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Fiscal Reform Subcommittee Preliminary Report (June 2001) (2/3)

Introduction

The Fiscal Reform Subcommittee took advantage of the opportunity presented by the organization of the new Ministry of Finance on January 6, 2001 to review Japan's current fiscal structure. The subcommittee organized topics for discussion concerning Japan's future fiscal policies, and beginning in February conducted local surveys, an overseas survey, local symposia within Japan and an Internet questionnaire and vigorously debated the issues the subcommittee was instructed to address.
Today Japan is being urged to address the need for socioeconomic structural reforms. Japan's fiscal policies are not an exception. In order to build a system that will function stably during the future, we must design specific systems based on an objective understanding of the role Japan's fiscal policies have played in the past and selection of discussion topics that focus on reform.
In the following report we have attempted to present ideas that will provide the foundation for these reforms.


I  Outline

1. International Comparison and Changes to Macro Fiscal Structures
  The following is a discussion of Japan's fiscal structure compared to the U.S. and various European countries, based upon the ratio of GDP at the general government level, comprised of the central government, local governments and the social security fund, to GDP.

(1) Overview
  When we review changes in fiscal revenues and expenditures, fiscal revenues and expenditures in the U.S. and European countries began to improve in the latter half of the 1980s as the result of fiscal reform efforts. Although the fiscal situations in these countries deteriorated for a period of time during the recession in the early 1990s because of increased outlays such as unemployment benefits, we can see improvements as a result of enhanced efforts to again undertake fiscal reform after the mid-1990s.
  In contrast, Japan set out fiscal reform objectives several times in the latter half of the 1980s, and as a result of continual efforts to reduce annual expenditures, Japan's fiscal revenues and expenditures did begin to improve for a period of time. More recently, however, particularly since the mid-1990s, Japan's fiscal situation has deteriorated significantly as the result of successively enacted economic stimulus packages and the influence of lower taxes.

1)   Comparison of Annual Expenditure Levels
  Annual expenditure levels rose in the U.S. and Europe in the 1970s from increases such as higher social security expenditures due to recession. During the 1980s, however, these countries tried to control annual expenditures as a whole with a focus on social security expense. Although annual expenditure levels climbed again in the early 1990s because of higher unemployment benefits and other outlays, governments used levers such as the European Union to redouble their fiscal reconstruction efforts, established limits on annual expenditures, and controlled or reduced overall annual expenditures through various measures such as social security system reform. Annual expenditure levels fell as a result. In particular, governments were able to reduce interest payments as faith in governments' efforts to restore fiscal consolidation lowered interest rates, and to cut back defense spending with the end of the cold war. Both contributed greatly to reform efforts.
  In contrast to Europe and the U.S., the level of annual expenditures in Japan was relatively low. This was the result of a lower level of final consumption spending due to factors such as lower level of social security expenses than in the U.S. and Europe because Japan's population was aging less rapidly at the time, and the number of civil servants were less. Nevertheless, as a result particularly of increased expenditures for the rapid aging of Japan's population in the 1990s and successive economic stimulus packages following the collapse of Japan's so-called "bubble economy", Japan was the only developed country to raise its expenditures level. Excluding the United States, Japan is now approaching the levels in Europe.
  Given its present interest rate levels and the size of defense spending, Japan cannot anticipate the same effects from interest payment expense and defense spending that accompanied fiscal reforms in the U.S. and European countries. Japan must therefore move ahead in the future with a review of annual expenditures that until now have been untouchable. In particular Japan cannot avoid reviewing social security, public investment and local finances, the three principal annual expenditure sectors.

2)

  Comparison of Annual Revenue Levels
  During the 1990s, the tendency for annual government revenue to grow was seen in the U.S. and various European countries because of changes such as tax increases that were part of fiscal restoration plans. Japan, on the other hand, has the lowest level of annual revenue compared to the U.S. and European countries because of Japan's economic recession and policies such as permanent tax cuts. The premise when implementing future fiscal revenue and expenditure improvements will be to first thoroughly review central government and local government annual expenditures, but there appears to be room for improvement of annual revenue as well.

(2) Comparison of the Three Principal Sectors

1)   Social Security
  The U.S. and European countries had adjusted and expanded their social security systems by the beginning of the 1970s. Since the 1980s, these countries have proceeded to reform their social security systems, including pensions (raising the age at which payments of pension benefits begin, etc.) and medical care (control of total medical care expenses, etc.), based on developments such as the long-term aging of their populations.
  The changes in social security expenditures in Japan have shown roughly the same movement as in the U.S. and European countries. In recent years in particular, Japan is showing a large growth in expenditures compared to the U.S. and European countries because Japan's population is rapidly aging. This has also led to problems involving the entire system, including inefficiency of benefits and problems of inequity between generations.
  In the future, Japan is expected to have the world's most rapidly aging population and the highest percentage of senior citizens. This means Japan's most pressing need is to take a comprehensive viewpoint stretching across systems and to restructure its social security system in a way that ensures future sustainability while balancing benefits and burdens between generations and achieving a balance between the economy and government finances.

2)

  Public Investment
  Compared to the U.S. and European countries, Japan was slow to develop its social infrastructure. Although Japan proceeded to aggressively develop its social infrastructure, in the first half of the 1980s the government's level of general government total fixed capital formation (Ig) decreased through use of measures such as negative ceiling. Thereafter the level of infrastructure spending remained stuck at low levels because of factors such as the recession caused by the strong yen following the 1985 Plaza Accord, and demands from foreign countries for Japan to expand its level of domestic consumption. In the 1990s Japan's government again began to raise the investment level, and now continues to invest at an extremely high level approximately two to four times the levels of the U.S. and European countries.
  The levels of Ig in the U.S. and European countries in the 1990s were unrelated to changes in the economic growth rate and generally exhibited a declining trend, suggesting that governments did not use public investment as an economic measure. Japan, on the other hand, adopted a posture of aggressively utilizing public investment to support the economy.

3)

  Local Government Finance
  Because of differences among national systems it is impossible to indiscriminately compare the levels of total local expenditures in each country. Japan's level of administrative expenses is high compared to countries such as the U.K., which like Japan have not adopted a federal system, because of Japan's high level of public investment and the large scale of its industrial policy.
  When we examine the changes in central and local government expenditure levels in contrast to countries such as England where local government expenditure levels during the 1990s changed in a controlled fashion, in Japan the growth in local government expenditures in Japan became quite large compared to the growth of central government expenditures. This is believed to be a reflection of the absence of mechanisms 1) to maintain fiscal discipline in local administration, such as England's public expenditure plan (an annual expenditure plan for three years that includes the central government, local governments and public corporations) and Italy's domestic stabilization agreement (an agreement between the central and local governments, stipulating fiscal revenues and expenditures that should be improved in all provinces and assigns improvement objectives to each region).

(3) Summary
  In contrast to the U.S. and European countries, which continued efforts during the 1990s to maintain fiscal discipline at both the national and local levels in order to improve fiscal revenues and expenditures, Japan has rapidly expanded its fiscal deficit.
  Two large factors forming the backdrop in which the expansion of fiscal deficits has been tolerated in Japan are the successive uses of fiscal policy to stimulate the economy, and the resulting gradual weakening of the relationship between benefits and costs.


2. Concepts Concerning Fiscal Management ~ Looking at fiscal management in the 1990s ~

(1) Fiscal Management and Economic Trends in Japan in the 1990s

1)   Issues
  Looking back over fiscal management and economic trends since the collapse of Japan's so-called "bubble economy" (since the economic peak in February 1991), with the exception of 1996 and 1997, Japan adopted an expansionary fiscal policy stance of unprecedented scale. During this period Japan implemented a total of 11 economic stimulus packages (a scale of activity totaling more than 130 trillion yen) as part of supplementary budgets. Nevertheless, Japan's economic growth rate has generally remained sluggish and a recovery centered on private demand was seen only for very short periods.
  The problems concerning fiscal management during this period were concentrated in two areas.
  The first is that by focusing unduly on the problem of demand shortage as the cause of economic stagnation, the government underestimated the seriousness of the non-performing loan problem in the financial system. This made it difficult to form a consensus for addressing the carnage in the banking system and cleaning up these loans.
  This was linked to the judgment that stimulating additional demand through fiscal policy was both necessary and effective for lifting the economy, and led the government to repeatedly approve substantial fiscal outlays of funds. In addition there are also indicators that the weakness of the private sector's ability to recover while saddled with the non-performing loan problem was not adequately acknowledged when the government began to undertake fiscal reforms in 1997.
  The second problem is that from a viewpoint of economic stabilization (economic adjustment), the government relied too heavily on the use of expansionary fiscal policy. Two factors acting as restrictive conditions when giving fiscal policy an economic stabilization function are (a) not to sacrifice resource allocation efficiency and (b) ensure that it is possible to maintain the fiscal policy (sustainability). In addition fiscal policy has the defect of being less flexible than monetary policy. It must therefore be said that during the 1990s, Japan came to rely too excessively on fiscal policies that exceeded the limits permitted by these restrictive conditions.
  As a result of these problems, the central government's efforts failed to achieve the expected intent of lifting the economy. They also left fiscal policy itself with two serious structural problems by (a) reducing the confidence in resource allocation efficiency and (b) fanning doubts with regard to the sustainability of fiscal stimulus.

2)

  Effects of Expansionary Fiscal Policy in the 1990s
  Based on the fact that Japan's economic growth rate was generally sluggish in the 1990s despite the large-scale and repeated mobilization of fiscal resources, it has been pointed out that the effects from an expansionary fiscal policy have diminished. Certainly according to weighting models, the public investment multiplier effect has decreased in recent years. As shown by the existence of a repercussion effect, however, it cannot be said that the expansionary fiscal policy of the 1990s was totally ineffective in supporting the economy.
  Moreover, factors pointed to as the reasons why effects of an expansionary fiscal policy were offset, include (a) a high level of crowding out of private investment due to a rise in interest rates, (b) the muting of the expansionary economic effect by the yen's appreciation when interest rates rose (Mandel-Fleming effect), and (c) doubts about the sustainability of the government's fiscal policy that caused excessive uneasiness over future tax increases and weakened the stimulative effect on private consumption. With regard to (a) and (b) however, monetary policy was also eased during this period, and the remarkably high interest rates and tendency for the yen to appreciate that should be the grounds for these arguments were not observed. With regard to concerns about future tax increases, however, we believe this was not seriously acknowledged as a matter of concern before. To the extent the cumulative base of public debt has risen during the past several years, however, it is possible this has become a cause for the decline in the fiscal policy effects.
  Based upon the above, we believe the generally sluggish growth rate during the 1990s was caused by the low potential growth of Japan's economy as resources were locked into low-productivity, inefficient sectors, or the delay in disposing of non-performing loans at banks, rather than an inadequate expansionary fiscal policy effect.

3)

  Relationship Between Fiscal Management in 1997 and Economic Conditions
  Next we shall consider the point that the increase in the national burden in 1997 (increase in the consumption tax to 5%, abolition of the special tax reduction, increase in social insurance premiums and increase in the personal portion of medical care expenses) had a restrictive effect on the economy.
  With regard to the view that the rise in the national burden led to the recession and worries about the financial system, it is natural to think that concerns about the financial system emerged because the bills for the non-performing loan problem and financial institution mismanagement - postponed since the collapse of the so-called bubble economy - became too large to ignore at this time. Conversely, it is difficult to conceive that uneasiness over the financial system would not have occurred had there been no policies that increased the national burden.
  On the other hand, let's examine the idea that the effect of the national burden increase on the economy was non-existent because consumption had begun to recover during the July-September 1997 timeframe. When we look at the effect of fiscal policy on consumption, for example, the consumption tax rate increase created tremendous urgent demand during the first quarter of 1997 and a large reactionary plunge in consumption during the April to June period. However, this effect may be considered to have been a temporary phenomenon. But since the national burden increase was linked to a decrease in disposable income, the possibility that this had a negative effect on household consumption during Fiscal 1997 is not completely incontrovertible.
  We do not consider this to be the principal cause of the recession, however. The direct situation that led to a full-blown recession from November 1997 was the crystallization of worries over the financial system in the wake of successive failures of major financial institutions. The tightening of credit and disappearance of consumer mentality caused by these events exerted a serious, negative effect on private capital investment and household consumption.

4)

 Relationship Between Fiscal Reform and Economic Conditions
  We believe that fiscal reform will contribute to continual economic growth as the result of qualitative review of fiscal structure and improvement of fiscal revenue and expenditures. Because of topics 2) and 3) above, the possibility cannot be denied that reforms may give rise to factors such as a quantitative reduction in annual expenditures that may have a temporarily negative effect on economic conditions. Therefore when implementing reforms, the government must simultaneously implement policies to minimize the pain as much as possible.
  Specifically, for example, the government should enact the following types of measures as a package.
a.  Heighten the positive effects of annual expenditures on the economy, such as the private investment inducement effect, by reducing inefficiency expenditures, putting greater emphasis on allocations and improving expenditure efficiency.
b.  To heighten the autonomous growth capability of the private sector, promote deregulation that is linked to new job creation and economic policies that emphasize the supply-side such as reform of capital markets.
c.  Provide an employment-side safety net that will enable the labor market to smoothly handle the manpower shift that accompanies lower public demand.
  In this sense, it will be important for the government to devise a policy package that ties together socioeconomic structural reforms and fiscal reform as a whole.


(2) Orientation of Fiscal Management Reforms (Concepts that should be reaffirmed)
  In addition, with regard to Japan's fiscal management, the orientation of the necessary reforms must (a) ensure efficient resource allocation and (b) ensure sustainability. This means (c) reduction of government participation in economic stabilization is required.

1)   Ideal Economic Stabilization Policies
  In various foreign countries, the degree of government participation in economic fiscal stabilization has been decreasing.
  In the United States, for example, the monetary policy conducted by the central bank from the 1970s through the 1980s was established on the principal of responsibility for policy management aimed at economic stabilization. Even during the 1990s, the central bank assumed that preventive and flexible monetary policy management stimulated price and interest rate stability and contributed to long-term economic expansion.
  Moreover, assigning the role of economic stabilization to monetary policy is assumed to be appropriate for the following reasons:
a.  It is reasonable to use monetary policy for economic stabilization in terms of policy allocation since fiscal policy must also fulfill a resource allocation function
b.  Monetary policy can be more flexibly managed than fiscal policy
c.  While expansionary fiscal policy can be expected to lead to an increase in direct effective demand, it generates a large expense in the form of a current or future tax burden
  Therefore the government in Japan as well should use monetary policy principally for its economic stabilization function, and use fiscal policy for its resource allocation function while maintaining fiscal discipline. Fiscal policy has the function of easing business fluctuations because of its automatic stabilization mechanism ("built-in stabilizers")2) supplementing this with discretionary use of monetary policy should be limited to only those situations where a recession is extremely serious3) and the latitude for exercising monetary policy is extremely limited.
  Given that Japan's economy has grown to a size where the GDP exceeds 500 trillion yen, the government should refrain from taking a leading role in the economy and should also note that continual economic growth cannot be obtained without an autonomous recovery of the private sector.

2)

  Appropriate Fiscal Management for Efficient Allocation of Resources
  The government's source of funds is taxes collected from taxpayers. The government must therefore use this capital efficiently and without waste. As explained below, the government must also reduce the fiscal deficit in the future from a perspective of fiscal policy sustainability, and when doing so, must show greater awareness of the quantitative limits on annual expenditures. Based on the above, the government must conduct future fiscal policy with greater emphasis on efficient allocation of resources.
  At such time, the government should reaffirm two ideas that have been pointed out in the past:
a.  Entrust to the private sector those matters the private sector can manage (priority on private initiative)
b.  Provide at minimum cost, the administrative services deemed necessary by taxpayers (efficient investment of fiscal capital)

a

. Priority on Private Initiative
 
The private sector relies upon market mechanisms for resource allocation decisions. When markets function appropriately, resource allocation is achieved more efficiently through competition than through government intervention. Thus in order to provide the supply of financing and services that can be judged as appropriate under market mechanisms, the government should limit its activity to the minimum level required, based upon the idea of entrusting economic activity as much as possible to the private sector.
  As noted above, the annual expenditure level of Japan's general government base is low compared with various foreign countries. If we consider that (a) the level has continued to rise in recent years and (b) when restoring the government's consolidation, Japan cannot hope for interest expense and national defense expense reduction effects as large as those in foreign countries. If we require strict reduction efforts in other annual expenditure areas, then under such thinking it will be important to review the roles allocated to the government and the private sector and reduce the size of the government.

b

. Efficient Investment of Fiscal Capital
 
For financing and services for which market mechanisms will not achieve the efficient allocation of resources, the government should supply the proper amounts.
  Even in these situations, the government must take the taxpayers' viewpoint and (a) try to efficiently provide the administrative services assumed to be necessary for taxpayers at (b) the minimum expense.

(1

) Providing Administrative Services based on Taxpayer Needs
  Unlike cases that rely upon market mechanisms, when the government determines the distribution of fiscal capital, we cannot expect price information to automatically transmit needs. Thus to maximize economic welfare and improve the level of taxpayer satisfaction, the government must adopt a conscious approach to accurately understand taxpayers' needs and adequately reflect this when distributing fiscal capital.
  As a specific attempt at such an effort, this subcommittee utilized the Internet to conduct an "Opinion Survey Concerning Fiscal Policy." It will undoubtedly be important for the government to heighten its sensitivity to taxpayer needs through this type of approach.

(2

) Minimizing Expenses
  From the standpoint of effectively utilizing its limited fiscal capital, the government should adopt the means for administrative participation that enable it to provide the administrative services deemed necessary by taxpayers at the minimum expense.

  So-called NPM (New Public Management) will be important when providing efficient investment of fiscal capital from the above-mentioned point of view. This approach applies private sector techniques to the public sector, in order to clarify administrative service objectives and improve delivery efficiency. Although policy evaluation techniques have been introduced in Japan based on this thinking, Japan must continue to push forward with this type of effort aimed at reform of administrative techniques in the future.

  At the same time it will also be necessary to clarify the relationship between the costs and benefits of administrative services. Clarifying such costs and benefits for taxpayers is also likely to lead to greater public awareness of the costs involved.

  Furthermore, in relation to the above-mentioned point, the Public Corporation Accounting Section Committee of the Legislation and Public Corporation Accounting Subcommittee plans to complete by the middle of this month its report on introducing administrative cost accounting for the financial affairs reports of public corporations and other institutions, in order to comprehensively understand the public's true burden including future burden and inherent losses. We anticipate such an approach will contribute to the debate concerning reviews geared towards the efficient distribution of fiscal capital.


(3) Ensuring Sustainability

1)   Given that the fiscal deficit is financed in the market in the form of government bond issues, the government will be unable to maintain fiscal management from the start based on the premise of deficits if the market does not accept government bonds.
  However, the market's assessment of government bonds is normally reflected in interest rates. Interest rates are influenced by the level of trust in fiscal sustainability, which is determined by factors such as the expected value of government policy management and policy changes, including the outstanding amount of government bonds, the size of annual fiscal deficit, the direction and transparency of medium to long-term fiscal management and the legislature.
  Under present conditions, the interest on government bonds is at an extremely low level, influenced by factors such as the relative relationship between other investment alternatives and government bonds and the high liquidity of government securities. Given that the outstanding balance of government debt and the deterioration of fiscal revenues and expenditures caused by fiscal management in the 1990s described earlier has reduced the trust in sustainability, depending on the market's evaluation the possibility that the interest on government debt will begin to climb is undeniable. Japan's government must quickly restore trust in the sustainability of its fiscal management.

2)

  With regard to this point, Italy at the beginning of the 1990s, the loss of trust in financial sustainability caused the sudden rise in the government bond interest rate. Because Italy's government used the issue of membership in the European Union as a lever to forcefully proceed with fiscal restoration efforts, it was able to restore trust in the sustainability of government finances. This caused the interest rate on Italian government debt to fall, which in turn has had a good effect on Italy's economic activity as a whole.

3)

  Trust in the sustainability of government financial management, decreases future uncertainty and exerts a positive influence on consumption and investment activity as well. Therefore, the government must restore trust in its fiscal management, keeping in mind not only the markets but also by keeping in mind the people in general.

4)

  Two factors are required for sustainability, namely
  A. Presentation of a realistic and specific plan that is perceived as achievable, and
  B. Initial actions to secure trust in the government's ability to execute the plan

  With regard to Point A, in the process to ensure sustainability it is rational to focus first on the "primary balance"4) because the government must maintain a situation that keeps the balance of outstanding government debt below a prescribed percentage compared with the country's economic power. In this sense Prime Minister Koizumi's cabinet statement that this is an objective of fiscal reform will be positively evaluated.
  With regard to Point B, as the first step towards restoring sound fiscal consolidation, the Koizumi Cabinet specified a concrete objective of "government bond issues totaling 30 trillion yen or less in Fiscal 2002." If this objective is achieved, trust in the government's ability to execute its plans will be secured.

5)

  To aim at fiscal sustainability for all of Japan, however, merely discussing the primary balance on a general account basis is inadequate. The government should focus on the primary balance at both the national and local basis, including the special accounts and local governments. Moreover, when the economic growth rate is less than the interest rate, balance in the primary balance is insufficient and a primary balance surplus, is required. Furthermore, if the ratio of outstanding government debt to GDP that currently far exceeds 100% is the premise, after achieving a primary balance surplus the government must heed carefully the need for fiscal management aimed at lowering the ratio of outstanding government debt compared to GDP.

6)

  In addition, in its reform plan the government must clearly set course for rebuilding government finances over the intermediate-term, such as the starting time, years by which objectives will be achieved and the strength of revenue and expenditure improvements. After completing a thorough, short-term study in the future from various aspects such as the effects on the economy and the relationship to the schedule for system reforms, the government must decide upon the plan content and execution schedule. It will also be necessary to remember that Japan's total population will start to decline in 2008, and implementation of the plan should begin as soon as possible.

7)

  When undertaking this effort, the problems of annual expenditures and a debate over what form and what level of national burden is necessary, will be unavoidable. The government must debate these questions thoroughly in conjunction with the question of what procedure to adopt, in order to obtain the people's understanding.

8)

  Furthermore, in order to restore trust in the sustainability of the government plan, it will be important that an annual expenditure control incentive system is "built-in" as a system. It will be important for the government to adequately consider this viewpoint when reforming the systems in each sector as part of future fiscal reforms.

1)

In Japan items such as the local allocation tax are excluded from general expenditures.

2)

A mechanism that automatically eases business fluctuations through instruments such as the social security system or tax system without accompanying system revision (for example, through lower tax revenue or an increase in unemployment benefits because of the recession)

3)

In its "Mutual Agreement on Stability and Growth" the EU member countries agreed that no sanctions would be applied even if the general government fiscal deficit exceeds 3% of GDP, except in the following exceptional cases:

(1) When uncontrollable circumstances in the country in question have a serious effect on the general government fiscal position
(2) When the real GDP growth rate for that year for the country in question is -2.0% or less
(3) When the real GDP growth rate for that year for the country in question is from -0.75% to -2.0%, and the Ministers of the Economy and Finance Board of Directors judge the current fiscal situation is exceptional based upon considerations such as past economic circumstances in the country in question
4)

The primary balance refers to the condition where annual revenues excluding income from public debt are in balance with annual expenditures excluding interest expense (In the General Account debt repayment expense is accounted for in annual expenditures; this amount and interest expense must both be excluded). If the rate of economic growth and the interest rate on government debt are equal, then under the primary balance the ratio of outstanding government debt to GDP is fixed.


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