A. Introduction

1. Japan’s key fiscal challenge is to put public finances on a more sustainable footing. Large government budget deficits have boosted Japan’s net public debt to over 85 percent of GDP, one of the highest in the OECD. In the years ahead, rising health and elderly care costs will add strain to public resources. The Cabinet Office estimates that in the absence of further policy adjustments, social security expenditure will reach 22 percent of GDP by 2025, up from about 18 percent of GDP in 2005. ¹² As a result, the government’s net debt could continue to rise. Rising debt could increase interest rates, lower investment, and ultimately hamper growth in the context of population aging.

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Fiscal Balance and Net Public Debt

(In percent of GDP)

Citation: IMF Staff Country Reports 2006, 276; 10.5089/9781451820683.002.A002

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2. The authorities are committed to addressing these risks by achieving a primary balance of the general government (excluding social security) by 2011. Although the government has not yet announced a detailed plan on how to attain this target, there is a growing consensus that consolidation would contain a mixture of both expenditure and revenue measures. The debate focuses on how to design a successful adjustment, while minimizing the output costs. A menu of options to underpin consolidation will be unveiled in the forthcoming releases of the “Roadmap for Income-Expenditure Reform” and the Basic Policies for FY2006.

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

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

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

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

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

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

4. The main findings are:

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

• An ambitious consolidation that stabilizes the debt ratio involves greater long-term benefits than an adjustment that just targets a primary balance.¹³ Such a strategy carries only somewhat larger short-term output costs.

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

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

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

B. Analytical Framework

5. The framework used is a two-country version of the IMF’s Global Fiscal Model (GFM) calibrated to the Japanese economy. GFM is a macroeconomic model developed specifically to examine a range of fiscal issues. ¹⁴ In GFM, fiscal policy affects both aggregate demand and aggregate supply. Aggregate demand responses result from the absence of debt-neutrality and consumers’ impatience—i.e. their preference for immediate rather than deferred consumption. Aggregate supply responses arise inter alia from the distortionary effects of payroll and corporate income taxes.

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

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

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

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

7. The model has been parameterized to reflect key macroeconomic features of Japan (Tables II.1 and II.2). In particular, the ratios of consumption, investment, government spending, wage income, and income from capital relative to GDP are set to their current values. Similarly, key fiscal variables—revenue to GDP ratios from taxation of corporate, labor, and personal income and consumption tax, as well as government debt and current government spending—have been calibrated to Japan’s fiscal structure. ¹⁵

Table II.1.

Key Macroeconomic Variables in the Initial Steady State

Source: IMF staff estimates.

Table II.1.

Key Macroeconomic Variables in the Initial Steady State

				Japan	Rest of the World
Country size				11.5	88.5
	% share of world real income			11.4	88.7
National expenditure accounts at market prices
Consumption				57.0	51.5
	rule-of-thumb			12.4	7.2
	forward-looking			44.6	44.3
	domestic			47.4	50.1
	imported			9.5	1.4
Investment				18.1	18.7
	for tradables			3.1	4.2
	for non-tradables			15.0	14.6
	domestic			15.1	18.2
	imported			3.0	0.5
Government expenditures				22.7	30.0
Exports				14.4	1.6
	of consumption goods			10.4	1.2
	of investment goods			4.0	0.4
Imports				12.2	1.8
	of consumption goods			9.1	1.3
	of investment goods			3.0	0.5
Tradable/nontradable split
	Tradables			15.7	20.2
		domestic		1.1	18.6
		imported		12.3	1.9
		net exports		2.3	-0.3
	Nontradables			84.3	79.8
Factor incomes
	Capital			37.7	36.1
	Labor			62.4	63.9
Interest rate
	Real short-term interest rate			2.0	2.0
Government
	Debt			87.5	40.0
Tax rates
	On workers' social security contribution (effective)			20.1	32.4
		revenue as a % of GDP		4.8	11.7
	On employers' social security contribution (effective)			11.0	11.0
		revenue as a % of GDP		4.5	5.0
	On corporate income
		revenue as a % of GDP		3.7	3.3
			of which: on capital income	7.5	7.5
			of which: revenue as a % of GDP	1.0	1.0
			of which: on dividend income (profits)	7.5	7.5
			of which: revenue as a % of GDP	2.7	2.3
	On personal income			9.5	9.5
		revenue as a % of GDP		7.5	7.1
	On consumption (effective VAT rate)			4.4	6.0
		revenue as a % of GDP		2.5	3.0

Source: IMF staff estimates.

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Table II.1.

Key Macroeconomic Variables in the Initial Steady State

				Japan	Rest of the World
Country size				11.5	88.5
	% share of world real income			11.4	88.7
National expenditure accounts at market prices
Consumption				57.0	51.5
	rule-of-thumb			12.4	7.2
	forward-looking			44.6	44.3
	domestic			47.4	50.1
	imported			9.5	1.4
Investment				18.1	18.7
	for tradables			3.1	4.2
	for non-tradables			15.0	14.6
	domestic			15.1	18.2
	imported			3.0	0.5
Government expenditures				22.7	30.0
Exports				14.4	1.6
	of consumption goods			10.4	1.2
	of investment goods			4.0	0.4
Imports				12.2	1.8
	of consumption goods			9.1	1.3
	of investment goods			3.0	0.5
Tradable/nontradable split
	Tradables			15.7	20.2
		domestic		1.1	18.6
		imported		12.3	1.9
		net exports		2.3	-0.3
	Nontradables			84.3	79.8
Factor incomes
	Capital			37.7	36.1
	Labor			62.4	63.9
Interest rate
	Real short-term interest rate			2.0	2.0
Government
	Debt			87.5	40.0
Tax rates
	On workers' social security contribution (effective)			20.1	32.4
		revenue as a % of GDP		4.8	11.7
	On employers' social security contribution (effective)			11.0	11.0
		revenue as a % of GDP		4.5	5.0
	On corporate income
		revenue as a % of GDP		3.7	3.3
			of which: on capital income	7.5	7.5
			of which: revenue as a % of GDP	1.0	1.0
			of which: on dividend income (profits)	7.5	7.5
			of which: revenue as a % of GDP	2.7	2.3
	On personal income			9.5	9.5
		revenue as a % of GDP		7.5	7.1
	On consumption (effective VAT rate)			4.4	6.0
		revenue as a % of GDP		2.5	3.0

Source: IMF staff estimates.

Table II.2.

Behavioral Assumptions and Key Parameters in the Initial Steady State

Source: IMF staff estimates.

Table II.2.

Behavioral Assumptions and Key Parameters in the Initial Steady State

				Japan	Rest of the World
Behavioral assumptions subject to sensitivity analysis
	Planning horizon of consumers			20 years	12.5 years
	Labor disutility parameters			0.92	0.92
	Fraction of rule-of-thumb consumers			0.40	0.25
	Intertemporal elasticity of substitution			0.33	0.33
Other key parameters
	Elasticity of substitution between capital and labor			0.93	0.93
	Effective discount rate			0.92	0.92
	Depreciation rate on capital			0.12	0.07
	Capital adjustment cost parameters			1.00	0.60
	Elasticity of substitution between varieties
		Tradables sector		4.85	7.67
			Price markup over marginal cost	1.26	1.15
		Nontradables sector		3.44	4.23
			Price markup over marginal cost	1.41	1.31
	Capital share in production tradables sector			0.42	0.42
	Capital share in production nontradables sector			0.42	0.42
	Utility from real money balances			0.02	0.02
	Price stickiness parameters			0	0
	Home bias in government consumption			yes	yes
	Home bias in private consumption			no	no
	Elasticity of substitution between traded and nontraded goods			0.75	0.75
	Bias towards domestically produced tradables over nontradables			0.20	0.30

Source: IMF staff estimates.

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Table II.2.

Behavioral Assumptions and Key Parameters in the Initial Steady State

				Japan	Rest of the World
Behavioral assumptions subject to sensitivity analysis
	Planning horizon of consumers			20 years	12.5 years
	Labor disutility parameters			0.92	0.92
	Fraction of rule-of-thumb consumers			0.40	0.25
	Intertemporal elasticity of substitution			0.33	0.33
Other key parameters
	Elasticity of substitution between capital and labor			0.93	0.93
	Effective discount rate			0.92	0.92
	Depreciation rate on capital			0.12	0.07
	Capital adjustment cost parameters			1.00	0.60
	Elasticity of substitution between varieties
		Tradables sector		4.85	7.67
			Price markup over marginal cost	1.26	1.15
		Nontradables sector		3.44	4.23
			Price markup over marginal cost	1.41	1.31
	Capital share in production tradables sector			0.42	0.42
	Capital share in production nontradables sector			0.42	0.42
	Utility from real money balances			0.02	0.02
	Price stickiness parameters			0	0
	Home bias in government consumption			yes	yes
	Home bias in private consumption			no	no
	Elasticity of substitution between traded and nontraded goods			0.75	0.75
	Bias towards domestically produced tradables over nontradables			0.20	0.30

Source: IMF staff estimates.

8. Other main aspects of the model are:

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

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

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

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

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

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

9. Notwithstanding some simplifying assumptions, the framework provides a strong basis for analysis. The model does not allow for nominal rigidities, productive public investment, and multiple tax rates for each type of tax. Nonetheless, the framework provides a good platform for discussing the relative merits of alternative fiscal consolidation measures. ¹⁶ In particular, the structure of the model permits an assessment of the following options: (i) lower government transfers; (ii) lower government spending; ¹⁷ (iii) higher workers’ social security contribution; (iv) higher employers’ social security contribution; (v) higher personal income taxes; (vi) higher corporate income taxes; (vii) higher consumption taxes; or (viii) a package that combines some expenditure reductions and some tax increases.

C. Alternative Fiscal Adjustment Strategies

Composition

10. A primary balance could be attained by 2011 through expenditure or tax measures—or a combination of both. ¹⁸ The needed adjustment amounts to about ½ percent of GDP on average per year for five years. As shown in the table below, if the adjustment relies only on one type of measure, substantial changes will be necessary. For example, to reach a primary balance by 2011, as the authorities intend, would require: a doubling of the consumption tax rate to 10 percent; a 5 percentage-point increase in the corporate income tax; or about a 25 percentage-point cut in spending on goods and services of the central government’s general account (as defined in the table). On the whole, given the size of the necessary adjustment, consolidation is likely to be accomplished through a combination of expenditure and revenue measures.

Illustrative Fiscal Consolidation Measures

(In percent)

Notes to Table:

^1/Includes education and science, energy measures, major foodstuff measures, national defense, miscellaneous, local allocation tax, special local allocation tax, transfer to the industrial investment special account, small business, economic assistance, and contingencies.

^2/Includes social security and government employee pension and others.

^3/Cumulative percent change 2006-2011.

Illustrative Fiscal Consolidation Measures

(In percent)

				Before	After
Revenue
	Consumption/Sales Tax (VAT)
		Actual rate		5.0	10.0
		Effective rate		4.5	8.3
		Revenue (in percent of GDP)		2.0	4.5
	Corporate Income Tax (CIT)
		Actual rate
		Effective rate		7.5	12.5
		Revenue (in percent of GDP)		2.6	5.1
	Employers’ Social Security Contribution (ESSC)
		Actual rate
		Effective rate		11.0	22.3
		Revenue (in percent of GDP)		4.7	7.2
	Personal Income Tax (PIT)
		Actual rate
		Effective rate		9.5	12.0
		Revenue (in percent of GDP)		2.5	5.0
	Workers’ Social Security Contribution (WSSC)
		Actual rate
		Effective rate		20.1	27.6
		Revenue (in percent of GDP)		5.6	8.1
	Expenditure
		Spending on Goods and Services 1/
			in percent of GDP	6.2	3.7
			percent change		-25.03/
		Transfers 2/
			in percent of GDP	4.1	1.6
			percent change		-54.3 3/

Notes to Table:

^1/Includes education and science, energy measures, major foodstuff measures, national defense, miscellaneous, local allocation tax, special local allocation tax, transfer to the industrial investment special account, small business, economic assistance, and contingencies.

^2/Includes social security and government employee pension and others.

^3/Cumulative percent change 2006-2011.

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Illustrative Fiscal Consolidation Measures

(In percent)

				Before	After
Revenue
	Consumption/Sales Tax (VAT)
		Actual rate		5.0	10.0
		Effective rate		4.5	8.3
		Revenue (in percent of GDP)		2.0	4.5
	Corporate Income Tax (CIT)
		Actual rate
		Effective rate		7.5	12.5
		Revenue (in percent of GDP)		2.6	5.1
	Employers’ Social Security Contribution (ESSC)
		Actual rate
		Effective rate		11.0	22.3
		Revenue (in percent of GDP)		4.7	7.2
	Personal Income Tax (PIT)
		Actual rate
		Effective rate		9.5	12.0
		Revenue (in percent of GDP)		2.5	5.0
	Workers’ Social Security Contribution (WSSC)
		Actual rate
		Effective rate		20.1	27.6
		Revenue (in percent of GDP)		5.6	8.1
	Expenditure
		Spending on Goods and Services 1/
			in percent of GDP	6.2	3.7
			percent change		-25.03/
		Transfers 2/
			in percent of GDP	4.1	1.6
			percent change		-54.3 3/

Notes to Table:

^1/Includes education and science, energy measures, major foodstuff measures, national defense, miscellaneous, local allocation tax, special local allocation tax, transfer to the industrial investment special account, small business, economic assistance, and contingencies.

^2/Includes social security and government employee pension and others.

^3/Cumulative percent change 2006-2011.

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

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

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

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

• Finally, a package of measures involving lower government spending, lower transfers, and a higher consumption tax would have an impact on growth that compares favorably with that of a strategy based solely on increasing the consumption tax rate or on reducing government expenditure. ¹⁹ This result comes from the limited impact on growth of a consumption tax hike and a reduction in transfers (as described above) and is independent of the sequencing of these measures.

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Growth Effects of Alternative Fiscal Strategies

(Deviation from control; in percentage point)

Citation: IMF Staff Country Reports 2006, 276; 10.5089/9781451820683.002.A002

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12. Among the revenue measures, a consumption tax increase has the least negative effect on output.

• This result stems from the fact that the tax base is the discounted stream of future income and accumulated savings—a broad concept of permanent income. With this tax base, there is less distortion in the consumption-leisure decision as a result of this tax increase, with smaller adverse effects on the supply side. ²⁰

• Raising the corporate income tax rate would involve larger short-term output costs than any other tax because it directly discourages investment (by raising the after-tax cost of capital) in addition to the negative impact on consumption (for those consumers who own capital). ²¹ Overall, the effect of corporate taxation on the economy depends on the relative sensitivity of capital and labor to changes in the respective tax rates. The model is calibrated so that capital is more sensitive to taxes than labor, in line with empirical evidence. ²²

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Impact on real GDP Growth of Tax Hikes: Consumption vs. Corporate

(Deviation from control; in percentage point)

Citation: IMF Staff Country Reports 2006, 276; 10.5089/9781451820683.002.A002

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

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Path of Government Debt under Alternative Scenarios

(as a percent of GDP)

Citation: IMF Staff Country Reports 2006, 276; 10.5089/9781451820683.002.A002

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14. The planned consolidation of 2½ percent of GDP over 5 years will have limited spillover effects to the rest of the world. This result is largely invariant to the consolidation strategy. Spillover effects occur in the model through two channels: trade and financial.

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

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

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Effects on World GDP Growth

(Deviation from control in percentage point, 25-year average)

Citation: IMF Staff Country Reports 2006, 276; 10.5089/9781451820683.002.A002

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Size, Pace and Timing of Adjustment

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

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The Effects of More Ambitious Fiscal Adjustment on Real GDP Growth

(Deviation from adjustment of 1/2 percent of GDP per year, in percentage point)

Citation: IMF Staff Country Reports 2006, 276; 10.5089/9781451820683.002.A002

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

17. Model simulations suggest that the timing of the adjustment also matters. Two alternative scenarios to stabilize the debt ratio have been simulated: a gradual and a stop-and-go scenario. The gradual scenario envisages a sustained adjustment of ½ percent of GDP a year over nine years (to yield the primary surplus excluding social security necessary to stabilize the debt ratio). The stop-and-go scenario envisages a pause in the adjustment for three years (see table above). The chart above compares the different impact on growth of these two scenarios with that of a more ambitious consolidation (“Staff Plan”, see ¶ 15). The simulations suggest that a gradual adjustment may limit the short-term negative effects of consolidation on growth but also reduces the long-term benefits. This stems from the fact that the delayed adjustment yields higher debt, which in turn would crowd out private domestic and foreign investment through higher interest rates. ²³

Illustrative Consolidation Paths

Illustrative Consolidation Paths

Year	Government Plan	Staff Plan	Gradual	Stop-and-Go
1	0.5	1	0.5	0.5
2	0.5	1	0.5	0.5
3	0.5	0.75	0.5	0.5
4	0.5	0.5	0.5	0.5
5	0.5	0.5	0.5	0.5
6	0	0.5	0.5	0
7	0	0	0.5	0
8	0	0	0.5	0
9	0	0	0.25	0.5
10	0	0	0	0.5
11	0	0	0	0.5
12	0	0	0	0.25

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Illustrative Consolidation Paths

Year	Government Plan	Staff Plan	Gradual	Stop-and-Go
1	0.5	1	0.5	0.5
2	0.5	1	0.5	0.5
3	0.5	0.75	0.5	0.5
4	0.5	0.5	0.5	0.5
5	0.5	0.5	0.5	0.5
6	0	0.5	0.5	0
7	0	0	0.5	0
8	0	0	0.5	0
9	0	0	0.25	0.5
10	0	0	0	0.5
11	0	0	0	0.5
12	0	0	0	0.25

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The Impact of the Timing of Consolidation on Real GDP Growth

(Deviation from Staff Plan, in percentage point)

Citation: IMF Staff Country Reports 2006, 276; 10.5089/9781451820683.002.A002

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Tax Reform

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

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Tax Reform Effect on Real GDP Growth

(Deviation from control, in percentage point)

Citation: IMF Staff Country Reports 2006, 276; 10.5089/9781451820683.002.A002

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D. Sensitivity Analysis

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

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

• The longer the planning horizon of households or the more private consumption responds to the interest rate, the smaller the impact of fiscal consolidation on real interest rates, output, and the current account. ²⁴

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

E. Concluding Remarks

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

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Net Present Value of Growth

(in deviation from control, percentage point)

Citation: IMF Staff Country Reports 2006, 276; 10.5089/9781451820683.002.A002

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