Commentary / World

A standard approach to fiscal reconstruction

by Heizo Takenaka

Much has been discussed about the need to quickly rebuild Japan’s fiscal health, in which government debts have mushroomed to more than twice the nation’s gross domestic product. Among the issues discussed in the campaign for the Oct. 22 general election was the question whether the consumption tax should be hiked from the current 8 percent to 10 percent in 2019 as scheduled. The administration of Prime Minister Shinzo Abe has so far twice postponed the hike to 10 percent. In that sense, whether the government will go ahead with the planned hike in 2019 and how it plans to realize fiscal rehabilitation deserve close attention.

Deflation and fiscal policy

When Abe formed his current administration at the end of 2012, his immediate policy task was to put an end to the deflation that had gripped the nation for nearly 20 years. Deflation was at the root of the stagnation of Japan’s economy, and fiscal reconstruction was impossible as long as deflation continued to keep a drag on the growth in nominal GDP. Therefore, the government and the Bank of Japan for the first time introduced an inflation target, and the central bank under Gov. Haruhiko Kuroda launched unprecedented monetary easing programs. The 2 percent annual inflation target remains elusive today. But the Nikkei average on the Tokyo Stock Exchange has surged to more than double the level when the administration was launched, and consumer prices have risen — albeit slightly.

Amid these circumstances, an interesting discussion developed over the ways of fiscal policy. The so-called Sims Theory — by professor Christopher A. Sims of Princeton University, a winner of the 2011 Nobel Prize in economics — suggests that Japan, in its efforts to bust deflation, should pursue an aggressive fiscal policy because monetary policy will no longer be effective. In Japan, the theory appears to be deemed too extreme and unrealistic. However, it is a mistake to take the Sims Theory in such a short-circuited way.

The paper by Sims in itself is quite theoretical, but his concrete proposal is clear-cut and easy to understand. In short, it warns against taking deflationary measures such as a consumption tax hike until the 2 percent inflation target is achieved. Abe twice postponed the consumption tax hike — on the grounds that deflation has not yet been overcome. In that sense, the Abe administration can be deemed to have already put the theory into practice.

There is another important point that Sims has highlighted. That is, Japan’s fiscal deficit are not as huge as they are popularly thought. The outstanding government bonds of ¥1.3 quadrillion — which is often cited as evidence — is nothing more than the total amount of the government’s debts. The figure is not incorrect, but there are the roughly ¥800 trillion assets on the other side of the balance sheet. Therefore, the government’s net liability is around ¥500 trillion. Moreover, the BOJ holds some ¥500 trillion of the outstanding government bonds. Since the central bank belongs to the public sector, it can be deemed that the government debts — as viewed in a consolidated balance sheert like the ones used by private-sector businesses — are quite small.

That does not mean that fiscal reconstruction is unnecessary. What is says is that Japan, if it’s really serious about rehabilitating its fiscal conditions, should first get over the deflation even by expanding fiscal spending — and that Japan still has room for fiscal expansion for the time being.

Crucial social security reform

In the campaign for the October general election, Abe promised to 1)proceed with the consumption tax hike in 2019; and 2) divert much of the increased revenue from the tax hike on fiscal expenditures, instead of repaying debts as planned. His message was that the government will raise the tax as planned because the market might get too concerned if it defers the hike for the third time, but that it will expand fiscal spending so that the hike would not have a deflationary impact. For the purpose of fiscal reconstruction and busting deflation, it is a policy that is understandable as a second-best choice.

What’s needed for the government, while implementing macroeconomic policies aimed to overcoming deflation, is to fully review the social security expenses that keep building up every year. Tax hikes should be considered only after such steps are explored. This is the standard way to fiscal reconstruction.

Discussions on social security in Japan concentrates on pension, medical services and nursing care. The system is characterized as a scheme that supports the weak and disadvantaged members of society. What is important today, however, is to build a mechanism that enables more women and the elderly to proactively join the labor market so that they can support themselves. In other words, social security should exist to enable people to work without worrying about themselves and strengthen the economy’s supply side.

A look at social security benefits provided in Japan shows that the ratio of pension benefits to GDP is above the OECD average and even higher than the level in Britain. Medical services also exceed the average of OECD members. There may be problems in individual programs, but the system provides decent pension benefits and medical services as far as international comparison goes. However, social security spending for the younger generation, including child-rearing support and job re-education after maternity and child-rearing leave, as a ratio to GDP remains one-third or a quarter of the level in major European countries. While it was decided in 2012 that the consumption tax would be raised in two stages from 5 percent to 10 percent, a mere 0.3 percent of the increased revenue from the 5 percentage point hike would be spent on social security for the younger generations.

What is needed today are the standard efforts for fiscal reconstruction, such as overcoming deflation and overhaul of the social security system.

Heizo Takenaka, a professor emeritus of Keio University, served as economic and fiscal policy minister in the Cabinet of Prime Minister Junichiro Koizumi from 2001 to 2005. He is a member of the government’s Industrial Competitiveness Council.