Fiscal Reforms of Japan: Redesigning the Frame of the State

* This publication is in Japanese. An English translation is not available.

What Fiscal Reforms Does Japan Need?

From December 2002 to March 2004, the Research Institute of Economy, Trade and Industry (RIETI) carried out a research project on Japan's fiscal problems. This book, which presents the findings of the 15-month project, aims to enhance public discussion of this important issue. Rather than offer a set of specific policy proposals for fiscal reform, the project team was organized so as to allow each participant to offer insights and theoretical contributions based on his or her unique perspective. Naturally, the members of the project had their own well-defined perception of the fiscal problem, which initially prompted them to participate in the project. As the project progressed, however, we gained a deeper understanding of the issues and came to share a set of perceptions or questions that need to be addressed in implementing fiscal reform. Setting aside subtle differences among the contributors, and at the risk of oversimplifying, these questions can be summarized as follows:

- Since the 1990s total public debts, including those held by the central and local governments, those owed by troubled or near-defunct special public corporations, and unfunded benefit obligations of social security programs, have snowballed. Do not such debts amount to a "time bomb," one that may lead to a fiscal crisis? Public sector debts are not a problem per se as long as they are balanced by a comparable amount of public assets. However, given the current fiscal imbalances, are these debts sustainable?

- Assuming the existing fiscal imbalance needs to be corrected, can this goal be achieved simply by making marginal adjustments to tax rates, social security contributions, restraints on fiscal expenditures and so forth while keeping the existing structure of fiscal system intact? Or is it necessary to overhaul the budget formulation process and the social security system? If so, how should we redesign these systems?

- Are the fiscal difficulties that have become apparent a reflection of the distortions and contradictions that have built up within the "frame of state" or the existing institutional structure of Japan? Is it necessary to reexamine the persistent collusion between various vested interests and the government agencies that oversee them: the inertia-driven policymaking mechanism that gives little if any consideration to the increasing burden on future generations; the economic and regulatory structures that protect existing producers' interests at the cost of providing better value to consumers and ordinary citizens; and the distorted incentives and career opportunities for bureaucrats locked into a compartmentalized administrative structure?

- If so, how can the existing structure be reformed in a way that is consistent with ongoing technological innovation, aging of the population, and of the public's increasingly diverse values and abilities? To enable such reforms, what roles should each member of the society - taxpayer-voters, politicians, bureaucrats, fiscal experts, and so forth - play?

It is inherently difficult to address these wide-ranging problems in a comprehensive manner within each academic field. At the same time, however, no meaningful insights can be gleaned from a general discussion that is not underpinned by technical expertise and competent analysis. Thus, the project evolved in an interdisciplinary direction so as to deepen our awareness and understanding of the problems described above. In other words, the project team was designed to include people with diverse backgrounds and expertise. Project members included officials from the Ministry of Finance as well as from spending ministries and agencies; economists specializing in fiscal policy, institutional systems, organizations and incentives, and economic history; political scientists researching both the administration and political parties; experts with experience in the fiscal administration of a foreign country and/or comparative studies of fiscal administrative systems overseas; and business consultants who consider system designs from the viewpoint of strategy and management. Through rigorous and focused discussions, project members sought to cultivate a common understanding of problems, while each member sought to contribute a unique viewpoint based on his or her expertise. This book is the product of these discussions. The outline of the book is as follows:

In the introductory chapter, Masahiko Aoki develops the arguments concerning the questions listed above from the viewpoint of institutional analysis, thereby introducing the key concepts - "bureaupluralism," "working horizontal stitches across the vertical threads (i.e., providing cross-sectoral links to the vertically segmented administrative structure)," "common pool problems" and so forth - that are repeatedly referred to in the ensuing chapters. While giving due consideration to the positioning of each chapter of the book, the introductory chapter also presents summary proposals for resolving the fiscal problem.

In chapter 1, Kotaro Tsuru provides an overview of the problems plaguing Japan's fiscal system and examines "common pool problems," which are a type of free-rider problem that has attracted increased attention in recent fiscal publications as a cause of fiscal deficits in democracies. Taking lessons from successful reform initiatives in other countries, chapter 1 underlines the need to implement reform measures by focusing on institutional systems. Specifically, Tsuru calls for centralizing decision-making authority in the budget formulation process to prevent common pool problems,, and enhancing the transparency of the fiscal system to alleviate the trade-off between discipline and flexibility in budget formulation.

Chapters 2 and 3, by Kazunari Kainou and Yoichi Takahashi, respectively, ponder the question of whether the existing fiscal system is sustainable based on detailed numerical data. Kainou develops numerical models that internalize fiscal expenditures and revenue as well as public debts, using data from the 1990s and taking into account the relationships between the central, prefectural and municipal governments and the public pension program. Then, presenting the results of various scenarios, he discusses what changes need to be made to the consumption tax rate and other relevant policies. Using an analytical method that incorporates the effects of discounted cash flows on government finances, Takahashi, in chapter 3, examines the sustainability of the pension system and the impact of the privatization of four public highway corporations in terms of the burden on taxpayers to determine the extent of the overall burden on future generations.

Chapter 4, by Jun Iio, chapter 5, by Nario Kadono and Hirokazu Takizawa, and chapter 6, by Tetsuji Okazaki, discuss the relationships between government finance and the political and bureaucratic systems. Highlighting the paradox that the maturing of democracy has weakened fiscal discipline under the "bureaucratic Cabinet system," the chapter by Iio calls for fiscal reconstruction based on solid bipartisan agreement, and stresses the importance of transforming bureaucratic government into an organization capable of autonomously pursuing the national interest. The Kadono-Takizawa chapter analyzes how rigidities in the personnel management system of bureaucratic organizations generate incentives for bureaucrats to grab the maximum budget allocations for their respective ministries and agencies. The chapter then discusses the need to reform the personnel evaluation system, to clarify the division of roles and responsibilities of various, and to increase the mobility of personnel between them, as well to and from the private sector. The Okazaki chapter focuses on prewar Japan and reveals, in quantitative terms, the presence of strong expansionary pressures on the government budget under mounting requests from various interest groups, just as is the case today. The chapter also examines the process by which such pressures became irresistable as the role of genro (senior statesmen) as guardians of fiscal discipline declined, particularly from around World War I.

Chapter 7, by Hideaki Tanaka, and Chapter 8 by Yoshinori Yokoyama, put forward proposals for budget management reform. Providing detailed descriptions of cases from other leading members of the Organization for Economic Cooperation and Development, the Tanaka chapter stresses that Japan must introduce a mechanism for controlling the budget based on forecasts and ex-post facto analysis of the impact of fiscal policy on the macroeconomy, while at the same time promoting the strengthening of political decision-making functions and the implementation of a midterm fiscal framework. The chapter by Yokoyama presents administrative reform ideas from the viewpoint of building a social system that provides value to consumers as ordinary citizens. Specifically, the chapter recommends that a group of mid-career bureaucrats be assigned to the Cabinet Office to draw up policy in an integrated manner.

Chapter 9, by Shigeki Kunieda, and Chapter 10, by Ichiro Sakata, focus on the tax system. The Kunieda chapter first takes up the basic theoretical problem of fiscal sustainability in terms of satisfying intertemporal budget constraints. The chapter then calls for a bipartisan study on the possibility of raising consumption taxes and establishing a "basic law for ensuring intergenerational equity" in order to correct the extreme disparities in the burden between the young and the elderly. The Sakata chapter focuses on corporate taxes and calls for comprehensive institutional reform, including drastic reclassification of entities for taxation purposes and possible revision of corporate accounting rules and the Commercial Code. He advocates the principles of neutrality, transparency and adaptability, particularly in implementing reform in two important domains: the institutional infrastructure (basic rules) of taxation, and national investment utilizing taxes (tax incentives).

Chapter 11, by Tomitaro Kitami, takes up the issue of fiscal discipline vis-a-vis local governments. Summarizing the changes in the administrative and fiscal oversight of local governments, the chapter recommends that Japan, over the medium to long term, shift to a stakeholder governance system, including the possibility of placing a local entity under the control of external stakeholders such as taxpayers and creditors in the event of a financial emergency such as a default, in order to improve internal fiscal discipline under normal circumstances without undermining regional diversity.

Chapter 12, by Mieko Nakabayashi, introduces a series of grassroots initiatives for reducing fiscal deficits in the United States, such as fundraising, nonprofit organization (NPO) activities and election campaigns. She argues that public awareness of fiscal conditions, as well as the presence of fiscal experts, is indispensable to the success of fiscal reform.

As the project progressed, all of us in the project team came to realize that simply discussing plans for fiscal redesign within the closed circle of politicians, Ministry of Finance officials and other fiscal experts would not be enough to transform Japan's fiscal system into the one that is both sustainable and adaptable to internal and external changes. To achieve this end, it is necessary that taxpayer-voters have a sufficient understanding of the fiscal problems the country is facing today, and that they actively participate in efforts to solve these problems. At the same time, experts such as the authors of this book must not limit themselves to providing theoretical backing for policies that politicians or the Ministry of Finance believe should be implemented. Neither should we be content to criticize the existing system nor simply to burnish our academic credentials. We believe that what we have learned through this project has important implications for reforming Japan today and for future generations. We are thus strongly motivated to disseminate our findings to the general public and to ask for their judgment. Although some readers may find this book too hefty and technical for a general audience, the reforms Japan requires cannot be accomplished through half-baked analysis or political favoritism. The members of the project team, despite differences in their expertise and background, have come to share certain perceptions and findings that are theoretical, analytical and policy-oriented. We believe and hope that our conclusions, though not perfect, will be shared by many people and that they will contribute to the realization of a mature society in Japan.

On behalf of the members of the project
Masahiko Aoki and Kotaro Tsuru