Japan: Selected Issues
Author: International Monetary Fund. Asia and Pacific Dept
Publication Date:
02 Aug 2016
eISBN:
9781475522525
ISBN:
9781475522525
Language:
English
Keywords:
ISCR; CR; wage; debt; firm; IFI head; a number of IFIs; IFI webpage; IFI to the government; envisaged policy measure; Multilateral development institutions; Budget planning and preparation
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Japan: Selected Issues

Abstract

Japan: Selected Issues

An Independent Fiscal Institution for Japan1

In response to the recent financial crisis and the ensuing buildup in public indebtedness, an increasing number of advanced economies have created independent fiscal institutions (IFIs) to improve the quality of public finances and to strengthen the credibility of government policy. A review of Japan’s fiscal policymaking over the past decades suggests that Japan would greatly benefit from establishing an IFI in line with internationally accepted standards of good practice. Such an institution could help correct critical weaknesses in policymaking and anchor expectations, especially if introduced as part of a fiscal framework with a medium-term perspective.

A. Background

In recent years, a new generation of independent fiscal institutions (IFIs) has proliferated in advanced economies, as well as in some emerging markets, partly in response to the financial crisis and the ensuing buildup in public indebtedness. The rationale for IFIs stems from the quest for transparency in public finances, and thereby, for improving fiscal policymaking. In general, IFIs are entrusted with vigilance over public finances mainly by evaluating fiscal policy usually before and during the decision-making process. They are charged with real-time forward-looking surveillance of fiscal policymaking, with a focus on macro-fiscal effects in the short to medium run, and on public debt sustainability over the long run. The purpose of this chapter is to examine the case for establishing an IFI for Japan, given past trends, current conditions, and the outlook. To this end, the rationale, experience, and effectiveness of existing IFIs are reviewed to assess their potential relevance for Japan. In addition, drawing on international good practice, the paper explores the features of such an institution that would be most suitable to address Japan’s public finances.

B. International Experience

Origins: According to origin, IFIs can be classified as the result of local political conditions; prompted by fear of, or recovery from, a crisis; or owing to an external commitment by the government. While a number of IFIs emerged due to a confrontation between political parties (e.g., United States), more recently they were established in the aftermath of a crisis to recuperate erosion in credibility (e.g., United Kingdom), or simply as a requirement under a Fund-supported stabilization program (e.g., Ireland) or under EU membership.

Rationale: The foremost argument for establishing an IFI has been the need for transparency in public finances, as the key to informed and quality policymaking. More specifically, through comprehensive and timely access to information on the government’s policy intentions and execution, the IFI is intended to correct three interrelated deficiencies in fiscal management: deficit bias, procyclicality bias and optimistic bias. If successful, the IFI can also help anchor fiscal expectations, much like an independent central bank can help anchor inflation expectations.2

Statutes: IFIs are rather heterogeneous in their statutory basis, structure, and functions (Table 1). In most countries, the enabling statute of the IFI is set in a law, while in a few countries, presumably due to historical circumstances, the IFI has been established by executive decree.

Table 1.

Advanced Economies: Statutes and Structure of Independent Fiscal Institutions

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Sources: Kopits (2013a) and update from IFI webpages.

Structure: The organizational structure of IFIs varies significantly across countries. Roughly one half of IFIs are endowed with a monocratic authority, while the other half (mostly in Europe) operate under the collective leadership of a council. The monocratic model can ensure a higher degree of non-partisanship to the extent the IFI head is under stricter public scrutiny than a collective IFI where the members may represent different political parties or interest groups, thereby diluting the evaluation of a budget bill or of some policy proposal. On the other hand, collective leadership of non-affiliated experts can reduce groupthink, especially if the council includes some members from abroad—as in Ireland, Portugal, or Sweden.

Remit: Most IFIs prepare estimates and forecasts of the fiscal and macroeconomic consequences of the budget bill and proposed fiscal measures in time for consideration by the legislature before enactment. Detailed estimation of the budgetary cost of each major proposed expenditure or tax measure is undertaken by only handful of IFIs (Table 2). In a number of countries, prior to submission of the budget bill, the IFI prepares short- and medium-term no-policy-change projections to serve as the baseline to judge the realism of the government’s projections. In addition, periodically, the IFI prepares quantitative long-term scenarios and sensitivity analyses for specific policy options, with clearly spelled out macroeconomic and demographic assumptions. Some IFIs are developing and incorporating stochastic techniques to assess risks around medium-to long-term fiscal projections, stemming from various sources, including the accumulation of contingent liabilities. Notably, in a few countries (Netherlands, UK), where in the past the government’s projections had lost credibility owing to a persistent optimistic bias, the IFI is assigned the responsibility of preparing the official macro-fiscal projections. In countries where governments are subject to fiscal rules, the IFI has the added mandate of monitoring compliance with such rules. The IFIs usually have no policy-making authority, and by implication, they cannot have legally binding enforcement power.

Table 2.

Advanced Economies: Functions of Independent Fiscal Institutions

article image
Sources: Kopits (2013a) and update from IFI webpages.

Effectiveness: Good practice for IFIs has been codified in the Principles for IFIs by an OECD reference group, consisting of heads of these institutions, and recommended formally to member countries, including Japan, by the OECD Council. 3 Besides following these best practices, the IFI must be home-grown and home-owned, developed on the basis of the broadest possible consensus; it must be endowed with adequate financial and human resources, with proven competence to perform quantitative analysis; and it must possess communication skills to gain the support of the media and the general public. Moreover, to earn credibility, it is essential for the IFI to demonstrate non-partisanship and technical competence at the initial phase of operation. But, even after a successful start, upon having met all the foregoing conditions, IFIs are still exposed to the will of elected officials and require an extended tenure before being well established. To claim success, an IFI needs to operate at least over two electoral cycles, with major political parties alternating each other in government. Ultimately, the success of the institution depends on public’s demand for transparency and accountability from elected political leaders.

C. The Case for an IFI in Japan

Japan’s large public debt burden, together with its declining potential growth and low equilibrium interest rates, is posing significant policy challenges, in particular with respect to ensuring a growth-friendly, gradual and credible fiscal adjustment process. In the meantime, the stop-and-go nature of fiscal policy and the frequent use of supplementary budgets are leading to policy uncertainty and rendering fiscal policy less transparent. The downside risks of prolonged stagnation in the future, coupled with a continued rise in public indebtedness, cannot be exaggerated especially with the dramatic contraction of the labor force—predicted to decline by one half between now and the 2080s. The home bias in sovereign bond holdings and extraordinary monetary expansion cannot be counted upon to last indefinitely.

Challenging trends: Over more than two decades, Japanese policymakers have struggled to emerge from the prolonged stagnation that followed the financial crisis of the early 1990s. Periodic attempts at stimulating the economy through monetary and fiscal policies did not yield a much-hoped sustained revival. The formulation of fiscal policy in Japan has straddled an unenviable dilemma between boosting economic activity on the one hand and preserving debt sustainability on the other.

Stop-and-go nature of fiscal policy: In the dynamics of the budgetary process, the Ministry of Finance tends to set rather conservative revenue forecasts despite optimistic macroeconomic projections provided by the Cabinet Office. In the course of the fiscal year, as the revenue outcome is usually more favorable than forecasted, the new information gives rise to additional demands that are met with added spending in a routine supplementary budget. During the past twenty years there have been more than 40 supplementary budgets, averaging about two per year, estimated to increase primary spending by 6 percent over initial appropriations (excluding 2008-09 and 2011). This practice creates unpredictability, and may prevent automatic stabilizers from being the first line of defense against procyclicality. The optimistic bias is evident mainly in the medium-term projections, especially for the high-growth “revitalization” projection, which can be interpreted as the government’s elusive goal, and to a lesser extent for the “prudent” projection, which implicitly incorporates some specific tax or expenditures measures. Altogether absent is a no-policy-change baseline projection against which to assess the estimated effect of the envisaged measures. Optimistic medium-term projections in return hamper the credibility of medium-term fiscal targets by reducing the implied adjustment needs.

Opacity and uncertainty: The lack of clearly spelled out priorities and of a credible commitment to a medium-term plan, along with mid-year improvisations through serial enactment of supplementary budgets tend to undermine the efficacy of fiscal policy and creates uncertainty for the private sector. Thus, fiscal expectations are unanchored, which at least in part may explain the overall reluctance of households and enterprises to consume and to invest, respectively. Such an outlook begs for a break with past habits of opacity and a determined shift to a fiscal framework characterized by a high level of transparency that would be conducive to a steady progress toward solving Japan’s public debt sustainability problem, paving the way to sustained growth. The establishment of an IFI can go a long way in enhancing credibility and transparency, especially if introduced as part of a fiscal framework with a medium-term perspective.

D. Design Options for Japan

Japan already has two fiscal institutions, embodied in the Prime Minister’s Council on Economic and Fiscal Policy and the Finance Ministry’s Fiscal System Council, but neither of these institutions meets any attributes enumerated in the OECD Principles. Instead, the Councils perform a useful advisory and analytical role, much like similar official bodies around the world. Drawing on the experience of IFIs with a successful track record and taking into account its own needs, Japan can select from among a number of good practices regarding the functions, statutes and structure of a prospective IFI. Ideally, the IFI should be a key component of a new fiscal policy framework.

Functions: The IFI would encourage the government to set targets for the general government balance and expenditures, along with major envisaged structural reform measures, over a medium-term horizon. As part of this approach, the government would refrain from resorting to enactment of within-year supplementary budgets, except when warranted by extraordinary unanticipated events beyond its control. The IFI would prepare a medium-term macro-fiscal baseline (no policy change) projection that would serve as the backdrop for evaluating the realism of (i) the government’s projection that incorporates the envisaged policy measures and (ii) the annual budget bill and its consistency with the target. Estimates of the output gap would allow real-time estimates of the structural (or cyclically adjusted) budget balance and assessment of the fiscal policy stance. Over time, the IFI could be entrusted with the preparation on a regular basis of long-term quantitative baseline scenarios to assess public debt sustainability, which is even more critical in the case of Japan given its large adjustment needs which will need to be met over a long horizon. Besides relying on a baseline scenario, fiscal sustainability analysis should possibly be complemented with a risk assessment applying sophisticated techniques.4 At a later stage, responsibility for preparing the official medium-term macro-fiscal projections could be shifted from the government to the IFI, to guarantee impartiality as well as greater time consistency. Also, consideration could be given to deepening the evaluation function by costing each proposed mandatory expenditure or tax measure. As this is the most resource-intensive function, it should await the availability of sufficient manpower to activate it in full. Normative functions should be permanently excluded from the role of the IFI. It must be emphasized that the IFI is not a decision-making body under any circumstances.

Statutory basis: The IFI should be created through an informed and open debate, and enshrined in legislation reached on the basis of a broad political consensus. The institution should not be established simply through a government decree or legislated along party lines, in order to bestow on it the status it deserves and to assert its nonpartisanship. A strong statutory basis can serve as signaling a regime shift toward improved and transparent fiscal governance. Formal affiliation of the IFI to the government, much like an advisory function, carries the risk of government capture. Far less risky would be affiliation to the Diet, or possibly no affiliation at all. In either case, the enabling law should ensure de facto independence for the IFI. Furthermore, to enhance its effectiveness, the IFI should be charged with oversight beyond the central government and its agencies, that is, with jurisdiction over subnational governments and the rest of the public sector.

Structure: The IFI can consist of an individual head or a collective leadership, but its assessments and projections should be based on impartial, export opinion. The IFI’s work, if limited to the above envisaged functions, could be performed by a lean staff of professionals.

E. Conclusions

In response to the recent financial crisis and the ensuing buildup in public indebtedness, there has been a surge of interest in creating independent fiscal institutions (IFIs) with a view to improving the quality of public finances, and to strengthening the credibility and transparency of government policy. A strong case can be made for establishing an IFI to help correct critical weaknesses in Japan’s fiscal policymaking. An IFI by itself cannot, of course, remedy all potential failures of policymaking, but it can certainly constitute a major improvement, especially if it is introduced as part of a broader reform of the fiscal framework that would incorporate a medium-term perspective and abandonment of the discretionary short-run approach—exemplified by the routine practice of mid-year supplementary budgets.

References

  • Kopits, G., B. Ferrarini, and A. Ramayandi (2016) “Exploring Risk-Adjusted Fiscal Sustainability Analysis for Asian Economies,” ADB Working Paper Series No. 483, May.

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  • Leeper, E.M. (2010). “Monetary Science, Fiscal Alchemy” in Macroeconomic Challenges in the Decade Ahead, A Symposium Sponsored by the Federal Reserve Bank of Kansas City, Jackson Hole, Wyoming, August 26–28.

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  • OECD (2013) Principles for Independent Fiscal Institutions, Paris, February 12. http://www.pbodpb.gc.ca/web/default/files/files/files/Revised%20IFI%20Principles_EN%20-%2013-Feb-13.pdf

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1

Prepared by George Kopits (APD/FAD Visiting Scholar) with inputs from Elif Arbatli (APD). A more detailed version of this paper is forthcoming as an IMF Working Paper.

2

See the analysis underlying this point in Leeper (2010).

3

In all, these 22 internationally accepted principles are grouped under nine broad headings: local ownership; independence and non-partisanship; relationship with the legislature; access to information; transparency; communication; and external evaluation. See OECD (2013).

4

See the roadmap for a comprehensive risk-adjusted fiscal sustainability analysis provided by Kopits, Ferrarini, and Ramayandi (2016).

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Cover IMF Staff Country Reports
Japan: Selected Issues
Author: International Monetary Fund. Asia and Pacific Dept
Volume/Issue:
Volume 2016: Issue 268
Publisher:
International Monetary Fund
ISBN:
9781475522525
ISSN:
1934-7685
Pages:
86
DOI:
https://doi.org/10.5089/9781475522525.002