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We would like to thank Warwick McKibbin and seminar participants at Stanford, Georgetown, Hawaii, Australian National University, and the American Economic Association annual meetings for helpful comments on an earlier draft.

Abstract

Existing estimates of the costs of unification are inadequate for a number of reasons. In this paper we use a dynamic computable general equilibrium model to calculate South Korean and total peninsular income streams under a variety of unification (and non-unification) scenarios. We find that there is a scenario in which the present discounted value of South Korean income is higher with unification than without it. Although lower income groups in South Korea experience reduced incomes under this scenario, with redistribution of the gains, everyone can be made better off. Indeed, this scenario, which involves relatively low levels of South Korean private investment in the North together with relatively high levels of North-South migration, is also the one which generates the highest level of total peninsular income as well. The latter point is critical in that it suggests that there is no necessary conflict between the economic interests of North and South Koreans after unification.

Introduction

A cottage industry now exists devoted to the estimation of the prospective costs of Korean unification (some of the more notable studies are summarized in Table 1). These studies have adopted one of two approaches. The first is to take data from the German experience and apply it to the Korean case (S. M. Lee, 1993; Bae, 1996). The concept of cost here is government expenditure, and benefits are viewed through a similarly narrow prism of offsetting possibilities for budgetary expenditure reduction (primarily through military demobilization). A second approach attempts to measure the resources necessary to raise North Korea to some share of South Korean income (Hwang, 1993; Yeon, 1993; Y.S. Lee, 1994; Noland, Robinson, and Scatasta, 1997) . Cost in these studies is measured in terms of resource transfer, typically taking the form of investment capital or government expenditure. Benefits are typically ignored. With one exception, all of these studies are based on simple spreadsheet calculations; only Noland, Robinson, and Scatasta use a behavioral model as the basis of calculation.

This paper extends this literature by adopting a conceptually superior measure of the costs and benefits of potential unification, namely the present discounted value (PDV) of income under alternative scenarios about unification.¹ We calculate this measure for both South Korea alone, and for the peninsula as a whole, allowing us to identify both the set of conditions that would maximize South Korean income (were it to behave selfishly under unification) as well as the conditions that would maximize peninsular income (were South Korea to behave altruistically). Furthermore, our model permits us to examine the distributional implications within South Korea for these alternative paths. In making these calculations we identify the key economic forces key policy issues that may shape economic outcomes on the peninsula. To preview the bottom line, we identify one scenario in which the South Korean PDV income stream is higher than the one associated with the baseline scenario of no unification. This scenario, in which unification yields positive net benefits to South Korea, is characterized by relatively low levels of South Korean private investment in the North combined with relatively high levels of North-South labor migration.

Conceptualizing the Costs and Benefits of Unification

There are two basic approaches to conceptualizing the costs and benefits of unification. The first takes the government budget as the fundamental variable of interest, the second focuses on transfers as the relevant measure. With respect to the former, costs are measured in terms of budgetary expenditures, which are relatively straightforward to calculate. For example in the case of German unification, one can measure net transfers from the West to the East (i.e. expenditures less taxes paid). Likewise, budgetary benefits associated with things like military demobilization, reduction in expenditures on duplicative diplomatic activities, etc. can be measured in terms of spending. These are the initial direct budgetary impacts. Most analysts, Bae (1996), for instance, stop there.² This is not the end of the story, however. For concreteness sake, take the example of military demobilization. Both East and West Germany maintained conscript armies (as do both North and South Korea). Conscripts are presumably paid less than what they could earn in other activities in the civilian economy. Their wages are not the true measure of the cost to the economy of maintaining the army-the wages they would have otherwise earned are. So, when the army demobilizes resources, which are released from relatively low productivity activities (the army) into relatively higher productivity activities in the civilian economy, national income increases, and with it so does the tax base. In other words, those lowly paid conscripts leave the army, join the civilian economy and begin paying taxes on their higher wages.

But this logic applies to the whole economy-not just the government budget. The process of unification will be accompanied by a reallocation of resources throughout the economy as factors are deployed in more productive ways. The result is an increase in national income, and an increase in tax receipts. Calculations such as Bae's, which ignore these general equilibrium effects, systematically underestimate the benefit side of the cost-benefit calculus.

Even if one were to implement the budgetary analysis properly, it is not at all clear that budgetary savings is best measure of net benefits. The government's budget balance in and of itself is not very interesting-what is relevant is not the size or sign of any imbalance, but rather its implications for income and consumption growth, which are the ultimate measures of economic welfare. (For example, most people would choose a future of slight budget deficits and steady robust growth over one characterized by fiscal balance and negative growth.) The second set of studies, which measure the costs of unification in terms of overall resources transfers could be interpreted as heading in this direction-they measure the transfer costs, but do not measure the benefits. For example, if the transfers take the form of investment in the North by Southern owners of capital, those investments will yield a stream of profits remitted to Southern investors that directly adds to Southern income. Moreover, to the extent that the rate of return on capital investment is higher in the North than the South, those investors will earn higher returns than if they had invested in the South. Again, more generally, opening up of exchange between the North and South could be expected to be accompanied by reallocation of resources that would raise the level of income in both economies. Unfortunately, none of the studies surveyed attempt to measure the impact of economic integration in either the narrow or broader sense noted above.

In summary, there is a substantial literature on the costs of unification, but the measures of costs are inadequate and potential benefits are ignored. The remainder of this paper is devoted to addressing this problem.

Measuring the Costs and Benefits of Unification

To properly measure the net benefits of any particular economic integration or unification scheme, one must specify a counterfactual. To do this one needs a measure of the dynamic growth path of the economy in the absence of unification, and some alternatives with which to compare it. We generate both baseline projections of the North and South Korean economies and projections of eight alternative unification scenarios using the Korean Integration Model (KIM), a simple dynamic two-country computable general equilibrium (CGE) model linking North and South Korea. KIM is a member of a growing family of trade-focused, multi-country, CGE models designed to analyze the impact of trade liberalization and the formation of free trade areas, customs unions, and monetary unions. It consists of two linked country CGE models, one for North Korea and one for South Korea. The rest of the world is included by means of a simple representation of fixed world prices for North and South Korean exports and imports. The countries are linked by trade flows, and the model solves for all internal prices, including commodity and factor prices, and external prices of all traded goods. Domestically produced and traded goods are specified as imperfect substitutes, which provides for a realistic continuum of "tradability" and allows for two-way intersectoral trade. The model also includes quantity rationing of both exports and imports. North Korea is assumed to have levels of "desired" exports and imports that would be typical for a country of its size and per capita income, but that in practice, exports and imports are rationed physically, yielding the low levels observed in the base data.³ South Korean trade with North Korea is similarly assumed to be rationed in physical terms, and "desired" trade between the two countries is assumed to equal levels that would be predicted from a gravity model.

The model has eight sectors: agriculture/forest/fisheries, mining, light manufacturing, industrial intermediates, capital goods, construction, public administration, and services. There are three "demanders": a single aggregate household which buys consumer goods, a government which spends on goods and public administration, and an aggregate capital account which purchases investment goods.⁴ Primary factors of production are capital, agricultural labor, high-skill urban labor, and low-skill urban labor. Land is not explicitly modeled as a separate factor and can be considered as subsumed in agricultural capital.⁵ (Additional description of the model is contained in the appendix.)

The model was calibrated for 1990, the most recent year for which reliable (we use this term advisedly) data on North Korea were available. The labor force growth of the two economies is set exogenously on the basis of economically active labor force projections released by the Ministry of National Unification. Total factor productivity growth rates were set exogenously on the basis of econometric estimates. Capital accumulation was calibrated to reproduce the pattern of economic growth observed over the period 1991-1996. KIM is essentially a long-run equilibrium model and is not designed to capture short-run cyclical effects.

To obtain the baseline scenario, the model was run out to 2007 under the assumption of no change in policy in either North or South Korea.⁶ In the case of South Korea, the growth rate of the economy steadily slows, averaging between four and five percent real growth for the period 1998-2007. In the case of North Korea, the rate at which the economy shrinks moderates, and North Korea averages between negative two and negative three percent growth for the period.

The alternatives take the form of economic integration scenarios. These are modeled by removing all quantity rationing and imposing a common external tariff equal to South Korean tariffs, together with the specification of a fixed internal exchange rate between North and South Korea and a unified, fixed, balance of trade for the two countries together (implying a monetary union). In the case of North Korea, the economy experiences significant gains due to the static reallocation of factors, as well as an "obsolescence shock" reduction in the value of its pre-integration capital stock.⁷ It also experiences an increase in total factor productivity (TFP) associated with the importation of capital equipment and new technology from South Korea and the rest of the world. We make two assumptions about the nature of this technological transfer. In the scenarios in which capital transfers are "low," the level of North Korean TFP in each sector rises to the level of its South Korean counterpart at the end of the decade-long integration process. This is consistent with the German experience. In the scenarios in which capital transfers are "high," North Korea literally adopts South Korean technology. At the end of the integration process, North Korea has not only attained South Korea's level of TFP, but it is using the same intermediate input mix as well. The implication is that North Korea stops wasting produced intermediate inputs. Sectoral results reported by Noland, Robinson, and Scatasta (1997) and Noland, Robinson, and Liu (1997a) indicate that reform in North Korea would be accompanied by an enormous shift in the composition of output and employment towards the light industry sector (and to a lesser extent mining), while agriculture and the capital goods sector would tend to contract as factors were reallocated in a more economically rational way. Similar results were obtained in the exercises described below, but for the sake of brevity are not reported here.

Scenarios

Economic integration between North and South Korea could occur in many ways. For the purposes of modeling costs and benefits of unification, we assume that in 1998 North Korea undergoes fundamental economic reform and forms a monetary union with South Korea. One can interpret this as the economic manifestation of political union, but this is not necessary.⁸

In such a situation, a key determinant of economic outcomes would be the extent of cross-border factor mobility.⁹ In the case of labor migration, following Park (1997), we posit a "high" migration condition in which 2 million workers migrate from North to South over the course of the decade.¹⁰ Under the "low" migration assumption, we cut Park's estimate in half. Similarly, in the "high" capital transfer scenario, South Korea transfers between five and six percent of its base national income annually, following the German example as analyzed by Kwon (1997).¹¹ (Unlike the German case, we assume that these transfers go to investment, not to support consumption.)¹² Again, in the "low" capital transfer case we cut in half Kwon's figure for Germany. Since we identify technological convergence with the magnitude of capital transfer, in the "low" capital transfer case, we impose "low" productivity gains (i.e. attainment of South Korea's level of TFP), while in the "high" capital transfer case we impose "high" productivity increases (i.e. attainment of South Korea's level of TFP plus adoption of South Korea's intermediate input requirements).¹³

A final issue involves the nature of capital transfers from the South to the North.¹⁴ These could take the form of grants, or they could take the form of private investment. In the former case, capital would be transferred to the North, and there it would remain, providing economic benefits to the Northern economy. In the latter case, Southern investors would retain ownership, and the investments would yield a stream of remitted profits that would add to Southern income. In the event of unification, actual transfers would probably reflect a mix of grants (perhaps funding public infrastructure) and private profit-making investments (factories, etc.) . We have simulated the model treating the capital transfers both ways.¹⁵

All together, there is a base scenario of no integration and four integration scenarios:

• Scenario 1A: labor migration is "high," capital and technology transfers are "low," and capital transfers take the form of grants.
• Scenario 1B: same as Scenario 1A, except capital transfers take the form of private investment.
• Scenario 2A: labor migration is "low," capital and technology transfers are "low," and capital transfers take the form of grants.
• Scenario 2B: same as Scenario 2A, except capital transfers take the form of private investment.
• Scenario 3A: labor migration is "low," capital and technology transfers are "high," and capital transfers take the form of grants.
• Scenario 3B: same as Scenario 3A, except capital transfers take the form of private investment.
• Scenario 4A: labor migration is "high," capital and technology transfers are "high," and capital transfers take the form of grants.
• Scenario 4B: same as Scenario 4A, except capital transfers take the form of private investment.

Results

Simulation results are shown graphically in Figures 1-6 and summarized in Table 2. In response to unification in 1998, in seven of eight cases North Korean income drops as the obsolescence shock dominates the static reallocation gains, and then begins rising as the effects of capital transfers and technological change kick in. The exception is Scenario 3A in which the combination of high grant transfers, rapid technological change, and low migration means that aggregate income rises from the outset in 1998. The 1990 base level of income is reattained in one to four years, with the high grant transfer Scenarios 3A and 4A, exhibiting the most rapid income gains, and Scenarios 1B and 4B displaying the slowest.¹⁶

In the case of South Korea, the economy experiences a one-time static income gain, equal to approximately one percent of national income with the opening of trade with North Korea. In the four private investment scenarios (Scenarios 1B-4B) and the scenario with low grant transfer and high migration (Scenario 1A), this effect is sufficiently large that the economy actually experiences a temporary acceleration of growth. In the other three cases (Scenarios 2A-4A) the negative impact of the grant transfers overwhelms the positive trade shock and the economy experiences an initial slowdown in growth.

The present discounted values (PDV) of these income streams are summarized in Table 2.¹⁷ From a South Korean perspective the worst case is Scenario 3A (high grant transfers and low migration) in which the PDV of the South Korean income stream is more than one half trillion dollars lower than the base.¹⁸ With the combination of high grants and low migration, one might think of this as the German scenario. However, South Korea is actually better off in Scenario 1B (low private investment, high migration) with the PDV of its income stream in this scenario $35 billion higher than the base. In other words, in Scenario 1B South Korea is actually better off with unification than without it.

From the standpoint of the peninsula as a whole, the PDV of peninsular income is maximized under Scenario 1. This result is critical, since it implies that a social welfare function that ignored the interests of North Koreans, and one that treated all Koreans equally, would select the same set of policies-relatively low levels of private investment flows combined with substantial migration. Peninsular income is minimized under Scenario 2. There is effectively no difference between the grant and private investment cases, since the returns to capital remain on the peninsula in both cases. However, although Scenario 1 generates the highest income stream, it is also associated with the slowest reduction in inequality between North and South. Some previous studies have looked at per capita income differences among South Korean provinces, American states, and members of the European Union, and have concluded that cross-jurisdictional per capita income differences on the order of 40 percent are consistent with social stability (Chun, 1993; Noland, Robinson, Scatasta, 1997). Depending on the political context in which economic integration arose, this assumption would appear to raise questions about the sustainability of the South Korean-preferred Scenario 1B, absent additional capital flows, or some mechanism for limiting migration.

Distribution

Thus far the results have been discussed in terms of the aggregate effects on the two economies. Economic integration will also have effects on the distribution of income, as well as on its level. An example of this is shown in Table 3, which reports the distribution of income in the base case, as well as Scenarios 1A and 1B, calculated with respect to current residents of South Korea (i.e. migrants' wages are excluded from the calculation). Economic integration with the North leads to a shift in the distribution of income away from labor income and towards capital income. This is particularly pronounced in Scenario 1B in which the capital transfers to the North take the form of private investments yielding a stream of remitted profits. Indeed, as the agricultural and urban low-skilled wages fall and urban high-skilled wages rise in absolute terms, there is also a shift within labor income toward higher-skilled groups. If the ultimate owners of capital are predominately the higher-skilled, this suggests that, absent some redistributive mechanism, economic integration with the North is likely to be accompanied by increased income and wealth inequality in the South. However, aggregate income in Scenario 1B is higher than the base, so that with redistribution, everyone in South Korea could be made better off with unification relative to the no unification case.

Conclusion

Existing estimates of the costs of unification are inadequate for a number of reasons. In this paper we have used a dynamic computable general equilibrium model to calculate South Korean and total peninsular income streams under a variety of unification (and non-unification) scenarios. We find that there are scenarios in which the present discounted value of South Korean income is higher with unification than without it. Although lower income groups in South Korea experience reduced incomes under this scenario, with redistribution of the gains, everyone can be made better off. Indeed, this scenario, which involves relatively low levels of South Korean private investment in the North together with relatively high levels of North-South migration, is also the one which generates the highest level of total peninsular income as well. The latter point is critical in that it suggests that there is no necessary conflict between the economic interests of North and South Koreans. However under this scenario after a decade of adjustment the level of North Korean per capita income would still be less than 40 percent of the South's. Whether this degree of disparity would be politically sustainable in a unified Korea is an open question.

References

Bae, Jin-Young. 1996. "The Fiscal Burden of Korean Unification," Joint U.S.-Korea Academic Studies, Volume 6.

Chun, Hong Tack. 1993. "A Gradual Approach Toward North and South Korean Economic Integration," KDI Working Paper No. 9311. Seoul: Korea Development Institute.

Golan, "mos., Judge, George, and Robinson, Sherman. (1994). Recovering Information from Incomplete or Partial Multisectoral Economic Data. The Review of Economics and Statistics, LXXVI(3), 541-549.

Hwang, Eui-Gak. 1993. The Korean Economies, Oxford: Clarendon Press.

Korean Development Bank. (1994). North Korea's Economy and Industry. KDB Economic and Industrial Focus, Seoul (September).

Kwon, Goohoon. 1997. "Experiences with Monetary Integration and Lessons for Korean Unification," Washington: International Monetary Fund, processed.

Lee, Sang-Man. 1993. "A Study on Patterns of Economic Integration Between North and South Korea," East Asian Review, 5:3 91-133.

Lee, Young Sun. 1994. "Economic Integration of the Korean Peninsula: A Scenario Approach to the Cost of Unification," in Sung Yeung Kwack ed. The Korean Economy at a Crossroad, Westport CT: Praeger.

Noland, Marcus. 1996. "The North Korean Economy," Joint U.S.-Korean Academic Studies, 6, 126-78.

Noland, Marcus. 1997. "German Lessons for Korea: The Economics of Unification," in C. Fred Bergsten and Il SaKong editors, The Korea-United States Economic Relationship, Washington: Institute for International Economics, 1997. Korean translation appears as "Hanbando T'ongil Chonmang" in SaKong Il and Fred Bergsten editors, Segyehwasidaeui Han Mi Kwanggye, Seoul: Segyekyongjeyonguwon, 1997.

Noland, Marcus, Sherman Robinson, and Li-Gang Liu. 1997a. "The Economics of Korean Unification," Working Paper Series, 97-5, Washington: Institute for International Economics.

Noland, Marcus, Sherman Robinson, and Li-Gang Liu. 1997b. "Calibrating the Costs (and Benefits) of Unification," in Marcus Noland editor, Korean Economic Integration, Washington: Institute for International Economics, forthcoming.

Noland, Marcus, Sherman Robinson, and Monica Scatasta. 1997. "Modeling Economic Reform in North Korea," Journal of Asian Economics, 8:1 15-38.

Park, Jin. 1997. AThe Economic Impacts of Migration After Unification," Seoul: Korea Development Institute, processed. Summers, Robert and Alan Heston. 1991. "Penn World Tables (Mark V)," Quarterly Journal of Economics, 106:2 327-68.

World Bank. (1985). China: Economic Structure and International Perspective, Washington: International Bank for Reconstruction and Development.

Yeon, H. C. 1993. "Economic Consequences of German Unification and its Policy Implications for Korea," KDI Working Paper No. 9303. Seoul: Korea Development Institute.

Appendix

KIM has a standard neoclassical specification, except that the model incorporates severe quantity controls in exports and imports, with concomitant distortions in domestic product and factor markets. The markets for goods, factors, and foreign exchange are assumed to respond to changing demand and supply conditions, which, in turn, are affected by government policies, the external environment, and other exogenous influences. The model can be considered medium-to-long run in that all factors are assumed to be intersectorally mobile. It is Walrasian in that only relative prices matter. Sectoral product prices, factor prices, and the exchange rate are determined relative to an aggregate consumer price index, which defines the numeraire.¹⁹

Sectoral production technology is represented by a set of Cobb-Douglas functions of the primary factors, while intermediate inputs are demanded according to Leontief, fixed input-output coefficients.²⁰ On the demand side, import demand functions are specified as AIDS (Almost Ideal Demand System)-translog-which allows substitution elasticities to differ between domestic-, Korean partner-, and rest-of-the-world-produced goods.

KIM focuses on real trade flows, relative prices, and the real exchange rate. The aggregate price level in each country is taken as exogenous, and the model does not include money or other assets. The model includes the basic macro aggregates for each country, including the government deficit, the balance of trade, and the savings-investment balance. The combined North-South trade balance of trade with the rest of the world is fixed exogenously (except when modeling full integration), so the model does not consider any possible macro feedbacks from trade liberalization to changes in international capital flows. The macro "closure" for each country is simple. Government revenue is determined endogenously, given a variety of fixed tax rates, while government expenditure is fixed exogenously. The government deficit is endogenous. Aggregate investment in each country is assumed to be a fixed share of GDP, and aggregate savings is assumed to adjust to equate total savings and investment.

In the case of North Korea, the major distortion in the economy is assumed to be quantitative controls on both imports and exports. Because of data problems we assume no other sources of price distortions such as sectorally differentiated taxes and subsidies, which we treat explicitly in the case of South Korea. Such sectoral distortions undoubtedly exist in North Korea, but due to the organization of the North Korean economy are effectively impossible to conceptualize much less measure, so we focus only on trade liberalization.²¹ (However, the "high" technological transfer scenarios in which North Korea adopts South Korean technology, imply the elimination of any non-trade related distortions in factor markets as a product of economic liberalization.) We implicitly assume that North Korea is on, rather than inside, its production possibility frontier, though our method of modeling technological transfer would put them on the frontier whether they started off on it or not.

The model utilizes four main databases, macroeconomic and microeconomic Social Accounting Matrices (SAMs) of North and South Korea for 1990, the most recent year for which data were relatively unaffected by the severe macroeconomic shocks that North Korea began to suffer in 1989. In the case of South Korea, construction of the SAMs was straightforward. However in the case of North Korea, the approach we adopted was to draw on a variety of data sources and use a matrix balancing technique to ensure consistency that is essentially Bayesian in that it stays "close" to known controls (or Bayesian prior) while imposing all the consistency requirements of the balanced accounts.²²

Data for the North Korean macroeconomic SAM were primarily derived from North Korean government budget data as reported in Hwang (1993). One assumption made to build the macro SAM is that the North Korean government makes all investments. Government revenues are treated as being derived solely from direct household and enterprise taxes. Indirect taxes, import tariffs, and export tax rates are set to zero. In reality, revenues are raised from a transaction tax which varies depending on the legal status (state-owned, co-op, etc.) of the transacting parties, thus obviating the whole notion of a sectoral tax rate. In the absence of precise information about tax incidence, this was computed on the basis of a number of assumptions: (I) households' marginal propensity to save is between 30 percent and 40 percent; (ii) private savings are seized by the government via a number of instruments which are here summarized as a direct income tax; (iii) data about government current expenditure and investment are assumed to be reliable; (iv) part of capital/land returns are distributed to households, but capital/land income from public enterprises is appropriated by the government in the form of a enterprise tax.

The input-output coefficients are contained in a microeconomic SAM which was derived from a pre-reform (1979) Chinese input-output table compiled by the World Bank. This table was constructed to SNA standards, expanding on the material product accounts (World Bank, 1985). The assumption is that a good starting point (or prior) for inter-industry input-output relations in North Korea is pre-reform China, reflecting their common links to 1970s vintage Soviet manufacturing technology. This does not imply that the structure the of the North Korean economy is the same as China's, only that the inter-industry input-output relations are the same in the baseline scenario.

Urban workers are divided into high skilled (professional, technical, and managerial) and low skilled (the remainder). The initial starting point for industry employment structure was taken from the Chinese data. The wage premium was calculated on the basis of South Korean data. While one might expect a priori that wage dispersion in the