Reasons for the Fiscal Insufficiency in Korean Local financeByeongho Choe, Jong-Phil Jung, and Keunjae Lee
Dept. of Economics, Pusan National Univ.

Introduction

Korea has experienced a rapid expansion in the volume of local public finance as well as institutionalchanges since the local autonomy system was put in forth in 1995. Nonetheless, the scope and extent of local
autonomy in terms of local public finance remain as a controversial and hot issue between central and local
governments in Korea.
The local governments have been complaining of the limited self-governing authorities and then argue that
more resources should be allocated to them to meet the increasing demand for local public services. On the otherhand, the central government insists that local governments should be more responsible to their own matters by
improving their fiscal accountability, transparency, and capability.
We propose that this controversy is required to be tested based on the theory of public finance. This paper
tries to investigate the reason why the local governments in general complain that they do not have enoughfinancial resources. Specifically, we focus on the structural features of local revenue system and optimal size oflocal government.
The rest of this paper is as following. Section 2 deals with the political behavior of local governments interms of revenue-raising resulting from current local revenue structure. Section 3 examines the minimum
efficient size of local governments and shows the high cost structure of Korean local autonomy system
accompanied with inefficiently small size of local governments. Section 4 summarizes the results and provides
some of implications.

Revenue structure, political interest and insufficiency in local public finance

The total amount of local government budget in 2007 is around 112 trillion won, having grown to 2.14 times
that of 1995. The shares of central and local governments to the total national budget are 61.2% and 38.8%,
respectively. As far as the revenue sources of the local governments are concerned, grant-in-aids and own
revenues account for 38% and 62% of the budget for the local governments, respectively. The share of grant-inaids in local finance is relatively high, compared to the case of developed countries. Furthermore, the local tax,
which is regarded as the most important local revenue source, makes lower contribution to the local
government's revenue than the grant-in-aids.

Table 1. The share of revenue resource between central and local government
Volume of revenue resource (hundred million won)Central government(Including educationalbudget)

Local government

Total revenue (C)National tax
Other rev.
Total (A)
Local share tax
Grant-in-aids
National subsidy
Sub-total
Local tax rev.
Non-tax rev.
OwnRevenue
Local debt
Sub-total
Total (B)
2,887,425

1,473,025 ( 83.3%)
294,536 ( 16.6%)
1,767,561 (100.0%)
214,083 ( 19.1%)
211,590 ( 18.9%)
425,673 ( 38.0%)
380,731 ( 34.0%)
278,509 ( 24.9%)
34,950 ( 3.1%)
694,190 ( 62.0%)
1,119,864 (100.0%)

Ratio (A/C, B/C)
61.2%

38.8%

100.0%

Source: Ministry of Government Administration and Home Affairs, Summary of Local Budget Fiscal year
2007, 2007.

It should be noted that for the most local taxes, the local governments have been granted the leeway ofincreasing or decreasing their tax rates within 50 percent of the rates set by law. However, they have seldom
exercised their right to change local tax rates to raise their own revenues even if they have complained ofinsufficient fiscal resources. Based on this fact as well as the structure of local revenue in Table 1, one could
hypothesize that it is natural on the part of a local government to make an appeal to the central government for
its fiscal insufficiency instead of raising burdens of local taxpayers. That is, to maximize his or her politicalinterest, the leader of a local government would not want to exercise his of her right to raise local tax rates. On
the contrary, he or she would rather make efforts to obtain more revenue through the central government’s grantin-aids system. Based on that statement, we set up the following hypothesis.

Hypothesis 1: The heads of local governments will maximize their political interest by obtaining more revenue
from the central governments and by keeping the local tax rate same under implicit collusion among localgovernments.

Because the interest of politicians is closely related to the winning of next election, we try to estimate amodel of re-election for the heads of local governments in order to test Hypothesis 1. The dependent variable is adummy variable set to 1 if the current head succeeded in being reelected in 2006, otherwise it is set to 0. The
data for dependent variable includes only 124 former heads of basic local governments out of total 232 because
the rest did not attend the final race for the election in 2006. As the determinants of re-election success, thegrowth rates of conditional and unconditional grants as well as the growth rate of own revenue during the periodof his or her inauguration is considered. As the control variables, voting rate, dummy variables of Hannara party,
city and county are also taken into account.

The model is estimated using a binary logit method because the dependent variable is binary discrete data.
The estimation results are presented in Table 2. With the R-squared value of 0.255 and the log likelihood valueof -54.71, the model specification is appeared to be significant at the 1% level based on the LR test. Because thedata is cross sectional, robust standard errors are estimated to avoid heteroskedastic problems and then p-valuesof all coefficients are also calculated based on the robust standard errors.
According to the estimation, the vote rate has negative association with likelihood of re-election significantly
at the 1 % level. The current heads running for office in cities and counties have higher probability to be reelected than them in autonomous districts. For the case of explanatory variables related to the local finance, both
the growth of unconditional grant and the expansion of own revenue are shown to be insignificant at any
significant level. Contrary, the growth of conditional grants is significantly associated with the probability of reelection.
These results support the hypothesis 1, reflecting that the leaders of the local governments usually have madepolitical use of the performance in receiving such grants under the situation that the allocation of conditional
grants in part is considered to be a political process. In summary, in order to enhance their political interest, it isa good strategy for the local leaders to obtain subsidy from the central government’s grant-in-aids as much as
possible. To do so, the local governments in Korea have cried out for more subsidies with strong insist of
insufficient local fiscal resources. That is one reason for the insufficiency problem in Korean local finance.

Table 2. Determinants to win re-election
Variable

Coefficient

Robust Std. Err.

z-StatisticProb.

Constant

6.29**

2.77

2.27

0.0234growth rate of conditional grants

0.04***

0.02

1.85

0.0638growth rate of unconditional grants

-0.01

0.01

-1.52

0.1289growth rate of own revenue

0.02

0.01

1.260.2091

vote rate-0.15*

0.05-2.800.0050

Hannara party dummy

0.94

0.92

1.020.3084

city dummy

4.25*

1.45

2.94

0.0033county dummy

5.80*

1.94

2.990.0028

Log likelihood-54.71375*

LR statistic

37.48421

R-squared

0.255148

Number. ofObservation

Obs with
Dep=0
Obs with
Dep=1
Total obs

3588
123

Note: *, **, *** denote statistical significance at the 1%, 5%, and 10% level, respectively.
Size of local governments and the insufficient in local public financeThis section examines the relationship between the sizes of local governments and insufficiency problem inlocal public finance in Korea. The theory of local public finance says that the preference of residents is betterreflected with the smaller size of local government in providing local public services (Oates, 1972). Aside fromthe matter of economies of scale and spillover effect, the smaller local government would be likely to improve
the welfare of the local residents. In practice, however, there often exist scale economies as well as spillover ofbenefits in providing local public services. Therefore, there would be possible efficiency loss it the size of local
government is too small. The optimal size of a local government is the matter of the trade-off between benefits
from reflection of local residents’ preference and costs by losing economies of scale and positive externalities.
We are examining the scale economies in Korean local autonomy system to estimate the minimum efficient
size of local government. That is, we suspect that the insufficiency problem in local finance could be attributable
to the inefficiently small size of local government. The hypothesis to be tested here is as follows,

Hypothesis 2: The local governments are faced with insufficient local resources because the structure oflocal autonomy system has a high cost structure in providing local public services.

To test the hypothesis, we try to estimate the minimum efficient size of local governments. Before
performing the empirical estimation, we depict the relationship between per capita expenditures and population
sizes of all Korea’s local governments. Figure 2 shows a negative association between the two variables,meaning that the per-capita cost decreases as the size of population increases. Furthermore, the figure suggeststhat there would exist economies of scale in terms of population.

10, 000

Expenditure per capital (in1000 won)

8, 0006, 0004, 0002, 000

0200

400

600

800

1, 0001, 200

Pop u la tion ( in th o u n s a n d )Figure 1. The relationship between population and per capita expenditure

The model to be estimated is set by

TC / N = f ( N , N 2 , S ) ,where TC is total cost in terms of expenditure of a local government and N and S stand for number of populationand size of area of a local government, respectively. Thus, the dependent variable, TC/N is per capita expenditureof the local government and determined by the numbers of population, and population squared and the size ofarea.

Table 3 presents the results of GLS estimations. The second column in the table shows the estimates for thecase of all basic local governments included. The estimates for city, county, and district government are shown in
the third, fourth and fifth columns, respectively. As results of the estimations, the coefficients of populationsquared are all strongly and positively significant at 1 % level, suggesting that there is U-shape relationshipbetween population and per capita expenditure. Based on the estimates in Table 3, the minimum efficient size ofpopulation can be calculated. The minimum efficient sizes for city, county, and district turn out about 647
thousand, 138 thousand and 445 thousand, respectively, as shown in Table 3.
However, as of the end of 2006, the actual average numbers of population are 294 thousand, 58 thousand and328 thousand for city, county, and autonomous district, respectively. These numbers are just 47%, 43% and 74%of the minimum efficient size of population, meaning that the local governments have high cost structures owing
to the small population size. This result implies that the integration of neighboring small local governments
should be considered to reduce the cost of local public services provision. It is also required for the local
governments to supply public services jointly with other local governments, which will lead to cost reductionthrough economies of scale and internalize the spillover effects between the cooperating local governments.
Table 3.
variable

Minimum efficient size(MES) of basic local governments in Korea.
Total
CityCounty(Lower level localgovernment)

District

2391.90*(10.67)-0.008596*(-7.57)
7.41E-09*(5.39)
0.47***(1.84)
440.50*(3.23)
1394.08*(5.59)

2541.09*(13.62)-0.006876*(-7.76)
5.31E-09*(6.22)
0.63*(4.27)

7120.52*(13.02)-0.084638*(-8.03)
3.05E-07*(6.02)
0.12(0.45)

1379.22*(12.67)-0.004637*(-6.63)
5.20E-09*(5.53)
0.44(0.82)------

R-squared

0.77

0.73

0.80

0.71

F statistic

154.09*62.10*

113.70*51.85*MES of Population
580,027
647,458
138,751
Note: *, **, *** denote statistical significance at the 1%, 5%, and 10% level, respectively.

445,865

constant
populationsquare of populationarea
city dummy
country dummy

Conclusion

This paper addressed two structural features pertaining to insufficiency in Korean local public finance. The
first one is that local finance in Korea relies relatively heavily on dependent revenues. That structural featuredrives the leaders of local governments to make focus on obtaining additional subsidies from the central
government. That statement was supported by the estimated model of re-election determinants, showing that themore conditional grants a local leader has acquired during his or her term of office, the higher the likelihood towin be re-elected in the next election. That result reflected the fact that in order to achieve the political interest
through obtaining more subsides, the heads of local governments have been strongly appealing of insufficiency
problem in local public finance. That is one explanation that how people come to perceive the local governments
have insufficient resources.
The second one is related to high cost structure and optimal size of a local government. The empirical resultsin Section 3 showed most of Korea’s basic local governments were too small to achieve economies of scale inpopulation size. In particular, for the autonomous districts in metropolitan cities, optimal size of an autonomousdistrict is sure to be much larger than minimum efficient size estimated in Section 3. That is because
geographical location of autonomous districts is so compact that intergovernmental positive externalities areconsiderably large.
The findings can provide some of implications. As explained before, politicians are now driven to rely more
on dependent revenues from the central government rather than use their own revenue-raising power. As thetheory of local public finance suggests, this phenomenon brings up the problem of allocational inefficiency
under the decentralized decision making system. The local taxes are required to play the role of benefit tax toenhance the efficiency of decentralization system.
Another policy implication is that the integration of neighboring small local governments should beconsidered to reduce the cost of local public service provision. It is also required for local governments to supply
public services jointly with other local governments, which will lead to cost reduction through economies ofscale and internalize the spillover effects between the cooperating governments.

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