Japan
Selected Issues
Author:
International Monetary Fund
Search for other papers by International Monetary Fund in
Current site
Google Scholar
Close

Although fiscal consolidation has short-term costs, the potential long-term benefits are considerable. Although adjustment is important for securing fiscal sustainability, reforms that raise potential growth could also support consolidation. Simulations show that the external environment also matters, but domestic policies should be the priority to raise medium-term growth. In Japan, public policies can help create an environment for more effective capital formation. For Japan, reforms to stimulate private consumption hold significant promise for boosting growth, and this could be achieved by boosting household disposable income.

Abstract

Although fiscal consolidation has short-term costs, the potential long-term benefits are considerable. Although adjustment is important for securing fiscal sustainability, reforms that raise potential growth could also support consolidation. Simulations show that the external environment also matters, but domestic policies should be the priority to raise medium-term growth. In Japan, public policies can help create an environment for more effective capital formation. For Japan, reforms to stimulate private consumption hold significant promise for boosting growth, and this could be achieved by boosting household disposable income.

I. The Impact of Fiscal Consolidation and Structural Reforms on Growth in Japan1

A. Introduction

1. With Japan’s public debt at historic levels, concerns are rising over the growth impact of needed fiscal adjustment. The severe recession and sizeable fiscal stimulus have pushed up Japan’s public debt from 188 percent of GDP in 2007 to 218 percent of GDP in 2009. Bringing down the public debt ratio to more sustainable levels would require a large and sustained adjustment that has raised concerns about the possible impact on growth. Monetary policy is limited at the zero-bound to support fiscal consolidation, while Japan’s aging population and low trend growth provide little room to absorb falling demand. At the same time, the evolution of the external environment will also affect Japan’s growth prospects.

2. Fiscal consolidation will require a sustained adjustment in the fiscal balance, covering both revenue and expenditure measures. Based on staff’s analysis, stabilizing and bringing down debt ratio over the medium-term would require a gradual adjustment in structural primary balance of about 10 percent of GDP over a decade. While a part of the adjustment could come from the expiry of fiscal stimulus package and cyclical factors, given the limited space for further expenditure cuts, the rest of the adjustment would have to rely on additional revenue measures including increases in the consumption tax.

3. The growth effect of fiscal consolidation is a concern in the short-run. The growth impact of such a large scale adjustment would depend on the composition of the measures adopted and will change over time. In the absence of any offsetting policies, growth is likely to slow in the short-run due to the withdrawal of demand. However over the medium-run, the benefits of fiscal consolidation are likely to dominate. International evidence suggests that sizeable fiscal consolidation could have limited growth effects if accompanied by positive supply response. For example, Germany’s comprehensive tax reform in 2007 had an initial moderate negative impact, which was then offset by strong external demand and robust investment growth, in response to corporate tax reform in 2008.2 Growth remained robust in 2008.

4. Structural reforms could help offset the negative impact of fiscal consolidation and raise medium-term potential growth. In this context, policies aiming at raising services sector productivity through deregulation or increasing competition and labor market flexibility could support fiscal consolidation through higher tax revenues.

5. At the same time, changes in the global economy could affect the growth impact of consolidation in Japan. A year after the global crisis, emerging market economies are leading the global recovery, while the pace of the recovery in advanced economies has been slower, and is still heavily dependent on policy support. As a result, output in most advanced economies remained below pre-crisis levels at end 2009. Japan’s share of exports to advanced economies in total exports had been declining even before the crisis, from 75 percent in early 2000s to about 60 percent in 2008. After the crisis, this trend has continued, with the share of exports to China increasing to about 19 percent at the expense of exports to the United States and Euro Area. With the world still adjusting to post-crisis conditions, demand for Japanese products is likely to continue to shift from advanced economies to the fast growing emerging market world.

uA01fig01

Japan: Direction of Exports

(In percent)

Citation: IMF Staff Country Reports 2010, 212; 10.5089/9781455207886.002.A001

Source: CEIC database.

6. To assess the growth implications of fiscal consolidation and structural reforms, the chapter uses a 5-block version of the IMF’s Global Integrated Monetary and Fiscal (GIMF) model. 3 The model provides a good framework to capture the implications of the domestic and external changes. The model is non-Ricardian and has a rich set of fiscal instruments, which makes it suitable for simulating a detailed fiscal consolidation scenario. At the same time, the 5-block version features a detailed trade matrix allowing for an analysis of possible spillovers vis-à-vis the rest of the world. Simulations show that fiscal consolidation may not be very costly in the medium-term and, if combined with structural reforms, could hold the key for renewed economic strength. In addition, comprehensive reforms would allow Japan to benefit from changes in the world economic landscape as it reorients its economy to fast growing emerging market economies. The remainder of the chapter lays out this argument in detail.

B. Impact of Fiscal Consolidation on Growth

7. About 10 percent of GDP adjustment in structural primary balance is needed to stabilize and reduce debt, with a part of the adjustment coming from cyclical factors and the rest from structural changes. In particular adjustment of about 2½ percent of GDP could come from the expiry of fiscal stimulus package and cyclical factors. The remaining 7½ percent of GDP adjustment would need to come from additional expenditure and revenue measures. Given the limited space for further expenditure cuts, additional adjustment would rely mainly on revenue measures, including increases in the consumption tax. The scenario assumes a phased in increase of the consumption tax with some frontloading, raising revenues by 5 percent of GDP and a decline in corporate income tax, reducing revenues by ½ percent of GDP. In addition, the scenario builds in a decline in government consumption by 2 percent of the GDP and in public investment by ½ percent of GDP. The rest of the adjustment comes from transfers.

uA01fig02

Fiscal Consolidation Scenario: Improvement in Fiscal Balance

(cumulative, in percent of GDP)

Citation: IMF Staff Country Reports 2010, 212; 10.5089/9781455207886.002.A001

Source: IMF staff estimates.

8. Without any additional policy measures, fiscal adjustment would depress GDP in the short-run by about 1 percentage point.4 The increase in the consumption tax, lower government consumption, and declining public investment all reduce domestic demand. However, the negative impact on investment is limited by the reduction in corporate taxes.

uA01fig03

Fiscal Consolidation Scenario: Real GDP Level

(Percentage difference from baseline)

Citation: IMF Staff Country Reports 2010, 212; 10.5089/9781455207886.002.A001

Source: IMF staff estimates.

9. It is important to note that the particular composition of the fiscal consolidation is illustrative and can change the dynamics in both short and medium term. On the revenue side, large increases in consumption tax will reduce consumption, but could be offset partly by lower corporate taxes, which stimulate investment. Higher investment would also increase demand for labor, increasing wage income and consumption. As consumption taxes are less distortionary in terms of their effect on output than labor and capital income taxes, a budget-neutral shift from corporate to consumption taxes would raise output. This effect, however, would be small in this scenario as the reduction in corporate taxes are limited compared with the increase in consumption taxes. On the expenditure side, reduction in public investment is likely to reduce private output in the medium-term as public sector infrastructure generally supplements private production. However, in Japan given that public investment is already low (about 2.5 percent of GDP), there is not much room for further significant cuts. Transfers, on the other hand, are likely to have more short term impact, particularly on individuals who are liquidity constrained.

10. Over the medium-term, however, real GDP could rise above the baseline by about 2–3 percentage points. The main factors contributing to positive growth effects from fiscal consolidation are:

  • Reduction in precautionary savings. Part of the decline in consumption due to higher consumption taxes would be offset by a reduction in precautionary savings. In particular, younger generations who are concerned about fiscal sustainability and the pension system are potentially saving more now than otherwise. Although the size of the precautionary savings is hard to identify, we assume a conservative decline in savings by about 1 percentage points.5

  • Limiting increases in the risk premium. Although there is scant historical evidence of a sizeable risk premium on Japan’s public debt, such a risk premium is likely to emerge over time in the absence of fiscal consolidation. Staff’s calculations show that without any policy adjustment and given current trends in savings, gross public debt6 could exceed gross households’ financial assets in about 5 years (Tokuoka, 2010). This would likely lead to a higher risk premium and raise the cost of capital, thereby depressing investment and growth. Credible fiscal consolidation could contain increases in the risk premium, raising GDP above the levels in the no policy adjustment scenario. It is assumed that fiscal consolidation would reduce the risk premium by 50 basis points.7

  • Switch to less distortionary corporate taxes. As capital income taxes are more distortionary than consumption taxes, reducing corporate taxes would improve long-term output through higher investment. The chapter assumes a limited decline in corporate taxes, and higher reductions would enhance the growth benefits. There is a tradeoff, however, between these benefits and the amount of fiscal adjustment needed to bring the debt to sustainable levels.

  • Confidence effects. A credible fiscal consolidation could also improve business confidence and encourage investment and bring forward some of the growth benefits. With concerns over the fiscal situation and its implications for long-term growth prospects, business sentiment is likely to stay weak. However, improved expectations of stable economy and higher growth potential in the future would strengthen business sentiment and investment. This is consistent with evidence from firm-level data on investment in Japan, which show that uncertainty about the economic outlook has hampered investment, especially among SMEs (Syed and Lee 2010).

11. Fiscal adjustment will also raise national savings compared to the baseline. This would pull up the medium-term trade balance by about 1 percentage point. A higher equilibrium current account surplus would imply more depreciated real exchange rate.

12. Monetary policy is assumed to be constrained by the zero interest rate bound, limiting its role in supporting fiscal consolidation. With the policy rate held at zero level, inflation would fall below the baseline in the short-run, pushing up real interest rates and depressing demand further. However, over the long-run, higher national savings and lower risk premium would help lower real interest rates.

C. Impact of Combined Policy Package of Fiscal Consolidation and Structural Reforms

13. Structural reforms to boost potential growth could support growth during consolidation. The authorities’ medium-term growth strategy (to be released at end-June) highlights the importance of developing certain key sectors such as health and education. In this context, this chapter focuses on two main areas: increasing the productivity in the services sector and enhancing competition in labor and product markets.

14. Japan has considerable scope for raising productivity in the services sector. Since 1990s, labor productivity level and growth in services have been lower than those of Japan’s manufacturing sector.8 Reasons include: a high degree of regulation in certain sectors, such as health, elderly care, and childcare, which may hold back needed productive investment. Retail services is another sector which has room for further efficiency gains. While identifying specific structural reforms to raise productivity in these sectors is beyond the scope of this analysis, this chapter looks at the implications of productivity increases in these sectors on the rest of the economy. Based on some sector-level studies and targets determined by the authorities’ growth strategy, a reasonable assumption for productivity increase would be about 0.5–1 percentage points. The specific scenario assumed here is that the productivity in the non-tradables sector increase by one percentage point.

15. Furthermore, increasing competition in services and in labor markets would enhance productivity gains. Relaxing barriers to entry in sectors such as medical and elderly care, and price regulations in a wide range of sectors in health and education could enhance competition and efficiency. In addition, introducing a new, more flexible regular labor contract could improve employment by encouraging new hires, especially among temporary workers. To simulate the improvement in competitiveness in product and labor markets, the mark-ups in the non-tradable and labor markets are reduced by about 2 percentage points.9

16. A combined policy package of fiscal consolidation and structural reforms would improve GDP even in the short term. The gains from improved productivity and competitiveness have the potential to offset the negative demand effects of fiscal consolidation in the short term. While productivity increases will accumulate gradually, a credible policy package, securing sustainable public debt as well as higher potential growth and competitiveness would advance investment and improve growth expectations.

uA01fig04

Real GDP

(% difference from baseline)

Citation: IMF Staff Country Reports 2010, 212; 10.5089/9781455207886.002.A001

Source: IMF staff estimates.

17. Higher investment through structural reform would make up for the initial decline in consumption. Real consumption would be still depressed in the short term with high consumption taxes, but will gradually recover in the medium term.10 Wage capital income will be higher with higher investment and the associated increased demand for labor.

18. Monetary policy is assumed to adjust in this scenario, allowing both inflation and nominal rates to rise. With higher growth and inflation, interest rates turn positive allowing monetary policy to play a larger role. With the full adjustment in both exchange rates and interest rates, the real exchange rate depreciation is larger than otherwise, contributing further to export performance and trade balance. Higher GDP in the short-term also raises inflation above baseline. Although nominal interest rates are also higher, with higher inflation, real interest rates are lower than in the previous scenario.

uA01fig05

CPI inflation

(% difference from baseline)

Citation: IMF Staff Country Reports 2010, 212; 10.5089/9781455207886.002.A001

Source: IMF staff estimates.

D. Spillovers from the Rest of the World

19. Changes in the pattern of growth in the rest of the world are also likely to affect the impact of Japan’s consolidation. A year after the global crisis, attention has turned to policies to sustain balanced growth over the medium term, which would have implications for Japan’s growth prospects. This section focuses on spillovers from two regions: emerging Asia and the U.S.

20. In emerging Asia, a comprehensive set of reforms is assumed to be implemented to sustain medium-term growth. These reforms include: (1) structural reforms in the services sector that raise productivity accompanied with a shift in households’ preference toward non-tradable goods; (2) fiscal reforms aimed at reducing precautionary saving by increasing coverage of education, health care, and pensions, and improving infrastructure in rural areas; (3) further financial development and liberalization (including interest rates) to enable better smoothing of household consumption, capital allocation, and improved risk management by banks, reducing credit constraints for households; and (4) a gradual real effective appreciation of the Asian currencies—10 percent over 10 years for illustrative purposes—that supports the transition to greater reliance on the non-tradable sector and stimulates private consumption by raising labor’s share of income. 11

21. In the United States, the private saving rate is assumed to increase in the aftermath of the recent global crisis. In particular, it increases by 2½ percent of GDP above the baseline, while private investment is assumed to decline on account of household deleveraging and tighter financial regulation.

22. While the increase in savings in the U.S. reduces the demand for Japanese products, rebalancing in Emerging Asia has the potential to counter this decline. The increase in U.S. savings has two main implications for Japan. First, demand for Japanese products decline, and second the yen appreciates, reducing trade balance and real GDP in Japan.12 The rebalancing in emerging Asia, on the other hand, has offsetting effect, with demand for Japanese products increasing and the yen depreciating in real terms.

uA01fig06

Trade Balance/GDP

(3 years, % difference from baseline)

Citation: IMF Staff Country Reports 2010, 212; 10.5089/9781455207886.002.A001

Source: IMF staff estimates.

23. Spillovers from the rest of the world are likely to benefit Japan over the medium-term, but sustaining growth in Japan still requires domestic policy action. While the adjustment in the rest of the world has positive spillovers on Japan, the growth impact is rather limited. Therefore, domestic policy adjustment is still needed to boost medium term-growth.

24. A combined policy package of fiscal consolidation and growth enhancing reforms along with positive spillovers from the rest of the world would increase real GDP further. Under a full adjustment scenario, the decline in consumption is much milder, and mainly affects liquidity constrained agents. Over the long-run, labor shifts from tradable to non-tradable sector, and overall employment and wages increase. In the new equilibrium, the trade balance is still higher and the real effective exchange rate remains depreciated.

25. The degree of productivity increases, decline in mark-ups, and confidence effects are all factors determining the magnitude of the growth impact. If the structural policies raise the productivity and reduces the mark-ups further, the long-term growth benefits would be higher than those obtained with these simulations. On the other hand, if the combined policy package is viewed as not credible, the confidence effects are not likely to advance the growth effects, and short-term negative demand effects are likely to dominate.

uA01fig07

Real GDP

(3 years, percentage difference from baseline)

Citation: IMF Staff Country Reports 2010, 212; 10.5089/9781455207886.002.A001

Source: IMF staff estimates.

E. Conclusions

26. Although fiscal consolidation has short-term costs, the potential long-term benefits are considerable. With debt to GDP reaching historical levels, fiscal consolidation is unavoidable for Japan. The chapter shows that while fiscal consolidation has short term costs due to a sizeable increase in consumption taxes and expenditure containment, benefits would accrue in the long-term through lower precautionary savings, risk premium and corporate taxes, and improved confidence and investment. If policies are implemented credibly, the growth benefits can be captured earlier through increased investment.

27. While adjustment is important for securing fiscal sustainability, reforms that raise potential growth could also support consolidation. In particular, raising the productivity in the services sector has tremendous potential for offsetting negative demand effects from fiscal consolidation.

28. Simulations show that the external environment also matters but domestic policies should be the priority. A full package of rebalancing in emerging Asia has the potential to offset the decline in demand from advanced economies, but its overall impact on growth is limited. Therefore, sustaining growth in a meaningful way would still require fiscal consolidation combined with structural reform.

References

  • Khatri, Yougesh and Ogawa, Sumiko, 2007, “Japan: Boosting Productivity in Services-Priorities for Deregulation”, Japan: 2007 Article IV Consultation—Selected Issues Paper, IMF Country Report No. 07/281 (Washington: International Monetary Fund).

    • Search Google Scholar
    • Export Citation
  • Kiyota, Kozo et.al, 2009, “Measurement of the Market Power of Firms: The Japanese Case in the 1990s”, Industrial and Corporate Change, Vol. 18, No. 3, pp. 381414.

    • Search Google Scholar
    • Export Citation
  • Kumhof, Michael, et.al, 2010, “The Global Integrated Monetary and Fiscal Model—Theoretical Structure”, IMF Working Paper, No. 10/34 (Washington: International Monetary Fund).

    • Search Google Scholar
    • Export Citation
  • N’Diaye, Papa, et al., 2010, “Does Asia Need Rebalancing?,” Asia and Pacific Department, Regional Economic Outlook, April 2009, Chapter III (Washington: International Monetary Fund).

    • Search Google Scholar
    • Export Citation
  • OECD, 2008, “OECD Economic Surveys: Japan”, Vol. 2008/4, April 2008 (Paris: Organisation for Economic Co-operation and Development).

    • Search Google Scholar
    • Export Citation
  • Sommer, Martin, 2009, “Why are Japanese Wages So Sluggish?,” IMF Working Paper, No. 09/97 (Washington: International Monetary Fund).

    • Search Google Scholar
    • Export Citation
  • Syed, Murtaza and Lee, Jinsook, 2010, “Raising Medium-Term Growth: What Role can Investment Play?,” Japan: 2010 Article IV Consultation—Selected Issues Paper, (Washington: International Monetary Fund).

    • Search Google Scholar
    • Export Citation
  • Tokuoka, Kiichi, 2010, “The Outlook for Financing Japan’s Public Debt”, IMF Working Paper, No. 10/19 (Washington: International Monetary Fund).

    • Search Google Scholar
    • Export Citation

Appendix

Households and Firms

Each country is populated by two types of households, consuming final retail output and supplying labor to unions. First, there are liquidity constrained households who do not have access to financial markets, and who consequently are limited to consuming their after tax income in every period. Second, there are overlapping generation households with finite planning horizons. Each of these agents faces a constant probability of death. In addition to the probability of death, households also experience labor productivity that declines at a constant rate over their lifetimes. Households are subject to uniform labor income, consumption and lump-sum taxes.

Firms and unions are owned by households and therefore are myopic and have finite planning horizons. Except for capital goods producers, entrepreneurs and retailers, they are monopolistically competitive and subject to nominal rigidities in price setting. Manufacturers buy capital services from entrepreneurs and labor from unions. Unions buy labor from households. Entrepreneurs buy capital from capital goods producers. Entrepreneurs are subject to an external financing constraint and a capital income tax. Capital goods producers are subject to investment adjustment costs. Manufacturers sell to domestic and foreign distributors, through import agents located abroad. Distributors combine a public capital stock with nontradable goods and domestic and foreign tradable goods, subject to an import adjustment cost. They sell to domestic and foreign consumption and investment goods producers. Consumption and investment goods producers combine domestic and foreign output, again subject to an import adjustment cost. Consumption goods are sold to retailers and the government, while investment goods are sold to capital goods producers and the government. Retailers, who are also monopolistically competitive, are subject to real rigidities, which supplements inertial consumption dynamics.

The regions trade with each other at the levels of intermediate and final goods, with a matrix of bilateral trade flows that are calibrated on recent historical averages. International asset trade is limited to nominally non-contingent bonds denominated in U.S. dollars. The world economy’s technology grows at the constant rate.

The Government and the Central Bank

Fiscal policy consists of a specification of government spending, lump-sum transfers, tax rates on labor, consumption and capital, and lump-sum taxes. Government consumption spending is unproductive, while government investment spending expands a stock of publicly provided infrastructure capital that depreciates. Tax revenue is endogenous and given by the sum of labor, consumption, capital and lump-sum taxes.

A fiscal policy rule stabilizes deficits and the business cycle. First, it stabilizes the interest inclusive government deficit to GDP ratio at a long-run target (structural) level which rules out default and fiscal dominance. Second, it stabilizes the business cycle by letting the deficit fall with the output gap. Fiscal policy can be characterized by the degree to which automatic stabilizers work, which is estimated by the OECD.

Monetary policy uses an interest rate rule to stabilize inflation. The rule is similar to a conventional inflation forecast based rule that responds to one year ahead inflation. In certain simulations in this paper, interest rates are kept constant to simulate effect of the zero bound on interest rate.

1

Prepared by Pelin Berkmen. This chapter will be published as a forthcoming working paper.

2

The tax reform package included an increase of the value added tax (VAT) rate from 16 to 19 percent, a reduction in payroll tax relief equivalent to 0.4 percent of GDP, and a reduction in the corporate income tax rate from 40 to 31 percent combined with some base broadening. Plans were announced in November 2005, and the increase of the VAT rate and the reduction in corporate income tax rate were implemented in 2007 and 2008 respectively. The structural fiscal deficit declined by 1 percentage point in 2007 helped by expenditure reductions, which were carried out in parallel.

3

The five regions are the United States, the Euro Area, Japan, emerging Asia and other countries. The details of the model are presented at Kumhof and others (2010) and will not be repeated here. The appendix provides a brief summary of the model.

4

The growth rate would be lower by 0.3–0.5 percentage points on average.

5

There is a wide range of estimates of precautionary savings in Japan (ranging from 0 to 15 percent). Most studies are done with micro-level data for gross savings. As the net savings based on national income data are already relatively low, the precautionary effects are assumed to be limited to 0.5–1 percentage points.

6

Including public debt owed by the Fiscal Investment and Loan Program.

7

Given that most tail risk scenarios feature 100–200 basis points increase in risk premium, this is quite a mild assumption.

9

This estimate is rather on the low side. There is a wide range of sector specific mark-ups. For example, OECD (2008) estimates that mark-ups in non-manufacturing sectors are three times higher than the mark-ups in manufacturing. Kiyota, et. al. (2008) finds that even in the low mark-up sectors, firms enjoy mark-ups above unity and entry of a firm has a negative impact on mark-ups.

10

Consumption of the liquidity constrained agents would be lower owing to decline in transfers.

11

This scenario is consistent with the rebalancing scenario analyzed in Chapter 3 of the Asia and Pacific Department’s Regional Economic Outlook, April 2010.

12

Higher national savings in the U.S., in the absence of any other changes in the rest of the world, would imply a higher current account and real effective depreciation in the U.S.

  • Collapse
  • Expand
Japan: Selected Issues
Author:
International Monetary Fund