Fiscal Problems and Organizational Reform

Consulting Fellow, RIETI

Looking back on the Fiscal Reform Symposium

The Policy Symposium "Fiscal Reform of Japan: Redesigning the Frame of the State" was held on March 11 and 12 under the auspices of RIETI. From the outcome of the symposium, I find three major implications in the methodology of it.

First of all, this symposium presented a unique approach to addressing the problem of administrative compartmentalization. In principle, the officials of one government ministry should not intervene with issues which fall under the jurisdiction of another ministry or agency, as they have no capacity to account for the outcome. This, however, does not apply to cases in which bureaucratic sectionalism poses a major obstacle to problem solving, thereby undermining national interests and imposing burdens on future generations. The problem of fiscal deficits is one typical example. And in solving such problems, it is important to mobilize resources and expertise across administrative boundaries. In this regard, it is quite meaningful that RIETI, a quasi-governmental research institute located in the midst of the Kasumigaseki central administrative district, shares a sense of crisis regarding these problems with those sent by the government ministries and agencies concerned, initiates and deepens constructive discussions based on the relevant data and theories, and then disseminates the outcome.

Secondly, the symposium provided an occasion for dialogue between two different domains, namely, administration and academia. In Japan, tacit knowledge accumulated by administrators concerning policymaking procedures is hardly codified and made public. Also, it is often the case in Japan that researchers propose and advocate unrealistic ideas while cocooned in the ivory towers of academia. The result of this is that huge opportunities are lost. In this fiscal reform project, which culminated in the symposium, researchers exclusively affiliated with RIETI, administrators from the Ministry of Economy, Trade and Industry as well as from the Ministry of Finance, university professors and those with business backgrounds gathered together and discussed face-to-face. Inspired by the views of those with different professional backgrounds, participants had very stimulating discussions, from which various innovative ideas and diverse theories emerged. At the same time, care was taken to prevent debate from becoming unrealistic and irresponsible. Specifically, the government officials explained the realities of the policymaking process while the scholars organized various arguments and opinions in the light of theories. The positive synergy of non-collusive and competitive interactions between industry, academia and government was observed.

Thirdly, the symposium demonstrated the effectiveness of institutional analysis. Important issues that concern more than one ministry cannot be solved by implementing patchwork policies or resorting to reform measures that focus only on one specific aspect. The concept of institutional complementarity is very effective for sorting out and organizing such complex problems in an integrated manner. It is very much expected that institutional analysis will be utilized in analyzing a number of policy issues, and not be limited to just those in the area of fiscal problems.

Fiscal reform and organizational theory

Under this fiscal reform project, RIETI Fellow Hirokazu Takizawa and I worked on the theme of "Why does the government's budget balloon and how can it be curbed?" from the viewpoint of bureaucrats' incentives. In other words, we looked at fiscal problems in the light of organizational and institutional theories. Fiscal discipline is a matter that concerns the decision-making of the state. It is therefore necessary to examine the complex interactions between various factors, ranging from the long-term relationships among government officials, lobbyist politicians representing specific interests and industry groups, to competition among government ministries in capturing policy resources and its effects on political rules as well as on the general public. This time, we constructed our argument by focusing on the structure of bureaucrats' incentives. (In using the term "bureaucrats," I refer to the so-called "career bureaucrats," those classified as "category I" national government officials. For analysis on the dynamism of politics and its relations to the general public, please refer to "Two Aspects of Japan's Bureaucratic System as Seen in Fiscal Procedures" presented by Faculty Fellow Jun Iio and "The Role of Public Awareness in Fiscal Reform" by Fellow Mieko Nakabayashi.) We have shown that various correlated factors - the coevolution of bureaupluralism (compartmentalized pluralism) and industrial structure in the postwar high-growth period, the continuation of single-party rule, customary long-term employment practices, and so forth - are forming the kind of strategic equilibrium where it is optimal for bureaucrats to pursue tactics to grab greater budget allocations. In drawing up an effective reform plan, it is very important to analyze incentives driving the behavior of the players concerned and identify which buttons to push.

Immobile personnel management system

We particularly focused on the point that the incentive structure for bureaucrats can be completely different depending on whether the employment and personnel management system allows career mobility. For instance, the current personnel system under which each government ministry takes care of the placement of retiring officials (this is called "compartmentalized immobile personnel system") can be defined as ministerial familism with each government ministry behaving and managed like a communal family. Under such a system, each ministry official is assessed on his or her performance in budget-related tasks and other assignments based on his or her reputation circulated and shared within the ministry. And this helps overcome the problem of information asymmetry to some extent. Ministry officials, for their part, can invest in themselves to improve their skills for ministry-specific tasks without any regard for displacement cost. At the same time, however, this kind of familism makes it mandatory for each ministry to constantly secure jobs for both employees and retirees, thereby creating an environment where norms designed to maintain and expand organizational resources are apt to emerge. Thus, under a soft budget constraint, each ministry has an incentive to compete for budget allocations, a key organization resource. Meanwhile, from the viewpoint of individual ministry officials who are engaged in multiple tasks, it is generally difficult to have their specific performance evaluated and budget-grabbing is one of very few tasks in which they can show results in a visible manner for evaluation. And reputations regarding their budget-related performance tend to be circulated within the ministry as well as among politicians and those in the relevant industry groups. These factors provide compelling incentives for bureaucrats to race for budget allocations. At the same time, the "shared expectation" (whether true or not) would form among bureaucrats that they would receive poor scores for their performance if they failed to secure sufficient budgetary allocations, whereby the self-enforcing nature of their behavior, such as that seen in the Prisoner's Dilemma, would become evident.

As such, and with external opportunities limited due to the prevalent practice of long-term employment, incentives for ministries and individual ministry officials have grown in the same direction. Such a budget-grabbing policy would not necessarily be bad in a situation where significant fiscal needs exist, for instance for infrastructure construction and so long as tax revenue continues to grow, as was the case in the postwar high-growth period. Present Japan, however, is in no such situation. Watching nearly half the national budget be debt-financed, many Japanese taxpayers are questioning the way in which budgets are allocated and the efficacy of fiscal expenditures. The existing incentive structure is problematic in a sense that it aggravates the common pool problem (the problem of free-riding in which the government would be induced to make fiscal expenditures for the partial interests of a specific industry or region that is not making its share of contribution).

Then, if we put an end to the ongoing practice of long-term employment and implemented a system that gave greater career mobility to government officials, would it solve the problem? Unfortunately, things are not that simple. If we were to shift completely to a political appointee system, such as the one in the United States, the cost of performance evaluation and monitoring would become exorbitant because of the problem of information asymmetry (and therefore such a system would likely be replaced by short-term numerical targets). Also, individual bureaucrats would become less motivated to invest in themselves to improve their skills, as required by their respective organizations. Far worse, as administrative members would come and go after each national election, bureaucrats might begin busying themselves with post-hunting activities, reviving the practice of their prewar predecessors. Indeed, this is what makes organizational reform difficult. The following table shows that the structures of bureaucratic organization and the personnel system, evaluation system, and incentives for individual bureaucrats are inseparably linked with each other and form complementary relationships with one another. This fact must be fully taken into account in reforming the organizational structure and personnel system.

Complementary structure of personnel management system for bureaucrats
 Immobile personnel management systemMobile personnel management system
Recruitment- Internal recruitment.
- Demand equals supply = All employees have their own post and all posts are filled by internal members.
- External recruitment.
- As a premise, external job market must allow for sufficient job mobility.
Personnel management authority- Because demand equals supply, the division in charge of personnel affairs has full authority over personnel adjustments.- Personnel best qualified for specific tasks are recruited from outside. Each relevant division possessing the most information about specific tasks has direct authority.
Organization's incentives- It is important to secure enough organizational resources (such as budget allocations and regulatory authorities) to provide for all the employees so as to make them work faithfully for the organization. Continuation of the organization is essential.- It is important to produce results within a certain period of time and fulfill accountability obligations. Preparing evaluation standards and securing talented personnel capable to produce results are necessary for achieving this.
Individual bureaucrat's incentives (degree of loyalty)- Self-investment for improving organization-specific skills
(external opportunities shrink as a consequence).
- Organization's continuation and improvement of its status
Organization's incentives match those of individual bureaucrats.
- Securing salaries and remuneration of an amount matching the degree of effort made.
- Studying and self-investing for one's own future, defining the current career as a stepping stone.
Responsibility- Each organization provides its employees with an implicit guarantee for continued employment and job placement after retirement.- Individuals are responsible for finding a new job by themselves.
Level of effort and productivity- With their post guaranteed, employees feel comfortable with investing in themselves to improve organization-specific skills, whereby skills and know-how are systematically handed down. Productivity will be enhanced in the initial stages but may go down afterward due to free-riding and moral hazard.- In an environment that allows for full job mobility, productivity remains dynamically stable.
Evaluation system- Employees are evaluated on their accumulated credibility based on "reputations" within the organization and among relevant external parties. Substantive evaluation can be made at a low cost.- Employees are evaluated against formal criteria such as numerical targets or goals. Measures have been developed to compensate for the shortcomings of such formal evaluation.
Negotiation cost- Entrusted to the discretion of the division in charge of personnel affairs, but on the premise of implicit job guarantee.- Employees negotiate with their supervisor for the renewal of job contracts and salaries for each term.
Discipline and norms- Discipline is to be maintained by means of mutual monitoring within the organization. However, there is a possibility that internal collusion pervades the whole organization and results in the loss of discipline (systemic cover-up).
- Actions and behavior that contribute to the securing of organizational resources (e.g. budget allocations) are apt to be established as a norm.
- Discipline is to be maintained by means of clearly-stated rules and penalties supported by institutionalized monitoring and information disclosure systems.
Relationship with politics- Independence from politics can be maintained relatively easily. Under a single party rule, however, informal interventions by concerned parties tend to occur.- Administration acts more in tandem with politics (e.g. political appointees) but there is a greater likelihood for bureaucrats to become engaged in post-hunting activities.

(Note) Organizations with greater human resource mobility are divergent in nature, while those allowing for little mobility are convergent and rigid. Put in terms of complex system theory, the boundary between them (self-organized criticality) is deemed to be an unstable equilibrium.

Organization's mechanism for the restoration of discipline

How can we minimize the negative aspects of an immobile personnel management system (the loss of discipline as a result of communal collusion, the formation of norms for securing organizational resources, i.e. in this case a budget-grabbing policy), while maintaining the positive aspects (the lower cost of evaluation by means of mutual monitoring, employees' incentives for self-investment for the benefit of the organization)? In the case of private-sector companies, market discipline functions as a mechanism for ensuring optimum allocation of resources. A mechanism for restoring internal discipline, which is an alternative to the market, exists for administrative organizations.

As mentioned above, an organization's activities to maintain and expand its organizational resources often evolve in tandem with budget-grabbing policies. Such organizational activities, however, are subject to the restriction that they must not go against public interests in a broad sense. (Here, I do not go into the question of what are these "public interests" are, although it is a very profound question.) When a certain ministry comes under fierce public criticism with many people coming to see the ministry's behavior to expand the organization as self-benefiting and not serving national interests, the social status of the ministry goes down and so does the overall value of the ministry's organizational resources. This mechanism of criticism comes to the fore and functions particularly on occasions when the government's commitment to the public is tested, for instance, when there is a change in the political regime or when a major scandal has been revealed. When this happens, each relevant ministry corrects its behavior and reinforces measures to pursue public interests. (However, because bureaucrats are transferred from one post to another in a relatively short period of time, every two to three years, there is often a substantial time lag before the ministry as a whole wakes up to its responsibility to the public and takes necessary actions.)

This mechanism - under which government ministries pursue public interests while mediating the other various interests under their respective jurisdictions - is called bureaupluralism (Aoki 1988) and is closely related to the non-mobility of the personnel management system for bureaucrats. For instance, let us say that a certain government ministry comes under public criticism and its social status goes down. If there were a labor market that allowed for extremely high career mobility (such as the one similar to the classical labor market), employees of the ministry would have the option to exit (find a new job). However, when there is little mobility, it is very difficult to opt out. Under such a situation, there is a possibility that ministry officials - under pressure from the Diet and the general public - embark on an organizational reform to restore the social status of their ministry. And this is how an organization restores internal discipline through a self-evolving mechanism. The Political Economy of the Japanese Financial Big Bang: Institutional Change in Finance and Public Policy authored by Tetsuro Toya provides detailed and concrete analysis of this dynamism. Also, America Kaiheitai ("The U.S. Marine Corps") (Chuko Shinsho, 1995) by Ikujiro Nonaka depicts how the U.S. Marine Corps has been able to self-innovate by continuously redefining its mission.

Reform of bureaucratic organizations and their personnel systems

From what I have argued above, the following conclusion can be derived. In order to prevent the loss of discipline, a defective aspect of long-term employment, while maintaining the beneficial effects of the system, it is necessary to have a built-in incentive system for bureaucrats to expose any problem or crisis at an early stage so that those in charge share the same recognition and quickly act on the problem or crisis, thereby facilitating the proper functioning of a discipline-restoration mechanism. I explain in more detail in the Discussion Paper "Why Does the Government's Budget Balloon and How Can it be Curbed?: Focusing on Incentives for Bureaucrats," but here I would like to provide a brief summary.

Firstly, the budget process must be made transparent and implemented in line with rules that enable adequate evaluation of budget-related performance of bureaucrats as well as clarifying where responsibility lies. Introducing a rule-oriented document management and disclosure system, such as the one included in the Ministry of Foreign Affairs' organizational reform plan, may be one way to prevent politicians from informally intervening in the personnel reshuffles within government ministries and agencies. Also, we should not fall into formalist arguments over the choice of ex-ante versus ex-post evaluation. Instead, we should discuss how we can reinforce the mutual monitoring function of the immobile personnel system so as to enable substantive evaluation at a low cost. For instance, by having budget execution performance reflected in the assessment of budget requests in later years, we can create an environment where information concerning an individual bureaucrat's performance - not only in terms of the amount of budget allocation secured but also in terms of efficiency and tenability in budget execution - would be circulated and reflected in personnel evaluations. Furthermore, internal evaluation can be refined by adding external monitoring functions such as those played by external board members or by implementing a multi-faceted evaluation system, for example, a screening mechanism under which an individual is evaluated by his or her senior supervisors, colleagues and subordinates to make it difficult for the individual to manipulate his or her reputation.

Secondly, greater mobility in human resources should be ensured. Although there are several points of argument, here I would like to focus on just one, that is, the way in which individual bureaucrats invest vis-a-vis the organization they belong to. As seen in a recent patent dispute between a private-sector company and its former employee, it is extremely difficult to dissolve relationships between an employer organization and its employees under the long-term employment system. Therefore, in order to facilitate personnel mobility, it is important for individual employees to routinely build their capability in a way so as not to become overly dependent on their employer organization. In the case of a government organization, this would help prevent excessive inclination toward budget-grabbing policy. (Given the aging of the bureaucratic population, those holding authority over personnel affairs do have incentives to create such an environment.) In this regard, it is a worthwhile idea to let government officials turn their tacit administrative know-how - such as that on policy planning, international negotiations and so forth - into a certain form of explicit knowledge as part of their routine work. For instance, a government official who has completed a two-year term in one section might be given a one-month moratorium period before getting transferred to another section to compile a policy report or a book. This would be beneficial to the future of the organization as well as to the individual concerned (though it depends on the individual's awareness of his or her function). Dissemination of useful analysis also benefits the general public.

As discussed above, organizational and personnel system reform is an unglamorous yet long-lasting task. Simply doing things that are opposite to the status quo under the banner of reform is no good. It is important to make efforts to prevent the deterioration of the existing self-correcting mechanism by "partially" implementing such measures as the introduction of external staff, the exploration of the mid-career recruitment market, and the promotion of personnel exchanges on a senior official level. Unlike under a classical perfect labor market, self-motivated organizational evolution takes place intermittently in an immobile organization. Delay in putting a discipline restoration mechanism into motion would result in greater pain in reorganization. Metaphorically put, what is important is to design a mechanism for inducing minor earthquakes to release the tectonic energy so as to prevent a major earthquake.

April 27, 2004

April 27, 2004