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Kimiko TERAI


The political economy of fiscal consolidation in Japan: why is Japan suffering from persistent fiscal deficits?





 

Japan’s accumulated public debt is over twice its GDP; this figure is high compared to that of other developed countries. In the 1980s, Japan’s public debt was not substantial. Nevertheless, the country’s public debt grew rapidly in the 1990s, while other major developed countries were engaged in fiscal consolidation from the late 1990s onwards.

The figure below shows the transition of construction and deficit-financing bonds issued by the Japanese national government. 

 

Since FY1966, construction bonds in order to finance public work projects have been issued invariably. After the economic bubble in the 1980s, Japan experienced a severe recession in the 1990s. It undertook expansionary fiscal measures by appropriating supplementary budgets for public works expenditure and utilizing construction bonds as a source of funding this expenditure. Apparently, the scale of issuance of construction bonds increased steadily, reflecting increased public investments as an emergency economic measure to cope with the recession. Since the 2000s, however, the national government has curbed the issuance of construction bonds. This can be attributed to the fact that certain public works projects were criticized as inefficient and wasteful after completion. Moreover, some empirical studies revealed that the multiplier effect of public works was weaker compared to that during the 1980s (see, e.g., Ihori et al. (2002); Kameda (2014)).

On the other hand, the scale of issuance of deficit-financing bonds, which began to grow in the mid-1990s, is currently massive. The graph displays the actual values of bond issuance up to FY2012. For FY2014, the national government plans to issue deficit-financing bonds by 35 trillion yen, which is approximately six times the amount of construction bonds. Clearly, the Japanese government is suffering from persistent fiscal deficits.

One plausible reason for the persistent fiscal deficits is the reduction in tax revenues due to an economic depression. Another reason can be attributed to the composition of government expenditure. Today, approximately one-fourth of the general account’s budget is being utilized for national debt service, reflecting the large-scale public debt outstanding. Moreover, approximately one-third of the budget represents social security expenditures, owing to the rising aging population in Japan. These expenditures are mandatory, and therefore, the government cannot control their expansion readily. Eventually, despite a decline in public works expenditure, the total expenditure rose and caused persistent fiscal deficits, thereby resulting in public debt accumulation. Today, approximately half the national revenues are from issuing government bonds. Japan is confronted with the pressing need to control the accumulation of fiscal deficits. A question that arises here is why Japan has not yet succeeded in achieving fiscal consolidation.

Our recent book titled The political economy of fiscal consolidation in Japan (to be published by Springer) adopts a politico-economic approach to fiscal consolidation. The book clarifies the roles of the recession in the 1990s and the rapidly changing demographics for Japan’s persistent fiscal deficits. Moreover, it attempts to identify the political and institutional elements that have hindered the implementation of fiscal consolidation.

In post-war Japan, the Liberal Democratic Party (LDP) has formed the government, except during the period of administration by the Democratic Party (August 2009–December 2012). The ruling party has frequently focused on excessive public works expenditure, as part of a Keynesian stimulus package. After adopting an initial annual budget, the Japanese government later adopted a supplementary budget. The government has attempted to limit the size of the initial budget by setting a fiscal cap on discretionary spending included in it. However, the supplementary budget has been free from fiscal restraint. The budget, being used for public works, may have favored local vested interests and related politicians. Therefore, we need to analyze the role of special-interest politics to understand why Japan’s government relied on pork-barrel projects.

Currently, Japan is experiencing rapid population aging. Consequently, the government has increased social security expenditures for the elderly, such as the expenditures on pensions and medical care. Such expenditures are expected to increase further because baby boomers are now retiring in large numbers. The higher ratio of retired population leads to their growing political power relative to that of the working population. Furthermore, collective decision-making under the majority rule tends to overrepresent the opinion of the majority. Therefore, we cannot analyze social security expenditures without taking into the account the political economy of an aging population.

The book comprises three parts. The first part presents comprehensive views of Japan’s fiscal problems. Chapter 1 summarizes Japan’s fiscal policies and fiscal situation in the 1990s and 2000s, with particular emphasis on special-interest politics. The chapter shows that macroeconomic measures to cope with business cycle risks are not always desirable in the face of privileged political pressures. The importance of the government’s commitment to fiscal consolidation is also emphasized. Chapter 2 analyzes how demographic aging influences intergenerational and intragenerational redistribution through social security funding, and consequently the choice of wage or consumption tax funding. The results presented in this chapter may be helpful in explaining why some developed countries prefer financing social security expenditures by increasing the consumption tax rate.

The second part of the book is devoted to important fiscal problems in Japan. Chapter 3 examines the effect of an expanding female labor force on economic growth and fiscal revenues. Encouraging potential female laborers to work as full-time labor force participants is expected to increase tax revenues and contributions to the public pension scheme, which could eventually improve the fiscal situation in Japan. The simulation results, however, indicate that its impact on the economy and fiscal situation is small. The next two chapters discuss the reasons for local governments’ inefficient spending on public works. Chapter 4 focuses on the incentive problems caused by the intergovernmental transfer scheme. Expecting an ex post bailout by the central government, local governments spend inefficiently ex ante. Chapter 5 employs the fiscal competition model to illustrate how the concentration of economic activities occurs in a few regions, with many other regions failing to attract industries despite overproviding public infrastructure.

The third part argues the way in which the institutional design aggravated fiscal problems. Chapter 6 points out that under population aging, the current electoral system, which allocates seats in the Congress, works to overrepresent the interests of the elderly generations. The author proposes introducing a new electoral system that defines electoral districts by region and generation. Agency problems in the budgetary process are explored in Chapter 7. Japan’s budgetary process is divided into two stages; decisions on fiscal caps by the Ministry of Finance (MOF) and the allocation of budgets among projects by spending ministries. A spending ministry can exploit asymmetric information between the MOF and itself to obtain a larger budget.

Thus, the book illuminates the linkage between political factors and fiscal problems faced by Japan. Political institutions have worked toward exaggerating the policy preferences of a particular group and increasing the expenditures for the benefit of that group. The results derived from our studies on Japanese fiscal problems have meaningful implications, which can be applied to other democratic countries struggling with fiscal deficits. Our studies also provide Japanese researchers and policy makers with insights into incentive designs and institutional reforms necessary for fiscal consolidation. After the long-lasting rule by the LDP, Japan recently experienced successive regime changes. The Democratic Party came to power in 2009, with the LDP being out of office; however, in 2012, the LDP returned to power. The Democratic Party spent a larger budget for redistributive purposes, as it had promised in its manifesto. After the LDP returned to power, expenditure on public works have risen subsequently. Consequently, we need structural reforms to restrain the expansion of fiscal deficits.

References:
Ihori, Toshihiro, Toru Nakazato, and Masumi Kawade (2003) “Japan’s fiscal policies in the 1990s.” The World Economy, vol. 26, pp. 325-338.
Ihori, Toshihiro, and Kimiko Terai, eds., The Political Economy of Fiscal Consolidation in Japan, Springer, forthcoming.
Kameda, Keigo (2014) “What causes changes in the effects of fiscal policy? A case study of Japan.” Japan and the World Economy, vol. 31, pp. 14-31.

Kimiko TERAI is Professor of Economics at Keio University, Japan. Professor Terai's principal research areas include public economics and public finance, with special focus on the political economy of redistributive policies. 
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