As the debate surrounding a proposal to raise the base level of deduction for income tax has gone astray politically, uncertainty over future prospects has grown. It is believed that the purpose of the proposal was to increase after-tax income for workers and to eliminate the “1.03 million yen barrier” of working hours. However, increasing after-tax income through the tax cut only generates a one-time “level effect,” so unless the tax cut amount continues to increase, the positive effect on income will wear off from the next year. In the case of flat-rate tax cuts and the provision of cash benefits aimed at increasing after-tax income, it would cause a reactionary decline in income in the next year.
To achieve sustainable wage growth comparable to the rate of inflation, economic growth based on increasing productivity is essential. However, an increase in government debt and uncertainty over fiscal management could have a negative impact on economic growth.
The large-scale economic policy package and tax system revisions that have recently been adopted have reduced the possibility that the government will be able to achieve the goal of attaining a primary balance surplus by FY2025. So long as the fiscal deficit persists, government debt will keep piling up. Under the massive government debt, not only will the increased debt-servicing cost put pressure on the budget, but it could also have the effect of crowding out private-sector investment, a situation that did not materialize under the zero-interest-rate regime. Many studies have shown that fiscal uncertainty has negative effects on economic activity.
According to a survey conducted by the author that asked Japanese companies about policy issues over which there was a high level of uncertainty, 48%, the largest percentage, cited “government finances.” The uncertainty over the future of fiscal management has significantly increased since the COVID-19 pandemic: when a similar survey was conducted in the mid-2010s, only 26% cited “government finances.” It will become more difficult than ever to implement policies that impose a higher burden on the people under the minority government. There are concerns of a vicious circle of increased government debt dragging down economic growth.
One factor behind the fiscal deficit and the increasing government debt is the optimistic bias in economic forecasts. Over the past 20 years, on average, the actual economic growth rate has always fallen short of the government’s projection by more than one percentage point. The optimistic bias of governmental projections is not a problem specific to Japan, and the bias tends to be more significant in medium- and long-term projections in particular. Many studies have indicated that the bias of macroeconomic projections contribute to fiscal deficit expansion, depressing the economic growth rate, for example by creating debt overhang.
One reason why economic growth projections are biased is that while actual growth rates may be negatively impacted by unforeseen shocks such as a global financial crisis, a natural disaster, or a pandemic, the reactionary growth that occurs after a temporary decline in growth rate arising from such negative shocks can be anticipated in advance and incorporated into projections. As a result, projections made by private-sector economists have a 0.8 point upward bias on average. However, governmental projections have a somewhat larger bias. The difference between the biases of private-sector and governmental projections represents a bias particular to the government sector.
It is often suggested that the solution to the problem of optimistic bias is to have a politically neutral independent fiscal institution formulate economic forecasts. I do not deny that this could play an effective role, but if private-sector economists’ projections are also biased, merely using neutral institutions to improve projections may have limited effect. It is also necessary to make improvements in how fiscal management is carried out. One option would be to manage government finance based on conservative growth projections that are adjusted based on bias observed in the past.
>> Original text in Japanese
* Translated by RIETI.
December 27, 2024 - Published in Nihon Keizai Shimbun's "Economist 360° Perspective"