This Selected Issues paper analyzes macroeconomic developments and prospects for Japan during the 1990s. Following a surge in activity during 1996 and early 1997, the economy fell into recession in the second quarter of 1997. Real GDP fell by 3¾ percent during the four quarters ended March 1998; the unemployment rate reached historical highs; and deflationary pressures reemerged. The downturn was largely unexpected, and most forecasters had projected growth of about 2 percent in 1997. This paper also examines fiscal policy issues for Japan.


This Selected Issues paper analyzes macroeconomic developments and prospects for Japan during the 1990s. Following a surge in activity during 1996 and early 1997, the economy fell into recession in the second quarter of 1997. Real GDP fell by 3¾ percent during the four quarters ended March 1998; the unemployment rate reached historical highs; and deflationary pressures reemerged. The downturn was largely unexpected, and most forecasters had projected growth of about 2 percent in 1997. This paper also examines fiscal policy issues for Japan.

II. Fiscal Policy Issues1

1. Fiscal policy in Japan is directed through three main channels, all of which have been used in recent initiatives: the general account of the central government (which covers most central government activities); the Fiscal Investment and Loan program (the FILP, which takes money from the postal saving and social security systems and lends it to the private sector and local governments); and local governments (whose fiscal autonomy from the central government is limited).2 After reviewing recent fiscal developments, this chapter examines the effectiveness of counter-cyclical policy in Japan in the 1990s and analyzes the medium-term sustainability of Japan’s fiscal situation. These sections are followed by discussions of three areas of potential fiscal reform: transparency, the tax system, and public investment policy.

A. Recent Developments

2. Between FY1991 and FY1996, policy was geared to providing stimulus to the economy. A series of expansionary supplementary budgets was used to provide support for demand (Table II.1). As a result, the general government deficit (including social security) deteriorated by over 7 percent of GDP and the corresponding structural deficit expanded by about 6 percent of GDP (Chart II.I).3



Citation: IMF Staff Country Reports 1998, 113; 10.5089/9781451820447.002.A002

Sources: Ministry of Finance; Economic Planning Agency: and staff estimates and projections.1/ The fiscal year is from April to March.
Table II.1.

Japan: Summary of Economic Stimulus Packages, 1993–98

(In trillions of yen, unless otherwise indicated)

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

Includes ¥0.3 trillion in welfare benefits.

Public investment comprises general public works (including land purchases), disaster reconstruction, buildings and equipment, and independent public works projects by local government.

Excludes land acquisition for public works projects, which is included in public works spending.

Includes loans by the Pension Welfare Service Public Corporation.

Includes ¥1.3 trillion in lending by the Japan Corporation for small business.

3. The FY1997 budget switched the fiscal stance from expansion to consolidation. Measures included an increase in the consumption tax from 3 percent to 5 percent (raising revenues by about ¥4 trillion per year); termination of temporary individual income tax cuts (raising revenues by ¥2 trillion per year); and higher copayments for medical treatment (implemented in September 1997 and raising social security revenue by about ¥1½ trillion on a full-year basis). In addition, the phasing out of the September 1995 fiscal stimulus package contributed to a substantial fall of public investment during the latter half of 1996 and early 1997 (Chart II.2). The September 1996 increase in pension contributions (raising contributions by about ¥2 trillion on a full-year basis) also contributed to higher general government revenues in FY1997 compared to FY1996. Overall, the structural general government deficit was reduced from 3.6 percent of GDP in FY1996 to 2.4 percent of GDP in FY1997 (Table II.2).



Citation: IMF Staff Country Reports 1998, 113; 10.5089/9781451820447.002.A002

Sources: Economic Planning Agency.
Table II.2.

Japan: General Government Balances, FY1991–98 1/

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Sources: Economic Planning Agency, Annual Report on National Accounts, 1996; and staff estimates and projections.

The fiscal year begins on April 1.

In percent of potential GDP.

4. The government also laid down a path for medium-term fiscal consolidation in the Fiscal Structural Reform Act (FSRA), passed in November 1997. The FSRA (i) set two medium-term fiscal targets to be achieved by FY2003—a reduction of the general government deficit (excluding social security) to under 3 percent of GDP, and an end to the issuance of deficit-financing bonds by the central government’s general account;4 (ii) placed limits on various categories of government spending between FY1998 and FY2000; and (iii) required that the issuance of deficit-financing bonds not increase from one year to the next between FY1997 and FY2003. (Further details are provided in Box II.1).

5. In early December 1997, the government responded to weakness in the economy by announcing ¥2 trillion in income tax rebates, provided as a fixed rebate for each tax payer and dependent.5 The tax rebates were designed to be implemented as rapidly as possible, with ¥1 trillion in relief provided between February and April 1998 and much of the remainder within the following three months.6 These rebates were subsequently included in the FY1997 supplementary budget. This budget also contained additional spending of about ¥1.9 trillion, mainly for disaster relief (together with plans to accelerate implementation of ¥1.5 trillion in FY1998 public works spending). Given savings in other areas of government spending in FY1997 (particularly interest payments), however, the increment to net government spending was a modest ¥0.7 trillion (or 0.1 percent of GDP).7 The outturn for the FY1997 general account deficit will be higher than forecast in the supplementary budget, as tax revenues were about ¥1½ trillion lower than expected. The short-fall was mainly due to lower corporate tax receipts, reflecting the fall in profits from weaker-than-expected activity.8

The Fiscal Structural Reform Act

The Fiscal Structural Reform Act (FSRA) was approved by the Diet in November 1997. Its major components were:

  • Medium-term fiscal targets. By FY2003, the general government deficit (excluding social security) would be reduced to no more than 3 percentage points of GDP, and the issuance of deficit-financing bonds by the general account of the central government would be ended.

  • Expenditure restraint. FY1998–2000 were defined as the “Special Reform Term.” Concrete quantitative targets were set for major expenditure categories:

    • ◦ Increases in social security transfers from the central government, which would have risen by ¥800 billion without measures, would be contained at ¥300 billion for FY1998. For FY1999 and FY2000 these expenditures would increase by no more than 2 percent per year.

    • ◦ Public works spending would be cut by 7 percent in FY1998. For FY1999 and FY2000, public works spending would be no more than that in the previous year’s initial budget.

    • ◦ General account ODA spending would be cut by about 10 percent in FY1998. For FY1999 and FY2000, ODA spending would be no more than that in the previous year’s initial budget.

    • ◦ Defense-related expenditures during FY1998 to FY2000 would be no more than that in the previous year’s initial budget.

    • ◦ General expenditure in the Local Public Finance Plan for FY1998 would be no more than that in the previous year’s initial budget.

    • ◦ The ten-year ¥600 trillion government investment plan for FY 1995–2004 would be extended by three years. Investment over the original ten-year term would be reduced to about ¥470 trillion.

  • Constraints on the issuance of debt. The issuance of deficit-financing bonds would be no more than that in the previous year’s initial budget during FY1998 to FY2003.

The FSRA was amended in May 1998 to make it more flexible in the face of weak economic conditions. The date by which the medium-term fiscal targets would be met was extended by two years (from FY2003 to FY2005). In addition, the government can waive the constraint on issuance of deficit-financing bonds in the face of difficult economic conditions, defined as:

  • ◦ Less than 1 percent real GDP growth (annualized) in two consecutive quarters; or

  • ◦ Less than 1 percent real GDP growth (annualized) in the most recent quarter with sluggish monthly indicators of private consumption, private investment, and employment; or

  • ◦ A sharp economic downturn caused by unexpected internal or external economic shocks.

These provisions were applied to achieve passage of the FY1998 supplementary budget.

Although deficit financing constraints have been revised, the spending ceilings for different categories of expenditure have not been relaxed (except for social security). In particular, public works spending in the FY1999 budget remains constrained to be below that in the initial FY1998 budget. Given the large increase in public works spending in the FY1998 supplementary budget (¥2.8 trillion in additional spending compared to planned spending in the initial budget of ¥9.0 trillion), this implies a significant contraction in public works spending in FY1999.

6. The FY1998 initial general account budget, announced at the same time as the FY1997 supplementary budget, was contractionary (Table II.3). The general account deficit was to be reduced to ¥15.6 trillion, about ¥3.5 trillion (0.8 percent of GDP) lower than the revised deficit for FY1997.9 The reduction largely reflected expenditure cuts mandated by the FSRA, with overall expenditures projected to decline from 15.5 percent of GDP in the revised FY 1997 budget to 14.9 percent of GDP.10 Expenditure measures included:

  • A 7.8 percent reduction in planned public works spending.

  • A 10.4 percent reduction in ODA expenditures to ¥ 1.0 trillion (0.2 percent of GDP).11

  • A 2 percent increase in transfers to social security (compared to an “unchanged policy” projection of around 5 percent), implemented through cuts in drug costs and restraints on reimbursement of doctors.

Table II.3.

Japan: Central Government General Account Budget, FY1994–98

(In billions of yen, fiscal years)

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Source: Data provided by the Japanese authorities.

Includes repayments of principal and running costs.

7. The FY 1998 initial budget also contained tax measures that implied a net tax cut of ¥0.8 trillion (excluding income tax cuts) (Table II.4). Details included:

  • A reduction in the national corporate tax rate of 3 percentage points, to 34½ percent, with partially offsetting base-broadening measures (including reduced tax allowances for bonus payments, retirement payments, and tax-free reserves against loans) to be phased in over several years.

  • Halving the securities transaction tax and taxes on derivatives trading, with a view to abolishing these taxes in FY1999 in conjunction with reform in capital gains taxes.

  • The suspension of the landholding tax, a reduction in the capital gains tax on land transactions, and the suspension of double taxation of capital gains on corporate land deals.

  • An increase in deductions from individual income tax for educational expenses.

Table II.4.

Japan: Tax Receipts of the Central Government General Account, FY1994–98

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Source: Data provided by the Japanese authorities and staff calculations.

Percentage changes calculated relative to most recent data of previous year.

8. The FY1998 FILP budget and local finance plan were also contractionary. FILP general spending (i.e., excluding portfolio investment) was budgeted to fall by 6.8 percent in FY1998 from the initial FY1997 level, the second consecutive year of decline (Table II.5). However, funds for public financial institutions that lend to small- and medium-sized enterprises (SMEs) were increased to help alleviate the impact of constraints on private bank lending (discussed further in Chapter III). The local finance plan for FY1998 projected zero growth in total government expenditures. Discretionary expenditures (i.e., excluding debt payments) were budgeted to decline by 1.6 percent, with local public works being projected to decline by 6 percent, similar to the reduction in the central government’s general account public works spending mandated in the FSRA.

Table II.5.

Japan: Fiscal Investment and Loan Program (FILP), FY1994–98

(In billions of yen, fiscal years)

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Source: Ministry of Finance.

As of June 1998

Difference between “sources of funds” and “uses of funds” reflects short-term off-program investments of the Trust Fund Bureau.

Reflects the funding of the “lend-back” system under which the postal savings system, public pension funds, and the postal life insurance fund receive funds for portfolio management on their own account.

Excludes portfolio investment.

Compared with revised plan of the previous year.

9. Together with the FY1997 budget, these plans represented a considerable down-payment on medium-term fiscal consolidation. Overall, the general government deficit (excluding social security) was projected to decline by 1.2 percentage points of GDP. The fall in the general government deficit (excluding social security) by 2 percentage points of GDP from FY1996 to FY1998 would have cut in half the distance from the FY2003 deficit target in just two years.

10. However, planned fiscal consolidation efforts were overtaken by events. As activity continued to weaken in early 1998, the government came under increasing pressure to stimulate activity through fiscal measures. In April 1998, immediately after the passage of the FY1998 initial budget, a ¥16.7 trillion stimulus package (the largest ever such package, see Table II.1) was announced, including ¥12 trillion (2½ percent of GDP) in “real water” measures directly affecting economic activity. The extra spending included:

  • ¥7.7 trillion in additional public works spending, comprising ¥6 trillion in additional public investment jointly financed by the central government and local governments,12 ¥0.2 trillion in disaster relief, and ¥1.5 trillion in public works autonomously financed by local governments.

  • ¥4.3 trillion in tax cuts, comprising ¥2 trillion in income tax cuts in 1998, a further ¥2 trillion in 1999, and ¥0.3 trillion in other FY1998 tax relief aimed at stimulating investment through various tax deductions.13

  • ¥4.7 trillion in additional measures (not included in the “real water”), including ¥2.3 trillion in spending to support the real estate market (largely earmarked for land acquisition) and ¥2 trillion in additional lending to small- and medium-sized enterprises (SMEs) through the FILP.

11. The central government portion of the stimulus package was contained in a supplementary budget approved by the Diet in June 1998 (see Table II.3). The budget included ¥3.6 trillion (¾ percent of GDP) in additional social capital spending (the central government’s share of the additional public works spending, implying that local governments are responsible for the remaining ¥4.1 trillion), ¥1.4 trillion (¼ percent of GDP) in income tax rebates (the central government’s portion of the additional ¥2 trillion in tax cuts in 1998), as well as ¥0.6 trillion in additional official aid, mainly for the countries affected by the Asia crisis. Before the supplementary budget could be approved, however, the FSRA had to be amended to allow the limit on deficit-financing bonds to be waived (this was accomplished in May, see Box II.1). The FILP budget was also amended, to authorize additional general spending of ¥2.6 trillion (½ percent of GDP).

12. The Government forecasts that these measures will increase the FY1998 general government deficit (excluding social security) by 2 percent of GDP (from 4.7 percentage points of GDP to 6.7 percentage points). The staffs projections, based on real growth of 0.5 percent (compared to the official forecast of 1.9 percent) and including the costs of increased government land acquisition and possible future DIC injections to the banks, is for a deficit of 7.8 percent of GDP (Table II.2). As a result, the structural deficit (excluding social security) is projected to increase from 5.0 percent of potential GDP in FY1997 to 6.1 percent of potential GDP in FY1998.

13. Despite increases in contributions, the social security surplus is expected to decline in FY1998 (Chart II.3). Even with a weak economy, the staff projects that social security contributions will increase by 3.3 percent in FY1998, owing to the increase in pension contribution rates in September 1996 (the contribution rate for the EPI, the earnings-related part of the public pension system for private sector employees, was raised from 16.5 to 17.35 percent of eligible income) and higher health charges implemented in September 1997 (when co-payments for many beneficiaries were raised from 10 to 20 percent and charges for prescriptions were also increased).14 However, expenditures are estimated to rise even more rapidly, largely reflecting the aging population. As a result, the social security surplus is projected to fall from 2.1 percent of GDP in FY1997 to 1.6 percent of GDP in FY1998, most of which reflects the impact of weak growth on revenues.



Citation: IMF Staff Country Reports 1998, 113; 10.5089/9781451820447.002.A002

Sources: Economic Plonning Agency, Annual Report on Notional Accounts; and staff estimates.1/ Figures for FY 1997 ond FY 1998 ore staff estimates.

B. How Effective is Counter-Cyclical Fiscal Policy?

14. Despite vigorous counter-cyclical fiscal policies in the 1990s, demand has continued to be weak, raising questions about the effectiveness of fiscal policy in providing support for activity. In contrast, consolidation in FY1997 led to a larger and longer downturn in private demand than expected. Why did fiscal policy have such seemingly different impacts at different times in the 1990s? How does Japan’s experience compare with those of other major industrial countries? And, what is the expected impact of the recent stimulus package on activity?

15. While Japan’s structural deficit deteriorated significantly in the 1990s, other major industrial countries generally consolidated, with particularly large improvements in the structural balances of Italy, Canada, and Germany (tabulation below and Chart II.4).15 This consolidation was accompanied by a slowdown in growth in most countries (with the important exception of the United States). However, the relative growth performance across countries is not obviously connected with changes in the fiscal balance. For example, the slowdown in growth was very similar across the three continental European economies, although the fiscal consolidation in France has been much smaller than Germany or, in particular, Italy, while the largest slowdown in growth was in Japan, which also had the greatest fiscal expansion.

Change in Structural Fiscal Balance and Growth, 1991–96

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Source: WEO database.Notes: North America is a PPP−weighted GDP average of the United States and Canada, Western Europe is a PPP-weighted GDP average of Germany, France, Italy and the United kingdom.


Citation: IMF Staff Country Reports 1998, 113; 10.5089/9781451820447.002.A002

Source: IMF, World Economic Outlook and staff estimates. The value• for western Europe and North America are calculated using PPP weights.

16. The apparently loose connection between fiscal policy and growth performance does not necessarily mean that fiscal policy provides no boost to output. The relationship is complicated because the causation can go the other way, with poor performance leading to a looser fiscal stance. This is certainly true in Japan, where most of the deterioration in the structural deficit reflected deliberate counter-cyclical policies announced in supplementary budgets. In addition, fiscal policy has only a temporary impact on aggregate demand, as the benefits (costs) of stimulus (consolidation) erode quite rapidly over time. Hence, there is unlikely to be a close relationship between medium-term changes in fiscal policy and growth.

17. There are two main approaches to estimating the size of fiscal multipliers—simulations using macroeconomic models and direct econometric estimation. Macroeconomic models have the advantage that the transmission channels are well defined, and that simulations can take account of particular circumstances.16 The staffs multipliers have been based on simulations of changes in fiscal policy from a version of the Fund’s MULTIMOD model. The “rules of thumb” derived from these simulations are that structural changes in direct expenditures have a multiplier of 1–1.2, while structural changes in transfers less taxes have a multiplier of around one-half.17 These fiscal multipliers have been used by the staff to assess the impact of specific initiatives and are also incorporated into a more general assessment of the state of the economy through their role in the financial conditions index (FCI), which measures the net impact on aggregate demand of changes in fiscal policy, short-term real interest rates, the real exchange rate, and real stock prices.

18. Direct econometric estimates of fiscal multipliers generally yield smaller values. Studies of Japanese responses have found it particularly difficult to identify significant effects of taxes and transfers on output.18 A possible limitation is that these studies typically do not consider the effects of asset prices, despite the fact that the bursting of the asset price bubble in the early 1990s was a major cause of the subsequent slowdown in activity. To investigate the role of asset prices further, an empirical counterpart to the staffs FCI index including fiscal policy variables, monetary variables, and asset prices (including real land prices in order to measure the negative impulses to the economy from the declining price of land) was estimated on quarterly data over 1980–96.

Output Gap Regression

The regression results were:


where LGAP is the log of the output gap, RINT is the real short-term interest rate, LREX is the log of the real exchange rate, GDIR is structural government spending on goods and services as a ratio to potential GDP, TAX is the structural value of government revenues net of other government spending, RLSTK is the log of real stock prices, and RLAND is the log of real land prices.

19. The results from this equation are broadly consistent with the effects assumed in the staffs FCI index, although the implied lags are somewhat longer than might have been anticipated and the coefficient on real stock prices is small, incorrectly signed, and insignificant.19 In terms of fiscal policy, the coefficient on direct government spending is found to have a large and significant impact on output, consistent with the predictions of macroeconomic models. The coefficient on taxes net of transfers, however, while being correctly signed, is not significant at conventional levels, and the implied multiplier is significantly smaller than that derived by the staff from macroeconomic simulations, although broadly similar to the VAR results discussed earlier.20

20. The effectiveness of fiscal policy varies with circumstances. Some of the most important are:

  • The composition of fiscal policy. Direct spending on goods and services (government consumption and investment) will generally have a larger short-term impact on aggregate demand than taxes or transfers because all of the money allocated to goods and services is spent, while changes in income from taxes and transfers will be partly offset by saving.21 In Japan, direct spending rose significantly during the fiscal expansion of FY1992-FY1993, fell significantly in FY1997, and is planned to rise again in FY1998 (see tabulation below). By contrast, annual direct government spending remained relatively stable during FY1994–FY1996.22

  • The monetary response. A supportive monetary policy will tend to increase the impact of fiscal policy on demand. Japanese interest rates were steadily lowered over the first half of the 1990s, although the support for counter-cyclical fiscal policy was dampened by falling inflation (which raised real interest rates) and the appreciation of the yen in 1994 and early 1995. The subsequent depreciation of the currency, together with the demand shifting caused by the consumption tax hike of April 1997, helps to explain the high level of growth in 1996 and early 1997. Consolidation in FY1997 occurred against a background of unchanged (although very low) short-term interest rates, so that monetary policy provided no additional assistance for the economy.

  • The time path of policies. Theory generally suggests that temporary and permanent policies could have different effects on private sector activity, and that compared to a temporary tax reduction, the anticipated increases in income in future years from a permanent tax cut could generate a larger boost in the consumption of forward looking consumers.23 (This issue is discussed further below, using simulations from the IMF’s macroeconomic model MULTIMOD.) The income tax cuts announced in early 1994 were temporary, as were those announced in late 1997 and early 1998, which may have decreased their effectiveness. Anticipated policy changes can also be important. Planned future increases in social security contributions may have depressed demand recently, while the anticipation of the consumption tax hike clearly created a significant shift in demand in early 1997 (see Chapter I).

  • The economic cycle. Fiscal policy will generally be more effective when the economy is depressed than when it is overheated, as it is less likely to crowd out private sector demand. This implies that policy should have been more effective since the bursting of the asset price bubble, and should be particularly effective in current circumstances, given the level low level of private demand. However, the benefits of expansionary fiscal policy may well be obscured by the negative impulses to the economy from banking sector problems and, more recently, the Asia crisis.

  • The policy context. If fiscal policy is on a clearly unsustainable path, then a credible move toward fiscal consolidation can spur private sector demand, as investors lower long-term interest rates in anticipation of future benefits. In Europe, credible adjustment is often associated with reductions in spending on transfers, signaling a willingness to cut bloated and inefficient government programs.24 In Japan, the long-term fiscal position may become a concern, particularly as gross general government debt approaches 100 percent of GDP and continues to rise.

Composition of Changes in Fiscal Policy

(In percent of GDP)

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Source: Economic Planning Agency and staff calculations.

Mainly net interest revenues and land acquisition.

21. Simulations using a version of MULTIMOD helps to illustrate the importance of some of these factors. The tabulation below reports (absolute) values of first-year multipliers from fiscal policy simulations which vary: (i) composition (direct government spending or taxes and transfers); (ii) timing (temporary or permanent);25 and (iii) monetary response (a constant or flexible nominal interest rate). The multipliers broadly conform to the rules of thumb used by the staff, ranging from 1.07–1.30 for direct spending and 0.54–0.62 for taxes and transfers. Allowing interest rate changes to partly offset the fiscal expansion can lower multipliers significantly—from 1.30 to 1.07 for a permanent direct government spending shock. The results also confirm that (abstracting from monetary responses) a permanent tax change has a larger impact than a temporary one, although this effect is smaller than might have been anticipated, possibly reflecting the important role of disposable income (reflecting the behavior of liquidity constrained individuals) in the consumption function.

Fiscal Multipliers Under Alternative Assumptions

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Note: Absolute values of multipliers are reported. The results come from simulations on a version of MULTIMOD adapted to conform more closely to the Japanese data.

22. How do these considerations help explain the apparent lack of stimulus from of fiscal expansion through much of the 1990s, followed by a pronounced slowdown FY1997? Two underlying factors are important:

  • Cyclical impulses. Asset deflation and exchange rate appreciation operated against fiscal expansion in the early 1990s. These factors waned in 1996 when a cocktail of fiscal expansion, exchange rate depreciation, and low interest rates allowed the economy to expand relatively vigorously. However, 1997 saw fiscal contraction compounded by the Asia crisis and constraints on bank credit.

  • The composition and implementation of fiscal policy. The stimulus to demand from fiscal expansion in the middle of the 1990s was limited by the small role played by direct government spending and the temporary nature of the announced tax stimulus.26 By contrast, consolidation in FY1997 was associated with very significant cuts in government investment and permanent tax and social security contribution increases.

C. How Serious Is Japan’s Fiscal Situation?

23. While recent fiscal stimulus has been justified by the need to support the economy, the large fiscal deficit raises concerns about the longer term sustainability of the fiscal position. The appropriate trade-off between these two competing needs—providing short-term support for activity and achieving a more sustainable stance over the medium term—requires an assessment of both the effectiveness of fiscal stimulus and the seriousness of the current fiscal situation. The previous section discussed the first issue, concluding that fiscal policy can be an effective macroeconomic tool. This section focuses on assessing the longer-term sustainability of the current fiscal position.27

24. Fiscal sustainability is generally analyzed in terms of the trajectory of government debt implied by current policies. If the debt dynamics imply an explosive path, or an increase of debt to unmanageable levels, then the policy is considered unsustainable. In Japan, such an assessment is complicated by the large amount of financial assets owned by the general government. Social security assets, which are accumulated to help pay for future public pensions, now sum to over 50 percent of GDP. However, if one takes into account the accumulated liabilities to future pensioners, the public pension system is in fact considerably underfunded. For this reason, staff analysis generally distinguishes the social security system from the remainder of general government, focusing on general government net debt (excluding social security) as the basic measure of the government’s underlying debt position, while separately assessing the longer term viability of the social security system.28 A further complication is that financial claims held by the government—for example, claims on public enterprises—may in fact be worth less than the book value. The trajectory of gross general government debt thus also provides useful information on the gravity of the debt position, although care must be taken in interpreting the figures since double counting caused by government financial intermediation inflates the data.

25. Japan’s deficit is high by international standards, implying that debt is increasing rapidly. Japan’s general government deficit has been rising since the early 1990s, and, on current plans, the staff estimates that the general government fiscal deficit will be over 6 percent of GDP in FY1998, considerably higher than in the other major industrial countries (see tabulation below).29 Adjusting for the large output gap reduces the deficit significantly—the structural deficit is estimated at 3.6 percent of GDP—but even on this basis Japan’s deficit is the largest of the major industrial countries. Excluding the social security surplus, the general government deficit is estimated at almost 8 percent of GDP.

General Government Balances for the Major Industrial Countries, CY1998

(In percent of GDP)

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Source: WEO database and EPA.

Percent of potential GDP.


The structural balance excluding social security in Japan is −6.0 percent of potential GDP.

26. If social security assets are included, current levels of net general government debt are quite low. In fact, at about 20 percent of GDP in 1997, Japan’s net general government debt remains the lowest amongst the major industrial countries, even though it has risen by 15 percent of GDP since 1991 (see tabulation below). On current policies, the staff estimates that net general government debt would rise by slightly over 20 percentage points of GDP by FY2001.30 However, the pace is projected to slow significantly after this, as fiscal consolidation is implemented to achieve the medium term fiscal targets laid out in the FSRA, and the net general government debt ratio is projected to stabilize at somewhat below 50 percentage points of GDP (Chart II.5).31

Major Industrial Countries—General Government Debt Position, CY1996

(In percent of G DP)

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Source: OECD, Economic Planning Agency, and staff calculations.

Data for CY 1997.

The larger figure is the official data, the lower figure the value used by the OECD (which excludes “nonprofit institutions controlled by the government”).



Citation: IMF Staff Country Reports 1998, 113; 10.5089/9781451820447.002.A002

Source: WEO database. Projection based on currently announced policies.1/ The debt data for Japan from 1998 onwards include an allowance for the debts of the JNRSC and Fishery Service.

27. The present social security system, however, implies large unfunded liabilities. Japan has the most rapidly aging population amongst the major industrial countries, and to help to pay for this the public pension system has been running significant surpluses which helps to reduce net general government debt. However, the system is projected to move into deficit by 2010 as the dependency ratio rises and the system matures. Indeed, international comparisons indicate that Japan’s unfunded pension liability is at the upper end of the range for industrial countries (see tabulation below).32

Net Pension Liabilities 1995–2050

(In percent of GDP)

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Source: S. Chand and A. Jaeger, Aging Populations and Public Pensions Schemes, IMF Occasional Paper No. 147 (December 1996).

Intergenerational equity is also an issue—generational accounts indicate that among the large industrial countries Japan has the largest imbalance between the fiscal liabilities of current and future generations.33

28. Maintaining the current system of pension benefits will require very large increases in contributions. If the government follows the path laid out in the 1994 pension reform plan, contribution rates would need to approximately double, from 17.35 percent of basic pay currently to 34.3 percent by 2025.34 As part of its efforts towards reform, the Government has recently publicized some fairly general reform options, including cutting benefits by 40 percent over time to avoid the need for significant future hikes in contribution rates. The paper also provided estimates of the impact of alternative approaches to cutting costs.35 Opinion polls on these proposals indicate that a majority of the public is in favor of a moderate reduction in benefits and more limited future increases in contribution rates than implied by the current system.

29. Excluding the social security system from the fiscal data reveals a much less favorable medium-term fiscal picture. Net general government debt (excluding social security) was almost 65 percent of GDP in 1997, considerably lower than in Italy but at the upper end of the other major industrial countries (Chart II.6). Furthermore, the debt dynamics also look less satisfactory. The rate of increase in debt over the last few years has been faster (over 30 percentage points of GDP since 1991). Staff projections, based on the plans for consolidation contained in the FSRA, indicate that net general government debt will continue to rise from its current level, stabilizing early in the next century at close to 100 percent of GDP.36 To maintain this debt level over the longer term, however, further consolidation in general operations would be needed, to help provide a cushion for increasing transfers to the social security in the future due to an aging population.37



Citation: IMF Staff Country Reports 1998, 113; 10.5089/9781451820447.002.A002

Source: WEO database. Projection based on currently announced policies.1/ U.S. figure exludes social security trust funds; Germany and U.K. figures do not exclude social security, owing to data unavailability.2/ The debt data for Japan from 1998 onward include an allowance for the debts of the JNRSC and Fishery Service.

30. Gross general government debt is significantly higher than net debt (excluding social security), reflecting the important role played by the government in financial intermediation. Largely due to the complex web of financial transactions between the general government and public sector financial institutions associated with the FILP, the general government held financial assets with face value of over 35 percent of GDP in FY 1997. This implies gross general government debt of almost 100 percent of GDP in 1997. On present policies, this measure of debt would stabilize at close to 140 percent of GDP early in the next century (Chart II.6). However, this crude measure of gross general government debt almost certainly significantly overstates the true level of gross debt, in part due to the double counting caused by the inclusion of public financial intermediaries in the official definition of the general government sector.38

31. However, the true value of general government net debt is likely to be higher than the official data since the recovery value of general government assets (largely claims on the FILP lent to public financing corporations) is likely to be considerably lower than the book value. In the FY1998 budget, the central government took responsibility for nets debts of ¥26 trillion (5 percent of GDP) in debt of the Japan National Railway Settlement Corporation (JNRSC) and the Forestry Commission (both of which had received considerable amounts of money from the FILP), increasing general government net debt by the equivalent amount. Problems of this type may well exist in other areas of the FILP.39

32. Market signals such as long-term interest rates show no signs that investors believe that the fiscal position is unsustainable. Indeed, interest rates on long-term government bonds have recently fallen to historic lows reflecting confidence in future government fiscal policies and low demand for funds from the private sector.40 Low bond rates imply that the funding cost of additional debt will be limited, while the high degree of slack in the economy will tend to reduce private sector crowding-out from fiscal expansion.

33. In sum, Japan retains short-term room for maneuver but has a serious long-term fiscal problem associated with an aging population that will eventually need to be addressed. The aging population will require medium-term consolidation of the general government position (excluding social security) as well as measures to ensure the viability of the social security system. Nevertheless, the government retains room to use fiscal policy in the short term as a macroeconomic policy tool, particularly in the absence of alternative instruments.

D. How Predictable is the Fiscal Stance?

34. One of the difficulties in analyzing fiscal policy in Japan is the lack of transparency of the fiscal accounts. The budget accounts are highly fractured, and assessing the future path of fiscal policy is hindered by the lack of medium-term budgetary planning. As a result, it is often difficult for analysts (and, possibly, even the Government) to assess the impact of announced policy changes on the underlying fiscal stance. The Fiscal Structural Reform Act (FSRA) has improved the situation by mandating that budgets include projections of the general government deficit (excluding social security), providing a medium-term target for fiscal policy, and incorporating plans for future spending in some areas, but the available information remains well short of best international practices identified in the Fund’s Code of Fiscal Transparency.

35. There is no unified budget for the central government, but rather budgets are presented separately for the major government accounts. The central government’s general account is the most important account for budgetary planning. It includes most central government tax revenues (but not social security contributions) and finances the majority of central government spending, although there are also numerous special accounts which oversee particular expenditure items. In addition, the FILP budget, which determines how funds raised through social security and postal savings are spent, is also used for policy purposes. FILP spending is about two-thirds of that of the general account. Consequently the FILP budget is often referred to as “the second budget.”

36. These complexities are particularly important because national accounts data are only available with a considerable lag. Data on the overall general government stance are available nine months after the end of the fiscal year, while details of the behavior of subsectors of government (central government, local government, and social security) take somewhat longer, so that the fiscal stance in the recent past typically needs to be estimated on the basis of limited information. Earlier staff work has shown that the general account deficit is of only limited use in predicting the deficit on a national accounts basis, partly reflecting complications to do with the timing of supplementary spending.41

37. More recent staff analysis has considered the most useful indicators for projecting the components of general government expenditures and revenues. Preliminary results indicate that several types of information, including revised budget projections and monthly indicators, are useful for predicting the fiscal stance currently and in the recent past, but that there is much more limited information available about the future outcomes. In particular, the outcomes for government investment and tax revenues—two of the major components of the overall fiscal stance—are better predicted by monthly indicators than budget projections.

38. Difficulties in projecting the overall fiscal stance are only partly eased by the FSRA. In order to monitor progress in achieving the medium-term fiscal target laid down in the legislation, the FSRA requires the government to publish projections of the general government deficit (excluding social security) for the next fiscal year in initial and supplementary budgets. These projections provide useful information in assessing the government’s fiscal stance. However, since the estimates of the deficit are calculated from the financing side (using planned issuance of debt), corresponding projections of general government expenditures and revenues are not available. Expanding the methodology by incorporating projections of expenditures and revenues would provide a useful check of the consistency between the deficit projections and existing budgetary plans.

39. Projecting fiscal policy over the medium term is complicated by the lack of detailed multi-year expenditure planning. The budget process focuses almost exclusively on spending in the next fiscal year.42 This encourages the use of short-term fiscal measures—such as temporary boosts to government investment and temporary income tax rebates—particularly in supplementary budget operations, as well as generating unnecessary uncertainty about the medium-term path of policy. Again, the FSRA has provided a medium-term target for fiscal consolidation and increased transparency by including some future spending commitments. However, even with these changes, the government’s intentions as regards the path of government expenditures over the next few years remain highly uncertain.

E. The Tax System—Where is Reform Needed?

40. The recent weakening of economic performance has led to increasing attention to tax reform as a means to provide both short-term support for demand and longer-term supply-side gains. The principal focus of this discussion has been on reducing high marginal income tax rates on individuals and firms, lowering the tax burden on property transactions, and widening tax bases as a means of stimulating activity and improving economic efficiency.

41. Japan’s overall tax burden is not heavy compared to other industrial countries. General government revenues as a percentage of nominal GDP are among the lowest in the major industrial countries (28.5 percent of GDP in 1995, see tabulation below). While revenues are more highly dependent on direct tax revenue than is typically found in European countries, they are less so than the United States. The most striking feature of the tax system is the large amount of revenue raised from corporate income tax as compared to other major industrial countries (Chart II.7). This reflects, at least in part, the fact that local taxes on business are mainly levied on income.

General Government Revenue in 1995

(In percent of GDP)

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Source: OECD, Revenue Statistics, 1965–96.


Citation: IMF Staff Country Reports 1998, 113; 10.5089/9781451820447.002.A002

Source: Ministry of Finance.

42. Despite a low overall tax burden, the personal and corporate income tax systems are characterized by high top marginal tax rates and narrow bases. The minimum income level for personal income taxes is among the highest in the five major industrial countries (Table II.6), and only one-third of firms pay corporate income taxes (Table II.7). As a result, a limited number of individuals and corporations provide a large portion of tax revenues.

Table II.6.

Japan: International Comparison of National Income Taxes 1/

(Salaried Worker with Wife and Two Children)

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Source: Ministry of Finance.

Foreign exchange rates applied to the calculation: US$1 = ¥119; £1 = ¥195; 1DM = ¥67; IFF = ¥20.

In addition to the national tax, a local income tax, which has three brackets (5–15 percent).

In addition to the national tax, there are local income taxes are imposed by state, county, and city. (For example, in New York state, the local income tax has five-brackets ranging from 4–6.85 percent).

In addition to the national tax, there is a Joint and Additional Tax (5.5 percent of the tax amount) imposed.

Table II.7.

Japan: Effective Corporate Tax Rates and Distribution of Firms

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Source: National Tax Administration.

43. The personal and corporate tax systems have both undergone reforms in the 1990s. In 1995, individual income tax rates were lowered significantly (offset by an increase in the consumption tax rate, from 3 percent to 5 percent, implemented in April 1997). As regards corporate income taxes, the central government tax rate was reduced by 3 percentage points in April 1998, from 37.5 percent to 34.5 percent. This was accompanied by a range of base-broadening measures to be implemented over several years.

44. More recently, the Government has announced its intention to consider more sweeping tax reform. More specifically, Prime Minister Obuchi pledged to reduce the corporate tax rate to an international comparable level (generally interpreted as a 40 percent tax rate compared to just over 46 percent currently) from FY1999, and to lower the top marginal tax rate from 65 percent to 50 percent from CY1999. The tax cuts would be implemented in the context of a longer term review of the tax system.

Individual Income Tax System

45. Effective tax rates on most individuals are low because of generous deductions. The basic allowance and dependent allowances are amongst the highest in the major industrial countries; salaried workers are also able to claim a generous earned salary exemption, to compensate them for the numerous business allowances provided to the self-employed and farmers; social security contributions are deducted from taxable income; and allowances for pensioners are also generous.43 As a result, a “typical” salaried worker who earned ¥8 million in 1996 (around $55,000) with a wife and two children had income tax payments of only ¥ 0.38 million (4.8 percent of earnings, see tabulation below).

Calculation of National Individual Income Tax: 1996

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Source: Ministry of Finance.

46. High top marginal tax rates skew income tax revenues toward the wealthy. The top marginal tax rate is 65 percent (50 percent for central government income taxes and 15 percent for local income taxes), the highest in the five largest industrial countries. However, these very high tax rates are only relevant for those with very high incomes. As a result, the top 6½ percent of taxpayers (those who earn more than ¥15 million) paid about 40 percent of central government income taxes in 1996 (Table II.8).

Table II.8.

Japan: Number of Taxpayers, Total Employment Income, and Income Tax Payment by Income Bracket (1996)

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Source: Ministry of FinanceNote: Of the total 44,896,000 employment income earners who worked throughout the year, 5,706,000 (12.7 percent) were nontaxpayers.

47. The taxation of pension income is light. Public pension contributions are tax deductible, and, while benefits are subject to income taxes, multiple deductions (for public pension income and for old age, etc.) substantially raise the tax threshold. The benefits from private defined-benefit pension plans are generally paid in a lump-sum, which also receive generous tax treatment. As a result of these allowances, the pension income of most households is largely tax exempt.44

48. Investment income is largely taxed on a withholding basis, rather than being integrated with the taxation of wage income. In particular, interest payments are subject to a flat 20 percent withholding tax. The main reason for separating the taxation of investment income from wage income is the difficulty of tracking investment income. Proposals for the introduction of tax identification numbers (tax IDs), which would allow the integration of the taxation of earned and unearned income and help to lower tax avoidance, have failed to achieve sufficient political support.45

49. Future reforms of the income tax system should aim improve work incentives by reducing the upper marginal tax rates, while widening the tax base to maintain revenues, and integrating taxation of different types of income. Options for base broadening include:

  • Lowering basic exemptions (particularly for spouses), as well as reducing the earned income allowance and the associated business allowances provided to the self-employed and farmers.

  • Reducing allowances for pension income and unifying the tax treatment of all forms of pensions (i.e., public, private defined-benefit, and private defined-contribution plans). A government committee is currently considering how to reform the taxation of pensions.

  • Taxing of fringe benefits, in particular housing benefits.

  • Introducing a tax ID system. This would help to reduce tax avoidance and make the taxation of investment income more progressive, thereby helping to alleviate the concerns about equity associated with reducing high marginal tax rates.

  • Gradually increasing consumption tax rates (in small enough increments to avoid the economic dislocation caused by the most recent consumption tax hike). Taxing expenditures rather than income would help maintain tax buoyancy in the face of an aging population with a declining workforce and reduce the intergenerational inequities noted above.

Corporate Income Tax System

50. The corporate income tax rate is high, but many firms do not pay taxes. The basic corporate income tax rate is about 46 percent, higher than in the United States, the United Kingdom, and France (but lower than that in Germany).46 In 1996, however, 65 percent of companies did not pay any corporate income tax, reflecting low economic growth, generous carry-over provisions, and generous allowances for SMEs (Table II.7). As a result, a small number of large firms pay most of the taxes. In 1995, the largest 3¼ percent of total firms in terms of capitalization (which represent slightly less than one-third of total sales) paid 72 percent of total corporate income tax revenue (Table II.9).

Table II.9.

Japan: Stratification of Corporations by Capitalization, 1995

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Source: Annual Statistics Report, National Tax Administration

51. While a significant number of tax allowances were eliminated in the FY1998 budget, there remains scope for further broadening of the corporate tax base, particularly as regards SMEs. Base-widening reforms could include:

  • Switching the tax base for local corporate taxes from income to a broader measure of activity, such as turnover. By widening the number of firms liable for corporate taxes, the tax burden on profitable firms would be lowered.

  • Lowering the five-year time period for the carry-over of tax losses. About 20 percent of firms are profitable but do not pay taxes because of past losses. There are over ¥55 trillion—10 percent of GDP—in tax losses outstanding.

  • Reducing the ¥8 million annual income below which a lower central government tax rate (of 25 percent) is levied. This would lower the incentives for large companies to use small subsidiaries as tax shelters (see below).

  • Decreasing entertainment allowance for SMEs (companies whose book-value of capital is less than ¥50 million) and reducing donation allowances.

52. Introducing consolidated taxation is also an important reform objective. Corporate taxes are currently levied on an unconsolidated basis, so that wholly owned subsidiaries are taxed separately from the parent company. Introducing consolidated taxation might provide greater incentives to set up holding companies, to the extent that losses in one company could be offset against profits in another. This could raise the incentives for needed corporate restructuring, at the cost of lower corporate tax revenues. Consolidated taxation would also end the incentive for large companies to create numerous small “subsidiaries” which are able to take advantage of the lower tax rates and more generous allowances allowed to SMEs.47 Consolidated corporate taxation could be linked to the introduction of consolidated corporate accounting, due to occur on a limited basis in FY1999. While introducing consolidated taxation, due consideration will need to be given to other related issues, such as the design of the Commercial Code, the control of tax evasion, and the revenue effect.

Property Taxes

53. Although tax rates have been reduced recently, taxes on many property transactions remain high, reducing liquidity and underlying values. Property market transactions have been sluggish through most of the 1990s. The FY1998 budget incorporated a number of reforms of taxes on assets, aimed at reviving the property market and supporting “big bang” financial reforms (discussed earlier). Additional reforms could include:

  • Reducing the 5 percent real estate registration tax for large houses.

  • Lowering the 4 percent real property acquisition and the 3 percent special land holding taxes.

  • Exempting transfers of property or mortgages from one financial institution to another from the registration, license and real property acquisition taxes. These taxes are a disincentive for the acquisition of assets of failed institutions, and hence an impediment to solving problems in the financial system.

  • Lowering taxes on inheritance and gifts, which reduce incentives to transfer properties.

F. Public Investment: Sources of Inefficiency and Prospects for Reform

54. Concern regarding the efficiency of government public investment has grown in recent years. This partly reflects fear that the massive increase in government spending since the early 1990s has led to a wasteful misallocation of resources, as well as growing awareness of the need for substantial fiscal consolidation in the medium term in order to prepare for demographic pressures.

55. There is growing empirical evidence of diminishing returns to public investment since the 1980s. Figure II.1 contains staff estimates of the marginal productivity of the government capital stock, which suggest that such productivity has declined sharply over time and possibly even turned negative during the 1990s.48



Citation: IMF Staff Country Reports 1998, 113; 10.5089/9781451820447.002.A002

Factors underlying low returns to public investment

56. An important explanation for the diminishing returns to public investment is its sheer size in Japan, which is substantially larger than in other industrial countries (Chart II.8).49 For example, after averaging around 6½ percent of GDP during the latter half of the 1980s, general government public investment grew rapidly during the 1990s and peaked at 8¾ percent of GDP in 1996. This compares with ratios to GDP of only about 2 percent in other industrial countries. As a result of high public works spending, roughly 11 percent of the labor force is employed in the construction sector, compared with around 5½ percent in the United States. A recent study by Daiwa Institute of Research suggests that one reason why the impact of public investment on economy-wide labor productivity is negative is that it diverts labor and other resources to the construction sector, which is relatively inefficient.50



Citation: IMF Staff Country Reports 1998, 113; 10.5089/9781451820447.002.A002

Source: Bank of Japan; staff estimates.

57. The productivity of public investment in Japan may also be adversely affected by its volatility, which has been considerably greater than in other industrial countries, especially in recent years (Chart II.8). The higher volatility reflects a number of factors, including the greater use of public investment as a tool of counter-cyclical policy, as well as the use of public investment for disaster—especially earthquake—relief. Given the rigidities in Japanese employment practices, this volatility implies a larger-than-otherwise level of employment in the sectors most affected by public investment. For example, employment in the construction sector is over 10 percent of the labor force in Japan, versus around 5½ percent in the United States (Chart II.8).

58. Limited control by the central authorities over project implementation, and weak incentives for local governments to achieve cost effectiveness, may also have reduced the quality of public investment.51 The fiscal system in Japan is highly centralized, in the sense that most spending and tax policies are set by the central government. However, while roughly two thirds of total public investment is funded by the central government’s general account or the FILP, over 70 percent of spending is actually performed by local governments and public enterprises (Chart II.8).52 As a result, though local governments collect only about 40 percent of tax revenues in Japan, they administer well over 50 percent of government spending, a difference that is well above the ratio in other countries. The fact that only a modest share of local government investment is funded from own tax revenues reduces incentives to achieve efficiencies.

59. The use of public investment to achieve distributional objectives also has contributed to inefficiencies. An explicit policy objective for public investment spending in Japan has been to “correct regional disparities,” which has meant that spending is skewed toward low-income and rural regions.53 Political factors may also have affected the distribution of spending; rural areas have a relatively large voting weight in the Diet.54 Econometric evidence prepared by the Economic Planning Agency suggests that the return to social capital in cities is roughly twice the rate of return in the outlying regions.55

60. A specific example of the effect of distributional objectives on efficiency is reverse contracting. Local government and public corporations have tended to favor small-and medium-sized contractors during the bidding process (in some cases, companies were required to be headquartered in the area in which the project was to be implemented).56 In practice, however, local contractors subcontract out projects to larger companies, in turn restricting competition and increasing project costs.

61. Inflexible project allocations are another source of inefficiency. Ministries’ share of public investment is determined on the basis of negotiations between the spending ministries and the Ministry of Finance. The share of funds allocated toward projects administered by the Ministry of Construction and the Ministry of Agriculture have remained relatively high and constant over the last 20 years, possibly reflecting the political importance of the construction and agricultural sectors (tabulation below). Some observers suggest that this has implied excessive construction of dams, ports in rural areas, and agricultural infrastructure projects.57

Share of Public Works in Japan’s General Account, by Objectives

(In percent)

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Source: Ito, The Japanese Economy, and data provided by Japanese authorities.

62. Noncompetitive and nontransparent bidding procedures have significantly inflated construction costs. The OECD estimates that the cost of civil engineering projects is 80 percent higher in Japan than in the United States and almost 60 percent above costs in the European Union.58 High costs reflect high domestic prices and practices that have limited competition, including from foreign firms, including reverse subcontracting and the designated bidder system (which restricts the firms eligible to bid on contracts to those that have demonstrated an ability to work in Japan). In addition, “discretionary contract procedures” (zuii-keiyaku)—which allows local governments to assign design and consulting projects without competitive tenders, and the practice of prearranging the winner of public works tenders (dango) are reported to be common.59

63. Weak governance, and the close ties between the government and corporate sectors, may also have exacerbated waste and inefficiency. The Ministry of Construction wields significant influence over the construction industry—it is responsible for licensing firms, establishing eligibility criteria for tenders, and formulating spending priorities.60 At the same time, however—the practice of amakudari—i.e., of hiring retired government officials—is especially prevalent in the construction industry.

Recent efforts to reform public investment

64. An Action Plan on the Reform of the Bidding and Contracting Procedures for Public Works was adopted by the government in 1994. The Plan included commitments to hold open tenders for projects, and reduce constraints on foreign firms, established more transparent bidding procedures, and sought to limit the scope for bid rigging (dango). More recently, the Action Guidelines on Measures to Reduce Public Works Costs were adopted as part of a June 1997 cabinet decision. The Guidelines aimed at reducing the cost of public works by at least 10 percent over the three-year period beginning in FY1997, and included a commitment to curbing “illegal acts.”

65. In addition, a Reassessment System has been adopted in order to improve the efficiency of ongoing public works projects. The system involves a review of project implementation five years after approval including consideration of: (i) progress toward completion; (ii) the social and environmental implications of the project; (iii) potential revisions to the cost-benefit implications of the project; and (iv) consideration of the scope for cost cutting. Sixty-eight projects were canceled in FY 1998 under this system. Moreover, cost-benefit analysis for pubic works also has begun to be applied. The system was adopted on a trial basis in FY 1997, and was applied more widely beginning in FY 1998.61

66. Most recently, a Private Financing Initiative has been endorsed by the Government. This initiative is modeled on a similar U.K. program that aimed to increase private sector involvement in implementation and administration of public works projects. The Government envisages encouraging greater private sector involvement in three areas: (i) projects where user fees are involved, including toll roads; (ii) projects where the public and private sectors had a joint interest, including urban renewal; (iii) projects where private sector administration of facilities was practical, e.g., prisons.


Prepared by Tamim Bayoumi, Christopher Towe, and Ichiro Oishi.


A more detailed description of Japan’s fiscal accounts is provided in Tamin Bayoumi, “The Japanese Fiscal System and Fiscal Transparency,” in B. Aghevli, T. Bayoumi, and G. Meredith (eds.), Structural Change in Japan (Washington: International Monetary Fund, 1998).


Further details can be found in JapanEconomic and Policy Developments, IMF Staff Country Report No. 97/91 (October 1997).


Japanese government debt is divided into construction bonds (used to finance public investment) and deficit-financing bonds. Eliminating the issuance of deficit-financing bonds would bring Japan back to the “golden rule” policy (in which debt is only issued to finance investment spending) followed before the first oil shock.


¥26,000 per taxpayer and ¥13,000 per dependent.


The tax rebates comprised ¥1.4 trillion in central government income tax cuts and ¥0.6 trillion in local income taxes. The timing of the rebates in 1998 varies by the type of taxpayer (worker or self-employed) and the type of tax (national or local).


FILP lending to small- and medium-sized enterprises was also raised by over ¥1 trillion, to help alleviate the effects of the “credit crunch.”


In addition, in March 1998 the DIC injected ¥1.8 trillion in funds to the banks, out of ¥13 trillion set aside from this purpose. While this had no impact on the general account, these injections are included in the calculation of the general government deficit.


The FY1998 initial budget also included plans for the government to take responsibility for ¥26 trillion (5 percent of GDP) in debts of the Japan National Railway Settlement Corporation (JNRSC) and the Japan Forestry Service, raising government debt by an equivalent amount.


Discretionary expenditures (total spending excluding national debt payments and local allocation tax grants) were projected to fall even more than overall expenditures.


This refers only to ODA expenditures that pass through the general account.


¥1.5 trillion for the environment and energy, ¥1 trillion for telecommunications, science and technology and another ¥1 trillion for social welfare, medical care and education, and ¥0.8 trillion each for transportation, disaster prevention, and redevelopment of urban districts.


The 1998 tax cuts will be administered in a very similar manner to the earlier ¥2 trillion in tax rebates—each taxpayer and dependent will have their tax allowance increased by ¥29,000 and ¥14,500, respectively. The nature of the 1999 tax cuts has yet to be determined.


More details can be found in JapanEconomic and Policy Developments, IMF Staff Country Report No. 97/91. The reduction in demand for health services stemming from this increase in charges has been larger than anticipated. Health care costs, which rose by 4.5 percent in FY1995 and 6.0 percent in FY1996, were projected to have risen by only 2.0 percent in FY1997 (compared to an estimated increase of 4.7 percent if no reforms had occurred). The Ministry of Health and Welfare is also committed to proposing significant further health reforms by FY2000, although no legislation has been proposed. Proposals will likely include reforms to drug pricing (to eliminate the premium between the prices paid by the health insurance system and those charged to patients), increasing medical charges for the aged, and reforming the nursing care system.


By contrast, Japan’s structural balance improved steadily in the 1980s while those in other countries remained relatively stable or deteriorated.


For example, JapanEconomic and Policy Developments, IMF Staff Country Report 97/91 (October 1997) included a discussion of the impact of the credibility of future fiscal actions on fiscal multipliers. On the other hand, simulations rely on a given model structure, which may not always capture all of the mechanisms at work in the economy.


For more details on the simulations, see G. Lipworth and G. Meredith, “Indicators of Monetary and Financial Conditions: A Reexamination” in JapanSelected Issues, IMF Staff Country Report No. 96/114 (October 1996), reprinted in B. Aghevli, T. Bayoumi and G. Meredith (eds.) Structural Change in Japan: Macroeconomic Impact and Policy Challenges (Washington: International Monetary Fund, 1998). Other models produce similar results. For example, the Economic Planning Agency model has a multiplier of around 1¼ on government spending (K. Kawasaki, “Development of the ERI Compact Model,” Discussion papers No. 64, (Tokyo: Economic Planning Agency, April 1996) and the OECD INTERLINK model has a short-term multiplier of 1.2 for government spending and 0.8 for taxes (OECD Economic SurveysJapan 1996, Paris: Organization for Economic Cooperation and Development, 1996).


See, for example, M. Matsuoka, “Measuring the Effects of Fiscal Policy on Japan,” mimeo, Daiwa Institute (November 1996) and J. Saito, “The Japanese Business Cycle After 1991,” Journal of Asian Economics, Vol. 8:2, pp. 263–93 (1997). Both papers, which use vector autoregressions to identify the impact of fiscal policy on the economy, conclude that the multipliers are quite small.


By contrast, the coefficient on real land prices, which is not included in the FCI, is highly significant, indicating that much of the deflation associated with the bursting of the asset bubble may have come through the effect of land prices on wealth and the banking system.


The staff equation was also estimated as a VAR, which produced similar overall results.


The marginal propensity to consume may also vary depending on the instrument being used, with changes in top tax rates and interest payments likely to have a smaller impact on private sector activity than equivalent changes in welfare benefits.


More generally, the high quarter-to-quarter volatility of government investment (Chart II.2), as well as uncertainties created by a lack of fiscal transparency, may well have impaired private sector activity.


This is one of the major results from the permanent income/life cycle models of consumption. Temporary changes in direct government spending, on the other hand, will, if anything, tend to be more effective as the impact on interest rate and the needed offset through tax policies will be less.


There have been a number of papers on “expansionary fiscal contractions,” surveyed and extended in A. Alesina, R. Perotti, and J. Tavares, “The Political Economy of Fiscal Adjustments,” paper presented at the spring 1998 Brookings Panel and forthcoming in Brookings Papers on Economic Activity. European countries may have also benefited from the credibility provided to fiscal consolidation programs by the fiscal criteria laid out for entry into EMU.


A temporary shock is maintained for one year, a permanent shock for 5 years.


Although there were ¥3.5 trillion in permanent income tax cuts in 1995, the revenue losses were subsequently offset by the 1997 consumption tax hike.


This section focuses on fiscal data using the national income account definition of the general government. In addition to making international comparisons easier, this choice reflects the lack of fiscal autonomy of local governments and the complexity of the Japanese fiscal system, which make it difficult to assess the overall fiscal position from the central government’s budget accounts.


An alternative approach is to calculate very long-term projections of general government net debt to take account of future social security obligations, which yields very similar results to the staffs approach. For example, longer-term projections prepared through 2080 by the OECD indicate that, because of the rapidly aging population, Japan’s net debt will rise more rapidly than that in other major industrial countries over the future. See “The Macroeconomic Implications of Ageing in a Global Context,” OECD Report ECO/CPE/WP 1(98)1.


This is the largest deficit ratio since the current national income accounts were started in the mid-1950s.


This includes a 5 percent of GDP increase in 1998 caused by acceptance of responsibility for debts of the JNRSC and Forestry Service.


The staff projection assumes a relatively smooth adjustment of the fiscal deficit to the medium-term goal set out in the FSRA. The debt trajectories are relatively insensitive to reasonable alternative paths for the deficit.


The Pension Bureau of the Ministry of Health and Welfare estimates that the unfunded pension liability at current contribution rates is ¥490 trillion (close to 100 percent of GDP) for those in the system in March 2000, while the implied future liabilities of the system add a further ¥420 trillion (80 percent of GDP) to this total. J. Sakamoto, “Pension Reform and the Funding Alternative,” paper given at the International Social Security Association held in Tokyo May 20–21 (ISSA/ACT/SEM/2/1(b)).


This reflects the reliance on income-based taxes and contributions in the fiscal system, together with generous allowances and benefits for retirees, which means that the working population is the main provider of general government revenue while most transfers accrue to the elderly. A. Auerbach, L. Kotlikoff and W. Leibfritz, “Generational Accounts Around the World,” Bank of Japan Institute for Monetary and Economic Studies (IMES) Discussion Paper 98-E2.


These are the contribution rates for the EPI, the earnings-related public pension system for most private sector employees. Half of the contribution is paid by the employee, the other half by the employer. Alternative economic assumptions generate somewhat different estimates for the final contribution rate, but this variation is relatively small compared to the projected increase in rates.


These indicate that it would be possible to cap the contribution rate at around 20 percent of basic pay through a combination of costing-saving measures including raising the age of eligibility of the earnings-related scheme from 60 to 65, indexing benefits to consumer prices rather than wages (net of taxes), and cutting the income replacement rate from 62 percent to 50 percent.


As noted earlier, the staff projections assume a relatively smooth adjustment path for the general government structural deficit (excluding social security), but the calculations are relatively insensitive to reasonable alternative paths.


The aging population will increase government transfers to the health care system, which is funded on a pay-as-you-go basis. The impact of higher medical costs on general government transfers to the health service is estimated by the staff to add around 1¼ percentage points of GDP between 1995 and 2025. In addition, rising transfers to the public pension system are estimated to raise spending by ¾ percent of GDP over the same period. See K. Okamura, “Japan’s Medium- and Long-Term Fiscal Challenges,” in JapanSelected Issues, IMF Staff Country Report No. 96/114 (October 1996).


One source of double counting is that the official data include “non-profit institutions controlled by the government” in general government. The OECD adjusts the official data by placing these non-profit institutions in the public financial institution sector, on the basis that the most important of these corporations perform similar activities to other public financial intermediaries. Adjusting for this double counting reduces the figure for gross debt by just over 10 percent of GDP. See OECD “Policy Considerations in the Current Economic Situation,” ECO/CPE/WP/98/5.


Potential bad loans associated with the FILP are discussed further in D. Asher and A. Smithers, “Japan’s Key Challenges for the 21st Century,” SAIS Policy Forum Series, Johns Hopkins University (March 1998).


This reflects, at least in part, the government’s ability to achieve significant fiscal consolidation during the 1980s (albeit at a somewhat slower pace than originally planned), and the clear concern to address medium-term consolidation demonstrated by the recent passage of the FSRA.


Bayoumi, “The Japanese Fiscal System and Fiscal Transparency.”


Exceptions exist, such as the medium-term investment plan, which originally involved a commitment to spend ¥630 trillion on government investment between FY 1995 and FY 2004. However, there is little evidence that the investment plan was integrated into the annual budget process.


H. Takahashi, “Prospects for Personal Income Tax Reform in Japan,” JEI Report 24A (June 26, 1998) contains a more detailed discussion of personal tax allowances.


On the other hand, no tax benefits are currently provided for defined-contribution pension plans.


Tax avoidance is believed especially significant in the case of the self-employed and the agricultural sector, as exemplified by the “9-6-4 (Ku-ro-yon)” and “10-5-3 (To-go-san)” sayings. These numbers refer to the proportion of income that is understood to be reported to the tax authorities: 90–100 percent for salaried workers, 50–60 percent for the self-employed, and 30–40 percent for farmers.


The national tax rate is 34.5 percent, while local taxes add a further 10 percent. SMEs are subject to a lower national tax rate of 25 percent on income of less than ¥8 million.


For example, Sony has over 800 “subsidiaries.”


The estimates are based on a regression equation relating economy-wide productivity to private capital-labor ratio and the government capital stock:


where Y is real GDP, L is a measure of trend employment, K is the net stock of business capital, and G is the net stock of government capital (estimation was over 1960–97, t-statistics in parentheses).


Despite rapid government investment growth, in some areas Japan’s social capital does lag behind that of other industrial countries. For example, only 54 percent of the population has access to underground sewers, versus ratios of 70–100 percent in other industrial countries. Park area per capita also is low, as is the ratio of high speed motor ways. See Japan 1998: An International Comparison (Tokyo: Keizai Koho Center, 1997).


Daiwa Institute of Research Ltd., Economic Forecasts & Review, April 1998. Annual reports by the Board of Audit suggest frequent cases of waste and inefficiency. The FY 1994 report noted ¥85 billion had been spent on six sub-projects of the Multipurpose Dam Project over 19–29 years, but that there seemed to be no particular plan for the start of the main project. For a discussion, see the Economic Planning Agency, Economic Survey of Japan: 19961997, (Tokyo: Government of Japan, 1997), p. 77.


For a discussion of fiscal federalism in Japan, see D. Mihaljek, “Intergovernmental Relations and Local Public Finance in Japan,” in Teresa Ter-Minassian (editor). Fiscal Federalism in Theory and Practice (Washington DC: International Monetary Fund, 1997). Mihaljek presents evidence to suggest that decentralization of spending responsibility has tended to help reduce total public spending in Japan, but notes that the relatively modest local government tax base reduces the incentives for expenditure efficiency.


Funding of local government projects from the central government’s general account is principally in the form of grants, earmarked for specific projects. In addition, the FILP provides loans, either directly to public enterprises and public financial institutions, or in the form of purchases of local authorities’ bonds.


See, for example, the June 1997 Cabinet decision on fiscal structural reform.


Yoshihisa Kitai, “The importance of public investment in local regions,” in LTCB Monthly (November 1997) reports that there has been a strong positive correlation between the number of Diet seats per capita and cumulative public investment per capita in different regions. Rural areas also have a disproportionate voting weight in the Diet owing to the massive shift in the population toward urban centers occurred during the 1950s and 1960s. The emphasis on using public investment to equalize income across regions also intensified after 1970 in response to the disparities that resulted from rapid growth of urban areas during the previous decade. The November 1994 Election System Reform Bill, which shifted a number of seats from a proportional constituency to a winner-take-all basis, is expected to reduce relative importance of rural constituencies in the Diet.


The social capital stock in urban areas is considerably lower than in rural regions. For example, in Tokyo, Osaka, and Nagoya is there is only one mile of paved road per automobile versus over two mile per automobile in the regions. Other indicators (including number of hospital bed, libraries, and nursing homes) are similarly skewed. See Economic Planning Agency, Economic Survey of Japan: 1996–1997 (Tokyo: Government of Japan, 1997), pp. 75–85.


A recent report by the Central Council on Construction Contracting Business “Future Directions of the Construction Industry Coping with Structural Change of the Market” (February 4, 1998) has called for limits on the practice.


For a discussion, see Takatoshi Ito, The Japanese Economy (Cambridge MA: MIT Press, 1996), Chapter 6.


OECD, Economic Survey, Japan 1997 (Paris: Organization for Economic Cooperation and Development, 1997), pp. 66–69.


For example, it is reported that books are published that list preset prices for construction projects and lists companies that are allowed to supply materials. For a discussion, see Mark Tilton, “Regulatory Reform, Antitrust, and Market Opening in Japan,” in Mark Tilton and Lonny Carlile (editors), Is Japan Changing Its Ways? Regulatory Reform and the Japanese Economy (Washington, D.C.: The Brookings Institution Press, forthcoming). Efforts to reduce bid rigging intensified following a number of high-profile bribery scandals in 1994.


William H. Cooper, “Japan—U.S. Trade: The Construction Services Issue,” Congressional Research Service: Report No. 93-957E (November 1993).


Although the cost-benefit analysis appears to be somewhat rudimentary, insofar as it focusses on comparing projects within sectors, but not across different sectors.