Income Distribution and Welfare Effects of Trade Liberalzation in Korea

Chul Chung, Bonggeun Kim, Young Jun Chun and Joun Won Lee

Over the last few decades, the world has achieved notable progress regarding globalization, followed by economic growth through the proliferation of Free Trade Agreements (FTAs), and multilateral trade liberalization under the General Agreement on Tariffs and Trade (GATT) and World Trade Organization (WTO). Despite the improvement of the overall standards of living thanks to trade liberalization and rapid economic growth in South Korea, however, critics argue that the income inequality has worsened as a result of globalization. According to them, fruits of globalization and economic growth are biased toward certain classes and mainly the upper class. As issues of worsening income inequality and wider economic disparity between classes are not only limited in South Korea, but is rather considered global phenomena which can be easily observed all around the world, including in the developed countries such as the United States and Europe, as well as in the developing countries. Therefore, establishing policies for alleviating social conflict, and the search for development balancing the classes has long remained a necessity that transcends national borders.
This study, therefore, mainly aims at not only giving profound analysis of the correlation between openness and income distribution facilitated by liberalization, but also examining the effects of how liberalization actually affects levels of welfare depending on the income class. This is achieved through statistical and econometric analysis and policy simulation via careful scrutiny of actual impacts of liberalization on the real income of each class and income inequality. Also, we expect this study to be used as a foundation for establishing necessary policies aiming at remedying the income inequality in Korea.
To give a summary of the research methodology used in this study, we first calculate the consumer price index (CPI) and import price index (IPI) associated with each income class. Then we recalculate the real income of each class using those calculated price index measures to examine the trend of the income inequality for the last two decades. We also employ Hamilton (2001 and 2005)’s methodology to measure price indices since the movement of the Engel curve may vary with income class. Lastly, we conduct a simulation analysis by applying the general equilibrium model to evaluate how the liberalization affects the welfare of each income class.
The primary findings of this study can be summarised as follows; in chapter 2, we confirmed that Korea has continuously made progress in liberalization by examining the trend of Korea’s openness in terms of the share of trade (or import) relative to GDP and the average tariff rate. From 1996 to 2012, the average bound tariff rate has dropped from 11.3% to 4.4, which clearly shows that trade liberalization has been accomplished in gradual but consistent fashion. When we divide the households into 10 classes based on incomes and investigate correlations between trade liberalization and the percentages of household expenditure, we found that the average tariff rate for certain in-demand items, weighted by the percentages of household expenditure, tend to be lower for the high-income class. In terms of the average tariff rate, the reduction rate for the low-income class is much higher than the high-income class, and we believe this is closely linked with not only the difference of items demanded by each income class, but also the tariff reduction rate and percentages of household expenditure for the certain items. When looking into the correlation between trade openness and household expenditure for specific consumption items by income class, it can be seen that in most items there exists a positive relationship between the degree of liberalization and percentage of expenditure for the high-income class, whereas it is inversely related for most items (except fuel expenses) for the low-income class. It implies that the overall percentage of consumption expenditure increases proportionately with the degree of liberalization for the high-income class.
In chapter 3, we present an econometric model and examine the trend of income inequality based on the statistical analysis of chapter 2. First, we derive an index for costs of living by reflecting the difference in consumption structure for different income classes. Then, we investigate the real income inequality based on real income, which is recalculated using the costs of living index for each income class. Results show that levels of income inequality, measured by the Gini coefficient and the deciles distribution ratio (P90/P10, the ratio of the upper bound value of the ninth decile (i.e. the 10% of people with highest income) to that of the first decile), have increased particularly fast in Korea since the 1990s, during which trade liberalization had started to accelerate. This means that the income inequality has become worse, even when we use different measures of real income, which take costs of living for different income classes.
However, conventional price indices have the problem of overestimation as in the well-known CPI bias, which might have distorted the income inequality measure. In order to address this bias, we employ the Engel curve methodology to measure the price index more accurately for income classes, and the results show that the income inequality was exacerbated to a lesser degree compared to results when using the conventional price index. In particular, when limiting data to households with more than 2 people and labour income for consistency over the entire period, the analysis using the Engel curve methodology suggests that the income inequality has not significantly changed for the past two decades, or possibly even improved
The caveat of this study is the limited coverage of data only including households living in the city and hence unintentionally excluding farming and fishing households. Thus the difference in living expenses depending on the income classification does not account for huge areas of the real income distribution. Nonetheless, the results in chapter 3 clearly show the validity of constructing the real income inequality by using the Engel curve methodology to account for the difference in living expenses depending on income class in relation to trade liberalization. They are expected to be useful in establishing relevant policies or serve as a base for further research in any related field.
In chapter 4, we conduct policy simulation analysis in the general equilibrium model on how trade liberalization affects the welfare of different income groups in which all the income classes are divided into three groups: high-income, middle-income, and low-income group. The result shows that the reduction in tariff rates leads to an increase in the general production level, particularly raising production significantly in the import sector. These changes in the production structure of the Korean economy following the tariff reduction increase the demand for skilled labor disproportionately more, which in turn raises skilled labor wages. Since the majority of the high-income group consists of highly skilled workers, whose income gains disproportionately more as trade liberalization takes place, liberalization obviously enhances the welfare of the high-income group. Meanwhile, the tariff reduction lowers price index for the low-income group, who consumes disproportionately more on imports and import substitutes, of which prices decline with tariff cuts. Consequently, the low-income group also benefits from trade liberalization as their real income rises. On the whole, the reduction in tariff rates improves overall welfare by minimising the distortion of consumption components. It can be argued that trade liberalization leads to an overall increase in economic efficiency and welfare for the entire income groups, a “Pareto improvement.” Notwithstanding, the degree of welfare-enhancement varies with income groups and classes. It is worth to note that the middle-income group, which accounts for the majority in the Korean economy, benefits the least from it. This is obviously one of the areas for the government to establish policies for improving the condition and path of the economic growth as well as alleviating potential conflicts in the economy.