Saving Japan from fiscal collapse


Japan’s budget for fiscal 2020 was formulated in December 2019 before COVID-19 hit and pandemic considerations could be taken into account. Spending is expected to reach 102.7 trillion yen ($ 939 billion) and the primary budget deficit-to-GDP ratio is expected to be 2.7 percent.

The government has set itself the objective of achieving a primary surplus in national and local administrations by 2025. These budgetary consolidation objectives were defined within the framework of the “Basic Policy on Economic Management and Reform and Budget 2018 ”.

The pandemic seemed to deprive Japan of the will to continue fiscal discipline. In 2020, the government developed three COVID-19 Supplementary Budgets, and as a result, spending swelled to 175.7 trillion yen (US $ 1.6 trillion). Yet unlike the UK and US – which have already started talks about future tax hikes – there is very little talk in Japan about fiscal consolidation. The lack of debate is problematic because Japan has the world’s worst public debt-to-GDP ratio.

There are three possible reasons why the debate on fiscal consolidation has not progressed in Japan. First, a lot of people don’t care about financial issues. A investigation on public finances and tax burdens revealed that the average rate of consumption tax that citizens considered desirable is changing by around 2 percent with and without a prior explanation of Japan’s fiscal position. The Japanese public seems to ignore the risks associated with debt and the need for fiscal consolidation.

Second, there is confusion about fiscal consolidation measures. The debate over Japan’s fiscal strategy is vast. Some argue that spending cuts are more effective than tax increases. Others propose to increase nominal incomes and nominal GDP by raising prices and stimulating economic growth to reduce real public debt. Raising taxes is another option, although it is unpopular.

The different approaches to reduce real public debt also creates divisions. One view suggests that economic growth increases through structural reforms on the supply side. Another perspective aims to achieve both higher prices and economic growth through monetary easing. Another approach suggests that the fiscal expenditure multiplier is large enough and that fiscal consolidation is possible if fiscal expenditure increases. This confusion prolongs the debate on fiscal consolidation in Japan, resulting in “Consolidation fatigue‘. The longer the period of fiscal consolidation, the greater the likelihood that the chosen fiscal consolidation measure will not be completed sufficiently.

Third, a consumption tax is unpopular with Japanese citizens. Given the shrinking working-age population in Japan and the global competition for corporate tax cuts, a consumption tax should be the last candidate to achieve fiscal consolidation. The regressiveness of the tax burden inherent in a consumption tax is likely to run counter to the maximize the welfare preferences of the Japanese public. A consumption tax hike is the most politically unpopular fiscal consolidation strategy, but remains one of the few remaining options.

Fiscal consolidation in Japan is quite a difficult task. But the consumption tax rate in Japan is still only 10 percent. This figure is low compared to other developed countries – Japan still has a tax room of around 10 percent to increase the consumption tax if the example of other developed countries were followed. A 5 percent increase could fully cover the average primary budget deficit to nominal GDP ratio generated over the past ten years.

Japan is extremely unlikely to face financial collapse short term. Whatever the political difficulty of fiscal consolidation, the government currently has levers to activate if the financial crisis becomes imminent. But the effectiveness of these levers may decrease in the long term. The aging of the Japanese population will continue to reduce fiscal space due to the rising cost of social security and the consequent increase in public debt. The aging process will also reduce the national savings rate, and given the current stagnant economic and fiscal situation in Japan, it is difficult for the Bank of Japan to escape its low interest rate policy.

These factors will lead to future economic turmoil without fiscal consolidation now. Low interest rates will mean that the Japanese economy will face a large domestic and foreign interest rate spread, and the resulting yen carry trade will cause the yen to depreciate. If the overseas holding rate of Japanese government bonds (JGBs) is high enough due to the shortage of domestic savings, combined with significant depreciation for foreign investors, the price of JGBs will collapse.

The Bank of Japan can avoid a sovereign default because it can buy and support JGBs, but this will inevitably lead to further depreciation of the yen. This depreciation will bring great upheavals to the economy through, for example, the rise in oil prices. If this happens in the middle of winter, it could affect the lives of the poor living in the northern regions more severely. Japan’s GDP will also decline in dollars. No one knows how big or small this fall will be, but it could mean that Japan will pull out of the developed world.

As time is running out to avert a fiscal catastrophe, the Japanese government must implement effective fiscal consolidation measures as soon as possible.

Keigo Kameda is Professor of Economics at the School of Policy Studies at Kwansei Gakuin University.


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