January 30, 2003
The year 1993 was a turning point at which Japan entered the era of institutional transformation. That year, the burst of economic bubble was recognized and the single-party rule by the Liberal Democratic Party came to an end. Since then, social rules, which people had taken for granted, have begun to falter. Nevertheless, people generally remain numb to the change in Japan's institutions.
I believe this numbness is attributable to the fact that the framework of the state, formed by relationships between politicians and businesses, between politicians and voters, between bureaucrats and bureaucrats, and between bureaucrats and politicians remains unchanged. To foster innovation in the private sector and promote the evolution of a Japanese model, it is necessary to carry out drastic reforms on the political and administrative systems and enhance their complementary functions.
A fiscal system forms the foundation of a state as an institution. A government, in exchange for providing public goods and services, is given power to levy taxes as a means to finance its activities. Giving such authority to a government, however, also means giving the government the potential ability to unilaterally infringe on people's personal property rights.
From this fundamental structure evolves the form of a state; this is the institutional framework that controls or allows for the discretionary exercise of power by a government. In today's Japan, I am afraid that the very "form" of the state is being questioned.
Many people say that Japanese households have financial assets worth 1.4 quadrillion yen despite Japan's economic stagnation. In reality, however, half that value has been virtually eroded for the future repayment of government debts. Worse still, because most of the debt repayment burdens extend over future generations, we embrace the problem of intergenerational distribution.
It is selfish for older generations to blindly rush for economic pump-priming measures through expansionary fiscal expenditure with no regard for the future. Yet, no fundamental solution will emerge by simply calling for streamlining administration and restricting the issuance of government bonds. The question is how we create a mechanism that enables taxpayers to monitor the efficiency and fairness of government activities.
First, let's take a look at the decision-making mechanism for fiscal expenditures. Currently, intensive prior screening of budgetary requests by the Ministry of Finance's Budget Bureau and the single-year budget system, under which budget needs to be implemented strictly within a single fiscal year, form the backbone of the mechanism. As the world is becoming increasingly complicated, however, the existing mechanism is insufficient to deal with emerging problems.
Even budgetary officials, who are austere and capable, would find it difficult to assess, in line with the principle of zero-based budgeting, the relevance of meticulous budgetary requests filed by each government ministry. Thus, every year, budget negotiations between MOF and each requesting ministry center on varying allocations for routine budgetary items.
As a result, officials at ministries earn kudos by winning additional budget allocations, not by saving funds. Meanwhile, new budget items must be "prudently" negotiated for several years and then go through a stage at which they receive preparatory funds from before becoming a full-fledged budgetary item entitled to budget allocation under its own name. The existing decision-making mechanism for budget expenditures, thus, has a built-in inertia that leads to rigid expenditures.
A paradigm shift from the ex ante screening system to an ex post assessment system must take place. For instance, we can assume a mechanism in which the Council on Economic and Fiscal Policy would set basic guidelines for the functional distributions of fiscal expenditures in line with the Cabinet's policy priorities. Based on the guidelines, MOF would draft a plan on lump sum budget allocations for respective ministries, which would be deliberated and approved by the Diet.
Based on a Diet decision, government ministries would formulate more concrete budget plans respectively. In doing so, however, they would be allowed to fine-tune their actual expenditures flexibly even beyond a fiscal year. MOF, while seeking advice from external experts, is to conduct strict ex post assessment on the effect of fiscal expenditures by each ministry and report its assessment results to the Diet.
A mechanism that facilitates the feedback of ex post assessment results would help curb government waste. Politicians, for their part, would be able to wipe out their conventional image as a mediator of individual interest groups by participating in a budget formulation process through more fundamental policy dialogue.
Second, there is the question of taxation reform. Under the name of neutrality, Japan has developed a complex web of tax laws. Criticism is growing over the exclusive and arbitrary role of the LDP's Research Commission on the Tax System in changing the nation's taxation system. Due to the rigidity of the taxation system, the government has been almost entirely counting on fiscal measures to stimulate economy. But it has now become clear that the multiplier effect of spending is minimal in creating jobs.
The taxation scheme should be transformed into one that motivates companies to invest and recruit staff, for instance, through neutral reduction of corporate tax burdens. This paradigm shift will also call for the leadership of the Cabinet. Politicians' knowledge of taxation systems should be demonstrated in the course of transparent processes such as open debates at the Diet and elsewhere. Furthermore, the tax base needs to be expanded through universal rule.
From the standpoint of those who are exempted from taxes, the state is nothing but an indulgent guardian from whom they one-sidedly seek rents. Moral hazard, where managers of small enterprises intentionally generate losses by lavishing on themselves so that they can evade tax payments, has been rampant.
In order to create a country with discipline, the minimum taxable income needs to be lowered, thereby obliging more low-income earners to pay income tax, while pro-forma standard taxes should be imposed, as a general rule, on all companies that receive the benefits of public services, such as the protection of contracts. The measure would increase taxpayers' incentive to monitor government waste.
Third, fiscal authority should be decentralized. In distributing public assets such as roads and nursing services for the elderly, the government conventional management cannot fulfill people's increasingly diversifying needs. The time when providing uniform centrally managed services was a top policy agenda has come to an end.
For instance, having privatized companies own roads so as to limit their fresh investment within the scope of their respective toll revenues should not be the only institutional device for preventing wasteful expenditures on road constructions. The measure may end up keeping toll rates at high levels, which may undermine Japanese industry's competitiveness in the global market.
Roads, as a public asset, call for financing by taxes. Still, it is necessary to create a mechanism that facilitates investment in accordance with economic needs by preventing a budget-grabbing game among local governments and wasteful investment. Towards this end, it is necessary to transfer decision-making authorities and relevant taxation authorities from the central to each local government that is held directly accountable to beneficiaries.
The Ministry of Public Management, Home Affairs, Posts and Telecommunications' guarantee attached to bonds issued by local governments and the existing subsidy system for public investments drive local governments to lax fiscal expenditures, creating moral hazard among them. In this regard, the concept of fiscal federalism, which has been lately attracting attention in the fields of political economy and public finance, is quite suggestive.
According to this concept, a central government needs to make promise that it will not bail out a local government in fiscal crisis as an incentive to enhance fiscal discipline in the provision of public assets. The integration of the European Union is illustrative. As a result of giving the European Central Bank the exclusive right to issue currency, the member states of the EU have been effectively forced to surrender to budgetary disciplines, as they are no longer able to print their own bank notes.
In order to realize the reforms as described above in Japan, allocation of responsibilities among the Cabinet, agencies, and local governments needs to change drastically. The relationships between politicians and administrators and the mindsets of citizens must be changed, too. But this is no easy road and neither politicians in Nagatacho nor bureaucrats in Kasumigaseki will likely initiate such changes.
Ultimately, voters hold the key to selecting a model such as the one described here. Sooner or later, people may become more conscious about making choices. The tendency observed in a series of recent local elections and by-elections points to such a possibility. And it again reminds us why the year 1993 was a milestone.
Author, Masahiko Aoki
President
Research Institute of Economy, Trade and Industry (RIETI)
Editor-in-Chief, Ichiro Araki
Director of Research
Research Institute of Economy, Trade and Industry (RIETI)
e-mail: araki-ichiro@rieti.go.jp
tel: 03-3501-8248 fax: 03-3501-8416
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The opinions expressed or implied in this paper are solely those of the author, and do not necessarily represent the views of the Ministry of Economy, Trade and Industry (METI), or of the Research Institute of Economy, Trade and Industry (RIETI).
