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Despite reforms, future looks grim without consumption tax hike

by Yoshio Nakamura

In the “Okuda Vision (Japan 2025)” report released in January 2003, Keidanren used a simulation to present the medium to longer-term prospects for Japan’s fiscal and social security systems. We made it clear that the measures which would be needed to maintain the sustainability of national and local government finances — including social security programs — would involve cuts in public spending and a hike in consumption tax to the upper half of the 10 to 20 percent range.

During the roughly 1 1/2-year period that has since elapsed, a Cabinet decision was made requiring the government to cap government expenditures as a proportion of GDP and to aim for a surplus in the primary fiscal balance by the early 2010s. The Diet also enacted pension reform legislation earlier this year. In light of these developments, Keidanren has updated the simulation used for the report, and found, in short, that this series of reforms is still not sufficient to sustain our fiscal and social security systems and that further spending cuts and tax increases are necessary.

In revising the simulation, we also updated the macro-econometric model we compiled for the Okuda Vision. This model forecasts Japan’s potential growth based on estimates of the nation’s workforce, total factor productivity and other elements. It also takes into account the mutual dependency between macroeconomic performance and the fiscal and social security systems.

Using this model, we came up with three scenarios.

The first one assumes that the systems and government policies already in place will be kept intact and that no further reforms will be implemented. In this case, the primary balance continues to deteriorate and the amount of outstanding government debt balloons to a level roughly five times larger than total GDP. Social security continues to be burdened by heavy deficits, and as Japan’s fiscal health continues to worsen, GDP growth falls more each year.

This effectively constitutes a state of collapse for state finances and cannot be considered a practical option.

The second scenario aims to achieve a fiscal and social security balance by merely cutting back on expenditures. In this case, government spending in fiscal 2025 has to be trimmed to roughly half the level that would be permissible in an economy in which future reforms are enacted.

Social security and medical benefits, for example, have to be reduced by 20 percent.

The third scenario sees a gradual hike in the consumption tax beginning in fiscal 2007, alongside cuts in public spending. Ultimately, the tax has to be raised to 16 percent, but the nation only needs a 20 percent cut in government spending and a 10 percent reduction in medical benefits.

There are, of course, objections to raising the consumption tax. But a Keidanren analysis shows that the negative effects it would cause on the real economy would only be temporary, and that the nation would again find itself running on a growth track. The consumption tax in European countries is around 20 percent.

Based on these simulations, Keidanren plans to release more concrete proposals on redesigning the nation’s fiscal, social security and tax systems for the future.