Confronting Japan’s Unpleasant Fiscal ArithmeticPolitics Economy
Japan’s national consumption tax jumped from 5% to 8% on April 1 as the government raised the rate for the first time in 17 years. Under legislation passed in 2012, the consumption tax is scheduled to rise again in October 2015, to 10%. But Prime Minister Abe Shinzō faced a fresh wave of opposition just before he approved phase 1 of the increase in October last year. With the economic recovery finally gaining traction, thanks to a push from “Abenomics” (as Prime Minister Abe’s expansionary policies have been dubbed), calls for tax hikes and spending cuts to stabilize the public debt seem to have lost momentum.
On December 2, 2013, the Canon Institute for Global Studies hosted a policy conference on Abenomics and Sustainability of the Public Debt. The conference organizers, of which I was one, invited a number of Japanese and American macroeconomists to share their views on Japan’s fiscal future. Both of the American participants painted a dismal picture. In the following, I discuss the implications of their conclusions, with an emphasis on the analysis presented by Richard Anton Braun of the Federal Reserve Bank of Atlanta.
Bleak Outlook Reported in 2011
Toni Braun is a distinguished macroeconomist who has taught at the University of Tokyo and has carried out extensive research on the Japanese economy. Braun and Douglas Joines of the University of Southern California have been using computer modeling to study the implications of demographic trends on Japan’s economic growth, social security policy, and the fiscal situation.
In August 2011, Braun and Joines presented their initial findings in a report titled “The Implications of a Greying Japan for Government Policy.” To project long-term population growth, they extended the projections published by the National Institute of Population and Social Security Research. According to their calculations, if the total fertility rate remains low, at around 1.3, the population will shrink from slightly under 130 million to 40 million around the end of the twenty-first century. Even if the fertility rate were to suddenly rebound to 2.0, Japan’s population would drop to about 80 million by the end of this century.
In the industrialized world, workforce productivity has risen at an average annual rate of 2% over the past 100 years, and this rate is unlikely to increase significantly owing to the fundamental nature of technological progress today. By adding the growth rate of workforce productivity to the growth rate of the workforce, we arrive at a fairly reliable rough estimate for long-term economic growth. What this means is that, given Japan’s declining population, the nation will be lucky to maintain economic growth at a rate of 2%, even assuming the best possible outcome for Abe’s economic policies.
Under the circumstances, how high would Japan need to raise the consumption tax in order to stabilize the public debt? At the time of their initial report three years ago, Braun and Joines concluded that fiscal stabilization would require a permanent increase to 33%. (I discuss their more recent findings below.) This is a mind-boggling figure, particularly given today’s political climate. Still, the analysis of Braun and Joines concluded that this was the rate needed to stabilize the debt-to-GDP ratio at 60% by the year 2100, assuming no substantial recovery in the fertility rate, 2% growth in productivity, 1% inflation, and no changes in the government’s social security system.
Braun and Joines ran alternate simulations using more optimistic scenarios, but the results were still discouraging. For example, even if the fertility rate immediately recovered, jumping from 1.3 to 2.0, a consumption tax rate of 28.5% would be necessary to put government finances on a sustainable footing. It seems that boosting the birth rate would have little impact on the nation’s fiscal health at this point. Moreover, even in the event of 2% inflation and 2% productivity growth—assuming the best possible outcome for Abe’s economic policies—a 25.5% consumption tax would be needed to bring the debt under control.
Such figures come as a shock to lay people, as they are rarely mentioned in the mainstream media, but they are not inconsistent with the views of other economists. A 2013 study by Gary Hansen, professor of macroeconomics at the University of California Los Angeles, and Selahattin Imrohoroglu, professor of finance and business economics at the University of Southern California, suggested that a final consumption tax rate of 35% would be needed to stabilize government finances. Japanese economists, including experts at Japan’s Ministry of Finance, have arrived at similar conclusions.
In short, scholars analyzing Japan’s economic, fiscal, and social-security situation objectively had already concluded three years ago that, even in the best-case scenario, the additional revenues needed to return Japan to fiscal sustainability amounted to a consumption tax rate in the neighborhood of 30% or more.
It Gets Worse
As noted above, however, these conclusions are based on a simulation performed three years ago. In the interim, Japan’s fiscal situation has deteriorated further, and as a result, the bill to future taxpayers has increased dramatically.
At the Canon IGS conference last December, Braun and Imrohoroglu both presented the results of their most recent analyses. Braun indicated that in order to restore fiscal stability using the consumption tax alone, the government would need to increase it incrementally between now and about 2070, when it would reach a peak rate of 53%. Later, in the first half of the twenty-second century, it would be able to begin reducing the rate again, but only to 40%. Imrohoroglu suggested that it would be necessary to raise the rate to about 60% between 2019 and 2087 before allowing it to level off at 47%.
The problem, of course, is that no democratic government—or, indeed, any sort of government—can get away with a tax increase of that magnitude or an equivalent reduction in public expenditures. It may be that a solution to Japan’s fiscal dilemma is already beyond the capacity of democratic decision making or any other political decision-making process. But surely there can be no productive or meaningful discussion of the debt problem unless we first come to grips with its immense scale. The “unpleasant arithmetic” presented by Braun and others is a truth that the Japanese people can no longer afford to ignore.
Consequences of Inaction
What would happen, then, if the government did no more than adhere to its current plan of raising the consumption tax to 10% in 2015?
Perhaps nothing much for the next three years or so. The financial markets thus far have displayed little alarm over Japan’s precarious fiscal position because most of the market’s participants have no reason to look more than two years into the future. But the real economy will still be around to suffer the consequences 50 and 100 years hence. Unlike investors, the government has a responsibility to manage its finances with those long-term consequences in mind.
From a long-term or even medium-term perspective, Japan’s fiscal situation is in real danger of deteriorating to something resembling Greece’s position on the eve of the recent debt crisis. Japan currently relies on a high domestic savings rate, rather than external debt, to fund deficit spending, but given current trends, it will only be 10 or 15 years before the national debt has overtaken household financial assets. In another 10 years, the Japanese government will doubtless be selling its bonds to foreign investors as a matter of course, and when that happens, bond prices will be subject to the whim of those investors. As in Latin America in the 1980s or southern Europe more recently, the government will come to depend on a constant infusions of foreign capital in order to pay its bills. Even assuming that Japanese manufacturing can remain globally competitive over the next decade or so, Japan is likely to be running a chronic current account deficit by that point, since an aged population tends to consume more than it saves. All this puts the government at high risk for a collapse in bond prices.
Of course, even if bond prices collapse, the Japanese government can always meet its debt obligations by having the Bank of Japan buy as many government bonds as necessary. But in this case, the unrestrained infusion of money into the market will cause inflation to spiral out of control. In other words, rampant inflation is the inevitable consequence of a Japanese fiscal crisis. The officials at the Ministry of Finance are aware of this, of course. Indeed, they seem to have concluded that allowing inflation to erode the value of the debt is easier than convincing the public of the need for higher taxes and reduced spending and pushing through the necessary tax and social security legislation.
It will only be easier on those officials, however—not on the Japanese people. For the people, the costs of such a policy are likely to be higher than anything timely tax increases and spending reductions would impose. As inflation spirals, interest rates will go up as well. Higher interests rates will mean higher yields on bonds issued to refund the debt, increasing the overall debt burden. This is the trap Brazil, Argentina, and other Latin American countries fell into repeatedly from the 1980s on. High inflation also disrupts the economy, blunts economic growth, and undermines living standards. Moreover, the resulting increase in the debt burden forces the central bank to buy still more bonds, further exacerbating inflation.
Each year the Japanese government issues refunding bonds totaling roughly ¥120 trillion to service a public debt that has reached around ¥1 quadrillion. As inflation drives interest rates up, the cost of servicing the debt will skyrocket.
Inflation reduces the value of people’s savings and other financial assets. This includes the value of outstanding government bonds. Thus, by using inflation to erode the public debt, the government would in effect be transferring assets from the people to the government to the tune of ¥10 million for each Japanese man, woman, and child. In other words, a high rate of inflation is tantamount to a tax on assets. When one takes into account the disruption to the economy and the impact on the standard of living, the economic cost to ordinary people is far higher than that of a 30% consumption tax.
Preparing for the Inevitable
A nation does not simply rise again unscathed from the ashes of a fiscal meltdown. The after-effects can be expected to continue for another 20 or 30 years at least. A debt crisis in Japan would weaken the nation and ruin its standing in the international community.
Argentina was the world’s eighth-largest economy early in the twentieth century, but its position has declined sharply since then owing largely to fiscal instability. A similar fate could await Japan if it continues on its current course.
Still, tax hikes or spending cuts on the scale necessary to stabilize government finances may not be politically feasible. This means we must accept the possibility that government bond prices will fall and inflation will soar. If Japan cannot prevent this from happening, it should certainly develop a contingency plan to prepare for such a situation.
At the very least, we must start grappling with some basic hypotheticals now, before the crisis is upon us. For example, in the event that we are obliged to cut outlays for pensions or medical care for seniors, how much do we cut, and where? Without such advance planning, the government could end up slashing benefits wildly in a desperate bid to avert an all-out crash. In this case, those with the least political clout are likely to bear the brunt of the burden, and the people could end up sacrificing more than they need to. A failure of emergency planning is bound to take a disproportionate toll on the weak, just as it did during the March 2011 nuclear accident in Fukushima, when the elderly accounted for the vast majority of evacuation casualties.
The Japanese government routinely brushes off such concerns by saying that it will not respond to hypothetical questions. But refusing to hypothesize a very conceivable crisis is simply an evasion of responsibility. It is the duty of those entrusted with protecting the livelihood of the people to prepare for emergencies by confronting and deliberating hypothetical questions of this sort.
(Originally published in Japanese on April 2, 2014. Title photo: Sign in an electronics store giving information about the April 1, 2014 tax hike. Photo by Shizuo Kambayashi/AP Photo/Aflo.)