Public Disclosure Authorized

D'RDMA22I

DISCUSSION PAPER

Report No.DRD2.21

THE VALUE ADDED TAX IN KOREA

By
Public Disclosure Authorized

Seung Soo Han

Seoul National University

February 1987
Public Disclosure Authorized

Development Research Department

Economics and Research Staff
World Bank
Public Disclosure Authorized

The World Bank does not accept responsibility for the views expressed herein
which are those of the author(s) and should not be attributed to the World
Bank or 'to its affiliated organizations. The findings, interpretations, and
conclusions are the results of research supported by the Bank; they do not
necessarily represent official policy of the Bank. The designations employed,
the presentation of material, and any maps used in this document are soLely
for the convenience of the reader and do not imply the expression of any
opinion whatsoever on the part of the World Bank or its affiliates concerning
the legal status of any country, territory, city, area, or of its authorities,
or concerning the delimitations of its boundaries, or national affiliation.
 THE VALUE-ADDED TAX IN KOREA

By

Seung Soo Han

Seoul National University

February 1987

Development Research Department

Economics and Research Staff
World Bank

The World Bank does not accept responsibility for the views expressed herein
which are those of the author(s) and should not be attributed to the World
Bank or to its affiliated organizations. The findings, interpretations, and
conclusions are the results of research supported by the Bank; they do not
necessarily represent official policy of the Bank. The designations employed,
the presentation of material, and any maps used in this document are solely
for the convenience of the reader and do not imply the expression of any
opinion whatsoever on the part of the World Bank or its affiliates concerning
the legal status of any country, territory, city, area, or of its authorities,
or concerning the delimitations of its boundaries, or national affiliation.
 THE VALUE ADDED TAX IN KOREA

Abstract

The paper providesarguments for and against the adoption of VAT in

South Korea, the reform process,the structureand administrationof the VAT,
concentratingespeciallyon the differencesin these aspects before and after
the tax reform. The VAT system is evaluated,and problemsand prospects
outlined. The author concludesthat while the VAT has contributedto the
simplificationof the indirecttax system and is satisfactoryfrom the revenue
viewpoint,its stabiilzationfunctionhas yet to be tested and it seems to
have aggravatedthe income inequalityin Korea. This paper was prepared for
the Conferenceon Value-AddedTaxation in DevelopingCountries,sponsoredby
the Public EconomicsDivision,DevelopmentResearch Department,The World
Bank.
 OUTLINE

I. Background .1............................................

A. Indirect Tax before VAT............................................. 1

B. Arguments for VAT . ...... . .................................. 1

C. Arguments against the Adoption of VAT................................3

II. Reform Process ..................... .. 4

A. Source of VAT Initiative .......... ..................................

4

B. Feasibility Study of VAT .. ........ .................................

5

C. Preparation before Implementation .....................................

6

III. Structure..............................................................8

A. Tax Base.. . .........................................8

B. Taxpayer............................................ 9

C. Rate Structure. ........................................... 13

D. Exemption and Zero-Rating. . .........................................

16

E. Small Business Relief. . . .........................................

18

IV. Administration...... .. ........................................

19
 A. Indirect Tax Administration before VAT.............................. 19

B. Changes in Tax Administration....................................... 22

V. Evaluation..............................................................27

A. Revenue ................................. 27

B. Price Changes................................. 29

C. Equity Aspects ............................... 31

D. Investment and Export ........................... 34

VI. Changes, Problems and Prospects ...................................... 35

Footnotes

References
List of Tables

Table 1: VAT Tax Base, Taxpayers, Tax Collected

and Refunded, and Tax Revenue ....... . 10

Table 2: The Number and Composition of Taxpayers ... 12

Table 3: Comparison of Tax Rates between the Pre-

and Post-VAT Indirect Tax Regime .. 15

Table 4: Comparison of Tax Base and Invoice Issuance....................... 21

Table 5: Correction for Business Tax and VAT ...............................23

Table 6: Nonmatching and Error in VAT Invoices ...... 25

Table 7: Composition of Tax Revenue........................................28

Table 8: Price Changes before and after VAT ................................30

Table 9: Indirect Tax Burden before and after VAT ..........................33

 THE VALUE ADDED TAX IN KOREA

I. Background

A. IndirectTaxes before VAT

In December 1976, the National Assembly passed a law on tax reform in

Korea. The tax reform was mainly concernedwith introducingthe value added

tax (VAT) and special excise tax. The governmenthad been preparing for the

reform of the indirect tax for some years and the passage of the VAT Law

marked the arrival of a new indirect tax regime in Korea. The law was put

into effect from July 1, 1977.

Before the adoption of VAT in Korea, the indirect tax system was

rather complicated. There were eleven taxes under the heading of indirecttax

in 1976, of which eight taxes were substitutedby the new VAT. These included

business tax, commodity tax, textile product tax, petroleum product tax,

electricityand gas tax, travel tax, admissionstax, and entertainmentand

food tax. The others such as liquor tax, telephone tax and stamp duty still

function today as separate indirecttaxes.

B. Arguments for VAT

There were several arguments for or against the adoption of VAT in

Korea. Some of the arguments advanced by those who favored the introduction

of VAT can be summerizedas follows. l/

One of the arguments for VAT was the simplificationof indirecttax

system. There were eleven differentkinds of indirect tax at the time of

adoptingVAT in Korea. Eight indirect taxes which were replaced by the VAT

had, among them, 53 different rate brackets. The business tax was a multi-

stage turnover tax imposed on all businesseswhereas the commodity tax,

textile product tax and petroleumproduct tax were imposed only at the

manufacturingand importingstage. Therefore there was a genuine need for

 - 2 -

simplifying the tax system and the general idea was to introduce the compre-

hensive income tax and VAT as principal players in the direct and indirect tax

structure. The comprehensive income tax was already adopted in 1974. VAT was

also believed to promote tax neutrality and help allocate resource more

efficiently.

The second argument was the enhancing tax neutrality in international

trade. Under the old indirect tax regime, it was not easy to estimate the

exact amount of refund for export or to calculate the correct amount for

import compensatory tax. Due to this difficulty, the hidden tax in the

process of production and distribution was either overcompensated or under-

compensated. The statistical evidence seems to suggest that it was more a

case of undercompensation than of overcompensation. Under the destination

principle of taxation, the undercompensation would erode the competitive edge

of exports and also place the domestic industry at disadvantage over imports.

The third argument was the promotion of investment. In a consump-

tion-type VAT where the investment is excluded from the tax base, it is self-

evident that the domestic investment is to be promoted. When the capital

goods are purchased, the VAT on the invoices on purchases of these goods is

credited. This implies that as compared with the case where there is no

investment, the total VAT burden can be much reduced.

Another argument for VAT was that it would reduce tax evasion. The

VAT system requires that tax invoices must be issued in transactions and that

the taxpayers would keep invoices in order to benefit from tax deduction.

This would enable the tax authority to cross-check the declared transactions

between taxpayers, consequently reducing the propensity to evade tax.

 The other revenue consideration was that the VAT system would provide

the government with a constant source of revenue. Due to the relatively low

income elasticity of demand for goods that are subject to VAT as compared with

income tax or special excise tax, the tax revenue from this source would not

fluctuate as much as the other two major taxes.

C. Arguments Against the Adoption of VAT

There were several arguments against the adoption of VAT in Korea.

One was that the system of bookkeeping was not ready to operate the VAT

system. The argument was that the business and traders lacked the bookkeeping

capability and more time was needed to develop this capacity.

Perhaps the strongest argument against the VAT came from those who

were worried about the likely impact of VAT on the price increase.

Another argument was that the VAT was a regressive tax. Although the

single VAT rate envisaged in Korea would be regarded as an advantage in terms

of efficient allocation of resources, this in turn was singled out as a factor

that would work against the equitable distribution of income in Korea. The

special excise tax was introduced at the same time meant to complement the

regressive nature of VAT. 2/

At the time of deliberating VAT, the administrative capacity and

capability were also questioned. As the VAT system would require a different

type of tax expertise, the quality of tax officials was one of the major

issues for tax reform.

 -4-

II. Reform Process

A. Source of VAT Initiative

Since the first five-yeareconomic developmentplan (1962-66),one of

the primary aims of governmenttax policy was how to mobilize the domestic

resourcesmore effectively. During the process, new taxes were introduced

broadeningthe tax base and the new organizationwas institutionalized,the

best example being the establishmentof the Office of National Tax Adminis-

tration (ONTA) in 1965.

The initiativeto study VAT with the aim of eventual adoption came

from the Ministry of Finance in their policy document in 1971. The Ministry

of Finance initiativewas relayed to the Office of Senior Presidential

Secretaryfor EconomicAffairs, where it was also receivedwith favorable

response. In order to analyze the feasibilityof VAT in Korea, Mr. James C.

Duignan, a member of fiscal panel at the IMF, was invited in 1972, and

Professor Carl S. Shoup in July 1973.

In 1974 the Ministry of Finance dispatcheda working group to Europe

to observe and report on the European practice and experiencein VAT. The

team headed by the Director-Generalof Taxation was composed of three tax

officials and two economists. They visited the UK, W. Germany, Belgium and

the Commissionof the EuropeanCommunities,and Taiwan and Japan on their way

back. They prepared a report in which the majority view was for adopting the

VAT in Korea. The only dissentingminority view came from one of the

economists. The Director-generalof Taxation was sent to the UK once again in

1975 with a view to carry out a more detailed study of VAT system there. 3/

At the same time, the Korean governmentinvited Mr. Alan T. Tait of

the IMF both in 1975 and 1976 to carry out a detailed study on the possible
 - 5 -

impact of VAT on price and income distribution. Mr. Duignan was also invited

in 1976 for consultationon the drafting of the VAT Law and other adminis-

trative preparation.

In the meantime, the Senior PresidentialSecretary for Economic

Affairs was appointed the Minister of Finance in 1974 and was particularly

active and instrumentalin pushing the enactment of the VAT Law. On the other

hand, the Economic PlanningBoard which was charged with responsibilityfor

price stabilitybecame increasinglyskepticalabout the timing of VAT reform

due to its possible impact on the price increase. As there was such a

division of opinion even in the cabinet as to the adoption of VAT, it was

entirelydue to the decisionmade by the Presidentthat the VAT was introduced

in 1977.

B. FeasibilityStudy of VAT

As a groundworkfor the adoption of VAT, the Bureau of Taxationat

the Ministry of Finance produced three studies related to VAT. Foreign tax

played rather significantroles here, and Mr. Duignan and Mr. Tait both pro-

duced reports on VAT in Korea.

In his report in 1972, Mr. Duignan argued for the introductionof VAT

in Korea. He observed that the basis of VAT already existed in Korea with the

administrativemechanism and bookkeepingsystem in operation. For example,

the businesstax imposedat multi-stage turnoverswas instrumentalin making

the tax administrationrapidly become computerized. This implied that taxing,

controllingand estimatingthe value added would be much easier than other

wise. Although he recognizedsome obstacles to the adoption of VAT such as

the lack of any practical experienceof certifiedpublic accountantsand the

 -

difficulty of enforcing the bookkeeping by small businesses and others, he

strongly supported the adoption of VAT in Korea. 4/

Mr. Tait in his report in 1975 dealt with the number of taxes which

the VAT would substitut:ecthe VAT rate, the scope of tax exemptions and the

problems arising during the transitional period. He proposed to redress the

regressivity of VAT by either maintaining the commodity tax or by introducing

a special excise tax. His report in 1976 maintained that the single rate of

10 percent would be sufficient to recoup the revenue loss from the indirect

tax reform. He showed that the price change would be insignificant within the

range of plus/minus L percent. /

C. Preparation before implementation

Although the VAT was to substitute a number of existing indirect

taxes, taxpayers tended to regard it as a very complex tax and as an addi-

tional burden. In order to dissipate some of the general worries and to

answer some of the questions surrounding the adoption of VAT, the government

had to correctly inform the general public and the potential taxpayers in

particular. Apart from the need for public relations exercise there was a

need for training the tax officials about the new tax, making the taxpayers

get acquainted with the new system, administering prices and reorganizing tax

administration.

With the help of the Korea Chamber of Commerce and Industry and other

economic associations, daily newspapers, TV and radio and other mass media,

the government campaigned for the case of VAT. There were series of articles,

questions and answer sessions, feature stories and lectures for the need of

adopting VAT. Even a movie was made ahout the VAT and shown in all the movie

theaters in Korea. There were a series of seminars, conferences and meetings

on VAT. About 30 different kinds of pamphlet on VAT such as, The VAT, What

Kind of Tax Is It? Explaining the VAT Law, Tax Invoice and How to Report it,

etc. were printed and about 16 million copies were distributed.

The preliminary exercise on filing tax returns was conducted three

times before the actual implementation of VAT. The first exercise was held in

January 1977 with 49,814 taxpayers participating. In the second and third

exercises held in April and July 1977, 99.3 percent and 99.2 percent of poten-

tial taxpayers participated. The exercise not only helped the taxpayers

understand the new tax but also the feedback from this exercise was found to

be useful in further refining the administrative details of VAT system.

The Ministry of Finance formed a Task Force on VAT in which officials

and private sector representatives were invited to participate. They

deliberated not only the problem of implementation but also participated in

discussing the draft of the Presidential Decree and other administrative

regulations on VAT.

As the success of the new tax depended as much on the quality and ex-

pertise of tax officials, it was necessary to train those who would be charged

with collecting VAT. The training of tax officials started with training the

instructors, who then went on to train the tax officials. The total number -f

training sessions amounted to 449 and the total number of tax officials pa'-

ticipating in these sessions were 64,072. At the same Lime, the Office of

National Tax Administration was reorganized in March 1977. VAT and Excise Tax

Divisions were newly created at each level of tax authorities, i.e. Office of

National Tax Adnministration,Regional Tax Office and District Tax Office.

Three Divisions on liquor tax, personal tax and withholding tax were

abolished.
 Because of the likely impact which the new tax might exert on the

price increase, a particularpolicy attention was given to stabilization. The

Price Stability Law placed a maximum limit on wholesale price for 251 items

and controlledthe retail price of 45 items in Seoul area. At the time of

introducingVAT, price guidelineswere applied to 851 items to protect the

consumers.

III. Structure

A. Tax Base

The VAT in Korea is charged on the supply of goods and services and

the importationof goods. The goods include all tangibleand intangible

objects which have the value of property. Tangible objects include com-

modities, products, raw materials,machinery,buildingsand other objects

which have tangible forms. Intangibleobjects include motive power, heat and

other controllableforces of nature. The servicesmean all servicesand other

actions which have the value of property other than goods. 6/

The supply of goods includesdeliveringand transferringof goods due

to all contractualand legal actions, self-supplyof goods, personaluse and

donation, inventorygoods at the time of closing-downof business and trans-

actions through a consigneeor an agent. The supply of servicesincludes

rendering of servicesor having a person use or utilize goods, facilitiesor

rights due to all legal and contractualactions,and the self-supplyof

services.

The importationof goods include goods arrived in Korea from abroad

includingmarine productsgathered in high seas by foreign vessels. 7/

 - 9 -

As shown in Table 1, the tax base increasedvery steadilysince the

adoption of VAT in 1977. The tax base which amounted to 44,495 billion won at

current prices in 1978 increased to 143,421 billion won in 1983, an increase

by 3.2 times in five years. During the same period, the GNP at current prices

increased by 2.4 times. The tax base expandedby an annual increaseof about

35 percent between 1978 and 1980. This was reduced to 32 percent in 1981 and

then to about 16 percent in 1982 and 1983.

The total amount of VAT paid in 1978 was 1,311 billion won which

accounted for only 2.9 percent of the total tax base. In the same year, there

was a total transactionof 12,267 billion won which was subject to zero-

rating. After the refunding due to zero-rating,the net total tax revenue

from VAT received by the Treasury amountedto 835 billion won, 1.9 percent of

the tax base. The VAT paid in 1983 was 3,493 billion won accountingfor 2.4

percent of the tax base. The total net sum of VAT accrued to the Treasury

after the refundingwas 2,559 billion won in 1983, accountingfor 1.8 percent

of the tax base. The most of tax refundedaccrued to the export sector. The

share of refund to capital investmentdecreased from 12 percent in 1978 to 11

percent in 1979, 5 percent in 1980, 6 percent in 1981 and 7 percent in 1982.

The rest of the share accrued to the exporters.

B. Taxpayer

A person who is independentlyengaged in the supply of goods or

services in the course of business, regardlessof whether the businessis

profit-motivatedor not, is liable to VAT. The taxpayers include individuals,

corporationsincluding state and local authorities,and foundationswhich are

not incorporated. They are usually called the general taxpayers. There is
 TAble 1: VAT Tax Hase, Taxpayers, Tax Collected and Refunded, and Tax Revenue

(uintt: billion won, 1,000 persons and Z)

Tax
Tax Wase Taxpayers Collected Tax Refund Tax Revenue

1978
General Taxpayer 41,129.3(92.4) 203(23.1) 1,255.1(95.8) 475.3(99.9) 779.8(93.4)
-Corporation 32,(95.6(75.1) 22(2.5) 1,037.3(79.1) 432.7(91.0) 604.6(72.4)
-Individual 9,()3'1.7(20.3) 181(20.6) 217.8(16.6) 42.3(8.9) 175.2(21.0)
Special TaApayer 3,3,5.3(7.6) 675(76.9) 55.5(4.2) 0.2(0.0) 55.3(6.6)
Total 44,494.6(1lil) 878(100) 1,310.6(100) 475.5(100) 835.1(100)

1979
General Taxpayer 55,435.7(92.5) 205(22.0) 1,553.0(95.3) 542.4(100) 1,010.6(92.9)
-Corporation 43,952.9(73.4) 25(2.7) 1,320.9(81.0) 493.4(91.0) 827.5(76.i)
-Individual 11,483.0(19.1) 189(19.3) 232.1(14.2) 49.0(9.0) 183.1(16.8)
Special Taxpayer 4,478.9(7.5) 728(78.0) 77.1(4.7) - 77.1(7.1)
Total 59,914.8(100) 933(10t) 1,630.1(100) 542.4(100) 1,087.7(100)

1980
General Taxpayer 75,551.5(93.7) 221(22.5) 2,033.0(95.9) 651.9(100) 1,381.1(93.9)
-Corporation 62,507.3(77.6) 27(2.S) 1,757.8(82.8) 587.3(9n.1) 1,170.5(79.6)
-Individual 13,044.2(16.1) 194(19.7) 275.2(13.0) 64.6(9.9) 210.6(14.3)
Special Taxpayer 5,035.4(6.3) 759(77.5) 89.3(4.2) - 89.7(6.1) 0
Total 80,586.9(100) 980(100) 2,122.7(100) 651.9(100) 1,470.8(100)

1981
General Taxpayer 100,5S5.7(94.6) 241(21.8) 2,485.6(95.6) 796.3(100) 1,689.3(93.6)
-Corporation 83,723.5(78.8) 31(2.8) 2,131.7(82.0) 717.5(90.1) 1,414.2(78.4)
-Individual 16,832.2(15.8) 210(19.0) 353.9(13.6) 78.8(9.9) 275.1(15.2)
Special Taxpayer 5,711.1(5.4) 863(78.2) 115.4(4.3) - 115.4(6.4)
Total 106,266.8(100) 1,104(100) 2,601.0(100) 796.3(100) 1,804.7(100)

1982
General Taxpayer 117,498.3(95.1) 262(23.2) 2,822.2(96.0) 844.9(100) 1,977.3(94.4)
-Corporation 97,/11.1(79.1) 34(3.0) 2,381.3(81.0) 747.7(88.5) 1,633.6(78.0)
-Individual 19,147.2(16.0) 228(20.2) 440.9(15.0) 97.2(11.5) 343.7(16.4)
Special Taxpayer 6.038.6(4.9) 866(76.8) 117.0(4.0) - 117.0(5.6)
Total 123,136.9(14)0) 1,128(100) 2,939.2(100) 844.9(100) 2,094.3(100)

1983
General Taxpayer 116,878.2(95.4) 289(24.7) 3,364.6(96.3) 933.9(100) 2,430.7(94.9)
-Corporation 112,281.9(78.3) 37(3.1) 2,808.6(80.4) 813.0(87.1) 1,995.6(78.0)
-Individual '!4,956.3(17.1) 252(21.6) 556.0(15.9) 120.9(12.9) 435.1(16.9)
Special Taxpayer 6,S42.9(4.6) 879(75.3) 128.5(3.7) - 128.5(5.1)
Total J43,421.1(100) 1,168(100) 3,493.1(100) 933.9(100) 2,559.2(100)

Source: Ministry of Fisi.az.te, k t rentceData for Subco _ittee on Consumption Tax (1984).

Nots.-: Tax base here is lti it'ji its the gross sales at each turnover.
 - 11 -

another group of those who are called the special taxpayers. They are those

who are not liable to 10 percent on their value added but to a special rate of

2 percent on their gross sales.

The change in the number of each categoryof taxpayerstogetherwith

its compositionis shown in Table 2. At the time of adoptingVAT in 1977,

there was a total of 824,192 taxpayersof which the general taxpayersac-

counted for 19 percent only. There were 667,243 special taxpayers,81 percent

of total taxpayers. In the categoryof general taxpayer,the individualsac-

counted for 16.7 percent and the corporationsfor 2.3 percent of the total

taxpayers in the same years.

The number of VAT taxpayers increasedto 1,200,260by the first half

of 1984, an increaseof 46 percent in seven years. There has been a slow

change in the compositionof taxpayers between the general and special

category. The share of general taxpayers increasedto 25.4 percent by 1984,

and that of special taxpayersdecreased to 74.6 percent. The individual

general taxpayers accounted for 22.1 percent, and the corporationgeneral

taxpayersfor 3.3 percent of the total taxpayers in the same year.

From the data given in Tables 1 and 2, several interestingfacts

emerge. Firstly, the corporationtaxpayers,only about 2-3 percent of total

taxpayers,accounted for almost or over three quartersof total tax base over

the years. The share of corporationsin the VAT base tended to increase

during this period.

Secondly, the individualtaxpayers,17 to 22 percent of total tax-

payers over the year, accounted for 16 to 20 percent of the VAT base.

However, contraryto the case of corporationtaxpayers,it can be seen that

 Table 2: The Number and Composition of Taxpayers

(persons and %)

General Taxpayers Special

Year/Taxpayer Individual Corporation Sub-Total Taxpayers Total

1977 137,767(17) 19,182(2) 156,949(19) 667,243(81) 824,192(100)

1978 152,562(18) 20,622(2) 173,184(20) 680,093(80) 853,277(100)
1979 177,273(19) 23,763(3) 201,036(22) 713,330(78) 914,366(100)
1980 184,757(19) 26,369(3) 211,126(22) 742,517(78) 953,643(100)
1981 200,565(18) 29,826(3) 230,391(21) 863,135(79) 1,093,526(100)
1982 217,035(19) 32,432(3) 249,467(22) 867,044(78) 1,116,511(100)
1983 237,934(21) 35,978(3) 273,912(24) 877,139(76) 1,151,051(100)
1984 265,578(22) 39,274(3) 304,852(25) 895,408(75) 1,200,260(100)

Source: Ministry of Finance, Reference Data for Subcommittee on Consumption Tax (1984).

Notes: The year refers to the first half of respective year except 1977 where the
figures relate to the second half.
 - 13 -

the individualtaxpayers'share in the VAT base is inverselyrelated with the

proportionof individualsin total taxpayers.

Thirdly, there is a slow but decreasingtrend in the proportionof

special taxpayers in total taxpayersand their share in the tax base.

Fourthly, the share of each group of taxpayers in total VAT revenue

correspondedmore or less to its share in the tax base. More specifically,

the corporationtaxpayerswhich accounted for 72.1 percent of the tax base and

72.4 percent of VAT revenue in 1978 accountedfor 78.3 percent of the tax base

and 78.0 percent of tax revenue in 1983. The individualtaxpayerswhich ac-

counted for 20.3 percent of the tax base and 21.0 percent of tax revenue in

1978 accounted for 17.1 percent of the tax base and 16.9 percent of tax

revenue in 1983. The special taxpayerswhich accounted for 7.6 percent of the

tax base and 6.6 percent of tax revenue in 1978 accounted for 4.6 percent of

the tax base and 5.1 percent of tax revenue in 1983.

C. Rate Structure

Since the adoption of VAT in 1977, the tax rate has been kept at 10

percent. However, the basic VAT rate specifiedin the VAT Law is 13 per-

cent. The Law specifiesthat the basic rate can be made to move within 3

percent limit upwards or downwards. Although the economicrationalebehind

the flexiblerate structurewas to institutionalize

the tax system which can

be made responsiveto the conditionsand fluctuationsof the nationaleconomy,

the determinationof the current rate was much influencedby the business

circle as well as those in the governmentparty against the adoptionof VAT.

In order to neutralizethe opposition,the lowest VAT rate which the Law could

allow was adopted.

 - 14 -

The choice of relevant VAT rate was one of the crucial problems that

faced the government at the time of studying and preparing for VAT. When the

Ministry of Finance with the assistance of the Research Department of The Bank

of Korea and the Korea Development Institute attempted to estimate the pos-

sible VAT rate, several assumptions had to be made. It assumed, first of all,

that the VAT would be of consumption-type tax, making use of tax credit

method. The VAT was assumed to substitute the business tax, commodity tax,

textile product tax, petroleum product tax, electricity and gas tax, travel

tax, admissions tax, and entertainment and food tax. The exports were assumed

to be zero-rated and there would be several exemptions both in the domestic

supply of goods and the imports. (See the next section on exemptions and

zero-rating for detailed items) The small businesses with an annual turnover

of less than 12 million won were assumed to be separately treated as special

taxpayers. Lastly the tax base would include the consideration inclusive of

special excise tax in the case of domestic supply of goods and the

consideration including CIF, customs duty and special excise tax in the case

of importation of goods.

By making use of GNP data supplied by the Bank of Korea and of the

tax data supplied by the Office of National.Tax Administration, The Ministry

of Finance estimated that the VAT rate would be 11.23 percent when based on

the national income statistics, 12.15 percent when based on the national ex-

penditure and 12.03 percent when based on the national output. On the basis

of this exercise, the Ministry of Finance argued for the VAT rate to be

determined in the range of 13 percent. 8/

Table 3 shows the current tax rate of VAT together with the special

rate to be applied to the special taxpayers, the number of items and the range
 Table 3: Comparison of Tax Rates between the Pre-
and Post-VAT Indirect Tax Regime

Previous Tax Regime Present Tax Regime

Tax Rates Tax Rates
Tax Number Maximnuim Minimum Tax Number Maximum Minimum

Business 5 3.5 0.5 VAT

Commodity 17 100.0 2.0 (General) 1 16.0 10.0

Textile
Product 7 40.0 10.0 (Special) 2 3.5 2.0

Petroleum
Product 4 300.0 10.0 Special
Excise Tax 10 100.0 5.0
Admission 12 250.0 5.0

Travel 3 20.0 5.0

Electricity
& Gas 1 15.0 15.0

Entertainment
and Food 4 20.0 2.0

Sources: Ministry of Finance, The Survey on the Value Added Tax (1980).

Notes: The maximum rate of special excise tax was 180 percent at
the time of introduction but was lowered later. Although
the VAT rate is given as 10 percent, the basic rate is 13
percent which oeneven be raised to 16 percent.
 - 16 -

of tax rate of special excise tax and the rate of various indirect taxes which

the VAT substituted.

Although there are some merits in adopting the multiple rate of VAT

in particularlyredressingthe problem caused by the regressivityof VAT, the

single rate was put forward by almost all the proponentsof VAT in Korea. The

exception of course is the case of special taxation of small businesses. For

example, the small businesseswhose annual gross sales do not exceed 24 mil-

lion won are subject to the tax rate of 2 percent on their gross sales. Those

who are engaged in brokerageor intermediaryservicesare subject to the tax

rae of 3.5 percent on their turnoverwhen it does not exceed 6 million won.

The regressivenature of VAT due particularlyto a single tax rate

was corrected to some degree by the adoptionof a special excise tax. There

are 33 groups of items that are subject to special tax and the tax rates cur-

rently range from 5 percent to 100 percent. When the specialexcise tax was

adopted in 1977, there were 13 rate bracketsranging from 10 percent to 180

percent. Admissionsto places like race course, sauna bath, golf course,

casino, ski resort, cabaret and night clubs are also taxed at a special rate

as specified in the Special Excise Tax Law.

D. Exemption and Zero-Rating

There are several cases of exemptionsand zero-ratingin Korea's VAT

system. The exemptionrefers to the case where the supply of goods and ser-

vices is subject to exemptionwhilst the tax on purchases incurredthereon is

not refundable. On the other hand, the zero-ratingrefers to the case where

the supply of goods and servicesis zero-ratedand thereforethe tax on

purchases is fully refundable.91

 - 17 -

The goods and servicesthat are subject to the exemptionare given in

the following. First of all, the basic life necessitiesand servicesare sub-

ject to the exemption. They are (1) basic foodstuffsnot processed (including

agriculturalproducts,livestockproducts,marine productsand forest products

that are used for food) and agriculturalproducts,livestockproducts,marine

products and forest productsprescribedin the Presidentialdecree which are

produced in Korea but are not used for food, (2) piped water, (3) briquetsand

anthracitecoal and (4) passengertransportationservicesexcept those by

aircraft, express bus, charteredbus or taxi.

Secondly,the social welfare servicesare also subject to the

exemption. They include (1) books, newspapers,magazines,officialgazettes,

communicationand broadcastingexcludingadvertisement,(2) artisticworks,

pure artistic events, culturalevents and nonprofessionalsport games and (3)

admissionsto libraries,museums, art galleries,zoo or botanic gardens.

Fourthly,the personalservices that are similar to labor are also

exempted. They include (1) personal servicesrendered in the course of

business carried on by lawyers,certifiedpublic accountants,tax accountants,

and customs accountants,(2) personal servicesrenderedby actors, singers,

radio performers,composers,writers,designers,professionalsportsmen,

dancers, waitresses,insurancepersons,translators,shorthandwriters, and

etc., (3) academic and technicalresearch services,(4) system analysis and

programmingservices,and (5) servicesof harbor pilots.

Fifthly, the factors of productionsuch as (1) land, (2) finance and

insurance servicesand (3) lease of house or the land as prescribedin the

Presidentialdecree. In addition,there are miscellaneousgoods and services

that are exempted from VAT. They are (1) monopoly goods, (2) postage stamps
 - 18 -

excluding those for collection, revenue stamps, certificate stamps, lottery

tickets and public telephone, (3) such goods or services rendered by the

religious, charitable, scientific or other similar organizations, and (4) the

goods or services supplied, without any consideration, to the central govern-

ment, local authorities, or public benefit organizations. The duty-exempt

goods prescribed in the Customs Law are also exempted from VAT.

On the other hand, the supply of the following goods and services is

zero-rated and the taxpayers are able to get refund. They include the goods

for exportation, the services rendered outside Korea, international

transportation by ship or aircraft and other goods or services supplied to

earn foreign exchange. The zero-rating is applicable only to those who are

residents or domestic corporations. However, in the case of international

navigation of aircraft or ship, those who are nonresidents or foreign corpor-

ations can also benefit from zero-rating where there is an bilateral

arrangement based on the reciprocity principle.

E. Small Business Relief

Although some larger businesses are able to absorb the accounting and

procedural requirement at a reasonable cost, the small businesses are neither

capable of keeping books nor of rendering tax returns in a required format.

Yet in terms of the number of taxpayers, the small businesses comprise an

important proportion of total businesses. With a large number of small

businesses which had no good ability to keep records in correct form and were

scattered around the whole country, there was a political as well as an

economic need for alleviating the burden of a complicated VAT system on these

businesses with small turnover. Therefore the relief measure of small

business was incorporated into the VAT regime in Korea.

 - 19 -

The individualtraders who supply the goods or servicesfor which the

VAT-inclusiveannual turnover is less than 24 million won are subject to the

tax chargeableon the basis of turnover. In the case of transactionthrough a

proxy, agent, intermediary,consignee or contractor,the traders are also sub-

ject to the tax on their turnover if it does not exceed 6 million won. As

these traders are treated separatelyfrom the general taxpayers,they are

called as special taxpayers.10/

The tax base of special taxpayers,therefore,is the annual

turnover. The special taxpayersare subject to the tax rate of 2 percent on

their turnover, and 3.5 percent in the case of transactionthrough a proxy and

others. When the special taxpayers submit tax invoicesreceivedby the

government,an amount equivalentto 5 percent of taxes on purchasescan be

deducted from the tax payable.

As shown in Table 2 above, the special taxpayers numbering667,243

accounted for 81.0 percent of total taxpayers in 1977. As the national

economy grew rapidly and the size of businessesexpanded, the proportionof

the special taxpayers decreased. By the first half of 1984, the number of

special taxpayers increasedto 895,408 but accountedfor 74.6 percent of total

taxpayers. Despite of the larger proportionof special taxpayersin the VAT

system, their share of tax base and tax paid was not very significant. For

example, it accounted for about 4 to 5 percent in 1983.

IV. Administration

A. IndirectTax Administrationbefore VAT

As mentioned earlier, there were eight indirect taxes that were

substitutedby the VAT in 1977. Of the eight indirect taxes, the businesstax
 - 20 -

was the most relevant and useful in preparing for the adoption of VAT. The

fact that Korea had operated the business tax facilitated the introduction of

VAT. As the business tax was a tax on turnover, the traders had to maintain

some form of bookkeeping. The government made use of the business tax as a

stepping stone to introducing VAT and reformed it accordingly in 1974.

The business tax reform in 1974 reduced the number of tax rates from

six to five but raised the tax rate. The business tax base was also expanded

from the manufacturing and some wholesale sectors to all manufacturing, mining

and wholesale sectors. All the traders were obliged to issue the standard

invoice (similar to the tax invoice under the VAT system) and those who did

not were made to pay penalties. The system of registration number was intro-

duced at this time and this greatly facilitated the process of

computerization.

One of the strong arguments for VAT was an elimination of tax ir-

regularities such as evasion or avoidance and it appears that the adminis-

trative performance improved under the new tax system. Although the amount of

tax evasion or avoidance cannot be easily estimated, there is an indication

that the administrative mechanism worked better under the VAT than under the

pre-VAT indirect tax system.

Table 4 shows the administration preformance of the business tax and

the VAT in terms of invoices issued. In the first half of 1977, the business

tax base was 10,945 billion won but the amount rendered by the standard

invoices amounted to 7,801 billion won. The issuance of standard invoices

accounted for 71.3 percent of the business tax base.

 - 21 -

Table 4: Comparison of Tax Base and Invoice Issuance

(unit: billion won)

Business VAT Tax Invoice

Tax Invoice
1977.1 1977.2 1979 1981 1983 1984.1

Tax Base (A)

General 15,493 55,436 100,681 136,878 69,969
Special 1,440 4,479 5,711 6,543 3,439
Total 10,945 16,033 59,915 106,392 143,421 73,408

Amount
Issued (B)
General 7,801 12,572 47,302 85,964 117,032 59,128

Ratio(B/A) 71.3 81.1 85.3 85.4 85.5 84.5

Sources: Ministry of Finance, Reference Data for Subcommittee on Consumption Tax (1984).

Notes: 1977.1 refers to the first half of 1977. 1977.2 refers to the second half of 1978.
 - 22 -

In the second half of 1977 when the VAT was adopted, the issuance of

tax invoices accounted for 81.1 percent of VAT base. This was increased to

about 85 percent which has been maintained over the years.

Another indication of improved performance in tax administration is

shown in Table 5 where the degree of correction for the business tax and VAT

is given. The correction is a process in which the government reassesses the

tax base and tax amount payable when the details of final tax return are

either erroneous or have any omission.

The fact that the correction ratio of the business tax for the number

of taxpayers as well as the tax base was much higher than that of the VAT

implies that the administrative performance of the indirect tax system far

improved by the introduction of VAT. For example, under the business tax

system in the second half of 1976, 51.2 percent of total taxpayers and 7.3

yercent of tax base had to be corrected. Under the VAT system, both were

drastically reduced to 13.2 percent and 1.4 percent respectively in the second

half of 1977 and continued to remain low.

B. Changes in Tax Administration

Under the VAT system in Korea, any person who wishes to start a

business must register with the district tax office within 20 days from the

date of commencement of business. The district tax office will issue a

trader's registration certificate within seven days of receiving an appli-

cation. The trader's registration certificate is subject to government

inspection twice a year in January and July. Any registered trader who is

suspending, closing down the business or changing any of the registered

particulars has to report to the district tax office without delay.

 - 23 -

Table 5: Correctionfor BusinessTax and VAT

(unit: No. of taxpayer and billion won)

1976.2 1977.1 1977.2 1978.1 1978.2

Taxpayers
Reported (A) 651,912 713,768 824,192 853,277 878,429

Tax Base
Reported (B) 11,657 12,982 16,932 19,710 24,876

Taxpayers
Corrected (C) 334,358 308,566 109,435 110,656 135,598

Tax Base
Corrected (D) 857 845 241 50 120

Ratio (%)
A/C 51.2 43.2 13.2 12.9 15.4

D/B 7.3 6.5 1.4 0.2 0.4

Sources: Ministry of Finance, The Report and Survey of Value Added Tax (July 1980).

Notes: I refers to che first half and 2 to the second half of the respective year.
 - 24 -

A record of the trader registeredwith the district tax office is put

on a computer file. The taxpayer'sinformationincludes the registration

number, his name and address, name and address of the business,telephone

number, business code, trade classification,date of registrationand the date

of starting business. When the goods or servicesare supplied, the supplier

is required to issue a tax invoice, which includesan informationon the date

of supply, the supplier'sname and address,his registrationnumber, the

purchaser'sname and registrationnumber, the value and identityof goods or

services suppliedand the amount of VAT.

The general taxpayers are required to issue tax invoiceswhich are

usually used for the deduction of taxes paid on the purchases. The special

taxpayersmust issue a 'simplified'tax invoice which is usually used as an

evidence for transaction. The retailers,restaurantsand inns are required to

operate cash registers. In the absence of these, the tax authoritymay

enforce the stoppageof business. All traders are requiredto keep records.

In the second half of 1977, the total number of tax invoices pro-

cessed by the computercenter was 52.2 million. The number of tax invoices

processed remainedabove 50.0 million until the second half of 1979. This was

almost halved in the second half of 1980 showing the processed invoices

numbering 23.0 million. The number of computer-processed

invoices decreased

drastically since the lower limit of the transactionswas increased from

100,000 won to 300,000 won from June 1980. The total number of tax invoices

processed by the computer in the second half of 1983 was 20.9 million.

It is usual that there tends to be some discrepancybetween the sales

and purchases invoices. Table 6 shows the number of total transactionspro-

cessed, nonmatching and error in VAT invoices. The nonmatchingrefers to

 - 25 -

Table 6: Nonmatchingand Error in VAT Invoices

(unit: in thousands)

Non- (I) (II) Total (III)

M*atching Error Processed I/III(%) II/III(%)

1977.2
Sales 1,566 1,944 34,128 4.6 5.7
Purchases 2,195 1,164 18,117 12.1 6.4
Total 3,761 3,108 52,245 7.2 5.9

1978
Sales 1,596 2,342 71,017 2.2 3.3
Purchases 2,741 1,144 41,122 6.7 2.8
Total 4,337 3,486 112,139 3.9 3.1

1979
Sales 911 1,394 64,780 1.4 2.2
Purchases 2,006 491 37,286 5.3 1.3
Total 2,917 1,885 102,066 2.8 1.8

1980
Sales 554 673 40,891 1.3 1.6
Purchases 1,929 268 25,654 7.5 1.0
Total 2,483 941 66,545 3.7 1.4

1981
Sales 443 334 58,324 0.8 0.6
Purchases 1,205 194 34,702 3.5 0.6
Total 1,648 528 93,026 -1.8 0.6

1982
Sales 397 188 58,057 0.7 0.3
Purchases 973 155 40,879 2.4 0.4
Total 1,370 343 98,936 1.4 0.3

1983
Sales 431 240 65,773 0.6 0.4
Purchases 1,065 214 42,343 2.5 0.5
Total 1,496 454 108,116 1.4 0.4

Sources: Ministry of Finance,Reference Data for Subcommitteeon

ConsumptionTax (1984).
 - 26 -

the case where the sale and purchase invoicesare inconsistent,and the error

to the case where the sale and purchase invoicesmatch but the details of the

invoicesdo not.

It is interestingto note that the nonmatchingratio for sales

invoices is about half of those for purchases invoices. This peculiar

behaviorof taxpayersmay be explained by the fact that the taxpayerswould

always try to minimize the VAT liabilityby maximizingtheir claims on

purchases.

The number of total transactionsprocessedby the computerexpanded

from 24.7 million at the time of businesstax in the first half of 1977 to

52.2 million in the second half of 1977 when the VAT was introduced. The

number of transactionsprocessed by the computingcenter increasedto 56.4

million in the second half of 1983.

In order to discouragevarious violations,the VAT Law has a series

of penalty clauses. For example, the traders who have not registeredwithin

20 days of businesscommencementhave to pay a penalty of 1 percent in the

case of individualtaxpayersand 2 percent in the case of corporationtax-

payers of a surchargeon their considerationof goods or servicessupplied.

Similar penalty is imposed on those who fail to receive the bi-annual inspec-

tion held in January and July, fail to issue tax invoicesor delay the sub-

mission of tax invoices,or have filled no or erroneousfigures in tax in-

voices. Errors in tax returns and payment are charged with a penalty

amounting to 10 percent of the total tax due.

 - 27 -

V. Evaluation

A. Revenue

The introductionof VAT has contributedto the steady growth of

indirect tax revenue in Korea. The VAT now is the single most important

source of governmenttax revenue. The VAT share in total tax revenue was 20.5

percent in 1978, which increased to 22.3 percent by 1983. The personal income

tax, the second important source of tax revenue accounts for about 10 percent

of total tax revenue.

The compositionof the tax revenue in Korea is shown in Table 7.

Compared with the revenue effect of the pre-VAT indirecttaxes, the relative

contributionof VAT does not seem to be particularlymarked. For example, the

share of eight indirecttaxes for which the VAT was substitutedaccounted for

29.9 percent of total tax revenue in 1913. This share increasedsharply to

32.8 percent in 1974. This share decreased somewhatbut still accounted for

28.7 percent of total tax revenue in 1976.

In comparing the revenue aspect of the pre-VAT indirecttaxes with

the post-VATregime, the revenue effect of the special excise tax which was

adopted at the time of introducingVAT should be also included. As shown in

Table 7, it accounted for 8.0 percent of total tax.revenue in 1978 and 6.9

percent in 1983. It is interestingto note that even the sum of both taxes

does not much change the share of indirecttaxes in total tax revenue. Al-

though the VAT is the most important tax in terms of raising revenue in Korea,

its relative contributionto total tax revenue when includingthe specialex-

cise tax remains more or less similar to the pre-VAT indirecttax regime.

The VAT revenue in 1983 totalled2,559 billion won, of which 1,025

billion won was collected from the domestic supply of goods and services,and
 Table 7: Composition of Tax Revenue

(unit: %)

1973 1976 1978 1979 1980 1981 1982 1983

Total Tax Revenue 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0
I. National Tax 88.7 90.5 89.2 88.8 88.3 88.8 88.9 87.9
A. Internal Tax 67.3 59.2 55.0 56.7 55.8 56.2 55.6 54.1
1. Direct Tax 30.4 23.7 20.6 21.0 17.9 18.9 19.9 18.3
2. Indirect Tax 36.4 33.9 34.4 35.6 37.0 36.3 35.1 34.2
-VAT - - 20.5 20.3 22.3 22.1 22.2 22.3
-SET - - 8.0 9.0 8.8 8.1 7.0 6.9
B. Customs Duty 12.6 11.9 15.8 13.7 11.6 10.9 10.7 12.8
C. Defense Tax - 11.6 11.6 11.8 13.1 13.4 12.4 11.4
D. Monopoly Profits 8.7 7.7 6.8 6.7 7.7 8.3 8.0 7.3 1
E. Education Tax - - - - - - 2.1 2.3 t
II. Local Tax 11.3 9.5 10.8 11.2 11.7 11.2 11.1 12.1 *

Sources: Ministry of Finance, Financial and Monetary Statistics,

Bank of Korea, Economic Statistics Yearbook
 - 29 -

1,534 billion won from the importationof goods. Of the VAT revenue from the

domestic supply, 24.3 percent accrued from the manufacturingsector and 21.4

percent from the constructionsector. Both sectorsaccountedfor 47.6 percent

and 10.4 percent respectivelyof the VAT base in the same year. It can be

seen from above that the manufacturingtax base was substantiallyzero-

rated. The manufacturingand constructionsectors accountedfor 10.8 percent

of total taxpayers and 51.8 percent of general taxpayers. The third largest

revenue contributorwas the retailers,from which 10.0 percent of VAT revenue

accrued. It accounted for 7.2 percent of the tax base and 37.1 percent of

total taxpayers. This was the sector with the largest number of special tax-

payers, accountingfor 42.3 percent of special taxpayersand 45.8 percent of

revenue from special taxation.

B. Price Changes

As mentioned earlier, one of the reasons advancedby those who op-

posed the adoptionof VAT was its potentiallyadverse impact on price

changes. At the time, the Korean economy was going through a turning point

and the inflationarypressurewas unusually strong. The annual rate of whole-

sale price increasewas 12.2 percent, and that of consumerprice increasewas

15.4 percent in 1976.

As shown in Table 8, the wholesaleprice increasedby 9.0 percent,

and the consumerprice by 10.7 percent in 1977 when the VAT was adopted in

July. Even then, the price increasewas led by the food and beveragecaused

by the agriculturalfailure due to weather condition. For example, the whole-

sale price of food and beverage increasedby 15.5 percent in 1977 when that of

nonfood items increasedby 6.4 percent only. The consumerprice change was

similarly affected. This trend continued until 1978 and the price of food and
 - 30 -

Table 8: Price Changes before and after VAT

(unit: %)

1976 1977 1978 1979

Wholesale Price
All Items 12.2 9.0 11.6 1.8
Food & Beverage 17.8 15.5 24.4 11.2
Nonfood 9.9 6.4 5.8 22.9

Consumer Price
All Items 15.4 10.2 14.4 18.3
Food & Beverage 17.9 11.6 16.6 13.8
Nonfood 13.3 8.8 12.4 22.6

Sources: Economic Planning Board, Major Statistics of Korean

Economy 1985.
 - 31 -

beverage which were exempt from VAT was leading the general price change. It

was only from 1979 that the increaseof price of nonfood items was faster than

that of food and beverage. It then appears to suggest that the introduction

of VAT did not have any markedly unstable impact on price changes in

Korea. 1-/

Several reasons can be offered to explain this. One is that the VAT

was designed to substituteeight indirecttaxes with the level of tax revenue

kept constant. The price impact of differentialindirecttax incidencecan be

said to have been fairly neutral.

Secondlyand more importantly,the active pricing policy must have

had some dampening effects on the likely price increase. At the time of

adoptingVAT, the prices of 251 goods were tightly controlledby the govern-

ment with the ceilings set on the factory and wholesaleprices. The govern-

ment also went out to publicize the recommendationof consumer prices for some

sensitiveconsumer goods.

It is worth noting that, regardlessof the general economiccondi-

tions during the latter half of 1970s when the Korean economy was going

through a stage of rapid increasein wage rate due to an excess demand in the

labor market, the price impact of the VAT was almost neutralizedin Korea.

C. Equity Aspects

Another argument advancedby those who objectedto the adoption of

VAT was that it was a regressivetax. AlthoughKorea was then singledout by

several scholars as one of the developingcountrieswhere the fast economic

growth was brought about with a minimum adverse impact on income distribution,

there was a sign that the income inequalitywas widening in the middle of

1970s. It was untimely, so it was argued, to aggravate the situationby

 - 32 -

introducinga regressivetax. The results of some studies seem to support

this argument.

The indirect tax burden distributionbefore and after the introduc-

tion of VAT is given in Table 9. It is shown that the effectiveVAT burden on

the lowest income decile of nonfarm householdwas 9.4 percent in 1978 and the

tax burden decreasedas the income increased. The effectiveVAT burden on the

highest income decile if nonfarm householdwas 3.8 percent in 1978. The re-

gressivenature of VAT was also shown in the case of farm household. The VAT

burden on the lowest income decile of farm householdwas 8.4 percent and the

effectiveburden decreasedas the household income level increased,showing

2.9 percent for the highest income decile. Although the general burden of VAT

was lower in the case of farm households,the tax burden distributionshowed a

similar pattern in both nonfarm and farm households.

An interestingfact emerges when the effective indirecttax burden is

compared between 1976 and 1978. In 1976 when eight indiret taxes for which

the VAT was substitutedin 1977 were still in operation,the effective in-

direct tax burden of the nonfarm household was shown to be lower in the case

of low income groups and higher in the case of high income groups as compared

with the burden distributionin 1978. The indirecttax burden of the middle

income groups, particularlythose in the 5th to 7th income decile, seemed to

have been least affectedby the change of the indirecttax system. On the

other hand, the indirect tax burden of the farm householdwas generally higher

in all income brackets in 1978 than in 1976. Thus the studies seem to support

the argument that the VAT is a regressivetax. 12/

 Table 9: Indirect Tax Burden before and after VAT

(unit: as X of income)

Year/Income Decile 1st 2nd 3rd 4th 5th 6th 7th 8th 9th 10th

1976
Nonfarm Household 15.7 13.1 12.4 11.9 11.5 11.2 10.8 10.4 9.7 9.1
Farm Household 11.0 8.7 7.6 7.3 6.9 6.5 6.2 5.8 5.2 4.6

1978
Nonfarm Household 20.4 15.8 13.8 13.1 12.1 11.4 10.6 9.9 9.0 7.1
(9.4) (7.5) (6.7) (6.4) (6.0) (5.7) (5.4) (5.1) (4.7) (3.8)
Farm Household 18.1 16.4 10.9 10.8 8.9 8.7 7.7 7.2 6.4 5.7
(8.4) (6.0) (5.1) (5.0) (4.2) (4.2) (3.7) (3.5) (3.2) (2.9)

1980
Nonfarm Household 28.0 19.4 16.6 15.1 13.9 13.0 12.1 11.2 10.1 9.0
(13.9) (9.5) (8.1) (7.3) (6.8) (6.4) (6.0) (5.6) (5.2) (4.3)
Farm Household 18.2 13.8 12.3 11.6 10.6 10.1 9.3 8.6 7.8 6.5
(9.2) (7.1) (6.4) (5.9) (5.5) (5.2) (4.9) (4.5) (4.1) (3.5)

Sources: Seung Soo Han, "TwezityYears of Public Finance in Korea--with particular reference to
allocation and distributLoiialfunction" (in Korean), Korean Economic Journal, vol. XXI,
no. 4 (December 1982), p. 414.

Note: Figures in parentheses are VAT burden.

 - 34 -

D. Investmentand Export

The consumption-type
VAT is regarded to promote investmentbecause

the tax paid on the purchasesof capital goods is fully credited. As compared

with the old indirecttaxes, therefore,the investmentcost would be reduced

by the amount of tax refundedunder the VAT system, providingsome incentive

for investment.

Since the introductionof VAT in Korea, the largest share of refund

on capital investmentaccrued to the manufacturingsector until 1981. For

example, the share of manufacturingsector in tax refund on capital investment

was 73.3 percent during the second half of 1977. The second largest share

accrued to the electricityand gas, accountingfor 9.2 percent of the total

tax refund during the same period. The electrictyand gas industrysharply

increased its share, receiving47.7 percent of total tax refund on capital in-

vestment in 1982 whilst the manufacturingsector received25.2 percent in the

same year. The tax refund as a percentageof capital investmentfluctuated

between 0.3 percent as in 1980 and 0.8 percent as in 1978. It was 0.5 percent

in 1982.

One of the other stated goals of adoptingVAT was the eliminationof

hiddle tax elements in the internationalflow of goods with the consequence

that any tax distortionsin the export sector would now be removed. With the

exports zero-ratedunder the VAT system, the indirecttax refund increased

very sharply. For example,the indirecttax refund as a percentageof export

increased from 0.04 percent in 1973 and 0.06 percent in 1976 to 0.09 percent

in 1978 and 0.10 percent in 1982. This seems to suggest that the hidden tax

elements were removed from the exportablesunder the new VAT system.
 - 35 -

As the relativeamount of tax refund to exports increased,the tax

rebate per dollar of export also increasedrapidly. It was 22.7 won in 1973,

which increasedto 53.6 won in 1978 and to 86.6 won in 1982. During the

period, the Korean won was devalued from 397.5 won to 484.0 won in December

1974 and from 484.0 won to 580.0 won in January 1980. Although it is diffi-

cult to quantifythe impact of VAT on export, the above figures seem to sug-

gest that the change of the indirect tax system removed some of the tax dis-

advantagesplaced on the export sector by the old indirecttax system. 13/

VI. Changes,Problemsand Prospects

With the passage of VAT Law in the NationalAssembly in 1976, the

value added tax was introducedin Korea on July 1, 1977. Since the adoption

of VAT, there were severalchanges in the VAT Law as well as in the

Presidentialdecree governingthe VAT. Perhaps the most important change was

to increasethe upper limit of turnoverfor special taxpayersfrom 12 million

won to 24 million won in 1979. Regardlessof minor amendmentsof the VAT Law,

the essence of the VAT still remains intact as it was introducedalmost a

decade ago.

As there were no major changes in the VAT system, the problems that

existed at the time of inception still remain to be resolved. Of the

problems, the most importantappears to be how to deal with the system of

special taxation. Currentlythe special taxpayerswith an annual turnoverof

24 million won or less pay tax at the rate of 2 percent on their annual gross

sales. The low tax burden from the special tax treatmenttends to perpetuate

the propensityparticuLarlyamongst the services such as food and beverage,

construction,transportationand storage,to remain as special taxpayers.

They tend to try to remain as special taxpayersby reporting false tax

 - 36 -

returns,by evading to accept tax invoicesor by falsely reporting the

closing-downof business and at the same time opening it elsewhere. There is

a stream of constant request and politicalpressure to expand the minimum re-

quirementof special tax treatment. According to a survey conductedby the

Ministry of Finance,most of the complaintscame from those with an annual

turnoverfrom 20 million won to 40 million won. 14/

Secondly, the treatmentof farmers poses another problem. Although

the VAT should be applied to all goods and services,agriculturaland fishery

products are exempt from VAT so as to reduce tax burden on low income

groups. Accordingly,the farmers or fishermenhave no VAT obligations. They

do not need to registerat the district tax office and are exempt from the

various bookkeepingobligationson their productionand sale. At the same

time, they are not entitledto get the refund of the tax paid during the

productionand distributionprocess of agriculturaland fishery products.

There is still a debate whether to introducea special system of taxation for

the farmers such as, for example, a zero-rating.

Thirdly, there is the problem of tax treatment of the services of-

fered in the banking and insurancesectors. Although they are currently ex-

cluded from the VAT liability,there has been an increasingdemand for taxing

them. The taxationof these sectors would certainly enhance equity and raise

revenue. However, there are theoreticalas well as practical problems in

taxing these sectors. The financial service such as capital can be regarded

as a factor of productionand the estimationof value added in the financial

service is not an easy task.

Fourthly, there is the problem of taxing the personal servicesof

lawyers,certified public accountantsand other professionalpeople. In this

 - 37 -

respect,the exemptionsspecifiedin the VAT Law would need to be reviewed

with a view to make the VAT as broadly-basedas possible. 15/

No one can deny that the value added tax contributedgreatly to the

simplificationof indirect tax system and has become one of the most important

revenue sources in Korea. On the other hand, the VAT seemed to have aggra-

vated the income inequalityin Korea. Whether for good or bad, the allocation

and distributionfunction of the VAT have thus been amply exhibitedduring the

last 9 years. However, the stabilizationfunction of the VAT is yet to be

tested. The determinationof a maximum and minimum rate at the time of intro-

ducing the VAT implied that the tax would be used as a macroeconomicpolicy

instrument. This was also the expressedview of the proponentsof the VAT.

An attempt to test the value of, and then use, the VAT as an effective tool of

macroeconomicpolicy objectives,therefore,may be the task that is left to

the governmentin the coming years.

 - 38 -

Endnotes

1. The views of the proponentsof VAT in Korea are summarizedin Chin-Bae

Choi, Value Added Tax of Korea (Sammunsa,Seoul, 1984) (in Korean), pp.

70-74 and the Ministry of Finance,The VAT, What Kind of Tax Is It?

(1977) (in Korean), pp. 23-24.

2. The views of those who opposed the adoption of VAT because of its likely

adverse impact on price and income distributionare discussed in Chin-Bae

Choi, op. cit., pp. 102-105.

3. Informationthrough a conversationwith Dr. Chon-In Kim who was one of

the professionaleconomistson the observationteam.

4. For a more detailed discussion,see James C. Duignan, Report on the

Feasibilityof Introductionof United Income Tax and Value Added Tax in

Korea (October 1972).

5. For a more detaileddiscussion, see Alan A. Tait's two reports,Report on

the PossibleKorean Value Added Tax (December 1975) and Report on the

ProposedKorean Value Added Tax (June 1976).

6. The VAT tax base is defined in the Articles 1 and 13 of the VAT Law. See

of Certified Public Accountants,A Summary of Tax Laws

Korean Associatior.

(May 1985) (in Korean), p. 261 and pp. 271-273.

 - 39 -

7. The supply of goods and services is defined in Articles 6-8 of the VAT

Law. See ibid., pp. 264-265.

8. For a detailed discussionof the methodologyand estimation,see Choi,

Chin-Bae, op. cit., pp. 77-85.

9. See the full list of the goods and services that are exempt and of the

goods that are zero-ratedin the Ministry of Finance,Korean Taxation

1983, pp. 168-172and p. 168.

10. Articles 25-26 of the VAT Law define the special taxationand its tax

base.

11. An internationalcomparisonof price changes after VAT seems to suggest

that Korea belongs to the group of countrieswhere the introductionof

VAT did not particularlydestabilize the price changes. The Ministry of

Finance,The Survey Report on the Practice of Value Added Tax in Korea

(1980) (in Korean), pp. 168-170.

12. Seung Soo Han, "Twenty Years of Public Finance in Korea with particular

reference to the allocationand distributionfunction,"Korean Economic

Journal (in Korean), vol. XXI, no. 4 (December1982), pp. 414-416.

Although the level of tax burden differs, the regressivenature of the

VAT was also estimatedin other studies. See Peter S. Heller, "Testing

the Impact of Value Added and Global Income Tax Reforms on Korean Tax

Incidence: An Input-Outputand SensitivityAnalysis," IMF Staff Papers,

 - 40 -

vol. 28, no. 2 (June 1981) and Yeon-CheonOh, An Evaluationof the Tax

Reform for a Value Added Tax in Korea with special reference to

Distributionof Tax Burden, AdministrativeEfficiencyand Export

(unpublishedPh.D. thesis, New York University,1983).

13. Investmentand export-relatedfigures after 1980 are from Kwang Choi,

"The Value Added Tax in the Republic of Korea," EconomicBulletin for

Asia and the Pacific (December 1983), p. 27 and p. 29. Others are from

the Ministry of Finance, The Survey Report, p. 180 and p. 185.

14. Tax College and Korean Economic Research Institute,Survey on the

Taxpayers'Perceptionof Taxes (KERI, Seoul, 1983) (in Korean), pp. 122-

123.

15. IMF recommendationson some of these issues are summarizedin the

Ministry of Finance, A Summary of the IMF Report on the Reform of the

Value Added Tax System in Korea (January1983) (in Korean).

 - 41 -

References

1. Byung-KwanCha, Medium- and Long-termDirection for the Reform of Tax

System in Korea (Korea Chamber of Commerce and Industry Study Series,

1983) (in Korean).

2. Chin-Bae Choi, Value Added Tax of Korea (Sammunsa,Seoul, 1984) (in

Korean).

3. Kwang Choi, "Value Added Taxation in the Republic of Korea," Economic

Bulletin for Asia and the Pacific (December1983), pp. 15-40.

4. James C. Duignan, Report on the Feasibilityof Introductionof United

Income Tax and Value Added Tax in Korea (October 1972).

5. Economic Planning Board, Economic Policy during the levelopmentDecade

(1982) (in Korean).

6. , Social Indicators in Korea (1981) (in Korean).

7. Federationof Korean Industries,Tax Policy Direction for the 1980s

(1982) (in Korean).

8. Seung Soo Han, The Tax Burden Distributionand Optimal Tax Rates (Korea

EconomicResearch Institute,Seoul, 1982) (in Korean).

 - 42 -

9. , "Twenty Years of Public Finance in Korea with particular

reference to Allocationand DistributionFunction,"Korean Economic

Journal (in Korean),vol. XXI, no. 4 (December1982), pp. 385-426.

10. Peter S. Heller, "Testing the Impact of Value Added and Global Income Tax

Reforms on Korean Tax Incidence;An Input-Outputand Sensitivity

Analysis," IMF Staff Papers, vol. 28, no. 2 (June 1981).

11. Korean Associationof Certified Public Accountants,A Summary of Tax Laws

(May 1985).

12. Ministry of Finance,Korean Taxation 1983 (1983).

13. , The Present Status of Tax-Systemin Korea (1984) (in Korean).

14. , ReferenceData for the Subcommitteeon ConsumptionTaxes

(November 1984) (in Korean).

15. , Summary of IMF Report on the Reform of VAT System in Korea

(January 1983) (in Korean).

16. , The Survey Report on the Practice of Value Added Tax (1980) (in

Korean).

17. , Theory and Practiceof Value Added Tax (1975) (in Korean).
 - 43 -

18. , The VAT; What Kind of Tax Is It? (1977) (in Korean).

19. Yeon-CheonOh, An Evaluation of the Tax Reform for a Value Added Tax in

Korea with special reference to Distributionof Tax Burden, Adminis-

trative Efficiencyand Export (unpublishedPh.D. thesis, New York

University, 1983).

20. Alan A. Tait, et al., Korea: Taxes in the 1980s (1979).

21. , Report on the Possible Korean Value Added Tax (1975).

22. , Report on the Proposed Korean Value Added Tax with special

reference to the Effects on the Retail Price Index and HouseholdExpend-

iture (1976).

23. Tax College and Korea EconomicResearch Institute,Survey on the

Taxpayers' Perceptionof Taxes (KERI, Seoul, 1983) (in Korean).

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