Economic Insights: Will inflation really make Japan’s fiscal position more sound?

SATO Motohiro
Faculty Fellow, RIETI

According to an estimate by the Bank of Japan, the rate of year-on-year increase in the consumer price index (excluding fresh food) will stay at around 2% in fiscal 2025 and 2026 after rising to the 2.5% to 3% range in fiscal 2024.

This inflation trend may steer the government’s fiscal position for the better. That is because although the amount of Japan’s combined outstanding public debt, including debt owed by the national and local governments, is larger than 1,200 trillion yen, inflation holds down the debt amount as a proportion of nominal gross domestic product (GDP) because price increases push up nominal GDP.

Inflation’s Impact on Japan’s Fiscal Position

According to an estimate by the Cabinet Office, the outstanding amount of combined public debt as a proportion of GDP, which came to 211.8% in fiscal 2022, will fall back to 206.1% in fiscal 2024. This turnaround is attributable to the difference between interest rates and the nominal GDP growth rate and a change in the primary balance.

If inflation pushes up the nominal growth rate and if interest rates stay below the nominal growth rate, the outstanding debt as a proportion of GDP will fall.

Inflation will also increase income and other tax revenues. The government’s annual tax revenues have surpassed 70 trillion yen and rewritten record highs in recent years. On the other hand, governmental expenditures, excluding pensions and similar expenses, are not necessarily linked to inflation. Therefore, inflation could also improve the primary balance (= tax revenues – governmental expenditures).

Until this point in the year, the government has aimed to steadily reduce the outstanding combined national and local government debt as a proportion of GDP while simultaneously achieving a primary balance surplus in FY2025. If inflation continues, this goal may be attained as a matter of course. In that case, optimism is likely to grow that inflation will create more room for an expansionary fiscal policy.

However, will this work out well in the end?

Fiscal consolidation achieved through inflation is equivalent to an implicit tax being imposed on the taxpayers. If the rate of wage growth lags behind the rate of inflation, real wages drop and household purchasing power declines. According to the Ministry of Health, Labour and Welfare, real wages in fiscal 2023 fell 2.2% from the previous year. This situation is no different from a consumption tax increase.

Inflation also functions as a tax on assets. Financial assets held by households in Japan total more than 2,000 trillion yen, of which slightly more than 1,000 trillion yen’s worth is held as cash and deposits. If the annual inflation rate is 5%, the real value of cash and deposits is reduced by approximately 4.8% (= 5% ÷ <1 + 5%>) per year. This is known as an “inflation tax.” Letting inflation reduce national debt is the same as imposing a tax on the taxpayer given that the debts are equivalent to their financial assets.

Rising Interest Rates and Inflation Mitigation Measures

Inflation pushes up both the nominal growth rate and interest rates. Despite continued monetary easing by the Bank of Japan, interest rate hikes are expected soon. In May 2024, the benchmark long-term interest rate rose above 1% in the bond market, marking their highest level in 12 years. In Japan, where the issuance of government bonds is huge, once interest rates rise, there is a risk of a snowball effect of escalating interest payments.

Moreover, although governmental expenditures are not institutionally linked to inflation, there has been a real-world, historical correlation. The supplementary budget in FY2023 reached 13.2 trillion yen, of which slightly over 2.7 trillion yen was allocated for measures to mitigate the impact of inflation, such as the gasoline price subsidy program. If substantial supplementary budgets continue, improvement in the primary balance is unlikely.

Ultimately, improving the government’s fiscal position through inflation without imposing a burden on the people is unlikely. In the end, taking market and political trends into account in addition to the above analysis, optimism seems unwarranted.

>> Original text in Japanese
* Translated by RIETI.

June 22, 2024 Weekly Toyo Keizai

July 24, 2024

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