Annual Report on Japan' s

Economy and Public Finance


- No Gains Without Reforms -

December 2001

Cabinet Office

Government of Japan

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Chapter 3

   Overall Assessment of Japan' s Public Finance

Section 1 Expanding Budget Deficits

   Massive budget deficits have remained in Japan as government spending has far exceeded revenues. As a result, the government has been plagued with massive debts. This section reviews the state of budget deficits and considers the following points:
(a) Since the collapse of the bubble economy, Japan' s budget deficits and outstanding debt issues have been expanding considerably. The expansion in budget deficits and outstanding debt issues has resulted from slumping revenues and increasing spending caused by the prolonged economic weakness, frequent economic measures and increased social security costs.
(b) Most of the present budget deficits are structural deficits that will not diminish even on a pickup in the economy.
(c) If the present situation continues, Japan' s public finance will collapse on an explosive increase in outstanding debts.
(d) A prefecture-by-prefecture breakdown of per capita fiscal spending (benefits to residents) and tax payments (costs) indicates that inter-regional disparity has been widening since the early 1990s.

1 State of Japan's Budget Deficits

 Budget deficits expanded substantially in 1990s
   Japan' s budget balance has been deteriorating almost persistently since the collapse of the bubble economy. The nation' s general government financial balance, which consists of national and local government budgets and the social security fund on an SNA basis, posted a substantial deficit amounting to 7.4% of gross domestic product in FY 1999(1). The social security fund as part of the general government financial balance has up to now been in surplus since premium revenues for the public pension system has exceeded benefit payments. The social security fund surplus, though shrinking gradually over the past few years, stood at 0.8% in surplus of GDP in FY 1999. Since the social security fund surplus should be taken as a reserve to cope with a future rise in benefit payments on the aging of the population, however, it may not be included in the financial balance to indicate an effective annual budget deficit. Excluding the social security fund, the national and local government financial balance posted a deficit amounting to 8.2% of GDP in FY 1999, indicating more severe financial conditions for Japan than signaled by the general government balance (see upper part of Figure 3-1-1).
   Of the general government budget deficit, the annual national government deficit has been widening over the past period since FY 1992, after the collapse of the bubble economy, excluding FY 1997, when there was a temporary deficit shrinkage on a consumption tax rate rise and other developments. The national government deficit came to 6.8% of GDP in FY 1999. On the other hand, the annual local government deficit is shrinking slightly, reaching 1.4% of GDP in FY 1999 after having been deteriorating until FY 1995. (see the lower part of Figure 3-1-1).
   FY 1999 is the latest year for which SNA-based financial balance data are available at present. We then investigate the national general account budget balance for FY 2000 and 2001. Annual government debt issues for the national general account stood at ¥18.5 trillion in FY 1997 before rising far beyond ¥30 trillion from FY 1998 to 2000 on a settlement basis. Such debt issues are planned at ¥28.3 trillion under the initial FY 2001 budget before supplementation. Since most of the SNA-based national government budget deficit is from the general account and since most of the national and local government deficit is a national government deficit as shown above, we can say that the national and local government deficit remained substantial for FY 2000 and 2001(2).
 Details of Financial Balance Deterioration
   We would here like to consider revenue and spending factors that have contributed to the deterioration of the SNA-based national and local government financial balance. The following analysis can confirm that the budget deficit expanded substantially in the 1990s as revenues slumped on a fall in direct tax revenue and spending remained on an uptrend.
   In revenues, corporate and other direct tax revenues that are sensitive to economic trends declined considerably as a percentage of GDP. The decline in direct tax revenues reflects not only slack individual and corporate (company) income on the collapse of the bubble economy, but also the autumn 1994 tax reform that permanently lowered individual income tax, two special tax cuts in FY 1998, and permanent cuts in individual and corporate taxes since FY 1999. Direct tax revenues have declined for both national and local governments. But those for the national government have dropped faster than for local governments. Local tax allocation and other national revenue transfers to local governments have increased from their levels during the bubble economy period (see Figure 3-1-2). National and local government revenue conditions have thus differed. This is because national government revenues center on tax revenues vulnerable to a prolonged economic slump and tax cuts, while local government revenues concentrate on stable state funds including the local tax allocation and subsidies.
   In expenditures, the national government' s public investment has remained high after increasing on frequent economic stimulus packages following the collapse of the bubble economy. In contrast, local governments' public investment has slightly declined, mainly in independent local projects (public works that local governments independently finance without national government subsidies) since the mid-1990s. Government consumption has increased for both national and local governments. The national government' s transfer expenditures have expanded substantially. The sharp expansion has come on payments to other areas than the general government, including (a) local allocation tax and subsidies to local governments, (b) payments to the social security fund to cover social security costs (public pension benefit payments and medical expenses) that have been increasing on the aging of the population, and (c) the takeover of JNR long-term obligations and financial assistance to the Deposit Insurance Corporation of Japan for disposing of failed financial institutions (see Figure 3-1-3).
   The national and local government financial balance has continued deteriorating since the collapse of the budget economy as revenues have remained sluggish on a prolonged economic slump and tax cuts and as expenditures have continued to rise on frequent economic stimulus packages and expanding social security spending amid the aging of the population. The financial deterioration has been remarkable, especially that of the national government. On a general government basis including the social security fund as well as national and local governments, medical expenses and pension benefit payments in the social security fund have been rising on the aging of Japan' s population, contributing to the financial balance deterioration (reduction of the social security fund surplus).
 National and local government long-term debts amounting to 130% of GDP
   The budget deficit shown above has served to increase outstanding long-term debts including government securities. A Ministry of Finance report of 2001 says the outstanding long-term debts of the national and local governments expanded from ¥278 trillion, (about 60% of GDP) at the end of FY 1991, to about ¥600 trillion, (about 120%) at the end of FY 1999. Outstanding debts at the end of FY 2001 are estimated at about ¥666 trillion (about 130%).
 Japan' s financial conditions are worst among major industrial nations
   The OECD Economic Outlook in June 2001 compared the general government financial balances of Japan and other major industrial nations. General government budget deficits (as a percentage of GDP) have improved since the 1990s in all major industrial nations except Japan, and deteriorated substantially only in Japan (see Table 3-1-4). Outstanding general government debts have leveled off or decreased since the latter half of the 1990s in all major industrial nations except Japan. Those in Japan alone have increased substantially. At the end of CY 2000, gross outstanding general government debts in Japan exceeded those in Italy and were the largest among major industrial nations (see Table 3-1-4).

2 Structural Deficit Level and Sustainability of Budget Deficits

 Cyclical and structural deficits
   The budget deficit as discussed above can be divided into two parts, a "cyclical" part (cyclical deficit) and a "structural" part (structural deficit). The cyclical part is the part that fluctuates on an increase or decrease in tax revenues and unemployment benefits in response to a pickup in the economy or decline. Excluding the "cyclical" part from actual budget deficits, the remainder is a "structural" part. The structural deficit does not diminish on a pickup in the economy. We here divide the budget deficit into the cyclical and the structural since the early 1990s to analyze factors behind the budget deficit expansion. The analysis yields the following findings:
(a) The structural budget deficit has swollen on frequent economic measures and rising social security costs, accounting for more than 80% of the actual annual budget deficit (at 7.4% of GDP in FY 1999) for recent years.
(b) The cyclical budget deficit increased on economic weakness in the early 1990s following the collapse of the budget economy. It declined slightly on an economic recovery in the mid-1990s before rising again since FY 1997. The cyclical deficit amounted to some 0.8% of GDP in FY 1998, 1999 and 2000.
(c) The structural deficit remains substantial in FY 2001. If GDP in FY 2001 levels off from the previous year in real terms and contracts 1% in nominal terms, the cyclical deficit would rise slightly, which means that the automatic stabilizer is working.
   We now examine the details of these findings.
   Based on the estimated GDP gap in Chapter 2, we first divide the general government financial balance into the cyclical and the structural (see Figure 3-1-5)(3). This shows that both the cyclical and structural balances worsened dramatically in the FY 1990-93 period, the period of the collapse of the bubble economy. As a percentage of GDP, the cyclical budget balance deteriorated by 1.6 percentage points to a 0.7% deficit. The structural balance also deteriorated by 3.2 percentage points to a 1.5% deficit. After FY 1993, the cyclical budget deficit declined temporarily on an economic recovery in FY 1996, increased again in FY 1997 and remained at 0.8% of GDP in and after FY 1998. On the other hand, the structural deficit continued an uptrend on frequent economic measures including tax cuts, as well as on rising social security costs (including medical expenses and public pension benefits). In recent years, the structural deficit has remained as high as some 6% of GDP(4).
   If GDP in FY 2001 remains unchanged from the previous year in real terms and shrinks 1% in nominal terms, the cyclical deficit will expand slightly with the structural deficit continuing to be substantial. Even if GDP growth is estimated by 1% higher or lower, the estimation will not change so much.
   The expansion in the cyclical deficit means that a built-in stabilizer in public finance is working to reduce tax revenues and boost government spending, such as unemployment benefit on an economic decline(5). On the other hand, an expansion in the structural deficit reflects discretionary economic policies to expand fiscal outlays and tax cuts in response to economic changes. Since the government implemented aggressive economic measures in response to economic weakness while allowing social security costs to expand in the 1990s, structural budget deficits from FY 1992 to 2001 total about ¥200 trillion, equal to about 40% of FY 2001 GDP(6). Fiscal policies to support the economy for the immediate future have eventually failed to lead to sustainable economic growth while leaving substantial structural budget deficits. Even if the Japanese economy achieves its potential growth with the cyclical deficit eliminated, without fundamental fiscal structural reforms, an annual structural deficit amounting to some 6% of GDP may remain. In order to achieve fiscal reconstruction, Japan will have to take positive measures to reduce the structural deficit that accounts for most of the overall budget deficit(7).
 Are budget deficits sustainable?
   We next consider whether such budget deficits could be sustainable in future.
   If the government intends to spend more than tax and other revenues, it has to borrow the excess and allow a budget deficit. Since most borrowings to cover a budget deficit take the form of public debt issues to raise funds on the bond market, the government (debt-issuers) and bond buyers must agree on appropriate prices on the market to ensure successful public finance management in accordance with the budget deficit. Long-term interest rates, or yields on long-term government bonds, which depend on various factors, now remain at historic lows. This indicates the market' s reasonable confidence in the sustainability of Japan' s budget deficits. Depending on future budget deficits, outstanding public debt issues and medium- and long-term fiscal policies, however, the market could doubt the government' s bond redemption capacity. In such case, government bond prices could decline fast with their yields rising.
   An apparent yardstick of the future sustainability of budget deficits is whether the government' s fiscal policy is allowing outstanding public debt issues as a percentage of nominal GDP to continue to rise and diverge in the future. In order to prevent outstanding debts as a percentage of GDP from exploding, the government will have to limit the annual debt growth rate to a level below the annual nominal GDP growth rate. This can be done by achieving a primary budget equilibrium or surplus, on condition that the nominal interest rate is equal to the nominal GDP growth rate.
   The primary budget balance is the gap between "tax and other revenues excluding borrowings" and "outlays excluding interest payments on and redemption of past borrowings." A primary budget equilibrium means that outlays other than interest payments on and redemption of past borrowings are equal to tax and other revenues and do not depend on any new borrowings. In other words, new borrowings in a year may finance only interest payments on and redemption of earlier borrowings. If the nominal economic growth rate remains equal to the nominal interest rate, the maintenance of the primary budget equilibrium will keep outstanding debt issues as a percentage of GDP at the present level and prevent debts from diverging unlimitedly.
   The SNA-based national and local government primary budget balance has been in deficit since FY 1992. The primary budget deficit has been expanding, standing at about 5% of GDP in FY 1999 (see Figure 3-1-6). As discussed earlier, the national and local government budget deficit in FY 1999 stood at 8.2% of GDP. Although net interest payments on debt issues remained stable at 2% to 3% of GDP in the 1990s, a plunge in tax revenues and an expansion in outlays led to an increase in the primary budget deficit(8). The interest payments were stable in the 1990s because nominal interest rates declined, offsetting the effect of a rise in outstanding debt issues.
   Nominal GDP growth has remained negative since FY 1998 while long-term interest rates have been stable in a rough range of 1% to 2%. The excess of long-term interest rates over economic growth leads to an increase in outstanding debt issues as a percentage of GDP, even if the primary budget balance is met.
   Japan' s public finance is thus faced with a large primary budget deficit and nominal interest rates' excess over nominal economic growth. If these conditions remain unchanged, Japan' s public finance will collapse with outstanding debts continuing expanding and leading to an explosion.
   What would happen if public finance should collapse on an explosion of outstanding debts? It would be difficult for the private sector to absorb new government debt issues. The Finance Law prohibits the Bank of Japan from underwriting government debt issues. Therefore, the government would have to take an extremely austere fiscal policy to substantially reduce non-debt-service outlays (social security, public investment and other administrative services) and increase taxes. This would dramatically disturb the livelihood of the people. In order to prevent outstanding debts from exploding, Japan will have to achieve sustainable economic growth led by private sector demand and implement fiscal reforms to achieve a primary budget surplus.

3 Prefecture-by-Prefecture Breakdown of Budget Outlays and Tax Contributions

 Benefits and costs of administrative services
   As discussed in this section' s beginning (State of Japan' s Budget Deficits), national and local government deficits have expanded on slumping tax revenues and rising spending since the 1990s. What features will come out of a prefecture-by-prefecture breakdown of national and local government expenditures and tax revenues? For local residents, national and local government spending can be interpreted as "benefits" of administrative services, and national and local tax payments as "costs" for receiving administrative services(9). We here give a quantitative analysis of per capita benefits and costs for each of the 47 prefectures in Japan.
 Measurement of benefits and costs for local residents
   The methodology of the analysis follows(10). We have first estimated budget outlays disbursed to each region through national and local government activities as "benefits" that local residents receive from administrative services. On the other hand, we have estimated taxes, fees and contributions paid by local residents to national and local governments as "costs" of administrative services. A true prefecture-by-prefecture breakdown of national taxes cannot be given because of tax collection system restraints. Therefore, we have distributed tax revenues to the prefectures under certain assumptions. Based on these estimates, we have calculated "excess benefits" (= benefits-costs) and "benefit-cost ratios" (= benefits / costs). Our analysis has covered each of the 47 prefectures, using per capita benefits and costs for comparison between prefectures. We have subjected FY 1980, 1985, 1990, 1995 and 1998 to the analysis in order to look into changes in relations between benefits and costs in each prefecture over the past 20 years.
   We must take note of the following points in interpreting the results of the analysis here. First, the economies of scale can allow some administrative services in densely populated metropolitan regions to cost less than in other regions for the same per capita benefits. Even if such services for residents in metropolitan regions are the same as those in other regions, per capita benefits as estimated here for metropolitan regions may be less than for other regions. Second, industrial waste disposal facilities, power stations and dams as water reservoirs located in rural regions can bring about great benefits to metropolitan residents. Benefits and costs in this respect are not taken into account here. Third, national and local government revenues in a certain fiscal year include not only taxes, fees and contributions, but also public debt issue proceeds and property-related income, and surpluses carried over from the previous year. The latter revenues are not taken into account as "costs" here. Therefore, benefits tend to exceed costs on a nationwide basis. We must take note of this.
 Changes in benefits and costs
   According to prefecture-by-prefecture benefits in FY 1998, the ratio of the average for the top five prefectures (¥1.2 million) to that for the last five (¥0.76 million) is 1.6 (see Figure 3-1-7). As for prefecture-by-prefecture costs, the ratio of the average for the top five prefectures (¥0.86 million) to that for the last five (¥0.52 million) is 1.7.
   Excess benefits (= benefits-costs) average ¥0.63 million for the top five prefectures. Forty-five of the 47 prefectures have positive excess benefits. Only two prefectures have negative excess benefits, meaning that costs are more than benefits.
   The economies of scale allow per capita administrative costs in densely populated metropolitan regions to be lower, meaning that those in less-populated regions are higher. Overall, the higher per capita income is, the lower the benefits and the higher the costs. Therefore, excess benefits (= benefits-costs) tend to be lower for regions with higher per capita income.
 Tendency of inter-regional disparity in benefits and costs
   Next, we use benefit/cost ratios (= benefits / costs) to indicate how relations between regional benefits and costs have changed over the past 20 years (see Figure 3-1-8).
   Reflecting the trend of national and local government financial balances, the national average benefit/cost ratio dropped by 37.0 points from FY 1980 to FY 1990 amid economic bubbles, but increased by 33.9 points in the 1990s. The substantial rise in the ratio in the 1990s came as costs declined on a plunge in national and other tax revenues and as benefits increased sharply by 24.4% on local government spending expansion under frequent economic stimulus packages and revenue transfers from the national government to local governments.
   Inter-regional disparity in benefits and costs has expanded since the 1990s. Let' s compare the top five prefectures in the benefit-cost ratio with the last five. Prefectures having higher benefit-cost ratios see relatively lower per capita income. Those having lower benefit-cost ratios enjoy higher per capita income.
   In the 1980s, benefit-cost ratios declined for both the top and last five prefectures. But the top five indicated a faster decline than the last five. In the 1990s, the benefit/cost ratios increased substantially for the top five prefectures, while those for the last five posted a far smaller increase and almost leveled off in the latter half (FY 1995-98) of the decade.
   Let' s look into whether such expansion of the inter-regional disparity emerged from benefit or cost factors (see Figure 3-1-9). In the top five prefectures in the cost/benefit ratio, costs declined in the 1990s, while benefits continued growth similar to that in the 1980s. In the last five prefectures, however, benefit growth slowed along with cost growth and turned negative in the latter half of the 1990s. These changes indicate that the expansion of the inter-regional disparity in benefits and costs was attributable to the high benefit growth in the top five prefectures.

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