Issue:

It came as a surprise news that the Korea Customs Service (KCS) fabricated the rankings of duty free store applications by distorting data during the Park Geun-hye administration. Now it’s obvious that the new administration needs to overhaul our duty free system to prevent a recurrence of similar irregularities. The current scheme in which licenses must be renewed every five years through open bidding is no longer tenable. Allowing companies to open duty free shops autonomously is long overdue.

Cost:

The current duty free shop licenses are given out by the Korean government every five years. Such system inevitably creates uncertainty and risks for duty free companies, as they are only able to plan their future strategies up to five years.

For example, once their license expires and is expropriated to competing firms, their fixed investments and future contracts all become obsolete and lost investments. This has already happened to Lotte Group in 2015, which had to close down its profitable duty free business and give the license to Doosan Group which was new to the duty free industry. Social costs arising from unemployment, confusion and loss of expertise from forced closure were enormous.

In addition, it also creates perverse incentives for duty free companies to excessively lobby the government, as the license is a life or death issue for their business survival. While bribery and lobbying should not be accepted morally, such all-or-nothing monopoly license system has forced companies to do their best in lobbying even in unethical ways, which has resulted in duty free license scams.

Lastly, oligopoly creates the possibility of collusion and may result in social deadweight loss. As entry to the duty free market is controlled by government, the licensed companies can distort the market by colluding with other companies to set the market price higher than they would have under free competition. Higher prices inevitably lead to less consumption for consumers, which is a welfare loss to society as a whole.

Benefit:

Duty free industry largely depends on economy of scale because duty free shops need to buy a large number of goods through efficient retail distribution network and sell them to customers at a competitive price. The current license system ensures that the market is run by qualified large companies that are able to bear the upfront investment costs and have such network.

In addition, government licenses prevent market oversupply or emergence of a monopoly company. The market is virtually immune from over-supply and over-competition as market entry is not open to everyone, and monopolization of duty free industry is also improbable if the government gives licenses to a number of companies.

Lastly, government control over duty market ensures the amount of tax exemption given to companies is within its control. Whether the amount of tax collected under free competition is higher or lower than under licensing system depends on how much special exemptions are given out to the companies, but most likely the amount of tax under licensing system would be more predictable as the government has the discretion to issue the license.

Policy Recommendation:

While government license guarantees some degree of market stability and quality, it entails inefficiencies and risks for companies. Recognizing such problems, the Korean government plans to grant duty free conglomerates the right for renewal of their license up to five years in 2018.

In addition, small and medium-sized operators will be allowed up to two consecutive renewals, in which case they may run their businesses for a maximum of 15 years. While this is a significant improvement from the current system—the companies now bear less risk and could plan for longer term strategies—the end goal should be a complete liberalization of the duty free market.

The government should loosen the strict regulations and requirements for duty free license in the short run and gradually open up the duty free market to competition in the long run to maximize social welfare.