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4. Strategies for Fiscal Consolidation

Author(s):
Alessandro Zanello, and Daniel Citrin
Published Date:
November 2008
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Introduction

Japan’s key fiscal challenge is to put public finances on a more sustainable footing. Large government budget deficits have boosted Japan’s net public debt to over 85 percent of GDP, one of the highest in the Organization for Economic Cooperation and Development (OECD) (Figure 4.1). In the years ahead, rising health and elderly care costs will add strain to public resources. The Cabinet Office estimates that in the absence of further policy adjustments, social security expenditure will reach 22 percent of GDP by 2025, up from about 18 percent of GDP in 2005.1 As a result, the government’s net debt could continue to rise. Rising debt could increase interest rates, lower investment, and ultimately hamper growth in the context of population aging.

Figure 4.1Fiscal Balance and Net Public Debt

(%)

Source: IMF staff estimates.

The authorities are committed to addressing these risks by achieving a primary balance of the general government (excluding social security) by 2011. Although the government has not yet announced a detailed plan on how to attain this target, there is a growing consensus that consolidation would contain a mixture of both expenditure and revenue measures. The debate focuses on how to design a successful adjustment, while minimizing the output costs. A strategy for consolidation has been unveiled in broad contour in the “Roadmap for Income-Expenditure Reform” and the Basic Policies for fiscal year (FY) 2006.

This chapter investigates the macroeconomic implications of alternative fiscal strategies that differ in the composition, pace, and timing of the measures. It uses a two-country version of the IMF’s Global Fiscal Model (GFM), calibrated to the Japanese economy. Specifically, the chapter poses the following questions:

  • What are the output costs of expenditure cuts versus selected tax increases?

  • What is the effect of a more ambitious consolidation that aims at stabilizing the debt to GDP ratio by achieving a primary surplus for the general government (excluding social security) rather than at achieving a primary balance?

  • What is the tradeoff between a gradual and a stop-and-go adjustment?

  • What are the gains from a revenue-neutral shift from corporate taxation to consumption taxation?

  • What are the international spillovers of fiscal consolidation in Japan?

The main findings are:

  • Lowering social transfers has a less negative impact on growth than other measures. Amongst possible tax measures, raising the consumption tax entails the smallest output cost. (Given the limited room for further reducing transfers, there is a need to increase taxes and or reduce other expenditures.)

  • An ambitious consolidation that stabilizes the debt ratio involves greater long-term benefits than an adjustment that just targets a primary balance.2 Such a strategy carries only somewhat larger short-term output costs.

  • A less front-loaded or a stop-and-go approach limits short-term output costs, but also reduces longer-term benefits.

  • Shifting from corporate taxation to consumption taxation facilitates fiscal adjustment by spurring growth.

  • The spillovers to the rest of the world from consolidation in Japan are positive in the medium term, albeit modest.

Analytical framework

The framework used is a two-country version of the IMF’s Global Fiscal Model calibrated to the Japanese economy. GFM is a macroeconomic model developed specifically to examine a range of fiscal issues.3 In GFM, fiscal policy affects both aggregate demand and aggregate supply. Aggregate demand responses result from the absence of debt-neutrality and consumers’ impatience—i.e. their preference for immediate rather than deferred consumption. Aggregate supply responses arise inter alia from the distortionary effects of payroll and corporate income taxes.

In GFM, fiscal policy matters because of the following departures from Ricardian equivalence:

  • Consumers have finite horizons. As a result, even temporary changes in fiscal policy may affect consumption because any offsetting future action required by the government’s intertemporal budget constraint is (perceived to be) borne by future generations.

  • Taxes are distortionary because labor supply and capital accumulation decisions are endogenous and taxes are proportional rather than lump-sum.

  • A fraction of consumers are liquidity constrained. Liquidity constrained consumers do not save and cannot borrow. Therefore, any change in fiscal policy that affects their disposable income immediately changes their consumption as well.

The model has been parameterized to reflect key macroeconomic features of Japan (Tables 4.1 and 4.2). In particular, the ratios of consumption, investment, government spending, wage income, and income from capital relative to GDP are set to their current values. Similarly, key fiscal variables—revenue to GDP ratios from taxation of corporate, labor, and personal income and consumption tax, as well as government debt and current government spending—have been calibrated to Japan’s fiscal structure.4

Table 4.1Key Macroeconomic Variables in the Initial Steady State
JapanRest of the World
Country size11.588.5
% share of world real income11.488.7
National expenditure accounts at market prices
Consumption57.051.5
Rule-of-thumb12.47.2
Forward-looking44.644.3
Domestic47.450.1
Imported9.51.4
Investment18.118.7
For tradables3.14.2
For non-tradables15.014.6
Domestic15.118.2
Imported3.00.5
Government expenditures22.730.0
Exports14.41.6
Of consumption goods10.41.2
Of investment goods4.00.4
Imports12.21.8
Of consumption goods9.11.3
Of investment goods3.00.5
Tradable/nontradable split
Tradables15.720.2
Domestic1.118.6
Imported12.31.9
Net exports2.3-0.3
Nontradables84.379.8
Factor incomes
Capital37.736.1
Labor62.463.9
Interest rate
Real short-term interest rate2.02.0
Government
Debt87.540.0
Tax rates
On workers’ social security contribution (effective)20.132.4
Revenue as % of GDP4.811.7
On employers’ social security contribution (effective)11.011.0
Revenue as % of GDP4.55.0
On corporate income
Revenue as % of GDP3.73.3
Of which: on capital income7.57.5
Of which: revenue as % of GDP1.01.0
Of which: on dividend income (profits)7.57.5
Of which: revenue as % of GDP2.72.3
On personal income9.59.5
Revenue as % of GDP7.57.1
On consumption (effective VAT rate)4.46.0
Revenue as % of GDP2.53.0
Source: IMF staff estimates.
Source: IMF staff estimates.
Table 4.2Behavioral Assumptions and Key Parameters in the Initial Steady State
JapanRest of the World
Behavioral assumptions subject to sensitivity analysis
Planning horizon of consumers20 years12.5 years
Labor disutility parameters0.920.92
Fraction of rule-of-thumb consumers0.400.25
Intertemporal elasticity of substitution0.330.33
Other key parameters
Elasticity of substitution between capital and labor0.930.93
Effective discount rate0.920.92
Depreciation rate on capital0.120.07
Capital adjustment cost parameters1.000.60
Elasticity of substitution between varieties
Tradables sector4.857.67
Price markup over marginal cost1.261.15
Nontradables sector3.444.23
Price markup over marginal cost1.411.31
Capital share in production tradables sector0.420.42
Capital share in production nontradables sector0.420.42
Utility from real money balances0.020.02
Price stickiness parameters00
Home bias in government consumptionyesyes
Home bias in private consumptionnono
Elasticity of substitution between traded and nontraded goods0.750.75
Bias toward domestically produced tradables over nontradables0.200.30
Source: IMF staff estimates.
Source: IMF staff estimates.

Other main aspects of the model are:

  • Consumption and production are characterized by constant elasticity of substitution functions. Firms and workers have some market power, so that prices and wages are above their perfectly competitive levels.

  • There are traded and nontraded goods that allow for a bias toward domestic goods in private or government consumption.

  • There are two factors of production—capital and labor—which are used to produce traded and nontraded goods. Capital and labor can move freely between sectors, but are not mobile internationally.

  • Investment is driven by a “Tobin’s q” relationship. Because of adjustment costs, firms respond sluggishly to differences between the discounted value of future profits and the market value of the capital stock.

  • Wages and prices are fully flexible. The central bank targets monetary aggregates.

  • There are two kinds of financial assets, government debt (traded internationally) and equity (held domestically). International trade in government debt implies the equalization of nominal interest rates across countries over time. However, real interest rates across countries could differ because of the presence of nontraded goods and home bias in consumption.

Notwithstanding some simplifying assumptions, the framework provides a strong basis for analysis. The model does not allow for nominal rigidities, productive public investment, and multiple tax rates for each type of tax. Nonetheless, the framework provides a good platform for discussing the relative merits of alternative fiscal consolidation measures.5 In particular, the structure of the model permits an assessment of the following options: (i) lower government transfers; (ii) lower government spending;6 (iii) higher workers’ social security contribution; (iv) higher employers’ social security contribution; (v) higher personal income taxes; (vi) higher corporate income taxes; (vii) higher consumption taxes; or (viii) a package that combines some expenditure reductions and some tax increases.

Alternative fiscal adjustment strategies

Composition

A primary balance could be attained by 2011 through expenditure or tax measures—or a combination of both.7 The needed adjustment amounts to about ½ percent of GDP on average per year for five years. As shown in Table 4.3, if the adjustment relies only on one type of measure, substantial changes will be necessary. For example, to reach a primary balance by 2011, as the authorities intend, would require: a doubling of the consumption tax rate to 10 percent; a 5 percentage-point increase in the corporate income tax; or about a 25 percentage-point cut in spending on goods and services of the central government’s general account (as defined in the table). On the whole, given the size of the necessary adjustment, consolidation is likely to be accomplished through a combination of expenditure and revenue measures.

Table 4.3.Illustrative Fiscal Consolidation Measures(%)
BeforeAfter
Revenue
Consumption/sales tax (VAT)
Actual rate5.010.0
Effective rate4.58.3
Revenue (% of GDP)2.04.5
Corporate income tax (CIT)
Actual rate
Effective rate7.512.5
Revenue (% of GDP)2.65.1
Employers’ social security contribution (ESSC)
Actual rate
Effective rate11.022.3
Revenue (% of GDP)4.77.2
Personal income tax (PIT)
Actual rate
Effective rate9.512.0
Revenue (% of GDP)2.55.0
Workers’ social security contribution (WSSC)
Actual rate
Effective rate20.127.6
Revenue (% of GDP)5.68.1
Expenditure
Spending on goods and servicesa
% of GDP6.23.7
% change-25.0c
Transfersb
% of GDP4.11.6
% change-54.3c
Source: IMF staff estimates.

Includes education and science, energy measures, major foodstuff measures, national defense, miscellaneous, local allocation tax, special local allocation tax, transfer to the industrial investment special account, small business, economic assistance, and contingencies.

Includes social security and government employee pension and others.

Cumulative % change 2006-11.

Source: IMF staff estimates.

Includes education and science, energy measures, major foodstuff measures, national defense, miscellaneous, local allocation tax, special local allocation tax, transfer to the industrial investment special account, small business, economic assistance, and contingencies.

Includes social security and government employee pension and others.

Cumulative % change 2006-11.

Simulations suggest that in the short run there may be modest differences in the output cost of the various options.

  • A strategy based on reducing only social security transfers would be less damaging to economic growth than one based on cutting other spending or increasing taxes. In fact, reducing transfers acts like increasing a lump-sum tax and does not distort consumers’ labor supply decisions. While demand falls along with households’ after-tax income, aggregate supply is largely unaffected, limiting the decline in output. In addition, under the assumed parameterization, the real interest rate falls by more than with alternative consolidation measures. This in part reflects the fact that household demand is less biased toward consumption of nontraded goods than government spending (see below).

  • An increase in the consumption tax has qualitatively similar effects to a cutback of social transfers (Figure 4.2). A higher consumption tax reduces demand and real interest rates, crowding in investment and limiting the decline in output. On the external front, lower imports and a real depreciation improve the current account.

  • A reduction in government spending on goods and services decreases demand, particularly that of nontraded goods, and leads to a decline in the nominal interest rate and inflation. Inflation falls more than interest rates (because of the bias in public consumption toward nontraded goods), increasing the real interest rate and crowding out private investment. This reinforces the adverse effects of fiscal consolidation on output. On the external side, the real exchange rate depreciates, although by less than in the case of the consumption tax increase or a transfer cut, providing less support to the current account.

  • Finally, a package of measures involving lower government spending, lower transfers, and a higher consumption tax would have an impact on growth that compares favorably with that of a strategy based solely on increasing the consumption tax rate or on reducing government expenditure.8 This result comes from the limited impact on growth of a consumption tax hike and a reduction in transfers (as described above) and is independent of the sequencing of these measures.

Figure 4.2Growth Effects of Alternative Fiscal Strategies

(deviation from control, in percentage points)

Source: IMF staff estimates.

Among the revenue measures, a consumption tax increase has the least negative effect on output (Figure 4.3).

  • This result stems from the fact that the tax base is the discounted stream of future income and accumulated savings—a broad concept of permanent income. With this tax base, there is less distortion in the consumption-leisure decision as a result of this tax increase, with smaller adverse effects on the supply side.9

  • Raising the corporate income tax rate would involve larger short-term output costs than any other tax because it directly discourages investment (by raising the after-tax cost of capital) in addition to the negative impact on consumption (for those consumers who own capital).10 Overall, the effect of corporate taxation on the economy depends on the relative sensitivity of capital and labor to changes in the respective tax rates. The model is calibrated so that capital is more sensitive to taxes than labor, in line with empirical evidence.11

Figure 4.3Impact on Real GDP Growth of Tax Hikes: Consumption vs. Corporate

(deviation from control, in percentage points)

Source: IMF staff estimates.

Different consolidation strategies have different implications for the debt ratio in the long run. The consolidation scenario with transfers yields the lowest debt ratio (around 125 percent), mostly because of the smaller negative impact on output. Lowering government spending on goods and services, on the other hand, would generate the highest debt ratio (around 135 percent), as the real interest rate tends to be higher and GDP lower, mainly because of the bias in public consumption toward nontraded goods (Figure 4.4).

Figure 4.4Path of Government Debt under Alternative Scenarios

(as % of GDP)

Source: IMF staff estimates.

The planned consolidation of 2½ percent of GDP over five years will have limited spillover effects to the rest of the world (Figure 4.5). This result is largely invariant to the consolidation strategy. Spillover effects occur in the model through two channels: trade and financial.

  • Initially, consolidation lowers Japan’s demand for imports, which reduces foreign growth. However, given the share of Japan’s economy in world output, the effect on world output is small (trade channel).

  • In the medium term, a lower debt ratio is associated with higher national savings, slightly lower world interest rates, and somewhat higher investment at home and abroad (finance channel).

Figure 4.5Effects on World GDP Growth

(deviation from control in percentage points, 25-year average)

Source: IMF staff estimates.

Size, pace, and timing of adjustment

A more ambitious consolidation than envisaged by the authorities would stabilize the debt ratio and secure longer-term gains (Figure 4.6). Staff estimates indicate that stabilizing the general government debt (excluding social security) would require achievement of a primary surplus of 1¼ percent of GDP or an average annual adjustment of at least ¾ percent of GDP. This adjustment entails somewhat larger output costs in the short run, but would raise longer-term growth: labor supply and consumption are stimulated in the longer term, relative to the baseline, because a lower debt ratio lowers the anticipated tax burden, and thus raises after-tax real wages. The positive effect on output is stronger the larger the effect of interest rate on consumption, which in turn depends on how much consumers discount future consumption.

Figure 4.6The Effects of More Ambitious Fiscal Adjustment on Real GDP Growth

(deviation from adjustment of ½ percent of GDP per year, in percentage points)

Source: IMF staff estimates.

The rest of the world would also benefit from additional fiscal consolidation in Japan since world interest rates would be lower. Although consolidation in Japan reduces demand for imports, this effect is more than compensated by the decline in Japan’s demand for world saving, which creates financing room for additional capital spending in the rest of the world.

Model simulations suggest that the timing of the adjustment also matters. Two alternative scenarios to stabilize the debt ratio have been simulated: a gradual and a stop-and-go scenario. The gradual scenario envisages a sustained adjustment of ½ percent of GDP a year over nine years (to yield the primary surplus excluding social security necessary to stabilize the debt ratio). The stop-and-go scenario envisages a pause in the adjustment for three years (see Table 4.4). Figure 4.7 compares the different impact on growth of these two scenarios with that of a more ambitious consolidation along the lines described above (“Staff Plan,” in Table 4.4). The simulations suggest that a gradual adjustment may limit the short-term negative effects of consolidation on growth but also reduces the long-term benefits. This stems from the fact that the delayed adjustment yields higher debt, which in turn would crowd out private domestic and foreign investment through higher interest rates.12

Figure 4.7The Impact of the Timing of Consolidation on Real GDP Growth

(deviation from Staff Plan, in percentage points)

Source: IMF staff estimates.

Table 4.4.Illustrative Consolidation Paths
YearGovernment PlanStaff PlanGradualStop-and-Go
10.510.50.5
20.510.50.5
30.50.750.50.5
40.50.50.50.5
50.50.50.50.5
600.50.50
7000.50
8000.50
9000.250.5
100000.5
110000.5
120000.25

Tax reform

A tax reform that shifts the burden from direct to indirect taxation could support output growth. The fall in corporate taxes spurs investment, and ultimately output growth. On the external side, the spillovers to the rest of the world would be positive, albeit modest. Moreover, a revenue-neutral shift to taxation of consumption also could be justified on intergenerational equity grounds since it would foster burden-sharing in the context of an aging population (Figure 4.8).

Figure 4.8Tax Reform Effect on Real GDP Growth

(deviation from control, in percentage points)

Source: IMF staff estimates.

Sensitivity analysis

The results outlined above are sensitive to changes in the parameterization of the elasticity of labor supply and some aspects of consumption behavior. In particular:

  • Consolidation through expenditure reduction becomes less costly in terms of output if workers are more sensitive to changes in real wages. In this case, a payroll tax or a consumption tax increase would have a larger impact on their consumption-leisure decision.

  • The longer the planning horizon of households or the more private consumption responds to the interest rate, the smaller the impact of fiscal consolidation on real interest rates, output, and the current account.13

  • On the whole, however, the results are robust to changes in the behavioral parameters of the model.

Concluding remarks

The simulations presented in this chapter suggest that the design of fiscal adjustment matters for growth. Net present value calculations indicate that the cumulative impact of consolidation on growth may be positive for strategies based on reducing transfers, increasing the consumption tax, or a combination of expenditure cuts and tax increases (Figure 4.9). The results also indicate that the cumulative impact may be negative for strategies based on raising corporate taxes or personal income taxes.

Figure 4.9Net Present Value of Growth

(deviation from control, in percentage points)

Source: IMF staff estimates.

References

    BatiniNicolettaPapaN’Diaye and AlessandroRebucci2005The Domestic and Global Impact of Japan’s Policies for GrowthIMF Working Paper 05/209 (Washington, D.C.: International Monetary Fund) reproduced in Chapter 15 of this volume.

    BaylorMaximilian2005Ranking Tax Distortions in Dynamic General Equilibrium Models: A SurveyWorking Paper 2005-06 (Ottawa: Department of Finance).

    BotmanDennisDouglasLaxtonDirkMuir and AndreiRomanov2006A New Open Economy Macromodel for Fiscal Policy EvaluationIMF Working Paper 06/45 (Washington, D.C.: International Monetary Fund).

    LaxtonDouglas and PaoloPesenti2003Monetary Rules for Small, Open, Emerging EconomiesJournal of Monetary Economics Vol. 50 No. 5 pp. 110952.

The 2004 reform of the pension system (discussed in Chapter 6) will help contain longer-term pension outlays by streamlining the benefits and gradually increasing the contributions of employees and employers. Most of the demand on the budget will be related to healthcare.

The GFM imposes a fiscal reaction function that re-establishes debt sustain-ability in the very long run. The simulations in this chapter focus on benefits over a shorter policy horizon (about 25 years).

See Botman and others (2006) for details on the micro-foundations of the model.

Other structural parameters have been calibrated using evidence from Laxton and Pesenti (2003), and Batini and others (2005, and Chapter 15 of this volume).

The model has been applied by IMF staff for background work for recent Article IV consultations with Canada, the United Kingdom, and the United States.

Government spending is defined here as all expenditure excluding social transfers and interest payments.

A primary balance for the general government (excluding social security) is the authorities’ goal, but it will not stabilize the debt ratio.

The package includes a reduction in spending of 0.5 percent of GDP during the first two years, followed by a lowering of transfers by 0.5 percent of GDP a year for the next two years, and a 1 percentage point increase in the consumption tax rate in the fifth year.

If consumption were to depend only on current income, then a consumption tax would be equivalent to a payroll tax and an increase will lead to a more pronounced withdrawal of labor effort and a larger supply-side impact. The output cost would still be smaller than with a corporate income tax hike.

This result is in line with evidence from Baylor (2005).

The model probably understates the sensitivity of investment to taxation as capital is assumed to be not internationally mobile.

This tradeoff increases with the shortening of consumers’ planning horizon as future consolidation measures are less discounted. It should also be noted that GFM does not incorporate costs of price adjustment (menu costs), which may provide an additional reason against a gradual increase particularly in the consumption tax rate.

The sensitivity of consumers to changes in interest rates depends on their degree of impatience, captured through the parameterization of the intertemporal elasticity of substitution. With a lower degree of impatience (higher intertemporal elasticity of substitution), consumption would be more sensitive to changes in interest rates, which implies that smaller changes to interest rates will be necessary to re-equilibrate world savings and investment flows.

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