Japan has become a mature society and we are beginning to see limitations in the ability of uniform policies at the central government level to grasp the detailed needs of each region. Against this backdrop, the reforms that have received the most attention in recent years are reforms of local public finances geared toward decentralization. Decentralization aims to create more efficient fiscal management and local governance by: (1) delegating authority and responsibility for raising revenue to local governments; (2) reducing the involvement of and regulation by the central government; and (3) introducing the principle of competition to local governments. The idea behind these reforms is that it is better to give authority and responsibility over matters that can be handled locally to local governments and allow the central government to deal only with policies that affect the country as a whole.
Decentralization has moved from the discussion stage to the implementation stage through the so-called Trinity Reforms that will be carried out from fiscal 2004 to fiscal 2006. These reforms were hammered out by the cabinet of Prime Minister Junichiro Koizumi with a view to reforming local public finances, and are based on the idea of reforming three pillars of local government finance in one package: national treasury disbursements under the jurisdiction of individual government ministries and agencies, which subsidize a portion of the public services offered by local governments; local allocation taxes, which are disbursed to local governments under the jurisdiction of the Ministry of Internal Affairs and Communications; and the transfer of tax sources, which would allow local governments to collect taxes themselves.
The limits to reform: the lack of distinction between the roles of the central and local governments
In terms of local public finances, I believe there are two main roles the central government should play. First, it must guarantee the financial means to manage local government finances (maintaining a national minimum). Second, it must make fiscal adjustments so as to correct inequities (ensuring equal opportunity). In order to fulfill the first role, there is the need to discuss what the central government should guarantee as a national minimum, and to clarify the roles of the central and local governments in ensuring this minimum. At the same time, in order to fulfill the second role, it is necessary to discuss the extent to which inequality can be tolerated separately from the issue of guaranteeing revenue sources.
In reality, however, existing systems make it difficult to conduct clear-cut discussions on these issues. In other words, the functions of guaranteeing revenue resources and making fiscal adjustments are entwined within the local allocation tax problem. In this situation, the extent of central government responsibilities is unclear. In the name of guaranteeing revenue, there may be an excessive degree of fiscal adjustment. As a result, local governments become dependent on the local allocation tax. In addition, even for projects properly handled by the central government, there are cases where the ministry or agency with jurisdiction over the matter subsidizes part of the cost, while the Ministry of Internal Affairs and Communications tacitly shoulders the local government's burden; because of the mismatch between the source of project financing and the involvement of the parties, the issue of who is responsible for the project becomes ambiguous.
The aims of the ongoing efforts toward decentralization were to clarify the roles of the central and local governments, and to provide local governments with incentives to manage their finances effectively by making them responsible for their fiscal situation. However, in reality, two numerical targets - reducing national treasury disbursements by ¥4 trillion and transferring more than ¥3 trillion worth of tax sources to local governments - were set prior to any discussions on clarifying the roles of the central and local governments. The aim of the reforms is now focused only on achieving these targets. In addition, with respect to reforming the local allocation tax, which makes the roles of the local and central governments unclear and blocks incentives to manage local public finances efficiently, the current measures have only reviewed how such taxes are calculated and reduced them accordingly. Because regional disparities brought about by the transfer of tax sources to local governments were corrected with the local allocation tax, disbursements of this tax have increased without solving the essential problem of incentives. Thus, while the government has made clear its commitment to decentralization, there has been no discussion regarding the extent to which regional disparities should be tolerated. Also, because tax revenue sources were handed over to local governments without discussion of the issue of central government involvement, far from resolving the problem of discrepancies between revenue sources and involvement, the problem has been aggravated. Under these circumstances, it is not possible to clarify the roles of the central and local governments. In other words, we cannot have a thorough discussion on the level of a national minimum and the central government's involvement.
How the reforms should proceed
Although a detailed discussion is not possible here, I propose a system under which the roles of the central and local governments can be clarified and the issue of how to guarantee revenue sources can be discussed.
Regarding which projects the central government should be responsible for, first, the relevant government agency should disburse 100% of the specified revenue sources necessary to complete the project. Second, there must be an appropriate degree of involvement on the part of the central government, which has been justified by an exhaustive discussion. On the other hand, for projects selected by local governments, first, excessive participation by the central government should be avoided by ensuring that the project is left to the discretion of the local government. Second, local projects should match the cost-consciousness of local residents by financing them through additional taxes paid by the residents themselves.
Below is a tentative proposal for a new set of Trinity Reforms that the government should strive to achieve as the most desirable form of local public finance. As seen in the table, the proposal aims to build sustainable local public finances through a qualitative transformation of local public finances to ensure the central government does not provide ex-post facto compensation for any revenue shortfall on the part of local governments. The proposal is based on the recognition that a comprehensive overhaul of the local allocation tax is necessary through such means as limiting the scope of revenue guarantees offered by the central government; limiting the use of the local allocation tax to fiscal adjustment so as to clarify the division of responsibility between the central and local governments; and transforming national treasury disbursements into subsidies to eliminate excessive involvement by the central government in local government finance.
Table: A New Scheme for the Structure of Local Government Finances
(Goal of the New Trinity Reforms)
Main points of the new reform proposal
First, the present practice of providing broad fiscal guarantees to a wide range of services should be abolished and the scope of central government guarantees limited to ensuring a national minimum for basic services. Basic services would include firefighting and policing, compulsory education, a minimum level of social welfare and disaster recovery, but the same standards should be guaranteed nationwide because if they were left to the discretion of local governments, their supply might fall short of the social optimum, which in turn could adversely affect Japan as a whole. As for additional local public services, the roles of the central and local governments should be clearly separated by having them implemented at the discretion and responsibility of local municipalities.
Second, in order to provide the maximum degree of local autonomy, the fiscal guarantees given for basic services should, in principle, be fully disbursed to local governments in the form of subsidies. Although the fund's use should be limited by sector because it comes from specified revenue sources, specific means of managing the fund (including delegating tasks to the private sector) should be left to the discretion of local governments. In addition to transforming such disbursements into subsidies, the actual basic services provided by local governments (outputs) should be disclosed and a system introduced that assesses performance based on results. As for any increase in subsidies, fiscal discipline should be secured by dealing with such needs by raising taxes locally, thereby preventing unnecessary expansion.
Third, government agencies with jurisdiction over specific projects should be responsible for the subsidies needed to complete them. Under the present practice of guaranteeing funding, the fiscal responsibility for projects is ambiguous, with part of the burden being shouldered by national treasury disbursements and the remainder by local allocation taxes. These funding guarantees for basic services should come in the form of subsidies and be placed under the relevant agencies' control so that they are clearly held responsible for the level of services offered and the extent of their involvement.
Fourth, the current local allocation tax should be reorganized to focus on adjusting finances from the viewpoint of fairness and equal opportunity. This new tax would finance individual local governments' public expenditures. The fact that fiscal guarantees and demands to adjust finances have become entangled is one reason why local allocation taxes have ballooned. To remedy this problem, the use of local allocation taxes for local government bonds should be abolished, and the fund disbursed in proportion to population. It should be made clear that fiscal adjustments are distributions of revenue sources solely for the purpose of implementing additional services, and that their scope should be linked to the national budget at a certain percentage of revenue from the nation's main taxes. They should be kept from expanding by limiting discretion in the form of fiscal guarantees such as borrowing from the special account for local allocation tax and additions from the general account. (This is a part of local tax revenue that is not calculated in the local allocation tax.) As for retained revenue, levels should be sharply raised, while taking into account the degree of fiscal adjustment, so as to provide local governments with incentives to become fiscally independent.
Conclusion
I can appreciate the fact that the Trinity Reforms launched last year were an effort to understand and correct problems in the local public finance system, which has never undergone a comprehensive overhaul despite the obvious need. However, in reality, the sole aim of these reforms has become quantitative reduction. After repeated political compromises the reforms ended without debating the role and involvement of the central government in local public finance. They simply filled budgetary gaps with local allocation taxes and transferred tax sources without discussion on the issue of regional disparities.
The reforms as they now stand do not encourage local governments to end their dependency on local allocation taxes. They have left the involvement of the central government intact with no discussion on the matter. The division of the roles between the central and local governments has become increasingly ambiguous. Nor do the reforms resolve the structural problem of weak fiscal discipline that results from the ex-post facto compensation of shortfalls in local government budgets by the central government. A sweeping review of the local allocation tax system and a clarification of the roles of the central and local governments through discussion on the issue of involvement are the first step toward the original aim of decentralization, which is to allow local governments to be truly independent, and to provide public services in line with regional needs based on their own fiscal responsibility.
