Chapter

12 Fiscal Policy: Summary of Staff Views

Author(s):
Tamim Bayoumi, Guy Meredith, and Bijan Aghevli
Published Date:
June 1998
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Author(s)
Guy Meredith

Japan’s fiscal position has exhibited large swings over time, deteriorating through the 1970s, improving through the 1980s, and then deteriorating again through the first half of the 1990s (Figure 12.1). While some of these movements reflect cyclical factors, most of the changes in the deficit have been structural. To gain some perspective, it is instructive to go back to the late 1970s, when the general government deficit reached 7 percent of GDP. In response to this fiscal deterioration, the government embarked on a medium-term fiscal consolidation program by setting a number of deficit reduction targets. These targets, however, had to be deferred repeatedly in the early 1980s, and it was not until the emergence of the bubble economy in the latter part of the decade that sharp increases in revenue brought the general government account into balance. This experience points to a common misconception about the fiscal process in Japan: the fiscal process is immune to political pressures for higher spending, and therefore, the Ministry of Finance is in a strong position to quickly correct any fiscal imbalances.

Figure 12.1.General Government Balance, Fiscal Years 1971-961

(In percent of GDP)

Sources: Ministry of Finance; Economic Planning Agency; and IMF staff estimates and projections.

1The fiscal year is from April to March.

With the economic downturn in the early 1990s, the fiscal position deteriorated rapidly: between FY 1991 and FY 1996, the general government balance deteriorated by about 7 percent of GDP, with the increase in the structural deficit accounting for two-thirds of this fall. Much of this fiscal deterioration represented a deliberate effort on the part of the government to stimulate the economy, largely through tax cuts and higher public investment (Table 12.1 and Figure 12.2). The analysis presented in Lipworth and Meredith (Chapter 11, this volume) suggests that underlying fiscal multipliers in Japan are about one-half for taxes and transfers and close to unity for government spending. On this basis, during 1991–96, fiscal policy added nearly 4 percent of GDP to aggregate demand.

Table 12.1.Source of Deterioration in Structural Balance: 1990/96(Percent of potential GDP)
Change in

Structural Balance
Impact on

Aggregate Demand
Taxes and fines-42
Government investment-1¼
Net other factors¼
Total-53
Source: IMF staff estimates.
Source: IMF staff estimates.

Figure 12.2.Public Investment Profile

(In billions of yen; logarithmic scale)

Sources: Ministry of Finance; Economic Planning Agency; and IMF staff estimates and projections.

The staff has been generally supportive of this policy stance, taking the view that the size of the slowdown in the 1990s warranted significant countercyclical fiscal measures. Monetary policy alone would not have been sufficient, given the relatively long and uncertain lags involved, financial sector weakness, and the impact of the appreciation of the yen. In fact, with hindsight, it can be argued that a larger fiscal stimulus could have been provided in the early stages of the recession. But, on the whole (and contrary to some perceptions), the fiscal packages were substantial. As a result, by 1996, all of the improvement in the fiscal position attained in the 1980s was completely reversed. The fiscal situation is, therefore, quite precarious, particularly given the future spending pressures associated with the aging population.

The short-term issue in early 1997 was, therefore, the appropriate pace, rather than the need, for fiscal consolidation. Specifically, was the economy sufficiently robust to handle the pace envisaged in the proposed FY 1997 budget? These proposals include significant tax increases (a rise in the consumption tax from 3 percent to 5 percent and the termination of ¥2 trillion in temporary tax cuts); a cut in public investment as the impact of past stimulus packages unwinds; and reforms to medical benefits. The staff estimated that these policies, together with the impact of the October 1996 hike in pension contributions, would improve the structural balance by almost 2 percent of GDP and reduce aggregate demand by about 1¼ percent of GDP (Table 12.2).

Table 12.2.Fiscal Retrenchment: 1996/97(Percent of potential GDP)
Change in

Structural Balance
Impact on

Aggregate Demand
Taxes and fines
(Of which: consumption tax)(1)(-½)
Government investment½
Other (including social security)¼0
Total2-1¼
Source: IMF staff estimates.
Source: IMF staff estimates.

While fiscal consolidation would undoubtedly slow growth in 1997, the staff believed that there were good policy and economic reasons why such actions should be started as soon as possible. On the policy side, failure to enact the proposed hike in the consumption tax—a major component of the deficit reduction effort—would signal a lack of political will to deal with public finances and would have made it difficult to achieve this required policy change in the future. On the economic side, withdrawal of aggregate demand would be partially offset by the effects of low interest rates and the recent depreciation of the yen. In addition, delay could increase the size of the required fiscal adjustment, as rising debt levels increase the burden of interest payments. Nevertheless, the staff’s judgment on the proposed fiscal retrenchment in FY 1997 was predicated on its relatively optimistic short-term forecast of economic growth.

The size of the required fiscal adjustment partly reflects the long-term fiscal pressures caused by an aging population. The Japanese government has been mindful of these pressures, and the pension reform plan of 1994 provides a detailed set of measures to ensure that the pension system will remain solvent. In addition, the health care reform in the 1997 budget will lower the implied increase in health care transfers somewhat. Nonetheless, central government transfers for pension and health care are expected to add significantly to an already large budget deficit.

The government’s long-term fiscal goals were legislated in the Fiscal Structural Reform Act, passed in late 1997. By FY 2003, deficitfinancing bonds, which finance the general account of the central government, would no longer be issued (leaving only construction bonds to be issued). A clearer goal is the planned reduction in the general government deficit to below 3 percent of GDP by 2003, and subsequent measures to stabilize the level of debt. The articulation of specific medium-term goals is helpful, and legislation will be a useful way to achieve these targets. However, these initiatives raise some questions.

One issue is the justification for the chosen medium-term deficit target of 3 percent of GDP—that it is “European Monetary Union consistent”—which leaves open the question of what fiscal target would be appropriate for Japan’s circumstances. In addition, the deadline of FY 2003 appears unambitious given the projected increase in government debt over the next few years. For example, if nominal GDP growth were to average 3 percent a year, such a deficit would imply that net debt would converge to 100 percent of GDP in steady state.

Staff estimates of the requisite fiscal adjustment are significantly higher than those implied by the government fiscal targets. As shown in Okamura (CHAPTER 15, this volume), a further fiscal adjustment implying a general government deficit of about 1 percent of GDP is needed for long-term fiscal sustainability, resulting in net government debt stabilizing at about 30 percent of GDP. Measures to achieve such a fiscal adjustment could include a further hike in the consumption tax to 7 percent, tighter taxation of pension benefits, a downward revision to the public investment plan, and compression of current spending, particularly on health care.

Turning to the existing fiscal structure, the experience of the early 1990s has illustrated some of its strengths and weaknesses. On the one hand, the speed at which the fiscal packages were implemented, even when they were quite large, allowed fiscal stimulus to be provided in a timely and generally effective manner. On the other hand, the lack of a well-defined medium-term framework has led to uncertainty about the timing and magnitude of the fiscal consolidation that is now required. Furthermore, the rapid expansion of government investment spending has raised questions about the social return on underlying projects. Finally, the size and effects of the stimulus packages have been difficult to gauge due to uncertainties about the timing of spending, the convoluted arrangements for the implementation of some of the measures (particularly those directed through the Fiscal Investment and Loan Program—FILP), and ambiguity about the extent to which packages included additional, new projects—their so-called “real water” content.

The recent formation of a panel to look into the reform of the FILP is, therefore, timely. As discussed in Lipworth (1996), the government’s involvement in financial intermediation through postal savings and the FILP is potentially damaging, in part because it is difficult to ensure a level playing field with private sector financial institutions. While acknowledging the formidable difficulties involved, the staff believes that the easiest and surest way to guarantee economic efficiency is to ensure that the FILP is operated like a private fund, which can most easily be achieved by transferring its role in financial intermediation to the private sector. More generally, the staff fully endorses the government’s focus on administrative reform of the fiscal system, so as to reduce existing rigidities and inefficiencies in the system, including the allocation of public works spending. It is hoped that the government’s emphasis on these issues will result in rapid and specific proposals for reform.

Japan is embarking on a fiscal consolidation path over the next few years that, while essential, will undoubtedly be both painful and difficult. The recently announced consolidation plans, although courageous, fall short of what is needed to place the fiscal position on sound footing. The main medium-term challenges ahead include raising additional taxes; continuing reform of the health care system; paring down public investment; and carrying through with plans to review public works plans and the operations of the FILP. This process will be greatly enhanced by establishing a more transparent accounting of budgetary operations and clearly articulated medium-term goals. This topic is discussed in the next CHAPTER.

References

    LipworthGabrielle1996“Postal Savings in Japan,” in Japan—Selected Issues IMF Staff Country Report 96/114 (Washington: International Monetary Fund) pp. 13549.

    LipworthGabrielle and GuyMeredith1998“A Reexamination of Indicators of Monetary and Financial Conditions,” in Structural Change in Japan: Macroeconomic Impact and Policy Challengesed. by BijanAghevliTamimBayoumi and GuyMeredith (Washington: International Monetary Fund) pp. 15767.

    OkamuraKenji1998“Japan’s Medium- and Long-Term Fiscal Challenges,” in Structural Change in Japan: Macroeconomic Impact and Policy Challengesed. by BijanAghevliTamimBayoumi and GuyMeredith (Washington: International Monetary Fund) pp. 21539.

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