Economic Survey of Japan 2005: Achieving fiscal sustainability


What needs to be done to ensure the sustainability of public finances?

Addressing the government's budget deficit should be an important aspect of an exit policy as it would help avoid an abrupt rise in interest rates. Strong economic growth and spending restraint reduced the deficit in the primary budget (which excludes net interest payments) from 6¼ per cent of GDP in 2003 to an estimated 5 per cent in 2004. However, the current fiscal situation is clearly not sustainable. The impact of the sharp run-up in debt over the past decade has been limited by the exceptionally low level of interest rates on government bonds, reflecting easy monetary policy, the risk aversion of investors and the persistence of deflationary expectations. Consequently, government interest payments as a share of GDP are lower than a decade ago despite the higher level of public debt. The transition to positive rates of inflation will boost interest payments, creating a risk of financing strains. As long as higher interest rates are accompanied by a pick-up in nominal growth, the risk is limited as there should be higher tax revenue, although the tax base has been eroded by various exemptions introduced during the past decade. A more serious threat to the fiscal situation would be a rise in the real interest rate.

The government's Medium-Term Economic and Fiscal Perspective, revised in early 2004 and extending through FY 2008, set a target of a primary budget surplus by the early 2010s. Indeed, a surplus is likely to be necessary to stabilise government debt, depending on the path of growth, interest rates and inflation, implying a fiscal adjustment of more than 5 per cent of GDP. The Perspective calls for limiting the size of general  government spending to near its FY 2002 level (38 per cent of GDP) through FY 2006, combined with some unspecified revenue increases, to reduce the primary deficit by ½ per cent annually over the next four years. Preliminary budget plans suggest that a reduction of around ¼ per cent of GDP will be achieved in 2005, thanks to continued economic growth, spending restraint and some revenue measures, including a hike in the pension contribution rate. Even if consolidation advanced at the ½ per cent of GDP pace included in the Perspective, it would take more than a decade to meet the target, by which time gross debt might have risen to 200 per cent of GDP or more, imposing a significant burden on the economy and increasing the possibility of a rise in the risk premium. The negative impact of the high debt in Japan, however, is limited by the high private-sector saving rate and the low level of interest rates. Nevertheless, the medium-term plan should be more ambitious, even though special circumstances make fiscal consolidation more challenging in Japan than in other OECD countries. At a minimum, the government should achieve its goal of a ½ per cent reduction in the budget deficit per year. However, if economic outturns are better than expected, the pace of consolidation should be faster. The credibility of the Perspective should be enhanced by establishing a stronger link to spending and revenue decisions, as well as by securing effective policy feedback to prevent slippage from the target. Finally, the medium-term plan should be extended beyond 2008 and should be based on more realistic economic assumptions.

The objective of freezing government expenditures as a share of GDP should be achieved through FY 2006 and continued efforts to restrain spending are necessary in the future. This will likely require further reform of social security programmes - pensions, healthcare and long-term nursing care - given the spending pressures related to population ageing. Despite the 2004 reform to cut pension benefits, social security outlays are projected to rise by 1½ per cent of GDP by 2010, and this may underestimate the impact of population ageing. Legislation passed in June 2004 to increase the pension contribution rate for the Employees' Pension Insurance from 13.6 to 18.3 per cent by 2017 may help finance rising expenditure. However, already in 2002, the proportion of pension contributions that are evaded was 37 per cent - well above the level assumed in the government's projections - and the increase in the contribution rate may further reduce participation in the system and weaken work incentives. The 2004 reform is projected to reduce the pension benefit replacement rate from 59 to 50 per cent - the minimum level allowed - over the next two decades. Contribution rates should not be raised further, even if unfavourable developments were to require lower replacement rates. Moreover, reforms are needed to slow the growth of public spending on health and long-term nursing care. Given the challenge of limiting social security expenditures and rising interest payments, significant cuts in discretionary outlays are required to achieve the spending ceiling. In particular, public investment, much of which is characterised by low efficiency, should be cut further. At 5 per cent of GDP, public investment remains above the OECD average of 3 per cent.

Achieving the target of freezing public expenditures as a share of GDP will be challenging in the context of population ageing, as well as rising interest payments. Consequently, the necessary fiscal consolidation - more than 5 per cent of GDP - will require increases in government revenue, which, at 30 per cent of GDP, is among the lowest in the OECD area. To increase revenue, the government should put more emphasis on closing loopholes and streamling tax relief and allowances so as to broaden the tax base, thus limiting the extent of tax hikes, which have negative effects on growth. Nevertheless, given the size of additional revenue that is needed, higher tax rates will be necessary, particularly for the consumption tax. However, the timing of such increases should take into account economic conditions.

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