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Taxation alone won’t save Japan from its public debts

by Kevin Rafferty

Special To The Japan Times

Jun Azumi has joined the chorus of those promising the imminent prospect of a rise in Japan’s consumption tax. As finance minister, one would think — hope, perhaps pray — that Azumi should know what he is talking about.

He told Keidanren chairman Hiromasa Yonekura that the government will submit legislation to raise the consumption tax rate “next year along with bills reforming the tax and social security systems.”

That’s a lot of important legislation lumped into a single sentence. Infuriatingly, Azumi did not offer any inkling of his thoughts on when the tax rise should happen or at what rate. Nor, even more infuriatingly, did he announce the start of a national debate on these very large issues of the parlous state of Japan’s government finances.

May I suggest that Azumi, Prime Minister Yoshihiko Noda, all the government mandarins dealing with finance and social affairs — as well as academics, media and other commentators who aspire to be partners in a national debate — should begin by reading a small 164-page book just published from Geneva, titled “Public Debts: Nuts, Bolts and Worries.”

The book makes it clear that Japan, along with most of the mature developed economies of the West, is in a mess, and that Japan faces the biggest mess of all.

There is an essential urgent need to change policies to try to tackle the question of government deficits and debts. But before running around like a scared rabbit muttering the mantra of “must increase the consumption tax,” Noda and Azumi, and the finance mandarins, should open their minds to a variety of possible policies, all of which have important consequences, which should be considered BEFORE introducing new laws.

In an attempt to kick-start a debate, let me throw in three scary factoids from the book’s chapter on Japan. If Japan does nothing about tackling its deficits, then by 2035, thanks to the remorseless aging of the population, government debts will rise to 685.1 percent of gross domestic product.

On the other hand, if the government wants to tackle the issue by raising the consumption tax, it would have to increase the tax to 24.1 percent. If, instead, it decides to cut government spending, it would have to slash spending by 20 percent.

All of these courses would be potentially disastrous. Since ministers and mandarins are busy, they can get by reading the 23 pages of the chapter on Japan, written by Robert Feldman, managing director of Morgan Stanley and one of the most thoughtful Tokyo-based economists.

But it would also be useful to read the executive summary, just six pages, and the six pages of recommendations pertaining to Japan. The other distinguished authors are Barry Eichengreen from Berkeley University, Jeff Liebman from Harvard, Jurgen von Hagen from Bonn, and Charles Wyplosz, director of the Geneva-based International Center for Money and Banking Studies, which is the book’s co-publisher with the Center for Economic Policy Research.

All too belatedly, world leaders from Washington to all points in Europe have set alarm bells ringing over the high levels of government debt and the grave consequences for global financial and economic stability.

This round of the impending crisis is potentially more dangerous than the original 2008 outburst because the major financial players have exhausted their frontline weapons and, equally important, exhausted their belief in themselves that they can sort out the problems.

If you look at the horrendous gross government debt levels causing dire predictions of gloom and the end of the capitalist world as we know it — including Greece (143 percent of gross domestic product), Italy (119 percent), eurozone (85 percent), the United States (93 percent) — Japan is one country that has the granddaddy of government debt, which will reach 228 percent of GDP this year.

Japan’s indebted plight has not bothered global capital markets because 95 percent of the debt is owed to its own citizens — unlike, say, Greece where 91 percent of its debt is owed to foreigners.

Japan Inc., in the form of banks, insurance companies and pension funds, is happy to buy 60 percent of the bonds, and governmental organizations and the Bank of Japan hold another 20 percent. Japan indeed pays the world’s lowest interest rates on its debt of 1 percent, which is attractive in an era of deflation.

Although the government is nearly bust, Japanese households sit on a pot of ¥1,500 trillion in savings. But it is time for the Japanese people to set their own alarm bells ringing. The bill surely is about to come due, especially as Japan’s population ages. The government will not be able to afford growing pension and health care costs of an elderly population.

Today’s leaders owe it to their children and grandchildren to address the issues, which are far graver and more structural than any other country faces.

“Public Debts: Nuts, Bolts and Worries” not only outlines some of the scary options if Japan is to get on top of its debt issues, but shows how unprepared politicians, let alone public opinion, are for the hardships and sacrifice that might be involved.

The Japan chapter starts off with a challenge: “Solving Japan’s problems requires a coordinated package to raise productivity growth, end deflation, and reorient spending toward productivity growth such as R&D (research and development) spending, along with tax reform to promote more efficient resource allocation. Political governance reforms are also called for, including reforms of the electoral system, of the regional structure of government, and of budget procedures.”

The value of Feldman’s work is that he tries to inject some economic common sense. He points out that Japan especially suffers from a lack of accurate and timely data on the true state of its finances. He then goes on to offer updated and accurate information for the fiscal year 2008.

According to the central government’s initial budget, which formed the basis of the argument in the Cabinet and the parliament, the budget size was ¥83.1 trillion, with social insurance costs of ¥21.8 trillion and debt service of ¥20.2 trillion, tax revenues at ¥53.6 trillion and the financing requirement at ¥25.3 trillion. On these figures, Japan clearly has problems.

But the figures represent only a partial truth about Japan’s deficit and debt mess since they omit local government and social insurance funds, as well as many “special accounts” of the government and the autumn supplementary budgets that have been a common feature of Japan’s real financial year.

Consolidating all of these factors into a comprehensive government budget for 2008, Feldman finds that the true size of the budget was ¥196.7 trillion. Tax revenues jumped to ¥139.8 trillion, but social benefit spending leaped to ¥104 trillion.

He then looks at the accounts another way, by dividing them into public goods provisions, such as education and defense, social benefits, interest payments and capital transactions. According to this, Japan actually runs a tight fiscal ship except in social benefits, which ran a deficit of ¥46.5 trillion or 9 percent of GDP, accounting for more than the total net financing of ¥41.3 trillion. Social spending was about 5 percent until recently when benefits began to outpace contributions.

Japan’s scenario is bleak as the population ages rapidly and pensions and health care costs threaten to gobble up an increasing share of the budget. Feldman describes Japan “common pool” problem, which happens when the marginal costs of public spending are not aligned with the marginal costs of associated funding. Specifically, the elderly are beginning to take a bigger and bigger share while not contributing as much as they take.

The problem has a political dimension in the over-representation of the elderly in the electoral process, thanks to Diet constituencies gerrymandered in favor of rural areas.

The budget process also suffers from problems in planning and processing, the sharing of information, lack of cooperation between central and local governments, and a failure to define, nail down and enforce budgetary contracts.

Feldman and his co-authors try to be positive, pointing out that economic growth can play an important role and ease the strain of budget cuts or tax rises. In economic jargon, they say that, “The debt-to-GDP ratio has not just a numerator but a denominator. The least painful way of reducing that ratio is by growing the denominator.”

This is where Japan Inc. should hang its head in shame. As Feldman charges, since Junichiro Koizumi stepped down as prime minister in 2006, “growth strategy has been mostly an afterthought.”

Surely the Kasumigaseki mandarins, if not the stubborn politicians, are aware that the rest of the world is laughing at Japan. The word “Japanization” has been coined for the fate that the United States and Europe are desperately trying to avoid — decades of deflation and slow to no growth, while underlying economic problems grow.

It is the classic syndrome of the frog in water that is being boiled: The creature actually enjoys the rising warmth, oblivious of the fact that he is being cooked. The new ruling party has got used to deflation and pinned its faith in tax hikes as a solution to Japan’s woes, apparently with no understanding of how tax hikes will damage growth — in which case the country must be prepared to pay a painful price that will test even Japan’s legendary stoicism in the face of adversity and social cohesion.

It does not have to be this way. Japan is a country with an ancient and sophisticated culture, with much experience, many talented and intelligent people, cutting-edge industries (albeit some being driven out by the high yen and government incompetence).

It is surely time to start a national debate about economics, politics and tax rates: What are the prices to be paid for different courses of action and what is acceptable, which too painful?

Would political reform and deregulation help to inspire creativity and growth so long elusive for modern Japan?

Kevin Rafferty is author of “Inside Japan’s Powerhouses” a study of Japan Inc. and internationalization.