Priorities for the Japanese Economy in 2015 (January 2015)

Toward the Integrated Reform of Expenditures and Revenues Ver. 2.0

TSURU Kotaro
Faculty Fellow, RIETI

On November 18, 2014, Prime Minister Shinzo Abe announced his decision to postpone the planned consumption tax rate hike originally scheduled for October 2015 by 18 months to April 2017. At the same time, he pledged to: 1) implement the planned tax rate hike with no further delays regardless of the economic conditions, 2) adhere to the goal of achieving a primary surplus by FY2020, and 3) develop specific plans toward that end by summer 2015. In this light, it is fair to say that how to reconcile two conflicting policies—a growth strategy as the third arrow of Abenomics and fiscal consolidation—will be the most important policy agenda for the Abe administration in 2015.

Was Prime Minister Abe's decision to postpone the planned consumption tax rate hike right? That is for historians in future generations to decide. My personal belief is that Prime Minister Abe should have increased the consumption tax rate as originally planned. However, this policy change has certain commendable aspects as it provides some important suggestions that would be helpful in considering plans for fiscal consolidation going forward.

Problems regarding the "flexibility clause"

The first suggestion concerns problems regarding the so-called "flexibility clause." In its supplementary provision, the consumption tax rate hike law stipulates as follows: "Prior to the enforcement of each tax increase provision, appropriate measures including the possible suspension of the enforcement shall be taken as deemed necessary, in view of the measures referred to in the preceding paragraph, and after conducting a comprehensive review of economic conditions and other relevant circumstances to confirm the favorable development of the economy by checking various economic indicators such as nominal and real economic growth and price trends."

Thus, according to the intention of the clause, the decision of whether or not to proceed with the planned tax rate hike should have been based on the "comprehensive review of economic conditions." In reality, however, too much focus was placed on the economic performance in the period immediately before the decision-making deadline (December 2014), or more specifically, preliminary gross domestic product (GDP) figures for July-September 2014. Because of this, when Japan's real GDP betrayed widely-held expectations by posting negative growth, it looked as if the government had convincing reasons for postponing the tax rate hike. However, in assessing economic performance, it is important to look at not only changes but also levels. Partly thanks to a weaker yen, many listed companies reported record profits. The ratio of job offers to job seekers, which is sensitive to economic fluctuations, has been at a fairly high level consistently. Given those observations, it is questionable whether Japan's economic conditions are really so bad as to warrant the postponement of the tax rate increase.

Meanwhile, Prime Minister Abe's decision to ensure the definite implementation of the forthcoming tax hike by leaving no room for flexibility is commendable as it demonstrates his government's extraordinary commitment to fiscal consolidation. Still, I believe that some sort of emergency escape provision should be enshrined into law so as to enable the government to suspend the tax rate hike in the event of a huge unexpected shock.

Significance of allowing a three-year interval before the next tax rate hike

The second suggestion concerns the time interval at which to raise the consumption tax rate. Raising the consumption tax rate by five percentage points all at once would have too significant of a deflationary effect on the economy. This inevitably limits the size of the tax rate increase to two to three percentage points at a time. Thus, once a political decision is taken to raise the consumption tax rate by five percentage points, the remaining question is the interval at which it should be implemented. Setting the interval too long would make it difficult for the same existing government to promise and implement a tax rate hike within its tenure. The initial interval of a year and a half between the first hike in April 2014 and the second in October 2015 must have been determined by taking those considerations into account. However, a year and a half is undeniably too short. The timing at which the government needs to decide on the second hike is too close to the periods affected by the last-minute surge in demand prior to the first hike and the subsequent plunge, making it difficult to capture the basic trend of the economy as discussed above.

Conversely, Prime Minister Abe's decision on the tax rate hike postponement can be interpreted as an attempt to justify the consumption tax rate increase to 10% as the government would be able to implement the hike boldly without worries after waiting three years since the previous one. Indeed, a period of three years is considered long enough to allow the effects of the previous consumption tax hike to fade away. If so, the government should aim to raise the consumption tax rate at least to a level comparable to value-added tax rates in Europe (above 15%) within 10 years, for instance, by implementing a two or three percentage point hike every three years in 2017, 2020, and 2023, and seek to build a public consensus on the need to do so in order to ensure the sustainability of the fiscal and social security systems.

What it takes to achieve the Integrated Reform of Expenditures and Revenues Ver. 2.0

The third and last suggestion is about specific plans toward achieving fiscal sustainability in FY2020, a goal to which Prime Minister Abe vowed his commitment. Obviously, his decision to delay the consumption tax rate hike will allow government debt to have a negative impact on the government's endeavor for fiscal sustainability as it accelerates the pace of debt accumulation. On the other hand, a change in the tone of the media over the recent months has been a positive development. Those taking a critical stance against the Abe government naturally would have questioned his decision, asking "Can we afford to postpone it any longer?" However, what we are increasingly seeing is newspapers—including those that were previously cautious or skeptical about pressing forward fiscal consolidation that could inflict significant pain on taxpayers—urging the government to make unwavering efforts to reduce expenditures including those for social security. Certainly, it is no exaggeration to say that the postponement of the consumption tax rate hike paradoxically has given rise to momentum for fiscal consolidation.

The Integrated Reform of Expenditures and Revenues, a key component of the government's Basic Policies for Economic and Fiscal Management and Structural Reform 2006 (Basic Policies 2006), would provide a useful guide in identifying measures that need to be taken going forward. The situation back in 2006 was akin to what we see today, in that the government had to develop a roadmap for fiscal consolidation toward achieving primary balance in five years' time, i.e., in FY2011. The gap that had to be closed to achieve that goal was approximately 16.5 trillion yen. While eliminating 70% to 90% of that gap—worth 11.4 trillion to 14.3 trillion yen—by curtailing expenditures in various areas, the government made it known, discretely but unmistakably, that some sort of revenue-boosting measure (i.e., consumption tax rate increase) would be necessary because the goal of fiscal consolidation could not be attainable by budgetary cutbacks alone. This laid the groundwork for the consumption tax rate increase in April 2014.

Now, what should be the key elements of the Integrated Reform of Expenditures and Revenues Ver. 2.0, which will be incorporated into the government's new Basic Policies to be compiled this summer? First, the government needs to present realistic figures, i.e., how much money will have to be saved and/or raised in order to achieve primary balance. Although it has been repeatedly pointed out that the government should use conservative and prudent economic assumptions in preparing fiscal forecasts, this is not necessarily practiced in reality. If so, the government should at least consider three different scenarios assuming nominal GDP growth of 1%, 2%, and 3%, and project for each scenario how much money would be required to fill the gap between the government's revenues and expenditures in FY2020.

Second, as was the case in 2006, the political leaders must demonstrate strong leadership and specify the spending cuts that should be made in each category as part of the total amount of spending cuts needed to reduce overall government expenditures to a sufficient level. What is different this time around is that a significant portion of the spending cuts must be achieved by reducing and curbing expenditures in the area of social security. Japan's non-social security expenditures measured as a percentage of GDP are already among the lowest in the member countries of the Organisation for Economic Co-operation and Development (OECD). Although there still remains some room for further cuts in spending in public works projects, expenditures in other non-social security areas are fairly streamlined. Efforts toward eliminating wasteful expenditures must continue indefinitely. However, making uniform cuts across the board is not the way to go. In this regard, to what extent the government can come up with specific spending cuts in the area of social security—where spending from the national budget alone has been growing at the pace of about one trillion yen per year—will be the focal point.

Third, we must be prepared for further consumption tax rate hikes before FY2020 because, based on reasonably prudent assumptions about economic growth, it is impossible to achieve primary balance solely by cutting expenditures. In this regard, too, the government should start considering another consumption tax rate increase in 2020 as part of the aforementioned long-term schedule for fiscal consolidation.

Experts and specialists should offer specific ideas for fiscal consolidation

With the beginning of 2015, the discussion at the government's Council on Economic and Fiscal Policy will be getting into full swing toward formulating specific plans for fiscal consolidation. In order to prevent this discussion from ending up being a mere exchange of abstract ideas, it is important to keep a close watch on and monitor discussions within the government and stimulate active debate. In particular, experts and specialists in the relevant fields should proactively offer specific reform ideas (measures for reducing expenditures and boosting tax revenue) based on numerical data. This may be what is most needed to enable the government to face squarely this enormous challenge of fiscal consolidation without running away.

January 6, 2015

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