Section 4 Local Finance Problems

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Chapter 3

Overall Assessment of Japan' s Public Finance

Section 4 Local Finance Problems

As decentralization works to expand local governments' policymaking authorities and responsibilities, they are required to ensure the fairness of administrative services and improve their transparency. Especially, local governments are increasingly required to gain residents' understanding about and cooperation for local fiscal conditions that have grown tighter.

The people' s interest in local public finance has grown since the "Basic Policies for Macroeconomic Management and Structural Reform of the Japanese Economy" (hereinafter referred to as "Basic Policies" ), as compiled by the Council on Economic and Fiscal Policy and adopted by the Cabinet in June 2001, proposed local public finance reform as one of the Koizumi administration' s seven reforms. This section analyzes the state and problems of local public finance from the main viewpoint of relations between national and local public finance.

The findings through the analysis in this section follow:

• (a) Local governments are faced with a serious financial crisis on the accumulation of long-term debts.
• (b) As long as gaps exist between local economies, some financial adjustment system must be developed to correct financial capacity gaps between regions. But the present local administration and finance system is based on the national government' s engagement in local government spending and its massive fund transfers to local governments, working to discourage local governments from taking their own measures for regional development and prompting them to beg to the national government for funding.
• (c) In reforming the local administration and finance system, we must reconsider the minimum administrative services guaranteed for the people and develop a system that allows local residents to consider their benefits and contributions and base their choices on their own decisions and responsibilities. To this end, we will have to cut national and local government spending, promote municipal mergers, reduce the national government' s engagement in local administration, consolidate national subsidies to local governments, review the Local allocation tax, and expand local tax revenues through a redistribution of tax bases between the national and local governments, including a transfer of some national tax bases to local governments. In this process, we must consider the respective financial situations of the national and local governments and the effect of reforms on individual local governments.

1 Local Fiscal Conditions Growing Tougher

Deteriorating local public finance

Japan has some 3,300 local governments including prefectural and municipal ones. These local governments provide school education, welfare, public health, policing, fire-fighting and other administrative services indispensable to the daily lives of citizens. But the financial conditions for many local governments have deteriorated since the latter half of the 1990s with their borrowings increasing. Present local public finance is in a state of crisis.

Amid a prolonged economic slump after the collapse of the economic bubbles, local government revenues have declined on tax cuts as well as falling tax revenues mainly from the two corporation taxes (corporation enterprise and inhabitants taxes). On the other hand, local governments have expanded spending due to their positive participation in the central government' s series of economic stimulus packages including additional public works. Local governments have thus had to increase their debt issues and dip into reserves (for future financial demand including redemption of debt issues). The local budget balance (or real balance), the gap between revenues (including proceeds from local government bond issues) and spending (including debt-service costs) after adjustments for transfers of financial resources between years, has deteriorated rapidly, especially for metropolitan governments since the early 1990s (see Figure 3-4-1). Among prefectural governments, Tokyo, Kanagawa, Aichi and Osaka, which depend heavily on the two corporation taxes, posted real budget deficits for the two consecutive years to FY 1999. The 47 prefectural governments as a whole also registered real deficits for the two consecutive years. Local governments faced with serious financial crises are reviewing welfare and other services for citizens. Financial reconstruction has become a key challenge for them.

Accumulating local bonds

Amid the prolonged economic slump in the latter half of the 1990s, local governments have expanded debt issues to cover their public works spending and permanent local tax cuts accompanying the central government' s economic stimulus packages(39). As a result, the rate of dependence on debt issues, or debt issue proceeds' share of total revenues, expanded rapidly in and after FY 1994 and has remained in a high range of 12% to 15%. In FY 2001, the rate stood at 13.3%(40). The range is the highest in history with the exception of one period in the mid-1970s. As a result, outstanding local government bonds increased gradually from ¥52.2 trillion in FY 1990 to ¥125.6 trillion in FY 1999, a 2.4-fold jump. A redemption schedule for outstanding local government bonds indicates that redemptions will swell toward the FY 2002-2005 period with FY 2004 as a peak. Local governments will have to use the debt reduction fund (reserves for future local debt redemptions) and other resources to control debts from the medium- and long-term viewpoint.

Growing financial burden other than debt issues

Local governments are entitled to specify and shoulder future financial burdens for multi-year projects. Such financial burdens have increased fast since the early 1990s. Future spending plans based on such future burdens stood at ¥15.3 trillion at the end of FY 1999. Although the sum represented a fall of ¥1.8 trillion from a peak at the end of FY 1995, we have to take into account future financial burdens as well as outstanding debt issues when considering local government debts.

While introducing such effective borrowings, local governments have been building up reserves to meet future spending including bond redemptions. The reserves expanded substantially on a revenue increase amid the bubble-ridden economy in and after FY 1989 before turning down in and after FY 1992. This is because local governments have had to dip into the reserves to raise financial resources on tough financial conditions since the early 1990s(41).

Real future financial burdens, or an excess of outstanding local government bonds and future financial burdens over outstanding reserves, came to ¥125 trillion in FY 1999, a 2.7-fold rise from ¥46 trillion in FY 1990 (see Figure 3-4-2).

In addition to these multi-year borrowings, local governments use temporary borrowings to cover cash flow for annual budget implementation. Some local governments depend heavily and as a matter of course on temporary borrowings.

On top of the above-discussed debts for individual local governments, they jointly shoulder debts at the Special Account for Allotment of Local Allocation Tax and Transferred Tax (hereinafter referred to as Local Allocation Tax Special Account), which will be discussed later. We must consider local governments' share of outstanding borrowings at the special account that have increased rapidly and are expected to reach ¥28.5 trillion at the end of FY 2001.

Expanding budget sizes for national and local governments

Local governments' annual spending increased from ¥78.4 trillion in FY 1990 to ¥101.6 trillion in FY 1999. The 1990s thus saw a 30% expansion. This is not only because the national government implemented a series of economic stimulus packages to increase public works amid a serious economic slump and a tax revenue slowdown, but also because local governments are obliged under some laws to provide certain administrative services requiring spending that is out of their control. Unless such laws and relevant national policy measures are reviewed, local governments will have difficulties adapting their spending to changing tax revenues(42). Another factor behind the fast-increasing local government spending is the expansion of public works that has forced local governments to spend more on interest payments on and redemptions of local bonds and on maintenance and management of various facilities built under public works projects. Certain constraints thus exist on the spending-saving efforts of local governments. Therefore, a thorough review of national policies and expenditure must be coupled with local governments' spending-saving efforts.

The present systems have made it difficult for local governments to hold down spending. Eventually, both the national and local governments have been forced to expand spending and become plagued with budget deficits.

Financial resources shortages are expanding for local governments

Local finance, Local Allocation Tax and other laws require the national government to secure financial resources for the basic administrative services of local governments. The national government thus works out an annual Local Financial Plan (subject to a cabinet decision around February each year) to secure financial resources for local public finance as a whole. If resources shortages are projected, the national government takes additional measures to cover such shortages (local financing measures).

Financial resources shortages in annual Local Financial Plans have expanded sharply since FY 1994 to reach ¥14.2 trillion, amounting to 15.9% of the total Local Financial Plan size (¥89.3 trillion) in FY 2001 (see Figure 3-4-3). The following measures are usually taken to cover the shortages:

• (a) Allowing local governments to make additional bond issues on condition of future local allocation tax financing interest payments on and redemptions of such bonds.
• (b) Special fund transfers are made from the national general account to the Local Allocation Tax Special Account.
• (c) The Local Allocation Tax Special Account introduces borrowings.

Under the first measure, the national government increases local bond issue proceeds' share of spending mainly on construction projects and approves additional local bond issues (financial resources bond issues). This forces local governments to pay interest on and redeem these bond issues in future years. When these bond issues are redeemed, the national government sets aside interest payment and redemption costs in an annual Local Financial Plan and incorporates the costs into the standard financial demand. Under the second measure, the national government transfers a legally fixed amount of funds as well as a certain part (statutory portion) of the five national taxes from the general account to the Local Allocation Tax Special Account to make up for any shortage in the tax grants to local governments. For FY 2001, the national government made a special transfer of ¥2 trillion from the general account to the special account to cover a financial resources shortage.

Under the third measure, the Local Allocation Tax Special Account borrows funds to cover shortages in the tax grants to local governments. The local allocation tax is allotted to local governments through the national government' s Local Allocation Tax Special Account. As financial resources for the local allocation tax, the government transfers a certain part (statutory portion) of the five national taxes, including the income and consumption taxes, from the general account to the special account. On the other hand, the local allocation tax for actual allotment to local governments through the special account is based on a local financial resources shortage as worked out in an annual Local Financial Plan. As a result, a gap usually exists between the "statutory portion" amount and the required local allocation tax size. During the bubble-ridden economic expansion, a tax revenue increase allowed part of the "statutory portion" amount to offset past borrowings in the special account. However, the "statutory portion" amount peaked out in FY 1991 and has declined dramatically on an economic slump and tax cuts since then, while the required local allocation tax size has expanded substantially. As a result, the financial resources for the local allocation tax have remained in shortage since the supplementary budget for FY 1992 was formed. The resources shortage, or a gap between the "statutory portion" amount and the larger required local allocation tax size, amounted to 31.3% of the required size in FY 2001 (see Figure 3-4-4).

The balance of borrowings at the Local Allocation Tax Special Account will reach ¥42.6 trillion at the end of FY 2001. The sum is about three times as large as the "statutory portion" amount. Of the balance of local allocation tax borrowings, the national government is set to shoulder ¥14.1 trillion and local governments as a whole the remaining ¥28.5 trillion.

Since the national and local governments' shares of the balance of local allocation tax borrowings have remained ambiguous, some people have complained that local governments have little felt the relevant financial burden. In response, the national government made an institutional change under the FY 2001 local financial measures. The FY 2001-2003 institutional change, aimed at improving the transparency of national and local government finances, has replaced the traditional equal sharing of local allocation tax borrowings between the national and local governments with a new system, in which the national government makes a special funding addition (an extra financial addition) to cover its share in its general account, with local governments covering their share with special bond issues (extra financial measure bonds) under Article 5 of the Local Finance Law.

In a bid to improve local public finance, which is now in a critical situation, the government is now reconsidering and prioritizing national and local government expenditures to hold down the annual Local Financial Plan size and lower the local financial resources shortage and borrowings.

2 Problems with Local Revenue Bases

Revenue bases of local governments

From the viewpoint of local autonomy, it is desirable for local governments to raise financial resources for their administrative services by collecting tax from local citizens. In reality, however, large economic gaps exist among the some 3,300 local governments ranging from Tokyo with population of more than 11 million to Tokyo' s Aogashima Village with only 200. In FY 1999, local tax revenues slipped below 20% of total revenues for half (23) of the prefectural governments and for some 60% (1,813) of the municipal governments. The revenue bases of local governments are thus vulnerable in general.

In Japan, local governments are mainly responsible for providing public services. For part of these services, the national government determines the mechanisms and standards to ensure uniform nationwide administrative services. It has also provided national treasury disbursement (including subsidies) and financial adjustments through the local allocation tax to secure financial resources for local administrative services so that any local government can implement systematic administrative management. This has allowed local governments with vulnerable revenue bases to provide almost the same administrative services as others.

Financial resources transfers from the national to local governments

Financial resources transfers from the national government to local ones take place through national treasury disbursement (including subsidies), local allocation tax, special local allocation subsidies, local transferred tax and other systems (see Figure 3-4-5). The national treasury disbursement means that the national government subsidizes or funds all or part of specific projects. The disbursement is allotted in accordance with burden-sharing rules for each administrative item. The local allocation tax to secure financial resources for local governments is based on an excess (financial resources shortage) of the standard financial demand as calculated in accordance with reasonable standards over standard tax revenues (see Column 3-2 "Local Allocation Tax System" ). In the FY 2001 Local Financial Plan, the national government' s financial resources transfers to local governments amount to ¥34.9 trillion, accounting for 39.1% of total local government revenues (¥89.3 trillion).

The national government has thus been involved in spending at local governments while securing financial resources for them. This system has played a great role in the provision of administrative services in Japan, allowing local governments to offer uniform services nationwide in spite of widening economic gaps between local communities. However, some problems with the financial transfer system have become issues of controversy. First, the system has allowed local governments and residents to feel less responsible for financial burdens and loosen their fiscal discipline. As a result, those who are responsible for growing budget deficits at local governments have remained unspecified. Second, the system has tended to discourage local governments from making independent decisions on their spending and revenues or from implementing measures that respond flexibly to the needs of local residents. We must note that these problems for local governments could emerge for the national government that has issued massive bonds to finance economic stimulus measures.

National treasury disbursement failing to meet needs of local residents

The national treasury disbursement (including subsidies), as well as local tax and the local allocation tax, is a major financial resource for local governments, playing a key role in promoting post-disaster restoration and large-scale construction projects. Public works projects that local governments implement with the national treasury disbursement have contributed to stability of regional economies and livelihood and to balanced national land development. For the national government, the national treasury disbursement has worked as an effective tool to guide local administration into the national policy direction.

But the national treasury disbursement is designed to finance projects meeting unified national standards and can lead to administrative services becoming stereotyped. The disbursement is also believed to include measures that were introduced decades ago and that are failing to meet social and economic changes. Some measures may be too small in funding size to have any effect. The present national treasury disbursement may allow even low-priority projects to be implemented with no sufficient considerations to priorities. It may have been distorting the decisions of local governments that have been trying to utilize regional wisdom and ideas for independent fiscal and administrative management to meet the needs of local residents(43).

National subsidies to local governments totaled some ¥20 trillion in FY 2000, accounting for more than 70% of total national subsidies as booked in the year' s national budget before supplementation. National subsidies to local governments can be divided into three-(a) "national financial contributions" to finance part of projects for providing indispensable administrative services for national livelihood; (b) "national financial subsidies" based on the national government' s plans to promote specific projects or make financial assistance; and (c) "national financial commissions" to finance services that local governments provide on behalf of the national government. The national financial contributions account for some 80% of the subsidies to local governments. We must review the national financial contributions when we reconsider the sharing of burdens between the national and local governments, and consolidate and rationalize the national government' s involvement in local administration.

The national financial subsidies occupy less than 20% (some ¥4 trillion) of the total national subsidies to local governments. The Committee for the Promotion of Decentralization, in its report, "Creation of a Decentralized Society" (August 2000), recommended that the national financial subsidies be abolished or reduced in principle(44). Of the total national financial subsidies to local governments as covered by the national government' s general account, some 40% are for public works, some 25% for social security and some 10% for education and science promotion. The three categories occupy a large percentage of the total. Let' s break down the national financial subsidies by the time of establishment and the national share of contribution (= national subsidies / total works expenditure). Subsidies established before the war and in the postwar reconstruction period amounted to ¥471.2 billion, or 11.7% of the total. Those established 25 years ago or more came to ¥1.7 trillion, or 43.1% of the total. Subsidies and subsidized projects that were established a long time ago could have accomplished their goals or could be failing to meet social and economic changes. As for the national share of contribution, subsidies representing shares less than one-third accounted for 2.6% and those less than a half for 27.0% (see Table 3-4-6). For these subsidies representing small national shares of contribution, we will have to consider real effects and review those having only small effects.

The classification of the national financial subsidies and the national financial contributions here is in accordance with that by the Committee for the Promotion of Decentralization.

We will have to review the national financial subsidies and contributions to local governments, based on the view that a system should be established for local residents to make choices independently in accordance with their contributions in order to achieve real local autonomy. We may have to retain national financial subsidies and contributions to cover administrative services that generate nationwide or wide-area benefits and minimum services that must be guaranteed for the people. But others should be abolished or reduced.

Even national financial subsidies and contributions that must be maintained will have to be consolidated into a menu of choices and implemented more flexibly, in order to prevent the national government' s intervention affecting voluntary and independent initiatives of local governments. In FY 2000, the government created the consolidated subsidy system where local governments can make independent decisions on locations and other details of specific projects. The government will have to increase the number of projects subject to this system.

Growing local allocation tax

The total sum of the local allocation tax has been increasing since the second half of the 1980s, posting a 42.0% expansion for the 1990s. Since the local allocation tax is designed to provide financial resources for standard (reasonable, appropriate) administrative services, its role should decline in accordance with income improvements on economic growth unless the standards are upgraded with the coverage expanded. However, local allocation tax' s share of total local government revenues had been stable at around 20% before expanding on the economic slump and a fall in local government tax revenues following tax cuts in past years.

The local allocation tax increase has come as the "standard financial demand," estimated as costs for providing standard administration services, has continued to expand especially for municipal governments even since the early 1990s (see Figure 3-4-7)(45). As discussed above, part of investment outlays that have soared fast on the national government' s economic stimulus packages in the past years has been incorporated into the standard financial demand. Furthermore, interest payments on and redemptions of local bonds issued to raise funds for investment outlays and cover resources shortages have been subjected to the local allocation tax and included in the standard financial demand. These measures have contributed to expanding the standard financial demand.

On the other hand, the standard revenues have declined sharply for prefectural governments on plunges in revenues from two local corporation taxes, while rising for municipal governments. The ratio of standard revenues to standard financial demand for the whole of local governments has gradually declined from a peak of 72.1% in FY 1989, hitting a low of 58.2% in FY 2000. As a result, the local allocation tax as the gap between the standard financial demand and the standard revenues has continued an expansion.

Changing functions of local allocation tax and review of local allocation tax calculation methods

The local allocation tax is a general-purpose financial resource that local governments can spend freely and is different from the national treasury disbursement to subsidize specific projects. Over the past years, however, the local allocation tax has become a resource for specific projects.

As for local projects subject to the national treasury disbursement, local governments shoulder costs other than the national treasury disbursement with general-purpose financial resources including local tax revenues, local allocation tax and local bond proceeds. Local governments' shares of the projects costs, and interest payments on and redemptions of local bonds for these projects are partially included into the standard financial demand under the "public modification" and "debt-service" systems for the local allocation tax(46).

In this way, the local allocation tax is combined with the national treasury disbursement and local bond issues to ensure local governments' implementation of projects that the national government promotes. On the other hand, local governments have taken advantage of the local allocation tax system to secure certain levels of administrative services, instead of making independent efforts to raise funds for administrative services meeting regional needs.

In addition to these local allocation tax measures for subsidized projects, the national government since the mid-1980s has allowed local governments to cover most of costs for their independent projects with local bond issues and included part of costs for interest payments on and redemptions of these bonds into the standard financial demand. This has apparently generated great effects as a spending-inducing tool. The comprehensive local development project system for independent local projects has worked to promote independent town-building and welfare facility construction projects by local governments and ensure the implementation of independent local projects responding to the national government' s economic stimulus packages.

The sum of public modifications and debt-service costs as included into the standard financial demand totaled ¥3.9 trillion in FY 1995, accounting for 9.4% of the standard financial demand. Since bond interest payment and redemption costs have expanded on sharp growth in local bond issues to cover financial resources shortages over past years, the sum for FY 2001 increased to ¥6.3 trillion, occupying 13.4% of the standard financial demand. Public modifications' share of the standard financial demand in FY 1999 stood at 5.4% for prefectures and 7.5% for municipalities, indicating that such adjustments have had a greater impact on municipalities than on prefectures. This is because municipalities that unevenly implement large-scale projects use the public modification system instead of earmarking investment outlays as unit cost for calculation of the standard financial demand.

Local governments strictly compare the costs and benefits of projects using their own financial resources before deciding whether to implement them. But the present systems have allowed local governments to cover most of costs for many projects with a combination of national financial subsidies and some local allocation tax systems (including one that allows local allocation tax to cover redemption costs for local bonds issued for specific projects). This has prompted local governments to favor projects that require less local contributions and discouraged them from selecting effective projects independently and implementing them efficiently. The current systems, which have led local governments to lose their cost consciousness, should be scaled down and revised to encourage them to make independent choices and use their own resources for effective projects. The national government is considering limiting the scope of projects subject to the public modification system and cutting the local allocation tax' s share of project costs.

We here would like to divide all prefecture and city governments into two groups-local allocation tax recipients and non-recipient governments-and compare the spending growth rates of the two. In the latter half of the 1990s, when local tax revenues declined, the non-recipient governments reduced their spending, while the recipients with less financial capacity expanded their spending (see Figure 3-4-8).

Local allocation tax recipients with less local tax revenues have had more per capita general-purpose financial resources (local tax revenues plus local allocation tax) than non-recipient governments. One factor behind this phenomenon is the "adjustment coefficient" that is used to reflect natural and social differences in administrative costs for calculation of the standard financial demand(47). For underpopulated and other regions where administrative costs are relatively higher, the coefficient is used to reflect underpopulation and other special factors to increase local allocation tax.

Standard financial demand growth rates have differed between regions. We here use the coefficient of variation of growth rates in the latter half of the 1970s, the 1980s and the 1990s to compare differences between standard financial demand growth rates. While standard financial demand as a whole has reduced its growth gradually, the variation coefficient has increased. This indicates that local allocation tax gaps between regions have expanded in the 1990s(48).

In order to institutionalize spending-saving incentives for local governments, we must develop a simpler system to use more objective and simpler standards for calculating and distributing the local allocation tax. It goes without saying that we must consider reducing the national government' s involvement in local administration when developing such a system. The graded system of compensation (adjustment of local allocation tax according to local government sizes) must be reviewed to encourage local governments to rationalize administrative services and improve their efficiency(49). The local allocation tax' s financial coordination role is very important for local governments' efforts to develop more independent and autonomous financial management. Therefore, we must ensure a certain size for the local allocation tax while simplifying calculations of the local allocation tax for every local government.

Efforts to Increase Local Tax Revenues

As discussed earlier, local governments whose local tax revenues slip below even 20% of their total revenues account for some 50% of prefectures and about 60% of municipalities. Their revenue sources are thus very vulnerable. As for local governments revenues, the Local Tax Law has specific provisions on (a) possible taxes, (b) tax sources, (b) taxation standards, (b) tax rates and (d) other collectable charges, while leaving some room for local government to choose tax sources. On the other hand, the local allocation tax is given to cover the standard financial demand' s excess over the standard revenues (financial resources shortages). This system provides little incentive for local governments to make independent efforts to increase tax revenues. Even if local governments increase tax revenues on their own, the rise will only serve to expand their standard tax revenues and will be mostly offset by a cut in local allocation tax(50).

Even the current system gives the following considerations to prevent a tax revenue increase being offset by a cut in local allocation tax:

• (a) Not all local tax revenues are included into the standard revenues. Some portions (20% of prefectural tax and 25% of municipal tax, hereinafter referred to as withheld revenue rates) are withheld for independent projects by local governments.
• (b) Revenues from excess and extralegal taxes are not included in the standard revenues but designed to become general-purpose financial resources, leaving an incentive for local governments to expand tax revenues(51).

As long as local governments depend heavily on the local allocation tax, however, these measures have only a limited effect.

In a bid to increase incentives for local governments to expand tax revenues, we are now considering raising the withheld revenue rates. If the withheld revenue rates are lifted, it will expand financial resources for local governments and prompt them to step up tax revenue-boosting efforts(52).

In order to respect local governments' autonomy of taxation, the 2000 Decentralization Promotion Law revised the Local Tax Law to shift from the extralegal ordinary tax approval system to the consent-based consultation system with the scope of consultations narrowed and create extralegal earmarked taxes. Local governments are thus expected to independently and responsibly give positive considerations to taking advantage of the autonomy of taxation to meet regional realities, based on local residents' requests, on the taxation principles of equity, neutrality and simplicity, and on taxpayers' appropriate contributions. In fact, many local governments have been making independent taxation efforts(53). The utilization of taxation autonomy can contribute to specifying the benefit-contribution relationship and is desirable for decentralization. But, local governments use taxation autonomy to impose new taxes on corporations more frequently than on local residents.

Local bond issues should depend more on private funds and less on public funds

While working out the "local bond issuance plan" to fix the projection of local bonds that local governments issue in a year, the national government plays a key role in underwriting local bonds. According to the FY 2001 local bond issuance plan, the fiscal loan fund is to underwrite ¥5.2 trillion or 31.4% of local bond issues, the Japan Finance Corporation for Municipal Enterprises ¥2.0 trillion or 11.9%, the "Kampo" postal insurance fund ¥1.6 trillion or 9.9%, and the postal savings fund ¥1.0 trillion or 6.1%. Public funds are thus planned to underwrite about 60% of total local bond issues. These funds are lent over longer periods at less interest rates than private funds, covering projects that are more public.

The fiscal investment and loan program reform in April 2001 terminated the traditional system that had required postal savings and pension funds to be deposited at the Ministry of Finance Trust Fund Bureau. These funds are now available for their managers' independent investment in financial markets. As for the Kampo fund, traditional lending to FILP organizations has been abolished. In order to ensure funds for borrowings by financially weak local governments, however, postal savings and Kampo funds are exceptionally made available for direct lending to local governments within the framework of the local bond issuance plan and the FILP plan(54).

Private sector funds cover some 40% of total local bond issues. Only a quarter of the 40% is publicly issued to raise funds from the bond market. Financial institutions that local governments have designated as their trading partners underwrite the remaining three quarters as privately placed local bonds.

Public funds play a major role in underwriting local bonds since fund-raising capacity gaps between local governments are wide. From the viewpoint of decentralization, however, local governments should raise more private funds and less public funds. But designated financial institutions (regional banks, second-tier regional banks, etc.) may now have difficulties underwriting far more local bonds due to (a) their full introduction of mark-to-market accounting principles in September 2001 and (b) the introduction of the payoff limited deposit protection scheme planned for April 2002(55). In order to help local governments diversify their fund-raising means in private sector markets, the national government should try to expand bond issue sizes through their joint issues, diversify maturities and reflect secondary market forces in bond issue terms to improve the liquidity of local bond issues(56).

Local bond issues have been subject to approval by the national government. The Decentralization Promotion Law will terminate the approval system and shift to a prior consultation system in FY 2006 in order to ensure a smooth issuance of local bonds, local governments' financial resources and the soundness of their finances. In the future, we will have to work out standards for consents to specific local bond issues in line with the purpose of the institutional change and make preparations for facilitation of the consent-based consultation system.

3 Local Administrative and Fiscal Reform Efforts

Basic idea for local administrative and fiscal reform

As discussed so far, Japan' s local public finance has been in a severe situation and its improvement is urgently required. Various problems exist with administrative and financial relations between the central and local governments. An overhaul of systems connected with the relations between the central and local governments is required.

Financial relations between the central and local governments contain a special feature. While local governments mainly provide administrative services to the people, the central government is involved in local government decisions through its regulations and subsidies and collects financial resources for distribution to local governments. This system, while allowing uniform administrative services to be provided nationwide despite widening economic gaps between regions, has discouraged local governments from striving to independently promote regional development. Local governments tend to believe that it is rational for them to beg for financial resources from the central government. The system also leads inefficiency at the national government to cause inefficiency at local governments. As a result, similar towns and public halls are seen nationwide with local communities losing their respective unique features. Local governments have been allowed to implement even ineffective projects.

Needs for administrative services by local governments are expected to steadily increase in health care, welfare and environmental areas in Japan in the future, as the birthrate declines and the population ages and there is no high economic growth. We are now urgently required to develop a new system to efficiently utilize limited financial and human resources to meet new needs for administrative services. In this respect, we must reconsider traditional services that have become less necessary. We must also further specify the benefit-contribution relationship for various administrative services including welfare, education and social infrastructure development. A new system must be developed to allow local residents to compare their contributions to and benefits from administrative services and make independent and responsible decisions to determine levels of administrative services.

In pursuit of the original ideas behind the "balanced development" that has traditionally been given priority, we must shift the priority to "unique regional development" and "revitalization of wisdoms and development efforts through competition." We must take a step toward a new era after the present one where the national government has been deeply involved in local administration and has provided local financial resources to ensure stereotyped local administrative services.

The following points are important for promoting local financial reform:

First, we must review the total sum of local government spending to reduce local financial resources shortages that now total ¥14.2 trillion on an annual local financial plan basis. Reflecting on the fact that the national government' s series of economic stimulus packages have led to a substantial expansion in local government spending since the early 1990s, we should reconsider the minimum levels of administrative services that the national and local governments must guarantee for the people. This should lead to a review of local spending and the improvement of local government finance. The review should be linked to an overhaul of financial transfers through the national financial subsidy and contribution system and the local allocation tax system. In accordance with a review and reduction of administrative services the national government requests local government to provide, we should cut the scope and levels of services that are funded through national subsidies, the local allocation tax and the local financial plan. This will allow local governments to freely select and provide their respective unique services.

Local governments are required to further promote spending-saving rationalization efforts. They also should take advantage of their taxation autonomy to secure sufficient revenues and should promote municipal mergers in serious efforts to enhance their administrative and financial infrastructure.

Local governments should expand local taxes in order to establish "self-supporting and independent" revenue sources including financial resources that they can spend freely. To this end, we should build on a review of the burden-sharing system between the national and local governments to fundamentally reform national financial subsidies and contributions, and the local allocation tax as well as the distribution of tax revenue sources between the national and local governments, including the transfer of tax revenue sources.

Since local government finance systems and problems are linked to each other in a complex manner, we must comprehensively consider measures to reform spending and financial transfers and expand local tax revenues through the redistribution of national and local tax bases, including the transfer of some national government tax bases to local governments. Since these measures include financial transfer reform, tax base transfers and others deeply connected to the national public finance system, we must consider their effects on national public finance. For example, a national tax decline equal to a reduction in financial transfers to local governments could lead to the national budget' s dependence on government bonds increasing, since both national tax revenues and government bond issue proceeds are transferred to local governments. In this respect, we will have to consider how national and local taxes should be as well as how the existing stock of massive national and local government debts should be eliminated.

The basic direction of the local administration and finance reform was put forward in the "Basic Policies" as decided on at a Cabinet meeting in June 2001. The "Local Independence and Revitalization Program," as one of the "Seven Programs of Structural Reform," made the following points: Measures required for the "establishment of independent relations between the national and local governments" include municipal mergers, more efficient administrative systems, reconsideration of national administrative service levels, clarification of residents' benefits and contributions, and local finance system reform. The promotion of the independent development and revitalization of "unique local communities" is an important challenge. Local public finance should be reconstructed through prompt reorganization of municipalities, more efficient spending and specification of benefits and contributions. Based on the principle of "administrative services authority close to residents," simplification of various systems should be implemented, including consolidation and rationalization of national financial subsidies and contributions, reform of the local allocation tax system in line with the reduction of the national government' s involvement in local government, and reduction of systems that water down local governments' cost consciousness. On condition of improved efficiency in local administration and finance, local taxes should be expanded to allow local governments to independently raise basic financial resources for social infrastructure development and social security services.

Simulation of local public finance reform

We must promptly promote efforts and considerations for local administration and finance reform. To this end, large-scale debates are indispensable among the national government, local governments and the people. In this respect, individual and specific considerations should be given to how the present local public finance is at present and how the future situation would be after specific reforms.

For example, to obtain satisfactory local taxes, there are various measures, such as the distribution of the allocation of tax revenue sources between the national and local governments including the transfer of tax revenue sources, local governments' positive utilization of taxation autonomy to introduce extralegal and excess taxes, and local tax increases. In considering these measures, the "Basic Policies" states that we should "take into account respective financial conditions of the national and local governments and these measures' effects on each local government."

On some bold preconditions, we have simulated the local public finance reform below. The first precondition is that ordinary construction works expenditure after remarkable growth in the 1990s should be reduced. The simulation thus digests the effect of a spending review. Among local tax expansion measures, we have taken up the tax base transfer to simulate the local public finance reform, based upon some bold preconditions. As discussed earlier, however, the redistribution of tax bases between the national and local governments including the transfer of tax revenue sources must meet the goal of sounder public finance at a time when government has entered into a critical financial situation. Realistically, the local public finance reform must be incorporated into arguments for the structural public finance reform concerning both the national and local governments.

Since the reform' s effects on the public finance of each local government vary depending on the preconditions, the simulation results should be considered flexibly.

Preconditions for simulation

We have quantitatively analyzed how the revenue structure and the local allocation tax would change for each prefecture or municipality if spending cuts were coupled with tax base transfer. Therefore, we have ignored the spending changes of each local government accompanying revenue structure changes in this simulation. The analysis has covered the general accounts of the 3,299 prefectural and municipal governments in Japan for FY 1999(57).

Specific preconditions for the simulation are as follows:

(Precondition 1) A 10% cut in ordinary construction works expenditure in each local government Presuming that a spending review would lead to a 10% cut in ordinary construction works expenditure for each local government, we reduce local allocation tax, national treasury disbursement and local bond issues for such projects in a bid to find the effects on revenues(58). Ordinary construction works expenditure in FY 1999 totaled ¥26.1 trillion, accounting for 25.7% of total local spending. Therefore, the 10% cut in ordinary construction works expenditure amounts to 2.6% of total local spending.

(Precondition 2) As the national government implements a transfer of tax revenue sources to local governments, the local allocation tax and national treasury disbursement are simultaneously cut by the equivalent of the transferred tax base. The tax base transfer is thus neutral to local revenues.

Specifically, a ¥7 trillion tax base transfer from the national government to local governments is implemented in order to change the ratio of national taxes to local ones to 50-50 (see Figure 3-4-9). At the same time, the national government' s financial transfers to local governments including the local allocation tax and the national treasury disbursement are cut by the equivalent of the tax base transfer(59). For the local public finance as a whole, total revenues remain unchanged since the equivalent of the increase in local tax revenues is deducted from the local allocation tax and national treasury disbursement(60). For each local government, however, the tax revenue rise through the tax base transfer does not match the cut in the local allocation tax or the national treasury disbursement. For the national government, the tax revenues are cut by the same margin as spending, with borrowings remaining unchanged. Under Precondition 2, total national and local tax revenues remain unchanged. Since the tax bases for national taxes are different from those for local taxes, however, individual taxpayers' tax payments can change in accordance with tax base transfer.

(Precondition 3) A certain part of national taxes like income and consumption taxes that is the resources for the local allocation tax, is transferred to personal inhabitants and local consumption taxes that have less gaps between regions.

As for the individual inhabitants tax, three income-based tax rates of 5%, 10% and 13% are unified into 10% so that a wider range of inhabitants make less tax contributions. The unified tax rate comprises 3 percentage points for prefectures and 7 points for municipalities(61). No considerations are given to how the national income tax rates and tax bases would change on the tax base transfer.

The local consumption tax must be expanded to meet financial demand in a wide range of areas including welfare. In this respect, we have transformed part of the national consumption tax into the local consumption tax. At present, the 5% consumption tax comprises 4 percentage points for the national government and 1 point for local governments. We have transferred 1.5 points of the tax rate to local governments so that the national and local governments share the consumption tax equally-2.5% for the national government and 2.5% for local governments. The precondition here is the tax base transfer to the inhabitants and local consumption taxes. In reviewing the distribution of the allocation of the tax revenue sources between the national and local governments, we will have to prudently consider how the income tax as the key national tax and the consumption tax designed for welfare purposes should be.

We will now consider the details of the simulation results.

Improved local revenue bases

First, let' s look at how the whole picture of local public finance change. The local allocation tax, national treasury disbursement and other financial transfers decline to some 30% from the present 40% of local government spending, while local tax revenues increase to some 40% from the present 30% of local government spending. Local governments' independent financial resources including local tax and other revenues account for 59% of total revenues, a rise from the present 52%. Revenue bases are thus improved for the whole of local public finance (see Figure 3-4-10). As for the national government, tax revenues' ratio to spending declines and its dependence on bond issues increases, indicating a further deterioration of public finance.

At present, financially vulnerable local governments whose local tax revenues account for less than 20% of total revenues occupy some 50% of municipalities. This percentage falls to some 40% (1,297 municipalities). Stronger local governments whose local tax revenues account for more than 50% of total revenues occupy 15.4% (507) of municipalities, a rise from the present 7.4%. The tax base transfer can thus benefit not only local public finance as a whole but also individual local governments (see Figure 3-4-11).

Residents increase for local governments receiving no local allocation tax

Next, let' s look into the increase in the number of local governments receiving no local allocation tax.

At present, most municipalities (3,145 municipalities or 97% of total municipalities) receive local allocation tax. As the tax base transfer boosts local tax revenues, the share for municipalities receiving no local allocation tax increases from 3% to 8%. Non-recipient municipalities increase mainly in metropolitan regions. Among prefectures, Aichi becomes a non-recipient prefecture in addition to Tokyo as the only non-recipient. The other prefectures still receive local allocation tax even after the tax base transfer.

Let' s look at the number of residents for local governments receiving no local allocation tax. Such residents' share of Japan' s total population rises from only 12% to 39% on a municipality basis and from 9.3% to 14.8% on a prefecture basis (see Figure 3-4-12). The tax base transfer can thus increase the population share for residents served by local governments that receive no local allocation tax and depend on local tax revenues. Such local governments can be expected to independently and responsibly determine the levels and quantity of administrative services they provide. As a result, the total local allocation tax declines by 2.5% (¥5.2 trillion) from the present ¥20.8 trillion.

Finally, we note that the increase in the number of local governments receiving no local allocation tax can cause massive excess financial resources (¥1.7 trillion). The excess resources are an excess of the standard revenues over the standard financial demand and emerge for local governments (especially, large municipalities) receiving no local allocation tax. If the tax base transfer to local governments as a whole is equal to the cut in national financial transfers as in this simulation, revenues at local allocation tax-receiving local governments may decline in accordance with an increase in excess resources at non-recipient local governments. We must take note of this point. Depending on the extent of the tax base transfer, we will have to consider new financial adjustment mechanisms and better financial systems for giant cities.

Effects of the transfer of tax revenue sources differ depending on local government size

We have discussed some effects of the transfer of tax revenue sources. Looking at these effects on various sizes of local governments, we can see a different picture (see Figure 3-4-12).

The effects of the transfer of tax revenue sources are larger for municipalities whose population exceeds 100,000. Financial capacity can be improved substantially in any city with a population of more than 100,000. The number of such cities receiving no local allocation tax increases from 23 (10.2% of the total) at present to 108 (47.8%). The population share of residents in cities receiving no local allocation tax rises from less than 20% at present to 60%. In this way, larger local governments that have more population and more economic capacity can become independent of the national government.

On the other hand, financial capacity improvements are relatively limited for 3,003 municipalities (93.0% of the total municipalities) with population below 100,000. The number of such municipalities receiving no local allocation tax increases from 61 (2.0% of the total municipalities) to 122 (4.1%).

Even after the transfer of tax revenue sources, small municipalities that cannot become financially independent would still be abundant. Therefore, the view that the transfer of tax revenue sources could solve all financial problems facing local governments " turns out to be too optimistic. In order to establish a new relationship between the national and local governments based on self-help efforts and autonomy, we must encourage local governments to expand their administrative and financial capacity and improve their self-supporting capacity. Local governments should become able to support themselves without financially depending on the national government. To this end, we must promote municipal mergers for wider-area administration more strongly and stimulate prompt reorganization of municipalities with deadlines being set.

As the duties of local governments increase more and more on decentralization, we may have to reconsider the present system where local governments with populations only in the thousands provide the same administrative services as those with hundreds of thousands of residents. A new system must be developed to change the duties and responsibilities according to the sizes of local governments. For example, small local governments may be allowed to reduce their duties and responsibilities with the reduction covered by prefectures.

On the other hand, some financial adjustment system will be required to secure financial resources for administrative services at municipalities whose efforts to enhance financial bases are put under constraints.

Gaps between regions emerging from transfer of tax revenue sources

People who are cautious about the transfer of tax revenue sources argue that a transfer of tax revenue sources may expand the tax revenue gaps that already exist between regions.

This simulation has indicated that the tax revenue growth in value emerging from the transfer of tax revenue sources in big cities is more than in other municipalities. In this sense, tax revenue gaps may expand. On the other hand, growth rates in big cities are smaller than in other municipalities. The variation coefficient of per capita tax revenues (tax revenue disparity) declines after the transfer of tax revenue sources, indicating narrower tax revenue gaps between regions(62).

Conclusion

In this section, we considered the problems facing local public finance and discussed local tax expansion measures using the utilization of the taxation autonomy and local tax increases. We then selected the national government' s transfer of tax revenue sources to local governments that was combined with a 10% cut in ordinary construction works expenditure for a simulation to indicate the effects on local public finance. As a matter of course, the simulation results should be interpreted flexibly(63). Based on the above analysis, however, we can make the following points on an outline of local public finance reform:

(1) The transfer of tax revenue sources can enhance the local public finance infrastructure to some extent and allow big cities and other economically strong municipalities to become financially independent of the national government. For most of municipalities including rural ones, however, financial conditions do not improve so much.

The transfer of tax revenue sources can improve the current situation where even big cities with great economic capacity must receive local allocation tax. It can allow big cities and other economically powerful municipalities to implement more self-supporting financial management. At the same time, they may make responsible policy choices to improve administrative efficiency and save spending. But improvements may be limited in most municipalities including rural ones.

(2) The transfer of tax revenue sources alone cannot solve local public finance problems. The national government' s efforts to abolish or reduce its involvement in local governments must be combined with local governments' review of their independent measures and spending. At the same time, municipal mergers and other measures should be promoted to enhance the financial infrastructure of local governments.

The transfer of tax revenue sources alone cannot solve local public finance problems. This is an important finding of our analysis. In order to improve the current critical financial conditions, a spending review is indispensable. Also important are local governments' voluntary tax revenue expansion efforts using their taxation autonomy. Projects subject to national financial subsidies and national legal standards account for a great part of local general expenditures excluding debt-service and some other costs. Given this fact, we must review local governments' independent measures, and abolish or reduce the national government' s measures and its involvement in local administration in order to allow reductions in the whole of local government spending. This should lead to reductions in the scope and levels of expenditures whose resources include national financial subsidies and local allocation tax under local financial plans.

At the same time, financially weak local governments should promote wider-area administration through their mergers to enhance their administrative and financial infrastructure as basic administration units close to local residents.

Based on these efforts, we must review the burden sharing between the national and local governments and implement a comprehensive, fundamental local public finance reform including the consolidation of national financial subsidies and contributions, the modification of the local allocation tax and the redistribution of national and local tax resources including some transfer of tax revenue sources (64).

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