With recent weak economic figures and Covid-19, South Korea seems to be heading for recession. One indicator is foreign direct investment. Outward FDI from Korean companies has been rising while FDI coming to South Korea has been falling.
Such a stark contrast suggests that companies do not find South Korea attractive for investment. What could be driving this trend?
High tax rate, convoluted tax system
In 2017, the newly elected Moon Jae-in administration created a new bracket for corporate tax and raised the highest tax rate from 22% to 25%, which was primarily targeted at a few big conglomerates. The table below summarizes the changes.
Note: Rounded to nearest decimal point for simplicity
The problem with this progressive tax structure is that it limits company growth. Managers of small and medium-sized companies are reluctant to increase the revenue size of their companies because they will face higher tax rates and more regulations.
For instance, Kakao, which is a popular Korean messenger app like WeChat in China and Line in Japan, faced more than 40 new regulations out of 78 applicable when it became a big company. Such multi-layered tax brackets de-incentivize companies to grow and incentivize them to remain small.
South Korea’s corporate tax, which combined with the sub-central tax rate stands at about 27.5%, is also on the higher side of the Organization for Economic Cooperation and Development member countries. Though there are slight differences between statutory and effective corporate tax, Korea’s corporate tax is not low. The following chart also shows that South Korea ranks about 10th in statutory corporate taxation among the OECD members.
Another hurdle for companies in South Korea is high inheritance tax. On top of nominal 50% inheritance tax, there is an extra maximum of 20% premium applied to the total amount if the shares inherited are majority, making the total inheritance rate to up to 60% at maximum.
Although the 60% rate is rarely applied, many managers of Korean companies have expressed concerns that such a high tax rate hinders continuity of companies, and some have felt forced to sell and liquidate their companies. I have also written on how the inheritance tax rate may affect share prices in South Korea.
In fact, many companies have already shut down as heirs to the company were not able to pay the inheritance tax in cash. Examples include Unidus Corporation, the largest condom producer in the world, Three Seven (777) Co, the world’s No 1 nail-clipper firm, Lock & Lock Co, the biggest producer of food storage containers in South Korea, and Korean furniture brand Casamia Co.
The children of founders of all of these firms sold their management rights because of the hefty burden of inheritance taxes. Lee Woo-Hyun, chief executive of OCI Co, had to give up his position as the largest shareholder by selling his stock holdings to pay 200 billion won (US$175.36 million) in inheritance taxes.
South Korea (50%) has the second-highest inheritance tax among OECD countries, only after Japan (55%), let alone the 15 OECD countries that do not have inheritance tax. With the majority premium (20%), South Korea has the highest inheritance tax country in the world.
The exemption for family business succession is rarely, if ever, granted under complex and demanding regulations. The number of cases using the deduction system for family business succession was only 70 in 2013, 68 in 2014, 67 in 2015 and 76 in 2016. South Korea is yet to make any politically unpopular move to amend it.
South Korea has many regulations regarding big companies. Some examples are shutting down large retail stores at weekends to force consumers go to traditional markets, and banning large conglomerates from operating in markets dominated by small players, such as popular Korean-style fried chicken and stationers.
In addition, there are regulations obstructing innovative companies and practices. I have also written about how Uber is having a problem in South Korea. New sharing-economy-based car app Tada is facing a similar problem.
In an effort to provide a solution for intensifying conflicts between taxi drivers and car-sharing companies, the government said in July 2018 that mobility-platform operators would be permitted to do business if they contributed some of their earnings to the taxi industry. Still, South Korea has a long way to go to ease regulations for innovative startup companies and new business.
South Korea is one of the countries where labor unions are extremely active and labor flexibility is rigid. I talked about the labor union at Hyundai Motors in a previous article, specifically the following:
“Labor strikes at Hyundai Motor Company (HMC) caused losses of 7.5 billion won (US$6.73 million) in the five years from 2013 to 2017. Kia Motors likewise suffered from strikes, resulting in losses of 4.4 billion won worth of production.
“These strikes have become annual events, with labor unions demanding higher wages and better working hours even when Hyundai and Kia laborers already have among the highest wages and lowest productivity compared with competing companies such as Toyota. When they go on strike, companies suffer from not just halts in production but other administrative costs as well.
“Moreover, Hyundai Motor needs 26.8 hours of labor inputs to produce a car compared with Toyota’s 24.1 hours, GM’s 23.4 hours and Ford’s 21.3 hours. The average ratio of labor wages to net revenue for five auto companies in Korea is 12.2%, compared with 7.8% for Toyota and 9.5% for Volkswagen. The average annual wage for a Korean autoworker is also one of the highest in the world.
“All of these – low labor productivity, rigid flexibility and strikes – have not only caused operating losses and but also impaired Korean automakers’ brand images. The inefficiency and intangible losses caused by self-serving labor unions is unlikely to get better any time soon as they are still going out on strike in 2018 and plan to do so in the future.”
Although I do not personally want to make judgment on the validity of their claims, the very fact that such large group stages numerous strikes that often result in breaking rules and labor market rigidity is not a good condition for business to operate in South Korea.
Inconsistent policy as regimes change
South Korea is an ideologically polarized country, where left and right political parties completely change the directions of their predecessors’ policies after elections.
For example, nuclear power plants have been the main driving source of electricity under previous governments, but were scrapped under Moon’s government. In contrast, renewable energy, such as solar panels, is replacing nuclear energy under the auspices of the current government.
But such a sudden turnaround of what is supposed to be long-term energy-supply plan has caused much controversy and resulted in the loss of the huge nuclear energy market. Because renewable energy is much more expensive to produce, it is expected that the electricity price will increase in the future.
Other economic policies are also highly unpredictable as regimes change and are susceptible to political whims. For instance, in February 2016, because of the straining relationship with North Korea, the Park Geun-hye government shut down Kaesong Industrial Complex, a special administrative industrial region of North Korea (DPRK) that was formed in 2002 from part of the Kaesong Directly Governed City.
As a result, it is estimated that the business lost approximately US$1.3 billion and is yet to reopen under the current government.
Other examples of policy risks abound. I have also written an article about the duty-free industry in South Korea. Licenses for duty-free shops are given out by the government every 10 years. Although a recent change increased the duration of licenses from five to 10 years, after which the government will evaluate and select new winners for duty-free businesses, the risk of losing the entire business is high as the government can deny the license.
For instance, Lotte invested some 300 billion won ($3.6 million) to build a 10,990-square-meter duty-free store that opened in 2014. However, SK Networks and Lotte were forced to close down their lucrative duty-free stores – one each – after the government chose to give the license to rival bidders Shinsegae and Doosan in November 2015.
Unlike other stable countries, such as the US where the Democrats and Republicans do fight over policy orientations but still maintain the mainstay of economic policies, Korean politics is too radical and extremely unpredictable for stable economic policies. Business needs long-term, stable policies from the government to make long-term investment.
General hostility toward businessmen
According to a survey conducted in February 2017 by Hankyung TV, 55.1% of 1,039 adult respondents stated that they view Korean companies negatively. The following charts summarize how Koreans feel about Korean companies in general.
Source: Hankyung TV article
Half of the respondents stated that corporate profits should be contributed to society rather than shareholders. Some 51% of the respondents said Korean companies’ practices were unethical.
These negative views have contributed to and justified business-unfriendly policies, such as high tax rates and regulations. Such negative awareness dampens the prospect of business even further in the long run.
In conclusion, there are many other reasons as to why doing business in South Korea is difficult. The FDI statistics are most likely to continue to show diverging trends between outward and inward investments, and more and more business people will find South Korea to be a harsh place to do business unless changes are made.
This article is also published on Asianpolyglotview.
Joon Young Kwon holds a master’s degree in international economics and finance from Johns Hopkins University School of Advanced International Studies (SAIS), and currently works as an economics and finance consultant in Singapore. He runs his own blog and language-learning YouTube channel.