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In-depth The Challenge of Restoring Japan's Fiscal Integrity
The Convenient Assumptions Behind Japan’s New Fiscal Strategy

Morinobu Shigeki [Profile]

[2018.07.17]

Abe Shinzō’s new plan to restore sound public finances postpones for five years the achievement of a primary balance surplus. This does little to quell uncertainties about the management of economic and fiscal risks, since it assumes the economy will grow rapidly through the maintenance of loose monetary policies.

Postponing the Primary Balance Surplus

The 2018 Basic Policy on Economic and Fiscal Management and Reform, approved by the cabinet on June 15, included a plan to restore the integrity of public finances. This new plan postpones the achievement of a primary balance surplus by general government (central and local), the target for sound public finances, by five years, to fiscal 2025 from fiscal 2020. The plan also aims to steadily reduce the government’s debt-to-GDP ratio.

Reasons given for postponing the primary balance target by five years include (1) tax revenues growing more slowly than initially anticipated due to sluggish economic growth, (2) the effect of supplementary budgets and of delaying the increase of the consumption tax rate, and (3) the change in the way the consumption tax increase, now slated for October 2019, will be allocated to secure stable funds for revolutionizing human-resource development.

What the above suggests is that Abenomics, the economic policies of Prime Minister Abe Shinzō, have not proven effective; that attendant contradictions have caused tax revenues to fall below expectations; and that pork-barrel supplementary budgets on the expenditure side, labeled stimulus measures, have prevented the achievement of the primary balance target. Given the above, what effect will the new plan to restore sound public finances have on economic management?

Assuming High Growth and Continued Easing

First, there is concern about whether the plan to restore sound public finances—which puts off achieving a primary balance surplus for another five years—will be sufficient in managing Japan’s economic and fiscal risks. When considered in relation to the Bank of Japan’s exit policies, engaging in leisurely efforts on the revenue and expenditure sides until 2025 may expose Japan to the risk of a major economic shock.

The new plan assumes that the economy will grow at a rate of 2% in real terms, 3% in nominal terms. These are extremely high figures. Revenues are estimated based on these figures, making it highly likely that government planners are banking on inflated figures. Moreover, the plan assumes that the growth rate will exceed the interest rate until 2025, despite the tendency for long-term interest and economic growth to have similar rates of change in the medium term.

The assumptions above are related to the need to steadily reduce the debt-to-GDP ratio, which was newly added as a fiscal target to the Basic Policies on Economic and Fiscal Management and Reform 2017. If the growth rate of the economy is higher than the interest rate, it could trigger a drop in this new target ratio.

The assumption that growth will outpace interest rates until 2025 will place enormous pressure on the BOJ’s monetary policies. These policies will become subordinate to fiscal policies as they are used to finance fiscal deficits. Major risks will accompany Japan moving in the opposite direction when Europe and the United States are exiting from monetary easing. Also, this convenient assumption will immediately collapse when the BOJ does decide to exit from easing and interest rates are normalized.

No Debate of Higher Taxes Before 2021?

Second, while some effort has been made to curb the growth of expenditures to around ¥500 billion annually in fiscal 2016–18, the new plan includes no similar target for future years. There are reports that this is the outcome of the Kantei (Prime Minister’s Office) not wanting a cap placed on the government budget. But this will remove a standard for drafting each year’s budget, leading to the risk of ballooning expenditures.

Finally, nothing specific was recorded in the plan regarding the issue of revenues (tax system). Figure 1 illustrates the relationship between social security expenditures and the national burden ratio (the share of taxes and social security contributions in national income) as a proportion of GDP. The chart shows that Japan has fallen greatly out of step with the trend for advanced economies. In other words, seeing how its burden and benefit balance has come to differ from other advanced economies, Japan has missed an opportunity to begin a national conversation on the issue of benefits and burdens.

Meanwhile, the plan is drawing attention for its inclusion of new medium-term indicators and their verification. Indicators will be established for the midway year of fiscal 2021, and progress will be monitored. These indicators are the reduction of the ratio of the primary balance deficit to GDP to half of the figure for fiscal 2017 (about 1.5%), a debt to GDP ratio between 180% and 185% (the ratio is estimated to be around 189% in fiscal 2017), and a fiscal deficit to GDP ratio of less than 3%. When financial resources fall short despite efforts to reduce expenditures and despite the economy’s growth, there is no alternative but to raise taxes. This requires an honest debate. The new medium-term indicators, however, can be viewed as postponing this debate until the medium-term verification scheduled for fiscal 2021.

As the above discussion should make clear, the targets that have been established for restoring sound public finances are less than strict. They risk the sustainability of social security and risk lower government bond prices (higher interest rates). Is it reasonable to think that they can provide citizens with confidence in their future lives and gain the acceptance of markets?

  • [2018.07.17]

Professor of Law, Chūō University. Senior Fellow, Tokyo Foundation. Born in Hiroshima in 1950. After earning a law degree from Kyoto University in 1973, joined the Ministry of Finance. Served as head of the Co-ordination Division, Tax Bureau; director-general of Tokyo Customs; and president of MOF’s Policy Research Institute. Holds an LLD in tax law. Is the author of many books, including Nihon no zeisei: Nani ga mondai ka (Flaws in Japan’s Tax System) and Shōhizei: Jōshiki no uso (Common Misconceptions about the Consumption Tax).

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