In response to the COVID-19 pandemic, fiscal expenditures have continued to increase. Under the FY2021 general account, the total amount of expenditures came to 143 trillion yen, including additional expenditures of 36 trillion yen under the supplementary budget adopted at the end of the year. The total amount of outstanding government debt is around 2.5 times as large as the size of gross domestic product (GDP).
On the other hand, Japan's potential economic growth rate at present is lower than 0.5%, with the growth of total factor productivity in particular slowing. In short, the government's growth strategies, which have been formulated almost every year, have not succeeded in raising productivity. While total demand may increase if government expenditures are expanded, the potential growth rate will not necessarily rise. There is a widespread misperception that policies that are designed to increase demand are effective in enhancing the potential growth rate, but sustainable economic growth requires policy measures that lead to productivity growth on the supply side.
The figure below shows the negative correlation between the amount of outstanding government debt as a proportion of GDP and the economic growth rate since the global financial crisis. While not indicated here, there is also a negative correlation between the amount of net debt and the productivity growth rate. What those correlations indicate is not that government debt has negative causal effects on growth, but that government debt and growth affect each other. High growth reduces government debt as a proportion of GDP, because it increases tax revenue and also means an expansion of the size of GDP.
On the other hand, how government debt affects economic growth may need explanation. For one thing, an increase in the fiscal deficit and government debt prevents productive investments by increasing fund-raising costs through an interest rate rise. Under the zero-interest-rate environment, the effects generated on growth in this way are limited. However, when interest rates rise in line with economic recovery or due to concerns over inflation, the presence of a massive government debt may undermine economic activity in the private sector.
Some economists have also pointed to other mechanisms whereby government debt may affect growth, such as expectations that future tax hikes will lower expected rates of return on investments or, that increased uncertainties will trigger risk aversion. An empirical study showed that the negative causal effect of a debt increase arising from economic forecasts with an optimistic bias lead to lower economic growth and productivity growth rates. In politics, economic growth tends to be put before fiscal consolidation. However, this argument cannot be justified if a cumulative increase in government debt holds down growth.
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Among government expenditures, those that have an investment-like nature contribute to productivity improvement and economic growth. A breakdown of general government expenditures shows that public fixed capital formation has remained almost flat over the past 10 years or so. In contrast, the amount of government consumption has continued to grow as a trend, mainly because of an increase in expenditures on healthcare and nursing care. As a result, the share of public investments has been declining. Most of the increase in fiscal expenditures under the COVID-19 crisis was used for redistribution of income, including benefits provided to households and companies, and government consumption items, including healthcare expenditure.
Past studies regarding the effects of public capital generally show that expenditures on transportation and communication infrastructure generate a positive productivity effect in the medium to long term. In Japan, as the productivity effect is larger in metropolitan areas, improving the geographical distribution of public investments contributes to productivity growth at the national level. On the other hand, in non-metropolitan areas, developing infrastructure in ways that promote the creation of compact cities is expected to be effective in raising productivity.
However, innovation and improvement of human capital are the two main sources of economic growth. Most fiscal expenditures related to those two factors are not public investments in the narrow sense of the term but expenditures on intangible infrastructure. Under the government's recent growth strategy, emphasis has been placed on digital transformation (DX) and green innovation, but there are many other important fields of research and development. Given that little-noticed, basic research programs often become seeds of future innovation, there is a strong need to maintain infrastructure which may appear at a first glance to be not particularly important, but which underpins a wide range of research activities.
To cite one example, full access to the articles of past research is a prerequisite for implementing new research activities. However, prices of English-language academic journals continue to rise amid the growing oligopoly in the world of academic publications. Because of the rising prices, coupled with the weak yen, the research environment is becoming increasingly severe as university libraries and research institutions cut back on journal subscriptions. Although there are high expectations for currently planned "University Funds" to have a positive influence in this respect, the effects of the funds on the widespread degradation of the research infrastructure will be limited.
There are also many challenges facing human capital investment. According to the Japan Industrial Productivity Database, the contribution of quality improvement of labor to economic growth rapidly decreased in the 2000s and came to almost zero in the 2010s. In the meantime, government expenditure on education remained flat.
Prime Minister Fumio Kishida has pledged to double "investment in people." As a result, the government's economic package includes expenditures on training of workers to acquire digital skills and recurrent education (relearning). While those measures are aimed in the right direction, long-term predictability is required for human capital investment, including expenditure on improving the quality of schools and teachers. It is desirable to implement expenditures on a permanent and stable basis, rather than using supplementary budgets, for which the prospects are uncertain as the budget size varies significantly from year to year.
Primary/secondary education, tertiary education, and vocational training are all important items of human capital investment, and education of young people in particular does not involve a trade-off between growth and distribution. On the other hand, graduate school education is the critical foundation of innovation. The return on investment in graduate school education is higher than 10%. However, as a large portion of the return is delivered in the form of high incomes earned by individuals, it is reasonable to enhance scholarship programs that focus on students facing financial constraints instead of uniformly providing financial assistance.
In the United States, foreign students who study at U.S. graduate schools in the science and engineering fields have contributed to economic growth as drivers of innovation. At Japanese graduate schools, the share of Asian students, including Chinese ones, is growing. Amid the shrinkage of the working-age population, there are expectations for competent foreign students to find jobs at Japanese companies and contribute to Japan's economic growth.
Companies' investment in education and training delivers a high return compared with capital investment. However, educating and training employees brings no benefit to companies if educated and trained employees leave those companies. As a result, the higher the mobility in the labor market becomes, the smaller the incentive for companies to make human capital investment. Although tax breaks and other governmental support measures may be helpful to some degree, it is also important to enhance public vocational training.
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When discussing growth strategy, attention tends to focus only on policy measures that are focused on raising productivity, but it is also necessary to eliminate policy measures that work to lower productivity. Productivity growth at the macroeconomic level stems not only from a rise in productivity at individual companies but also from the resource reallocation effect due to the exit of inefficient companies and the increasing market share of highly productive companies. Many studies have shown that misallocation of resource has a considerable negative impact on productivity at the aggregate level.
The productivity of companies that received financial assistance, grants to support the continuation of business, and the employment adjustment subsidy under the crisis was found to have been 10 to 20% lower before the crisis than that of companies that did not. One may presume that the reason is the disproportionately strong impact of COVID-19 on small and medium-size restaurants and accommodation facilities with relatively low productivity. However, in the comparison, both industry and company size were controlled for.
It is likely to take more time before COVID-19 can be contained. To adapt to structural changes caused by persistent shocks, it is necessary to reconsider the scope of businesses eligible for assistance measures and gradually scale back the size of fiscal expenditures, although doing that is politically difficult.
Awareness about evidence-based policy development is growing. Unlike in the case of initial budgets, ex-ante assessment regarding supplementary budgets, which are compiled within a limited period of time, tends to become too lenient considering the size of programs. In the case of COVID-19-related subsidies, grants, and employment assistance measures, ex-post assessment has also been insufficient. At least for programs that require massive expenditures, the government should make it compulsory to present a framework for data disclosure so that objective ex-post assessment can be conducted by academic researchers.
Even if emphasis is placed on expenditures that contribute to productivity growth, and with the minimization of expenditures that work to lower productivity, it will take time before the effects begin to appear. Economic policies based on the assumption that it will be difficult to achieve an economic growth rate higher than 1% in real terms on a sustainable basis will be desirable not only for reducing fiscal risk, but also for achieving economic growth.