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South Korean corporate tax hike risks investment decline

South Korean corporate tax hike risks investment decline

SEOUL: South Korean President Moon Jae-in, elected in May following the impeachment of his predecessor Park Geun-hye, wants to raise the corporate income tax rate for large companies to provide more resources for social welfare spending. On the surface, South Korea seems to have ample room to do this, given that its corporate tax rate is low in comparison to that of many developed countries. Without additional reforms, however, higher corporate taxes could have a significant impact on business investment.

Moon’s proposal to raise the corporate tax rate to 25% from 22% for companies that earn more than 200 billion won ($175 million) annually has yet to be approved by South Korea’s National Assembly. But the planned increase contrasts with cuts implemented in many other developed countries in recent years, including Germany, Italy, the U.K. and Canada, with an eye to stimulating investment. Corporate tax rates in developed countries now range mainly between the U.K.’s 20% and Germany’s average rate of 30.2%. The U.S. rate is 35%, but President Donald Trump wants to cut that to 15%.

Seoul lowered the top corporate tax rate twice in the 2000s, and in 2012 raised the earnings threshold for the highest rate from 200 million won to more than 20 billion won. South Korea’s overall tax take is also relatively low, by comparison with other developed economies. The ratio of tax revenue to gross domestic product is 23.5%, about 10 percentage points below the average for members of the Organization for Economic Cooperation and Development, the global club of mostly rich countries. As a result, the government is less able to fund income redistribution and social benefits than most other OECD countries.

However, the tax department should think harder about the side effects of changing corporate tax rates. Adjustments to corporate tax rates can affect corporate strategies such as financing, investment, cash holdings and dividend policy. This is because differences between personal income tax rates and corporation tax rates lead to a distortion of resource allocation by creating a difference in capital costs between corporations and individuals.

Listed companies tend to expand investment significantly when corporate tax rates are reduced. In my analysis of nonfinancial companies in the Korea Stock Exchange’s KOSPI index in 2002-2014, a 1 percentage point cut in the average effective corporate tax rate caused the investment rate to increase by 0.2 percentage points. Correspondingly, investment would fall if the average effective corporate tax rate was increased.

The increase in investment noted in the study would have been higher but for so-called “tunneling activities” by company managers — the transfer of corporate cash assets to managers through excessive dividends or remuneration policies, or the use of cash assets in a variety of legitimate or illegal ways. For example, managers can create incentive structures that benefit themselves but conflict with the interests of shareholders.