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No.2 ,Economy  Sep 24, 2010

PROMOTING GROWTH AND RESTORING FISCAL HEALTH SIMULTANEOUSLY

These days people are talking about how Japan’s public finances are in danger of going bankrupt, but I frankly do not understand what they consider to be a state of bankruptcy. Certainly the government has gone heavily into debt, but for the most part, the outstanding government obligations are domestic in nature. That is, they are bonds held by Japanese parties, not by overseas investors. In effect, the Japanese are in debt with each other. It is like a family in which the husband has borrowed money from the wife, not from some loan shark. Under the circumstances, no problem will arise as long as inflation does not set in and interest rates do not rise too high. To be sure, the government needs to keep on meeting interest payments and rolling the debt over, but it has the financial tools for that.

The specific complaint one commonly hears is that the worsening health of public finance may prompt credit-rating agencies to lower the grade they assign to Japanese government bonds, but there is little chance of that. In international perspective, Britain, the United States, and France all have fiscal deficits larger than Japan’s measured as a percentage of gross domestic product, and Germany’s deficit is about the same size. In addition, as Bank of Japan Governor Shirakawa Masaaki has acknowledged, the nation has considerable leeway for hiking the consumption tax, which remains on the low level of 5%, and this is holding back moves to downgrade government bonds.

What would be more likely is that the government becomes unable to issue bonds as a result of turmoil in financial markets. The recent pattern has been for long-term interest rates to move down whenever stock prices plummet, but rates could instead move up, causing the bond market to crash and obstructing bond flotation. In the current situation, moreover, financial markets are quick to move funds around when even small differentials in interest rates open up. Government bonds could find themselves being targeted as an asset to avoid, not to acquire, and the authorities would become unable to raise funds.

Achieving Robust Public Finances

On June 22 the cabinet approved a fiscal management strategy featuring a scheme to improve the health of public finances. The strategy specifies the target of turning the deficit in the “primary balance,” or government expenditures and revenues excluding new bond issues and debt-servicing costs, into a surplus by fiscal 2020 (April 2020 to March 2021). It is unlikely that this plan will progress on schedule, though, on account of likely major changes in factors on which it is premised, such as interest rates, stock prices, and unemployment.

What is important today is not, however, the outstanding public debt or the balance between expenditures and revenues. The key question is how the authorities can secure a sufficient inflow of fiscal resources to sustain the public services that support the people’s lives even in the event they become unable to raise funds through bond flotation. Let me illustrate with a concrete example. Suppose that total tax payments amount to about 20% of GDP while total public spending is on the order of 26%, leaving a gap of 6 percentage points. The difference would ordinarily be covered by deficit-financing bonds, and if their issue ran into a roadblock, the public services the government supplies would have to be cut back to the 20% level of tax payments. Now suppose that the government strengthens its revenue base, lifting taxes to 26% of GDP, and that it also enhances the social security system, causing a 6-point increase in its expenditures to 32% of GDP. Again the emergence of obstacles to the issue of government bonds would necessitate cuts in public services, but they would only have to be scaled down to their original 26% level.

Prime Minister Kan Naoto has spoken of the need for realizing “robust public finances,” and this is what I see as a fiscal setup that could be fairly described as robust. It means, though, that the government must make an adjustment in the burden taxpayers are shouldering. After all, in the general account for fiscal 2010, taxes are estimated to account for only some 40% of total revenue.

At the Toronto summit of the Group of Twenty in June, the advanced countries adopted a declaration committing themselves to cutting their fiscal deficits in half by 2013 (although Japan was excepted in view of its special circumstances). But if the countries of the world move in unison toward austerity budgets, what might the result be?

At the onset of the Great Depression in 1929, John Maynard Keynes warned of the dangers of the “fallacy of composition,” the presumption that what is good for one individual must automatically be good when all individuals behave in the same way. That is, while each economic actor might see cutting back on spending as the best course of action, an economy would contract if they all reduced their consumption. The fallacy of composition was initially used to illustrate the adverse consequences of identical behavior by the actors within a single country, but it also applies to groups of countries and is a lesson from the past we need to keep in mind. Anyone can appreciate that the fallacy remains a concern even in the modern world. Paul Krugman, for instance, pointed out in his June 27 column in the New York Times that slashing spending in the middle of a downturn will only deepen the depression. In this light, we probably need not take the promise by the advanced countries to cut their deficits in half all that seriously.

In this context as well, we can appreciate that what Japan should do is construct a solid tax revenue foundation under the fiscal system, especially since financial conditions are so unsettled, with slight differences in interest rates triggering massive fund movements. At this stage, the government probably should not rush off on a quest to attain equilibrium in the primary balance.

Promoting a New Industrial Structure

What exactly should the government seek to accomplish? In a word, it should implement fiscal measures to ready the preconditions for the emergence of a new industrial structure.

In the course of the 1920s and 1930s, a period of financial panics and depression, the center of Japan’s industrial structure shifted from light industries like textiles to heavy industries like steelmaking and petrochemicals. The shift occurred quite dramatically. Starting from 1929, the consumer price index plummeted by 30% in merely two years. The prices of steel materials also plummeted, but just for a while. On an index with 1928 prices set at 100, steel prices dropped to 60 at the lowest, but then a recovery set in, and by 1933 they had regained their former level. Raw silk prices, by contrast, failed to bounce back. They dropped to the level of 40 in 1931, recovered some ground by 1933, but then fell back again to about 40. In short, the price mechanism was at work. In the course of the transition in industrial structure, companies in traditional industries that had fallen into decline were forced out of business.

Now the Japanese economy is going through another rough period, but the price mechanism is not functioning effectively. While a deflationary tone is causing prices to decline, steep drops are not occurring. Under the circumstances, the shift in industrial structure will take some time. In the background is the fact that Japan in 1929 was on the gold standard, while today it is not. It might also be observed that governments have now gained wisdom about how they can limit the tragic consequences of a crash that happens all of a sudden.

Inherently the lead role in the creation of a new industrial structure is played by the financial system. Financial resources need to be deployed from a long-range perspective without being diverted into schemes to make a quick profit. There should be a shift in money flows away from sunset industries and toward the new industries that people in the dawning age will require. At the present time, however, Japan’s financial system is not yet performing in this capacity. The government should, accordingly, use its fiscal tools to prepare the necessary conditions.

The Failure of the Rising-Tide Approach

Ever since the 1980s the authorities have applied a “rising tide” policy to tax cuts based on the reasoning that all will benefit from measures that give help to the wealthy and improve corporate profitability. At the same time, they have intruded into the formerly sacrosanct realm of social security and revised existing systems, limiting the extent of coverage. Let us consider why they opted for this course of action.

The idea was that Japan could boost economic growth by cutting income and corporate taxes, realizing a society that rewarded those who made the most efforts, and unleashing the will to work among all workers. Faster growth would then cause tax revenue to swell, enabling the government to attain a healthy fiscal position without hiking taxes. A trickle-down effect would manifest itself at the same time, it was said, spreading wealth from those who became more affluent to those without much money, thereby limiting the widening of social disparities. The rising-tide argument in this way made economic growth the supreme objective and anticipated such side effects as a balanced budget and minimal widening of the gap between the rich and the poor.

What actually happened, however, was something else. First, the government’s capacity to raise tax revenue declined, and while government spending followed an upward curve on a line graph, the tax revenue curve sloped steeply down, giving the appearance of a yawning alligator. The alligator’s mouth opened so wide, in fact, that fiscal deficits mushroomed, and even deeper cuts in social security may become necessary. Second, the tax system’s function of redistributing income was impaired, and poverty spread as income differentials widened. Third, the shift in industrial structure was obstructed, and economic development decelerated. That is, the government’s policy line led to stagnant growth, falling wages, and unemployment. Although the early years of the new century saw the start of a sustained expansion longer even than the famed Izanagi boom of the late 1960s, the pace of growth remained at a low level.

Results like these were not unrelated developments; they were linked in a negative chain whose links reinforced each other. We may say that overly large budget deficits arose as a result of the shift to an overly small government.

Taking Action on Three Fronts Simultaneously

How are we to break free of this negative chain created by a policy taking the rising-tide approach to tax cuts? Only if we set off in simultaneous pursuit of two rabbits–economic growth and fiscal rehabilitation–will we be able to overcome the reluctance to rise to the challenge of rebuilding the industrial structure, motivating companies to invest in human resources and move into new fields. This is the positive chain Prime Minister Kan had in mind when he called for the realization of “a strong economy, robust public finances, and a strong social security system, all at the same time.”

As I have already explained, public finances will become sound when essential public services can be sustained without depending on borrowing. Once the government is in a strong financial position, it can get to work on providing ample social security. A strong welfare system requires the construction of a safety net composed of livelihood and activity guarantees. This net should not just provide a sense of security but also assist efforts to rise to challenges. If it functions like a trampoline, welfare recipients can use it to jump at chances.

Livelihood guarantees should be provided in a set of cash benefits and services. If, for example, women are to join the labor force, they may need the guarantee of services that support raising children and caring for elderly family members. Activity guarantees should make use of schooling, retraining, and lifelong education, which is also called “recurrent education” and which provides people with the skills for entering the labor markets of a new industrial structure. A policy focused on activity guarantees shifts emphasis from the provision of physical infrastructure, such as the road and railway networks and the power grid, to the formation of human infrastructure. Labor productivity will increase as workers acquire more abilities, leading to faster economic growth. At the same time, when all of the members of society are engaged in honing their respective precious skills, a more equitable distribution of income becomes possible, and social fairness can be realized.

Strong social security provides the foundation for achieving a strong economy. The objective is to generate a qualitative change in the industrial structure, one that will both assure economic growth and employment and enhance social fairness through equitable income distribution. Once the economy acquires strength, the prospects for robust public finances will steadily improve.

In this trinity of a strong economy, robust public finances, and strong social security, action must go forward on all three fronts at the same time. In the conduct of fiscal management, allocation targets are selected first, and spending amounts are decided after that. In this respect, although the starting point should be seen as the attainment of strong social security, my concern here is the structure of expenditures and revenues in the budget for each year. Since it is the combined effects of the trinity that count, it would make no sense to ask about which element of the trinity to start with or demand that priorities be assigned among the three elements.
Taking Action on Three Fronts Simultaneously
How are we to break free of this negative chain created by a policy taking the rising-tide approach to tax cuts? Only if we set off in simultaneous pursuit of two rabbits–economic growth and fiscal rehabilitation–will we be able to overcome the reluctance to rise to the challenge of rebuilding the industrial structure, motivating companies to invest in human resources and move into new fields. This is the positive chain Prime Minister Kan had in mind when he called for the realization of “a strong economy, robust public finances, and a strong social security system, all at the same time.”

As I have already explained, public finances will become sound when essential public services can be sustained without depending on borrowing. Once the government is in a strong financial position, it can get to work on providing ample social security. A strong welfare system requires the construction of a safety net composed of livelihood and activity guarantees. This net should not just provide a sense of security but also assist efforts to rise to challenges. If it functions like a trampoline, welfare recipients can use it to jump at chances.

Livelihood guarantees should be provided in a set of cash benefits and services. If, for example, women are to join the labor force, they may need the guarantee of services that support raising children and caring for elderly family members. Activity guarantees should make use of schooling, retraining, and lifelong education, which is also called “recurrent education” and which provides people with the skills for entering the labor markets of a new industrial structure. A policy focused on activity guarantees shifts emphasis from the provision of physical infrastructure, such as the road and railway networks and the power grid, to the formation of human infrastructure. Labor productivity will increase as workers acquire more abilities, leading to faster economic growth. At the same time, when all of the members of society are engaged in honing their respective precious skills, a more equitable distribution of income becomes possible, and social fairness can be realized.

Strong social security provides the foundation for achieving a strong economy. The objective is to generate a qualitative change in the industrial structure, one that will both assure economic growth and employment and enhance social fairness through equitable income distribution. Once the economy acquires strength, the prospects for robust public finances will steadily improve.

In this trinity of a strong economy, robust public finances, and strong social security, action must go forward on all three fronts at the same time. In the conduct of fiscal management, allocation targets are selected first, and spending amounts are decided after that. In this respect, although the starting point should be seen as the attainment of strong social security, my concern here is the structure of expenditures and revenues in the budget for each year. Since it is the combined effects of the trinity that count, it would make no sense to ask about which element of the trinity to start with or demand that priorities be assigned among the three elements.

The Tax Reform Agenda

Exactly how should the tax system be reformed in order to strengthen public finances? On June 22 the Tax Commission subcommittee that I chair released an interim report on its discussions about revising the tax system. Here, while touching on the ideals lying behind this report, I will present its conclusions in my own words.

A tax system needs to be designed with four sets of principles in mind. One set consists of principles involving fiscal policy, such as the principle of adequacy (whether the tax system is adequate for sustaining public services) and the principle of flexibility (whether it allows for the collection of revenue to be expanded and contracted). Another set is the principles that guarantee equity. Then there are principles for facilitating economic policy and for managing tax administration. The interim report proposes seven agenda items for handling these four sets of principles, determining how revenue sources should be distributed between the central and local governments, and pulling the tax system together.

In the area of fiscal policy, satisfying the adequacy principle means securing sufficient tax revenue to provide public services. In its party platform, the ruling Democratic Party of Japan sets the goal of building a society in which people support each other. This goal can be attained through the sharing of resources by means of taxes. This is the first agenda item.

The second is restoring the function of redistribution based on the equity principle. Vertical redistribution, through which the rich share some of their wealth with the poor, is to be enhanced through a reform of income and asset taxes. Third on the agenda is securing stable financial resources for supporting the social security system. Action on this front is related to the flexibility principle of fiscal policy, and it aims to make use of the consumption tax, which serves to accomplish the key tax objective of facilitating horizontal redistribution.

In the area of economic policy principles, the tax system needs to be designed to enable economic growth. What is important, however, is forging a new industrial structure. This is a matter of qualitative change, not just quantitative growth. There is no strong evidence for the assertion that cutting corporate taxes will automatically promote growth. Some economists support this proposition, but others are in disagreement. If moves are made to lower corporate taxes, accordingly, steps should also be taken to broaden the corporate tax base. This is the fourth agenda item.

The fifth item deals with the issue of distributing revenue sources among the central government and the regions, and it seeks to reform the tax system so as to achieve “regional sovereignty.” The proposals in this area would revise the allocation of tax revenue and strengthen local consumption taxes. Japan probably has no choice but to move toward decentralization. In the work on constructing a safety net, the provision of services is a more important concern than the payment of cash benefits, but it is best that these services be fine-tuned as far as possible to match the realities of daily life in each local community.

The principles of tax administration are the concern of the sixth item, which proposes that the tax system be redesigned by shifting it from the “logic of the tax collector” to the “logic of the taxpayer (the people).” In particular, Japan needs a transparent system that can win the consent of taxpayers.

At the end, the interim report pulls all these proposals together in the seventh agenda item, which is to create a tax system with overall coherence. Based on the discussions among its members, the subcommittee believes it necessary to construct a tax system in which income taxes and value-added taxes (the consumption tax) serve in the main role of the two wheels of the cart while other levies, such as property taxes and environmental levies, which are specific taxes, play supplementary roles. In the proposed tax reform, accordingly, the respective components of the tax system, including income, corporate, consumption, and asset taxes, need to be considered not as separate items but as parts of a whole.

Limiting a Consumption Tax Hike

The assumption that the government intends to hike the consumption tax to 10% has taken on a life of its own, even though Kan, while campaigning for the July House of Councillors election shortly after he became prime minister, never made a specific pledge to that effect. The report of the Tax Commission’s subcommittee also makes no reference to a 10% rate. As I noted, the leeway Japan has for lifting the consumption tax to a higher level is helping to persuade credit-rating agencies not to downgrade its government bonds. In this light, perhaps Japan ought to retain room for hiking the tax, since this merit of a low rate would be lost if the government established a new rate at the 10% or 20% level.

It seems reasonable to say that even if the authorities decide to hike the tax, they ought to limit the extent of the increase as far as they can while reforming the rest of the system so as to secure a more ample supply of revenue from income and other taxes. A call has been made by the Liberal Democratic Party in the opposition for hiking just the consumption tax, setting it at a 10% rate, but an equal amount of revenue could be raised through a reform of the tax system overall. If, for instance, the income tax were hiked by 2 percentage points and maximum tax rates were lifted, the increase in the consumption tax might be held to 2 points.

Correcting the regressive nature of the consumption tax is another subject of debate. There have been calls, for instance, for introducing a credit for the consumption tax in the income tax system, so that low-income taxpayers would receive a refund for their payments. This, though, would dilute the effect of any hike in the consumption tax. Levying taxes on consumption is by nature a regressive practice, but when the tax applies broadly to the items people consume, it can bring in a large amount of revenue even if it is set at a low rate. There should be no need to remedy the regressive impact of the consumption tax independently, since equity in taxation can be achieved by also taking the income tax, which is progressive in nature, into account. Why turn a simple tax into a complicated one? I fail to understand why some people feel it necessary to resolve the regressive elements within each tax category. We need to pursue a discussion of the whole system, not just of its parts.

Getting Democracy to Work

Finally, I would like to add a word on the government’s trustworthiness. This is because the strong popular resistance in Japan to any tax hike is believed to stem partly from the people’s lack of trust in the government.

This is an issue that boils down to the question of whether Japanese democracy is functioning as it should. Here we need to learn from the lesson of Germany before World War II. By fanning the flames of popular discontent with the Reichstag, Germany’s parliament, and arguing that legislators served no useful purpose, the Nazis attracted an explosively growing political force and succeeded in forcing the Reichstag to pass the Enabling Act, which handed its constitutional functions over to Adolf Hitler. Today in Japan as well, a vicious circle has been set in motion by the poor functioning of the democratic process and the government’s failure to supply the kinds of services people desire. This is a very dangerous situation, since opportunities for critics to denounce democracy are being created.

In The Age of Uncertainty, John Kenneth Galbraith called attention to the differences between representative democracies, such as the United States and Britain, and direct democracies, such as Switzerland. In a direct democracy, Galbraith pointed out, citizens solve problems by themselves without delegating anyone to act on their behalf. In a representative democracy, by contrast, citizens engage in a search for representatives to act for them. We can find much food for thought in this comment about the proper operation of democracy.

Translated from “Keiki kaifuku to zaisei saiken no ‘nito’ o eru zeisei keikaku,” Chūō Kōron, September 2010, pp. 130-37; slightly abridged. (Courtesy of Chūō Kōron Shinsha) [September 2010]

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