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.
This makes it necessary for shareholders to monitor management closely, avoiding the accumulation of cash assets and ensuring that corporate resources are transferred to the owners through dividends. Tunneling by South Korean management is widespread. South Korean executives are estimated to use 0.09% of corporate operating profits and cash assets privately, which is nine times the comparable level in the U.S., as calculated by Boris Nikolov of the Swiss Finance Institute and Toni Whited of the University of Michigan.
In other words, corporate investment expansion in an environment where executives can pursue private interests will be lower than in an environment in which they are prevented from doing so. The existence of tunneling activities in South Korea implies that in today's corporate environment Moon's planned increase in the corporate tax rate could have a large negative impact on corporate investment.
Corporate tax hikes reduce cashflow, which could cause companies to use cash assets to make up for the reduction in investment. However, if there is an incentive for managers to tunnel cash assets they are more likely to curtail investment. This means that a higher corporate tax rate could actually exacerbate tunneling activities by management, leading to a deterioration in employment and investment performance and potentially undermining the income distribution effects of the government's proposed increase in welfare spending.
To prevent this the government needs to control inappropriate management behavior by strengthening internal and external monitoring and supervision to encourage companies to make reasonable decisions about employment and investment. More specifically, the supervision of managers must be enhanced by strengthening the independence and transparency of directors. Also, executives must be subject to more stringent hiring guidelines to ensure that only responsible individuals are appointed.
To ensure the independence of directors, board appointments should be entirely in the hands of committees of outside directors. Relationships between directors and management must be disclosed, together with the backgrounds of directors, and both should be considered during the appointment process. Anyone who is under administrative or judicial sanctions of a certain level must be excluded from appointment to a management role.
Finally, the government should consider whether a broader capital gains tax might serve its purposes better in generating revenue from the wealthy. South Korea does not tax capital gains on sales of stocks by most people, even though the government announced in early August that capital gains taxes on major shareholders would be strengthened.
Capital gains tax has the advantage of having little impact on corporate investment. It also does not affect the earnings of workers. Furthermore, it is much easier to collect taxes from individual shareholders than from companies.
Changwoo Nam is a research fellow at the Korea Development Institute and director of itsresearch coordination office.