Conditions for Japan to Avoid a Fiscal Crisis: Ultimate picture of the benefits-contribution relationship must be shown

OGURO Kazumasa Consulting Fellow, RIETI

Japan is in a state of fiscal emergency. Its tax revenue covers less than half of the government expenditures while social security costs are rising rapidly because the population is aging quickly and fertility remains below the replacement level. As a result, government debt measured as a percentage of the gross domestic product (GDP) is nearing the level of the prewar peak, which caused drastic inflation in the years immediately after the end of World War II (see Figure).

Figure: Ballooning government debt (as % of GDP)Figure: Ballooning government debt (as % of GDP)

Many people remain optimistic, typically noting that there is no need to worry because more than 90% of Japanese government bonds (JGBs) are held domestically, and only about 7% are held by foreign investors. That, however, is the case only when viewed in stock terms. When viewed in flow terms, the presence of foreign investors in the JGB market has increased significantly, accounting for 30% to 50% of the increase in government debt—including short-term JGBs—issued in recent years.

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In the latest ordinary session of the Diet, a series of bills designed to address the social security and tax systems, including one for raising the consumption taxes, were passed into law. It was subsequently determined officially for the consumption tax rate to be raised from the current 5% to 8% in April 2014 and then further to 10% in October 2015. However, this five percentage point increase is merely a band-aid remedy—not the ultimate cure—and thus Japan, in essence, has yet to stave off its fiscal crisis.

The planned five percentage point hike in the consumption tax rate will bring approximately 12 trillion yen in revenue (estimated on the basis of about 2.5 trillion yen per each one percentage point increase). On the other hand, social security costs are expected to increase at a pace exceeding one trillion yen per year, or by more than 10 trillion yen in 10 years' time from now, if no measures are taken to suppress the increase. Furthermore, with the amount of outstanding debt rising rapidly, the cost of interest payments—about nine trillion yen at the moment—is expected to increase by roughly eight trillion yen over the next 10 years to reach approximately 17 trillion yen, assuming that interest rates remain constant. All told, Japan's fiscal deficit will grow from around 44 trillion yen today to more than 50 trillion yen in the next 10 years, even taking into account the planned increase in tax revenue.

In the latest Economic and Fiscal Projections for Medium to Long Term Analysis issued at the end of August 2012, the Cabinet Office provided its trial calculation results, showing that, even with the five percentage point increase in the consumption tax rate, the primary combined balance of the central and local governments would be a deficit equivalent to about 3% of GDP in fiscal 2020. This means that Japan would have to raise the consumption tax rate by another six percentage points in order to achieve a primary surplus in fiscal 2020 (April 2020 through March 2021) as pledged at the latest meeting of the Group of Seven (G7) finance ministers and central governors.

However, presenting these inconclusive numbers may lead to the postponement of action needed to address the crisis by preventing taxpayers from having an accurate understanding of the rapidly rising social security costs. Based on their respective trial calculations, many Japanese and overseas researchers estimate that the consumption tax rate would have to be raised to above 30% if Japan is to restore fiscal stability without suppressing social security costs.

In this regard, a study conducted by R. Anton Braun of the Federal Reserve Bank of Atlanta, et al. provides important insights. It estimates that the consumption tax rate would have to be raised to 33% if Japan is to achieve fiscal stability with a one-time permanent tax increase in 2017 amid rapidly rising social security costs, and to 37.5% if the tax hike is postponed by five years to 2022. Since the difference is about five percentage points, each year of delay in tax reform translates into a one percentage point increase in the ultimate consumption tax rate. This is the cost of postponing reform. The more it is postponed, the higher will have to be the ultimate consumption tax rate and the greater will be the burden on the young and future generations. The ultimate consumption tax rate required to restore fiscal stability is 35%, according to Professor Gary Hansen of the University of California, Los Angeles (UCLA), et al., whereas Professor Keiichiro Kobayashi of Hitotsubashi University and I estimate that it would have to be raised to 31% (estimate) by around 2050. The common understanding or consensus underlying these studies is that raising the consumption tax rate to 20% would not be enough to ensure fiscal sustainability in the case where no measures are taken to suppress social security costs.

It is regrettable—even taking political constraints into account—that the latest round of debate on tax reform started with and remains fixated on the foregone conclusion of raising the consumption tax rate by five percentage points for now. No discussion was made on the ultimate level to which the government should aim to raise it, and there is no finish line in sight. "Missing the forest for the trees" might be the phrase to describe this situation. That is, Japan is like a ship setting out on a voyage without a destination. Given the fact that it took a lot of political muscle to ram through the bill to raise the consumption tax rate by just five percentage points, some people might say that it is politically impossible to discuss a consumption tax rate at 20% or above. However, by avoiding such discussion, we will be increasing the cost of postponing reform as shown by Braun et al.

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What politicians should be doing in this regard is to present to the public the following three options from which to choose: "high benefits with high contributions," "low benefits with low contributions," and "middle benefits with middle contributions." The reason why social security reform does not at all seem real is that politicians almost inevitably avoid making a choice on the overall framework for benefits and contributions, and the media's attention quickly drifts away from the big picture and focuses on small details.

Mistakes in strategy cannot be offset with tactics. No matter how refined in details, reform is doomed to fail eventually if sufficient discussion on the overall framework fails to take place and the existing problems of the social security system—i.e., far more benefits being paid out than can be covered by contributions—left unaddressed.

What matters in reform discussion is the order in which it takes place. In other words, before going into details such as the specific design of pension schemes, discussions on the overall framework for pension benefits and contributions must occur, based on the premise that the levels of benefits and contributions are kept equal. Although such discussions may be somewhat sketchy, it is desirable to discuss the overall framework and set the level of benefits (i.e., that of contributions) first and, only then, move onto details.

The high-benefits-with-high contributions scenario, in which no effort will be made to suppress the rise in social security costs, should be the starting point in discussing the overall framework. At the National Council for Social Security System Reform to be established soon, the government and ruling parties must accordingly present a clear picture of the burdens that would have to be borne ultimately by taxpayers in order to achieve fiscal stability under that scenario, including the possibility of raising the consumption tax rate to about 30%, based on their official calculation.

Only then, and if it is determined that the low-benefits-with-low-contributions scenario, one in which a hike in the consumption tax rate would be kept to the planned five percentage points, be considered as an alternative option, should they calculate and provide the size of the cuts in expenditures that would have to be made in order to achieve fiscal stability. According to our rough calculation, it would be necessary to reduce expenditures by about 50 trillion yen, an amount equivalent to foregone revenue that could have been generated by a 20 percentage point hike in the consumption tax rate. Most of this reduction in spending would have to be made in social security expenditures, which would otherwise be increasing at a pace of more than one trillion yen per year.

Currently, a total of 100 trillion yen in social security benefits—such as those for the pension, medical, and elderly care insurance programs—are paid out every year, of which about 60 trillion yen is covered by contributions or premiums and the remaining 40 trillion yen by public funds. The latter would have to be reduced significantly, resulting in drastic cuts in benefits.

If it is concluded that both scenarios are undesirable, then the middle-benefits-with-middle-contributions scenario is the only remaining option.

Even under this scenario, it is likely that the consumption tax rate will have to be raised to above 20%. Value-added taxes (VAT) in Europe are 20% on average, 25% in Sweden, and around 20% in the United Kingdom, France, and Germany. Suppose that Japan needs to raise the consumption tax rate to 30%, but 25% is the feasible limit in reality. In this case, it is necessary to implement an additional 15 percentage point hike in or after fiscal 2015, on top of the planned five percentage point increase. At the same time, Japan must reduce its expenditures by about 12 trillion yen, an amount equivalent to revenue lost by not levying an additional 5% in consumption taxes.

Japan also needs to consider raising the pension eligibility age in light of the moves in the United States and Europe (Italy is planning to raise it to 69 years old, the United Kingdom to 68 years old, and the United States and Germany to 67 years old). It is inevitable to implement drastic social security system reform—such as raising the non-taxable threshold on pension income and increasing the self-pay portions of medical and nursing care service fees—to suppress a future increase in social security costs to half of the expected natural increase (20 trillion yen) over the next 20 years.

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In any event, far more benefits are being paid out than can be afforded by contributions or premiums paid today, and "political leadership," in its true meaning, is to discuss and determine the overall framework in the face of this dire reality. This is not to deny the importance of discussing details, but such discussion should not come first. It is the role of politics—the most important one at the moment—to select and enforce the overall framework, as administrative agencies, which are vertically structured and thus inclined to pursue partial optimization, are not cut out for such task. Indeed, this is the decision that is most strongly and urgently needed from Japanese politicians.

Needless to say, an important reform philosophy that must be abided by in making such decision is to take a clear look at the limitation of the burden that can be passed onto the future generations and persuade those who are not facing trouble help those in their respective generations who are, wherever possible. "Don't worry whether it's liked, worry whether it's right" (Peter F. Drucker, The Effective Executive) is what is required of Japanese politicians today.

>> Original text in Japanese

* Translated by RIETI.

October 18, 2012 Nihon Keizai Shimbun

November 26, 2012