Chapter

Chapter 5. Options for Fiscal Consolidation in an Aging Society

Author(s):
Dennis Botman, Stephan Danninger, and Jerald Schiff
Published Date:
March 2015
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Author(s)
Ikuo Saito

The previous chapter argued that Japan needs substantial fiscal consolidation to put debt on a downward trajectory. This chapter tries to answer a more difficult question—how to bring about such a large fiscal adjustment sustainably and equitably without unduly hurting growth and the nascent exit from deflation? After all, fiscal consolidation would harm aggregate demand, at least in the short term, as some crowding in through higher investment should be expected over the medium term. Also, fiscal consolidation generally has implications for intra- and intergenerational equity (IMF 2014a; Tokuoka 2012), which in turn has implications for the political support for it and thus its feasibility.

The size of the adjustment needed to put debt on a downward trajectory is unprecedented. IMF (2014b) argues that the planned fiscal adjustment of 1 percent of GDP in 2014 and 2015 strikes the right balance between establishing fiscal policy credibility and preserving the recovery.1 However, policy discussions in Japan are bypassing long-term fiscal issues, with discussions on a medium-term plan expected to start only after the fiscal year (FY) 2015 budget has been formulated. The analysis in Chapter 4 highlighted that fiscal risks have remained largely unchanged under Abenomics as new stimulus has broadly offset the benefits of a wider growth—interest rate differential. After the April 2014 consumption tax hike, a further adjustment of 8.5 percent of GDP is needed over the medium term to put the debt ratio on a downward trajectory (Figure 5.1). About a quarter of the needed adjustment is identified from the next consumption tax hike, the waning of stimulus, and some expenditure restraint. This leaves a gap of more than 6 percent of GDP in yet-to-be-identified measures to restore fiscal sustainability, options and considerations for which will be discussed in this chapter. As the previous chapter noted, the debt outlook and, thus, the adjustment need are subject to a number of downside risks, but would benefit greatly from higher potential growth. Structural reforms are important, as such reforms would increase the chance of successful fiscal adjustment by offsetting its negative impact on growth and poverty. The next chapter discusses the broad contours of the structural reform agenda.

Figure 5.1Japan’s Gross Public Debt1

(Percent of GDP)

Sources: Cabinet Office; IMF staff estimates and projections.

1 Gross debt of the general government including the social security fund.

2 Automatic withdrawal of fiscal stimulus and a consumption tax rate increase to 10 percent are assumed.

3 Policy adjustment scenario assumes an 8.5 percent of GDP improvement (baseline scenario + 6¼ points) in the structural primary balance between 2015 and 2020.

The pace of fiscal consolidation, in addition to its size and composition, matters as well. Given its growth impact, it should ideally proceed gradually in the context of a medium-term framework if warranted by economic conditions and permitted by financing conditions (IMF 2012). On the surface, Japan seems to have the luxury of being able to undertake a gradual adjustment as the Japanese government bond market is calm and regarded as a safe haven so far. But the previous chapter revealed that this should not be taken for granted in the future. In addition, delaying fiscal consolidation is expected to increase its cost and exacerbate intergenerational inequality and potentially raise exit risks, including from fiscal dominance concerns, for the Bank of Japan once the two percent inflation target has been achieved in a stable manner as the primary deficit at that time would still be elevated.2 Thus, the right balance needs to be struck between gradualism and making sufficient up-front adjustment to maintain credibility in the longer-term fiscal objectives. In this regard, Abenomics would benefit from quickly formulating a concrete medium-term fiscal strategy, as it is currently lacking specifics other than the two-stage consumption tax rate hike, which was designed under the previous government, and, as argued above, by itself would be insufficient to put debt on a downward trajectory.

In terms of composition, spending cuts are generally regarded as superior to tax increases as the former are more likely to be permanent, while the latter create greater economic distortions. IMF (2013a) finds that during past, large, and sustained improvements in the primary balance, more than 75 percent was driven by a reduction in primary expenditure. However, given that Japan’s tax revenue-to-GDP ratio is one of the lowest among the Organisation for Economic Co-operation and Development (OECD) countries and its population is aging most rapidly, securing revenue should also play an important role.3 This is why the IMF has recommended action on both spending and revenue equally to put debt onto a declining path (IMF 2014b).

We argue that, regarding revenue measures, the consumption tax should play a larger role in the future (Keen and others 2011). Relatively speaking, it is growth friendly, excels in horizontal and intergenerational equity, has a large and broad tax base, and is simple to administer and comply with provided it has a unitary rate. In the context of a comprehensive and concrete consolidation package, room should be created to reduce tax rates on corporate and personal income. These taxes are generally seen as most harmful to the economy (OECD 2010), and hence reducing their rates would offer some relief from the overall negative impact of fiscal consolidation on growth. Nonetheless, while stimulating investment and growth, corporate income tax rate cuts are unlikely to be self-financing and hence need offsetting revenue measures (De Mooij and Saito 2014).

On spending, this chapter suggests that containing age-related spending is the first priority. Although social security spending is relatively small compared with other advanced economies (IMF 2014c), it still comprised more than 50 percent of total general government outlays in 2012. In addition, as alluded to in the previous chapter, the 2004 pension reform intended to contain the ratio of public pension spending to GDP may not have met its objectives, while health and longterm care spending is expected to continue to rise significantly based on demographic and past cost trends (Kashiwase, Nozaki, and Saito 2014). Efforts to contain or further reduce other expenses relative to GDP are nonetheless also critical.

Finally, as the consolidation is large and takes place over an extended period, the institutional setting is vital to success. In this regard, a key challenge will be to move toward a credible and flexible long-term fiscal framework. This should be grounded in independent and prudent long-term fiscal projections and policy recommendations. In addition, greater accountability (IMF 2013b), multiyear budget planning, and stricter rules on the use of supplementary budgets (IMF 2013a and 2014b) will also enhance the credibility of the adjustment efforts.4

In the remainder of the chapter, we first describe the recent trend and current profile of government expenditure and revenue. We argue that the consumption tax should play a central role in fiscal consolidation, while corporate income tax reform should only proceed as part of a comprehensive and concrete consolidation plan that puts debt on a downward path. We discuss options to reform the pension system and recommend ways to contain health and long-term care spending, while paying special attention to intergenerational equity.

Where does Japan Stand on Spending and Revenue?

Japan recorded its last fiscal surplus in 1992. Since then, the spending-to-GDP ratio increased by 8.5 percentage points, with social security benefits increasing particularly sharply by 10.6 percentage points. The combination of increased longevity and birth rates well below the replacement level has resulted in a declining population with a rising old-age dependency ratio, which has increased demand on the government’s redistributive policies (Figure 5.2).5 Since 1992 revenue has declined by 0.7 percentage point. Notwithstanding this modest reduction in total revenue, Japan remains at the low end of general government revenue collection relative to other advanced economies (Figure 5.3). It also masks a stark difference between the performance of revenue from direct and indirect taxes on the one hand versus revenue from social security contributions on the other: during the same period the former declined by 3.4 percentage points of GDP, while the latter increased by 3.9 percentage points (property income declined by 1.2 points). In combination, the rise in spending and sluggish revenue collection resulted in a deficit of 8.7 percent of GDP in 2012.

Figure 5.2Social Security Benefits and Contributions

(Percent of GDP)

Source: National Institute of Population and Social Security Research.

Figure 5.3General Government Tax and Social Security Revenue, 2012

(Percent of GDP)

Sources: Organisation for Economic Co-operation and Development and IMF, World Economic Outlook database.

Revenue from each tax source has fluctuated significantly. For example, at a central government level, personal income tax peaked at 5.6 percent of GDP in FY1991 around the bursting of the bubble and declined to 3.0 percent in FY2012; corporate income tax similarly fell from 4.7 percent of GDP in FY1988 to 2.1 percent in FY2012. These reductions were due to the economic slowdown as well as to discretionary tax reductions. On the other hand, revenue from the consumption tax increased to 2.2 percent of GDP in FY2012 owing to the tax hike from 3 percent to 5 percent in April 1997.6

The significant increase in social security spending can be broken down between pension outlays (5.7 percentage points during FY1990–2010) and spending on health and long-term care (4.2 percentage points). Also, spending on the social assistance system almost tripled, potentially reflecting aging and the “working-poor” problem.7 On the other hand, other spending declined as a percent of GDP. The central government’s spending on public works (general account) declined from 2.8 percent of GDP in FY1993 to the recent bottom of 1.2 percent of GDP in FY2010 because of the Koizumi reform and the previous government’s “from concrete to human” policy, which was partly reversed under Abenomics. Interest payments declined from 3.6 percent of GDP to 2.0 percent during 1990–2010 despite the rapid debt accumulation owing to declining bond yields. As a result, Japan’s ratio of non–social security spending to GDP is one of the lowest among OECD countries (Figure 5.4).

Figure 5.4OECD: Spending Excluding Social Security and Interest, 2013

(Percent of GDP)

Source: IMF, World Economic Outlook database.

Note: General government basis. Organisation for Economic Co-operation and Development (OECD) countries with missing data (for example, Italy) are not reported here.

So what should Japan do specifically to close the large financing gap? The discussion above suggests that the large deficit is not due to a spending spree, but rather to a failure to secure sufficient revenue to prepare for an aging society. The next sections take a closer look at important components of a growth-friendly and equitable fiscal consolidation strategy, including reform of the consumption tax, the corporate income tax, pension spending, and health care spending.

Why the Consumption Tax?8

As noted, additional revenue should play an important role in efforts to restore Japan’s fiscal health. Keen and others (2011) argue that raising the consumption tax rate is the most appealing option. First, it is less distorting compared with taxes on income. A simulation using the IMF’s Global Integrated Monetary and Fiscal Model in Keen and others (2011) shows that the negative growth impact is smaller for a consumption tax hike compared with an increase in the corporate or personal income tax rate, and that raising the consumption tax rate dampens growth initially, but this could be offset over time by improved confidence in the fiscal outlook (Figure 5.5).

Figure 5.5Impact of a Permanent Tax Hike of One Percent of GDP

(Percent of GDP)

Source: Keen and others (2011).

Note: GDP impact measured as deviation from baseline.

Keen and others (2011) also point out the following reasons in favor of the consumption tax: even when it increases to 10 percent, it will remain among the lowest in the world (Figure 5.6) and because it is broad based, by international standards, there is ample scope for raising additional revenue by raising the rate. Additionally, provided a unitary rate is maintained, it is relatively easy to administer. Furthermore, it is a stable source of revenue in an aging society (consumption being smoother than income, for instance). Finally, raising the consumption tax rate may be fairer than raising other taxes in helping offset the imbalance in the distribution of lifetime benefits across generations (ensuring that the retired pay a fair share).

Figure 5.6Value-Added Tax Rates

(Percent, standard rates)

Source: Organisation for Economic Co-operation and Development.

Note: All countries, except Chile and Japan, have multiple tax rates.

The Japanese government also views the consumption tax as a primary source of additional revenue. It increased the tax rate from 5 percent to 8 percent in April 2014 and plans to increase it further to 10 percent, which was originally scheduled to occur in October 2015 but this has now been delayed. On revenue potential, Japan applies a uniform rate, although some goods and services are exempted, including health and financial services, education, and rents. As a result, the country’s C-efficiency is one of the world’s highest at nearly 70 percent.9 Specifically, each percentage point of the consumption tax produces roughly 0.5 percent of GDP. Thus, a further 5 percentage point hike from 10 percent to 15 percent would contribute close to one-half of Japan’s unidentified adjustment need of 6¼ percent of GDP until 2020. A tax rate of 15 percent would still be modest by OECD standards. To fully utilize revenue potential, and avoid distortions as well as administrative and compliance complexities, maintaining a uniform rate system would be preferable.

A potential shortcoming of the consumption tax is its perceived regressivity. In Keen and others (2011), a simple static analysis using micro-level household data suggests that tripling the uniform consumption tax rate from 5 percent (at the time) to 15 percent in Japan will increase the tax burden for households in the bottom 20 percent of the income distribution by 9 percent of their current income, compared with only 4½ percent for those in the top 20 percent. However, such snapshots of the impact on a cross-section of households are widely recognized as misleading, since a household’s income at any particular time is likely to be an imprecise indicator of its members’ lifetime well-being. Young graduates may have high earnings prospects, for instance, that are reflected in their current consumption much more than in their current income, and the retired elderly may be able to finance high consumption even though their current income is relatively low. This is particularly relevant in Japan, which has a seniority-based wage structure. So differences in the apparent impact of a consumption tax increase across income groups largely reflect differences in saving rates. For instance, the average saving rate of the bottom 20 percent of households is only 5 percent, while for the top 20 percent, it is about 50 percent. As saving is just postponed consumption, the impact of a tax increase viewed over the lifetime of a household is less regressive than indicated by just looking at the static effects: indeed, a broad-based consumption tax would simply be a proportional tax on lifetime consumption.

Although the government could still consider introducing support measures for low-income households to address remaining equity concerns, doing so through multiple rates is a highly inefficient form of income support, creating various challenges. Household-level analysis shows that consumption tax rate differentiation could play only a very limited role in addressing equity concerns. Specifically, in Japan, setting a lower tax rate on food and offsetting the revenue loss by a higher standard rate does almost nothing for households in the bottom 20 percent of the income distribution. This is because the benefits of the lower tax rate on food products—quite small in the event, as the share of food in household budgets does not vary dramatically across income groups—are largely offset by the higher standard rate. It is thus questionable whether changing relative prices and shifting demand to lower-tax food products would address equity concerns. Moreover, rate differentiation makes implementation more costly for both taxpayers and tax authorities.

Keen and others (2011) argue that an important lesson from the experience of other countries is that rate differentiation, once conceded, is extremely hard to reverse or even to contain. Instead, a uniform tax rate combined with targeted transfers to low-income households would be more effective and efficient. Such transfers would, of course, reduce the net gain from a higher rate, but—for any given impact on the poor—much less so than a reduced consumption tax rate for specific goods. Indeed, this is exactly what the Japanese government did at the time of the hike in April 2014. Keen and others (2011) illustrate this point by considering applying a reduced tax rate on food of 5 percent instead of a rate of 10 percent. In Japan, annual food consumption for households at the top and bottom 20 percent of the income distribution is on average about 1 million yen and 0.4 million yen, respectively. Hence, the reduced rate saves 50 thousand yen for the rich and 20 thousand yen for poor households annually, representing a substantial budgetary cost for the government. Instead, the government could compensate the poor by transferring to them an equivalent 20 thousand yen while maintaining a uniform rate of 10 percent, and save the cost of the implicit transfer of 50 thousand yen to the top 20 percent.

They also argue that, although a consumption tax increase places a greater burden on older generations than an income tax, this may be fair given the imbalance in the distribution of lifetime benefits across generations. First, elderly households typically own large assets. Second, on a lifetime basis the current and soon-to-be elderly in Japan are significant net beneficiaries under the social security system; that is, their benefits are higher than their lifetime tax payments and past contributions. In contrast, the younger generations have been and will likely remain net contributors to the system, reflecting the pay-as-you-go pension system and shrinking population (Cabinet Office 2005). So a higher consumption tax, which in part raises revenue from the past savings of the current cohort of the elderly, may help restore the balance of intergenerational fairness.

Finally, Keen and others (2011) discuss the pace of raising the consumption tax rate. Their simulation shows that a faster tax increase dampens growth more in the short term, although it would eventually lead to higher growth and lower debt. Given relatively low potential growth in Japan, estimated currently at about 0.5 percent, a sharp rise in the tax rate should be avoided to mitigate and instead smooth the impact on growth, even though steep hikes would reduce debt more quickly.

In conclusion, Keen and others (2011) propose that raising the consumption tax rate in Japan should follow what they call the four Ss. It should (1) start sooner rather than later, (2) be done in steps, (3) be sustained for some time, and (4) be simple in design.

Comprehensive Corporate Income Tax Reform10

Japan has reformed its corporate income tax in recent years, but the statutory rate (35.6 percent in Tokyo) remains among the highest in the OECD and Asia (Figure 5.7),11 and several other distortions remain. Among taxes, the corporate income tax is generally seen as the most harmful to growth. To stimulate the economy and attract more investment to the country, the Japanese government announced its intention to reduce the statutory rate to below 30 percent in a few years. Japan’s high fiscal risk, however, requires careful analysis of the economic and fiscal impacts of corporate income tax reform.

Figure 5.7Corporate Income Tax Statutory Rates: Selected OECD Economies

(Percent)

Source: Organisation for Economic Co-operation and Development (OECD).

Japan’s corporate income tax system is relatively distortionary and complex, which warrants comprehensive reform. The country’s rate varies by firm size, income level, and region, while most countries apply a single corporate income tax rate. The effective tax rates, which decide investment distortions, are also high in Japan. Differences in treatment between debt and equity financing (Figure 5.8) and incorporated and unincorporated firms are large and lead to distortions and arbitrage.12 The proliferation of special tax incentives has reduced transparency and added distortions and complexity.

Figure 5.8Cost of Capital by Financing Measures, 2012

(Percent)

Source: Center for European Economic Research.

Corporate income tax reforms since 2009 have reduced some distortions and improved the competitive position of Japanese firms abroad. The move toward an exemption system for foreign dividends in 2009 has increased outbound foreign direct investment (FDI) and encouraged foreign affiliates to repatriate profits to their Japanese parent companies. Yet, Japan may have incurred some fiscal costs in terms of revenue foregone from repatriation taxes and may have become more vulnerable to income shifting by multinationals as foreign tax rates are now final taxes. The 2009 reform might therefore have made it more difficult for Japan to sustain its high corporate income tax rate, although it has strengthened anti-avoidance measures. Since 2012, it has also reduced the corporate income tax rate by 5 percentage points.13

A further cut to the rate could have a positive yet limited impact on investment, including through higher inward FDI. A large body of international literature suggests that a 5 percentage point cut may increase investment by some 2–3 percent. However, Japan-specific estimates point to potentially smaller effects. For example, Uemura and Maekawa (2000) find that the corporate income tax rate cut in 1999 increased investment by 0.2 percent per 1 percentage point cut. Moreover, the meta-analysis of De Mooij and Ederveen (2008) finds that a five-point reduction in effective corporate income tax rates increases the stock of FDI, on average, by 15 percent. However, given that inbound FDI is relatively small in Japan and more than half of FDI in advanced economies is, in fact, mergers and acquisitions rather than greenfield, this effect may not be as large. All in all, investment is expected to expand about 0.4 percent for each percentage point that the statutory corporate tax rate is reduced in Japan.

A corporate income tax rate cut is unlikely to be self-financing. The elasticity of taxable income is key to estimating the dynamic impact on the fiscal balance. Past studies suggest that income and debt shifting by SMEs and multinational corporations increases taxable income with an elasticity of −0.3, although the gain by SMEs comes at the expense of personal income tax revenue. In addition, micro evidence suggests that the elasticity for an average firm is in the range of −0.1 and −0.3. All considered, the initial, static, revenue loss following a corporate income tax cut—approximately 0.1 percent of GDP for every percentage point reduction in the rate—may be mitigated by perhaps 10–30 percent, far from fully offsetting its impact. With the possibility of a smaller response of investment to a corporate income tax rate cut in Japan, as mentioned above, the offset may be closer to the lower bound. Of course, higher economic growth or higher (expected) inflation as a result of a corporate income tax rate cut would improve the debt dynamics through a denominator effect, although such effects will depend also on how interest rates will change.

Revenue gains from base broadening seem limited, but streamlining tax incentives, including those for SMEs, is needed. Tax incentives come at an estimated overall revenue loss of 0.2 percent of GDP at the central government level. Some of these incentives may be justified on efficiency grounds, including for stimulating research and development, and eliminating them will partly undo the overall positive impact of a rate cut on investment. The number of tax incentives in Japan is very large, however, and not all seem effective, particularly those applicable to SMEs, including special reduced rates, which can, in fact, be distortionary. On the other hand, the generosity of depreciation allowances and loss carry forward provisions is not high compared with peer countries.

The IMF (2014b) has been advocating lowering the corporate income tax rate as part of a comprehensive fiscal adjustment package that would achieve debt sustainability. Although such a rate cut would raise the burden on taxes or expenditure savings, it would make the overall adjustment package more growth friendly. In addition to base broadening, two other options warrant consideration to contain fiscal risks. First, a gradual approach to lowering rates would reduce tax relief on past investments and thus fiscal costs. Second, consideration could be given to introducing an incremental allowance for corporate equity to stimulate investment, which has minimal fiscal costs in the short run. This would directly reduce the cost of equity financing, boosting incentives to invest. Moreover, it would also eliminate debt bias, which gives incentives for excessive debt accumulation, making firms more vulnerable to shocks. If an allowance for corporate equity is applied only to new equity, as recently introduced in Italy, revenue losses will be incurred only gradually. Alternatively, strengthening limitations on interest deductibility to bring them closer to those in Germany and France, for example, could also mitigate debt bias and would broaden the tax base but, by raising the cost of debt finance, risk lowering investment.

Options for Pension Reform14

Social security spending has been a main driver behind the rapid rise in debt as seen above. Within this category, public pension spending has played a large role: it increased from 5.2 percent of GDP in FY1990 to 10.9 percent of GDP in FY2012. This increase and further aging in store prompted the Japanese government to embark on comprehensive pension reform, which was adopted in 2004.

Pension benefits will be automatically adjusted to changes in real wages and demographic structure (that is, rises in the dependency ratio and longevity) in the future—or so-called macroeconomic slide (indexing).15 On the other hand, contribution rates will be gradually increased and fixed from FY2017, for example at 18.3 percent of income for the second-tier (earnings-linked) pension.16 Also, the Government Pension Investment Fund (GPIF) has invested around 130 trillion yen (as of end-September 2014) to contribute to pension finances. Finally, the 2004 reform increased the ratio of the government subsidy to the basic pension benefit by about one-half percent of GDP. All these factors are expected to contribute to securing the sustainability of the pension system, which is examined every five years for the next 100 years. Overall, this scheme is designed to contain public pension spending in terms of GDP—IMF (2014c) assumes that the pension-spending-to-GDP ratio would decline by 0.3 percentage point from 2014 to 2030.

However, macroeconomic indexing does not function well under a low price/ wage increase environment.17 Inflation was expected in both the 2004 reform and in the 2009 reexamination to rise to 1.0 percent, which did not happen. In addition, the indexing has never been activated as “excessive” payouts, caused by the fact that pension benefits were nominally maintained in FY2010–2012 despite price declines. Only recently did the government decide to reduce benefits in line with past price declines, and the first adjustment to the excessive payouts happened in October 2013 and the second in April 2014 (with a final adjustment planned for April 2015). The reexamination of pension finances was published in June 2014, which could urge the government to adjust the 2004 plan, and result in additional reductions in benefit levels or increases in public spending. Against this background, Kashiwase, Nozaki, and Tokuoka (2012) suggest further reforms to the pension system.

They analyze various reform options for their impact on fiscal consolidation, equity,18 and economic growth. They argue that increasing the pension eligibility age is the most attractive option in light of high and rising life expectancy. Other attractive options include improving targeting by “clawing back” a small portion of pension benefits from wealthy retirees, reducing preferential tax treatment of pension benefits, and collecting contributions from dependent spouses of employees covered by the employment-based pension system. In contrast, across-the-board cuts in the replacement ratio and higher pension contributions are less desirable. Separately, raising returns of public pension funds, including through further diversifying investments, could help enhance the sustainability of the pension system.19Kashiwase, Nozaki, and Tokuoka (2012) propose that fiscal savings from these reforms could be used to reduce pension contributions, which could stimulate the economy by improving incentives to work.

The pension eligibility age is being raised to 65 by FY2030, although the pace is somewhat different among pension programs and between sexes. Kashiwase, Nozaki, and Tokuoka (2012) argue that taking account of rising, healthy life expectancy will give scope to increase the eligibility age further. The gap between life expectancy and the pension eligibility age is larger in Japan than in most other countries, which have been increasing the eligibility age in line with increased longevity. Raising the pension eligibility age would also have a positive effect on economic growth and could be fairer from an intergenerational perspective as it would promote the continued labor force participation of older-aged workers and raise consumption through improved lifetime earnings. Unlike the option of raising the contribution rate, the burden would be more equally shared between younger and older generations (Tokuoka 2012). They also note that an increase in the pension eligibility age should be accompanied by an expansion of the safety net, especially for those with disabilities.

The 2004 reform included a plan to lower the pension replacement ratio.20Kashiwase, Nozaki, and Tokuoka (2012) argue that a further reduction in the replacement ratio should be well targeted rather than across the board. Although the latter could have a positive economic impact and help correct intergenerational imbalances, it could worsen old-age poverty as the current level of the basic pension benefit is not so generous and reductions might result in a higher demand for social assistance, offsetting fiscal savings. There are opportunities for improved targeting by introducing a claw-back, as the government currently subsidizes half of the basic pension benefit payments, regardless of the income level of retirees.

A higher contribution rate, on the other hand, would have a negative growth effect and aggravate intergenerational imbalances. Instead, the authors propose collecting pension contributions from dependent spouses. Dependent spouses of employees covered by the employment-based pension insurance are eligible for basic pension benefits without paying contributions. Because benefits for them are paid out of contributions from both single and married employees, they are effectively cross-subsidized, raising concerns about fairness. This preferential treatment also creates a disincentive to work, because a spouse is qualified only if his or her annual earnings are lower than 1.3 million yen. This reform option should be pursued in tandem with a similar one in health care (mentioned below) as these two systems adopt the same dependency threshold.

Finally, Kashiwase, Nozaki, and Tokuoka (2012) point out that eliminating the preferential tax treatment of pension income would generate sizable fiscal savings. At present, a substantial part of the public pension benefit is deducted from taxable income when calculating personal income tax liability. On an aggregate level, about three-fourths of pension benefit income is exempt from taxable income, which benefits wealthy retirees as well. Other countries, such as France and New Zealand, do not exempt pension benefits from taxable income (OECD 2010). The authors estimate that, all combined, the above reforms could reduce the annual government subsidy by up to 1¼ percent of GDP by 2020.

Options for Health Care Reform21

Although public health care spending is still around the average of advanced economies, it is rapidly increasing, with measures to contain spending yet to be formulated. Total health and long-term care spending hovered at about 4–5 percent of GDP during the 1980s, but more than doubled during the last two decades, from 4.5 percent in 1990 to 9.5 percent in 2010. The introduction of a public long-term care insurance system in 2000 seems to have contributed to this increase. At the same time, public health spending has rapidly increased from 4.1 percent of GDP in FY1990 to 8.3 percent in FY2012.

Kashiwase, Nozaki, and Saito (2014) estimate that two-thirds of the spending increase over the last two decades resulted from population aging and the rest from excess cost growth, which is the growth differential between health spending and GDP per capita after controlling for the aging factor. Aging matters as per capita health spending is significantly higher for the elderly,22 while excess cost growth is typically due to the higher share of health services consumption with rising income and technological advances. They argue that this trend will continue. Specifically, they estimate that total health spending can increase by about 6 percentage points of GDP in the next two decades, based on demographic changes and the past trend of excess cost growth, with each contributing about half of the increase.23

Kashiwase, Nozaki, and Saito (2014) further estimate that out of the 6 percentage points of GDP increase, about 3.5 percent of GDP should be financed by the government. They argue that the younger generations (0–64) would likely see their contribution rate rise more than older generations, resulting in an increasing imbalance between spending and contributions for different age cohorts.

Finally, Kashiwase, Nozaki, and Saito (2014) quantify potential fiscal savings through alternative reform options. Although Japan’s health care system is highly valued, it shows some inefficiencies relative to the OECD average, including a large number of beds per capita, long hospitalization stays, and a relatively large amount of expensive equipment. Based on past studies, they estimate that cost savings from addressing these inefficiencies including through introducing budget caps and gate-keeping and strengthening supply constraints could amount to 0.7 percent of GDP by 2030. Moreover, more use of generic drugs and focus on preventing lifestyle-related diseases are estimated to save 0.4 percent of GDP.

In addition, they argue for raising copayment (out-of-pocket payment) rates, which is expected to produce a double dividend of increasing revenue while reducing excess demand. Raising effective copayment rates by 5 percentage points for people aged 70 and older in the health care system and for all users in the long-term care system could add revenue equivalent to 0.6 percent of GDP by 2030. Another potential option is increasing copayment rates on expenses above the monthly cap and for medical services provided under the social assistance program.24 Although higher out-of-pocket payments would also contribute to reducing excessive demand, such payments may need to be accompanied by further differentiation of copayment rates based on income levels or means-testing to ensure fairness.

Kashiwase, Nozaki, and Saito (2014) also argue for collecting contributions from dependent spouses, which could increase revenue and reduce disincentives for second earners to work. Under the current system, as is the case with pensions, dependent spouses of employees are exempted from paying premiums if their annual earnings are below 1.3 million yen. This creates a disincentive to work beyond this threshold. Moreover, this special treatment of dependent spouses may be unfair vis-à-vis couples with both earning beyond the threshold and families of self-employed. They estimate that collecting contributions from dependent spouses could add revenue of 0.3 percent of GDP in 2030.

However, the total savings of up to 1.9 percentage points of GDP from raising copayment rates, more efficient use of health resources, and higher reliance on generic drugs, is smaller than the projected increase in government health spending of 3.5 percentage points of GDP. Fully offsetting the increase would require more radical reforms, such as further increases in copayment rates; increases in contribution rates, including by introducing a completely proportional contribution scale under the employment-based insurance;25 and a review of government-controlled prices of health and long-term care services. Thus, containing health spending is a key policy area that could be used to restore fiscal sustainability.

Intergenerational Equity

This section looks at the intergenerational impact of fiscal consolidation based on Tokuoka (2012). Intergenerational resource imbalances matter, as older generations may not transfer their net benefits to younger generations, and such transfers—if made—may not exactly match the net burden of each individual. Intergenerational inequality in resource allocation in Japan is already significant, even without accounting for future fiscal consolidation. The pay-as-you-go social security system has widened intergenerational resource inequality substantially because of rapid aging. The Cabinet Office (2005) estimates that, based on government policy at the time, the present discounted value of the lifetime net burden for future generations would be 100 million yen per household (about 20 times household annual disposable income) more than that for those aged 60 years or older.26 Therefore, implementing fiscal consolidation while minimizing further deterioration in intergenerational inequality is important.

Tokuoka (2012) analyzes the intergenerational implications of fiscal consolidation and concludes that combining social security spending reforms and revenue measures in a balanced manner would be the fairest way to distribute the burden of fiscal consolidation across the generations. However, an excessive reliance on these measures, in particular reducing pension benefits for current pensioners, would have a serious impact on the welfare of seniors.

In addition, his simulations show that delaying consolidation would exacerbate intergenerational imbalances. On the one hand, fiscal consolidation generally worsens intergenerational inequality compared with the level implied by existing policy, as the young have a longer remaining lifetime and would therefore feel the impact of fiscal consolidation for a longer period. However, a lack of fiscal consolidation would eventually lead to an increase in interest rates, which would lower output and reduce welfare substantially. In such a case, young generations would be hit harder, further aggravating intergenerational imbalances.

Specifically, Tokuoka (2012) uses a standard lifecycle overlapping generation model with perfect foresight, but without uncertainty about income or life length or heterogeneity within each generation (one representative agent in each generation). The model consists of the household, corporate, and government sectors. He calculates the lifetime resource burden from the following five measures, yielding 0.5 percent of GDP as a part of the 10 percentage point structural adjustment needed in Japan: (1) reducing the pension replacement ratio (while maintaining the pension eligibility age); (2) raising the pension eligibility age; (3) raising the pension contribution rate; (4) containing non-pension social security benefits; and (5) raising the consumption tax rate (beyond 15 percent already assumed).

He finds that reducing the pension replacement ratio or raising the pension eligibility age would keep the burden for young generations relatively low, with the former having a greater impact in correcting intergenerational inequality, as the latter would impose a zero burden on generations 65 years of age or older. The aggregate economic impact implied by the overlapping generation simulations is very similar for both measures.

Relative to reducing the pension replacement ratio, raising the pension contribution rate or the personal income tax rate would worsen the existing intergenerational imbalance as these would increase the lifetime burdens on younger generations. In addition, output would be lower, given the greater distorting impact of an increase in the pension contribution rate on labor supply and capital accumulation. The author argues that this finding is consistent with the empirical observation for OECD economies that growth is moderately, but negatively, correlated with social security contributions and the employee income tax.

Containing non-pension social security benefits would distribute the lifetime burden more equally across generations than reducing pension benefits or raising the pension contribution rate. The implications for intergenerational inequality of raising the consumption tax rate are similar to an adjustment of non-pension social security benefits. A consumption tax hike would also dampen aggregate output, but less than an increase in the pension contribution rate, because the latter has a larger negative effect on labor supply.

Next Tokuoka (2012) compares a gradual fiscal consolidation scenario with a delayed one. Under the latter, the lifetime burden would be smaller for all generations and the level of GDP would be higher initially relative to the former, owing to the lower (net tax) burden. However, as deficits and public debt remain elevated for longer, this would eventually crowd out investment through higher interest rates, implying higher cumulative output losses under a delayed adjustment scenario. These results may underestimate the costs of crowding-out, because they do not factor in the possibility of a nonlinear interest rate response to debt.

Assuming an eventual reduction in the ratio of debt to GDP to the same level, the overall adjustment would need to be larger by about 1 percentage point of GDP in the delayed scenario owing to accumulated interest expense. As a result, the increase in the lifetime burden for the younger generations would be larger, while it would be substantially smaller for senior generations, exacerbating the intergenerational resource imbalance. From a political economy perspective, the finding that delaying fiscal consolidation could lower the burden for older generations highlights the challenge faced by policymakers to implement fiscal consolidation early.

Finally, Tokuoka (2012) examines policy options to correct intergenerational imbalances. First, allowing greater immigration could correct the intergenerational resource imbalance. Assuming a constant size of new-born generations, instead of the annual decline of 0.75 percent under the baseline, reduces the per household lifetime burden of those currently aged 20 for financing pension benefits by 20 percentage points of current wage income per household (before taxes) relative to a no-immigration case, because a larger working population supports the public pension system. Since greater immigration would also reduce the debt-to-GDP ratio faster by boosting labor supply and the level of GDP, it could reduce young (and other) generations’ burden further by lowering the size of the needed fiscal adjustment for a given debt target. Second, raising productivity growth through structural reforms could similarly reduce young generations’ burden and help correct the intergenerational resource imbalance by trimming the size of the fiscal adjustment need. Third, expanding transfers to young generations, such as public education spending and child allowances, would help mitigate intergenerational imbalances, but the fiscal space for such policies may be limited. In this regard, raising the inheritance tax rate could be an option to secure revenue for financing larger education and family spending.

Conclusion

Japan faces the formidable task of steadily putting the debt-to-GDP ratio on a declining path. It needs to do so in a flexible and calibrated manner, contingent on economic conditions and progress in raising inflation, while maintaining financial stability. Structural fiscal adjustment of about 8.5 percent of GDP is needed to restore fiscal sustainability, with only about a quarter identified through the next increase in the consumption tax rate to 10 percent, the waning of stimulus, and plans for restraining expenditure, leaving a gap of more than 6 percent of GDP in yet-to-be identified measures.

Japan needs to take the aging of its population into consideration in deciding on the pace and content of fiscal consolidation as it is a primary driver behind the rapid rise in fiscal risks, sluggish growth, and the widening of intergenerational imbalances. In this chapter we examined specific measures on both the revenue and spending fronts for their impact on the government’s financial requirement, growth, and equity where possible.

On the revenue side, we suggested that a further hike in the consumption tax rate is promising as it has large revenue potential in an aging society, is relatively growth friendly, and enables fairer burden sharing among generations. On the other hand, reforming the corporate income tax would provide benefits by stimulating investment and could be considered an element of a comprehensive fiscal reform package that ensures fiscal sustainability in a growth-friendly manner.

We discussed specific reforms to the social security system to contain spending in a manner that supports growth and intergenerational equity. Among various pension reform options, raising the pension age should be the first priority. Other measures include a partial claw back of pension benefits from wealthy retirees and reducing the preferential tax treatment of pension incomes. Collecting contributions from dependent spouses is another option and should proceed simultaneously in both the pension and health care systems. Raising copayment rates for medical and long-term care services would reduce excess demand. Also, there seems to be room for more efficient use of health resources.

There are important synergies between these different measures. For example, an increase in the consumption tax rate can be coupled with well-targeted transfers to low-income households rather than a multiple rate system. Revenue losses from a reduction in the corporate income tax rate should be offset by fiscal savings elsewhere. Pension reform leading to a reduction in benefits can be accompanied by measures to address old-age poverty.

Steady progress with structural fiscal adjustment is needed to avoid incurring additional costs and exacerbating intergenerational imbalances. However, given that Abenomics also aims to raise aggregate demand and inflation, economic conditions may warrant combining such permanent consolidation with temporary and well-targeted stimulus. As adjustment will have to take place over an extended period of time, Japan should review its fiscal institutions, considering other countries’ experiences.

All in all, fiscal consolidation should be as growth friendly and equitable as possible. A credible and concrete medium-term framework to restore fiscal sustainability would also free up fiscal space in the near term to respond to downside risks when they emerge. By being concrete and credible, fiscal risks would be contained and such a plan would raise growth in the near term through confidence effects, supporting the exit from deflation. The fiscal sector could get a big boost from higher growth, which would lower the overall adjustment need. The next chapter discusses the structural reform agenda in detail.

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The consumption tax increase to 10 percent in October 2015 was assumed.

For example, Keen and others (2011) compare the cases of immediately starting a consumption tax rate hike and of delaying it by two years. Tokuoka (2012) argues that delaying fiscal consolidation could be costly and worsen intergenerational imbalances.

Moreover, IMF (2012) estimates that Japan’s fiscal multiplier is higher for spending measures than for revenue ones.

In addition, to reduce vulnerability, mitigating rollover risks through further extending maturity is also important (see Tokuoka 2010 and Lam and Tokuoka 2011).

The ratio of the population aged 65 or above to the working-age population (20–64) is the highest in the world and is expected to rise from 38 percent in 2010 to 57 percent in 2030.

The consumption tax, Japan’s value-added tax (VAT), replaced the excise taxes in April 1989.

The share of nonregular workers increased from 20 to 37 percent during the 1990–2013 period.

This section is based on Keen and others (2011).

Revenue from the VAT divided by total consumption times the standard rate, which is a crude indicator of how far a VAT is from the benchmark of a single rate levied on all consumption.

This section is based on De Mooij and Saito (2014).

The average in 2014 of 11 Asian economies (China, Hong Kong, India, Indonesia, Japan, Malaysia, Philippines, Singapore, South Korea, Thailand, Vietnam) is 25 percent.

Wage earners can claim the standard deduction that rises with income up to a certain threshold and the deduction is substantially higher than actual expenses and compared to other countries. This large wage income deduction creates incentives for small and medium-sized enterprises (SMEs) to become incorporated and distribute profits through directors’ wages, which could reduce corporate income tax liabilities (Tajika and Yashio 2005).

The government plans to further reduce the tax rate by 3.3 percentage points (2.5 percentage points in FY2015 and an additional 0.8 percentage point in FY2016).

This section is based on Kashiwase, Nozaki, and Tokuoka (2012).

For details, see Box 1 in Kashiwase, Nozaki, and Tokuoka (2012).

Equally split between employers and employees.

Macroeconomic indexing allows the increase in pension benefits to be smaller than price or wage increases to contain pension spending. However, when prices or wages decline, pension benefits cannot be lowered by more than the decrease in prices or wages.

The public pension plays an important role in helping reduce old-age poverty, as the system has a redistributive nature.

The GPIF announced on October 31, 2014, a substantial portfolio rebalancing from domestic bonds to equities and foreign securities, bringing the new portfolio benchmarks in line with targets used in other countries. The rationale for the reallocation, which had been planned since late 2013, has been threefold: (1) to prepare the GPIF for higher inflation: reducing the portfolio of JGBs limits potential capital losses once nominal interest rates rise while increasing returns on assets; (2) to provide more risk capital to the economy by infusing funds into private assets; and (3) to strengthen its governance structure.

Defined as a pension benefit for a representative couple divided by the average wage of the working-age population.

This section is based on Kashiwase, Nozaki, and Saito (2014).

In Japan, a person aged 80 or above spends about 19 times as much as a person aged 40–44 on health; this ratio is the highest among the OECD countries, whose median ratio is 6.2.

Assumptions are taken from the National Institute of Population and Social Security Research.

The social assistance program provides free medical care. The cost more than doubled to 0.3 percent of GDP in 2010 from the recent low in 1991.

Currently the monthly contribution amount is fixed beyond a certain threshold of monthly income, which makes the contribution scale regressive.

Tokuoka (2012) points out that intergenerational imbalances are worse than indicated by Cabinet Office estimates, as they do not take into account future fiscal consolidation, which this and previous chapters argue is unavoidable. He cites the results of Kotlikoff and Leibfritz (1999), which show that once needed expenditure cuts or future tax increases are considered, Japan is the most unequal economy in the world from an intergenerational perspective.

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