Economic and Fiscal Policy Agenda for 2007

Three months have passed since the inauguration of Prime Minister Shinzo Abe. In December 2006, the Council on Economic and Fiscal Policy (CEFP) unveiled a draft of the "Course and Strategy for the Japanese Economy" which is to set a framework for medium-term economic and fiscal policies under the new administration. In this column, I would like to examine economic policies under the Abe administration, as indicated in the Course and Strategy, as to how they differ from those under the preceding administration of Prime Minister Junichiro Koizumi, and what challenges Japan faces this year in fiscal and economic policies.

The core concept of the Course and Strategy is to improve and strengthen the growth potential of the Japanese economy; embodying Abe's slogan, "Japan can have no future without growth." On the other hand, Koizumi's familiar slogan was "no growth without reform." So, what are the differences between these two slogans? In his inaugural address, Prime Minister Abe expressed his determination to "keep the torch of reform burning." Thus, he has inherited his predecessor's desire to pursue reform. The Koizumi administration prioritized reform as a means to put the Japanese economy on a new growth course and therefore its ultimate goal was to achieve growth.

If I venture to highlight the differences between the two administrations, I would first point out that the Abe administration is distinctive in defining growth as "leverage" or the "driving force" for implementing further reform. The areas of reform that were left undone by the Koizumi administration are difficult ones and Abe will feel the walls getting higher around him as he tries to proceed with further reform. A kind of "flywheel effect" is now needed to overcome these walls. For instance, bolstering macroeconomic growth potential would help alleviate the sense of inequality, which has become pervasive in Japan over the past several years, by expanding the size of the economic pie and thus enabling everyone to get a bigger piece.

The same holds true for fiscal reconstruction, as Prime Minister Abe rightly puts it in his slogan, "no fiscal consolidation without growth." If Japan manages to post relatively sizable growth in the coming five years, the government's medium-term target of achieving a primary balance surplus in fiscal 2011 would be attainable without increasing taxes. At the time of formulating the Basic Policies for Economic and Fiscal Management and Structural Reform 2006 (Basic Policies 2006), the amount required to achieve that goal (the size of fiscal deficit that must be eliminated by reducing expenditures and/or increasing revenue) stood at ¥16.5 trillion. Now that the combined tax revenue of the central and local governments for the ongoing fiscal year is certain to exceed the initial estimate by more than ¥3 trillion, a simple calculation shows that the remaining deficit would be eliminated by fully implementing the expenditure reforms stipulated in Basic Policies 2006 - a reduction in expenditures of ¥14.3 trillion in five years.

The second distinctive feature of the Abe administration is its advocacy of a result- or performance-oriented approach. The Japanese economy is not a planned economy and the administration, by making economic growth the top policy goal in such a setting, has virtually made itself open to evaluation based solely on the "result," namely, its ability to achieve the intended growth. In contrast, Koizumi's slogan of "no growth without reform" was meant to be a commitment to subjecting his administration to evaluation based on its reform efforts. In other words, Koizumi left himself an "escape route." Had the economy failed to grow, he could have claimed his administration had done its job by making the utmost reform efforts and it could not be helped if, after these efforts, the economy still failed to grow. Unlike his predecessor, Abe seems to have cut off his own escape route, rushing headlong toward consequentialism.

Abe has voluntarily left the fate of his administration to the performance of the economy. So then, what sort of economic and fiscal policy agenda should such an administration be pursuing? In the area of fiscal policy, the very prospect that the government's medium-term target of posting a primary surplus will be achievable even with no tax increase is provoking new concerns over whether this brighter-than-expected prospect may result in a loosening of fiscal discipline, and some are arguing for a new target to pursue further fiscal consolidation. However, the Course and Strategy adheres to the integrated reform of expenditures and revenues as set out in the Basic Policies 2006. In addition, the strategic guideline has almost entirely incorporated the five principles for budget formulation and the mechanism for ensuring the achievement of the medium-term target by annually examining and recalculating the amount of fiscal deficit proposed by the private-sector members of the CEFP on November 24, 2006; a move that signals a major step forward. The five principles - particularly those calling for using any increase in tax revenue for the purpose of reducing future burdens, accelerating fiscal consolidation while the economy is booming and tax revenue increasing, and financing in principle any new expenditure item by cutting expenditures in other areas - would bring considerable fiscal discipline. Also, by committing itself to achieving fiscal consolidation without tax increase, the administration is left with no room to compromise on the self-imposed target of delivering the maximum possible benefits of the expenditure reform (reducing expenditures by ¥14.3 trillion in five years). It is expected that this commitment will head off mounting pressure for greater expenditures from the "forces of resistance" anti-reformists within the Liberal Democratic Party.

Also, any new target for fiscal consolidation should be considered in line with the ideas underlying the Basic Policies 2006 and the Course and Strategy. That is, rather than devising something beyond the context of the ongoing policy framework, the government should consider and set a new such target from the viewpoint of how its goal of steadily bringing down the public debt to GDP ratio toward the mid-2010s can be achieved; a prerequisite to ensuring fiscal sustainability. With respect to the expenditure reform, the Basic Polices 2006 call for transforming the tax system into the one "constitutionally capable of attaining the (aforementioned) medium- to long-term target ... in a structurally sustainable manner." Therefore, changes to the consumption tax system should be discussed from the viewpoint of ensuring an adequate level of primary surplus sufficient to prevent the public debt to GDP ratio from rising.

The shrinking labor supply, a logical consequence of declining fertility and hence a decreasing and rapidly aging population, stands to constrain the Japanese economy. Given such a prospect, the nation's growth strategy - one of the two main wheels, together with fiscal consolidation - should be centered on productivity reform, which would raise the productivity of the economy as a whole. In ongoing discussion in the CEFP, productivity reform is defined as one of the seven major reforms. However, it would be more appropriate to define productivity reform as a combination of various reforms because all such reforms will ultimately impact economic growth.

Yet, one must not be deluded into thinking that the government can freely manipulate private-sector productivity by devising certain policy measures, as if under a planned economy. To begin with, the government must clearly recognize that the private sector spearheads the implementation of productivity reform. The ideas that there can be no increase in the standard of living without improving productivity and that human capital is the very basis of productivity improvement must be widely shared, whereby nationwide momentum for both the government and the public sector to jointly make a long-term commitment to improving human capital (productivity) must be built. This should be the starting point for productivity reform.

On that basis, what specific roles should the government play in bringing about productivity reform? First, it needs to ensure sound management of macroeconomic policy so the private sector can work on productivity reform from a long-term perspective without worrying about sudden changes in government policy. Second, the government should support private sector initiatives in productivity reform by undertaking efforts in areas where the private sector cannot play a role, for instance, through the development of institutional infrastructure (enhancement of intellectual property protection and relevant enforcement mechanisms, tax reforms, etc.) and the promotion and facilitation of various collaborations between industry, government, and academia (such as university reform). Third, and most importantly, the government must facilitate structural shifts of resources from less productive to more productive industries, thereby achieving an efficient allocation of resources (industrial and organizational realignment, labor mobility, resource allocation, etc.), and strive to eliminate or alleviate regulatory obstacles hampering innovation (bottleneck problems). In particular, it is of great importance for the government to craft a design for the comprehensive reform of labor market and relevant institutions. The resulting new system should allow for more diverse and self-controlled work styles based on the autonomy of labor-management relations (which will be realized by shifting from the existing centralized system to a decentralized system) and be able to improve the quality and efficiency of the labor market (hence, increase workers' bargaining power). RIETI is fully aware of the importance of this problem and is currently preparing to launch a new research project toward that end. It is no exaggeration to say that human capital reform is the essence of productivity reform. I hope that this year will serve as a starting point for full-scale human capital reform.