FPIcy, Planning, and Research

WORKING PAPERS'& I

Macroeconomic Adjustmentand Grovlh

Country Economics DepartmentThe World Bank

May 1989WPS 205

VVhat DeterminesNational Saving?A Case Study of Korea

and the Philippines

Sang-Woo Nam

Adjustment policy packages that curb inflation aid improve thebalance of payments but that retard growth may be self-defeating- as deteriorating growth sharply reduces national saving andlimits the investment needed for adjustment.

The Policy, Planning, and Research Cranplex disrnbutes PPR Wodting Papers to disseminate the findings of work in progress and toencourage the exchange of ideas among Bank staff and all others interested in development iss ues. These papers carry the names ofthe authors, reflect only their views, and should be used and cited accordingly. Th frindings, interpretations, and conclusions are theauthors' own. They should not be attributed to the World Bank, its rioaxd of Directors, its management, or any of its member countries.

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Plc,Planning, and Research |

Macroeconomic A istmentand Growth

For this analysis of national savings behavior in T ax policy is a potentially effective meansKorea and the Philippines - Asia's most of nobilizing savings but the effect seems toheavily indebted countries - Nam conducted vary by country.dynamic simulations to determine how majorvariables interact across sectors. The policy implications of these findings

seem obvious. Any adj- stment policy packagesChanges in growth perfornance, more than designed to curb inflation and improve the

anything else, were responsible for the sharp balance of payments should also be designed todrops in aggregate savings in 1980-82 in Korea encourage growth - which is needed to encour-and in 1984-85 in the Philippines. age savii.gs and thus investment.

In Korea particularly, per capita income Overemphasis on maintaining positive realgrowth explained most of the changes in the interest rates may also do more harm ihan good,national savings ratio during the last two dec- because the benefits from a small incrcase inades. Savings in Korea are also significantly savings (if any) or more efficient investmentaffected by interest rate policy. Indeed, interest allocation may be overshadowed by a decline inrate reform in 1965 gave rise to increased investment activity.savings.

Sector studies are essential to effectiveIn the Philippines, by contrast, a higher national savings mobilization and the formula-

interest rate had a slightly negative effect - tion of viable adjustment programs. Institutionsbecause the positive effect on household savings and other factors that affect the behavior ofwas more than offset by the negative effect on economic agents are not the same in all coun-corporate and government savings. tries.

This paper is a product of the Macroeconomic t%djustment and Growth Division,Country Economics Department. Copies are available free from the World Bank,1818 H Street NW, Washington DC 20433. Please contact Raquel Luz, room N 11-061, extension 61762 (69 pages with charts and tables).

The PPR Working Paper Series disseminates the findings of work under way in the Bank's Policy, Planning, and ResearchComplex. An objective of the series is to get these findings out quickly, even if presentations are less than fully polished.The findings, interpretations, and conclusions in these papers do not necessarily represent official policy of the Bank.

Produced at the PPR Dissemination Ccnter

TABLE OF CONTENTS

Page

I. Introduction ......... 1

II* The Moe ................................. 5

A. The Overall Framework................................... 5

B. Household Saving out of Disposable Income............... 8

C. Corporate Income Determination........................... 13

D. Dividend Policyo.*.oicy.o* * oo..o.o.. o. oo..* .oo....*o. 15

E. Government Consumption.... oo.o....oe.*e. e ** **.* . 17

F. Effective Rates of Personal Direct Taxes andCorporate Income Tax 18

G. Allowances for Capital Depreciation................o. 20

III. Estimation Resultsoes u lt.sooeeoo.... 22

A. K o r eaooeo*ooooooooo*..oooo.o . 22

B. The Philippines.*****00000oo**oooooo 35

IV. Simulation Exercises......e e .o..... e ....... o 42

A. Base Simulation and Decomposition of Savings Performance 42

B. Savings Sensitivity to Exogenous Shocksocks...o...... 50

V. Summary and Conclusion...oe...e.. o....e.e......e.eee ... .e 64

Footnotes..... ......... o...o... .... ............. o..e.. .. o.... 68

Referenceso... . .. o..e.............. ...... o...e..o.......e..... 69

TABLES AND FIGURES

Tables Page

1. Savings Performance......... .. ................... ... . ......... 4

2. Regression Results for Household Saving (sh): Korea ....... 23

3. Performance of Base Simulation: Comparison of Actual andPredicted Values.........................................* 45

4a. Contribution to National Savings Ratio (NSR) byMajor Factor: Korea.* ........................... *** ** 47

4b. Contribution to National Savings Ratio (NSR) byMajor Factor: Philippines..... ................... ......... 48

5a. Movements of Major Savings Determinants: Korea............ 51

5b. Movements of Major Savings Determinants: Philippines...... 52

6. Effects of Interest Rate Change ......................... 54

7. Savings Effect of Discretionary Tax Policy................. 57

8. Savings Effect of Indirect or Personal Direct TaxesWorth 1% of GNP Replacing Corporate Income Tax............. 60

9. Savings Effect of Inflation and Growth....................... 61

Figures

la. Base Simulation Results: Korea............................ 43

lb. Base Simulation Results: Philippines..................... 44

2. Savings Effect of Real Interest Rate Change ............. 55

3. Effects of Discretionary Tax Policy on National SavingsRatio............................................ ........ t58

4. Effects of Inflation and Growth on National Savings

I would like to thank Bela Balassa for his valuable comments and Inbom Choifor his research assistance, particularly with the simulation exercises.

I. Introduction

The mobilization of national saving is always emphasized as a

critical determinant of economic growth. Recently it is even more critical,

as the debt crisis since che early 1980s has virtually dried up net capital

flows into many developing countries. National saving needs to be augmented

to maintain a high level of investment for sustained economic growth,

particularly for the industrial restructuring critical to the long-run

viability of heavily indebted economies. Thus, any macroeconomic adjustment

effort needs to pay major attention to the mobilization of national saving.

There have been numerous studies on the behavior of consumption and

saving: cross-section stidies on household saving, time-series analysis of

aggregate national saving and international comparative studies (for a recent

review, see Virmani 1986). Despite the vast theoretical and empirical work on

saving, the results have not provided clear ideas on how aggregate savings are

determined particularly in developing countries. The studies on cross-section

household saving, although useful, are incomplete since they omit other

important sectors (corporations and governments). The value of the time-

series studies of aggregate national saving is limited because the aggregation

obscures important sectoral relations in the determination of aggregate

savings and sectoral differences in savings behavior. Likewise, most

international comparative studies are too crude to guide the design of policy

reforms needed to mobilize national saving. Aside from their aggregate

nature, the socio-economic institutions directly or indirectly related to

savings determination are usually quite different across countries.

The alternative approach taken in this paper is to explain the

determination of sectoral savings within the national income framework and

explicitly to consider inter-sectoral relationships in the determination of

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income and saving. This "sectoral accounting apptoach" relies on a time-

series analysis that makes it possible to trace the evolution of natiorial

saving without paying much attention to the many underlying factors which

influence the taste and savings motivation, factors that are unique to an

economy and that are likely to remain stable unless important institutional

changes are introduced. Instead, the model pays greatest attention to the

roles played by financial and fiscal policies and the evolution of the economy

in terms of income growth and inflation. As such, this model is geared to

providing the savings implication of any macroeconomic adjustment package, as

well as serving as a useful framework for designing programs to augment

saving.

Since this approach looks at the process by which sectoral saving is

determined in the national income framework, it requires data on sectoral

income, saving and other factors. Unfortunately, in most developing

countries, sectoral national income tables are not readily available for

making meaningful time-series studies. Korea and the Philippines were chosen

because the data are available. Another reason for selecting Korea is its

remarkable success in raising the national savings ratio in the last quarter

century: the ratio increased from far less than 10 percent ia 1965 to 32.8

percent of GNP in 1986, based on rapid economic growth. During this period,

the proportion of the population in absolute poverty declined from as much as

40 percent to less than 5 percent. The increase in the national savings ratio

was not, however, always smooth. The ratio reached a 28 percent level as

early as 1977 but then slipped to 22 percent during 1980-82 with the slowdown

of economic growth, before rising sharply again.

The evolution of the Korean financial sec.or is also interesting.

Because Korea's formal financial market has long been repressed, an

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unorganized credit market has emerged. In 1965, the government had adopted a

policy of high interest rates, but it was phased out by the early 1970s. With

the acceleration of inflation during most of the 1970s, real bank interest

rates were negative. Since 1982, however, they have been significantly

positive as a result of price stabilization. The conscious efforts of the

government to promote non-bank financial institutions since 1972 paid off and

helped deepen the financial market. In recent years, Korea's sound fiscal

management, an essential element in the stabilization program, together with a

restrictive monetary policy, also seem to have played an important role in

increasing the aggregate savings ratio.

The Philippines contrasts sharply with Korea with respect to the

evolution of the national savings ratio. In the mid-1960s, the Philippines

had a much better savings performance as compared with Korea. The national

savings ratio ran as high as 20 or 21 percent during 1963-66, before dropping

to 17-19 percent during 1967-72. Although the ratio rose to 24 percent during

1976-81, it declined again to 16 percent by 1984-85.

The growth of the Philippine economy was fairly rapid during the

1970s. However, thc deterioration in the terms of trade in the late 1970s and

the rise in interest rates in the early 1980s constrained that growth. As

foreign creditor banks refused to roll over short-term credit or extend new

loans following the political crisis caused by the assassination of Benigno

Aquino, in late 1983 the government had to adopt restrictive fiscal and

monetary policies. This stance was mainly responsible for the negative CNP

growth and sharp drop in the national savings ratio during 1984-85.

As has been the case in Korea, the Philippine financial sector was

heavily repressed until 1980. Before the mid-1970s, real interest rates were

mostly negative. At that time, nominal interest rates were adjusted upward to

Table I

Savings Performance (S of GNP) a/

Korea b/ Philippines

Total National (Households) (Corporate) (Govt.) Foreign Total National (Households) (Corporate) (Govt.) Depreciation Foreign

1963 -- -- -- -- -- -- 19.6 20.4 9.4 2.6 1.9 6.7 -0.8

1964 14.0 7.2 2.7 4.0 0.5 6.9 21.2 20.2 8.8 2.5 1.9 7.0 1.01965 15.0 5.7 -1.1 5.0 1.8 6.4 20.9 20.4 10.6 1.6 0.8 7.4 0.51966 21.6 10.4 2.8 4.7 2.9 8.5 19.8 20.9 10.0 2.6 0.8 7.6 -1.11967 21.9 9.8 0.9 4.8 4.1 8.8 22.0 18.9 7.1 2.6 1.2 8.0 2.21968 25.9 13.6 2.3 5.2 6.1 11.2 22.1 17.6 5.6 2.9 1.1 7.9 4.11969 28.8 17.5 6.4 5.2 6.0 10.6 21.1 16.6 5.8 2.2 0.6 8.1 4.01970 25.3 15.7 4.5 4.8 6.4 9.1 20.3 18.3 4.2 2.8 2.1 9.1 1.91971 25.1 14.6 4.7 4.7 5.2 10.5 20.0 18.1 4.9 1.3 2.5 9.4 1.51972 22.2 16.5 7.5 5.6 3.5 5.1 22.0 17.6 5.6 1.5 I ' 9.5 1.51973 25.7 22.8 10.5 8.2 4.0 3.7 20.3 23.5 6.9 2.0 5.6 9.0 -3.81974 31.7 19.9 9.1 8.3 2.6 12.1 25.1 22.2 6.8 2.5 4.3 8.6 2.51975 30.0 19.1 8.2 7.1 3.7 10.1 29.6 22.4 6.9 2.8 2.8 9.9 6.81976 25.6 23.9 10.4 7.6 5.8 2.3 31.3 23.9 9.6 3.1 1.7 9.6 7.11977 27.7 27.5 14.' 8.1 5.2 0.6 29.0 24.4 9.5 2.4 2.9 9.5 4.41978 31.2 28.5 14.8 7.3 6.3 3,1 29.0 23.4 7.3 2.9 3.8 9.5 5.41979 35.6 28.1 13.8 7.3 6.9 7.1 31.0 25.3 5.4 5.5 5.0 9.4 5.31980 31.3 21.9 8.1 7.9 5.8 9.4 30.7 24.5 4.8 5.5 5.0 9.3 5.81981 29.1 21.7 8.4 7.0 6.2 7.7 30.7 24.4 5.3 5.3 3.7 10.1 6.01982 27.0 22.4 9.0 7.2 6.2 4.5 28.8 20.0 2.1 4.4 3.1 10.3 2.41983 27.8 24.8 9.4 7.9 7.5 2.9 27.5 18.9 0.9 4.3 3.4 10.3 8.11984 29.7 27.3 11.6 8.0 7.7 2.3 19.2 15.7 1.8 -0.3 3.7 10.5 2.61985 (31.1) (28.6) (21.7) (6.9) (3.1) 16.3 16.1 2.6 -0.5 3.0 11.0 -0.51986 (30.2) (32.8) (26.2) (6.6) (-2.7) 14.0 18.3 4.2 -0.3 3.5 11.0 -5.3

Notes:a/ Sectoral saving does not sum up to the total because of statistical discrepancies.

4

b/ For 1964-69, national saving and its components are adjusted for the base year change, while adjustments are not made fortotal and foreign saving. There are discontinuities in the data between 1984 and 1985, as Korea adopted a new system of nationalaccounts.

-5-

maintain positive real rates (except in 1979-80). Beginning in 1981, the

nomiral interest rate ceilings were gradually lifted. Although the financial

liberalization produced strong signs of financial development during 1981-63,

with the M3/GNP ratio rising from 25.6 percent in 1980 to 29.8 percent in

1983, this trend was short-lived. Instead, the decline in income, together

with the high inflation of 1984, resulted in a sharp drop in the level of

financial intermediation.l/

II. The Model

A. The Overall Framework

The national savings ratio (s) is the sum of the household,

corporate and government savings ratios, defined as shares of GNP (sh' Sc and

sg, respectively). That is,

= Sh + Sc + S (1)

Unincorporated businesses are included in the household sector, and each

sectoral saving includes the capital depreciation allowances.

Household saving is determined as household disposable income after

consumption, minus net transfers from abroad, plus depreciation allowances.

Net transfers from abroad are excluded because they are not part of national

saving but constitute part of foreign saving. Household disposable income is

after-tax household income plus net transfers received by households. That

is,

s Yhd * sd trf th and (2)5h h sh-th han

-6-

Yhd= Yh (1 - t*) + trh (2.1)

where

Yd Ratio of household disposable inccme to GNPh

sh = Household saving/dIsposable inicomte ratiof

trh = Net current transfers to households froxa abroad as share

of GNP

dh = Capital depreciation allowances for the household sector

(unincorporated businesses) as share of CNP

Yh - Ratio of household (before-tax) income to GNP

th = Ratio of personal direct taxes to household income, and

trh = Total net current transfers to households as share of GNP.

Corporate saving corresponds to corporate income after corporate

transfer payments, corporate income tax and dividend payments, plus corporate

capital depreciation allowances.

= (yc- trc) (l-tc) (1 - div ) + d (3)

where

y - Corporate income before transfer payments and taxes as

share of GNP

trc = Ratio of corporate transfer payments to GNP

*t = Ratio of corporate income tax to corporate income afterc

transf2r payments

-7-

div Ratio of corporate dividends (to the household sector) to

corporate income after transfer payments and taxes, and

dc a Corporate capital depreciation allowances as share of GNP.

Finally, government saving is defined as government current revenue

including net transfers fro.; households, minus gnvernment consumption (current

expenditures), plus depreciation allowances of government enterprises. Again,

since net transfers to government from abroad constitute part of foreign

saving, they do not enter into government saving.

g = r - c)- trf+ d and (4)

r = t * Y + tc (c - tr,) i t + g trh (4.1)

where

r = Government current revenue as share of GNPg*c = Ratio of government consumption to current revenue

trf, tr h,f = Net transfers to government from abroad, and from both

households and abroad, respectively, as shares of CNP

dg = Capital depreciation allowances of the government

sector as share of GNP

ti = Ratio of indirect taxes to GNP, and

yg = Government income from property and enterprises

as share of GNP.

The model is complete with the following GNP identity:

1 = Yh + YC Dividends/GNP + yg + ti + (dh + dc + dg), or

- 8 -

Y=1- [Y - (y - tr )(l - t*) div* +g y+ t + (dh d + d )] (5')

Of the above variabl.6. that determine the sectoral savings ratios, transfers

among sectors and the GNP ratios of indirect taxes (ti) and government

property and enterprise income (y ) are treated as exogenous. Thus, given the

above identities, the following nine variables are to be estimated for the

determination of the aggregate national savings ratio: (s*) (y ), (div*),

(c*), (t*) (t*), (dh), (d ), and (d ). Discussed below are theg h c hg

specifications of the equations estimating these variables.

B. Household Saving out of Disposable Income

How much households save out of their disposable income is very

critical in determining national saving because their income accounts for the

lion's share of GNP. The major savings (dissavings) motivation for households

is believed to be the desire to smooth consumption over their lifetime against

uncertainty about their income stream, time of death, expenditure needs and

the desire to leave a bequest to their children in such a way as to maximize

their utility. For the purpose of a time-series study cf aggregate saving,

uncertainty about future income is likely to be closely related to the recent

evolution of income growth, while the bequest motive is believed to be

associated with income level. Savings motivation to meet future expenditure

needs (including that arising from uncertainty about the time of death) may,

to some extent, depend on the availability of various social security and

insurance prog:ams.2/

Furthermore, consumption/saving decisions are subject to an

intertemporal budget constraint, so that the (real) interest rate potentially

-9-

plays an important role. However, the financial markets in developing

countries are far from perfect and households cannot easily borrow against

expected future income. Household consumption may therefore be significantly

constrained by liquidity. such as current income and financial assets.

With these points in mind, we may hypothesize the following

consumption function:

Aln c a= o+ a1Atn y + a2^AAn y + a3[tn (c) - in (C) ] (6) and

c 2~~~~~~~~~

c) =c ((y, y), fin/y, r _ pe, tr/y, Dem/Ssi) (6.1)y

where

c Per capita household consumption

y = Per capita household disposable income

(c/y) = Desired ratio of household consumption to disposable

income

fin = Household per capita holdings of financial assets

r = mepresentative market interest rate

*ep = Expected rate of inflation

tr = Per capita net current transfers to households, and

Dem/Ssi = Demographic factors and development of social

security/insurance programs.

(c), (y), (fin) and (tr) are given in real terms. However, if the differences

in implicit deflators for consumption and income are ignored, (c/y) and the

other ratios may be considered as nominal.

- 10 -

Consumption growth is specified to be determined by disposable

income growth and change in income growth as well as correction for any

discrepancy between the desired consumption/income ratio and its actual ratio

in the previous period. The faster the income growth accelerates, the more of

the income growth is usually considered as transitory, and vice-versa.

Househoids, in trying to smooth their consumption on the basis of a notion of

permanent income, are expected to reduce (increase) the share of consumption

out of income growth when the latter accelerates (decelerates).

The desired consumption/income ratio (c/y)* is assumed to be a

function of per capita income (y), household holdings of financial assets

relative to income (fin/y) and the real interest rate (r-ie). Very poor

households, for which the time discount rate is supposed to be high, cannot

afford much saving for future consumption, not to mention bequests for the

next generation. Thus, for developing countries, where income of a

substantial portion of the population is below the subsistence level, at least

in the earlier sample period, income level is supposed to be a critical

determinant of the (desired) savings ratio. However, the relation between the

level of income and the savings ratio is not likely to be linear, as evidenced

by the rather constant long-run savings ratios for most developed countries.

The tapering of the income effect on the savings ratio as income grows is

approximated by a quadratic function of income.

Other explanatory variables in the (cly)* equation include the

share of net current transfer receipts in household disposable income (tr/y),

demographic factors and the social security/insurance system (Dem/Ssi). The

household transfer receipts/disposable income ratio was introduced to see

whether the availability of unearned income, including transfer receipts from

abroad, makes any difference in the desired consumption/income ratio. In the

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life cycle theory of saving, the young and the old dissave, while the

economically active save. Thus, other things being equal, a decline in the

population dependency ratio is expected to result in a higher savings ratio.

Finally, the introduction of large-scale social security/insurance programs

may lower household savings.

Adding In c_1 i n y on both sides of equation (6) and rearranging

the terms results in

tn (c) = - (1 afAln y + y + a c*n (C) + (1 - a ) Qn (c) (7)y 0 1 2 3 ~~~y 3 y

since -in (c/y) 1-c/y = sh (household saving/income ratio) and UAn y j

equation (7) may be rewritten into the following savings ratio equation:

sh ao+(1 c1) ain y - 02AM4n y +m3(1- (c/y)*)+(1 - G 3) h i (8)

O- + et Ai + a (1-(c/y) ) + (1 - a ) s0 ' 1 2' 3 "3'h

From equation (6.1), the above equation can be expressed as

Sh = * (Y, ; (yA y2), fin/y, r-p e, tr/y, Dem/Ssi; s (9)h h Ih-

where the rate of change in the terms of trade (t t) is newly added to reflect

the fact that measured real income deviates from true (purchasing power)

income when the terms of trade changes.

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Interest Rate, Financial Development and Household Saving

Two financial variables are included in the above savings equation:

the real interest rate and the accumulation of household financial assets.

Since they are not independent of each other, careful investigation of their

interaction is indispensable in evaluating the impact of interest rate policy

on household saving. The interaction may be analyzed by endogenizing these

two variables as follows:

r = r (rd, fin/y, ip - inn,ae) (10)

finly = f (in y, rdpO,..l.. . 2 ,.. (11)

where rd = Representative regulated deposit rate,

Ap = Growth rate of domestic credit to the private sector,

Yn = Nominal growth rate of non-agricultural CNP, and

P = Inflation rate.

Major determinants of the free market interest rate are assumed to be the

regulated official interest rate (rd), the degree of financial development

approximated by household accumulation of financial assets relative to income

(fin/y), the short-run monetary policy stance represented by (Mp - in), and

the change in the expected inflation rate (ape). 3/ Given fairly tight

control over international capital transactions, the international interest

(or effective cost of overseas borrowing) is not considered a major

determinant.4/ Household holdings of financial assets relative to income are

thought to depend mainly on the real interest rate and per capita income

level.

- 13 -

An upward adjustment of the controlled interest rate is likely to

raise the free market interest rate in the short run, but also to accelerate

(with some time lag) financial development, a trend that in turn will put

downward pressure on the market interest rate. Whether the net effect will be

positive or negative is an empirical question, depending not only on the

direct savings effects of the interest rate and liquidity but also on the

effect of the interest rate on liquidity (or financial development).

C. Corporate Income Determination

To see how corporate income is determined, we may start with the

following simplified identity of a profit and loss statement for the corporate

sector as a whole:

* * * * *p V = wL + r D + wE (12)

where V . p = Corporate real value-added and its implicit deflator,

respectively

L , w = Corporate labor employment and the average wage rate,

respectively

D , r1 = Corporate debt and its average interest rate,

respectively, and

*E , it = Corporate equity capital and return on equity,

respectively.

Denoting GNP = pV, where V is real GNP and p is GNP deflator, the

above equation is rewritten into the following corporate income/GNP ratio, yc.

- 14 -

* * * * r *= RE V w L _ t D (13)

cpV pv p V p V

* **

, (.2...w.L*_rQ * V* ) 6d (13')

where 6 is the corporate share of real GNP (V /V).C

Assuming that, in the above equation, wages, interest rates, labor

productivity and the debt/value-added ratio for corporations can be

approxiinated by those of the overall economy, we may derive the following

behavioral equation:

c = Yc t (w)/Pd, rt in' or. Ain, i, 6a) (14)

where Pd = Labor productivity measured as value added per employment

n= Real growth rate of non-agricultural GNP, and

6 = GNP share of agriculture.

Since corporate activities are relatively concentrated in the

tradable sector, where domestic firms have limited influence over the terms of

trade, (p */p) in equation (13) is expected to be positively affected by the

rate of change in the external terms of trade O t). (in) or (Ain) and the

inflation rate (j) are included to incorporate the cyclical movement of

((D*/p)/V*). If (De), in book value, is relatively stable, the ((D*/p)/V*)

ratio will move counter-cyclically and in a direction opposite to the

inflationary trend. (in) will also have a positive impact on (6 c), to the

extent that corporate activities are procyclical in nature.

Inclusion of the GNP share of agriculture (6 a) is justified by the

fact that corporations are rarely in agriculture, and in many developing

7 *A - 15 -

countries the share usually declines drastically during industrialization.

Finally, the real wage/productivity ratio (w/Pd) and the cost of borrowingp

(r ) constitute part of the (yc) identity in equation (13). These variables

should also be essential in the behavioral equation, as they incorporate the

effects of important policies such as those related to income, taxes and

interest rates.

D. Dividend Policy

Corporate income after transfer payments (many of which are quasi-

taxes) and after taxes is divided into dividend payouts and retained earnings,

of which only the latter constitute corporate net saving. Finance theory says

that dividend policy is irrelevant for a value-maximizing firm in a perfect

market with no taxes or transactions costs. For the stockholders, any

additional dividends are exactly offset by a lower share value. For the firm,

additional dividend payouts (reduction in retained earnings) can be

supplemented by the same amount of new stock issues, so that the firm's value

is left unchanged.

In reality, however, dividend policy does matter because, among

other things, dividend income and capital gains are taxed differently, and the

cost of internal funds is usually different from that of new equity issues

because of the substantial issuing cost. On the other hand, a change in

dividend payment is supposed to provide information about the prospects for

corporate profitability. Thus, firms are usually cautious in changing

dividends significantly unless there is a sharp and prolonged drop in earnings

or a firmly established trend of rising earnings. Aside from the information

factor, dividend stability over time is believed to contribute to a higher

value for the firm, as most investors are risk-averse, and many have

- 16 -

relatively stable expenditure needs that can be matched with a stable dividend

stream without incurring significant transactions costs.

Thus, firms tend to have a long-run target payout ratio although

their actual payout ratio fluctuates over time around this target ratio,

depending on profits or prospects, as well as on investment requirements and

the external financing environment. These considerations suggest that the

aggregate dividend payment (Dv) may, along the lines of the early study of

Lintner (1956), be estimated by the following partial adaptation process:

ADv &aDv 1 + b (d E 1 DV 1) or (15)

Dv -b- E + (1 + a -b) Dv (15')-1 -

where E = corporate income after taxes and transfer payments, one-

period lagged because the dividends are paid from earnings

in the previous period.

d = long-run target payout ratio, and

a, b = positive constants.

Since div Dv/E = (E 1 /E) (Dv/E 1) and given equation (15'), we may

express and estimate (Dv/E 1) as follows:

Dv - = b-d + (1 + a - b) div 1 (16)

= dv ((1-t c)r - p, Mp - n, FBc/E_l, in, div_1 )

- 17 -

where tc = corporate income tax rate, and

FBc = corporate borrowing (flow) from abroad.

In the above, the aggregate target dividend ratio (d*) is assumed to

be affected by the financial market situation and the underlying prospects for

corporate earnings. The higher cost of after-tax real borrowing and scarce

domestic or foreign credit are expected to discourage high dividend payouts in

favor of more intert.al financing. An economic slowdown, as measured by the

non-agricultural GNP growth rate, may also lower the dividend payout ratio, as

in such an environment earnings prospects deteriorate, and the likely

concomitant downturn in the stock market makes new equity financing very

costly and less feasible.

E. Government Consumption

How much government revenue is saved for public investment or net

lending is another crucial determinant of national saving. The relative size

of government revenue and its division between consumption (current

expenditure) and zaving should largely reflect the nature and role of the

government. Nevertheless, insofar as those factors remain relatively stable

for a given country, government consumption/saving behavior may be

substantially influenced by budgetary and other economic conditions.

To the extent that current expenditures, including spending on

general administration and social services, are less elastic to aggregate

income than is revenue, the government consumption/revenue ratio will decline

when government revenue rises relative to GNP (rg). It may also be argued

that the composition of revenue sources as well as the volume of revenue have

an impact on government consumption/saving behavior. Of particular interest

- 18 -

is how net foreign transfers to the government affect its consumption/

saving. Moreover, an undisciplined government may use increased external

borrowing to supplement government consumption. A significant positive

c,insumption effect of transfers and borrowings from abroad indicates that

foreign saving is preempting national saving.

Finally, each different category of government expenditure must have

a different consumption/investment composition. For instance, spending on

general administration, defense and social services is more likely to involve

consumption expenditures, while most economic development spending consists of

investment outlays. This point, however, is not pushed too much here, and

only defense spending, which accounts for a substantial share of government

expenditures in countries like Korea, is highlighted.

The government consumption/revenue ratio (cg) may be estimated asg

follows:

cz = cg (rg, TRf/Rg, FBg/Rg, DF/Rg) (17)

fwhere TR = Net foreign transfers to the governmentg

Rg = Government current revenue

FBg = External borrowing (flow) of the government, and

DF = Government defense expenditure.

F. Effective Rates of Personal Direct Taxes and Corporate Income Tax

For a given set of tax rates, the effective tax rates are influenced

by such economic conditions as the business cycle and inflation, as well as

the progressiveness/regressiveness of taxes. To evaluate the effect of

discretionary fiscal measures on national saving, we need to separate this

effect from the time-series tax data, a task that is not easy because

discretionary tax changes usually cannot be measured accurately. For our

model, all changes in the indirect tax/GNP ratio (ti) are regarded as

discretionary, since indirect tax revenue is supposed to be roughly unit-

elastic with respect to nominal income or expenditures. For direct personal

taxes and the corporate income tax, adjustments are made for changes in (non-

agricultural) economic growth and inflation rates.

We first estimate the changes in the effective rates of direct

personal taxes (th) and corporate income tax (t*) as follows:h ~~~~~~~~~c

At* = th (Dth, A p (18)

At = t (t , Dt, Ai , Ap) (19)c c c c n

where Dt h = Dummy variable for major discretionary changes in personal

direct taxes

tc = (Highest marginal) corporate income tax rate, and

Dtc = Dummy variable for major discretionary changes (such

as exemptions and reductions) in corporate income tax not

reflected in (At ).c

Then, we rewrite the estimation results of the above equations as follows to

separate the discretionary and other parts (the "other" part includes the

correction for the business cycle and changes in inflation rates):

* ^ . A **(1'th -h Ay + h P tp (18')h y n p h

- 20 -

c cy in p P c (19')

where

hy, h ; c y, cp = Estimated coefficients for (Ain) and (Aj) in

equations (18) and (19), respectively, and

t , t = Residuals in each equation, reflecting allh c

"discretionary" tax measures.

G. Allowances for Capital Depreciation

Capital depreciation allowances are usually very stable and do not

make a significant difference in the annual national savings ratio. They are

endogenized, however, because they are believed to be affected by economic

conditions. Capital depreciation allowances (DP) may be viewed as consisting

of those for existing (before the current fiscal year) ard those for newly

acquired capital.

*~~~

DP (l- 6)DP_ + 61 or (20)

d DP/Y = (1 - 6) d_1 (Y_I/Y) + 6*(I/Y) (20')

where 6, 6 = Average depreciation ratios for existing and

newly invested capital, respectively

I Fixed capital investment (nominal)

Y = Nominal GNP, and

d = Ratio of depreciation allowances tc GNP.

- 21 -

In the above equation, the depreciation rate for existing capital

stock (6) should be stable, as its composition in terms of asset type and

age changes only slowly and the choices of depreciation methods are already

made. The depreciation rate for new fixed investment (6 ) may be somewhat

variable because firms can choose among alternative depreciation methods for

new fixed capital. It may increase when inflation accelerates, as more firms

adopt, say, the sum-of-the-years-digit method instead of the straight-line

method of depreciation. By doing so, they can reduce the inflationary erosion

of the present value of the total allowance stream over the life of a fixed

asset. FinaJly, the investment/GNP ratio (I/Y) is expected to move in a

procyclical manner.

Taking these considerations into account, the depreciation/GNP ratio

may be estimated as follows:

d = d [d_1 (Y_1 /Y), Ps in, Ddl (21)

where Dd = Dummy variable for any episodes of accelerated depreciation

allowed by the authorities (or abolition of such measures)

for the purpose of stimulating investment.

Noting, in equation (20'), that the ratio of corporate investment to GNP

shows a rising trend because of the increasing corporate role in the economy

and the rising capital/output ratio, and that the (Y 1/Y) ratio can be

approximated by (p) and (in) the equation for corporate depreciation (d c)

may be estimated as follows:

d= dc (jins,Qn Yn, Dt) (21')

- 22 -

where Yn Real non-agricultural GNP, with which relative corporate

activity increases.

III. Estimation Results

A. Korea

The equations were estimated for Korea using annual data. The

sample period runs from 1963 to 1984 (unless otherwise indicated). The years

1985-86 could not be included because some sectoral national income data were

not available and because the ne1w system of national accounts since 1985

entailed discontinuity in many of the sectoral data. Equations were estimated

by the ordinary least square method, and the t-values are presented in

parentheses below or beside the coefficients.

Household Saving

The estimated equations of the ratio of household saving to

*disposable income (sh) are presented in Table 2. They show that this ratioh

is heavily dependent on both the level (yq) and the growth rate (j) of

income. Change in the growth rate of income, (Gj) also turned out to be

significant. The quadratic income variable (yq) indicates that the positive

income (level) effect on the savings ratio becomes smaller and smaller and

will no longer pertain soon after the sample period. Changes in the terms of

trade (T t), however, have no significant effect.

The coefficients of the two financial variables are also

significant. Exclusion of one variable resulted in little change in the

- 23 -

Table 2 *Regression Results for Household Saving (s ): Korea

(Sample: 1964-84) h

(22-1)* (22-2) (22-3) (22-4)

Constant -0.323 (9.01) -0.291 (6.16) -0.256 (5.23) -0.324 (8.82)

i 0.730 (10.5) 0.704 (9.53) 0.671 (6.47) 0.712 (9.41)

T __ 0.045 (1.04) __ __

Ay -0.153 (2.65) -0.124 (1.96) -0.065 (0.79) -0.144 (2.39)

Yq 1.000 (8.01) 0.830 (4.04) 0.598 (4.83) 0.991 (7.72)

(fin/y) -0.0846 (4.25) -0.0642 (2.30) __ -0.0843 (4.14)

r _ p 0.00164 (4.74) 0.00137 (3.19) 0.00157 (2.98) 0.00172 (4.62)

tr/y 0.954 (2.54) 1.221 (2.69) 0.919 (1.61) 0.957 (2.49)

D(72.73) 0.0320 (5.27) 0.0310 (5.07) 0.0288 (3.14) 0.0314 (5.01)

hl 0.390 (3.83) 0.505 (3.36) 0.616 (4.67) 0.386 (3.70)

ADPR -- ___ __ -0.168 (0.68)

R2/D.W 0.989/2.31 0.990/2.32 0.973/1.60 0.990/2.30

Notes:yq = 0.000808 y - (4.31/107) y2

ru = Curb loan interest rate

p - Two-year moving average of inflation rate (p).

D(72.73)= Dummy variable for the August 3, 1972 measure (1 for 1972-73, 0otherwise), and

DPR = Population dependency ratio with ages 15-64 as the productiveage group.

- 24 -

coefficient of the other variable, the implication being no multi-

collinearity. This conclusion, however, should not be taken to imply that

holdings of household assets or the degree of financial development (fin/y) is

independent of the real interest rate. As a representative market interest

rate, the curb market rate (ru) performed better than other alternatives in

terms of the t-value as well as the overall fit o: the equation. To determine

the expected inflation rate that is needed to get the real interest rate, the

two-year moving average of the GNP deflator inflation (pm) was used after

different time lags were tried.

The household net transfer receipts/income ratio (tr/y) turned out

to be significant, with a coefficient close to 1.0. The implication is that

net transfer receipts have mostly replaced household consumption out of earned

income in Korea. The dummy variable D(72.73) was introduced to reflect the

August 3, 1972 curb market freeze: every outstanding curb loan was to be

registered with the tax office by both the lender and borrower, to be followed

by a government-imposed reschedAling of the repayment and a readjustment of

the curb interest rate. These steps together lessened the financial burden of

business firms substantially. This measure must have affected the

consumption/saving behavior of wealthy households, as it increased uncertainty

in their income prospect. It also produced a discontinuity in the curb loan

rate (which dropped from 46.4 percent in 1971 to 33.4 percent in 1973 before

rising to 40.6 percent in 1974) as a representative free market interest rate.

The population dependency ratio (DPR) was tried as a demographic

variable that might influence household saving. It showed no additional

effect. When DPR was used as a replacement for the income variable (yq), it

emerged as significant but caused a considerable deterioration in the overall

fit of the equation. The high multicollinearity between income and DPR, which

- 25 -

declined from 88 percent in the mid-1960s to 55 percent by 1984, is confirmed

by the following DPR equation:

DPR = 1.339 - 1.976 yq

(17.5)

Sample = 1964 - 84

R2 = 0.941 D.W. = 0.22.

Medical insurance is the only significant social security/insurance scheme in

Korea. Its coverage rose steadily after a major expansion in 1977 to reach 42

percent of the population by 1984. There is, however, no evidence that it

discouraged household saving.

Interest Rate and Financial Development

The interest rate differential between the curb loan rate (ru) and

the regulated bank deposit rate (rd) was estimated, instead of using (ru)

itself, as (rd) c)nstitutes the floor rate for (ru). Holdings of household

financial assets relative to disposable income (fin/y), or a measure of

financial development, proved to be the most significant variable in

determining the interest rate differential. That results should not be

surprising since the development of financial markets leads to the integration

of the curb and the official markets, thereby reducing interest rate

differentials between the two markets.5/ Another variable reflecting short-

run pressure in the money market, h(Mp - Yn), was marginally significant in

explaining the interest rate gap. The change in the (expected) inflation rate

showed a significant positive impact on the interest rate gap, a result

indicating that a 1 percentage point acceleration in the GNP deflator

- 26 -

inflation rate leads to a 0.22 percentage point increase in the curb loan rate

over the bank deposit rate. Finally, a dummy variable, D(64.65), was

introduced to reflect the major shift in the interest rate policy in Korea in

late 1965: the bank interest rate on a one-year time deposit, for instance,

was raised from 15.0 percent to 26.4 percent per year. This interest rate

reform seems to have shifted the demand for credit and supply in the curb loan

market substantially, the result being a net reduction of the interest rate

differential by more than 15 percentage points.

r - r = 37.14 - 24.36 (fin/y) 1 -0.0397 A(Ap - in) (23)u d _(24.8) (9.20) (1.69)

i 0.216 hp + 15.53 D (64.65)(3.77) (9.19)

Sample = 1964 - 84

R2 = 0.957 D.W. = 1.45

where rd = Bank interest rate on a one-year time deposit, and

D(64.65) = Dummy variable for 1964-65 (1 for these years,

0 otherwise), which represents the period of low

(official) interest rates.

Holdings of household financial assets relative to income (fin/y)

were estimated to be significantly influenced by per capita disposable income

(y) and the polynomially distributed lags of the bank deposit interest rate

(rd) and the inflation rate (pW. The estimated equation suggests that

interest rate regulation can severely repress financial development: a 1

percentage point increase in the nominal bank deposit interest rate raises the

- 27 -

(fin/y) ratio by about 0.009 in four years. The coefficient of the (weighted

average) inflation rate turned out to be almost twice as large as that of the

nominal deposit rate. Finally, household demand for financial assets seems to

be fairly income-elastic. The financial ratio actually rose from 0.23 in 1964

to 0.95 in 1984, largely because of income growth:

fin = -2.406 + 0.492 In y + 0.00885 rd - 0.01746 pw (24)

(8.60) (13.1) (2.82) (6.74)

Sample = 1965 - 84

R2 = 0.939 D.W. = 1.08

where rd =0*3r + 0.4r + 0.3r andd d_I d_2 _

= 0.39 j + 0.30 ._1 + 0.20 p_2 + 0.llp_3.

Corporate Income

Major cost factors, the business cycle and the GNP share of

agriculture were fairly significant in explaining the ratio of corporate

income to GNP (yc). However, with respect to the three cost variables --

terms of trade (t ) , real wage/productivity ratio (w/Pd), and cost oft p

borrowing (rb), the terms of trade were not significant. Although the

commodity shocks may have seriously affected the major macroeconomic

variables, Korean corporations seem to have managed to shift any rise in

intermediate import costs to the composite prices of their own products,

selling in both the export and domestic markets. As a representative

borrowing rate, the bank lending rate (r b) was one-year lagged, because this

approach improved the fit of the equation noticeably. There seem to be some

lags involved in the cost and inflation accounting of corporations and/or

between the announcement of a new rate and its application to existing loans.

- 28 -

The procyclical nature of corporate income is weakly confirmed by

the marginally significant positive coefficient of the rate of real (non-

agricultural) GNP growth (in). In the estimated equation, the GNP share of

agriculture (6 a), which dropped steadily from 43 percent to 14 percent

during the 1963-84 period, is the major trend variable for (Yc) in the absence

of an offsetting movement in some of the cost factors.

Dependent Variable: Yc

Constant r exrPdb r - R

(25-I ) 0.201 -- -0.00228 -0.00135 0.00071 0.00091 -0.248 0.901(5.63) (3.74) (4.82 (1.92) (3.70) (8.27) 1.50

(25-2) 0.211 0.013 -0.00245 -0.00135 0.00057 0.0009) -0.258 0.903(5.22) (0.56) (3.54) (4.73) (1.25) (3.63) (7.3a3 1.66

:ote- r f Bank interest rate on general loans.

It may be argued that the bank lending rate is not a good proxy for

the average cost of borrowing, since Korean corporations borrow heavily from

aboard and, to some extent, in the curb market. However, when a composite

borrowing rate, incorporating both (rb) and a measure of foreign borrowing

cost, was used, the equation showed a slight deterioration, and the curb loan

rate also turned out to be very insignificant. The foreign borrowing cost was

approximated by using the sum of the LIBO rate and the foreign exchange loss,

the latter measured as the five-year moving average of exchange rate

depreciation (in light of the deduction of the exchange rate loss allowed over

the ensuing five-year period for tax purposes in Korea).

- 29 -

Dividend Policy

As expected, corporate dividend payments seem to be heavily

influenced by those of the previous year. The after-tax real cost of bank

borrowing [(1-tc) rb - P] also proved to be significant in determining the

dividend payout ratio (Dv/E 1 ). The implication is that Korean firms try to

use more internal financing when they face a high cost of borrowing. However,

credit availability, either domestic credit to the private sector

(Ap - Yn) 1 or foreign borrowing (FBc/E 1), did not have any significant

impact on corporate dividend ,oLicy. The coefficient of (y ) indicates that

the dividend payout ratio moves procyclically, probably reflecting the

prospects for corporate earnings and new stock issues.

A dummy variable for 1973, D(73), was introduced to capture the

impact on the dividend policy of the August 3, 1972 curb loan freeze. As a

part of that measure, the "disguised" curb loans (those provided by the

executives or major stockholders of the firm, which amounted to about 30

percent of the total reported curb loans) were transformed by decree into

equity stock. The "disguised" curb loan lenders obviously tried to get as

much dividends as possible on their forced holdings of equity stocks. In most

years of the sample period, the dividend payout ratio ranged from 24 percent

to 64 percent. In 1973, it reached 115 percent.

Dv = -0.040 - 0.00527 ((1 -tc) rb - P] + 0.00135 (Ap - in)1E -1b

(0.54) (2.13) (1.15)

+ 0.0091 FBc/E + 0.00896 Y + 0.913 div* + 0.655 D(73) (26)

(0.36) (2.21) (v.781 (8.19)

R = 0.903 D.W. = 1.96

- 30 -

where D(73) = Dummy variable for the impact of the August 3 measure on

corporate dividend policy (1 for 1973, 0 otherwise).

Government Consumption

How much the government consumes out of its revenue (c ) isg

strongly related negatively with the size of government revenue relative to

GNP (r ). It seems that the income elasticity of demand for government

current spending is smaller than that of government revenue. Net government

receipt of foreign transfers (TR ) has a significant negative impact ong

government consumption. As far as the Korean government is concerned, there

seems to be no sign o' foreign saving preempting national saving. As foreign

transfer receipts replace tax revenue to leave total revenue unchanged, the

estimated equation says that Korean government saving increases by 17.5

percent of the transfer receipts. Government borrowing from overseas (FBg),

which is not part of current revenue does not, however, show any significant

impact on government consumption.

As an expenditure item, a one unit increase in defense sper.ding (DF)

is estimated to result in a 0.67 unit rise in government consumption.

Finally, a dummy variable for 1978-79, D(78.79), is significant.

This variable was introduced to incorporate the restrictive fiscal policy

adopted in Korea in response to the overheated economy and accelerating

inflation during 1976-78. The government's efforts to slow public spending

were focused mainly on cuts in current expenditures.

- 31 -

c = 0.770 - 1.991 r - 0.175 TR /Rg - 0.031 FBg/Rg + 0.674 DF/Rg

(9.36) (7.28) (2.49) (0.28) (5.32)

- 0.0456 D(78.79) (27)

(3.56)

R2= 0.940 D.W. = 2.22

where D(78.79) = Dummy variable for the restrictive fiscal policy

during 1978-79 (1 for those years, 0 otherwise).

Effective Tax Rates

The change in the effective personal direct tax rate (At*) turnedh

out to be positively affected by changes in the non-agricultural GNP growth

(in) and inflation (p) rates, although the latter was not statistically

significant. Korea's major personal income tax reductions in 1963, 1972 and

1977 seem to have lowered (t*) by an average of 0.5 percentage point in theh

first two years.

Ath = 0.187 - 0.493 Dt + 0.0386 Ain + 0.0097 Ap (28)h ~~~~h n(3.46) (5.09) (3.23) (1.26)

R2 = 0.685 D.W. = 1.08

where Dth Dummy variable for major changes in the personal income tax

burden (-1 for 1963-64, 1972-73, 1977-78; and 1 for 1976).

In contrast to the situation with personal direct taxes, the change

in the effective corporate income tax rate (At ) was estimated to be anti-c

cyclical (a negative coefficient for Ain), a result that is consistent with

- 32 -

the roughly unitary tax rate and the absence of a negative tax. The change in

the inflation rate, however, had no systematic impact. Turning to

discretionary tax measures,a 1 percentage point change in the representative

corporate tax rate (tc, the highest of the two or three marginal tax rates)

seems to have affected the effective tax rate by 0.58 percentage point. The

effective corporate income tax rate, however, was influenced more

significantly by other discretionary measures, such as administrative tax

reductions, an allowance of a deferred tax ;iyment, aimed at alleviating the

corporate profit squeeze in times of economic recession (1972 and 1980), and

the elimination of tax exemptions and reductions provided to "strategic"

industries (1982).

At = 2.26 + 0.577 At + 10.63 Dt - 0.325 ay (29)c c c n(3.06) (2.75) (8.72) (2.20)

R = 0.839 D.W. = 1.43

where Dtc = Dummy variable for the administrative reductions of the

corporate tax burden (-1 for 1972 and -2 for 1973), allowance

of deferred tax payment (-1 for 1980 and 1 for 1981), and

revision of the Tax Exemption and Reduction Control Law to

reduce tax benefits for "strategic" industries (1 for 1982).

When the "discretionary" tax rates (t* and t* ) were calculatedh c

through equations (18') and (19'), they emerged as not very different from the

actual rates. The implication is that the impact of business cycle or price

movements on the effective tax rates is relatively small.

- 33 -

Capital Depreciation Allowances

The estimated equations for capital depreciation allowances (as

ratios to GNP) for households (unincorporated businesses, dh), corporations

(dc) and the government (enterprises, dg) all look reasonable. The

coefficients of d- (Y1 /Y) in the (dh) and (dg) equations may look a little

small because they imply an average life of fixed capital of around three

years. For the aggregate data, however, which include newly established firms

as well as those going out of business, the coefficients can deviate from what

is expected for on-going firms only.

The inflation (p) and non-agricultural GNP growth (in) rates both

showed positive coefficients in the equations for household and government

depreciation allowances. It does not mean that the overall effects of these

variables on the ratio of depreciation allowances to CNP are necessarily

positive, however, because the explanatory variable (d 1(Y 1/Y)) is

negatively related to (p) and (Yn). Actually, in the equation for corporate

depreciation allowances, where the specification is different from that for

the household and government sectors, (p) and (Yn) show significant negative

coefficients. This situation occurs where depreciation allowances based on

purchase prices reduce the real value of the allowances in a highly

inflationary environment.

As the capital accumulation of corporations has been much faster

than GNP growth in Korea, their depreciation allowances increased steadily

from 2.4 percent to 6.7 percent of GNP during the 1963-84 period. This trend

is captured by the (in yn) variable in the equation. Also significant for

the household and corporate depreciation allowances is the dummy variable,

(Dd), which represents the active utilization of accelerated depreciation as a

means of investment incentives. Another dummy variable (D(82)) was necessary

- 34 -

in explaining the government depreciation allowances, as an important public

corporation was removed from the government sector.

dh = 0.752 h 0.672 dh (Y_1/Y) + 0.00922 j + 0.0102 y+ 0.320 Dd (30)1~~~~~~~~~~

(2.26) (4.30) (2.52) (2.08) (4.93)

R= 0.715 D.W. = 1.87

where Dd = Dummy variable for 1973-74 when accelerated depreciation was

widely allowed to stimulate fixed investment, and 1982 when the

Tax Exemption and Reduction Control Law was revised to

eliminate tax holidays and investment tax credit from the

optional set of tax incentives, and only accelerated

depreciation was retained (1 for 1973-74, 1982, and 0

otherwise).

d = -9.65 - 0.0421 p - 0.0379 Yn + 1.55 in y + 0.731 Dd (31)

(7.77) (4.46) (2.49) (13.6) (3.76)

2R = 0.956 D.W. = 1.62

dg = 0.0768 + 0.635 dg 1 (Y_1/Y) + 0.00295 p + 0.00365 Yn (32)

(2.34) (5.38) (2.76) (2.60)

- 0.146 D(82)(4.27)

R2 = 0.868 D.W. = 2.23

- 35 -

where D(82) = Dummy variable for 1982, when the Korean Telecommunications

Authority was no longer classified as part of the government

sector (1 for 1982, 0 otherwise).

B. The Philippines

While the analytical framework for the determination of national

savings is the same for Korea and the Philippines, the model had to be

slightly modified for the Philippines because of the unavailability of certain

data. The data that were unavailable for the whole of the 1963-85 sample

period included interest rate in the free market, corporate dividend payments

to the household sector and sectoral capital depreciation allowances. Thus,

the Philippine savings model, which is somewhat simpler than the Korean model,

has the following structure:

s sn + n + Sn + d (33)h c g

n d * fh =h *h - trh

d y = Y (1-(l t*) + tr (34.1)

Yh 11- (yc + yg + ti + d) (34.2)

sn = Y: (1 - tC* )35cc c

s = r (1 - c*) - trf (36)gg g g

- 36 -

rg th Yh tC YC + ti + Y g+ trh

(36.1)

where sn sn s = Net savings ratios (as shares of GNP, excluding the

capital depreciation allowances) of the household,

corporate and government sectors, respectively

d Capital depreciation allowances for all sectors as

share of GNP

Yc= Corporate income after transfer payments and dividend

payments to the household sector as share of GNP, and

t Ratio of corporate income tax to corporate incomec

after transfer and dividend payments.

The estimated equations for the above model are presented below.

All, the equations were run for 23 annual samples from 1963 to 1985 using the

ordinary least square method. The t-values appear in parentheses below or

beside the coefficients.

Household Saving (sh)h

(37-1)* (37-2) (37.3)

Constant 0.116 (3.28) 0.0961 (3.29) 0.357 (2.13)

i 0.453 (5.19) 0.459 (5.27) 0.472 (5.53)

In y __ __ -0.039 (1.47)

(M3/Y)_1 -0.321 (2.82) -0.287 (2.64) -0.197 (1.42)

A(r d_1-p)1 0.00043 (1.80) 0.00044 (1.85) 0.00041 (1.76)

tr/y -0.369 (1.00) -- -0.079 (0.19)

Shi 0.635 (6.91) 0.670 (7.86) 0.630 (7.08)

RtTD~.W. 0-. 9 16/1. 7 0 -0 .9H11/. 7 5 0.926/1.94

- 37 -

where M3/Y = Ratio of M3 (year-end) to GNP, and

rd = Year-end interest rate on one-year bank time deposit.

The explanatory variable (M3/Y) in the (sh) equation was endogenized usingh

the following equation:

M3/Y = -0.947 + 0.173 tn y - 0.00257 p w (38)(4.30) (5.53) (5.01)

Et = 0.656 D.W. = 1.33

where w = 0.44 p + 0.40 P_1 + 0.16 P 2

(b) Corporate Income

yc = 0.149 - 0.0228 (w)/Pd - 0.00089 r (39)C ~~~~~p

(6.07) (1.96) (1.37)

+ 0.00160 Y + 0.00026 P - 0.302 6n a

(1.75) (0.95) (3.46)

R= 0.745 D. W.= 1.14

1*. m3where r = 0.8 rmb + 0.2 (Libor + Ie ./4)

b i0O-2

rb Moving average of the year-end interest rate on one-year

bank loans (rb)

Libor = Short-term (three-month) LIBO rate, and

e = Rate of change in the exchange rate (per U.S. dollar).

- 38 -

(c) Government Consumption

* ~~~~~~~~~~~fc = -0.199 + 0.1003(1/r ) + 0.988 TR /Rg + 0.033 FBg/Rg (40)

(3.57) (18.3) (1.12) (1.05)

+ 0.590 DF/Rg - 0.091 D(84.85)(4.67) (4.09)

R = 0.960 D.W. = 2.09

where D(84.85) = Dummy variable for the restrictive fiscal policy

during 1984-85 (1 for those years, 0 otherwise).

(d) Effective Tax Rates

ath = 0.056 + 0.542 D(74.77) + 0.0297 Ai + 0.0110 Ap (41)h~~~~~~~~~~~(1.58) (7.13) (2.74) (3.24)

R = 0.795 D.W. = 1.53

where D(74.77) = Dummy variable for the effects of granting a tax amnesty

(1974) and the extension of the withholding tax (1977) to

income on financial assets (-2 for 1974, 1 for 1977, 0

otherwise).

At -2.24 - 3.994 Ai - 6.371 Ai + 1.210 Ai (42)c n n_

(0.73) (3.67) (5.34) (3.65)

R= 0.726 D.W. = 2.00

- 39 -

(e) Capital Depreciation Allowances

d = -4.848 + 0.858 d I (Y 1/Y) + 0.0364 j + 0.638 in yn (43)

(2.52) (11.4) (7.32) (2.82)

+ 0.521 D(70.71.75)(8.14)

R2 = 0.981 D.W. = 2.45

where D (70.71.75) = Dummy variable for 1970-71 when the Investment -

Incentive Act (1967) allowed accelerated depreciation

and for the investment boom of 1975 (2 for 1970 and

1975, 1 for 1971, 0 otherwise).

Surprisingly enough, the ratio of household saving to disposable

income (sh) for the Philippines was not positively affected by income

level. Actually, the income variable (in y) showed a negative coefficient,

although it was statistically insignificant when a variable representing the

level of financial development (M3/Y) was introduced. As per capita personal

disposable income grew at a rate as slow as 1.31 percent a year during 1964-

85, the income level itself does not seem to have been a major factor in

explaining household saving in the Philippines. On the other hand, the growth

rate of income (y) turned out to be very important, although change in the

terms of trade was very insignificant. As was the case for Korea, increased

household holdings of financial assets relative to income, approximated by

(M3/Y), seem to discourage new saving. The real bank deposit interest rate

did not have any substantial impact on household saving: only a lagged change

- 40 -

in the real interest rate, (A(rd d _ ))1) showed a marginally significant

positive coefficient. This result may not be surprising in view of the rather

inactive interest rate policy in the Philippines during the 1960s and 1970s.

Finally, unlike in Korea, there was no indication that household transfer

receipts (tr/y) have substituted their consumption out of earned income.

The financial developmen. variable WM3IY) was significantly affected

by the level of household disposable income (Qn y) and the (weighted average

of the current and lagged) rate of inflation (pj). Again, the nominal bank

deposit intereot rate did not have any positive impact on financial saving.

The (M3/Y) ratio, which averaged 25.4 percent during 1963-69 dropped to 21

percent in 1971-72, as inflation accelerated modestly, it then rose again to

almost 30 percent by 1983. In the serious stagflationary situation of 1984-

85, the ratio dropped back to 22-23 percent.

The ratio of corporate income to CUP (y ) was negatively affected

by the real wage/productivity ratio (w/Pd) and the composite cost ofp

borrowing. Since (yc) is net of dividend payments, it is positively

influenced by borrowing costs to the extent that the latter affect dividend

payments negatively. The fit of the equation was slightly better when the

cost of foreign borrowing was also incorporated in the calculation of the

borrowing rate. The relative size of the agricultural sector (6 ), non-

agricultural GNP growth rate (in), and inflation rate (p) also showed

expected coefficient signs.

The government consumption/revenue ratio (cc) for the Philippinesg

was well explained by the relative size of government revenue (r ), the ratio

of defense expenditure to government revenue (DF/Rg) and a dummy variable

for 1984-85. Facing the unfavorable overseas credit market in 1984-85, (cg)w

was reduced, despite a drop in (r 9), to narrow the fiscal deficit in a serious

- 41 -

stabilization effort. The estimated equation suggests that the fiscal

restriction amounted to about a 9.0 percentage point reduction in (c ). Theg

impact of net government receipts of foreign transfers (TR f/Rg) andg

government foreign borrowing (FBg/Rg) both turned out to be insignificant,

even though the relatively large positive coefficient for the former contrasts

with the negative coefficient for Korea.

The changes in effective rates of personal direct tax (Ath) and

corporate income tax (at ) seem to be affected significantly by changes inc

both non-agricultural GNP growth (hin) and the rate of inflation (hi). The

effects are all positive except for the strong negative impact of (Ad ) on

(At ) because of the absence of a negative tax. The dummy variable

D(74.77) included in the (At ) equation reflects the tax amnesty in 1972 andh

subsequent years and the extension of the withholding tax to dividend and

interest income in mid-1977.

Finally, the GNP ratio of the total capital depreciation allowances

(d) was fairly well explained by the lagged depreciation allowances

(d 1 Y 1/Y), whose coefficient (0.86) is roughly consistent with the

aggregate depreciation rate, inflation rate (j) and level of real non-

agricultural GNP (in Yn). The positive coefficient of (in Yn) may be

interpreted as reflecting the rising trent. of the aggregate capital/output

ratio. The dummy variable D(70.71.75) was introduced to capture the effects

of the Investment Incentive Act (1967) and to reflect the investment boom in

1975, when real fixed investment expanded 32 percent despite rather slow GNP

growth.

- 42 -

IV. Simulation Exercises

A. Base Simulation and Decomposition of Savings Performance

The identities and estimated equations were put together to form a

complete model, and a dynamic simulation was run to check the performance of

the model as an integrated system. For the dependent variable for which

alternative equations were presented, the one with an asterisk was used for

the simulations. The results of the base simulation are shown in Figures la

and lb, while the summary statistics are presented in Table 3. The models for

both Korea and the Philippines track the aggregate and sectoral savings ratios

remarkably well, although the fit for the Philippines is somewhat inferior to

that for Korea.

The correlation coefficient between the actual and predicted values

of the national savings ratio is 0.994 for Korea and 0.965 for the

Philippines, and the percent root-mean-squared error (RMSE) is about 3.5

percent for both. As to the sectoral savings ratios (net of depreciation

allowances for the Philippines), the percentage RMSE ranged from 5 - 9 percent

for Korea and 13 - 18 percent for the Philippines. The prediction of the

corporate savings ratio seems to be more difficult than that for household or

government saving, particularly for Korea. 'he base simulation results were

also fairly good for most of the other major endogenous variables. The

variables whose correlation coefficients between the actual and predicted

values are lower than 0.90 or whose percentage RMSEs are over 15 percent

include only the dividend payout ratio (div*) for Kozea and the GNP ratios of

M3 and corporate income (M3/Y and Yc) for the Philippines.

To determine the major factors responsible for the evolution of the

national savings ratio, a set of simulations involving shocks were run for the

Fiaure laBASE SIMULATION RESULTS: KOREA

(1965-84)

30 -

2-- Actual- - - -Simulated *

26APd24

22-

20-} 2 ° a National Savings Ratio

I 6 - H~~~~~~~~~~~~~ouseholdn Savings Ratio

10

, ! ~~~~~~~~~~~~~~~Corporate SavinTgs ~tlo

4

2:l~ I -.

65tg 667 9 7 1 73 70 77 79

Year

Flaure lbBASE SIMULATION RESULTS: PHILIPPINES

(1963-B5)

24

22 ~National Savings Ratio

20.1 1

- - - -Simulated

1 4

1 2 CHousehold Savings Ratio

10

4 A

2

4 Coprte Savings Ratio

2

-2-O3 67 71 7a 75 77 79 O1 * 5JS

Year

Table 3Performance of Base Simulation: Comparison of Actual and Predicted Values

Korea 1965-84 Phili ippnes 1963-85

Endogenous Correlation RM4SE a R iMSE RCAP b Endogenous Correlation iRMSE a/ S i 4SE RCAPVariables Coefficlent (S) (Rt4SE/Mean) Variables CoeffIcient (M) (R4MSE/Mean)

s 0.994 0.69 (3.5) 1.01 s 0.965 0.77 (3.7) 0.97

Sh 0.989 0.68 (8.7) 0.95 sn 0.977 0.79 (12.8) 1.26

s 0.951 0.42 (6.4) 1.03 sn 0.951 0.48 (17.7) 1.06c c

sg 0.987 0.26 (5.0) 0.99 Sn 0.948 0.46 (17.1) 0.95

ru 0.987 1.59 (3.7) 1.02 d 0.993 0.14 (1.6) 0.98

fin/y 0.969 4.42 (7.8) 0.99 M3/Y 0.788 1.46 (5.7) 0.97

Yh 0.989 0.52 (0.7) 1.05 Yh 0.963 1.25 (1.6) 1.21

Sh 0.986 1.90 (10.2) 0.94 5h 0.975 0.96 (10.3) 1.25

YC 0,937 0.50 (9.0) 0.97 yc 0.863 0.75 (17.2) 1.00

div* 0.851 10.79 (23.1) 0.89 __ __ __ __ __

r9 0.997 0.16 (1.0) 0.98 r9 0.971 0.32 (2.7) 0.97

c9 0.965 1.49 (2.3) 0.98 c 0.936 3.49 (4.5) 0.93

Notes:

a/ RMSE - Root - mean-squared error

b/ RCAP R Regression coefficient of actual on predicted.

- 46 -

major exogenous variables. The shocks included: (i) real bank (deposit and

lending) interest rates (rd, rb); (ii) discretionary tax policies

(t** t** and t , t (iii) per capita real GNP and personal disposable(h , n c'income (y); and (iv) the real wage/productivity ratio (p/Pd). More

pspecifically, these exogenous variables, individually or as a group, were

assumed not to have changed at all from the starting year of the simulation

(1964 for Korea and 1963 for the Philippines). The dynamic simulation results

were then compared with those of the base simulation to determine the net

effect of the shock, or the contribution of the respective variable.

Tables 4a and 4b show the contribution of these factors to the

national savings ratio. What is obviocs from the tables is the importance of

economic growth in the determination of aggregate savings, particularly for

Korea. In its case, the simulation results indicate that, without per capita

income growth throughout 1965-84, the national savings ratio would have been

26.4 percent points lower than the actual ratio of 27.3 percent in 1984. Also

clear is that the economic recession during 1980-82 was mainly responsible for

the considerable drop in the national savings ratio from 28 percent during

1977-79 to a 22 percent during 1980-82. In the Philippines, without the per

capita income growth, the national savings ratio during 1973-77 would on

average have been 2.3 percentage points lower than the actual ratio of 22-24

percent. The analysis also indicates th&t the sharp drop in the Philippine

national savings ratio from 24.4 percent to 16.1 percent between 1981 and 1985

was totally attributable to the decline in per capita income.

The changes in the real interest rate had little effect on aggregate

saving in the Philippines, although they played some role in Korea. The shift

to a high interest rate policy in 1965 seems to have contributed about 4.0

percentage points to Korea's national savings ratio during 1965-67. However,

- 47 -

Table 4aContribution to National Savings Ratio (NSR) by Major Factor: Korea

(S of GNP)

Real Intarest Discretionary Per Capita Wage/Productivity ActualRate Tax Policy GNP/Income Trend NSR!1

1965 3.78 -0.16 2.14 -0.18 5.701966 4.57 -0.32 7.77 -0.25 10.361967 3.54 0.36 8.56 -0.39 9.821968 1.81 1.00 11.30 -0.41 13.581969 0.79 0.99 15.74 -0.41 17.55

1970 0.19 1.89 15.33 -0.62 15.751971 0.43 1.80 16.03 -0.71 14.591972 -0.55 1.71 15.76 -0.80 16.541973 -1.03 1.55 20.35 -0.81 22.781974 -2.19 1.26 20.75 -0.45 19.89

1975 -1.69 0.14 20.24 -0.23 19.101976 0.05 0.38 23.92 -0.24 23.851971 1.86 0.52 27.16 -0.24 27.491978 1.57 1.54 27.85 -0.55 28.461979 1.10 2.19 26.60 -0.93 28.10

1980 0.67 2.20 20.07 -1.37 21.851981 1.38 2.28 21.29 -1.48 21.671982 1.60 2.53 22.62 -1.68 22.391983 1.30 3.36 25.55 -2.18 24.841984 0.84 4.50 26.35 -2.53 27.32

a/ The NSRs prior to 1970 are somewhat different from published figures, because they arederived from sectoral national Income data obtained by linking the 1975 base year data withthose of 1980 base year.

- 48 -

Table 4b

Contribution to National Savings Ratio (NSR) by Major Factor: Philippines

(S of GNP)

Real Interest Discretionary Per Capita Wage/Productivity ActualRate Tax Policy GNP/lncome Trend NSR

1964 -0.13 0.26 0.40 0.00 20.161965 -0.21 .0.17 1.03 -0.05 20.42

1966 -0.04 -0.25 1.23 -0.14 20.871967 -0.17 0.18 1.11 -0.13 18.881968 -0.21 0.20 1.31 -0.11 17.591969 -0.10 0.08 1.33 -0.12 16.63

1970 0.03 0.45 0.77 -0.01 18.251971 0.22 0,80 1.65 -0.10 18.071972 -0.26 0.94 1.48 0.08 17.621973 0.19 1.76 3.07 0.32 23.491974 1.04 2.48 2.27 0.61 22.21

1975 0.17 2.45 2.33 0.63 22.421976 -0.22 2.26 2.17 0.76 23.931977 0.57 2.33 1.84 0.81 24.371978 0.36 2.82 1.33 0.84 23.381979 0.46 3.31 1.42 0.86 25.54

1980 0.37 3.36 0.49 0.88 24.50

1981 0.G$ 2.61 -0.59 0.86 24.401982 -0.08 2.31 -1.85 0.87 19.961983 0.03 2.30 -2.53 0.81 18.931984 1.31 2.22 -7.51 0.91 15.661985 -0.54 2.04 -9.38 0.70 16.08

- 49 -

the gradual return to a low nominal intereE. rate thereafter, coupled with a

high rate of inflation during the period of the first oil price shock,

resulted in a contribution by the real interest rate of -2.2 percentage points

by 1974. Since then, its contribution reversed to a modest positive.

Discretionary tax policy seems to be potentially important in

determining savings in both Korea and the Philippines. For Korea, a

reflection of the strong tax efforts since the mid-1960s is that the

contribution of the discretionary tat. policy changes to the national savings

ratio reached 1.9 percent points by 1970. (t* ) and (t.) increased by 2.2h

percent and 4.8 percent points, respectively, between 1964 and 1970, even

though the positive savings effects of tnese tax changes were partly offset

(as will be shown sLortly) by the rising ( t_ ). As the effective tax rates

generally dropped during the first half of the 1970s, the savings contribution

of discretionary tax policy also declined substantially, before starting to

recover in the late 1970s. For the Philippines, there was a substantial jump

in the contribution of discretionary zax policy during the first half of the

1970s when tax enforcement was strengthened. Since 1981 when the economy was

in deep recession, the tax efforts were generally weak and reduced the

contribution by about 1.3 percentage points from the 1980 level.

Finally, the savings effect of changes in the real wage/productivity

ratio was rather stable and relatively small. In general, in Korea the real

wages increased faster than productivity, except for the mid-1970s, and since

the late 1970s has resulted in a growing negative contribution to aggregate

saving. There seems to be no evidence that Korea's income policy in the early

1980s affected labor workers unfavorably in any significant way. In the

Philippines, non-agricultural productivity grew faster than our measure of

- 50 -

real wages during the high-growth period of the mid-1970s, a phenomenon shared

by Korea; it made some positive contribution to the national savings ratio.

B. Savings Sensitivity to Exogenous Shocks

This section presents additional simulation results that evaluate

the savings effect of government policies and other exogenous variables. The

shocks for the simulation exercises include interest rate policy, tax policy

and the state of the economy in terms of inflation and growth.

(a) For interest rate policy, both bank deposit and lending rates

(rd and rb) were assumed to have been 1.0 percentage point higher

than the actual rates in real terms.

(b) For tax policy, two sets of simulation exercises were conducted.

First, to assess the effect of discretionary tax policy, tbh

effective tax rates (t. , tc and tc, t.) were individually assumed

to have been raised by some percentage points. Second, to evaluate

the savings effect of the tax structure, the effective rate of a tax

was increased while that of another tax was lowered to keep the

combined tax revenue constant.

(c) For the state of the economy, three simulation exercises were

undertaken, respectively, assuming: (i) an inflation rate 1.0

percentage point higher; (ii) a 1.0 percent increase in the real GNP

and income levels; and (iii) growth rates of real GNP and income 1.0

percentage point higher.

For both Korea and the Philippines, these shock simulations were run

starting with 1975. To evaluate the effect of the shocks, the results were

- 51 -

Table 5aMovaments of Major Savings Determinants: Korea

Effective Tax Rates (S) b Per Capita Wage/Productivity c/

Real Interest Real GWP Ratio (1980 = 100)

Rate (%) a t (t* ) t (t* ) ti Growth (3)h h c c

1964 -15,0 1.92 (2.05) 23.9 (22.8) 4.52 6.7 66.91965 11.6 2.31 (2.32) 22.9 (24.8) 5.76 3.2 76.81966 12.2 3.00 (2.83) 31.3 (32.1) 6.84 9.9 72.91967 10.5 3.28 (3.20) 35.5 (36.0) 7.68 4.2 '3.81968 10.2 3.85 (3.79) 39.7 (40.2) 8.99 b.7 76.91969 9.2 4.26 (4.32) 39.4 (38.9) 9.18 11.2 82.3

1970 7.1 4.08 (4.21) 39.4 (38.3) 9.34 5.3 86.51971 8.2 4.16 (4.22) 46.4 (46.2) 8.85 6.6 88.01972 -1.4 3.39 (3.53) 36.9 (35.5) 8.09 3.7 82.41973 -1.4 3.34 (2.97) 16.1 (19.5) 8.11 12.1 73.61974 -14.7 3.21 (3.41) 22.0 (19.0) 7.51 5.9 76.9

1975 -10.8 3.11 (3.16) 22.5 (22.4) 9.85 5.1 77.01976 -5.0 4.00 (3.74) 25.1 (27.7) 10.40 12.3 80.81977 0.0 3.51 (3.55) 28.1 (28.1) 10.31 11.0 87.31978 -5.2 3.41 (3.39) 32.2 (32.0) 10.81 8.1 92.61979 -2.5 3.52 (3.85) 42.0 (39.3) 11.02 4.9 97.5

1980 -2.7 3.40 (3.67) 37.6 (35.1) 11.68 -6.7 100.01981 3.4 3.61 (3.52) 51.2 (52.8) 11.99 4.6 102.71982 3.8 3.67 (3.64) 64.6 (65.5) 12.59 4.0 110.11983 5.0 3.85 (3.73) 54.3 (55.6) 13.74 7.8 113.31984 5.1 3.72 (3.76) 53.2 (52.8) 13.19 5.9 111.4

Notes:

a/ Real Interest rate = one-year bank time deposit interest rate - Inflation rate In terms of GNPdeflator.

* *b/ t and t are effective personal direct tax and corporate Income tax rates, respectively; and

- h** c s**

th and tc are correbponding 'tdiscretionary" tax rates. ti Is the GNP share of Indirect tax

revenue.

c/ Wage/productivity ratio = (Nominal manufacturing wages/GiP deflator)/non-agricultural value-added per

employee.

- 52 -

Table SbMovements of Major Savings Determinants: Philippines

Real Interest Effective Tax Rate (%) Per Capita Wage/Productivity

Rate (%, Real GNP Ratio (1980 = 100)

Year End) t (t t' (tC t. Growth (%)h h c c 2.

1963 -4.7 1.45 (1.35) 38.5 (39.3) 7.59 4.3 150.41964 0.0 1.66 (1.69) 38.9 (49.9) 7.72 0.4 150.31965 0.9 1.68 (1.73) 48.9 (38.8) 6.77 2.0 157.41966 1.0 1.54 (1.50) 34.0 (37.2) 7.10 1.3 165.31967 4.7 1.76 (1.77) 35.7 (48.0) 7.73 1.8 157.61968 -0.1 1.66 (1.65) 37,0 (36.1) 7.68 2.4 155.51969 0.2 1.67 (1.57) 44.7 (66.2) 7.26 2.1 157.9

1970 -7,8 1.71 (1,74) 40.1 (39.0) 8.06 0.9 143.51971 -7.1 1.94 (1,75) 59.8 (68.9) 8.20 3.5 160.61972 -0.0 2.09 (2.12) 50.6 (78.4) 7.99 2.4 133.71973 -11.1 2.44 (2.37) 63.6 (68.5) 9.17 6.2 113.8

1974 -24.0 1.42 (2.48) 49.2 (54.8) 10.89 2.6 92.4

1975 1.2 1.66 (1.51) 38.2 (47.7) 10.33 3.9 107.11976 0.3 1.60 (1.81) 34.9 (42.1) 9.24 4.1 94.01977 2.6 2.2' (1.64) 35.4 (49.0) 9.17 3.5 98.21978 0.8 2.29 (2.31) 34.2 (35.5) 9.84 3.0 101.71979 -5.2 2.50 (2.42) 19.2 (21.9) 10.53 4.0 99.3

1980 -3.6 2.33 (2.32) 19.0 (24.3) 10.02 2.2 ;00.01981 3.0 2.01 (2.04) 20.4 (9.4) 8.80 0.9 105.41982 7.2 1.84 (1*92) 23.2 (15.3) 8.80 -0.6 104.01983 2.5 1.66 (1,64) 22.8 (19.0) 9.27 -1.2 111.31984 -34.7 1.47 (1*79) 125.7 (44.6) 8.49 -9.2 117.11985 15.0 2.11 (1.58) 161.2 (141.5) 8.45 -6.2 132.8

Notes:

a/ t' and t' are, respectively, effective and corresponding "discretionary"' tax rates on corporateIncome after 1ividends.

b/ For 1981-85, manufacturing wages were obtained by linking to the manufacturing benefit index.

- 53 -

compared with those of the base simulation run for the same period. The

effect of a shock over time is presented up to five years after the shock, as

the effect usually shows little change thereafter.

The effects of a change in the bank interest rate are shown for

Korea in Table 6. Since Korea, with its curb market, offers an interesting

case in the study of financial repression, the effects on all the major

endogenous variables are presented. The table shows that a 1.0 percentage

point (sustained) increase in the bank real deposit and lending rates raises

the national savings ratio by roughly 0.15 percentage point for the current

and following two years at which time the effect dwindles. The savings effect

is more or less dominated by that on household saving, even though the

negative effect on corporate and government saving offsets an increasing share

of the positive effect on household saving as time passes.

The negative effect on corporate saving is attributable to a

reduction in corporate income, a development that in turn leads to lower

government revenue and saving. The attenuation of the savings effect over

time is caused by the positive impact of a higher interest rate on financial

development (fin/y). The (fin/y) ratio steadily rises 0.94 percentage point

by the third year after the interest rate change (by 1.0 percentage point), a

trend that in turn narrows the gap between the official and curb market

interest rates (by 0.23 percentage point) by the fourth year. Each of these

developments works to weaken the initial positive effect of the interest rate

change on household saving.

The results for the Philippines stand in sharp contrast. A 1.0

percentage point increase in the interest rates results in a slight about 0.03

percentage point) drop in the national savings ratio within three years after

the interest rate change. The reason for this negative savings effect is the

- 54 -

Table 6Effects of Interest Rate Change

1.OZ Point Sustained Increase in Real Bank Deposit and Lending Rates(Percentage Point)

Time Lags (Years After)Effects on 0 1 2 3 4 5

Korea

8 J 0.13 0.17 0.15 0.09 0.04 0.02

sh 0.12 0.27 0.24 0.16 0.11 0.09

0.01 -0.08 -0.06 -0.05 -0.03 -0.04

-0.00 -0.02 -0.02 -0.03 -0.04 -0.03

r 1.00 1.00 0.92 0.83 0.77 0.77

fin/y -0.01 0.34 0.68 0.94 0.94 0.94

Yh -0.01 0.11 0.10 0.09 0.09 0.09

sh 0.15 0.35 0.29 0.20 0.13 0.11

;c -0.00 -0.13 -0.13 -0.13 -0.13 -0.13

div* -0.32 -0.54 -0.03 -0.19 -0.49 -0.62

rg -0.00 -0.03 -0.03 -0.04 -0.05 -0.05

*C 0.00 0.06 0.07 0.08 0.11 0.10

Philippines

s -0.03 -0.04 -0.02 -0.04 -0.05 -0.06

8n 0.04 0.03 0.05 0.03 0.02 0.01

8c -0.04 -0.05 -0.05 -0.05 -0.06 -0.06csn -0.03 -0.02 -0.02 -0.02 -0.01 -0.01S

- 55 -

Fisure 2SAVINGS EFFECT OF REAL INTEREST RATE CHANGE

(1.0% point sustained increase in real bank deposit and lending rates)

KOIWA0.3~~~~~~K~

0.2,0.1

0.lj

I ~ ~ ~ ~ _

OAS

O 1 2 3 4 O

OmI

(G) ,|S

(C) T

Q 1 ~ ~ ~ ~~2 3 4O

3ears Arter the Shock

Nlotes: (N) is the nacLonal savings ratio.(H) is tne nousehold savings ratio.(C) is tne eorporate savLnes ratio.(C) LS cne 4vcrnc 5avLnis ratio.

- 56 -

weak positive impact the interest rate has on Philippine household saving,

compared with the negative impacts on corporate income and government revenue.

Table 7 shows the effect of discretionary tax policy on aggregate

and sectoral savings ratios. An increase in the effective rate of personal

direct taxes (t* ) or indirect taxes (ti) generally leads to higherh

aggregate saving in the medium run because the government's propensity to save

is usually larger than that of households. This positive savings effect is

stronger for the Philippines, where the difference in the savings propensity

between the government and households is relatively large. Actually, a 1.0

percentage point increase in the effective indirect tax rate raises the

government savings ratio by the same percentage point in the medium run for

the Philippines, the indication being that all the additional tax revenue is

saved. The somewhat smaller savings effect of the personal direct tax rate

compared with indirect tax rate mainly reflects a smaller tax base for the

former (household income as against GNP). Indirect taxes are commonly

believed to be inflationary. When a 1.0 percentage point increase in the

effective indirect tax rate was assumed to be associated with a 1.0 percent

rise in prices, the results (as presented in the parentheses of the table)

were not much different.

The effect of a higher corporate income tax rate (t and t )c c

turned out to be substantially negative for Korea but slightly positive for

the Philippines. When there is an income transfer from the corporate sector

to the government in the form of a corporate income tax, the reduction in

corporate saving (after dividend payments) surpasses the increase in

government saving for Korea, while the opposite is the case for the

Philippines.

Table 7Savings Effect of Discretionary Tax Policy (Percentage Point)

Koree I Phil ippinesTime Lags (Years After) Time Lags (Year After)

0 1 2 3 4 5 0 1 2 3 4 S

1.0% Point Sustained Increase in Effective Personal Oirect Tax Rate

s | -0.22 -0.02 0.10 0.26 0.36 0.36 s 1 0.33 0.49 0.61 0.73 0.77 0.81

sh -0.65 -0.52 -0.37 -0.27 -0.20 -0.14 | n -0.43 -0.28 -0.17 -0.08 -0.03 -0.0059 | 0.43 0.51 0.47 0,54 0.56 0.50 5 n h 0.76 0.77 0.78 0.81 0.80 0.81

10% (20% for the Philippines) Point Sustained Increase in Effective and Nominal Corporate Income Tax Rates -

s -0.30 -0.23 -0.23 -0.76 -0.10 -0.13 _ 0.01 0.02 0.04 0.09 0.11 0.13

Sh 0.03 -0.03 -0.05 -0.06 -0.03 -0.00 nh 0.00 0.00 0.00 0.00 0.00 0.00sc -0.71 -0.68 -0.54 -0.54 -0.46 -0.49 n -0.91 -1.05 -1.05 -1.06 -1.20 -1.2359 0.38 0.48 0.36 0.44 0.39 0.36 s 0.91 1.07 1.09 1.16 1.31 1.35 U"9 ~~~~~~~~~~~~~~~~~~~~9

1.0% Point Sustained Increase In Effective Indirect Tax Rate -

s -0.27 -0.00 0.13 0.34 0.46 0.46 s 0.43 0.64 0.80 0.95 1.01 1.07(-0.32) (-0.04) (0.18) (0.39) (0.49) (0.48) (0.44) (0.64) (0.85) (0.99) (1.03) (1.08)

Sh .-082 -0.66 -0.47 -0.35 -0.27 -0.19 h -0.56 -0.36 -0.21 -0.11 -0.05 -0.01(-0.92) (-0.67) (-0.41) (-0.29) (-0.22) (-0.18) h (-0.56) (-0.36) (-0.14) (-0.07) (-0.02) (0.01)

sc (0.03) (-0.02) (-0.01 (-0.01) (-0.01) (-0.00) sn (-0.04) (0.07) (0.00) (0.00) (0.00) (0.00)

sg 0.55 0.66 0.60 0.69 0.72 0.66 n 0.99 1.01 1.01 1.06 1.06 1.08(0.57) (0.65) (0.60) (0.69) (0.72) (0.66) 9 (1.06) (0.94) (1.00) (1.06) (1.06) (1.08)

Notes:

a/ For the Philippines, tax base for the effective corporate income tax rate is after-dividend corporate income.

b/ In the parentheses are effects when the effective indirect tax rate increase is accompanied by a 1.0 percent rise in prices.

- 58 -

Figure 3EFFECTS OF DISCRETIONARY TAX POLICY ON NATIONAL SAVINGS RATIO

0.6 -

0.5

OR~~~~~~~~~(

e-I0.2

j 0.1 -

6. -0.41

-0.4

0 2 X a

10.

0.8-

0.7

I 0.2

0.1 - (B)

0 4O 2 3

Years After the Shock

Notes: (A) LU%. point sustained increape in effective personal directtax race.

(5) 10.. (20% for Philippines) point sustained increase lne-iective and nominal corporite income tax rate.

(C) Lu" point sustained Lncrease ln effective Lndirecttax rate.

- 59 -

As to the savings effect of a change in the tax structure while

holding aggregate tax revenue constant, we may recall that a given amount of

indirect taxes and personal direct taxes has almost the same effect on

saving. The reason is that: (i) the ultimate burden of the indirect taxes is

assumed to be borne by households (resulting in a lower household income/GNP

ratio, Yh); and (ii) for a very low effective personal direct tax rate, the

same amount of change in indirect and personal direct taxes makes a negligible

difference on after-tax income.

Thus, it suffices to see how savings ratios are affected when a

given amount of indirect taxes replaces the corporate income tax. Table 8

shows that, when corporate income tax is cut to offset exactly a 1.0

percentage point increase in the indirect tax rate (or, equivalently, there is

a personal direct tax increase by 1.0 percent of GNP), the aggregate savings

ratio rises by 0.31 and 0.60 percentage point after one and three years,

respectively, for Korea. The rise is even larger for the Philippines.

However, the Philippine results have a limited validity, since all (98Z) the

reduction in corporate income tax is forced to end up with corporate saving by

the exogeneity of dividends in the model. To the extent that part of the

increase in after-tax income is distributed as dividends, the results for the

Philippines in Table 8 are biased upward for (s) and (sn). For Korea also,c

the corporate income tax cut results in an increase in corporate saving by

almost the same amount, which comes from the stickiness of dividends together

with the rising after-tax borrowing cost (discouraging dividend payouts).

Finally, as presented in Table 9, the savings effect of higher

inflation seems to be very weak, while that of high economic growth is fairly

strong. In the short run, higher inflation (with unchanged nominal interest

- 60 -

Table 8Savings Effect of Indirect or Personal Direct Taxes Worth 1% of GNP

Replacing Corporate Income Tax(percentage point)

Time Lags (Years After)0 1 2 3 4 5

Korea

0.15 0.31 0.48 0.60 0.66 0.74(0.11) (0.28) (0.55) (0.65) (0.70) (0.75)

sh -0.86 -0.62 -0.43 -0.29 -0.25 -0.22(-0.96) (-0.63) (-0.36) (-0.23) (-0.20) (-0.21)

SC 1.01 0.93 0.92 0.88 0.90 0.96(1.07) (0.92) (0.91) (0.88) (0.90) (0.95)

g9 (0.01) (-0.01) (0.00) (0.00) (0.00) (0.00)

Philippines

s 0.42 0.62 0.76 0.86 0.92 0.97

-h -0.56 -0.36 -0.21 -0.11 -0.05 -0.01

sn 0.98 0.98 0.98 0.98 0.98 0.98c

Note: In the parentheses are effects when the indirect tax increase isaccompanied by a 1.0 percent rise in prices.

Table 9

Savings Effect of Inflation and Growth (Percentage Point)

Korea Philippines

Time Lags (Years After) Time Lags (Years After)

0 1 2 3 4 5 0 1 2 3 4 5

Sustained 1.0% Point Higher Inflation Rate

s -0.04 -0.07 -0.03 0.02 0.05 0.06 s 0.00 -0.01 0.03 0.06 0.08 0.10

sh -0.08 -0.09 -0.05 0.00 0.04 0.05 n -0.00 0.00 0.07 0.11 0.13 0.14

Sc 0.02 0.01 -0.00 -0.01 -0.02 -0.01 Sn h -0.04 0.02 0.02 0.02 0.02 0.02

s9 0.02 0.02 0.02 0.02 0.03 0.03 c sn 0.07 0.02 0.01 0.01 0.01 0.01

(d) (-0.04) (-0.04) (-0.04) (-0.04) (-0.04) (-0.04) d -0.02 -0.04 -0.06 -0,08 -0.07 -0.07

Sustained 1.0% Increase in Real GNP/lncome Level

s 0.60 0.44 0.24 0.13 0.08 0.09 5 0.41 0.19 0.09 0.00 -0.04 -0.06

Sh 0,55 0.47 0.23 0.12 0.07 0.08 sn 0.27 0.25 0.09 -0.01 -0.04 -0.07

SC 0.04 -0.03 0.00 0.01 0.01 0.01 sn h 0.31 0.13 -0.36 0.00 0.00 0.00

sg 0.02 -0.00 0.00 0.00 -0.00 -0.00 c sn -1.14 -1.59 0.37 0.00 0.00 0°.0

(d) (-0.03) (0,02) (0.02) (0.02) (0.02) (0.02) d -0.06 -0.04 -0.02 -0.01 0.00 0.01

Sustained 1.0% Point Higher Res WSP/income Growth Rate

s 0.56 0.93 1.12 1.16 1.15 1.28 5 0.38 0.55 0.63 0.61 0.58 0.51

Sh 0.51 0.91 1.11 1.14 1.12 1.24 Sn 0.26 0.49 0.59 0.58 0.54 0.47

sc 0.04 0.00 -o.Ci -0.00 0.01 0.03 5n h 0.29 0.45 0.10 0.10 0.13 0.13

59 0.01 0.01 0.01 0.02 0.02 0.02 c sn -0.11 -0.30 0.06 0.06 0.03 0.03

(d) (-0.02) (-0.01) (0.01) (0.02) (0.03) (0.05) d -0.05 -0.09 -0.12 -0.13 -0.12 -0.11

- 62 -

Figure 4EFFECTS OF INFLATION AND GROWTH ON NATIONAL SAVINGS RATIO

K0RIA1.3

1.2

1.1 -

0.31

07-

S. 0.4

3 . (B)

0.2a!

0.7I =

0,- _ (A) ____

-0 1 -f -I -I , T ---'--

0 1 2 S 4 5

Years Aiter the Shock

sates: (A) Susc.ained LO0% point higher inilation rate.(a) Sus4ilned L.01. increase in real GNP/income level.(C) Sustained 1.0X0 point higher real GNP/incorne growth race.

- 63 -

rates) has a negative impact on aggregate saving in Korea, but almost no

impact in the Philippines. In the medium run, aggregate saving is poritively

affected by inflation for both countries, which is largely attributable to

lower household holdings of financial assets as a result of a lower real

interest rate, higher corporate income, and higher tax revenue for the

government. It is also clear that inflation has a negative effect on the CliP

ratio of capital depreciation allowances, despite evidence of attempts to

accelerate depreciation allowances when inflation is higher.

Sustained higher growth rates of real GNP and income of 1.0

percentage point are shown to raise the national savings ratio in the starting

year by 0.56 percentage and 0.38 percentage point for Korea and the

Philippines, respectively. The ratio is further raised by 1.12 percentage and

0.63 percentage point, respectively, by two years later. As the savings

propensity increases with income for Korea (but not for the Philippines), the

Korean aggregate savings ratio keeps rising slowly. The sectoral savings

contribution also seems very different between Korea and the Philippines.

While, for Korea, household saving accounts for the lion's share of the

additional national saving resulting from the accelerated growth, the

contribution of corporate saving is fairly substantial for the Philippines.

Actually, in the first two years, the corporate contribution is almost equal

to the household contribution.

This result for the Philippines comes mainly from the highly

significant effects of the business cycle on corporate income, as well as from

the effective corporate income tax rate. In spite of a relatively small CNP

share of corporate income, the Philippine corporate sector seems to be the

major beneficiary of accelerated growth in the short run. As the effective

corporate income tax rate for the Philippines drops with higher GNP growth,

- 64 -

the GNP ratios of government revenue and saving also decline in the short

run. A higher growth rate also has a short- and medium-run negative effect on

the GNP ratio of capital depreciation allowances for the Philippines.

V. Summary and Conclusion

This paper has looked at major factors determining the national

saving of Korea and the Philippines, which are Asia's most heavily indebted

countries and which have contrasting savings performance. Following the

national income accounting identities of sectoral saving, the model basically

explains how the sectoral income/GNP and saving/income ratios are determined,

given the state of economy and major government policies. Based on the

identities and estimated equations, dynamic simulations were conducted to

evaluate how the major variables interact across sectors in tracking the

savings performance and in determining their savings contribution. The

findings are summarized as follows.

First, the major factor responsible for the large swings in the

aggregate savings ratio, such as the sharp drops during 1980-82 in Korea and

in 1984-85 in the Philippines, was changes in growth performance.

Particularly for Korea, where the household saving/income ratio has been

significantly dependent not only on the growth rate of income but also on the

income level, per capita income growth explained most of the changes in the

national savings ratio during the last two decades. The simulation results

show that a sustained higher growth rate of real GNP of 1.0 percentage point

leads, by two years later, to about 1.1 and 0.6 percentage point increases in

the aggregate savings ratio for Korea and the Philippines, respectively.

- 65 -

Second, the role of interest rate policy in savings mobilization

seems to be relatively significant for Korea. However, national saving turns

out to be slightly negatively affected by a higher interest rate in the

Philippines, because the positive real interest rate effect on household

saving is more than offset by its negative effect on corporate and government

saving. This result is consistent with the neo-structuralist models (see

Taylor, 1983) where saving comes only from corporate profits. For Korea, the

strongest interest rate effect comes with a one year lag, when a 1.0

percentage point sustained increase in bank interest rates results in a 0.27

percentage point rise in the household savings ratio and a 0.17 percentage

point rise in the national savings ratio. This result seems to be comparable

with the observation of Fry (1986) that the estimated real interest rate

coefficient in a savings ratio function lies in the range of 0.1 to 0.2. In

spite of the seemingly small effect, the Korean interest rate reform in 1965

appears to have contributed about 4.0 percentage points to the national

savings ratio during 1965-67.

Third, tax policy seems to be potentially important to savings

mobilization. For Korea, any tax increase, particularly that of the corporate

income tax, results in lower national saving in the short run. In the medium

run, however, the initial negative impact of personal direct taxes or indirect

taxes on household saving gradually dies out, while its positive impact on

government saving remains relatively high, the result being a substantial

positive contribution to aggregate saving. For the Philippines, any tax

increase leads to higher national saving even in the short run. When indirect

or personal direct taxes equivalent to 1.0 percent of GNP replace the

corporate income tax, the national savings ratio rises about 0.3 percentage

point in the following year for Korea and further in subsequent years.

- 66 -

Finally, accelerated inflation has a weak negative impact, in the

short run, on aggregate saving in Korea and almost no impact in Philippines.

In the medium run, inflation seems to help raise national saving for both

countries. When nominal interest rate adjustments are accompanied so that

real interest rates remain unchanged, a sustained higher inflation rate of 10

percentage points raises the national savings rate by about 1.0 percantage

point in the short and medium run for Korea, while it has a smaller negative

impact in the short run and a negligible positive impact in the medium run for

the Philippines.

Some variables such as the terms of trade and foreign saving, which

other authors found to be important in explaining aggregate saving, were

insignificant in this sectoral savings analysis. Although the measured

household real income deviates from true income when the terms of trade

change, the latter was insignificant in the explanation of the household

saving/income ratio. Nor did the terms of trade significantly affect the

corporate income/CNP ratio. Although Giovannini (1985) and Fry (1986) found

that foreign saving had significant negative impact on national saving in

their cross-section time series studies, extreme care is needed in econometric

work, because, for a fairly open economy, the evolution of foreign saving as

well as the terms of trade are closely related to growth performance, real

interest rate development and other variables.

The implications of our findings are that the transfer component of

foreign saving has most likely substituted for national saving in the

Philippines, whereas such evidence was not found for Korea. For both

countries, however, there was no evidence that the availability of foreign

loans has any significant effect on corporate dividend policy or government

- 67 -

spending decisions. The overall results for Korea confirm Yusuf and Peters

(1984), who could not find any significant effect from foreign saving.

The policy implication of these findings seems obvious. Any

adjustment policy packages designed to curb inflation and improve the balance

of payments should pay careful attention to their impact on growth. These

policies may prove to be self-defeating, as deteriorating growth sharply

reduces national saving and limits the investment badly needed for

adjustment. Overemphasis on maintaining positive real interest rates may also

do more harm than good, because the benefits from a small increase in saving,

if any, or higher efficiency in investment allocation may be overshadowed by a

decline in investment activity.

Another implication is the need to look at sectoral details for

effective national savings mobilization. The institutions and other factors

that affect the behavior of economic agents are not the same across

countries. When growth accelerates, households are the only sector whose

saving is sensitive in Korea, whereas Philippine corporations also manage to

raise their saving. Household saving has hardly been sensitive to real

interest rates in the Philippines. The corporate sector has had the highest

marginal propensity to save in Korea, while it has been the government in the

Philippines. Understanding these types of findings and identifying their

causes are essential in the formulation of a viable adjustment program.

- 68 -

FOOTNOTES

1/ There were differences in the policies applied in Korea and thePhilippines. While Korea pursued an outward-oriented developmentstrategy, the Philippines practiced inward orientation.Correspondingly, Korea exhibited considerably higher economic growthrates before 1973 and was better able to respond to the subsequentexternal shocks than the Philippines. Also, while the Philippinefinancial sector was heavily repressed until 1980, this was less thecase in Korea. Real interest rates in the Philippines were morenegative than in Korea and there were greater constraints on theoperation of the financial sector. This shows in the more rapiditevelopment of financial intermediation, as indicated by the M2/GNPratio, in Korea than in the Philippines.

2/ This view suggested by Feldstein, however, has not been much supportedby empirical demonstration for the United States and other countries.

3/ As the free market rate, the curb market rate was used for Korea, whilethere is no such rate for the Philippines. The curb market in Korea isan unofficial market where professional loan dealers intermediatebetween large money lenders and corporate borrowers in need of short-term working capital. Financial repression with the resulting excessdemand for bank loans has been mainly responsible for the growth of thecurb market. Although the curb market has played an important role ofshort-term financing neglected by the organized financial markets andthat the money lenders seem to be efficient in evaluating credit-standing of borrowers, loan collection and pricing, it is veryinefficient in other aspects: it is an extremely fragmented market,information is far from being freely available to potential borrowersand lenders, and transactions cost is significant.

4/ The overseas borrowing cost turned out to be insignificant in explainingthe domestic free market rate, as the euro-dollar rate (Libor) adjustedby alternative measures of the annual expected rate of exchange ratedepreciation was used as the overseas borrowing cost.

5/ Some may suspect that the negative sign of fin/y in equation (23)reflects the positive correlation between fin/y and rd. However, while,in equation (23), current fin/y is associated with lagged rd, inequation (24), current rd is associated with lagged fin/y.

- 69 -

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