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In-depth Tax and Reform: Dealing with Japan’s Runaway Debt
Confronting Japan’s Unpleasant Fiscal Arithmetic

Kobayashi Keiichirō [Profile]


The Japanese government has faced stiff resistance to planned increases in the consumption tax, the first of which was implemented on April 1. But according to recent calculations, even the 10% rate scheduled for 2015 pales beside the revenue increases needed to avert a financial meltdown over the next few decades. Keiō University economist Kobayashi Keiichirō reviews this “unpleasant arithmetic” and urges the government to plan accordingly.

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.

  • [2014.05.07]

Professor of Economics at Keiō University. Completed a master’s degree in mathematical engineering at the University of Tokyo in 1991. Received his doctorate in economics from the University of Chicago in 1998. Has been senior researcher at the Research Institute of Economy, Trade, and Industry and professor at the Institute of Economic Research, Hitotsubashi University. His works include Nihon keizai no wana (The Trap of the Japanese Economy, coauthored with Katō Sōta).

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  • The Barriers to Budget Balance in JapanDespite the crisis-level size of its public debt, Japan continues to run large deficits financed by additional borrowing. Economic historian Okazaki Tetsuji examines the barriers to restoring health in government finances.

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