Background Papers

This Background Papers on Japan analyzes the recent movements of the yen from a long-term perspective. It reviews the movements in the real value of the yen during the post-war period. The paper highlights that movements in the Consumer Price Index (CPI)- and WPI-based real exchange rate are shown to be characterized by transitory deviations around stable time trends. The paper discusses potential explanations for the secular real appreciation of the yen. The paper also examines the tax reform issues in Japan.


This Background Papers on Japan analyzes the recent movements of the yen from a long-term perspective. It reviews the movements in the real value of the yen during the post-war period. The paper highlights that movements in the Consumer Price Index (CPI)- and WPI-based real exchange rate are shown to be characterized by transitory deviations around stable time trends. The paper discusses potential explanations for the secular real appreciation of the yen. The paper also examines the tax reform issues in Japan.

I. The Yen from a Long-Run Perspective

1. Introduction

After depreciating during 1989-90, the yen has appreciated considerably since 1991. The real effective appreciation (based on consumer price indices) was initially moderate, averaging 5 1/2 percent annually in 1991-92, before accelerating sharply to 16 percent in 1993, and a further 7 percent in 1994. Starting in late February this year, the yen began to strengthen rapidly again, jumping up by 6 percent in real effective terms during March and another 7 percent in April. Since the trough in 1990, there has been a cumulative increase in the real value of the yen of 60 percent, leaving it 33 percent above its previous peak in 1988.

This chapter analyzes the recent movements of the yen from a long-run perspective. It is organized as follows. Section 2 reviews the movements in the real value of the yen during the post-war period. Movements in the CPI- and WPI-based real exchange rate are shown to be characterized by transitory deviations around stable time trends, while the prices of Japanese exports relative to those of partner countries have fluctuated around a stable mean level since the mid-1960s.

Section 3 discusses potential explanations for the secular real appreciation of the yen. The evidence suggests that this appreciation can not be explained by Japan’s trade surplus or the associated buildup of the stock of net foreign assets. Instead, the explanation lies in differential rates of productivity growth between the traded and non-traded sectors in Japan relative to trading partners. A framework based on these productivity growth differences is then used to explain how export competitiveness was maintained, or even improved, despite the secular real appreciation of the yen based on consumer and wholesale prices.

Section 4 assesses the potential contribution of several factors in the recent appreciation of the yen relative to trend: (i) the decline in aggregate demand that led to the recession since 1991; (ii) the stance of monetary policy; (iii) portfolio effects; and (iv) trade frictions and negotiations between the United States and Japan. While some of these factors may have contributed to short-term yen appreciation, they do not suggest a permanent shift in the long-run level of the real exchange rate.

Section 5 examines the implications of the current exchange rate and the market’s forecast of its future movements for internal and external balance in the medium term. The exercise suggests that the current market forecast path for the exchange rate will yield a substantially lower current account surplus in the medium term than that indicated by projected savings and investment patterns. There is, therefore, an inherent tension between the medium-term achievement of internal and external balance on the one hand, and the market’s forecast of the path of the yen on the other. The adjustment in the exchange rate necessary to attain internal and external balance in the medium term is estimated to be substantial.

2. Recent developments in a historical context

Chart I.1 displays annual data on the real value of the yen based on consumer prices, wholesale prices, and relative export unit values over the last 45 years.



Citation: IMF Staff Country Reports 1995, 116; 10.5089/9781451820515.002.A001

Source: Staff estimates1/ CPI-based rate employs an average of G-7 partner countries; WPI-based rate employs an average of G-7 partner countries for which WPIs are available: US, GR, UK; relative export unit values are based on G-7 partner countries.2/ 1995 data are staff estimates based on monthly exchange rates and prices for May.

Consider first the behavior of the real exchange rate based on consumer prices. The data clearly display a deterministic trend in that the real exchange rate fluctuates around a fixed trend line. The estimated trend real value of the yen has risen at an annual rate of 3.1 percent a year over the last 45 years. A notable feature of the trend in the CPI-based rate is its stability across the fixed- and floating-rate periods, even though the underlying behavior of nominal exchange rates and price levels has been quite different in the two periods (Chart I.2). During the fixed-rate period, the nominal effective exchange rate was essentially unchanged, while CPI inflation in Japan exceeded that in its major trading partners--averaging 5 percent a year during 1951-71, compared with 2.8 percent in the other major industrial countries. So the yen appreciated in real terms by the inflation differential. In the floating-rate period, the nominal effective exchange rate appreciated consistently, while the inflation differential between Japan and partner countries declined through 1977 and was subsequently reversed.



Citation: IMF Staff Country Reports 1995, 116; 10.5089/9781451820515.002.A001

Source: Staff estimates.

Chart I.1 shows that wholesale prices in Japan relative to those in other major industrial countries fluctuated in a very narrow band during the fixed-rate period of 1951-71. During the floating rate period the average WPI-based real exchange rate has trended upwards at 1.5 percent a year. The direction and extent by which the WPI-based real exchange rate has deviated from trend corresponds closely to deviations of the CPI-based real exchange rate from its trend.

Chart I.1 shows that the price of Japanese exports relative to those of its partners, as measured by relative export unit values, fell by over 60 percent during 1951-65. Since 1965, there is no apparent trend, with short-run fluctuations around a mean level corresponding closely to deviations of the CPI- and WPI-based real exchange rates from trend. Japanese exporters were, therefore, able to improve competitiveness during 1951-65 and subsequently to maintain competitiveness in the face of the substantial trend appreciation of the CPI- and WPI-based real exchange rates. The likely mechanism whereby this occurred is discussed in the next section. 1/

The differential movements of the WPI in Japan and in other industrial countries have sometimes been interpreted as a measure of the deviations of the exchange rate from purchasing power parity. On this basis, using for example McKinnon’s (1993) methodology, yields that the real exchange rate currently exceeds its long-run equilibrium by over 50 percent. As Chart I.1 indicates, however, there has been a systematic secular divergence between the WPI-based real exchange rate and relative export unit values. Since the WPI subsumes exportables, which represent about a third of the goods in the WPI, the systematic divergence between the two suggests that the remainder of the goods in the WPI represent products that are in fact differentiated from exports. To the extent that goods comprising the WPI are imperfect substitutes for tradeable goods in partner countries, there is no reason to expect that the prices of the two sets of goods would be equalized over time. This interpretation, which is the one adopted here, implies that the deviation of relative wholesale prices from long-run trend levels (22 percent) is substantially less than that implied by deviations from PPP.

3. Explaining long-term movements in the yen

This section examines two potential explanations for the secular appreciation of the CPI- and WPI-based real exchange rates: the accumulation of net foreign assets by Japanese residents; and differential rates of productivity growth between the traded and non-traded goods sectors in Japan relative to its trading partners.

Chart I.3 displays data on the trade balance (top panel) and the cumulative current account balance (middle panel). It is evident that over the last 45 years, Japan’s trade balance has shifted from periods of surplus to deficit independent of the long-run rise in the CPI-based or WPI-based real exchange rates. Thus, the secular appreciation of these real exchange rates can clearly not have been caused by the year-to-year developments in Japan’s savings-investment balance. Similarly, note that the cumulative current account balance, which provides a measure of the build-up of the stock of net foreign assets (NFA) in the portfolios of Japanese residents, fluctuated around a relatively small average level of 3-4 percent of GDP until 1985. While the rapid rise of the stock of NFA after 1985 may have created systematic pressures for the yen to appreciate in real terms, the behavior of the stock of NFA is incapable of explaining the secular appreciation of the yen during 1951-85. Since the early 1980s, when capital controls in Japan were relaxed, it is possible that the stock of NFA has become a more important determinant of exchange rates because of portfolio balance effects. The behavior of NFA, however, is incapable of explaining the steady secular appreciation of the real exchange rate during the postwar period as a whole.



Citation: IMF Staff Country Reports 1995, 116; 10.5089/9781451820515.002.A001

Source: Nikkei Telecom and staff estimates.

The classic framework for explaining secular movements of real exchange rates is a model of differential productivity growth across the traded and nontraded goods sectors in the tradition of Balassa (1964). The fact that there has been a secular appreciation of the CPI- and WPI-based real exchange rates, but not in relative export prices, implies that Japan’s export prices have fallen relative to overall prices- at a faster rate than in partner countries (Chart I.4, first panel). For such a secular decline in the price of exports relative to overall prices to have been sustained, productivity growth in export industries must have exceeded that in other industries. This is a difficult proposition to test directly, however, because of a lack of availability of data on factor inputs into export industries as distinct from other industries.



Citation: IMF Staff Country Reports 1995, 116; 10.5089/9781451820515.002.A001

Sources: Nikkei Telecom; and staff estimates.

The data on productivity that are available (and comparable) across countries relate to labor productivity in the manufacturing sector. The behavior of average labor productivity in the manufacturing sector of Japan relative to a trade-weighted measure of productivity levels in the other industrial countries is presented in Chart I.3 (bottom panel). There is a clear secular pattern, with productivity growth in Japanese manufacturing consistently outpacing that in other industrial countries by, on average, 3.6 percent per year during the post-war period. In the following, the observed differential in productivity growth across manufacturing sectors is taken as indicative of a greater differential of productivity growth between the traded and nontraded goods sectors in Japan than that in the other industrial countries.

As discussed previously, the relative price of Japanese exports declined until the early 1970s and then remained relatively stable--so export price competitiveness first improved and was then maintained. 1/ McKinnon (1993) shows that during the fixed-rate period, nominal wages in Japan and its trading partners tracked the relative productivity differential well. As a result, while nominal wages in Japanese traded-goods sectors grew faster than in partner countries, relative unit labor costs were stable. Competitiveness in traded goods was, therefore, maintained, both in terms of prices and costs. Higher nominal wage growth in Japanese traded-goods sectors that accompanied higher productivity growth, however, spilled over to the rest of the economy and, in particular, to the services and other nontraded goods sectors. Since services and other nontraded goods are a significant component of the CPI but a smaller component of the WPI, the Japanese CPI could be expected to rise relative to the WPI. If the productivity differential between traded and nontraded goods in Japan consistently exceeds that in its partner countries, a secular appreciation of the Japanese real exchange rate, as measured by either CPIs or WPIs, should be expected, with a higher trend in the CPI rate. This is exactly as occurred. Chart I.4 (second panel) shows that growth of the CPI in Japan has far outpaced that in the WPI.

During the floating-rate period the mix between price and exchange rate movements was quite different. Under a regime of floating exchange rates, this mix is determined by the relative stance of monetary policies, which varied considerably during this period. In addition, in examining the data, a number of special factors, such as the oil price shocks of the 1970s, the removal of capital controls in Japan in the early 1980s, and changes in the product mix, all affected price levels and exchange rates. In any event, the secular appreciation of the CPI-based real exchange rate has continued during this period, while the competitiveness of Japanese exporters, at least as measured by relative export unit values, appears to have been maintained.

4. The recent appreciation of the yen and possible explanations

While the real exchange rate, based on either the CPI or WPI, appreciated steadily since early 1990, it remained below trend during 1991 and 1992 (Chart I.5, first panel). It is only In 1993-94 that it appreciated above trend. The sharp appreciation of the yen during March and April of 1995 has brought both the CPI- and WPI-based rates to some 22 percent above their trends. 1/ The prices of Japanese exports relative to partner countries are 28 percent above their historical average level. 2/



Citation: IMF Staff Country Reports 1995, 116; 10.5089/9781451820515.002.A001

Source: Staff estimates.

This section appraises the role of several factors in influencing the recent behavior of the yen. These include: (i) the decline in aggregate demand associated with the recession; (ii) the stance of monetary policy; (iii) portfolio effects; and (iv) the trade frictions and negotiations between Japan and the United States. Of course, these factors are not mutually exclusive in their effects on the yen. It is likely that they all played some role, albeit to different degrees at various points in time, during the last four years. The question is whether they can singly or jointly explain the recent appreciation of the yen.

a. Aggregate demand and the recession

The current recession in Japan is the deepest and longest since the early 1970s. Until the third quarter of 1994, GDP had remained below its level at the end of 1991, while potential output is estimated to have grown at 2 3/4 percent a year, creating a large output gap (Chart I.5, second panel). There is a consensus that the recession was led by a contraction in aggregate demand. 1/ The traditional Mundell-Fleming model in which capital is mobile predicts that contractions in private consumption and investment, due to declines in consumer and business confidence following the collapse of asset prices in Japan, should have led to a real depreciation of the yen in the short run. 2/ An autonomous temporary contraction in aggregate demand can be expected to lower domestic interest rates, leading to a capital outflow, and a depreciation of the real exchange rate on impact. Interest parity then implies that the decline in domestic interest rates translates to an expectation of future appreciation. That is, as aggregate demand recovers, and output returns to potential, the real exchange rate is expected to appreciate and return to trend. It is worth emphasizing that during the recession, the relatively depreciated exchange rate spurs net exports and ameliorates the decline in aggregate demand.

The real exchange rate fell below trend in 1990, even though output is not estimated to have fallen below potential until 1992. During 1991-92 the real exchange rate remained below trend, consistent with a contraction in aggregate demand. However, the subsequent sharp appreciation of the yen, which has raised it substantially above trend, is not consistent with output falling further below potential. In fact, the real appreciation since 1993 has made the recession deeper and longer than it would have been otherwise--becoming a cause rather than an effect of the output decline. The most recent round of appreciation in March-April 1995 has again threatened to stall the recovery.

b. The stance of monetary policy

The behavior of the real exchange rate during the business cycle depends importantly on the stance of monetary policy. As evidenced by the behavior of short-term nominal interest rates, monetary policy was tightened sharply in 1989 to contain the rapid rise in asset prices and economic activity (Chart I.6, first panel). Following the collapse of asset prices in 1990, as economic activity began to slow in early 1991, the Bank of Japan began to ease monetary conditions by mid-1991. As the recession deepened, monetary conditions were eased further. Short-term market interest rates fell from 8 percent in 1990 to little over 1 percent during April 1995. The decline in short-term rates was accompanied by a decline in long-term rates, though long-term rates declined by less. 3/ While the decline in nominal interest rates was broadly reflected in declines in real interest rates based on CPI or WPI inflation, declines in inflation offset part of the decline in nominal rates, so real interest rates declined by less than nominal interest rates (Chart I.6, second panel). 1/ Moreover, based on WPI, real interest rates remain at relatively high levels.



Citation: IMF Staff Country Reports 1995, 116; 10.5089/9781451820515.002.A001

Source: Nikkei Telecom.

Since monetary policy has operated primarily on short-term rates, one measure of the stance of monetary policy is provided by the slope of the yield curve. 2/ The slope of the yield curve remained negative in 1991, became positive at the beginning of 1992, and has risen steadily since (Chart I.6, third panel). This is consistent with the interpretation of a continued loosening of monetary policy in Japan during 1991-95.

While monetary policy in Japan may not have been loosened sufficiently to successfully counteract the recession, it would appear undebatable that monetary policy was loosened, and at the very least that there are no indications that a tightening occurred. The rise of the yen above trend since 1993, therefore, appears inconsistent with the stance of monetary policy in Japan.

Of course, the exchange rate depends not on the absolute stance of monetary policy in Japan, but on the stance relative to that in its trading partners. The relative stance of monetary policies is notoriously difficult to measure. Chart I.7 presents the indicators in Chart I.6 relative to those in G-7 partner countries. In line with the easing of monetary policy in Japan in 1991-92, short-term interest rates fell relative to those in partner countries (Chart I.7, first panel), albeit by noticeably less than the absolute decline in Japanese interest rates. Long-term interest rates hardly moved relative to those abroad during 1991-92. In mid-1993, both short and long-term rates moved up briefly relative to those abroad. Since late 1993, both rates again declined relative to those abroad. Real interest rates in Japan relative to those abroad fell during 1991, then rose in 1993, and have fallen since (Chart I.7, second panel). 3/



Citation: IMF Staff Country Reports 1995, 116; 10.5089/9781451820515.002.A001

Source: Nikkei Telecom and staff estimates.

The appreciation of the yen in 1993 may be partly attributable to a tightening of monetary policy in Japan relative to that abroad, but it is difficult to attach too much importance to this link once one considers the magnitudes involved. Short-term rates in Japan increased by 1/2 of a percentage point relative to those abroad, while the exchange rate appreciated by 16 percent during the year. Reasonable parameter estimates would suggest a far lower response, even after allowing for exchange rate overshooting of the type described by Dornbusch (1976). The relative tightening of monetary policy as measured by interest differentials cannot, therefore, explain the entire exchange rate appreciation in 1993. The subsequent appreciation of the yen during 1994 and 1995 are, of course, inconsistent with the behavior of relative monetary policies as measured by interest differentials.

The slope of the yield curve in Japan fell below that in the other G-7 countries in early 1990, remained below until late 1994, and subsequently rose above (Chart I.7, third panel). This factor suggests that from 1990 until late 1994, monetary policy in Japan was consistently tighter than that abroad. The sustained increase in the relative slope of the yield curves since early 1991, though, would imply that the degree of relative tightness was progressively reduced. By late-1994, the slopes had equalized, so that the stance of monetary policy in Japan was about the same as that abroad. The relative slope of the yield curve therefore implies that there should have been upward pressures on the yen during 1990-94. Further, these pressures should have been strongest in early 1991, and subsequently reduced. Therefore, while the appreciation of the yen during the period 1990-94 is consistent with this indicator of the relative stance of monetary policies, it is at odds with the timing of the appreciation, which accelerated sharply in 1993 and continued in 1994. Furthermore, the appreciation of the yen during 1995 is sharply at odds with this indicator of monetary policy since it suggests that monetary policy in Japan has been looser than that abroad.

c. Portfolio balance and capital flows

If assets denominated in different currencies are imperfect substitutes, and residents of each country have a preference at the margin for assets denominated in their own currencies, then the dynamics of asset accumulation associated with current account imbalances can be expected to result in systematic movements of nominal and real exchange rates. Current account surpluses, for example, should lead to a continually appreciating exchange rate due to the need to offset the incipient excess supply of foreign assets.

As noted earlier, since there was no substantial accumulation of claims on the rest of the world by Japanese residents until the mid-1980s, the evolution of the stock of NFA is incapable of explaining the secular appreciation of the yen during a large part of the post-war period. Some of the systematic appreciation of the yen during the 1980s, however, could be related to the persistent surpluses in the 1980s which increased the supply of (net) foreign assets in the portfolios of Japanese residents. 1/

More recently, there have been incidents when there appear to have been shifts in portfolio preferences that were unrelated to observed return differentials, and these have likely influenced the path of the yen. It has been suggested, for example, that a shift in investor preferences away from dollar-denominated assets may have contributed to the yen appreciation in early 1993. Numerous observers have suggested that Japanese institutional investors--particularly life insurance companies--having suffered considerable losses from yen appreciation in the past became reluctant to expose themselves further to the risk of unanticipated dollar depreciation. As Chart I.8 shows, even though returns on Japanese bonds have been low since mid-1990--except for very brief episodes--ex-post they have tended to dominate returns on U.S. bonds as a result of yen appreciation. They have done so consistently for the last 2 1/2 years, sometimes by more than 10 percentage points a year.



Citation: IMF Staff Country Reports 1995, 116; 10.5089/9781451820515.002.A001

Source: Nikkei Telecom.Note: Ex post return on holding government bonds for previous 12 months.

Over a long horizon, ex post yen returns on Japanese bonds have on average substantially exceeded those on foreign bonds. Since the early 1980s when capital controls in Japan were removed, the interest rate on long-term Japanese bonds averaged 6.2 percent, while that in partner countries averaged 9.6 percent. However, during this period, the nominal effective exchange rate appreciated by, on average, 5.6 percent a year. 1/ The average return on Japanese bonds of 6.2 percent, therefore, far exceeded the average return in yen on foreign bonds of 4 percent. 2/ It is worth noting that while this excess return is in part due to the sharp appreciation above trend of the yen since 1993, excess returns on yen bonds would have occurred even with just the trend rate of appreciation. Looking forward, with a trend of 3 percent in the CPI-based real exchange rate, and inflation in Japan 2 percentage points below that in partner countries, a substantial nominal interest differential--of 5 percentage points a year--would be required for ex ante returns on Japanese and foreign bonds to be equalized. As Chart I.7 (first panel) showed, such an interest differential has not been observed since 1984, and interest differentials currently would need to increase by 1 percentage point for yields to be equalized.

It has been pointed out that the bursting of the asset price bubble--by reducing the value of domestic assets--increased the relative proportion of foreign assets in the portfolios of Japanese residents. This effect may have led Japanese residents to attempt to re-balance their portfolios in favor of domestic assets. Also, the decline in domestic asset prices lowered the value of “hidden” reserves and capital of enterprises and financial institutions, and may have prompted more risk-averse behavior.

The shares of foreign securities in the total assets of the major categories of institutional investors are presented in Chart I.9. Several features are noteworthy. First, after a moderate buildup during 1981-85, the share of foreign securities in the total assets of banks has varied within a narrow margin, fluctuating around a modest average level of 2 percent. Second, the share of foreign securities in the asset portfolios of trust accounts of banks has increased steadily and in spite of the continued appreciation of the yen during 1990-94. Third, there has been a dramatic rise and fall in the share of foreign securities in the portfolios of life insurance companies. This share had risen to almost 16 percent in early 1990 and has been declining steadily since the collapse of the asset price bubble, falling below 7 percent by the end of 1994. Finally, since the collapse of the asset price bubble, the decline in the share of foreign securities in the aggregate institutional investor portfolio has been relatively modest, with the share falling from almost 5 percent in late 1989 to 4.2 percent by the end of 1994. 1/



Citation: IMF Staff Country Reports 1995, 116; 10.5089/9781451820515.002.A001

Source: Economic Statistics Monthly, Bank of Japan1/ excludes postal life insurance, data for which begin only in 1984.

While the portfolio behavior of Japanese life insurance companies suggests a marked shift away from foreign securities, there was only a modest decline in the share of the aggregate Japanese institutional investor portfolio devoted to foreign securities. 2/ Under a floating exchange rate, net capital flows equal the current account (less any intervention), and can provide little information on aggregate investor preferences. Since Japan continued to run current account surpluses in the 1990s, it is a matter of arithmetic that the declines in Japanese life insurance companies holdings of foreign assets must have been taken up by other Japanese investors. The extent to which this change in the composition of holders of foreign assets affected aggregate market preferences and was reflected in changes in asset prices (the exchange rate) is, however, difficult to determine. It is also difficult to match such shifts to the timing of exchange rate movements over the last four years and, in particular, to ascertain the role these shifts played in the sharp appreciations during 1993 and 1995. Nevertheless, it is likely that these portfolio shifts played some role.

d. Trade tensions and “talking up the yen”

Since the exchange rate--in the absence of exchange controls--is a forward-looking asset price, it responds to news about the likely course of all variables that affect the future path of the exchange rate. Chart I.10 provides a chronology of developments in trade tensions and negotiations along with the yen/dollar exchange rate during 1993-95. While on several occasions break-downs of the talks, or threats of potential retaliation by the United States, were accompanied by an appreciation of the yen, most notably in the period surrounding the Clinton-Hosokawa summit in February-March 1994, a systematic pattern is hard to discern over the entire period.

Chart I.10
Chart I.10


Citation: IMF Staff Country Reports 1995, 116; 10.5089/9781451820515.002.A001

There are several possible interpretations. Since the current exchange rate embodies a forecast path of all the variables that affect it, it is possible to tell several alternative stories depending on one’s reading of market participants’ expectations. For concreteness it is useful to discuss two interpretations.

First, it could simply be argued that, in an uncertain world, market participants’ forecasts incorporate probabilities for various outcomes. As news becomes available, these probabilities and forecasts are updated. So, sometimes when the trade talks floundered, the market updated its forecast path for the future path of all variables affecting the exchange rate. It could have been perceived, for example, that a successful resolution of the talks would reduce barriers to trade and lower the equilibrium yen exchange rate. Then a failure could lead to an appreciation if a successful outcome had been built into market expectations. At other times, developments did not result in market participants updating their forecasts, and so there was no effect on the exchange rate.

Second, it has been argued that the appreciation of the yen in response to signals of failure in the trade negotiations is difficult to explain in terms of expected developments in trade alone-which was, on the face of it, all that was being negotiated. This interpretation would argue instead that, in fact, the appreciation represented participants’ perceptions that the U.S. administration was not willing to accept the baseline path of current accounts and would act to depreciate the dollar if trade negotiations did not succeed. Market participants thus reacted to signals of failure in the trade talks by bidding up the yen. This has been referred to by several observers as “talking up the yen.” It should be noted that if either or both governments succeed in changing today’s market exchange rate by “talking”, they are in part credibly convincing markets of the future course of relative monetary and fiscal policies. Market participants could, therefore, have been reacting to an anticipated loosening of United States monetary policy or an anticipated expansion of Japanese fiscal policy.

5. The yen and external adjustment

One method for assessing the appropriateness of the current level of the yen is provided by examining the implications of the market exchange rate for the future path of the current account and the associated stock of net foreign assets. The question can then be asked whether the projected path is sustainable. Such an approach was adopted by Krugman (1985) in examining the value of the dollar in the first half of 1985. If the projected path for the balance of payments, or the projected stock or net foreign assets (liabilities) in the portfolios of Japanese (foreign) residents appears implausible or explosive, then the exchange rate can be judged to be unsustainable in that a correction will be required at some point in the future. Such stock considerations, however, are likely to be relevant only over a long horizon. We follow a procedure that concentrates on the implications for flow equilibrium rather than stock dynamics. 1/ In particular, we examine the implications of the market exchange rate for external adjustment and ask whether these are consistent with internal and external balance in the medium term.

There are three key ingredients to conducting such an exercise. First, since the evolution of the current account depends not only on today’s exchange rate but also on the future path of the exchange rate, an assumption is required on the future path. Second, a judgment must be made on what constitutes the appropriate path of the current account, that is external balance, over the medium term. Third, an econometric model is necessary to determine the path of the current account.

a. The market’s forecast of the exchange rate

What is the market’s forecast of the exchange rate over the medium term? If investors are risk neutral and assets denominated in different currencies are close substitutes, then the market’s forecast of the future change in the real exchange rate is provided by interest differentials. For a five-year maturity, nominal interest rates in Japan are currently about 4 percent below those in partner countries. This differential of 4 percent a year is used below as a point estimate of the market’s expected rate of future nominal appreciation of the yen.

b. Medium-term external balance

What is the appropriate current account for Japan over the medium term? One approach is to project savings and investment individually and obtain the external balance residually. This is the approach adopted in Meredith (1994), which deals extensively with the medium- and long-term outlook for the Japanese economy under alternative scenarios. In the baseline scenario identified there, as output gradually returns to potential and internal balance is restored, the external surplus is projected to decline from 3 percent of GDP in 1993 to 2 1/4 percent of GDP by 2000 (Chart I.11). In what follows, external balance is defined as a surplus of 2 1/4 percent of GDP achieved in the medium term--by 2000--as internal balance is restored.



Citation: IMF Staff Country Reports 1995, 116; 10.5089/9781451820515.002.A001

Source: Nikkei Telecom and staff estimates.Note: 4-quarter moving averages of actual and projected data are plotted.

The behavior of savings and investment underlying this projection is as follows. Total savings declines as government savings deteriorate due to higher social security payments, while private savings is reduced by a rising share of the elderly in the population and increasing financial wealth. The drop in savings is partially offset by lower investment: the share of residential investment in GDP falls to a level consistent with trend growth in the housing stock; business investment falls because of a downward trend in its relative price; and government investment falls from a peak in 1994-95.

c. The market’s forecast of external adjustment

The staff’s current account model was used to project the current account under the assumption that the nominal exchange rate appreciates during the third quarter of 1995 into the medium term at the current five-year nominal interest differential of 4.1 percent a year. 1/ The WEO projections for output, domestic wholesale prices, external demand, and foreign prices were employed in the projection, reflecting the assumption that the market’s forecast for these variables coincides with the WEO projections. Chart I.11 reports the results which should be compared to the baseline scenario in Meredith (1994). At the end of five years, that is in the last quarter of 2000, the market’s forecast path for the exchange rate implies an external surplus of 3/4 percent of GDP, 1 1/2 percent below the baseline surplus of 2 1/4 percent. Alternatively, we could ask what the level of the exchange rate would have to be today so that it would be consistent with external balance in the baseline scenario in the medium term (i.e., a current account surplus of 2 1/4 percent of GDP). This calculation yields a required depreciation of the yen in excess of 20 percent.

This point estimate is quite sensitive to the estimate of medium-term external balance and the behavior of trade flows. For instance, a reduction in the definition of medium-term external balance by 1 percent of GDP raises the estimated required adjustment in the yen by about 15 percent. Similarly, the current account model embodies an estimated import price elasticity of 0.43. If the elasticity were instead 1.0, the estimated required change in the yen would increase by 5 percent.

While the imprecision of parameter estimates and the definition of external balance inevitably leads to a range of estimates, it is perhaps worth reiterating that the point estimate around which this range clusters points to substantial tensions in the medium term. These estimates suggest that either the exchange rate will have to adjust--relative to the market’s present expectations--or internal and external balance will not be achieved in the medium term.

II. Tax Reform Issues in Japan

1. Introduction

Tax reform has been a long-standing policy objective in Japan. The most recent effort was initiated by the recommendations of the Tax Council in November 1993. While the discussion had not been completed, in view of the cyclical weakness in activity, a temporary 20 percent across-the-board reduction in personal income taxes was implemented in 1994 as a prelude to full-fledged reform. Following this development, the tax reform package was finalized in September 1994 and approved by the Diet in November 1994. The package includes two-tier cuts in income taxes--permanent (from 1995) and temporary (for 1995-96) portions--combined with an increase in the consumption tax in 1997. The staggered implementation is intended to provide demand support to the weak economy.

This chapter, extending last year’s staff study, revisits tax reform in Japan in light of the final reform package. 1/ As the short-term stimulative effects of temporary tax cuts as well as the broad impact of the shift from direct to indirect taxes were discussed in last year’s study, this chapter focuses on the permanent changes to the tax system in the context of medium-term tax policies. It reviews the objectives of reform, describes the content of the final reform package, and assesses the impact of the package in light of the objectives. Moreover, the chapter explores the scope for further reform, pointing to possible issues and directions for discussion.

The next section reviews the objectives of the latest reform initiatives. In view of the projected rapid population aging, they are aimed at distributing the tax burden more equally across generations and income levels. Before the reform, the burden of income taxes was heavy, particularly for middle-income salary earners, and horizontal equity was significantly impaired by evasion of income taxes and special treatment for small businesses in the consumption tax. 2/ These factors were regarded as having a detrimental effect on incentives to work. Moreover, it was initially intended to augment revenues to meet increasing expenditure requirements, although the final package ended up being revenue neutral.

Section 3 describes the reform package enacted in 1994. A reduction in income taxes has been realized by raising the tax threshold through an augmentation of various deductions, and widening the income brackets for each marginal tax rate. An increase in the consumption tax will be realized by raising the tax rate from 3 to 5 percent. The scope of existing special treatment will be reduced to improve horizontal equity, which will also increase consumption tax receipts. All the reform measures related to the consumption tax will take effect in April 1997.

Section 4 looks at the economic effects of the reform package. First, it alters the distribution of the tax burden across generations and income sources. The analysis of the reform’s overall impact on the effective tax rate across income levels suggests that a taxpayer with labor income exceeding ¥10 million would be a net winner, while a taxpayer below that income level would be a net loser. As the elderly and “underreporting” taxpayers tend to be below that level in terms of their labor income, a shift of tax burdens from the working generation to the elderly and from salary earners to others will be realized. Second, the package raises after-tax real wage rates (i.e., the price of leisure relative to work) for most taxpayers whose labor income is over ¥10 million. However, as the wage elasticity of labor supply appears to be small, the overall effects on labor supply are likely to be insignificant. Third, as the package includes no measures on investment income, it does not alter the after-tax rate of return on saving. The package would increase aggregate saving, however, by boosting the after-tax income of the working generations at the expense of the elderly. Fourth, the reform plan would enhance horizontal equity. Whether it would improve vertical equity depends on judgements as to the optimal level of progressivity of the tax system. Finally, despite the initial intention to augment tax revenues, the final package would be revenue neutral.

Section 5 explores the scope for further reforms. First, increasing taxation on pension benefits could be a viable option to raise revenues. Second, the taxation of investment income was not addressed in the recent package; 1/ nevertheless, the differential tax treatment of various forms of investment income causes distortions, including a nonneutrality between debt and equity financing of corporations. This should be a priority issue in the next round of the tax reform. Third, to address the compliance problem and, thus, ensure greater horizontal equity, the introduction of a taxpayer identification number system deserves consideration. Finally, a review of the securities transaction tax is called for, while the issue of the land value tax needs to be discussed in conjunction with overall land policy management.

2. Review of reform objectives

The main goal of this round of tax reform was to make necessary changes to the tax system in preparation for the rapidly aging society. Japan’s ratio of the aged to total population, which has been the lowest among the G-7 countries, is projected to increase rapidly to over 25 percent by 2020, becoming the highest among the G-7.

Specifically, the reform had three main objectives: to reduce the detrimental effects of taxes on the labor incentives of working generations; to achieve greater horizontal equity; and to secure sufficient and stable revenues to cover increasing expenditure requirements. The reform addressed these objectives by smoothing the progressive structure of personal income taxes and shifting part of the tax burden from income taxes to the consumption tax.

The burden of personal income taxes, particularly for middle-income salary earners, was viewed as having become unduly heavy and unequally progressive. Although the comprehensive tax reform in 1987-88 had substantially reduced the progressivity of the income tax system, 1/ progressivity subsequently increased as economic growth and inflation pushed up nominal incomes and caused taxpayers to face higher tax rates, 2/ While how to measure overall tax progressivity is not unanimously agreed, a widely accepted index developed by Kakwani compares a Lorenz curve with a tax concentration curve. 3/ 4/ By comparing the two curves, Chart II.1 indicates that the tax concentration curve became more concave in 1992 than in 1986, while the Lorenz curve remained unchanged. It suggests that the income tax in the early 1990s had become even more progressive than before the comprehensive reform in the late 1980s.



Citation: IMF Staff Country Reports 1995, 116; 10.5089/9781451820515.002.A001

Sources: Data provided by the authorities.

In addition to overall progressivity, concerns had grown that taxation was particularly heavy for middle-income salary earners. This group of taxpayers typically has annual earnings of about ¥10 million and, reflecting the seniority system in pay determination that prevails in Japan, ranges in age from the late 40s to the early 50s. Their domestic expenses tend to be at a peak in the life-cycle because of child education and housing costs. As the progressive structure of the tax schedule was particularly notable around an income level of ¥10 million, entry into higher tax brackets coincided with a peak in domestic expenses. Consequently, a call for wider distribution of tax burdens across generations--more evenly spread tax burdens over the life-cycle for an individual taxpayer--arose.

Horizontal equity is also an important motivation for reform. There is a widely held perception in Japan that the income-tax burden of salary earners is higher than that of the self-employed and farmers at the same income level. This is mainly because salary earners are subject to tax withholding, while the self-employed and farmers report their income based on “self-assessment.” This phenomenon is known as the “9-6-4 (Ku-ro-yon)” or “10-5-3 (To-go-san)” problem, which refers to the proportion of income effectively subject to taxation: 90-100 percent for salary earners, 50-60 percent for the self-employed, and 30-40 percent for farmers. Although this compliance problem should be dealt with primarily through systemic and/or administrative reforms in income taxes, shifting part of the tax burden from income to consumption taxes contributes to greater horizontal equity by increasing the taxation of groups that can avoid the full burden of income taxes.

The consumption tax, which was introduced in 1989, employed special treatment for small-sized enterprises, such as simplified procedures and exemptions, in order to mitigate compliance costs. The special treatment was applicable to a large number of enterprises and caused distortions in tax burden shifting. One is known as the “ekizei” problem, meaning that part of the taxes paid by consumers was pocketed by enterprises. 1/ As the severity of the problem grows along with the size of consumption tax revenues, solving the ekizei problem was called for as a prerequisite for an increase in the consumption tax.

As population aging raises government expenditures, government revenues should be increased in the medium term to meet expenditure requirements. To this end, the reform (at least initially) was intended to augment government revenues. Moreover, it was also intended to create a more stable tax base over the business cycle. The latter goal appears to conflict with automatic stabilizers and other countercyclical functions of tax policy. In practice, however, given the asymmetric political pressures for raising and reducing taxes, discretionary actions to lower taxes are easier for the authorities to introduce than discretionary tax increases. A stable revenue source in periods of cyclical weakness thus allows the authorities to have greater flexibility in achieving an optimal level of taxation through discretionary cuts in taxes.

3. Reform package enacted in 1994

a. Personal income tax

Under the Japanese personal income tax system, individuals are generally subject to personal income taxes on taxable income--income after deducting applicable allowances, costs, and exemptions--at marginal tax rates depending upon income brackets. 1/ The most common deductions to arrive at taxable income include: a personal basic deduction for the taxpayer and each dependent family member; a special spouse deduction (provided the total income of the taxpayer is less than ¥10 million); and an employment income deduction. 2/ Since January 1989, there have been five income brackets for the national income tax with marginal rates ranging from 10 percent to 50 percent, and three brackets for the local inhabitants tax with rates ranging from 5 to 15 percent.

The package changed the structure of both deductions and rates. The personal basic deduction was increased considerably for both national and local taxes. The employment income deduction was also enlarged by widening the income brackets to which higher marginal deduction rates are applied (Table II.1). As a result of the changes in deduction structures, the tax threshold was raised substantially (for instance, by about 8 percent for a married salary earner with two dependent children). 3/ The changes in the tax rate structure were realized by widening income brackets for each marginal tax rate, with higher weights on lower brackets (Table II.2).

Table II.1.

Japan: Reform of the Deduction Structure of Personal Income Taxes

(In thousands of yen)

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Source: Data provided by the authorities.

For self, spouse, and each of the dependent children.

Table II.2.

Japan: Reform of the Tax Rate (Income Bracket) Structure of Personal Income Taxes

(In millions of yen)

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Source: Data provided by the authorities.

Prefectural and municipal inhabitants taxes combined.

The above-mentioned changes to deduction and rate structures are illustrated in Chart II.2, which describes income tax schedules (national and local income taxes combined) both before and after the reform (see also Table II.3). The marginal income tax rate at a given income level has been significantly reduced; in particular, the previously observed rapid rise in marginal tax rates at income levels around ¥10 million was alleviated.



Citation: IMF Staff Country Reports 1995, 116; 10.5089/9781451820515.002.A001

Sources: Data provided by the authorities1/ National and local taxes combined. A married employee with two dependent children
Table II.3.

Japan: Combined (National and Local) Income Tax Schedule 1/

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Source: Data provided by the authorities.

A married employee with two dependent children.

In addition to the permanent changes, the reform package includes a temporary cut in personal income taxes for 1995 and 1996, equivalent to ¥2 trillion per year. The temporary cut is realized through a 15 percent reduction in taxes for all income levels, with a ceiling of ¥70,000 (¥50,000 for national and ¥20,000 for local tax) per taxpayer.1/ As the ceiling became binding at an income level of as low as ¥8 million, the temporary cut favored low- and middle-income groups. In order to provide flexibility to respond to cyclical conditions, the extension of the temporary cut into 1996 is to be reviewed in late 1995. 2/

b. Consumption tax

The consumption tax in Japan is a value-added tax levied at the national level at a rate of 3 percent. It was introduced in April 1989, replacing the former commodity tax levied on selective goods and services at different rates. 3/ The base of the consumption tax is wide and is estimated to cover over 90 percent of household consumption. 4/ 5/ Goods and services supplied for use in Japan are subject to the tax; imported goods are also subject to the tax, while exports are exempt.

The consumption tax is levied through the credit method, which requires enterprises (corporations and individuals) to calculate and report their tax liability as the rate times their sales. Against this amount, enterprises deduct a credit equal to the amount of the tax that was paid on their inputs at earlier stages of production. 6/ Thus, enterprises must file the net amount of consumption tax receipts (on their sales) less consumption tax payments (on inputs).

There are three types of special treatment to mitigate compliance costs for small enterprises: small enterprise exemption; marginal deduction system; and simplified taxation method. The reform package, while keeping the first treatment unchanged, will abolish the second and reduce the scope of the third.

Enterprises whose taxable sales are not more than ¥30 million are eligible for exemption from the consumption tax on their sales (small enterprise exemption), but would not be able to receive a credit for the tax paid on their inputs. As consumers are subject to 3 percent consumption tax payments regardless of the retailer’s tax status, exempt enterprises could retain at least part of these tax receipts from consumers. While the practice of small enterprise exemptions is common among industrial countries, the exemption limit in Japan is rather high by international standards and is considered to be well above the level that can be justified by the assumption that the costs of administering the tax for small businesses would exceed the yield from the tax. 1/ It is estimated that, even if the limit were to be lowered to ¥10 million, about 40 percent of the total number of enterprises would be eligible for exemption. 2/ The package, however, includes virtually no changes to the small enterprise exemption.

Enterprises whose taxable sales are not more than ¥50 million are eligible for the marginal deduction system. This system bridges the gap in consumption tax burdens from exemption (sales less than ¥30 million) to full taxation (sales over ¥50 million) by employing a linearly diminishing tax deduction depending upon sales values. 3/ As consumers are subject to the 3 percent rate, the deducted amount can simply be pocketed by the eligible enterprises. The package will abolish the marginal deduction system.

Enterprises whose taxable sales are not more than ¥400 million may elect to meet their consumption tax obligations under a simplified taxation method. Under the simplified method, in order to arrive at credit for consumption taxes paid on inputs, a fixed rate ranging from 90 percent (wholesale trade) to 60 percent (service sector) can be applied to consumption tax receipts on sales. 4/ Thus, enterprises whose actual inputs-to-sales ratio is lower than the fixed rate can pocket the difference. The package will reduce the sales limit for eligible enterprises from ¥400 million to ¥200 million.

The consumption tax rate will be increased from the current 3 percent to 5 percent. The new rate is comprised of 4 percent of national and 1 percent of local consumption tax. The local consumption tax will be newly introduced as a prefectural tax, replacing the existing consumption transfer tax that transfers 20 percent of consumption tax receipts to local governments. As the enforcement and implementation of the local consumption tax will be entrusted to the central government, little will change other than the level of intergovernmental transfers between central and local governments at this point. This could be viewed as the first step, however, toward an independent local consumption tax in the future, in keeping with on-going initiatives in the direction of fiscal decentralization.

Some conditionality is attached to the revision of the rate by a reexamination clause in the reform bill. The provision reads that “the Government, if necessary, will take any necessary actions by September 30, 1996, paying due consideration to such factors as financial resources to meet the expenditure requirements (including social welfare), the progress in administrative reforms, the proper review of the special tax measures and consumption tax system, and fiscal conditions.” This conditionality will provide flexibility to respond to cyclical developments.

4. Economic effects of the reform

a. After-tax income distribution

The reform was designed to significantly alter the distribution of the tax burden and, therefore, after-tax income. How the reform affects the after-tax income distribution can be assessed by comparing overall changes--net of reductions due to lower income taxes less increases due to the higher consumption tax--in effective tax rates across income levels.

First, effective income tax rates can be calculated based on the before- and after-reform tax schedules. Table II.4 shows changes in the effective rates for a married employee with two dependent children for sample income levels. As the income level goes up, the reform lowers the effective tax rate by an increasing degree. Chart II.3 illustrates the changes: the slope of the curve, which was particularly steep at income levels of ¥10-15 million before the reform, has been flattened, and the pace of increase in effective rates is more equally distributed across income levels.

Table II.4.

Japan: Effective Rate of Personal Income Taxes 1/ 2/

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Sources: Data provided by the authorities; and staff calculations.

National and local taxes combined.

A married employee with two dependent children.



Citation: IMF Staff Country Reports 1995, 116; 10.5089/9781451820515.002.A001

Sources: Data provided by the authorities; and staff calculations.1/ National and local taxes combined. A married employee with two dependent children

Secondly, the effect of the consumption tax increase on the effective tax rate (in relation to income level) depends on the relative size of the bases of the income and consumption taxes. Since household labor income and consumption in Japan differed by less than 1/2 percent in 1991-93, the two tax bases can be regarded as identical in terms of size. Hence, given the assumption that the increase in consumption tax affects all households proportionally, a 2 percent increase in the consumption tax rate raises tax burdens at all income levels by 2 percent of their income, resulting in a 2 percent rise in the effective tax rate.

Comparing those two effects, the overall impact on the after-tax income of individual taxpayers varies depending on income levels and sources. As shown in Table II.4, the decline in effective rates from the income tax reduction exceeds 2 percent at an income level slightly above ¥10 million: the net effect of the reform on after-tax income is thus positive for those whose income is greater than ¥10 million, and negative for those whose income is below that level. Two factors should be noted here. First, the elderly tend to be classified as “low-income,” as investment income is taxed on a separate basis. 1/ Second, given the existing practice of “underreporting” by the self-employed and farmers, income levels of these groups may be measured to be lower than their actual income, resulting in smaller actual gains from income tax cuts. Taking into account these factors, typical effects on after-tax income can be described as follows: (i) positive for middle- and upper-income individuals who rely mostly on labor income as income sources, such as middle-aged salary earners; (ii) negative for those who rely mostly on income sources other than labor, such as retirees; and (iii) negative for those who substantially benefit from underreporting of their income, including some of the self-employed and farmers. A shift of tax burdens from the working generation to the elderly, and from salary earners to broader groups of people will generally occur.

b. Labor supply

It is hoped that the reform will reduce the detrimental effect of taxes on incentives to work. The Government appears to assume that a slower rise in marginal income tax rates a priori has positive impacts on labor supply. However, careful examination is necessary in light of the measures in the reform package.

In analyzing the effects of the reform on labor supply, there are two key issues: how the reform alters after-tax real wages (the relative price of leisure); and how changes in after-tax real wages affect labor supply. After-tax real wages represent the opportunity cost of leisure, namely, the price at which leisure can be converted into work, income from which is to be used to buy consumption goods. In general, a reduction in income tax progressivity lowers applicable tax rates at the margin, and hence, raises after-tax real wages; an increase in the consumption tax raises the cost of consumption, which reduces after-tax real wages. Thus, whether the reform increases or decreases after-tax real wages depends on the relative size of these two effects.

As shown in Chart II.2, the reform lowers the marginal income tax rate by 10 percent for most taxpayers in middle- and upper-income classes (income over ¥10 million). In contrast, the increase in the consumption tax raises costs of consumption uniformly (including at the margin) by 2 percent for all income levels. Thus, for the majority of taxpayers whose applicable marginal income tax rates are reduced by 10 percent, the reform increases after-tax real wages, while for some taxpayers whose applicable marginal income tax rates remain unchanged, the reform decreases real wages.

Regarding how changes in after-tax real wages affect labor supply, economic theory is agnostic, with the income and substitution effects generally working in opposite directions. While higher income from higher wages increases the demand for leisure (the income effect), the higher relative price of leisure reduces the hours of leisure consumed (the substitution effect). The net effect can be empirically estimated and identified as the elasticity of labor supply with respect to after-tax real wages.

Although there are few econometric estimates of the wage elasticity of labor supply in Japan, it is generally thought to be small. There is a strong consensus among economists and tax specialists that male labor supply is little affected by changes in income taxation, in part because of the weight given to tenure and seniority in determining salary levels. 1/ For married women, who are typically the secondary income earner in a household, available estimates indicate that the labor supply elasticity with respect to household income is small and negative. 2/ 3/

To summarize, the presumption that the reform package would improve incentives to work is true only if: (a) the focus is on middle- and upper-income taxpayers; and (b) the labor supply elasticity is positive for chat group of taxpayers. In the event, as the labor supply elasticity appears to be small, the overall effects of the reform on labor supply are likely to be insignificant.

c. Savings

The staff study last year noted that a revenue-neutral shift from direct to indirect taxes in Japan would not alter sayings incentives given the separate taxation on investment income, but would increase the aggregate savings rate to compensate for higher tax burden during retirement. 4/ As the final reform package includes virtually no measures to alter taxation on investment income and corporate income, there is little need to update last year’s study on this issue.

In short, the reform package has no effects on saving incentives, because it does not alter the after-tax rate of return on saving, and hence, the relative price of future to current consumption. The package, however, would increase aggregate savings, because it shifts tax burdens from working to elderly populations and boosts the after-tax income of working generations, who typically have a higher propensity to save than the elderly.

d. Equity

The horizontal equity of the tax system has been enhanced by the reform. The capacity of the self-employed and farmers to evade taxes through the underreporting of income, as compared with salary earners, has been reduced by the shift from the taxation of income to consumption. Also, the reduction in special treatment in the consumption tax enhances horizontal equity. 1/

At the same time, the package has reduced the degree of vertical equity of the tax system. However, the issue of whether this reduction represents a cost or benefit of reform is more controversial. 2/ The package can be described as sacrificing some vertical equity for the sake of horizontal equity. In contrast, the authorities’ underlying stance--which is indicated in the reform objective of rectifying unduly heavy tax burdens on middle-income salary earners--is that the progressivity of income taxes before the reform was excessive, and hence, the reduction in progressivity serves to achieve a “better” degree of vertical equity. This idea seems to be widely shared and supported in Japan, where the distribution of income is already one of the most equal among the industrial countries. 3/

e. Revenue

The finalized reform package was designed to be neutral in terms of its overall impact on revenue. The effect of the permanent income tax cut on revenue is estimated to be ¥3.5 trillion yen (3/4 percent of GDP) in 1995, equivalent to about 10 percent of total revenues from personal income taxes before the reform. Combined with a temporary cut of ¥2 trillion (1/2 percent of GDP), the same size of income tax cut as in 1994 (¥5.5 trillion, or 1 1/4 percent of GDP) is maintained during 1995-96. As other permanent tax reductions totaling ¥0.7 trillion were implemented in 1994, 1/ the size of the tax cut amounts to ¥6.2 trillion per year in 1994-96.

Each percentage point increase in the consumption tax rate is estimated to generate net additional revenue of ¥2.1 trillion (gross revenue increase less the increase in the Government’s tax payments). Therefore, the increase in the consumption tax rate from 3 to 5 percent will raise revenues by ¥4.2 trillion in 1997. In addition, the reduction in special treatment for small enterprises is estimated to increase revenues by ¥0.3 trillion. As the temporary income tax cut will be discontinued in 1997, net effect of the reform on revenue will be slightly positive (¥0.3 trillion) in 1997 and thereafter (Table II.5). Offset by incremental debt service payments stemming from the bond-financing of the income tax cuts during the staggered period, the impact on overall revenue of the reform is broadly neutral.

Table II.5.

Japan: Revenue Effects of the Reform, 1994-97

(In trillions of 1995 yen)

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Source: Data provided by the authorities; and staff estimates.

5. Scope for further reform

Various issues have been left for future reform initiatives. Some of the major issues are noted below.

a. Taxation of social security benefits

As the final reform package ended up being revenue neutral, measures to raise tax revenue should continue to be sought in light of the large existing deficit and the fiscal strains that will result from future population aging. In this context, in addition to a further increase in the consumption tax rate, strengthening taxation of social security benefits could be a viable option for raising revenues.

The current taxation of public pensions is very light. At the contribution level, they are not taxed statutorily: an employer’s contribution is deducted from its corporate income, while an employee’s contribution is also deducted in full from personal income as a “social insurance premium deduction.” At the benefit level, in principle, pension income is subject to the personal income tax schedule, aggregated with other sources of income. However, because of the generous deductions--special deductions for pension income and a personal elderly deduction 2/--the tax threshold is effectively raised, which makes most pensioner households tax-exempt. 1/

The generous deduction structure for the elderly has generally been justified by their weak financial situation. However, as statistics indicate that elderly households are not poor on average, 2/ there seems to be a case for increasing taxation of pension benefits. The revenue implications of this measure would be substantial, amounting to, for example, ¥5.2 trillion (over 1 percent of GDP) in 1995, based on a hypothetical average taxation rate of 20 percent.

b. Taxation of investment income

The package includes no measures to alter existing distortions in the taxation of investment income. Taxes on investment income in Japan are “schedular” in nature: separate systems are applied to each type of investment income independently of other sources of income. Almost all interest income is taxed at a flat withholding tax rate of 20 percent (combined 15 percent national tax and 5 percent local tax). On capital gains, taxpayers have the option of paying either a 26 percent--combined national (20 percent) and local (6 percent)--flat rate on realized capital gains, or a flat rate of 1 percent on gross proceeds (regardless of realized capital gains) by means of a withholding tax. Dividend income is in principle aggregated with other income and subject to taxes on the combined amount under the progressive schedule; however, taxpayers have an option to pay a flat rate withholding tax on dividend income less than ¥500,000 for each individual stock holding per year (20 percent for less than ¥100,000, and 35 percent for ¥100,000-500,000), which is chosen in almost all cases. The above-described differential tax treatment of various forms of savings typically leads to differential treatment of investment in various assets, implying an inefficient allocation of capital across activities. 1/ In particular, the differential treatment, coupled with the existing corporate income tax, creates a major distortion between debt and equity financing for corporations.

The current system significantly favors debt financing, which stems from two factors: the double taxation of dividend income, and the differential tax treatment for dividend and interest income. As a firm’s income is measured for tax purposes from its owners’ viewpoint, interest payments are deducted from the firm’s taxable income; corporate income paid out as interest is taxed only once at the creditor level at a flat rate of 20 percent. In contrast, corporate income paid out as dividends is taxed twice, once at the corporate level and again at the shareholder level. On top of this double taxation, dividends are generally more heavily taxed than interest in the hands of the recipient. Consequently, as shown in Table II.6, total tax charged on dividends is much higher than on interest; the system favors the use of debt finance, where the return to the provider of funds takes the form of interest payments, over equity, where the return is provided in the form of dividends. Neutrality in treatment can be achieved by introducing a dividend deduction under the corporate income tax. Alternatively, removal of the present corporate deduction for interest payments could be considered. 2/ In either case, equal tax treatment between interest and dividend income is necessary to remove the distortion between debt and equity financing.

Table II.6.

Japan: Effective Tax Rate for Debt versus Equity Financing

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Sources: Data provided by the authorities; and staff estimates.

The effective rate of corporate income tax (national and local taxes combined) is about 50 percent.

A 35 percent tax rate is used here, as it is most commonly applied.

Another source of distortion is the different treatment of capital gains. However, this issue is more controversial. First, capital gains are practically impossible to measure as they accrue, since valuation of all the assets of each taxpayer at the appropriate market prices at the end of each period appears impracticable. Postponement of the tax liability until gains are realized provides a rationale for differential treatment of capital gains relative to income that is received in the form of cash. Second, the “turnover” option--1 percent of the sales value regardless of the realized capital gains--is currently chosen in most cases. As this option was adopted in view of the administrative difficulty in assessing capital gains even after their realization, a measure to allow authorities to capture realized capital gains for each taxpayer--such as a taxpayer identification number system--is required as a prerequisite to the equal treatment of the capital gains and other investment income.

c. Measures for greater horizontal equity

While a shift from income to consumption taxes enhances horizontal equity, compliance problems for income taxes would remain an important concern for horizontal equity as long as income taxes continue to be the largest source of tax revenue. As an administrative change that would significantly improve compliance of taxpayers outside the withholding system, a taxpayer identification number system could be considered. Such a system would also help reduce distortions in investment income taxation, as discussed above.

With regard to the consumption tax, as the weight of the tax increases, the special treatment of small enterprises threatens horizontal equity to a greater extent. Efforts to reduce the scope of the special treatment and to enforce invoice requirements in claiming tax credits more strictly should be continued. Moreover, given the fact that small businesses eligible for the special treatment are mostly the self-employed and farmers, a taxpayer identification number system and stricter enforcement of invoice requirements, reinforcing each other, would reduce the scope for tax evasion by these groups by making their income and business activities more transparent.

d. Securities transaction tax and the land value tax

In view of stagnant equity prices and declining land prices, calls for reducing the securities transaction tax and the land value tax have recently been heightened. Although both taxes are related to the value of assets, the two taxes are imposed on different types of activity--transactions and holdings, respectively--hence, a separate examination is needed.

The securities transaction tax, introduced in 1953, is levied on transfers of securities in Japan at a rate ranging from 0.01 to 0.3 percent depending upon types of securities and transfers. The taxable base is the actual price if the transfer is by sale, and the estimated market price if the transfer is by means other than sale (such as exchange). Gifts and bequests are excluded from the “transfers.” Receipts from the tax were in the range of ¥300-500 billion in 1991-94. 1/

The business community has called for the abolition of the tax to vitalize transactions in securities markets. Since a transaction itself is not directly related to ability-to-pay nor benefits from budgetary expenditures financed by tax revenues, the rationale for this tax appears unclear. It is currently under review.

The land value tax was introduced in January 1992 to increase the costs of landholding by increasing the effective tax rate on landholding. 1/ The tax is levied on owners and lessees of land at a rate of 0.3 percent of the total value (under the inheritance tax assessment) of all the land held by a taxpayer. Land used by owners as the primary residence, land used for rental housing, land used for public interests (such as hospitals, railways, and water and electric supply), farm land, and land valued at less than ¥30,000 per square meter are exempt from the tax. A taxpayer is entitled to deduct either of the following from the value of the taxable base: ¥1 billion (¥1.5 billion for individuals and certain small businesses); or ¥30,000 times the area in square meters of land held. Receipts from the tax were ¥600 billion in 1993. 2/

By increasing costs of landholding, the tax has been intended to serve two primary purposes as a means of land policy: reducing the preference for land among various assets; and encouraging the more efficient use of land. Declines in land prices do not necessarily mean that those purposes are no longer valid. 3/ Moreover, the tax would promote transactions of little-utilized land. Therefore, the case for reducing this tax is not unambiguous, despite strong calls from the business community, which is an important land owner. How to deal with this tax needs further examination in conjunction with a discussion of overall land policy management.

III. Japan’s Agricultural Policies: Past and Present

Agriculture is one of the most regulated sectors in the Japanese economy. Because of government controls, the price mechanism plays only a minor role in the markets for many agricultural products. The structure of various agricultural regulations has changed slowly in the postwar period and government intervention in agriculture intensified over the years, resulting in a protection level among the highest in OECD countries. While the Uruguay Round agreements on agriculture may accelerate structural adjustment in agriculture by making the levels of protection more transparent, Japan’s agricultural sector will remain relatively protected by international standards over the medium term.

This chapter provides an update on recent developments in Japanese agriculture (Section 1) and agricultural policies (Section 2). Japan’s commitments under the Uruguay Round Agreement on Agriculture are reviewed in Section 3. Section 4 discusses estimates of the costs of agricultural protection in Japan, and Section 5 discusses the prospects for a more competitive agricultural sector in the medium term.

1. Recent trends in Japanese agriculture

The decline in the size of Japan’s agricultural sector accelerated during the last two decades. The share of agriculture in GDP fell by two thirds between 1970 and 1993, and the share in total employment by one third. The growth of agricultural production was consistently below real GDP growth (Table III.1). The difference was especially pronounced in the last fifteen years, as real growth in agriculture declined successively from 2.3 percent in 1981-85 to minus 2.3 percent in 1990-93. The decline in agricultural employment--on average, by 2.8 percent per year since the mid-1980s--was also pronounced.

Table III.1.

Japan: Agriculture, Forestry, and Fisheries Selected Economic Indicators, 1971-93

(In percent)

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Source: Economic Planning Agency, Annual Report on National Accounts (various issues).

Calculated as the relative change in deflators for agriculture, manufacturing, and overall economy.

Partly reflecting the rapid decline in employment, productivity growth in agriculture was relatively high (about 3.3 percent) and unit labor costs declined faster than in overall economy in the second half of the 1980s (Table III.2). In the 1990s, however, agricultural output declined so rapidly that these favorable developments came to a halt, despite the stepped up exodus of the agricultural work force.

Table III.2.

Japan: Employment, Productivity, and Unit Labor Costs in Agriculture, Forestry, and Fisheries, 1986-93

(In percent)

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Source: Economic Planning Agency, Annual Report on National Accounts (various issues).

Given the stable or slightly rising rates of per capita food consumption, the decline in agricultural production has led to a widening imbalance between food supply and demand. The self-sufficiency rate for all food fell from 77 percent in 1975 to 65 percent in 1992 (Table III.3). 1/ Food imports rose considerably during this period and Japan became the largest net importer of agricultural products in the world. 1/

Table III.3.

Japan: Food Self-Sufficiency Rates, FY 1965-FY 1993

(In percent)

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Source: Ministry of Agriculture, Forestry and Fisheries (1994).Notes: 1. Self-sufficiency rate in main commodities and cereals is measured as the ratio of the quantity of domestic production to the quantity of domestic consumption.2. Self-sufficiency rate on a calorie basis is measured as the ratio of the amount of calories supplied by domestic products to the total amount of calories supplied.

The decline and aging of the farming population accelerated in the past two decades. The agricultural population declined from 23 million in 1975 (21 percent of the total population) to 13 million in 1993 (11 percent of the total). In 1990, two thirds of active farmers were over 55 years of age, compared with one half in 1985.

As a result of the constant outflow of the agricultural work force, increasing areas of farmland have been abandoned, underutilized, or uncultivated. Between 1975 and 1993, the area of cultivated land declined by 8 percent while the number of agricultural households dropped by 25 percent. However, the average farm size remained small (1.4 hectares) and only 13 percent of commercial farm households cultivated areas larger than 2 hectares in 1993. The number of Japanese farms that are incorporated is very small, with the total growing from about 3,200 in 1986 to 3,900 by 1993. Productivity of farmland declined for some major crops. In particular, rice output fell from 4.8 metric tons per hectare in 1975, to 3.7 metric tons per hectare in 1993. Given the high price of land in Japan, the suboptimal use of farmland indicates that efficiency gains could be realized by improving the allocation of land within the sector, as well as between agriculture and other sectors.

2. Evolving agricultural policy framework

a. Basic characteristics

Japan’s farm support policies were developed over the last 50 years for two basic purposes (Hillman and Rothenberg (1988)). One purpose was to maintain domestic production of food in amounts and diversity consistent with the interests of national security. The other purpose was to enable farmers to enjoy a standard of living comparable with that in faster growing sectors without extensive rural depopulation. While these purposes are similar to those used in other industrial countries to justify government intervention in agriculture, the emphasis given to them in Japan has been much greater, partly because of the uniqueness of Japan’s history, geography, and economic development.

The range of instruments used to protect Japan’s agriculture, including border measures, price and income support, direct subsidies, credit, and investment grants, is standard among industrial countries (Hillman (1991)). Some of the support is budgetary and taxpayers bear the cost, while most is built into the price system so that the bulk of the cost falls on consumers. What is distinctive about the instruments used to protect agriculture in Japan in comparison with other industrial countries, is the extent of state involvement in the supply and distribution of agricultural products (OECD (1987)). External trade, distribution, storage, and pricing of staple foodstuffs such as rice and wheat are handled almost exclusively by the state Food Agency.

Another noteworthy feature of agricultural policies in Japan is their product-specific nature, with no general system covering the sector as a whole (GATT (1995)). The extent of government control also varies widely. Protection is focussed on the traditional staples, particularly rice. This emphasis had two consequences. On the demand side, it reinforced the Westernization of the Japanese diet. Per capita consumption of meat, edible oils, and dairy products increased considerably over the past 20 years, while that of rice and vegetables declined (Table III.4). On the supply side, government protection of rice distorted the composition of farm output and encouraged patterns of land tenure and utilization that obstructed the adoption of efficient farming techniques (Van der Meer and Yamada (1990)).

Table III.4.

Japan: Annual Consumption of Food Per Capita, 1975-93

(In kilograms)

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Source: Ministry of Agriculture, Forestry and Fisheries (1994).

The last distinctive characteristic of Japan’s agricultural policy framework is the presence of strict controls on agricultural land tenure. The basis of Japan’s land tenure system was established by land reform during the 1945-50 period, which created a large number of owner-farmers out of the prewar’s landlord-tenure system (OECD (1987)). The Agricultural Land Law of 1952 aimed to protect the position of owner-farmers and tenants by introducing many restrictions on the holding and transfers of farmland. 1/ Among them were the setting of an upper limit for possessions of farmland per farmer (1 hectare, except for Hokkaido), and state control of rents, which reduced incentives for part-time farmers to lease out their holdings. Transfers of farmland were subject to the authorization of public bodies. These restrictions were subsequently relaxed, but many stringent regulations remained in force. 2/ Together, these factors constrained the possibility for increasing the operational size of farms. Another disincentive for farmers to enlarge their farms through land purchase was the rapid increase in the price of farmland during the 1960s and 1970s. As the price of farmland rose faster than the return to land in its use for agricultural production, the price of agricultural land exceeded the present value of an agricultural income stream (Hayami (1988)).

b. Pre-Uruguay Round agricultural regime

Japan’s existing agricultural policy framework has its origins in the rice-centered agricultural regime that evolved since the Second World War (Kawagoe (1993)). The food security doctrine, which is still one of the tenets of Japan’s agricultural policies, is based on the importance of rice as the single largest product in terms of both food consumption and farm output. In FY 1989, rice accounted for 6.5 percent of the average family’s spending on food and 26 percent of the average family’s calorie supply (Food Agency (1991)). About 30 percent of gross agricultural output is accounted for by rice. To secure a stable supply of rice, the Government has taken the approach of intervening directly in both the production and distribution of rice (Food Agency (1992)).

Historically, measures affecting the distribution of rice were introduced before those affecting the supply of rice (Minami (1993)). Rice trading was unrestricted prior to the 1920s, but after the Rice Riots of 1918, the Government adopted measures to store surplus rice and eliminate speculation in the rice trade (Food Agency (1992)). These measures were bolstered by the Food Control Law of 1942, under which the Government established permanent and systematic control of the rice trade. The Food Control Law was designed to ration the distribution of all staple food items during the severe shortages of the War and its immediate aftermath. As the food supply recovered, the compulsory elements of the Law were gradually relaxed for most food items. In 1952, wheat and barley distribution was shifted from direct to indirect control based on government purchase at minimum guarantee prices to producers. 1/ Since 1952, rice has been the only commodity whose distribution remains under direct government control.

Initially, the Food Agency, an administrative arm of the Ministry of Agriculture, Forestry, and Fisheries (MAFF), directly controlled the whole process of marketing rice and other staple foodstuffs from producers to consumers, and regulated prices from the farm-gate to the retail level. The Food Agency also maintained (and effectively still maintains) a monopoly on imports and exports of rice. In an effort to reduce the deficit of the rice marketing program, the Government introduced the so-called “voluntary rice” channel in 1969, under which cooperatives could sell directly to wholesalers at a negotiated price. The quality and total quantity of rice that each producer could sell through either (or both) official channels was determined by the Food Agency (Food Agency (1993)). In 1972, the control on marketing channels from wholesalers to consumers was removed, and retail pricing became free. However, the continued control of the wholesale marketing gave rise to illegal marketing of rice, which was estimated at about 15 percent of rice distributed through the two official channels (Hayami (1988)).

The Government’s more direct involvement in the production of rice, as well as the entire agricultural sector, began in the early 1960s (Hillman and Rothenberg (1988)). While in Western countries the decline in the agricultural population had raised substantially the productivity of farming relative to manufacturing, in Japan the manufacturing sector had achieved a decisive comparative advantage over agriculture (Hayami and Ruttan (1985)). Also, the costs of production of Japanese farmers had become very high relative to those in exporting countries because new, cost-effective farming techniques could not be applied on Japan’s predominantly mountainous terrain, while efficient-size farms could not be formed under Japan’s restrictive laws on the transfer and leasing of lard. Given these disadvantages, if the allocation of resources and mobility of manpower had been left to market forces and trade were free, the result would probably have been socially unacceptable levels of farm production and farm income (Hillman and Rothenberg (1988)). In response to these disagreeable prospects, in 1961 the Government passed the Agricultural Basic Law, which was aimed at correcting the distribution of income and retarding the transfer of resources from agriculture.

The principal means for maintaining rural-urban income parity became price and income supports for rice and--since the mid-1960s--the prohibition of rice imports. 1/ Rice prices were set according to the Production Cost and Income Compensation Formula. In this formula, the price of rice was determined by the cost of production at the paddy field in which yield per hectare was lower than the national average by one standard deviation, while wages for family labor were valued by non-farm labor in order to guarantee fair return for the labor of rice producers (Hayami (1988)). 2/ These measures provided a stimulus to production, and by the mid-1960s rice surpluses appeared and mean levels of income of farmers began to rise.

As average per capita incomes doubled in real terms during the 1960s and rice consumption declined both absolutely and relative to total household consumption expenditure, the rice price increases were initially not strongly resisted. However, as domestic production expanded in excess of consumption, large surpluses of rice accumulated in government storage, pressing hard on current budgetary expenditures in the form of increased storage costs (Food Agency (1992)). In addition, as the inventory was carried over time, the quality of rice deteriorated and rice had to be disposed of for uses other than domestic food, resulting in large capital losses. 1/

Another unintended consequence of rice policies was structural adjustment in the agricultural labor market in the form of “partial disengagement” (Hillman and Rothenberg (1988)). Rather than selling the farm and moving to a new location to seek nonfarm work, many farmers had found outside employment on a temporary or full-time basis, while one or more members of the household remained on the land to maintain the farm. 2/ High price support for rice and the ease of marketing it through the Food Agency have induced these part-time farmers to specialize in rice farming. The rising trend in mean levels of income in farm households owed much to the comparative prosperity of part-time farmers. For those families who continued to depend wholly on agriculture for their livelihood (about one third of total farm households), income disparities remained. 3/ Part-time farmers thus felt no inducement to leave agriculture altogether, while professional farmers still had good reason to take outside jobs whenever the opportunity arose (Hillman and Rothenberg (1988)).

In 1969, after three consecutive large harvests, controls on rice acreage were introduced to prevent the accumulation of surplus rice and shift resources into production of other crops (MAFF (1992)). The early set-aside programs met with only limited success, and higher subsidies had to be provided to encourage farmers to diversify into crops other than rice (Coyle (1981)). 4/ Stimulus to rice production continued, however. The sharp increases in world food prices during 1973-75, coupled with the U.S. soybean embargo, stirred up public anxiety and reinforced food security arguments (Hillman and Rothenberg (1988)). As a result, rice prices rose by about 15 percent between the mid-1970s and early 1980s.

By the early 1990s, the public became aware of the substantial food cost differential between Japan and other countries. The business federations, which stood to benefit from the Uruguay Round, adopted a strongly antiprotectionist position on agriculture given that agricultural trade issues emerged as the key to the completion of the Uruguay Round (Rapkin and George (1993)). In addition, Japan’s trading partners exerted strong and continuous pressure on Japan to open its agricultural markets. Under these diverse pressures, the Government developed a new set of agricultural policies in 1991-92, and subsequently accepted the Uruguay Round Agreement on Agriculture.

c. New policies for food, agriculture, and rural areas

A new concept of agricultural policies was presented in “The Basic Direction of New Policies for Food, Agriculture, and Rural Areas” (New Policies) (MAFF (1992)). The New Policies recognized that the gap between rural and urban incomes had not been closed, and that many inefficiencies remained in agriculture. Accordingly, the New Policies aimed to establish a more market-based agricultural regime. However, the rationale for the old regime was not completely renounced, but rather refined by introducing a number of public goods arguments. Thus, the New Policies argued that the Japanese-style dietary pattern, which had produced the world’s longest life expectancy, had the characteristics of a public good and as such had to be preserved. 1/ The New Policies also argued that agriculture was contributing public goods such as protecting the environment, national land, and rural resources, the value of which could not be measured solely in economic terms. 2/ Given these special roles and characteristics of agriculture, a certain level of border measures and domestic agricultural support was deemed necessary to maintain agricultural production and secure domestic food supply.

The New Policies established a broad range of goals for Japanese agriculture by the year 2000. These goals included: ensuring the most efficient production possible and implementing measures to reduce the gaps between domestic and international prices; sustaining domestic production and food self-sufficiency rates at the highest possible level; improving the demographic structure of agricultural population; developing nonagricultural sectors in rural areas; and protecting consumers’ interests in respect of food quality, safety, and the environment.

To implement these multiple and often conflicting objectives, the New Policies advocated that a new structure of agricultural production centered around the so-called farm management bodies be established. These bodies were defined as farm units consisting of one or more farm households that would be capable of setting up a scheme of working hours and ensuring an income comparable to that of workers in other industries. The New Polices set the number of the farm management bodies at about 390,000-450,000 in the year 2000. About 40 percent of the farm management bodies would be engaged exclusively in rice farming (compared with 45 percent in 1990); another 40 percent would grow single crops other than rice; and the rest would be engaged in multicrop farming. Since the New Policies were introduced before Japan agreed to lift the ban on rice imports in the Uruguay Round, the proposals with regard to rice control were aimed only at relaxing certain restrictions on the distribution of rice.

With regard to the efficient scale of farm management in the year 2000, the New Policies expected this scale to fall in the range of about 10-20 hectares. 1/ The New Policies specified a number of measures to promote the expansion of farms, including the leasing of farmland, the commissioning or entrusting of farm work, and establishing land-use rights on farmland cultivated by farm management bodies. However, the New Policies stopped short of recommending further review of the Agricultural Land Law.

3. Uruguay Round agreements on agriculture

a. Japan’s negotiating position in the Uruguay Round

The principal objective of the agricultural negotiating agenda in the Uruguay Round was the reduction of trade-distorting domestic and export subsidies, especially those of the European Community and the United States (Hathaway and Ingco (1995)). As Japan has no appreciable agricultural exports, it supported the reduction of export subsidies, but opposed the elimination of quantitative import controls and significant reductions of tariffs on agricultural products.

Japan’s key demand in the Uruguay Round negotiations on agriculture was to maintain its food security policy in respect of rice (Hemmi (1994)). As rice is a minor product in world agricultural trade (only 3 percent of total production is traded on world markets), Japanese negotiators argued that rice policies were less distorting for overall agricultural trade than the subsidization policies of the major exporting countries, especially those of the European Community and the United States (Rapkin and George (1993)). The negotiators also pointed out that Japan was already making a positive contribution to world farm trade as the world’s largest and fastest growing market for imported agricultural products, and that Japan had taken a number of market opening measures during the 1980s, including unilateral tariff reductions and the 1988 concessions on beef and citrus imports.

Japan’s demand for special treatment of its rice import ban proved to be a difficult case to make in negotiations with other major protagonists in the Uruguay Round, in particular the United States and the Cairns Group, who had sought global solutions to overcome agricultural exceptionalism (Hathaway and Ingco (1995)). 1/ They rejected Japan’s argument that food security required 100 percent self-sufficiency. However, the rice issue was not pushed to center stage in agricultural talks because the U.S.-EC dispute consumed most of the time and attention in negotiations (Greenaway (1994)). Japanese negotiators thus adopted a passive stance (“minimalist strategy”), waiting for the U.S. and EC representatives to settle their disputes before considering to make any concessions on the rice issue (Hemmi (1994)). 2/

As the United States and the European Community resolved their disputes, Japan was left relatively isolated in its demand for maintaining the rice import ban and was subjected to pressure to accept the compromise proposal on minimum access to its rice market (Rapkin and George (1993)). Meanwhile, pressure was also building inside Japan to accept this proposal. Given Japan’s substantial interest in the success of the overall Uruguay Round, Japanese negotiators agreed to a quota-based opening of the rice market in December 1993.

b. Summary of the Agreement on Agriculture

The Uruguay Round Agreement on Agriculture encompasses several broad areas: market access; domestic support; export subsidies; special provisions for developing countries; and constraints on the use of anti-subsidy actions. The process of agricultural trade liberalization began in 1995 and will last six years for industrial countries and ten years for developing countries. The market opening measures will be implemented according to a pre-determined schedule. A new round of negotiations on agricultural trade is scheduled to take place in the year 2000. This section discusses the agreements on market access and domestic support, which are of greatest relevance for Japan. 3/

The most significant aspect of the Agreement on Agriculture was a change in the rules regarding market access. Commitments in this area include tariffication, tariff reductions, and acceptance of minimum access limits.

Under tariffication, virtually all non-tariff barriers--quotas, variable levies, minimum import prices, discretionary licensing, state trading measures, voluntary restraint agreements, and similar border measures--must be abolished and converted into an equivalent tariff. Removal of non-tariff barriers was delayed in a few “special treatment” cases such as rice in Japan, Korea, and the Philippines; however, these countries had to introduce minimum access levels for imports at 4 percent of domestic consumption, rising to 8 percent over the implementation period. 1/ Also, import quotas on fishery products, a sector not included in the Uruguay Round, will continue.

As part of the tariff reduction agreement, virtually all tariffs on agricultural products need to be bound. 2/ Before the Uruguay Round, bound tariffs covered about 80 percent of the total value of agricultural imports in industrial countries; the corresponding shares for developing countries and transition economies were 25 percent and 54 percent, respectively. The new bound tariffs, including those resulting from tariffication and those which had been bound in previous negotiations, are to be reduced by 36 percent on a simple (unweighted) average basis over six years by industrial countries, with a minimum rate of reduction of 15 percent for each tariff item; the corresponding tariff reduction targets for developing countries are 24 percent and 10 percent, respectively, over a period of ten years. Special safeguard provisions allow the imposition of additional duties when there are either import surges or particularly low prices (both compared with 1986-88 levels). 3/

Under minimum access commitments, countries agreed to maintain or generate minimum access opportunities for imports of commodities subject to tariffication. These commitments were necessary to ensure a minimum degree of market opening in situations in which the tariffication of old quotas seemed likely to lead to prohibitively high tariffs. Where imports were less than 3 percent of base-period consumption, minimum access commitments were set at 3 percent in 1995, rising to 5 percent in 2000. 1/ Where current imports were greater than 5 percent in the base period, this level of access (“current access”) must be maintained. One incentive for exporting countries to fill the minimum access levels is reduced tariff (maximum of about 32 percent of the bound tariff rate) on such imports. 2/ Another incentive is that, in cases where exporters enjoyed preferential market access (or had voluntary export restraints agreements) in the past, their access opportunities were maintained under a “current access” provision. For the importing countries, the main incentive to grant minimum access was that trade arrangements under the old quota system were allowed to count as meeting the minimum access requirements. 3/

The second major area of agricultural trade reform was the binding of domestic support levels. As the proposal to reduce domestic support on a commodity basis was not accepted, the new rules and bindings were established on the level of total domestic agricultural support, called Aggregate Measure of Support (AMS). The AMS includes border price support through tariff and export subsidies and is based on fixed external prices in the base period (1986-88). The Agreement on Agriculture specified the determination of the AMS, and required that industrial countries reduce their total AMS by 20 percent over the implementation period (13.3 percent for developing countries). However, the Agreement exempted several categories of domestic support measures, including: (1) measures which transfer to producers less than 5 percent of the value of production (10 percent in developing countries); (2) measures which are deemed to have minimal or no distorting impact on production or trade; 4/ and (3) payments to producers under the production-limiting measures. 5/ Some of these measures are controversial because they are not fully neutral with respect to production (Ingco (1995)). For example, the EU compensation payments and the U.S. deficiency payments qualify as decoupled income support under Green Box provisions.

c. Agricultural market access commitments made by Japan

Japan accepted tarrification of all import quotas and other nontariff barriers, except in the case of rice. Existing import quotas on agricultural products are all to be converted into tariff quotas. 1/ Tarrification schemes differ by product category and can be quite complicated because they are intertwined with minimum access and tariff reduction commitments (Box 1). In many cases very high tariffs will replace previous import restrictions (Table III.5). Thus, the main effect of the Uruguay Round will be that the above-quota imports of such products as wheat, barley, dairy products, and raw silk, will be unrestricted from 1995 on, provided the relevant tariffs and charges are paid. The in-quota imports will continue to be handled by state trading agencies.

Table III.5.

Japan: Tariffication of Major Agricultural Products in the Uruguay Round

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Source: GATT (1995).

Based on base-period (1986-88) prices and initial bound rates.

Note: Tariff quota refers to current and/or minimum access commitments. In-quota tariff rate is applied to imports within these commitments. Imports above minimum commitments are subject to bound rates; shown here are the initial bound rate for 1995 and its ad valorem equivalent, and final bound rate in 2000.

The scope of Japan’s tariff bindings in agriculture will rise from 58 percent to 99 percent after the Uruguay Round, with the remainder being rice and rice products. Japan will also implement the mutually agreed tariff reduction of 36 percent on average over six years, with a minimum reduction of 15 percent. 2/ Several major products will be affected by the tariff cuts (Table III.6).

Table III.6.

Japan: Major Tariff Cuts in the Uruguay Round, 1994-2000

(In percent)

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Source: GATT (1995).

Simple tariff average on ISIC basis. Base rate refers to the 1988 bound rate; post-UR rate does not include tariffication.

Tariffication Scheme for Dairy Products

At present, seven dairy product items are designated as government import items and are imported exclusively by the Livestock Industry Promotion Corporation (LIPC). The LIPC imports such dairy products within a prescribed volume to stabilize their prices when the domestic market becomes tight and market prices rise above a certain level. From FY 1995, the import restriction is to be lifted under Japan’s market access commitment for dairy products (137,000 tons of raw milk equivalent per year in 1995). This “current access” volume is based on actual imports for FY 1986-88. The current level of tariffs will be applied to government imports within this access volume. The domestic selling price will be equal to the tariff inclusive import price plus the LIPC markup on imports (Figure III.1).

Private imports beyond the minimum access volume will be allowed, but a surcharge in the form of a (specific) tariff equivalent will be imposed on private imports at a rate higher than the LIPC Import markup. Under the tariff reduction commitments, both the import markup for state trading and tariff equivalents for private imports have to be reduced by 15 percent by the year 2000.

The tariff quota system will also apply to dairy products that are not state trading items and were imported under quantitative restrictions in the past. GATT estimates suggest that the ad valorem equivalents for the “above quota” imports of such items amount to several hundred percent. In most cases, these tariff levels will be reduced by 15 percent over the next six years, a minimum reduction in tariffs allowed under the Uruguay Round Agreement on Agriculture.

Figure III.1
Figure III.1

Japan: Tariffication Scheme Applicable to Dairy Products (Butter as an Example)

Citation: IMF Staff Country Reports 1995, 116; 10.5089/9781451820515.002.A001

Sources: Industrial Bank of Japan, based on information from Ministry of Agriculture, Forestry and Fisheries.

With regard to rice, Japan did not accept tariffication, but permitted for the first time rice imports on a regular basis as part of its minimum access commitments. An initial tariff quota was established at 379,000 metric tons (4 percent of domestic consumption in 1986-88), growing to 758,000 metric tons (8 percent of base-year consumption) in the year 2000 (Table III.7). The Food Agency will assume responsibility for purchases and sales of imported rice, and trading companies will conduct the actual imports on the basis of contracts with the Agency. Imports will be conducted on a global basis, without setting quotas by country. In terms of distribution, imported rice will be treated the same way as domestic rice.

Table III.7.

Japan: Rice Imports under the Uruguay Round, 1995-2000

(In percent)

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Source: Data provided by the Japanese authorities.

Imports allowed under simultaneous buy-and-sell system.

As in the case of tariffied products, the Food Agency will impose an import mark-up on the difference between the purchase and selling prices of rice. Japan has bound the mark-up on rice at a maximum of ¥292/kg, otherwise equivalent to an ad valorem rate of several hundred percent (GATT (1995)). Rice is unique in that, of all products affected by the mark-up, it is the only one for which the mark-up will not be reduced each year.

A simultaneous buy and sell system (so-called free imports of rice) will be introduced for a very small portion of rice imports (Table III.7). Traders participating in this program will be able to turn a profit by undercutting the Food Agency’s pricing system and importing rice from countries of their choice. 1/ However, only 1.3 percent of permitted imports was designated for this trading system in 1995, rising to 10 percent of imports in 2000.

With regard to domestic support measures, by 1995 Japan had already fulfilled the Uruguay Round commitment by reducing the AMS by more than 20 percent from the 1986-88 base. It is not clear whether Japan will reduce the AMS further. The administrative prices of major commodities remained almost unchanged since 1991 (Table III.8). 2/ In 1994, the purchase price for rice, the most important support price for farmers, was frozen despite a decrease in indicative prices calculated on the basis of production costs (OECD (1995)). In addition, an agricultural reform package was passed in October 1994 that includes over ¥6 trillion in assistance to farmers affected by the Uruguay Round over the next six years (discussed below).

Table III.8.

Japan: Administrative Prices of Major Agricultural Products, FY 1990-94

(In yen, per kilogram)

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Source: Data provided by the Japanese authorities.

d. Impact of the Agreement on Agriculture

The main achievement of the Uruguay Round Agreement on Agriculture is increased transparency in the rules governing international trade and the levels of domestic protection (Hathaway and Ingco (1995)). Tariffication, binding of all tariffs on agricultural products, and minimum access commitments in products where imports were previously banned or restricted represent a significant step forward and in theory imply liberalization by prohibiting countries from arbitrarily raising tariffs to new and higher levels (Martin and Francois (1995)).

In practice, the Uruguay Round reforms may not result in significant liberalization. 3/ The newly established tariffs, while lower than the implied unbounded rate under the old system (e.g., in the case of rice), remain very high and are likely to obstruct agricultural trade. Moreover, the Uruguay Round left major distortions such as state trading in agricultural products outside its scope. As a result, even after the tariff reductions committed to in the Uruguay Round, the ad valorem measure of the final tariff bindings will remain higher in most countries than the rate of protection during 1982-93 (Ingco (1995)).

Compared with other countries, Japan will achieve significant reductions in protection in major commodities (Table III.9). In most other OECD countries, the extent of intended liberalization was eroded because the base period chosen in establishing tariff bindings (i.e., 1986-88) was a period with the highest border protection in recent decades. 1/ Most other OECD countries also resorted to so-called “dirty tariffication,” as a result of which the new base tariffs would provide even higher protection than the level provided by the base-year non-tariff barriers they replaced. 2/ In contrast, in all the commodities considered, Japan offered base tariff equivalents significantly below the actual nominal rate of protection provided in 1986-88 (Chart III.1). Despite large tariff reductions, however, the final tariff levels in Japan will remain very high both in absolute terms and compared with other countries.

Table III.9.

Japan: Uruguay Round: Estimates of Average Import Price Reductions from 1989-93 Average

(In percent)

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Source: Ingco (1995).


Citation: IMF Staff Country Reports 1995, 116; 10.5089/9781451820515.002.A001

Source: Ingco (1995)1/ Pre-UR rate refers to the estimated ad valorem tariff equivalent (ETE) for 1986-88; UR base rate refers to the ETE of base rates declared in cuntry schedules (calculated using the 1986-88 prices); and the final UR rate refers to the ETE of the tariff rate in 2000.2/ Barley, maize, a

Japan’s opening of the domestic rice market, although small relative to domestic consumption, is expected to lead to a relatively large expansion in world rice trade. Based on country schedules of over 40 major trading countries, it is estimated that the access commitments under the Uruguay Round will expand world trade in rice by 7.5 percent compared with the level of world trade in 1992 (Ingco (1995)). The only two other products that are expected to open new trade opportunities are beef (2.8 percent increase in world trade above the 1992 level) and poultry (2.5 percent increase in world trade).

One reason why the Uruguay Round Agreement on Agriculture is not expected to have a major impact on agricultural trade liberalization is that one of the most serious barriers to trade, i.e., the use of government or government-controlled monopoly importing agencies, will not be removed (Hathaway and Ingco (1995)). Even if tariffs are lowered, such agencies may not pass on the lower import prices to consumers, and suppliers may not be able effectively to compete for the market. As there are no restrictions on the resale price of imports, the state trading agencies can use low-cost imports to finance domestic subsidy programs.

e. Post-Uruguay Round developments

In August 1994, an interim report on long-term agricultural reforms was issued. 1/ The main objectives of policy development set out in the report are to reaffirm the role and importance of domestic agricultural production; to minimize negative effects arising from the acceptance of the Uruguay Round Agreement on Agriculture; to implement structural reforms proposed in the 1992 New Policies as soon as possible; to revitalize hilly and mountainous areas that may be hard hit by the Uruguay Round; and to reconsider current agricultural regulations with a view toward increasing competition.

Unlike the New Policies, the Direction of Policy Development explicitly recognized that food imports had become essential to secure a stable supply of foodstuffs. The report also acknowledged that government rice policies failed to improve the productivity of rice farming and meet consumer needs, and called for a “drastic revision” of the production adjustment and distribution systems established under the Food Control Law. Another important difference with the New Policies was greater emphasis on market principles, and lesser emphasis on public goods aspects of agriculture. Reflecting this policy orientation, the report advocated a review of the Agricultural Basic Law.

Following these initiatives, in December 1994 the Food Control Law was replaced by the Law Concerning Stabilization of Supply-Demand and Price of Staple Food. Under the new law, rice producers will no longer be obliged to make sales to the Government, and rice traders will no longer be designated by the Government. The implementation of the Direction of Policy Development has also raised some concerns, however. In late October 1994, the Government announced a package of agricultural support measures worth ¥6 trillion over six years. The package included both measures to offset the impact of the Uruguay Round agreements on farmers (especially those in mountainous areas), and long-term measures aimed at improving productivity In the farm sector.

4. Estimates of the costs of agricultural protection

This section considers four complementary measures of the costs of agricultural protection: budgetary transfers to agriculture, estimates of subsidy equivalents received by producers and paid by consumers of agricultural products, total transfers associated with agricultural support, and welfare costs of agricultural protection. Although there is some overlap in terms of the costs that are being covered by these measures, the four measures are progressively more comprehensive.

a. Budgetary expenditure on agriculture

Given the small size of Japan’s agricultural sector (about 2.3 percent of GDP in the 1990s), budgetary expenditure on agriculture is relatively high (about 0.7 percent of GDP) (Table III.10). Relative to other programs, spending on agriculture increased between 1980 and 1994 and stood at about 10 percent of general expenditure in 1994. Most of this increase was accounted for by public works projects aimed at improving agricultural productivity. Current expenditure on agriculture, in particular food control expenditures, declined sharply since the early 1980s. The funds earmarked for agriculture under the Fiscal Investment and Loan Program (FILP) were roughly equal to agriculture’s share in GDP since the mid-1980s.

Table III.10.

Japan: Central Government Expenditure on Agriculture, Forestry, and Fisheries, 1980-94 1/

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Sources: Budget Bureau, Ministry of Finance, The Japanese Budget in Brief (various issues); and staff estimates.

Based on initial budgets.

Public works expenditure on agriculture, forestry, and fisheries.

Local governments contributed additional funds to agriculture from their own budgets. Net of intergovernmental transfers, prefectures and municipalities spent about 0.8 percent of GDP to support various agricultural programs in 1980, and about 0.6 percent in 1990 (Table III.11). Total budgetary spending on agriculture by all levels of government (1.3 percent of GDP in 1990) was thus equivalent to one half of the value of agricultural output (2.5 percent of GDP in 1990).

Table III.11.

Japan: Central and Local Government Expenditure on Agriculture, Forestry, and Fisheries, 1980-90 1/

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Sources: Budget Bureau, Ministry of Finance, The Japanese Budget in Brief (various issues); Jichi Sogo Center (1993); and staff estimates.

Net of intergovernmental transfers.

Based on initial budgets.

Public works expenditure on agriculture, forestry, and fisheries.

Based on actual outturn.

Portion of current expenditure not financed by the central government; estimated from the share of central government transfers in local government expenditure.

Portion of capital expenditure not subsidized or directly run by the central government.

Data compiled by the OECD indicate that, in terms of the budgetary expenditure on agriculture (“transfers from taxpayers”), Japan is on par with the European Community. In the United States, transfers from taxpayers to agricultural producers were higher and amounted to about 1.5 percent of GDP since the mid-1980s (Table III.12). In terms of the revenue from taxation of agricultural products, Japan is distinctly ahead of other OECD countries. The high yield of agricultural taxes reflects both Japan’s high dependency on food imports, and the relatively high level of agricultural tariffs.

Table III.12.

Japan: Decomposition of Total Agricultural Transfers in Selected OECD Countries, 1986-94

(In percent of GDP)

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Source: OECD (1995).Note: Transfers from taxpayers are defined as budgetary expenditures on agriculture, minus administrative costs and social security. For the European Community and the United States, these transfers also include subnational expenditures on agriculture by member states and states, respectively.Transfers from consumers are defined as the implicit tax on consumers due to market price support, including the effect of border policies.Budget revenues are calculated as the product of the tariff (or the price differential) and the difference between the consumption and production levels for commodities concerned.

b. Subsidy equivalents of agricultural protection

In addition to direct budgetary transfers, agricultural producers also receive indirect transfers from the budget and from consumers. Measures of producer and consumer subsidy equivalents include these additional transfers. The producer subsidy equivalent (PSE) measures the subsidy that would be necessary to compensate producers for removing government support under existing programs, while the consumer subsidy equivalent (CSE) measures the implicit tax imposed on consumers under these programs. 1/

Chart III.2 compares the PSE expressed as the ratio of the subsidy-inclusive price to the border price (the so-called nominal assistance coefficient on production) in Japan and selected OECD countries. The wedge between Japan’s domestic (subsidy-inclusive) price and the world price at the border expressed in yen was equivalent to about 800 percent for wheat, 670 percent for rice, and 550 percent for milk in 1993. 1/ Nominal assistance provided to sugar producers in Japan was on a par with that in the European Community, while the support to beef and veal producers was lower in Japan than in the European Community. For all agricultural products, Japan had one of the highest nominal assistance coefficients among the OECD countries (220 percent in 1993). The OECD data also indicate that the assistance to Japan’s agricultural producers, as measured by the nominal assistance coefficient, had increased from about 120 percent in 1979-81 to 230 percent in 1994. Most of this increase can be accounted for by the effect of the yen appreciation. The measures of producer subsidy equivalents that do not depend on the exchange rate (e.g., the total PSE or the PSE as a percentage of production) indicate that the support for most livestock products and crops had declined or remained constant since the mid-1980s (Table III.13).



Citation: IMF Staff Country Reports 1995, 116; 10.5089/9781451820515.002.A001

SOURCE: OECD (1995)1/ Nominal assistance coefficient (NAC) on production is defined as the ratio of the border price plus the unit producer subsidy equivalent (PSE) to the border price. NAC indicates the effective price wedge created by agricultural policies. A NAC equal to one indicates that the domestic producer price is equal to the world price at the border expressed in domestic currency
Table III.13.

Japan: Estimates of Producer Subsidy Equivalents, 1979-94 1/

(In billions of yen)

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Source: OECD (1995).

The producer subsidy equivalent (PSE) measures the value of the monetary transfers to agricultural producers from consumers of agricultural products and from taxpayers resulting from a given set of agricultural policies, in a given year.

With regard to consumer subsidy equivalents, the price wedge between the domestic consumer price and the border price was about 100 percent for all agricultural products in 1993 (136 percent for crops and 42 percent for livestock products) (OECD (1995)). Domestic consumer prices of rice and milk had the highest nominal assistance coefficient (580 percent and 330 percent of the border price, respectively). The implicit tax on consumers represented about 50 percent of the total value of consumption of agricultural products since 1989. Unit CSE was highest for beef and veal (about ¥430 per kilogram in 1993), rice (¥250 per kilogram), and pork (¥220 per kilogram).

c. Total transfers associated with agricultural support

The market price support captured by the PSE measures the difference between the domestic producer price and an external reference price for each unit of the commodity produced. As such, the PSE is. a good estimate of the transfers received by farmers due to policy measures, but not necessarily of the total transfers associated with agricultural policies that are effected within the economy as a whole. Namely, farmers receive only a portion of expenditure needed to implement agricultural policies. The expenditures incurred in the implementation of agricultural programs also include transfers to economic groups other than farmers. These groups include food processors and distributors, operators of public stockholding and commodity storage facilities, and recipients of grants for rural infrastructure development, food aid, and permanent withdrawal of resources from agriculture. The expenditures incurred in the implementation of such programs may be much bigger than those estimated as being received by farmers (i.e., the PSE). 1/

Total transfers to agriculture are broadly defined as the sum of all transfers from taxpayers and all transfers from consumers resulting from agricultural policies, minus budget revenues from tariffs on imports. Total transfers thus include all the forms of support measured by the PSE and CSE calculations, plus the additional budgetary outlays discussed above.

Total agricultural transfers in Japan declined from about 2.6 percent of GDP in the mid-1980s to 1.8 percent of GDP in 1994 (Table III.14). These figures are comparable to both the OECD average and the average for the European Community, but they are higher than in the United States (by up to 1 percentage point of GDP), and much higher than in Australia (by up to 2 percentage points of GDP). However, in Finland, Norway, Switzerland, and Austria, total transfers to agricultural producers were higher than in Japan.

Table III.14.

Japan: Total Agricultural Transfers in Selected OECD Countries, 1986-94 1/

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Source: OECD (1995).

Total transfers are defined as the sum of all transfers from taxpayers and all transfers from consumers resulting from agricultural policies, less budget revenue from tariffs on imports.