Annual Report on

The Japanese Economy and Public Finance

2005

- No Gains Without Reforms V -

Cabinet Office

Government of Japan


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Section 3 Reform of Local Public Finances

    As a provider of public services, local government plays a larger role than the central government. Therefore, in achieving small government by means of a shift from the "public sector to the private sector," the first requirement is expanding the discretion of the local governments whose standpoint is particularly close to local residents, the users of public goods, in order to enable services to be provided in accordance with the circumstances of that region. It is also important to promote administrative and fiscal reform in local government in its role as director of operations. Local public finance is currently the subject of a review of the reform of the fiscal relationship between central and local governments. In addition, the ongoing mergers of municipalities are expanding the scope of administration over larger regions with a view to enhancing its efficiency. This section will first present an overview of the reform of the fiscal relationship between central and local governments, and then turn to the question of the effectiveness of improvements in administrative efficiency brought about by integrating administrative services to cover larger regions, as seen in the drive toward the merger of municipalities. Finally, the causes of fiscal disparities between local governments will also be subjected to analysis.

1. Review of the Relationship between Central and Local Government

 Review of the relationship between central and local government
    Under the concepts "from public sector to private sector" and "from the State to the regions," an initiative is now underway that seeks to significantly enhance the authority and responsibilities of local government based on a clear division of roles between central and local government, and through these reforms, build an independent and autonomous decentralized administrative system. The specific goals of this reform will be achieved by increasing local discretion in the handling of expenditure and revenue through a reduction in the involvement of central government, and by clarifying for residents the relationship between benefits and burden. This will allow an expansion of the range of administrative services that local governments can choose to implement at their own initiative, enabling them to truly meet the needs of the people in an independent and efficient manner, with a view to building a simpler and more efficient administrative and fiscal system that encompasses central and local governments. With the above objectives in mind, the integrated reform of state subsidy contributions, local allocation taxes, and the transfer of tax revenue sources to local governments is moving forward, along with the expansion of the right to autonomy of local governments on taxation and the mergers of municipalities.

 Current relationship between central and local government
    The following is a brief discussion of the relationship between central and local government finances based on FY2003 figures. Starting with government spending, local governments accounted for about 60% of the total expenditures of central and local government (net budget). A breakdown by expense category yields the following figures, listed in descending order from those categories in which local expenditure is high: educational expenses (85.4%), institutional expenses including police, fire prevention, and general administrative expenses (78.6%), national land conservation and development expenses (70.2%), industrial and economic expenses (65.6%), and social and security-related expenses (58.0%). Local governments account for a high percentage of educational expenses because they provide compulsory education, operate the high schools and perform other tasks. The second highest percentage of institutional expenses is because they include expenses for administration of justice, police and fire prevention, etc. (Table 2-3-1). On the other hand, local governments account for a relatively low proportion of social security-related expenses because these expenses include pensions and other items that the central government handles through direct income transfers. In addition, although industrial and economic expenses include agriculture, forestry and fisheries expenses and commerce and industry expenses, the percentage of project subsidies for ordinary construction works expenses associated with agriculture, forestry and fisheries is high, and a large portion of commerce and industry expenses are covered by loans. For this reason, local governments account for a comparatively low percentage of spending in these categories.
Table 2-3-1 Proportion of central and local governments by category
    However, the spending ratios of central and local governments given above represent those after the transfer of funds between central and local government. Before these transfers, the proportion of spending accounted for by local governments is substantially less, particularly in social security-related expenses (58.0%rarr44.5%), national land conservation and development expenses (70.2%rarr59.7%), and educational expenses (85.4%rarr69.2%). These substantial decreases reflect the size of transfers from the central to local government.
    As the above shows, transfers from the central to local government fulfill an important role. Looking at tax revenues, however, the proportion accounted for by regions is a little more than 40%. After transfers by central government to local government through local allocation taxes and local transfer taxes, local tax income accounts for slightly less than 60% (this figure is out of line with expenditures because income from government bonds has not been taken into account (Figure 2-3-2).(39)
Figure 2-3-2 Proportion of tax revenue between central and local governments

 Overview of reform of the fiscal relationship between central and local governments
    This initiative calls for integrated reform of state subsidy contributions, local allocation taxes and the transfer of tax revenue sources to local governments. It seeks to realize efficient small government through an increase in local government's proportion of general income sources, an expansion of local taxes, and less dependence on allocation taxes. The following is a discussion of the state of progress of this reform to date.
(i) Reform of state subsidy contributions
    Under "Basic Policies 2003," state subsidies to local government will be abolished or reduced by about 4 trillion yen by FY2006. In FY2004, about 1 trillion yen in state subsidies were abolished or reduced. In FY2005, the following reforms were implemented: (1) Reform linked to transfers of tax revenue sources to local government (1,123.9 billion yen); (2) Reform for increasing the discretion of local governments and substantially expanding their autonomy (subsidy reform) (343 billion yen); (3) Reform for streamlining administration encompassing central and local governments (301.1 billion yen). These three reforms have resulted in a reduction totaling 1,768.1 billion yen.
    In specific terms, reform linked to the transfer of tax revenue sources to local government consists of reform concerning the state subsidy contributions for national health insurance (698.9 billion yen) (Figure 2-3-3), and, as a provisional measure for FY2005, a reduction of 425 billion yen in state subsidies for compulsory education. Subsidy reform consists of establishing of a new subsidy system extending across government offices (81 billion yen), as well as the expansion and creation of other subsidy systems (262 billion yen). Meanwhile, reform for streamlining administration will focus on the reduction of state subsidies relating to public works projects (a 251.5 billion yen decrease compared with the initial budget of FY2004).
Figure 2-3-3 Reform of state subsidy contributions, etc. for local governments
    The total amount of state subsidy contributions (total by general accounting and special accounting) was 20.4 trillion yen in FY2003, 20.4 trillion yen in FY2004 and 19.8 trillion yen in FY2005. Although these figures have been affected by the reform of state subsidy contributions, they also incorporate major increases in medical care, nursing care, welfare and other expenses related to social security (Figure 2-3-3).
(ii) Transfer of tax revenue sources to local governments
    Tax revenue sources will be transferred for those projects which still require implementation, which are now covered by state subsidy contributions that are to be abolished, with local governments continuing to play the key role. The targeted scale of transfers will be about 3 trillion yen, including amounts provided as measures in FY2004 for local transfer tax on income and special subsidies for expected transfers of tax revenue sources. This transfer of tax revenue sources is implemented by transferring income taxes to inhabitant taxes, and it is executed on the basis of individual inhabitant tax being determined by a flat rate percentage of income. In FY2004, transfer of tax revenue sources through introduction of local transfer tax on income including the portion of subsidies reform in FY2003 amounted to 424.9 billion yen. In addition, 230.9 billion in subsidies were established (special subsidies for expected transfers of tax revenue sources) to be granted as a measure during the period up until tax revenue source transfers are implemented. Transfers were also implemented in FY2005 in the amount of 691 billion yen through local transfer tax on income and in the amount of 425 billion yen as a financial resource measure implemented through special subsidies for expected transfers of tax revenue sources in order to offset income reductions accompanying provisional measures for state subsidy contributions for compulsory education. Through these initiatives, a total of about 1.8 trillion yen of tax and financial resource measures were implemented toward local government by FY2005.
(iii) Reform of local allocation tax
    In FY2005 and FY2006, the total amount of general income sources, including local allocation taxes and local taxes, required for stable fiscal management by municipalities will be secured, and efforts to reduce expenditures will continue along with measures for streamlining and improving the transparency of local fiscal plans. In FY2005, the amount of local allocation taxes will total 16.9 trillion yen, nearly the same level (albeit a 0.1% increase) as the preceding year.
    With regard to the increases in income that accompany transfers of tax revenue sources, in order to ensure smooth fiscal management and system changeover while preventing expansion of disparities in fiscal strength accompanying the transfer of tax revenue sources, 100% of these increases will be included in the standard fiscal income amount for the time being.
    The Council on Economic and Fiscal Policy (CEFP) has pointed out that in local fiscal plans, there are noticeable gaps between the planned amounts and the settlement amounts in, for example, investment expenses for individual projects, and that from the standpoint of accountability to the public, these gaps require correction and appropriate posting.(40)
    The governing party agreed that from FY2005, disparities between the local fiscal plans and settlements would be corrected and the amounts posted appropriately, and correction was also implemented in the FY2005 local fiscal plan. In addition, it has been decided to continue efforts toward simplifying and increasing the transparency of allocation tax assessment methods, and to consider reforms aimed at expanding the percentage (in population terms) of municipalities not receiving allocations.
    Looking at changes in the number of municipalities that receive and do not receive ordinary tax allocations, in FY2004, partially due to the recovery of the economy, the number of municipalities not receiving allocations was 134 (with Tokyo being the only prefecture), an increase of 19 municipalities from 115 in FY2003 (Figure 2-3-4). The population of municipalities not receiving tax allocations as a percentage of nationwide population was 17.7% in FY2004, up from 15.3% in the preceding year.
Figure 2-3-4 Trend in the municipalities that do not receive ordinary tax allocation

 Expansion of rights to autonomy of local governments on taxation
    With respect to rights to autonomy of local government on taxation, discretion by local government in determining tax items and tax rates is recognized to some extent, although there are certain restrictions.(41) With regard to tax item decision-making authority, the regional autonomy laws recognized, from April 2000, the establishment of special taxes for specific purposes in addition to those discretionary taxes hitherto recognized. In addition, with respect to the requirements for levying taxes not stipulated under law, a consultation system which requires consent also replaced the permit system.(42) For taxes not stipulated under law, municipalities have a large range of choices in taxation, and particularly in regard to special taxes for specific purposes, there is a clear relationship between benefits and burden for residents. Owing to amendments to the system, a large number of municipalities are engaged in initiatives aimed at establishing taxes not stipulated under law. With respect to tax rate decision-making authority, taxation using rates other than nationwide fixed tax rates, such as local consumption tax and automobile acquisition tax, is not recognized, but local governments can freely set tax rates for individual inhabitant tax, fixed asset tax and others taxes. Local governments may also freely determine tax rates for corporate inhabitant tax and enterprise tax as long as the rates are below the "restricted tax rate."
    With regard to current status of taxes not stipulated under law, the FY2003 settlement indicates that among municipalities that have established taxes not stipulated under law, there are 20 that have established discretionary taxes, and 13 that have established special taxes for specific purposes (Table 2-3-5). Of the 39.1 billion yen total amount of income from taxes not stipulated under law, local tax income accounted for 0.12%. A breakdown by tax item shows that many municipalities have adopted, among ordinary taxes, nuclear fuel tax and gravel extraction tax. With respect to special-purpose taxes, there are many instances where municipalities use taxes as a means of securing financial resources for implementation of policy, such as industrial waste tax and sportfishing tax.
Table 2-3-5 State of taxes not stipulated under law
    Under the Local Tax Law, when a nationwide fixed tax rate is not recognized, the standard tax rate (the tax rate deemed normal when municipalities levy taxes) is recognized. However, in other instances where required for public finance or for other reasons, municipalities can establish, by exception, taxes exceeding the standard tax rate (excessive taxation) by stipulating ordinances. Referring to the FY2003 settlement, the number of municipalities implementing excessive taxation based on the total under each tax item was 2,332, with the tax revenues from this taxation amounting to 426.9 billion yen (accounting for 1.3% of total local tax revenues) (Table 2-3-6). This shows that, to some extent, municipalities set tax rates in order to achieve fiscal stability. In Japan, however, there are some disparities in the maximum tax rate between municipalities. Although there is no disparity in the percentage of income used to calculate individual inhabitant tax, with respect to the individual inhabitant tax on per capita basis, there is a disparity of 1.5 times, for prefectural inhabitant tax on a corporation tax basis, a disparity of about 1.2 times, and for fixed asset tax, a disparity of about 1.25 times. Comparing these disparities with those found in an existing survey of the US and Europe, it is observed that the disparity in the United Kingdom's council tax is 3 times and the disparity in France's real estate tax is between about 2 to 4 times, indicating that the disparities in maximum tax rates in Japan are comparatively small (Table 2-3-7).(43) This reflects the fact that, in Japan, the restricted tax rate system has been adopted for most local taxes and that efforts have been made to equalize financial resources through the local allocation tax system.
Table 2-3-6 Implementation status of excessive taxation
Table 2-3-7 International comparison of tax rate disparities
    There are advantages to permitting disparities in tax rates between regions and municipalities autonomously determining tax rates in line with necessary expenditures. By clarifying the relationship between benefits and burden relating to public services, taxpayers develop a greater awareness of administrative operations, and this stronger administration monitoring function enhances the efficiency and convenience of administration. In this connection, it has been pointed out that in Japan, excessive taxation with respect to corporations is high but excessive taxation with respect to individuals is low, which means that the administrative monitoring function provided by these taxpayers is not functioning well. The situation thus requires continued promotion of the use of the right to autonomy by local government on taxation.

2. Administrative Efficiency through Expansion of Size

 Status of mergers of municipalities
    Progress in local decentralization is hastening the transfer of authority and administrative operations from central government to local government, and this is expanding municipalities' role in bearing the overall responsibility for providing resident services. The expansion of the authority of municipalities means that the government changes the appropriate modality of uniform nationwide service provision, and provides public services tailored to the circumstances of the area. This allows the government to reflect to a greater degree the preferences of areas residents, who are the users of public services, and thereby contribute to the effective and efficient use of limited fiscal resources. On the other hand, because municipalities will, from now, function as the primary administrative body with a higher degree of independence than before, it is essential to strengthen the administrative and fiscal foundation. Moreover, in view of the expected decrease in population due to declining birth rates and aging of the population in the future, it would be desirable to further expand and strengthen the size and functions of municipalities. For this reason, the mergers of municipalities are now proceeding at a rapid pace. As a result, the number of municipalities has been declining, a trend supported by fiscal policies specified in an amendment to the Law Concerning the Special Cases of Mergers of Municipalities in 1999. These policies provided that municipalities that applied for merger by the end of March 2005 would be able to use special merger bonds to finance certain projects undertaken by merged municipalities based on municipal construction plans. These administrative and fiscal special exceptions facilitated mergers, and as a result, municipalities declined from 3,232 at the end of March 1999 to 2,395 by April 2005. By the end of March 2006, when all municipalities which have already completed application for mergers will all have merged, the number will definitely decline to 1822 (Table 2-3-8).(44)
Table 2-3-8 Trend in the number of municipalities

 Economies of scale
    One of the reasons behind the merger of municipalities and integrated administration of large regions is the expectation that, as local governments increase in size to some degree, unit costs will decline. The question is, however, to what extent will these economies of scale actually function? Referring to existing research, using data from FY2003 concerning more than 3,000 municipalities, an investigation was made into the magnitude of the disparity in per-resident expenses of municipalities due to size of population and area.(45)
    First, by examining the relationship between per-resident wage and non-wage administrative costs and the scale of the population, it was found that as the population increases, these costs tend to decline (Figure 2-3-9). Exceeding a certain point, however, the trend is inverted and costs tend to increase instead. This is because some municipalities that exceed a certain threshold are designated as government-designated cities, major urban areas and specially designated cities and perform certain administrative operations in the place of prefectures.
Figure 2-3-9 Relationship between population scale and labor costs / cost of supplies
    Next, the size of municipalities in terms of area will be added to the explanatory variables along with per-resident wage and non-wage administrative costs and population size. If the size of population is the same, costs become large as area expands (Appended Note 2-5). This is because when the area becomes large, population density falls, and the efficiency of service provision declines. What is not considered here is also the major effect of geographical conditions, as in the example of mountainous regions.
    Using the results of the above estimates, a provisional simulation was made concerning the cost reduction effect that can be expected in an actual merged municipality (Figure 2-3-10). Specifically, for major municipalities which merged in FY2002 and FY2003, a theoretical value of per-unit costs was calculated using estimated parameters for a hypothetical case in which there was no merger and existing population and area did not change. This value was compared with a theoretical value of unit costs calculated using the population and area of the new municipality after merger. The results showed that with most municipalities, a decline in unit cost could theoretically be expected through merger. If a test calculation is made using this method in the case of a merger of two municipalities with large populations, unit costs theoretically increase after merger because the post-merger municipality performs a large amount of administrative work compared with the situation before merger and because the post-merger municipality has been designated as government-designated cities, major urban areas and specially designated cities. It is worth noting in this case, however, that since prefectural costs decline correspondingly, there probably is an improvement in efficiency for the entire area in question.
Figure 2-3-10 Trend in the effect of mergers
    The above analysis looked at disparities due to size concerning general local public finance. However, large disparities exist for each area in terms of individual cost categories. In particular, in the case of national health insurance, the municipality is regarded as the basic unit for insured persons, and therefore the disparity in insurance premiums between areas is large. The merger of municipalities contributes to stabilizing the fiscal base in the insurance field. For this reason, in the field of national health insurance, a fund has been established to support large-area administration of municipal national health insurance in prefectures and the mergers of municipalities. At the same time, linkages between prefectures and municipalities are being forged along with systematic reorganization and integration of insured persons. These efforts, aided by the use of associations of public services covering several local government areas, are expected to lead to stable insurance administration in prefectures.

3. Fiscal Disparities between Local Governments and Causes

 State of public finance in local governments
    In general, local public finance continues to operate under severe conditions. The ordinary balance ratio is often used as an indicator of the rigidity of local public finance. It indicates the proportion of general income sources that flow in each fiscal year, such as local taxes and ordinary allocation taxes (i.e. ordinary general income sources) that are accounted for by general income sources allocated to expenses paid each fiscal year, such as labor costs and national debt service expenditures (i.e. general income sources allocated to current expenses). As this proportion become large, public finance loses its elasticity. An examination of the trend of the ordinary balance ratio of nationwide municipal districts reveals that from the beginning of 1990s to FY2003 there has been a general uptrend, suggesting that the structure of public finance has become rigid (Figure 2-3-11). On the other hand, by examining the variation between municipal districts nationwide concerning the elasticity of fiscal structure by calculating the coefficient of variation of the ordinary balance ratio (found by dividing the standard deviation by the average), a consistent decline is seen after the 1990s, and thus disparities between municipalities are, instead, slightly narrowing. An analysis to determine the character of the distribution of the ordinary balance ratio between local governments in nationwide municipal districts in 1990 and 2003, shows that in both years, municipalities were distributed almost equally around both sides of the mode of the distribution, and that from 1990 to 2003, the overall distribution has translated in the direction of increasing the ordinary balance ratio. This indicates that the fiscal condition of many municipalities has generally deteriorated. However, since the shape of the distribution in 2003 has inclined toward the vicinity of the mode, it seems that the disparities between municipalities judging from the shape of the distribution are themselves narrowing.
Figure 2-3-11 Trend in the ordinary balance ratio of local governments

 Factors in the fiscal disparities between local governments
    Disparities in the ordinary balance ratio still exist between local governments, although in recent years these have narrowed slightly. In order to investigate the nature of the causes behind these disparities in the fiscal conditions of local governments, an estimate was made of the magnitude of the impact of various factors on the ordinary balance ratio of nationwide municipal districts in 2003, including fiscally-based factors, attributes of the various areas such as population structure and economic structure, and factors relating to the status of administrative reform (Table 2-3-12). In Case 1, an estimate was made using fiscally-based indicators and the attributes of the various areas as the explanatory variables; in Case 2, the status of administrative reform was added as an explanatory variable. The results of Case 1 indicated that there is not only a correlation between the ordinary balance ratio of the various local governments and factors relating directly to public finance such as the number of staff per resident and tax revenues, but also a correlation with the rate of population growth and industrial structure, etc. Looking more closely at the effect of area attributes, a relationship is observed whereby the higher the population growth rate, the lower the ordinary balance ratio. This, as seen before, is due to the fact that as population increases, the unit costs of administrations decline as economies of scale take effect. The local economy is also stimulated by the increase in population, and finances also receive a favorable impact from increased tax revenues and the like. With respect to industrial structure and the ordinary balance ratio, many municipalities whose proportion of manufacturing industry is high show a tendency for the ordinary balance ratio to be low. This is because in the case of the manufacturing industry, there are many businesses whose scale of operations is large, which likely has a favorable impact on public finance through tax revenues and the like. With regard to the proportion of elderly persons in the population, the greater the number of elderly persons, the lower the ordinary balance ratio, because, generally, a high proportion of elderly in the population brings disadvantages in the areas of spending and tax revenues. However, the impact of social security-related expenses on the ordinary balance ratio of local governments is not always clear since the central government provides subsidies.
Table 2-3-12 Relationship between the ordinary balance ratio and fiscally-based factors and attributes of the regions

 Effects of administrative and fiscal reform
    At present, a variety of initiatives are being implemented for administrative and fiscal reform based on local reform guidelines (Ministry of Internal Affairs and Communications), including optimization of staff management and salaries, a radical review of the tertiary sector and extra-governmental bodies, and efforts to increase the soundness of management of local public enterprises. Other initiatives include the promotion of private sector entrustment and PFI, promotion of e-municipality, and effective and proactive use of administrative evaluations. Hence, for Case 2, a variety of factors constituting indicators expressing some of these administrative and fiscal reform initiatives were added to the formula for determining the correlation between ordinary balance ratio and local attributes in order to investigate their correlation with the ordinary balance ratio. These factors included the status of use of administrative evaluation systems, numerical conversion of evaluation indicators, status of preparation of balance sheets, and progress in introducing the designated management entity as of June 2004 as indicated by a Ministry of Internal Affairs and Communications survey (Table 2-3-12 above). This analysis found a statistically significant trend toward low ordinary balance ratios in municipalities that have made an early start in the numerical conversion of evaluation indicators and in the introduction of the Designated Management Entity System. In addition, though the statistical correlation is somewhat weak, there is also a tendency for municipalities that prepare balance sheets to have low ordinary balance ratios.
    Next, in order to consider whether the administrative and fiscal reform initiative of optimization of staff numbers is principally manifested in the area of expenditure, the effect of administrative and fiscal reform was investigated by expressing local government expenses as a Cobb-Douglas cost function and estimating these costs. Specifically, the total amount of wage and non-wage administrative costs of local governments were used as the dependent variable, and, as the variables to explain this, factor income (labor costs per staff member) and production output indicators (resident population) were used. Also added into the formulas were attributes of local governments (percentage of elderly in the population, rate of population increase, and percentage of manufacturing industries), and, as an administrative and fiscal reform indicator, the increase or decrease in staff numbers over the past five years was added (Appended Table 2-11). The results indicate that the expenses of municipalities that had reduced staff numbers in the past were lower than other municipalities. As for variables that express the attributes of local government, municipalities with a high proportion of elderly in the population had high expenses, unlike in the estimate of ordinary balance ratio.
    In sum, the results indicate that among municipalities that have implemented administrative and fiscal reform initiatives, the ordinary balance ratio tends to be low, or conditions exist such that costs are held down.


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