Abstract
The Selected Issues paper analyzes the health of the corporate sector, areas of vulnerability, and the effect of corporate restructuring in Japan. It reviews the deflation and associated economic problems of Japan, demonstrates the impact of fiscal policies on public debt, and estimates the expenditure and revenue adjustments needed to restrain the growth of debt. It also analyzes the issues in the Japanese labor market, structural developments, changes in the behavior of stakeholders, policy issues on employment insurance, and the social safety net.
IV. Assessing the Long Term Fiscal Position of Japan1
A. Background
1. Public debt in Japan has grown rapidly in recent years and is now the highest among major industrial countries (Figure 1). By end-2002, gross debt is estimated to have reached 158 percent of GDP while net debt stood at 72 percent of GDP. The assets of the pension system (valued at 47 per cent of GDP) and financial assets of the central and local governments (38 percent of GDP) account for the difference between gross and net debt. The pension system in Japan is only partially funded—the social security assets are exceeded by the net future liabilities of the system.2 Demographic trends and pressures on the pension and healthcare systems are expected to make fiscal sustainability an increasingly challenging goal to achieve. This chapter demonstrates the impact of a continuation of current fiscal policies on public debt and estimates the expenditure and revenue adjustments needed to restrain the growth of debt.
Selected Advanced Countries: General Government Financial Balance and Gross Debt, 1990-2003
Citation: IMF Staff Country Reports 2003, 282; 10.5089/9781451820560.002.A004
Source: WEO.2. The increase in public debt reflects a decade of economic stagnation, during which the government pursued expansionary fiscal policy to support the weak economy. A series of tax cuts and weak growth resulted in a falling revenue-to-GDP ratio. Public expenditure increased from 30 percent of GDP in 1991 to 36.6 percent of GDP by 2001 as the aging of the population led to rising social security spending as a share of GDP.3 The general government deficit expanded, with most of the increase accounted for by a widening of the structural deficit.
General Government Revenue and Expenditure
(In percent of fiscal year GDP)
Citation: IMF Staff Country Reports 2003, 282; 10.5089/9781451820560.002.A004
Sources: Cabinet Office and staff estimation.3. The debt figures do not include the general government’s contingent liabilities. The government publishes information on explicit guarantees that it provides, which amounted to 12 percent of GDP (¥58 trillion) at the end of FY2001. Losses from the special public sector credit guarantee scheme for small and medium enterprises loans, implemented during October 1998–March 2001, are expected to amount to at least ¥1.5 trillion over the medium term (the total amount transferred between July 1999 and August 2002 was ¥1.9 trillion). The Fiscal Investment and Loan Program (FILP) is also a source of potential future government liabilities. The agencies that receive FILP loans typically get fiscal transfers from the government if they do not generate sufficient returns to pay for their obligations. The government estimates the expected fiscal cost of such transfers to be about 1.5 percent of GDP (FILP Report 2002); however, some analysts estimate the cost to be much higher (Annex 1). Many large infrastructure investments appear to generate less than the budgeted returns, which may imply significant contingent liabilities for the government.4 Finally, many analysts believe that the current problems of the banking system cannot be resolved without injections of public capital.5
4. The rapid rise in public indebtedness has prompted international rating agencies to downgrade Japan’s sovereign debt rating in recent years. Standard & Poor’s lowered Japan’s long-term local and foreign currency sovereign credit ratings by one notch to AA– from AA in April 2002, while Moody’s downgraded Japan’s long term local currency sovereign credit rating by two notches to A2 at end-May, 2002. Fitch also has downgraded its Japanese Government Bonds (JGBs) rating in November 2002 from AA to AA–. Currently, Japan has the lowest credit rating among the G-7 counties according to these rating agencies.
5. A continuous rise in public debt would eventually prompt a rise in risk premia. However, it is difficult to specify what level of debt would trigger a significant market reaction. Studies have shown that for emerging market countries, the probability of debt crisis increases once debt reaches 50 percent of GDP.6 Experience shows that developed countries can sustain much higher debt levels than some emerging markets without experiencing a liquidity crisis. There have been no instances of public debt default in industrial countries in recent decades. The probability of default in such countries is considered to be low since their governments typically have the ability to raise taxes sufficiently to service (or reduce) the debt. In addition, there are a number of favorable conditions specific to Japan that allow it to sustain high debt levels.
6. Public debt is denominated in yen and held almost exclusively by domestic investors, including by the government itself. Japan is a large net creditor and does not depend on foreign funds to finance its public debt. The current account surplus over the last ten years has averaged 2.4 percent of GDP. Private savings in Japan are very high by international standards and there is an institutional bias towards domestic investment. For example, pension funds are required by guidelines based on law to invest a significant share of their assets in domestic bonds (68 percent). Special treatment of the postal system (which has also been extended to the new Japan Post Corporation) allows it to provide favorable terms that attract a significant share of retail deposits (one third of all deposits presently). Some of those funds are channeled to the JGB market (Japan Post is the largest holder of JGBs). The distribution of JGB holdings is listed in the table.
Holdings of JGBs by Sector
(In percent of total)
Holdings of JGBs by Sector
(In percent of total)
| Mar. 1998 |
Sept. 2002 |
||
|---|---|---|---|
| General Government | 39.2 | 41.1 | |
| Fiscal Loan Fund | 23.2 | 13.4 | |
| Postal Savings | 7.7 | 12.4 | |
| Postal Life Insurance | 4.5 | 8.5 | |
| Central Bank | 11.5 | 15.5 | |
| Financial Institutions | 36.7 | 32.2 | |
| Domestic Banks | 12.6 | 12.4 | |
| Private Life Insurance Companies | 5.9 | 5.1 | |
| Private Nonlife Insurance | 0.3 | 0.4 | |
| Securities Investment Trusts | 1.0 | 1.8 | |
| Overseas | 6.0 | 3.7 | |
| Securities Companies | 0.7 | 1.7 | |
| Households | 2.7 | 2.6 | |
| Private Nonprofit Institutions | 1.9 | 1.2 | |
| Nonfinancial Corporations | 0.1 | 0.3 | |
Holdings of JGBs by Sector
(In percent of total)
| Mar. 1998 |
Sept. 2002 |
||
|---|---|---|---|
| General Government | 39.2 | 41.1 | |
| Fiscal Loan Fund | 23.2 | 13.4 | |
| Postal Savings | 7.7 | 12.4 | |
| Postal Life Insurance | 4.5 | 8.5 | |
| Central Bank | 11.5 | 15.5 | |
| Financial Institutions | 36.7 | 32.2 | |
| Domestic Banks | 12.6 | 12.4 | |
| Private Life Insurance Companies | 5.9 | 5.1 | |
| Private Nonlife Insurance | 0.3 | 0.4 | |
| Securities Investment Trusts | 1.0 | 1.8 | |
| Overseas | 6.0 | 3.7 | |
| Securities Companies | 0.7 | 1.7 | |
| Households | 2.7 | 2.6 | |
| Private Nonprofit Institutions | 1.9 | 1.2 | |
| Nonfinancial Corporations | 0.1 | 0.3 | |
Foreign investors currently hold only 3.7 percent of the outstanding stock of government securities, so further shifts in their portfolio out of JGBs would be unlikely to have a significant impact on the market. Households also hold directly a very small share of JGBs.
Close to 60 percent of all outstanding JGBs at end-September 2002 were held by government-related institutions, including government financial institutions, pension funds, and the Bank of Japan. Since the FILP reform was initiated, the JGB amounts held by the Fiscal Loan Fund, the Postal Savings, and Postal Life Insurance have been declining gradually. This may improve pricing signals and increase the market pressure for fiscal adjustment.7 However, the Bank of Japan has increased its purchases of JGBs, so the overall share of government holdings of JGBs has not changed significantly.
Domestic banks and life insurance companies hold 30 percent of outstanding JGBs. JGBs have been a safe asset of choice for private financial institutions as their risk appetite has declined together with the deterioration in their loan and equity portfolios. Fixed income investment in foreign instruments is pursued only if the expected profits significantly exceed the cost of currency hedging. Buying JGBs in recent years has proven a good strategy, as falling yields have brought capital gains to the holders, and real returns have remained high (in recent months, there has been a shift in bank holdings towards shorter maturities to reduce the risk from a possible steepening of the yield curve). Life insurance companies also choose to hold JGBs as safe liquid instruments that match the currency and maturity of their obligations.
7. The sharp decline of nominal interest rates will keep effective interest payments on government debt relatively low in the medium term. Nominal interest rates have declined sharply in recent years, reaching historically low levels in the first half of 2003, which has kept debt service costs very low (the 10-year government bond yield fell to 0.43 percent in early June, before rebounding more recently). The average remaining years to maturity of outstanding JGBs is about 5 years, so the current low interest rates, will keep down the effective interest payments on government debt for the next few years.
8. Despite these favorable factors, consolidation cannot be postponed indefinitely. While Japan has so far accumulated high debt levels without facing liquidity problems, the rapid aging of the society and the projected decline of the labor force will limit potential growth of the economy in the coming years, complicating efforts to restore fiscal sustainability. Further delays of fiscal adjustment would only increase the tax burden on future generations. If the projected burden becomes excessively high, the market may come to expect an eventual monetization of the deficit and factor a higher risk premium into interest rates. This may lead to increasing real interest rate and worsening debt dynamics, and potentially to liquidity problems.
B. Debt Dynamics and Sustainability Analysis
9. A number of studies have indicated that a continuation of current fiscal policies in Japan will lead to a rapid build-up of debt. Dekle (2002a, 2002b) estimates that with unchanged fiscal policies, Japan’s net debt will increase to between 700 and 1300 percent of GDP by 2040—clearly unsustainable levels. Using generational accounting, Takayama and Kitamura (1999) show that in the absence of adjustment in fiscal expenditure patterns, the result will be large intergenerational imbalances and future generations will have to bear very heavy tax burden. Based on their estimation, future generations would pay between 2.7 and 4.4 times more taxes as a share of income than the current generation pays to sustain the current level of government services.
10. However, economic theory provides little practical guidance for evaluation of debt sustainability. Theoretically, the current debt is sustainable as long as it is possible to generate sufficiently large primary surpluses in the future, so that their present discounted value equals the current debt level. The present value budget constraint (after imposing the transversality condition) is as follows:
where Debtt, is net public assets at time t, PBt is the primary balance (the fiscal balance excluding net interest payments), and R(t, t + j) is the discount factor applying between periods t and t + j (if the interest rate r is constant over time, R(t, t + j) = (1 + r)J). The present value budget constraint provides little practical guidance for fiscal policy since it allows for many different paths for debt, some of which may not be feasible in practice. For example, the government could run large deficits for a prolonged period of time, if it could commit to running sufficiently large primary surpluses in the future. However, such commitments may not be possible because of political and economic constraints, especially if the necessary adjustment becomes very large.
11. This paper employs three different approaches to assess debt sustainability. First, illustrative scenarios are prepared to show the path of government debt under announced fiscal policies and under a pension reform scenario. Second, the primary balance necessary to stabilize the debt-to-GDP ratio is estimated to illustrate the adjustment that would need to be undertaken by the government. Finally, results of empirical analysis of a fiscal policy reaction function of the government are reviewed.
Scenario Analysis
Baseline Scenario
12. The baseline scenario is broadly based on the authorities’ current policy targets. The main assumption is that the primary deficit of the central and local governments will be eliminated by the early 2010s. This implies a significant adjustment since the cyclically-adjusted primary deficit of the central and local governments as of FY2002 was about 4.5 percent of GDP.8 Real GDP growth, the GDP deflator, and the long-term bond rate follow the most recent WEO projections for the medium term (over 2003-2008 real GDP growth averages 1.6 percent, the annual change in the GDP deflator averages -0.5 percent, and the effective real interest rate on public debt averages 3.2 percent). In the long term, potential real GDP growth is presumed to be constant at 1 percent.9 The steady state inflation rate is also set at 1 percent and the real interest rate is assumed to be constant at 3 percent (equal to the 1994-2003 average of 10-year government bond yields). Government investment is projected to decline to about 3 percent of GDP (the current OECD average) and stabilize at that level. Government consumption also declines in the initial years and then remains flat at 10½ percent of GDP.
13. The pension contribution rate is assumed to remain at its current level (the contribution rate has been frozen by the government for the last few years). Pension benefits and health expenditures increase in line with the rise in the aged population. Annex II describes in detail the projections of social security income and expenditure. The cyclically-adjusted primary deficit of the social security system would increase from about Vi percent of GDP in 2002 to 2 percent of GDP in 2012 and would continue growing thereafter.
General Government Net Debt Forecast, 2001 - 2040
(In percent of GDP)
Citation: IMF Staff Country Reports 2003, 282; 10.5089/9781451820560.002.A004
Sources: Annual Report on National Accounts, Cabibet Office and staff estimation1/ The real interest rate is assumed to be 2 percent in the lower interest rate scenario (versus 3 percent in the baseline).14. Under the baseline scenario, the net public debt-to-GDP ratio continues to grow without bound (Figure). It is estimated to increase from 72 percent of GDP in 2002 to about 340 percent of GDP by 2040.10 The rapid increase is driven by increasing social security expenditure and by adverse debt dynamics (the assumed steady state GDP growth rate is lower than the interest rate). In practice, the assumption of steady growth and stable interest rates during a long period of high and rapidly increasing debt will not necessarily hold—probably interest rates will rise and an adjustment would be forced at a much earlier stage.
Pension Reform Scenario
15. The second scenario illustrates the effect of a gradual increase in the pension contribution rate on government finances. All other assumptions remain as in the first scenario. The Employee Pension Insurance contribution rate (as a share of employment income) is assumed to increase gradually from 13.6 percent in 2003 to 26 percent by 2020, and contributions to the National Pension increase by 100 percent in real terms over the same period. The assumed changes are similar to the profile of contribution increases that would make the pension system actuarially sound based on projections by the Ministry of Health, Labor, and Welfare (MHLW). This is a rather optimistic scenario—an increase of contribution rates of such a magnitude may not be politically feasible, and if achieved, may have adverse effects on labor participation, saving, and growth that are not captured in the simulation.
16. Nonetheless, even such significant adjustments in the pension system are not sufficient to stabilize the total debt-to-GDP ratio. The simulation shows net debt increasing to 220 percent of GDP by 2040 in the pension reform scenario (second panel of Figure 2). Of course, the dynamics of debt are very sensitive to assumptions about the long run interest rate and GDP growth. For example, assuming a real interest rate of 2 percent beyond 2009 (instead of 3 percent as in the baseline scenario) will lead to much slower debt accumulation.
17. The simulations suggest that Japan’s public finances are on an unsustainable track unless a significant adjustment is implemented. Even a combination of fundamental pension reforms and an elimination of the primary deficit of the central and local governments will not be sufficient to restore the sustainability of public finances, especially if the interest rate on public debt exceeds GDP growth, as it has historically. Substantial reductions in social security expenditures and an increase in general tax revenues will be needed to halt the increase in the debt ratio.
Fiscal Gap Analysis
18. A practical approach commonly used for assessing debt sustainability is based on the primary gap indicator developed by Blanchard (1990). The primary gap is defined as the difference between the actual primary deficit and the deficit required to stabilize the debt-to-GDP ratio (or bring the ratio down to a desirable level) over a certain time horizon. The required primary surplus to stabilize the debt-to-GDP ratio depends on the level of debt, the GDP growth rate, and on the interest rate.
where g is the nominal growth rate, r is the nominal interest rate, Debtt is the target debt-to-GDP ratio at time t (where debt is defined as net government assets), and
19. A significant adjustment in the primary balance will be required to stabilize Japan’s debt ratio in the medium term. For this exercise, the focus of analysis will be the general government account which combines the accounts of the central government, local governments, and the social security system. The primary balance of the general government will need to increase gradually to about 2 percent of GDP to stabilize net debt at around 100 percent of GDP by 2013 (the current level of the cyclically-adjusted general government primary balance is about -5 percent of GDP). Therefore, the required combination of expenditure reductions and revenue increases over the next ten years is on the order of 7 percent of GDP.11 This estimation is based on the steady state real GDP growth and real interest rate assumed in the baseline scenario. If the steady state real interest rate is lower (at 2 percent instead of 3 percent) or if the long-term growth rate is higher (2 percent instead of 1 percent), then the primary balance necessary to stabilize debt would be about 1 percent of GDP. The time horizon also matters—postponing consolidation to a later date would increase the needed adjustment as the cumulative debt would be higher.
20. The medium-term horizon is chosen in light of deteriorating demographics that would make debt consolidation increasingly difficult in the long run. The number of working-age people is already declining, and the decline will accelerate in the early 2010s (see Figure). That will reduce the potential GDP growth going forward. In addition, the rapid aging of the population is likely to lead to a reduction in private savings. Social security expenditure will continue to rise rapidly as a share of GDP in the coming years (Figure). These developments would negatively affect the fiscal position and make financing of the public deficit increasingly difficult.
Population Dynamics
Citation: IMF Staff Country Reports 2003, 282; 10.5089/9781451820560.002.A004
Social Security Burden Projections 1/
(in percent of GDP)
Citation: IMF Staff Country Reports 2003, 282; 10.5089/9781451820560.002.A004
1/ Defined as the sum of social security contributions and government transfers to the social security system.21. The adjustment indicated by the primary gap indicator represents a lower bound on what may be needed to restore sustainability, for three main reasons. First, since debt is already at very high levels, it may be desirable to reduce it rather than stabilize it and that would require a greater adjustment. Second, the estimated path of debt does not take into account the possible realization of contingent liabilities, which would increase the debt stock. Third, social security expenditure in percent of GDP will continue to rise beyond the stabilization horizon as the share of the aged in the population increases, so to keep the public debt ratio from rising, a corresponding increase in the tax burden will be required. Based on estimates by the Ministry of Health, Labor, and Welfare the tax burden of social security (in terms of GDP) would have to increase by about 5.7 percentage points between 2010 and 2025 to support the expected increase in benefits. An additional increase of revenue of that magnitude is probably not realistic, therefore a significant part of the adjustment will have to be implemented through expenditure rationalization.
Fiscal Reaction Function
22. An empirical analysis of the authorities’ fiscal reaction function also suggests that the current fiscal policies are unsustainable. Ihori and Sato (2002) apply the test developed by Bohn (1998) for Japan over the period 1965 to 1998 and conclude that the hypothesis that Japanese government debt is unsustainable cannot be rejected. The test rests on the intuition that if the primary surplus responds positively to an increase in debt, then the government’s fiscal policy reaction function is consistent with sustainability. This clearly has not been the case in Japan over the last decade—primary balances have declined in every year while debt accumulated rapidly. In that respect, Japan is an outlier among industrialized countries—similar analysis of industrialized countries for the period 1990-2002 (IMF WEO, Chapter 3, September 2003) finds that the primary surplus tends to adjust when the debt ratio rises, and the adjustment has been more aggressive once gross debt rises above 80 percent of GDP.
C. Options for Consolidation
23. To achieve the substantial consolidation required over the coming years, it would be important to secure broad political support for specific measures and commit to their implementation. The feasibility of specific policy options will depend on economic conditions and on social preferences. Persistent weakness of the economy has made it difficult to achieve political consensus on the appropriate timing and modalities of consolidation. The on-going debate on pension reform illustrates the divergence of views among business groups, academics, and different Ministries within the government. In order to gain consensus for consolidation, the government may have to raise public awareness of the dangers involved in delaying adjustment and to present a credible set of measures through which the needed adjustment could be achieved.12
24. The composition and sequencing of fiscal reform is an important factor in the sustainability and success of the consolidation, Based on other countries’ experiences, successful fiscal consolidations have typically relied on expenditure cuts in addition to revenue raising measures.13 The authorities have recognized that there is scope for reduction in inefficient government expenditure and public investment outlays have been cut substantially since 2001. Revenue measure will also be needed to restore sustainability, but may have to be introduced gradually to avoid adverse economic effects.
Expenditure
25. The level of public investment in Japan, at around 6 percent of GDP is higher than in other developed countries. The average public investment for the other G-7 countries was 3 percent of GDP in 2002 (Table). The higher level in Japan partly reflects the fact that infrastructure was not sufficiently developed in the past. However, as infrastructure accumulated, rigidity in the allocation of funds and institutional inertia have prevented public investment from falling. Indeed a number of studies have shown that returns on public investment have declined.14 Public investment also has been increasingly used as means of income redistribution.15 OECD (2000a) argues that the inefficiency of public investment in Japan stems from poorly defined objectives, lack of cost effectiveness, and poor design of the project bidding process. Starting in 2001, the government has acknowledged that the level of public investment is too high and that some investment projects are inefficient (especially in agriculture and rural infrastructure) and has made efforts to reduce public investment in these areas and redirect funds to urban infrastructure.
Gross Public Fixed Capital Formation, 2002
(In percent of GDP)
Gross Public Fixed Capital Formation, 2002
(In percent of GDP)
| Canada | 2.6 |
| France | 3.1 |
| Germany | 1.6 |
| Italy | 4.2 |
| Japan | 6.3 |
| United Kingdom | 1.5 |
| United States | 1.5 |
Gross Public Fixed Capital Formation, 2002
(In percent of GDP)
| Canada | 2.6 |
| France | 3.1 |
| Germany | 1.6 |
| Italy | 4.2 |
| Japan | 6.3 |
| United Kingdom | 1.5 |
| United States | 1.5 |
26. Current government expenditure should also be reviewed for possible savings. The current medium-term guidelines for budget formulation reflect that view—the projections assume annual reductions of personnel expenditures by about 0.5 percent, and in general material by about 1 percent over the next few years. Medical care expenditure has been the fastest growing component of the budget. Given the government commitment to finance a certain share of the costs of the different medical insurance schemes, especially for elderly care, government obligations in that area will continue to grow fast as the population ages. More fundamental reforms in the medical care system are needed to contain this trend. Delegation of greater expenditure flexibility to local governments, as envisaged in the current debate on local government reform, could improve the efficiency of public expenditure and help the consolidation effort.
27. Finally, downsizing off-budget expenditure could reduce the contingent liabilities of the government. The FILP reform initiated in 2001 aimed at improving the financial discipline of the recipient institutions through better financial disclosure and increased reliance on self-financing. The reform also envisaged a review of the role of a number of special-status public corporations, including the highway public corporations. The intention was to limit their scope, transfer some of the functions to the private sector and reduce government subsidies. The success of the reform will depend crucially on the design of the new entities that will replace the current public corporations. To reduce the future drain on the budget, the government should seek real reforms, avoiding a simple transformation to different public entities. Greater use of ex-ante cost-benefit analysis of projects should help increase the efficiency of public corporations.
Revenue
28. The government revenue-to-GDP ratio in Japan is low relative to most other developed countries (Figure). The size of the government is a matter of social preference and historically the U.S. and Japan have favored smaller governments compared to most European countries. However, the expansion of social expenditure in Japan would require a corresponding increase in revenue.
Government Revenue to GDP Ratios, Average for 1990-2002
Citation: IMF Staff Country Reports 2003, 282; 10.5089/9781451820560.002.A004
Source: WEO.29. Corporate taxes in Japan are close to the levels of other advanced economies. In fact, this was one of the objectives behind several reductions in tax rates during the 1990s, and thus there is not much scope for marginal rate increases in the future. The recent introduction of a local corporate value-added tax will help broaden the tax base and stabilize revenues (about two-thirds of all corporations do not pay income taxes currently as they do not have net profits).
30. Personal income tax revenue can be increased through tax base broadening. Effective personal income taxes are lower than in other major OECD countries (Figure). Although marginal personal income tax rates in Japan are similar to those of the US and UK, there are numerous allowances and credits, so the share of exempt income is large by international standards. Some of the existing exemptions and allowances distort labor market participation decisions (see OECD, 2000b). The decision to reduce the dependent spouse allowance starting in 2004 is a step in the right direction. Intergenerational equity in the tax system can be improved by reducing income deductions for the wealthy elderly (the minimum tax free income for an elderly family is about 50 percent higher that the tax-free income for a typical young family). Tax administration will also benefit from the introduction of a taxpayer identification system.
International comparison of individual income tax effective rate (National + Local)
(Salaried employee with a spouse and 2 children)
Citation: IMF Staff Country Reports 2003, 282; 10.5089/9781451820560.002.A004
Source: Ministry of Finance Japan.Note: The calculation was made on the assumption that one of the children is a special dependent in the case of Japan and is less than 17 years old in the case of the U.S. The exchange rates used are 1 dollar = 121 yen, 1 pound = 186 yen, 1 Euro=119 yen.31. Comparison with other G-7 countries shows that the tax treatment of social security is very generous. In Japan, social security benefits are practically exempt from taxes (only about 7 percent of public pensions are subject to taxes), which makes the tax burden very low for pension recipients. Social security contributions are also exempt from taxes (therefore the tax base will narrow further if social security contributions are increased in the next round of the pension reform). In Germany, pension benefits are fully taxable. In the United States and the United Kingdom, neither contributions nor pension benefits are tax-deductible.16
32. Higher consumption tax is likely to play an important part in the fiscal consolidation effort. The consumption tax rate in Japan is much lower than in most other countries (5 percent versus a 19.4 percent average for the European Union). Consumption taxes are efficient, easy to enforce, and have a very broad basis; therefore, a small rate increase results in significant additional revenue. On the downside, the consumption tax is regressive and highly politically unpopular.17 The regressiveness of the tax can be mitigated through targeted social transfers.
Social Security Reform
33. A fundamental reform is needed to restore the long-term solvency of the pension system. Currently, there is an active debate on different options—a reduction in benefits, an increase in contributions, or an increase in the share of government contributions (financed through an increase in the consumption tax rate).18 Most likely, a combination of these options would be necessary. As life expectancy increases, consideration could be given to increasing the required contribution period or further raising the age of eligibility for benefits. Partial consumption tax financing could improve intergenerational equity in the short run, since the elderly would shoulder some of the cost of the pension system (the current elderly generations receive higher returns on their pension contributions than the younger generations expect to receive). However, higher government transfers to the pension system would reduce the self-insurance nature of the pension system, and may raise objections on equity grounds since the National Pension is not means-tested. An increase in pension contribution rates is another option, although social security contributions are already relatively high (the amount of total contributions is 2.3 times the amount of personal income tax collected) and further substantial increases may have distortionary effects on the labor market.19
34. The discussion of social security reforms should be made in the context of a broader discussion of fiscal sustainability. Increasing the share of pension benefits financed by general government revenue will reduce the social security deficit, but not the deficit of the general government as a whole. Estimates by the Ministry of Health, Labor, and Welfare suggest that the funds necessary to support the social security system will increase from about 16 percent of GDP in 2002 to 24 percent of GDP in 2025, unless benefits are adjusted.20 Excessive reliance on revenue measures in social security reform could reduce the ability of the government to raise tax revenue to address the problem of rising public debt. Significant increases in contribution rates may also have negative growth effects. Faruqee and Mühleisen (2001) simulate the effect of different social security reform options using a general equilibrium model of Japan’s economy. Their results suggest that benefit reductions are the most preferable option with regard to growth and economic welfare. More generally, Alesina, Perotti, and Tavares (1998) find that fiscal consolidations relying mostly on cuts in transfers and government wages have typically been expansionary for OECD economies, while those relying mostly on tax increases have been contractionary.
35. The medical system’s reliance on transfers from the central and local governments will increase going forward. The portion of medical costs financed by general taxes revenue will rise significantly as the population ages, since the government finances a large share of the medical care provided to the elderly. Estimates by the Ministry of Health, Labor, and Welfare suggest that public subsidies as a share of medical expenditures will rise from about 27 percent in 2002 to 36 percent by year 2025. Therefore, maintaining a balance in the central and local government finances beyond the early 2010s (which is the current official target) will require continuing adjustments in areas other than medical expenditures, unless a fundamental reform of the medical system is undertaken.
Economic Growth
36. Finally, policies that enhance economic growth and tackle deflation would contribute significantly to the fiscal consolidation effort. It would be easier to implement the required adjustments under more stable growth and positive inflation. The government can play a role by creating an environment conductive to growth through the implementation of sound macroeconomic and structural policies.
D. Conclusion
37. Public debt in Japan has been rising rapidly over the last decade and stabilizing it would require significant adjustment. Continuation of the current fiscal policies would increase the debt stock further from an already very high level. The need to finance a sizable public debt may constrain private investment, limit the degree of fiscal policy flexibility, and increase the vulnerability of the economy to adverse shocks. There is no specific threshold above which public debt becomes unsustainable. However, the adjustment required to at least stabilize the debt-to-GDP ratio in Japan is already very substantial and further delay of consolidation is no longer an option.
38. Significant expenditure and revenue measures and a reform of the social security system would be needed to restore the health of public finances. The focus on expenditure restraint in the near term is welcome, since experiences of other countries show that successful consolidations have relied mainly on expenditure reduction. However, revenue measures would also be necessary to stabilize or reduce public debt. The forthcoming pension reform should adopt policies that would eliminate the net present liabilities of the system under conservative assumptions about demographics, growth, and return on assets. Frequent partial adjustments in the past have increased uncertainty and reduced public confidence in the pension system. Substantial reliance on revenue measures in social security reforms may result in too heavy tax burden on future generations. It would be important to secure political agreement on the needed measures to stop the increase in public debt and to commit to the reform. The alternative—to allow debt to continue growing fast-could eventually result in a rise in real interest rates and an abrupt fiscal adjustment with serious consequences for growth and economic welfare.
ANNEX I The Fiscal Investment and Loan Program (FILP)21
39. The FILP provides investment financing for public policy purposes.22 Historically, most of the funds for the FILP program came from peoples’ deposits in the Postal Savings system and from the pension system assets. The program has been an important tool for fiscal management—it extends loans to government financial institutions, public corporations, local governments, and several special central government accounts (jointly referred to as “FILP agencies”). In recent years, the largest loan allocations have been for mortgage financing, small and medium businesses, and road construction. While not formally a part of the general government sector, the FILP annual plan is formulated in coordination with the budget process, and is submitted by the Diet together with the general account and special accounts budgets. Owing to its size, the FILP is often referred to as the “second budget”. Total outstanding FILP loans at the end of FY2001 were equivalent to 66.5 percent of GDP (FILP Report 2002).
40. Reform of the FILP was initiated in April 2001, aiming at a gradual alignment of the activities of the program with market principles. The key elements of the reform were to increase the role of direct market financing for FILP agencies and to initiate subsidy cost analysis of FILP projects.23 As part of the reforms, the compulsory transfer of deposits from the postal savings and pension systems to the FILP has been abolished, and the FILP has to finance itself by issuing bonds (which are issued in the same auction and have the same yields as JGBs). For an interim time period of seven years, the postal savings and pension systems are to continue to underwrite FILP bonds, but at successively lower levels. The recipients of FILP funds are required to issue “FILP-agency bonds” directly to the market, and to apply for FILP loans only if sufficient funding cannot be secured in the market. The yields on these bonds have stayed very close to the respective JGB yields, suggesting that the market perceives the FILP-agency bonds to be implicitly guaranteed by the government. To assess the prospective financial implications of the program and to improve its efficiency, subsidy cost analyses of all FILP agencies have been undertaken and published. The most recent official estimate of the future cost of the program to taxpayers is ¥7.5 trillion (FILP Report 2002).
41. The FILP constitutes a key source of government contingent liabilities, recent efforts at reform notwithstanding. Kikkawa et al (2000) find that the FILP agencies have been very optimistic in their revenue forecasts and therefore the estimated subsidy costs probably underestimate the likely losses. Doi and Hoshi (2002) evaluate the balance sheets of FILP agencies and provide estimates (in net present value terms) of expected taxpayer cost related to FILP loans. They estimate the likely losses on loans to government financial institutions and special corporations to be ¥3614 trillion (about 7 percent of GDP).24 These expected losses are the sum of the estimated under-provisioning for nonperforming loans, overvaluation of assets, and subsidy costs. However, Takahashi (“Economic Society Policy”, May 2003, Cabinet Office) has questioned the accuracy of these estimates.
ANNEX II Social Security Projections, 2003–2050
42. The projection model is built around a set of equations for the revenues and expenditures of the pension and medical systems. The “median” official 2002 population projections are used in the simulation—these assume a recovery of the average fertility rate from the current 1.36 to 1.39. Japan’s social security system is very complex and consists of a large number of schemes with different contribution and benefit rules, different shares of government participation, and a complicated system of cross-transfers. Modeling it requires a large number of simplifying assumptions and the projections therefore represent only broad trends in social security finances. As with any long-term projection exercise, the assumptions underlying these projections are subject to great uncertainty.
43. The simulation of the pension system was roughly calibrated against the MHLW’s actuarial projections of the Employment Pension Insurance (EPI) and National Pension systems. Contributions depend on changes in the contribution rate as a share of income and on the rate of increase in employee compensation in the case of EPI and the Mutual Aid Associations, and on the flat contribution amount in the case of the National Pension. Benefit payouts grow in proportion to the growth in the elderly population, and inflation, and partially depend on wages (since the starting level of EPI benefits depend on the average level of the employee’s past salary). An adjustment is made in attempt to account for the 2000 pension reform plan, which called for a 5 percent reduction of benefits for new retirees starting in 2004, and a gradual increase of the pension eligibility age from 60 to 65 (the adjustment is made so that the results broadly follow the MHLW’s pension expenditure projections). Contributions from the government are assumed to remain at 1/3 of the basic pension (this is relevant only for the deficit of the social security system, not for the projection of the general government total net debt, which is independent of variations in the government contribution share).
44. Medical expenditure forecasts reflect the expected increase in per capita expenditures as the population ages. Based on data from the MHLW, per capita medical expenditures for people aged 65 and above are about 5 times higher than per capita expenditure for people younger than 65 and this differential is assumed to remain. The growth rate of the price for medical services over the last decade has exceeded CPI growth by about 1 percentage point in Japan and this is assumed to continue in the future. The actual growth of medical costs will depend on regulatory developments in the pharmaceutical and medical service sectors, and on future changes in the medical insurance system rules. Contributions are assumed to grow in line with employee compensation (proxied by GDP growth). Under the current system, medical benefits for the elderly are financed by transfers from the government and from employment insurance schemes (the elderly make practically no contributions to any insurance scheme, except that under the new long-term care system, elderly insured persons will also have make a small annual contribution). A detailed long-term government projection of the medical system finances under a consistent set of macroeconomic assumptions is not available, but a comparison with published MHLW’s projections for year 2025 show that our medical expenditure forecast is rather conservative.
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Prepared by Dora Iakova (ext. 35365).
The net present value of unfunded pension liabilities was estimated at above 100 percent of GDP (Actuarial Report of the Employee Insurance Program, Ministry of Health, Labor, and Welfare, 1999). No estimate is available for the medical insurance system, although medical expenditure is expected rise much faster than pension expenditure in percent of GDP.
Based on national income accounts data, social security expenditure increased from 9.6 percent of GDP in FY1991 to 15 percent of GDP in FY2001.
As an example, the government had to assume the liabilities of the Japanese National Railway Settlement Corporation (JNRSC) amounting to 5.2 percent of GDP in 1998.
While it is difficult to estimate the size of the needed public injection, one indicative measure is the amount of uncovered loan losses at major and regional banks. Callen and Mühleisen (2002) estimate this amount to be between 1.5 and 5 percent of GDP. Market analysts’ estimates of net loan losses vary between 4 and 14 percent of GDP (Kashyap (2002), Table 2).
IMF, World Economic Outlook (September 2003) finds that the probability of crisis increases when public debt reaches the 25-50 percent of GDP range. Most other studies have looked at how debt crisis probabilities change when external debt-to-GDP increases—or example, IMF (2002) suggest that 40 percent of GDP is a useful threshold and Manasse et al (2003) find that countries with external debt higher than 50 percent of GDP are more likely to experience default episodes.
As an example of the potential strength of market discipline, long-term interest rates recorded their largest monthly increase (105 bps) in the past 20 years in December 1998, when the Ministry of Finance announced the reduction of JGB purchases by the Trust Fund Bureau.
The calculation of the deficit of the central and local governments includes transfers to the social security system, but excludes the deficit of the social security system. In the simulation we assume that the adjustment is achieved by a combination of tax increases and expenditure reductions.
The Cabinet Office used 1 percent potential growth rate for its medium term fiscal estimates (“2002 Reference Estimates”). The Bank of Japan (Quarterly Bulletin, May 2003) also estimates the current potential output growth rate to be about 1 percent. However, a 1 percent real growth rate in the longer term may turn out to be a rather optimistic assumption, given the expected rapid decline in the working age population over the next 50 years. For instance, a significantly more pessimistic scenario is presented by Ishikawa (2002): accounting for the expected decline in the labor force and assuming a total factor productivity growth rate of 0.7 percent, he estimates that real GDP growth will decline to minus 0.4 percent by 2050.
The simulation is done in terms of net debt for analytical convenience since using gross debt would require specific assumptions on asset accumulation. Whether gross or net debt is the focus of analysis depends on the quality and liquidity of government assets. About a third of Japan’s government assets are in the form of liquid bonds and cash deposits. However, a large share of the assets are invested in long-term projects through the FILP system and are highly illiquid. Therefore, most assets may not be easily used to reduce gross debt.
For comparison, the debt-stabilizing adjustment in the primary balance of the general government is higher than the adjustments assumed in the baseline and pension reform scenarios of the last section by 4 percentage points and 2 percentage points of GDP respectively.
Strengthening the institutional framework for fiscal policy implementation can help sustain fiscal consolidation efforts. Fiscal adjustment in many OECD countries in the 1990s was accompanied by institutional reforms, including the formal adoption of fiscal rules, such as expenditure ceilings or balanced budget rules. For fiscal rules to be credible, they may need to be sufficiently flexible to accommodate automatic stabilizers and allow responses to unexpected negative shocks.
Alesina and Perrotti (1996) find mat in OECD countries adjustments that have relied mainly on current expenditure reductions have typically been more successful, and such adjustments have also tended to be expansionary.
See Doi (1998) and Yoshino and Nakano (1996). Kondo (2002) finds that rates of return differ significantly for different types of public capital and are relatively low in road construction and agriculture.
Braun and Kubota (2000) show that there is a strong negative correlation between the per capita income of prefectures and the level of public capital they receive. EPA (1997) estimates that the return to social capital in cities is roughly twice the rate of return in rural areas. The high level of investment in poorer areas has not stimulated self-sustaining growth as hoped. Instead, the areas have become heavily dependent on public construction.
Source: “Annual Report on the Japanese Economy and Public Finance, 2001-2002,” Cabinet Office, Government of Japan, page 165.
The 1998 downturn was widely ascribed to the 1997 VAT rate increase (from 3 to 5 percent), although there is no empirical evidence to that effect. The financial crisis that developed shortly after the VAT increase was a more likely cause of the economic problems. Short-term intertemporal consumption substitution may have also played some role.
Some academics also call for more radical changes of the system, such as moving to defined contribution plans (the public pension system in Japan is a defined benefit plan), or indexing benefits to aggregate macroeconomic variables (to account for the decline in population and possible decline in the potential growth rate). See Takayama (2003). The MHLW has also proposed a version of benefit indexation to macroeconomic variables.
In addition, currently about 37 percent of all participants do not make the required contributions to the National Pension system, and increasing the contribution amount may lead to a rising share of nonpayers.
Most of the increase is due to an expected rise in medical and long-term care expenditures. The finances of all the major schemes in the social security system—medical, pension, long-term care and unemployment insurance—have been deteriorating in recent years and all the schemes are currently either running deficits or are close to running deficits. Only the pension schemes have assets which can be used to cover the deficits. Therefore, unless benefits are reduced, substantial revenue measures would be required to meet rising expenditures.
Sanjay Kalra contributed to this Annex.
For a description of the institutional arrangements of the FILP, see Cargill and Yoshino (2002), and Doi and Hoshi (2002).
The subsidy cost of a project is the estimated total amount of subsidies, financial assistance and grants-in-aid to be provided by the treasury until the project’s completion. Subsidy cost analyses of FILP agencies are published by the Ministry of Finance (2002).
The authors also estimate that local governments would not be able to repay FILP loans equivalent to about 8 percent of GDP. However, these obligations should already be accounted for in the general government liabilities and therefore do not represent contingent liabilities.
