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ECONOMY > Economic Policy

Global Economy / Excuses won’t lead to Japan’s fiscal reform

  • August 27, 2017
  • , The Japan News , 9:30 p.m.
  • English Press

By Tatsuya Sasaki / Yomiuri Shimbun Senior Writer

 

Discussions over Japan’s fiscal reform are stalling. The theory of a U.S. economist who recommends “shelving tax increases” has attracted attention, and the government’s fiscal reconstruction goals are difficult to achieve. But there is little time for further postponement of fiscal rehabilitation.

 

Shelving tax increases

 

The graph of Japan’s expenditure and tax revenue is called the “crocodile’s mouth” (see graph 1). Government bonds, which add to national debt, are issued to fill the open part of the “mouth.” The combined balance of Japan’s central and local governments’ debts (long-term debt) already exceeds ¥1 quadrillion.

 

In spite of that, there is no growing sense of fiscal crisis. Under such circumstances, a particular economic theory has attracted attention.

 

Christopher Sims, a winner of the Nobel Prize in Economic Sciences and professor at Princeton University, presented his doctrine at a lecture in Tokyo in February this year. Called the “Sims Theory,” it says that in order to escape deflation, the expansion of fiscal expenditure is more effective than monetary policy, and it is necessary to state that taxes will not be increased.

 

To summarize the theory:

 

■ To escape from deflation, the government eschews tax increases but embraces fiscal expenditure increases

 

■ The public no longer needs to save in preparation for a tax increase

 

■ Anticipation spreads of “an increase in prices” and consumption increases as people make purchases before the price increase

 

■ The fiscal situation temporarily deteriorates, but tax revenues increase due to price increases (inflation), which also leads to fiscal reconstruction.

 

Conventionally, it has been considered that prices are influenced by central bank monetary policies. However, according to Sims, in a situation in which the policy interest rate is reduced to zero and there is no room for rate cuts, such as in Japan, it is also necessary to increase fiscal expenditures. This does not mean that fiscal reform is permanently abandoned, but he advocates that the consumption tax rate can be raised after a price increase is realized.

 

There are also many objections to the theory, which is described as “powerful medicine.”

 

Primarily, even if a tax increase is shelved, there is a question of whether the public will think that prices will rise. The Bank of Japan has already set a 2 percent inflation target and has advanced unprecedented monetary easing, but it has not been able to achieve its target.

 

While large-scale fiscal stimulus was carried out many times in the 1990s, the Japanese economy continued to stagnate. Even if a tax increase is temporarily shelved, there is no guarantee that people, who know about the government’s serious financial situation, will shelve their future concerns and start spending.

 

If there is inflation, it will effectively reduce the national debt, but the side effects need to be watched. If prices double, it is assumed that nominal tax revenues will also double, while the amount of debt will not change and the burden of repayments will essentially be halved. However, the value of the public’s deposits and savings will be greatly reduced. If inflation does not stop, people will find themselves in financial difficulties.

 

Still, for Japan, where the limits of monetary policies have been pointed out and measures to overcome deflation have come to a standstill, the Sims Theory can be seen as convenient.

 

Although it is necessary to make a careful judgment about the October 2019 consumption tax rate hike while watching the economic situation, some economists are cautious that “the Sims Theory may be used as a basis for postponing the consumption tax rate increase again.”

 

Changing sides

 

The government’s fiscal reform goal of turning the primary balance (see below) into a surplus in fiscal 2020 is also in danger. According to an estimate by the Cabinet Office, which was released in July, even in an optimistic “economic recovery scenario” with a nominal growth rate of around 3 percent, a deficit of ¥8.2 trillion will remain in fiscal 2020. A consumption tax rate of 10 percent is a prerequisite.

 

Although the government has not withdrawn its goal, the objective of a “stable reduction of [the ratio of] outstanding debt to total gross domestic product” was added to the “Basic Policy on Economic and Fiscal Management and Reform” decided in a Cabinet meeting in June.

 

Certainly, the ratio of outstanding debt to GDP is commonly used worldwide as an indicator of a fiscal situation. Japan’s is conspicuously high (see graph 2). According to a Cabinet Office estimate, an “economic recovery scenario” shows that the rate will fall from 190 percent in fiscal 2016 to 163 percent in fiscal 2025 (see graph 3). As the rate will fall if GDP increases due to fiscal spending, voices in the business community have been heard to say, “It could be used as an excuse to borrow money if the GDP increases.”

 

Of course, economic growth is indispensable to fiscal reform, and expenditure that is necessary to raise the potential growth rate, an indicator of the actual strength of the economy, should not be spared. However, in preventing the expansion of wasteful expenditure, it is also important to get the primary balance into the black.

 

Learning from the world

 

In the midst of a situation in which there is no prospect for fiscal reform, it is a problem if policies and discussions are aimed at “looking for excuses.”

 

Japan’s diligence and discipline are held in high regard, but there are many things that Japan should learn from other countries about the awareness of fiscal discipline, among others.

 

After the collapse of Lehman Brothers in 2008, every country carried out fiscal stimulus measures and their fiscal deficits expanded.

 

Looking at the data of the International Monetary Fund on the annual ratio of fiscal deficit to GDP, the United States, Britain and Spain were higher than Japan in 2009. However, they quickly changed direction toward fiscal reform and fell below Japan in 2013. Japan has improved its rate since then with tax revenue increases, but it was the second highest of the Group of Seven industrialized countries in 2016.

 

Due to a rapidly declining birthrate and aging society, the main cause of the worsening fiscal situation is the increase in social security spending.

 

In 2025, all of the baby boomer generation will be aged 75 or older and it is expected that social security spending will expand even further.

 

Reforms to curb social security expenditure are urgently needed, but the government has not released estimates for the fiscal situation beyond fiscal 2026.

 

If a country’s fiscal situation worsens, trust in government bonds will decline and the markets will issue a “warning” through a rise in long-term interest rates. But with the Bank of Japan’s large-scale purchase of government bonds, that mechanism will not work. It is probably one of the factors that stops the sense of crisis from spreading.

 

Last year, a panel of the Finance Ministry compiled a summary titled “Examining issues related to overseas research,” which pointed out that “successful cases of fiscal rehabilitation in various countries are fundamentally based on the formation of a national consensus.”

 

It is surely not the desire of the Japanese people to pass the burden on to the next generation. In order to spend more on growth areas, with the aim of economic reconstruction, the government and politicians need to think seriously about how to obtain a national consensus on reforms such as for the social security system.

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