Reconstructing the Governance of the Government Through Fiscal Policy and Budgetary System

Consulting Fellow, RIETI

The Differences in the Arguments over Fiscal Policy

As the fiscal deficit expands, debate continues between those who argue that "the economy should first be stimulated through active fiscal policy" and those who maintain that "fiscal reform should have priority," but I believe that such conflicting approaches threaten to blur the real focus of the issue. The essence of the problem lies in the defective governance of the state, in that the government is not doing enough to ensure efficient and effective budgetary allocation in line with the authority it has been given by taxpayers. Deciding on the scale of a supplementary budget when the effectiveness of the initial budget remains unclear is like drawing water with a bucket that has a hole, and calling for fiscal reform without a game plan for the entire economy is asking to have "the tail wag the dog." What is crucial is having a view to establishing a mechanism in the administrative body that uses limited resources effectively in the pursuit of finding how to build a sustainable socioeconomic structure to cope with the encroaching graying society.

For example, when we look at the supplementary budgets of recent years, it is difficult to agree that there is a rational decision-making process at work. The amount of fiscal funds needed to make up for the short-term fall in gross domestic product is decided amid political maneuvering, but this does not mean it is always decided through sufficient comparative consideration of its effect and opportunity cost (including sustainability and distribution among future generations). This tends to make those involved more inclined to place priority on content that looks good, making the figures as large as possible, but there is insufficient verification of the results of budget execution, and it is difficult to put the finger on where responsibility lies. Public works-related outlays are especially prone to such padding and increased during the 1990s, but productivity in the construction sector and of social capital stock has continued to fall. Moreover, in the latter half of that decade employment also decreased, and the economic models of the Cabinet Office show that their multiplier effect is on the decline. Bond issuances, which averaged an annual ¥8 trillion during the five years from 1988, have surged to some ¥35 trillion every year for the past five years, but if moral hazard and adverse selection increase, and autonomous recovery is hampered as a result of deepening dependence on fiscal policy, then the cart is being put before the horse. It is highly questionable whether the presuppositions of Harvey Road, pointed out by Keynes himself (on intellectual administrators, in other words, the presence of a rational system for making policy decisions), actually exist in this country.

As this shows, when considering fiscal policy it is first necessary, before anything else, to verify the government's decision-making structure regarding budget allocation. This is nothing less than questioning what governance of the state ought to be.

The Many Problems with Japan's Budget Process

By 2030, the nation's working-age population will have decreased by some 10 million from current figures and every two people who are still active will be supporting one senior citizen, according to the government's medium variant projection. In the future, the greatest pressure on the fiscal front will come from social security-related outlays such as pensions, medical costs and nursing care, and we cannot draw a picture of our economic or social future without stabilizing the balance of income and expenditure in this area. On the other hand, unless the economy itself regains productivity through such means as structural reforms (increasing the liquidity of economic resources), the fiscal deficit will rise due to a chronic tax revenue shortage. Similarly, simulations based on long-term macroeconomic models make it clear that the Japanese economy cannot become self-sustaining unless both the economy and the fiscal situation are reformed. In addition to reforms of systems, such as local finance that involves warped incentive designs and social security benefit levels, answers as to how to create a framework for discretionary outlays and, furthermore, special accounts that do not waste the taxpayer's money (budget process management) will come to be much sought after. (This will be all the more so later on once debate over the raising of consumption tax heats up.) From this viewpoint, the following problems can be pointed out.

First, despite having a stringent advance screening process, ex post facto budget evaluation is ambiguous and responsibility for results is unclear. The draft budget is compiled with much time and labor on the part of the screening authorities, and the government ministries and agencies making the requests. However, once the budget is enacted, it is difficult for anyone to be held responsible for the results of its implementation. While the final settlement of the budget is deliberated in the Diet two fiscal years later, after passing through the Board of Audit, it is unlikely that many people would be interested in a past budget. Furthermore, it is highly likely that, by the time of discussion in the Diet, those responsible for both the screening and requesting of the budget have been moved in personnel reshuffles. Despite the huge agency cost, there is no mechanism to reward it.

Secondly, because the budget is formed from the bottom up, it is difficult for it to be distributed strategically. Even over the past several years, there has been very little change in the budget's composition in terms of principal expenditures, appropriation to government agencies, and application of it. (The only slight difference that can be seen is the rise in social security outlays for the Ministry of Health, Labor and Welfare and the decline in public works spending by the Ministry of Land, Infrastructure and Transport.) But looking pragmatically from the point of view of the screening authorities, drastic changes in the distribution of money which could lead to the shouldering of responsibility on a political level are difficult to make, and it cannot be helped that inertia exists as a result of uniformity and the desire to secure more of the budget pie.

Thirdly, there is the issue of the time base. The government's economic projection for a particular fiscal year is decided in December of the previous year, in parallel with the formulation of the government's budget draft, and the mid-term projection, which covers a five-year period, is released in January the following year. However, normal logic would have it that the mid-term plan be decided first, after which the projections for individual fiscal years are drawn up.

Fourthly, there is the problem of inefficient budget execution that stems from rigid procedural regulations. For example, the rationality behind requests for carry-over expenditures must be explained to the Finance Ministry's Budget Bureau, but the benchmark for rationality is unclear, and it is difficult to predict whether the request will be granted or not. (Furthermore, because in recent years a supplementary budget is almost always compiled in the fall, this procedure for carrying over funds must be carried out soon after the initial budget's enactment.) As a result, there is the incentive to use up the budget before the end of the fiscal year, even if a portion of it turns out to be unnecessary. A study of the procedure for carrying over outlays, in connection with a certain research and development project, showed that it took five months for paperwork, such as drawing up a statement of accounts and requesting authorization, to go back and forth between the firm to which the project was assigned, the government-affiliated organization that assigned the work, the government body that supervised the project, and the authorities which screened the budget. This is quite a burden for those involved. This is not just a problem for those conducting the screening, and while partial efforts to improve the situation can be observed in recent years, so long as there is a system, there is a tendency to avoid the procedural burden at every checkpoint. While I am not saying that everything should be left to discretion, regardless of the relative importance of the procedure, its substantial cost is an issue.

Finally, the belief that securing more budgetary funds will be highly regarded on the personnel evaluation front still stubbornly exists. There is no motivation for each individual civil servant to actively reduce unnecessary expenditures and so, the budget tends to expand.

If I were to simplify the points mentioned above, I would say that the problem stems from inconsistencies among three factors - the mission (duty and role), authority (regulation and discretion) and responsibility (rewards for results) of an organization. For example, we can see such problems as: 1) no concentration or dispersal of authority among the Prime Minister's office and the Council on Economic and Fiscal Policy, the Ministry of Finance, and those ministries and agencies making budget requests in line with their respective individual missions (formulation of basic economic and fiscal strategy, fiscal management and effective execution of assigned duties); 2) no committed responsibility that matches the top-to-bottom authority of decision-making, in line with the internal power-relationships of both those screening and making the budget requests; and 3) no means for dealing with those responsible for results, nor in accordance with their level of responsibility. Added to this is the difficulty of achieving a system which points the finger at individuals, as opposed to organizations. This, along with the complementary relationship of the bureaucratic personnel system, which couples long-term employment with short-term rotations, is probably bringing about a "compound fracture" of the incentive system.

The Framework for a New Budget System

Western countries also suffered chronic fiscal deficits in the 1980s, but they undertook fiscal reforms in the 1990s, and coupled with economic growth they were successful, unlike Japan, in reducing expenditure levels. In Anglo-Saxon nations, especially, this review of fiscal policy was conducted through a method called new public management (NPM). NPM was initially a form of administrative management aimed at providing effective and high-quality public services to clients - namely citizens. However, can this concept which makes good use of ideas from the management of private sector firms, such as result-oriented evaluation and competition, not also be applied to the governance of a government? I believe the time has come to consider an organizational design that goes further than NPM, and is based on the following opinions. (note)

First of all, on the matter of making autheachority and responsibility consistent, we need to introduce political responsibility - in other words, a system in which decisions are made at the center of government, and move from the top down. For example, the Prime Minister's office should take the initiative in setting a mid-term fiscal program that dictates the distribution of resources for each major expenditure. This program should reflect economic and tax revenue projections based on an objective and highly transparent model crafted by the Council on Economic and Fiscal Policy. Revolving around the mid-term plan, the finance minister and the ministers of each government office should sign "contracts" for budget amounts necessary for certain policy goals, on the basis of each item. After ministerial-level agreements are reached in broad areas, details are gradually meshed out at lower levels of the bureaucracy. The budget screening authorities need not devote their time to checking specific estimates, but conduct policy discussions with each ministry based on request content to see how policy objectives can be achieved. This concept distributes commitment so that it matches the level of the budget discussed and the posts of the people involved.

Secondly, as for making authority and mission consistent, the budget needs to be made into a "flexible structure," through applying pressure to reduce the total budget while giving those doing the actual work free rein in deciding individual budget items. The work of the screening authorities should be concentrated on reducing the total budget and controlling major expenditures. Meanwhile, the budget can be utilized more effectively if decisions on whether to increase or cut individual items are made under the responsibility of the ministries and agencies in charge of their execution, as they possess the most information regarding the policies in question. As was the case with the Fiscal Structure Reform Law, enacted under the Cabinet of Prime Minister Ryutaro Hashimoto, a rigid structure that simply outlines detailed reductions for individual expenditures and only applies budget reduction pressure will tend to fail as it leads to friction between the screening authorities and the other ministries and agencies. On this point, for example even on issues such as multiple-year budgets and comprehensive budgets, there is plenty of room for innovation to realize the public's need for efficient budget execution that does not infringe upon Article 86 of the Constitution, which stipulates that the Diet deliberate the state budget each fiscal year. Some examples include the readjustment of budget items, increasing the flexibility of fund diversions and carry-over expenses, and the malleable application of rules regarding continued expenses and contract authorization. It is important to lower the cost of procedure through regulation and raise predictability. As for creating a system to correct the practice of distributing the budget vertically among ministries and agencies, and instead reallocating the budget more flexibly in strategic areas, the Prime Minister's office can exert leadership and draw up rules, based on guidelines set by the Council on Economic and Fiscal Policy, for priority distribution; for example, establishing a structural reform fund using a portion of the annual budget that has been slashed.

Thirdly, to harmonize mission and responsibility, we can shift from ex ante screening to ex post facto evaluation and disclose information regarding the budget compilation process. While easing budget restrictions on the one hand, ex post facto monitoring is essential. To achieve this, we need to establish a system to evaluate the results of budget execution and the degree to which policy objectives were met. At present, such an experiment has already begun with the operating budgets of incorporated administrative agencies, but in fact, there are many difficult problems, including how to set numerical targets and how to evaluate the degree to which objectives were achieved.

As shown in the model projects included in the policy package unveiled by the Council on Economic and Fiscal Policy this time around (albeit still lacking in terms of plans for incentive), it is important to maintain an approach of accumulating the best of what is learnt through repeated trial-and-error. What is needed is the creation of a forum in which exercised authority and responsibility are conformed, in other words, the creation of a framework that guarantees high transparency regarding information relevant to the decision-making process. The point is to clarify who will take responsibility and exclude from the process the interference of those in power who do not have the proper authority. As for the former, we can clarify accountability, for example, by having senior officials at the ministries that made the budget requests explain the extent to which policy objectives were met, and disclose the manner in which such explanations were reflected upon in the budget's screening the following fiscal year. As for the latter, one idea is to set up rules governing the clarification of the management of documentation at administrative organizations, as well as the reporting to ministers and appropriate disclosure of mediations by people such as politicians. Of course, as a condition, it is essential that a proper accounting system be in place. It should also be noted that securing the transparency of information regarding the budget process can be accelerated through the electronization of the management of budget results.

The Real Significance of Constructing Governance

The ideas stated above are a scheme that combines concentration and dispersion by: 1) strengthening the authority of the Prime Minister's office over such basic items as the distribution of resources among major priority areas; 2) securing the authority of the finance minister in managing the basic fiscal framework; and 3) allowing the individual ministries and agencies, that have the relevant information, to manage individual budgets to some extent. Through this, at a broad level we can exclude the moral hazard brought about by the asymmetry of information through concentration, while dispersing authority at more detailed levels where concentration would lead to a relative increase in screening procedural costs. This would give each module (the executing ministries and agencies) an incentive, and therefore make it possible to realize the nation's goals in an efficient manner. I repeat myself, but the key to such a scheme lies in the extent to which a framework where responsibility is made consistent with authority (be it concentrated or dispersed) can be guaranteed. One way to tackle this may be to redesign the system for bureaucratic personnel. For example, increasing the liquidity of human resources (such as increasing the opportunities for national civil servants to work outside their ministry or agency and hiring people from the private sector as senior-level bureaucrats) will be significant in correcting the time lag structure among the three factors that stem from incomplete contracts. Currently, study of the balance between diversity and homogeneity is being undertaken in the area of complex systems, but such an area of research could also be applied to organizational design.

The issue of governance will not simply stop at making fiscal policy more efficient. For Japan to continue enjoying peace and prosperity without triggering another unfortunate war, it must have national strength so that it does not fawn upon other major powers, even if the country's foundations lie on the bilateral security arrangement with the United States. In Japan's case, this means nothing less than building economic power. Indeed, it is through economic power that Japan will be able to forge a mature relationship with China, avoid the dangers posed by a dictatorial state, and encourage the development of free and liberal societies in Asia. Economic strength is the total strength brought about by the appropriate distribution of economic resources such as people, goods, money, technology and information. In order to maintain this in a society in which the population will decline, it is imperative to establish a "tough yet supple" economic model that provides a good balance between efficiency, fairness and diversity (the ability to deal with risk). To do so, the government, which is in charge of national strategy, must itself have a decision-making process that has flexibility and mobility so it can deal with changes in the environment and resist shock. The 21st century is an era in which even the governance of a government itself is exposed to international competition.

July 15, 2003

This column mainly focuses on the decision-making structure of the administrative arm of the government, but needless to say, it is of foremost importance that the relationship with politics be sorted out. In Japan's case, pertinent issues for discussion include opaqueness in commitment to and responsibility for election pledges and the term of their realization, as well as the coevolution of the ruling party and the bureaucracy within a system where it is rare for power to change hands.

July 15, 2003