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No.6 ,Economy  Jul 28, 2011

PROPOSAL OF THREE PRINCIPLES FOR RECOVERY

The topic of revitalizing the areas affected by the Great East Japan Earthquake has been much debated, particularly in the government’s Reconstruction Design Council. Unlike the Great Hanshin Earthquake, there appears to be a consensus that this time we should not simply “restore” the original townscape, but instead aim for “reconstruction” a new type of urban development with a long-term vision. However, when it comes to specific ideas about what this should look like, there are all kinds of conflicting opinions and there is not necessarily a clear sense of direction.

Should the reconstruction be led by local municipal governments that have a good knowledge of their local areas? Or should we be thinking about reconstruction strategies for a wide area, without being bound by the framework of municipal governments? How should we deal with the problem of striking a balance between the rights of individuals and corporations? Who should bear the cost of the reconstruction? And how? … By advocating the three principles below, we hope to provide pillars for the debate, so that we can work out how to sort through these kinds of confusions.

I. Intergenerational Equity

In Japan it is already clear that the net benefit that each generation will receive form the social security system will continue to decrease, with each generation receiving less than the generation before because of demographic changes that include a declining birth rate and an increasing proportion of elderly people. This is a system design error insofar as changes to population dynamics have exceeded expectations. Rectifying intergeneration equity is an important part of generational accounting. Thus at the very least we should not adopt policies that exacerbate intergenerational inequity even further.

II. Utilizing the Market

Since the turn of the century there has been vigorous debate about income “disparities,” and some people have started to distrust the “market mechanism” whereby resource allocation is decided through pricing. This trend appears to have become even stronger as a result of the global financial crisis.

Nevertheless, when it comes to allocating resources efficiently in a way that is proportional to effort, there is no socioeconomic system better than the market. By utilizing limited resources effectively the “social pie” can be expanded, enabling more prosperous lifestyles. If we forget this thesis, the Japanese economy will suffer secondary damage in the form of economic damage, compounding the damage inflicted by the earthquake and tsunami.

Of course, we are not trying to suggest that the market is all powerful. Economic textbooks teach that “government intervention is required in economies where there are externalities.” In cases where agglomeration benefits is anticipated, the government can effectively encourage resource allocation through urban planning and so forth.

III. Sustainability

Any outlook for the global economy of the twenty-first century must assume environmental constraints and resource constraints. Moreover, in thinking about the Japanese economy we must also take into account the declining population in Japan and the appalling financial situation in developed nations.

Sometimes policies that minimize short term pain end up threatening environmental and financial sustainability over the long term. When it comes to selecting policies, the principle that it is not acceptable to only think about the wellbeing of the current generation should also be important in debates about recovering from the earthquake.

In the discussion below, we will take these three principles as a starting point in discussing our thoughts on the way that costs should be borne, measures for addressing power shortages, and the future direction of urban development in the affected areas. Policies that are correct in terms of economic theory often tend to be criticized by the public. However, what we need is strong political leadership in order to recognize the necessity of these policies, convince the public and build a bright, prosperous future.

Do Not Pass the Bill for Recovery Costs on to Future Generations

The Cabinet Office has estimated the direct damage to various properties (such as homes, factories and social infrastructure) resulting from the earthquake and tsunami at somewhere between 16 and 25 trillion yen. This sum is nearly double the cost of the Great Hanshin Earthquake. If all of the assets lost in the disaster were to be restored, the burden on the government sector is likely to be at least 10 trillion yen. On the one hand, the GDP growth rate is forecast to increase by an additional one or two percent as a result of the increased investment over the next three years because of the restoration. But on the other hand, if we factor in the costs of ensuring the safety of the Fukushima nuclear power plant and compensating damages to the surrounding areas – which TEPCO will be unable to cover on its own – then we must accept that there will be additional government spending in the order of 15 to 20 trillion yen. If we do not come up with innovative solutions as to how to fund and direct this public money, then there is a risk that the Japanese economy will once again be trapped into a period of low growth, and even a risk of financial collapse as the cost of the recovery becomes too expensive.

On the financing side, long-term government debt has already mushroomed to about 190% of GDP, and serious consideration must be given to securing sources of revenue. There are several ways in which funds might be secured, such as reshuffling the budget priorities, constricting overall government spending, selling off government owned assets, issuing government bonds, and increasing tax. Sure enough, the funds gained from redirecting spending (such as ending pork-barreling) and constricting spending (such as cutting wasteful spending) cannot be expected to be particularly huge, unless child allowances (worth about two trillion yen) were to be abolished. The question then becomes whether to issue government bonds or increase taxes.

Issuing more government bonds to cover all 15 to 20 trillion yen and then repaying this debt slowly in the future is the correct option in an economy where the population is growing, economic growth is high and the ratio of government debt to GDP is low. Unfortunately, however, the current Japanese economy does not meet any of these three conditions. To issue additional “reconstruction bonds” to be repaid in ten years’ time would have the effect of shifting the burden from the relatively affluent baby boomer generation who are about to enter retirement onto the relatively poor younger generation who will enter the workforce in the next ten years. In the ten year period from 2011 to 2021, the working-age population (people aged between 20 and 64) will fall by roughly 10% from 75 million to 67.6 million, a drop of more than seven million workers (see Figure 1). In this ten year period, the cost per person of servicing this debt (in the form of higher taxes) will increase by 10% due to demographic factors alone. Surely nothing could be more unfair to the future generation that will be working in ten years’ time. The idea of “reconstruction bonds” involves postponing the eventual bill, and clearly lacks intergenerational equity.

Looking at the problem this way, we see that it is a mistake to frame the problem as a choice between higher tax versus government debt. The options should really be phrased as “should the burden be borne by the generation that is alive today, or by future generations?” With low growth and a declining population, let’s stop passing the bill on to the next generation.

There are also various ways of increasing taxes, but in order for the whole country to support those devastated by the earthquake and the tsunami, everyone in Japan will have to shoulder the burden of higher taxes, regardless of their age or occupation, so that the burden can be diluted broadly amongst the entire population. Everyone in Japan needs to realize that their standard of living will need to be lowered slightly. Specific measures that could be adopted include raising the consumption tax rate, adding a national surcharge to taxes on real estate, lowering the tax free threshold for income taxes, a special fixed-rate levy on income tax, and postponing the planned reduction in corporate taxes.

Consumption tax has a minimal impact on economic growth because it does little to diminish the willingness of employing either capital or labor to produce. Raising the rate of consumption tax from 5% to 10% would double the current receipts from consumption tax, bringing in about 10 trillion yen of additional revenue every year.

One criticism of increasing consumption tax is that it would lead to a recession by diminishing consumers’ willingness to spend. However, this criticism misses the mark in two senses. Firstly, investment is forecast to expand next year as both the public sector and the private sector make investments towards recovery in the earthquake-tsunami hit area. Even if consumption declines, this will be offset by the increase in investment so that total demand remains the same and economic conditions do not deteriorate. Secondly, it is known that consumption falls after the rate of consumption tax is raised. However, this trend can be expected to return to normal after a few months. Meanwhile, there will be significant demand from the rush to purchase goods, particularly durable goods, in the period leading up to the scheduled increase, which will have the effect of expanding the economy ahead of the full-scale expansion in investment. In contrast, taxing labor income and corporate income has a longer lasting impact as it lowers the potential growth rate.

Much real estate has been lost in the northeast of Japan. In order to restore this while sharing the burden throughout the country it is logical to collect a surcharge on real estate taxes from companies and individuals that have real estate all around Japan to assist people affected by the disaster. However, real estate taxes are local taxes, and so the surcharge would have to be a national tax. (On the other hand, there is a land value tax as a national tax, and so this proposal could also be expressed as expanding this taxation base to be like a real estate tax.) The total value of real estate taxes and urban planning taxes around Japan is more than 8 trillion yen. A 10% surcharge (or an expanded land value tax) would bring in about 800 billion yen in additional revenue.

The proportion of workers earning below the tax-free threshold for income bracket has increased as a result of fifteen years of deflation and the replacement of older workers with younger workers. Based on the concept that disaster recovery and national security should be supported by the entire country, it is important that more people pay even a small amount of income tax. We suggest considering lowering the tax-free threshold. At the same time, we would like to ask high income earners to pay a fixed-rate levy in order to shoulder more of the burden. If we assume that these kinds of tax reforms would increase income tax revenues by 10% over current levels, then we can anticipate about 3 trillion yen in extra revenue. If there are still insufficient funds even after these measures, then we would ask companies to share more of the burden by deferring the planned cuts to corporate tax rates by another two years. This would result in about 1 trillion yen of extra revenue. However, considering the pressures of globalization and given that the effective corporate tax rate in Japan is noticeably higher than in other countries, corporate tax cuts should only be deferred if it is not possible to come up with the necessary funds by other means.

Taken together, these measures would bring in about 15.5 trillion yen in additional income per year. If these measures were implemented for two years, we can easily secure the funds for the recovery. Regressive, neutral and progressive – these measures include combinations of all kinds of taxes. Collectively, we would like to refer to them as “recovery solidarity taxes.”

Of course, increasing taxes is never a popular strategy. But increasing taxes is necessary in order to recover from a huge earthquake in a country like ours with a falling population and low economic growth. The ability to convincingly argue that we cannot pass the bill on to future generations is what makes a true national leader.

Utilize Market Mechanisms to Address Power Shortages

In the area serviced by the Tokyo Electric Power Company (TEPCO), there are concerns about power shortages resulting from the problems at the Fukushima I Nuclear Power Plant. In the area serviced by the Chubu Electric Power Company supply and demand looks set to come under pressure as a result of the shutdown of the Hamaoka Nuclear Power Plant. Within TEPCO’s jurisdiction a decision has been made to oblige large scale subscribers to cut their usage by 15% over the summer, while also asking households to conserve electricity.

Shortages in electricity supply during summer occur during peak time periods on hot weekdays, and it is important that we first strive to shift demand away from these peak time periods. If we can lower peak usage rates and even out demand throughout the day then it may be possible to cover supply shortages without increasing the number of fixed power generation facilities. For work hours we need to allow full flextime systems, and expand the scope for individuals to choose when and where they work, whether that be early in the morning, late at night or at home, so that we can avoid working during peak times. The most effective method of encouraging companies and households to shift their peak usage hours is to adopt “peak load pricing,” whereby peak daytime electricity tariffs are raised substantially. By lowering the tariffs for other time periods by an equivalent amount, such a measure can be designed so as to be revenue neutral for TEPCO.

Another effective measure is to institutionalize long holidays. For example, schools, companies and government offices could be strongly encouraged to introduce long holidays and workplace closures for at least three weeks. Of course, the amount of electricity used at homes and vacation spots can be expected to increase, and so further efforts will be required to minimize this.

If these attempts to reduce peak loads are deemed to be not sufficient on their own, then initiatives to reduce overall demand and increase overall supply will also be required. This is probably the reasoning behind the government’s plan to cut usage by 15% across the board. However, this kind of centralized economic planning produces inefficiencies. Some industries would be severely affected by an interruption to the production process of even a few hours, whereas other industries could cope relatively easily with a power outage lasting a few hours on a hot day. Insisting on uniform cuts ignores the fact that different industries use electricity in different ways.

There are two complementary approaches for appropriate solutions to imbalances in the supply and demand of electricity. The first approach is to suppress demand by substantially increasing electricity tariffs, while still taking into account the differences between households in their capacity to pay. This approach goes hand in hand with approaches that encourage additional supply by raising the prices that electricity utilities pay to purchase electricity from households and companies that have the ability to generate their own electricity, using solar panels or emergency generators, for example. The second approach is to say that if large users still need to be forced to cut their usage then they should be allowed to achieve these cuts by trading “electricity usage permits” (permits that allow then to avoid making cuts).

Some large electricity users that need to be able to operate around the clock already have their own emergency generators, while others, such as Tokyo Disneyland, are looking to introduce and generate their own electricity (using gas turbines in this case). If the individual efforts of these large consumers are made without coordination then companies with ample funds available may prepare their own generation facilities based on a conservative estimate of their requirements and end up producing more electricity than they need, while at the same time small and medium-sized companies that make products that require nonstop operations or refrigerated warehouses may face hardships. This results in investments that are inefficient for society. The solution to this problem is to encourage companies that are able to produce more electricity than they need to be able to supply any surpluses (from reserve generators or new facilities) to the electricity distribution network (“the grid”) so that it can be used by companies that need to use electricity around the clock, even if it is a little more expensive than normal. In other words, this is a mechanism for coordinating supply and demand through free fluctuations in the wholesale price of electricity. For scarce resources where demand exceeds supply, in this case electricity, it is only natural for the price to rise.

One criticism is that allowing electricity tariffs to rise will only make TEPCO rich. However, higher electricity tariffs are necessary to increase supply and restrain demand through price signals. The goal is not to make TEPCO rich. If we are going to create a compensation fund, then it would be easy to create a mechanism whereby the additional revenue from higher tariffs goes directly into the compensation fund rather than to TEPCO. Another criticism is that this would shift the burden on to consumers, but we can take into account the differing ability of households to pay by keeping tariffs as they are for households that consume less than a certain amount of electricity and increasing tariffs for households that use more.

If we are going to require large businesses to cut their electricity usage by 15%, then it is important that we allow large consumers to trade “electricity usage permits” between themselves. Trading permits to emit greenhouse gases is a classic example of this kind of “cap and trade” approach. There are some companies within TEPCO’s jurisdiction that would only experience a minor impact on profits even if they cut their electricity consumption by more than 15% during peak times. By allowing these companies to sell their “electricity usage permit” to other companies that need to operate nonstop around the clock, efficient electricity distribution can be achieved even under the restriction of limited supply (See the explanations for Figure 2-1, Figure 2-2 and Figure 2-3.) By first specifying the days and times when electricity usage is likely to peak and allocating the sizes of the cuts required, we can then leave it up to companies to trade permits between themselves. Permits will be naturally traded between companies that can afford to shut down even on a weekday and companies that need to operate continuously.

Urban development that will still be sustainable in the future

When thinking about recovery options for the disaster affected areas, we cannot forgot the fact that both demographic trends (less children and more elderly people) and local government finances will become increasingly severe as time goes by. In those parts of the disaster zone that have been hit particularly hard by the earthquake and tsunami it will be difficult to continue the same degree of government services as before, even supposing we were able to reproduce the same kind of townscapes as existed before. In urban economics it is well understand that a certain level of population density is required in order to realize the benefits of urban agglomeration.

It is almost certain that tsunamis will continue to strike the Sanriku Coast once every few decades. We need to prohibit the reconstruction of houses on land along the coast and provide financial assistance for relocation to higher ground. Fishermen will need to commute to ports from homes on higher ground. There seems to be broad agreement on this point, but it would be desirable for public agencies to actively buy up residential areas that have been repeatedly affected by tsunamis in the past. (There are also people advocating an alternative proposal whereby high rise housing is built in the areas near ports, elevated on stilts so that the tsunami could pass straight through underneath.)

There is an urgent need to secure land for relocating residents, either on higher ground or further inland, and to rebuild towns. Some towns and villages face structural problems, such as young people migrating to larger cities and an increasing proportion of elderly people, and for some of these towns the cost of maintaining basic services for residents (such as maintaining water supplies and sewerage services, repairing roads and clearing snow) has become a huge burden. And in the future there are likely to be more towns and villages like this. In such circumstances, the earthquake and tsunami provide a good opportunity to “turn disaster into good fortune” and start from scratch on a blank slate. We should create “compact cities” by concentrating services (such as nursing, medical facilities, local government offices, schools, supermarkets and cultural facilities such as libraries and theaters) in areas that are out of reach of tsunamis, and building new residential blocks and downtown areas that are wheelchair friendly, with undercover sidewalks for protection from rain and snow. It would also be good if we could face the future challenge of escalating energy prices head on, making these compact cities models for a post-carbon society. We should make “compact eco cities” a reality by bringing together all of the collective environmental technologies, anti-seismic construction technologies and urban planning wisdom available in Japan.

To achieve this, both the national government and local governments will need to buy up land in the disaster zone (we will need to give up on restoration in some coastal areas), secure candidate sites for relocation, readjust town lots, and utilize special planning zones that are exempt from detailed regulations about land and buildings (such as relaxing rules about the ratios of building sizes to lot sizes). We need to push ahead with building the infrastructure for compact eco cities as soon as possible, through Private Finance Initiatives (PFI) and other measures that involve cooperation between the public and private sectors. In promoting these initiatives, there is a particular need for flexibility in the way that tax systems regarding land transactions and land exchanges are operated. There are many victims of the disaster who would dearly love to return to their old homes and their old way of life, but we need to explain that the old ways of life could not have been sustained in the long term even without the earthquake and tsunami, and to convince them – with blueprints – that they will be able to live happier and more prosperous lives in the compact eco cities. The goal is reconstruction, not just restoration. This is the time to come up with ideas for building regional areas that will still be thriving in twenty or thirty years’ time.

Conclusion

As discussed above, some correct policies are points of contention, such as the proposal for a recovery tax package that emphasizes intergenerational equity, and the idea of raising electricity tariffs during peak periods. Even so, we believe that a sign of true political leadership is a willingness to engage in convincing the public through logical arguments. Now is the time for strong political leadership as we minimize the damage from the earthquake and tsunami, value future generations, use resources efficiently and make a great transformation towards sustainable urban development.

graph : figures 1
graph : figures 2-1

Before the Accident

The supply curve is S1 and the demand curve is D1. Here, the equilibrium market price is determined by the electricity price P1, which occurs at Q1, where electricity production = consumption. (Actually, the supplier is effectively a monopoly, and so if the supplier were allowed to freely determine pricing then it might be able to increase profits by restricting supply and adopting high monopoly pricing. However, to prevent this, the government retains the power to approve prices.) The producer (of the electricity utility) is given by the blue triangle P1B1D, while the consumer surplus is given by the red triangle AB1P1.

graph : figures 2-2

Post-accident Response #1: Allowing market mechanisms to determine prices (auctioning electricity to large consumers)

The accident at the Fukushima nuclear power plant has shifted the supply curve to look like S2. Costs increase as a result of generating electricity by reopening thermal power plants rather than using nuclear power plants. There is also an absolute supply limit (Q2) as a result of the constraints of fixed facilities. On the other hand, the demand curve (D1) remains unchanged. If we then assume that the right to use this limited amount of electricity will be auctioned off, the price of electricity will be determined at P2. This then determines Q2, the point at which electricity production = demand = consumption. The producer surplus because the blue quadrilateral P2CB2D, while the consumer surplus becomes the red triangle ACP2. This response maximizes the sum “producer surplus + consumer surplus” under the new resource constraint. However, most of the surplus goes to the producer, and this may be regarded as undesirable in terms of income distribution. In this, additional measures are required, such as increasing taxes for producer’s profits and reducing taxes for consumers. Note that this model assumes that either (a) there are only small uncertainties with regards to the positions of the supply and demand curves, and that the price where supply matches demand can be found easily, or (b) supply and demand always match, so that the price responds instantly to changes in demand and demand responds immediately to changes in price, even if there are large variations in demand. However it may be technically impossible to set prices in response to supply and a level of demand that fluctuates from minute to minute due to climatic factors and so on. Similarly, it may be technically impossible for demand to be adjusted while tracking price changes in real time. Given the huge damages that would result from demand exceeding supply even temporarily (such as the risk of widespread blackouts), then it is unrealistic to rely solely on a minute-to-minute pricing mechanism when there is not much room to move on the supply side.

graph : figures 2-3

Post-accident Response #2: Cutting demand by 15% across the board, but with no change in electricity prices

The supply curve is the post-accident S2 curve. When we then draw the demand curve for when all consumers reduce their demand by 15% compared to pre-accident levels, we end up with D2, the “compulsory cuts” demand curve whereby consumers reduce demand by 15%, regardless of price – that is, the curve where the pre-accident demand curve has been shifted by 15% to the left, towards Q1. However, for all prices, the “true demand” (that is, demand whereby consumers think “I’d pay that price”) is in fact indicated by the curve D1. The horizontal distance between D1 and D2 is the result of a regulation that compels consumers to make cuts. This enables the point where electricity production=demand=consumption (Q2) to be achieved using the pre-accident electricity price. Basically, this is what the government is proposing. With this equilibrium, the producer surplus is given by the blue triangle P1B2D and the consumer surplus is given by the red triangle AP1B2. This response does not maximize the sum “producer surplus + consumer surplus” under the resource constraints. Compared to Post-accident response #1, the consumer surplus has lost an amount equivalent to triangle ACB2. This is because keeping prices artificially low has the effect of preventing electricity from going to people who would be prepared to pay higher electricity prices.

In a situation where matching supply and demand through a minute-to-minute pricing system is technically difficult, and temporary surges could cause widespread blackouts, it is easy to understand why the government would want to use a cap to restrict the quantity that can be used. However, with only a cap we are stuck with inefficient usage of resources.

graph : figures 2-4

Post-Accident Response #3: Cutting demand by 15% access the board, and then allowing consumers to freely trade electricity between themselves

In this response, we first implement response #2 (uniform cuts across the board), and then allow consumers to trade “electricity usage permits”, whereby the people who purchase these permits have the right to purchase more electricity, and the people who sell these permits are obliged to accept even further cuts. Companies where it is important to operate nonstop around the clock for technical reasons may well want to purchase additional electricity even if it costs more than P1. Conversely, there will also be some companies that are prepared to give up their electricity usage permits if they are offered a price that is considerably higher than P1. Some companies will be prepared to purchase electricity even at the highest price, that is, even as the price approaches point A (the horizontal difference between D1 and D2).There as many consumers that would be prepared to sell their permits if offered a price even slightly higher than P1 as the slope of D2 (the horizontal distance between D2 and the vertical position of Q2) The price at which demand matches supply (the price at which the number of permits that companies are prepared, at that price, to make additional purchases matches the number of permits that companies are prepared, at that price, to sell where the permits to be sold come from those that have been allocated to them) is P2. Depending on P2, those people that are prepared to purchase electricity even at a price higher than P2 will purchase a quantity given by Q2-Q3, resulting in an increase in the consumer surplus to the extent of the yellow triangle AC1C2. On the other hand, the number of people that are prepared to sell their additional electricity usage permits for the price P2 is given by Q2-Q3, and so their consumer surplus increases to the extent of the green triangle C1C2B2. By establishing uniform cuts and then trading obligations to meet them in this way, electricity can be used more efficiently in a resource allocation sense (although not in an income distribution sense). Ultimately, the price charged by the electricity utility is P1, but the price of additional electricity usage permits is P2.

Here, by allowing consumers to trade electricity, there will be people who are willing to sell electricity if they can receive a price higher than P2, and there will be people who are prepared to buy electricity even if it costs more than P2. The quantity purchased by people who want to purchase electricity even if it requires paying the price gap (P2- P1) matches the amount (Q2- Q3) sold by people prepared to sell electricity if they can receive a price of P2 .

In this way, consumer surplus increases by the extent of triangle ACB2, and the sum “producer surplus + consumer surplus” can be maximized.

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