local government has discretion in applying, matters more than just local tax revenue.
23) <Appendix Ⅳ-1> ~ <Appendix Ⅳ-10>
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〈Table IV-2〉Summary of evaluation result 1 Evaluation
Frame
Key point of
evaluation Evaluation result
Fiscal the local finance
- Proper to evaluate with (local tax + local grant tax) rather than just local tax
- No evidence that (local tax + local grant tax) is not enough - (standard fiscal revenue + local grant tax) is 96%~ among OECD members
- Local tax notion is so wide, so taxation autonomy is more important than (local tax/local gov’t revenue) ratio - The influence of in restriction of taxation autonomy
- Flexible tax rate is hardly used, so that local tax does not work as marginal resource of government expenditure - Local grant tax keeps flexible tax rate from being used Especially in 2005~2010
- (local tax + local grant tax) per person is high in provincial areas: the influence of fiscal demand overwhelms fiscal resource distribution
- The regional disparity of fiscal capacity index is big:
- Positive relation between private consumption expenditure and local tax
․ If private consumption expenditure increases, (local tax /private consumption expenditure) decreases
․ Provincial area benefits after introduction of local consumption tax
- The (local tax + local grant tax) distribution is unrelated to private consumption expenditure.
․ The revenue per person of provincial area is considerably big
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After introducing the local autonomy system, the subjects of flexible tax rates expanded to 80% of the taxation subjects (<Appendix IV-3>). This is nominally an important measure to expand taxation autonomy, but practically does not mean much. This is because the local governments hardly use the flexible tax rate system. Although the flexible tax rate system should work as a tool to raise the marginal resource of local government expenditure, the local grant tax system stands in the way. The local governments use only 30% of the increased tax income owing to flexible tax rates, and the other 70% is cancelled out because of decreased local grant tax (refer <Appendix IV-9> and
<Appendix IV-4>).
The disparity of local government revenue per person between regions has considerably decreased since the introduction of the local autonomy system. The disparity narrowed especially in 2005～2009, and the local consumption tax introduced in 2010 is also considered to have contributed to narrowing the disparity between regions (refer <Appendix IV-5> and <Appendix IV-6>).
If the local grant tax distributed regarding regional equality is considered together with the resource of the local government itself, the disparity between regions decreases drastically. The distribution of fiscal capacity index, which is standard fiscal revenue divided by standard fiscal demand, shows the lowest value of 0.19 (Jeon Nam) and the highest value of 1.01 (Seoul). It is clear that some local governments cannot run their local finance with only the local tax and non-tax revenue. However, the sum of standard fiscal revenue and distributed amount of general grant tax divided by standard fiscal demand is lowest 0.91 and highest 1.02, a dramatic decrease in the regional disparity. The sum of local grant taxes, including all the other grant tax such as real estate grant tax, and standard fiscal revenue divided by standard fiscal demand is between 0.96～1.06. In other words, the regional disparity of local tax revenue is very big, but the regional disparity of resources is not as big, after considering the local grant tax. Rather, the equalization function of the local grant tax is strong as an incentive to not use the flexible tax rate (refer <Appendix IV-7>
and <Appendix IV-10>).
In respect of the factors local tax should consider as a tax policy, there has not been much change since the introduction of local autonomy system.
However, unlike the past where the flexible tax rate system was merely nominal,
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local income tax is expected to be used actively as a resource of the local government to work as the marginal resource of the local finance. In that case, there would be a few significant problems.
Evaluation
frame Key point of evaluation Evaluation results
Tax policy - on migration between regions
- Local income tax on corporate income can possibly cause inefficiency of national economy by regional movement of companies
- Whether income- inconsistency of taxpayer’s residence and place of tax payment
․ Difficulty controlling local finance by residents ․ Concentration of tax revenue to regions where
there are many businesses - Simplification of tax
system and administration
- Drastic decrease in the number of taxes after the introduction of local autonomy system ․ while the taxation system remains the same: no
〈Table IV-3〉Summary of evaluation result 2
The most significant problem is that the flexible tax rate is being applied to the local income tax not only for individuals but also for corporations, which will move to other regions if there is a difference of taxation system between regions. In addition, local income tax takes the form of progressive tax as in national tax, which is not appropriate for local tax. Tax revenue has a positive relation with regional economy, so that if a progressive tax rate system is applied, the disparity between the rich and the poor might widen. Furthermore, people with higher income might move to regions with lower progressiveness of
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taxation, and people with lower income might move to regions with higher progressiveness, which is an inefficient movement. If such movements happen, the progressive tax rate system cannot function as a redistribution system.
The special collection system of local income tax is also a problem. In the case of withholding tax at the source, taxpayers should pay tax to the region where the withholders reside, not where the taxpayers reside. In this case, the taxpayers’ residence and the place for tax payment might be different, which makes it impossible for local residents to control the local finance, even though control is the key factor for local decentralization. In addition, tax revenue is concentrated where there are many businesses (refer <Appendix IV-8>).
The special collection system of local income tax is also a problem. In the case of withholding tax at the source, taxpayers should pay tax to the region where the withholders reside, not where the taxpayers reside. In this case, the taxpayers’ residence and the place for tax payment might be different, which makes it impossible for local residents to control the local finance, even though control is the key factor for local decentralization. In addition, tax revenue is concentrated where there are many businesses (refer <Appendix IV-8>).