Fiscal Policy Should Be Freed from the Deflationary Mindset

SATO Motohiro
Faculty Fellow, RIETI

New economic package

In 2023, fiscal policy apparently continued to focus primarily on the pursuit of large-scale economic stimulus. The government worked out a new economic package in November 2023 in an attempt to completely overcome deflation. As part of the effort, the government decided to implement fixed-amount income tax reductions totaling around 3 trillion yen, ostensibly in order to ease the tax burden on the people by returning a portion of the tax revenue increase to them (the tax reductions are scheduled to be implemented in June 2024). The scale of the supplementary budget that finances the package amounts to more than 13.1 trillion yen. That includes 2.7 trillion yen for mitigating the impact of inflation, 1.3 trillion yen for realizing a sustainable wage increase and regional economic growth, 3.4 trillion yen for promoting domestic investments, 1.3 trillion yen for dealing with population decline, and 4.3 trillion yen for increasing the resilience of social and economic infrastructure against natural disasters. In addition, the period of the gasoline subsidy scheme will be extended to the end of April 2024 (also under consideration is the invocation of the so-called trigger provision, which suspends the levy of the provisional portion of the gasoline tax during gasoline price upsurges). Also included in the supplementary budget is the establishment of a fund for expanding semiconductor manufacturing facilities in Japan. The government aims to promote a shift from the “cost-cutting economy” model, which is premised on low levels of prices and wages, to a “growth-oriented economy” model powered by the twin drivers of the expansion of supply capacity, including the expansion of domestic production of semiconductors, storage batteries and electric vehicles, and the return of a portion of the tax revenue increase to the people. However, it is uncertain whether those economic measures will deliver growth.

Fiscal policy trapped in the deflationary mindset

While the government is advertising the slogan of completely overcoming deflation, deflationary pressures in the Japanese economy are already diminishing. According to the Bank of Japan (BOJ), the output gap (the difference between supply and demand) of the Japanese economy was minus 0.07% in the April-June quarter of 2023. Meanwhile, the Cabinet Office estimates that the output gap turned positive in the same period and the inflation rate (as measured in terms of the consumer price index (CPI)) has risen above 2%. In the Outlook for Economic Activity and Prices report, published on October 31, the BOJ projected that the CPI (excluding fresh food = the core CPI) will rise 2.8% in each of FY2023 and FY2024 compared with the previous year. In short, the problem of demand shortage is being gradually resolved, with the economy turning toward an inflationary trend.

How fiscal policy should be conducted varies depending on whether or not Japan is still trapped in deflation. Under deflation, emphasis has been placed on the large-scale economic stimulus provided through fiscal policy measures. By stimulating macroeconomic demand, government expenditure and tax cuts are expected to generate a “virtuous economic cycle,” in which the resulting additional income leads to more consumption. This corresponds to the “multiplier effect” as referred to in Keynesian economics.

However, in a post-deflation economy, focusing on the scale of fiscal stimulus is not the policy course that should be taken. Untargeted stimulation of demand could foster inflation. Of course, there may be needy households and regions, including low-income families struggling to make ends meet due to the effects of inflation and regions where car ownership is an inevitable part of life because of a lack of access to bus service and other forms of public transport. If so, it is desirable to target support measures at those households and regions. With that as a premise, fiscal stimulus should be aimed at promoting the medium- and long-term growth potential of the economy, rather than giving a short-term boost to the economy. Japan’s potential growth rate has long been on a downtrend and is lower than 1%. To increase the potential growth rate, it is essential to improve productivity by spurring innovation and promoting industrial regeneration.

Change of policy course

The government has characterized the coming three years or so as a “period of change” toward supply capacity expansion. Even so, it is doubtful whether Japan’s supply capacity can change dramatically in three years. The government appears to be trapped in the mindset of trying to deliver results in the short term, just as it did when the goal of raising the inflation rate to 2% within two years was set at the time of the start of the unconventional monetary easing. Even if the original purpose of the government’s fiscal policy may be expanding supply capacity as part of growth strategy, the policy could end up being an industry protection scheme for small and medium-size enterprises (SMEs), for example, because the government’s economic policy tends to reflect existing companies’ interests. As a result, economic regeneration will make no headway. If government support is to be provided, the priority should be assisting startup firms, which will be a future driver of the Japanese economy. Meanwhile, there is suspicion that handing out subsidies has become the primary focus of supplementary budgets, as indicated by the recent decision to allocate 2 trillion yen to support measures for semiconductors and generative AI (artificial intelligence). For the next fiscal year (FY2024), there are requests to introduce a tax break for the manufacturing of strategic product-related infrastructure, which would give preferential tax treatment to companies based on production volume, in addition to a tax break for capital investment expenditure. It is doubtful whether economic growth led by the private sector can be realized on the premise of governmental support alone.

The government has argued that fiscal consolidation cannot be achieved without economic growth (led by the private sector). However, allowing the economy to depend further on fiscal stimulus—under the presumption that economic growth cannot be achieved without fiscal stimulus—is a contradiction of the government’s own argument. When the government provides fiscal support, it must review the progress and outcomes of the support measures provided—e.g., subsidies and tax cuts—and revise them as necessary and appropriate. The gasoline subsidy, for example, is nothing more than a short-term fix to alleviate the impact of price upsurges and provides no fundamental solution if energy prices remain elevated for the long term. Following a series of expansions and extensions of the gasoline subsidy scheme, the total amount of funds distributed to this point has already exceeded 6 trillion yen. If government support is to be provided in the energy sector, emphasis should be shifted to promoting energy conservation and the use of renewable energy and electric vehicles. Generally speaking, governmental support measures tend to be “all-inclusive,” extending assistance in every direction, as consideration is given to the interests of various stakeholders. As a result, governmental support ends up putting the brakes on the economy in some aspects (preserving existing, inefficient forms of energy consumption) even while cranking it up in other aspects (e.g., economic green transformation (GX)), with positive economic effects offset by negative ones.


As the Japanese economy has remained trapped in deflation for many years, it is said that the deflationary mindset has taken hold among households and companies. However, actually, it may be the government that is stuck in the deflationary mindset. The government may be finding it difficult to make a change of course in fiscal policy because large-scale fiscal stimulus packages implemented in the past have created vested interests in some areas (e.g., the initiative to increase the resilience of social and economic infrastructure against natural disasters and support for SMEs). It appears that the government’s fiscal policy stance—focusing on the scale of fiscal stimulus and placing emphasis on handing out fiscal support (subsidies)—has not changed much despite the signs of a “sea change,” such as the inflationary trend and the return of positive interest rates. Now is the time for fiscal policy to break free from the deflationary mindset.

December 22, 2023
>> Original text in Japanese

January 10, 2024

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