By Keigo Kameda*
Japan’s 2020 fiscal year budget was formulated in December 2019 before COVID-19 struck and pandemic-related considerations could be factored in. Expenditure was expected to reach 102.7 trillion yen (US$939 billion) and the primary budget deficit to GDP ratio was expected to be 2.7 per cent.
The government set out to achieve a primary surplus in the national and local governments by 2025. These fiscal consolidation targets were laid out under the ‘Basic Policy on Economic and Fiscal Management and Reform 2018’.
The pandemic seemed to rob Japan of the will to pursue fiscal discipline. In 2020, the government made three COVID-19 supplementary budgets, and as a result expenditure ballooned to 175.7 trillion yen (US$1.6 trillion). Yet unlike the United Kingdom and the United States — which have already begun discussions about future tax hikes — there are very few discussions in Japan about fiscal consolidation. The lack of debate is problematic because Japan has the worst public debt-to-GDP ratio in the world.
There are three possible reasons why the fiscal consolidation debate has not progressed in Japan. First, many people have no interest in financial problems. A survey on public finances and tax burdens found that the average consumption tax rate that citizens considered desirable shifts by about 2 per cent with and without prior explanation of Japan’s fiscal situation. The Japanese public appear to be unaware of the risks associated with the debt and the need for fiscal consolidation.
Second, there is confusion about fiscal consolidation measures. The debate concerning Japan’s fiscal strategy is wide ranging. Some argue that spending cuts are more effective than increases in taxes. Others propose increasing nominal revenues and nominal GDP by raising prices and stimulating economic growth to lower real public debt. Raising taxes is another option though it is unpopular.
The different approaches to reducing real public debt also create divisions. One view suggests that economic growth increases through structural reform on the supply side. Another perspective aims to achieve both a price increase and economic growth through monetary easing. Another approach suggests that the fiscal spending multiplier is large enough and that fiscal consolidation is possible if fiscal spending increases. This confusion is prolonging the debate about fiscal consolidation in Japan, resulting in ‘consolidation fatigue’. The longer the fiscal consolidation period, the higher the probability that the chosen fiscal consolidation measure will end insufficiently.
Third, a consumption tax is unpopular with Japanese citizens. Given the decrease in Japan’s working-age population and global competition for corporate tax reduction, a consumption tax should be the last candidate for achieving fiscal consolidation. The regressiveness of the tax burden inherent in a consumption tax likely goes against the maximin social welfare preferences of the Japanese public. A consumption tax hike is the most politically unpopular fiscal consolidation strategy but remains one of the few options left.
Fiscal consolidation in Japan is a fairly difficult task. But Japan’s consumption tax rate is still only 10 per cent. This is low compared to other developed countries — Japan still has fiscal space of about a 10 per cent to raise the consumption tax if the example of other developed countries were followed. A 5 per cent hike could fully cover the average primary budget deficit to nominal GDP ratio generated over the past ten years.
Japan is extremely unlikely to face financial collapse in the short term. No matter how difficult fiscal consolidation is politically, the government currently has levers to pull if financial crisis becomes imminent. But the effectiveness of these levers is likely to diminish in the long run. The ageing of Japan’s population will continue to shrink fiscal space because of the increased social security cost and the consequent increase in government debt. The process of ageing will also reduce the national savings rate, and given the current stagnant economic and fiscal situation in Japan, it is difficult for the Bank of Japan to escape its low interest rate policy.
These factors will cause future economic turmoil without fiscal consolidation now. Low interest rates will mean that the Japanese economy will face a large domestic and foreign interest rate gap, and the resulting yen-carry trade will cause the yen to depreciate. If the overseas holding ratio of Japanese government bonds (JGBs) is sufficiently high due to the shortage of national savings, combined with considerable depreciation for foreign investors, the price of JGBs will collapse.
The Bank of Japan may avoid sovereign default because it can buy and support JGBs but this will inevitably further depreciate the yen. This depreciation will bring great turmoil to the economy through, for example, rising oil prices. If this happens in the middle of winter, it could hit the lives of the poor living in the northern regions hardest. Japan’s GDP will also fall in dollar terms. Nobody knows how big or small this fall will be, but it could mean that Japan will drop out of the developed world.
As the clock is ticking on averting a fiscal disaster, the Japanese government must implement effective fiscal consolidation measures sooner rather than later.
*About the author: Keigo Kameda is Professor of Economics in the School of Policy Studies at Kwansei Gakuin University.
Source: This article was published by East Asia Forum