Annual Report on

The Japanese Economy and Public Finance


- Japanese Economy Heading for New Growth Era

with Conditions for Growth Restored -

Cabinet Office

Government of Japan

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Section 4 Trends in Fiscal Policy

(Fiscal conditions, though still severe, are improving)
    Both central and local governments have promoted expenditure reforms so that the size of government (ratio of general government expenditure to GDP) does not exceed the level of FY2002 until FY2006 and a surplus in the primary balance should be achieved in the early 2010s. Thanks to these efforts and increases in tax revenue accompanying economic recovery, the governments' fiscal balance, though still severe, has improved slightly.
    The deficit in the primary balance of central and local governments reached a high level with 5.7% relative to GDP in FY2002. After remaining unchanged in FY2003, the primary deficit decreased to 3.9% in FY2004. According to the "Structural Reform and Medium-Term Economic and Fiscal Perspectives - FY2005 Revision," the deficit in the primary balance is estimated at around 3.3% for FY2005 and is expected to decrease further to around 2.8% in FY2006. In order to see what factors have contributed to the improvement of the primary balance since FY2002, we have investigated the movements of individual expenditure and revenue items. The investigation has revealed the following characteristics (Figure 1-4-1).
Figure 1-4-1 Trends in the Primary Balance of Central and Local Government

(Primary balance is improving, reflecting the curtailment of public investments and increases in tax revenue, etc.)
    On the expenditure side, the expenditure of the central and local government combined excluding interest payment decreased from 23.2% of GDP in FY2002 to 21.6% in FY2003 and it is expected to continue to decrease in FY2005 and FY2006. A breakdown of expenditure items shows that public investments posted the largest decrease relative to GDP, losing by about 1.2 percentage points from FY2002 to FY2004. Final government consumption expenditures (police, diplomacy, defense, education and public health, etc.) consisting mainly of personnel cost and benefit in kind have also been decreasing slightly relative to GDP. On the other hand, social security-related expenditures have continued to increase every year due to the advancement of the aging society, and thus have been a factor expanding the deficit in the primary balance.
    On the revenue side, tax revenue decreased relative to GDP in FY2002 and FY2003. This was partly due to tax-break measures for R&D expenses and partly due to a reaction to a sharp increase in income tax revenue accompanying maturity of huge amounts of postal savings in FY2001. In FY2004, tax revenue increased relative to GDP and is expected to continue to increase in FY2005 and FY2006, reflecting corporate income's faster growth than GDP growth and the impact of the systemic reform of individual income tax, such as the abolition of the proportional across-the-board tax credit.
    In order to get a rough idea of which expenditure or revenue items contributed to the improvement in the primary balance, we have compared their changes in FY2002 and FY2006. It shows that the deficit in the primary balance of central and local governments is expected to decrease by 2.9 percentage points relative to GDP between FY2002 and FY2006 mainly contributed by public investment reductions and increased revenues.
    As for the overall fiscal positions (net lending / net borrowing) of general governments (central and local governments plus social security funds), the deficit (borrowings in excess of lending) relative to GDP is expected to improve from about 8.5% in FY2004 to about 5.4% in FY2005 and to 5.0%(27) in FY2006, reflecting the improvement in the primary balance.

(In FY2006 budget, expenditures restrained and revenue increased)
    As to expenditure, various reforms were implemented so that the ratio of general government expenditure to GDP does not exceed the level of FY2002 (Appended Figure 1-15). The FY2006 budget incorporates achievements of various expenditure reforms, such as medical care system reform, "The Reform Package of Three Issues" and reform of the total amount of personnel costs for government employees, and reduced general policy expenditures except for social security and science and technology promotion. As a result, both the general account expenditures and general policy expenditures were slashed from previous year's levels. The government also plans to reform special accounts, including abolition or integration with general account, within five years. In FY2006, the government used 13.8 trillion yen of surplus funds and reserves for fiscal soundness, including transfer of 12 trillion yen reserves of the Fiscal Loan Fund Special Account to the National Debt Consolidation Fund Special Account.
    On the revenue side, the government in its FY2006 tax reform abolished the proportional across-the-board individual income tax credit and streamlined corporate-related taxes, such as abolition of the special tax credit for R&D expenses and the IT investment promotion tax break (Appended Figure 1-16). Furthermore, as part of the "The Reform Package of Three Issues," the government transferred tax revenue sources of 3 trillion yen from national income tax to local inhabitant tax. On the other hand, with personal income and corporate income increasing thanks to the economic recovery, the tax and stamp revenue of the central government is expected to increase by about 1.9 trillion yen from the initial budget for the previous year.

(Economic cycle and improvement in fiscal balance)
    The fiscal position of the Japanese government has been improving thanks to expenditure reforms, economic recovery, and other factors. We can confirm this by studying the movements of structural fiscal balances that are not affected by cyclical economic fluctuations and cyclical fiscal balances that are affected by cyclical fluctuations. Generally speaking, fiscal balances are affected by economic fluctuations in the sense that fiscal balances improve during economic recovery periods due to natural increase in tax revenue and reduction in unemployment benefits, etc. We have estimated fiscal positions of general governments (central, local and social security fund) by dividing them into cyclical fiscal balances, which are affected by economic fluctuations, and structural fiscal balances, which are obtained when such factors are removed (Figure 1-4-2). The structural fiscal balances can be further divided into interest payment and others. The estimate shows that not only cyclical fiscal balances have been contracting since FY2002 but also cyclical deficits have been contracting since FY2003. The ratio of the fiscal deficit of general governments to GDP decreased by nearly 3% from FY2002 to FY2004, contributed mainly by the contraction of structural fiscal deficits. The contraction of cyclical fiscal deficits contributed only about 0.4%. Meanwhile, the net interest payment relative to GDP remained almost unchanged.
Figure 1-4-2 Cyclical and Structural Fiscal Balances of General Governments

(Policy implications of the improvement in fiscal balance in OECD countries in the 1990s)
    With respect to the OECD countries that succeeded in improving their fiscal conditions in the 1990s, an examination of the contribution to the improvement made by cyclical fiscal balance and structural fiscal balance based on OECD documents(28) shows the following characteristics. (Note that these trends are the average of the OECD countries that succeeded in improving fiscal conditions and that actual conditions differ from one country to another.) (Table 1-4-3).
Table 1-4-3 Situations of OECD Countries that Improved Fiscal Balance in the 1990s
    First, in the OECD countries that succeeded in improving fiscal conditions as a whole, the ratio of general governments' deficit to GDP improved by about 5% in the 1990s. The contribution to the improvement made by cyclical factors was about half of that made by structural factors (including interest payment), indicating that the contribution made by structural factors that reflect fiscal reconstruction efforts from both revenue and expenditure sides and declines in interest payments tends to be bigger than the contribution made by the impact of economic recovery.
    Second, declines in interest rates were effective in their own way, with about one-third of the improvement made by structural factors accounted for by a decrease in interest payments. In particular, in Euro area countries there was interest rate convergence to the level of low-inflation countries in the course of the introduction of the Euro and this contributed greatly to fiscal reconstruction. Moreover, in countries with high public debts, their fiscal reconstruction and prospects for reconstruction prompted interest rates to decline, reducing interest payment expenses, and this in turn contributed to fiscal reconstruction.
    Third, as to the speed of fiscal reconstruction, fiscal balances relative to GDP improved by about 0.8% every year on average in the OECD countries that succeeded in improving fiscal conditions. Again, it is necessary to note that the improvement varies from one country to another.
    Fourth, although many of the countries succeeded in reducing their government debt to GDP ratios thanks to the improvement in fiscal balance, some countries with high public debts were unable to reduce their government debt to GDP ratios due to declines in inflation rate in the course of their fiscal reconstruction. As a result, on average, the government debt to GDP ratio of the OECD countries that succeeded in improving their fiscal conditions rose marginally.
    Judging from the OECD countries' experience and given the facts that interest rates in Japan are already at a low level and that, therefore, a decline in interest payment expenses cannot be expected, it is necessary to keep in mind that Japan's fiscal reconstruction is severe compared with that of the OECD countries in the 1990s.

(Fiscal sustainability)
    As a criterion of fiscal sustainability, it is widely acknowledged that a government debt-to-GDP ratio should not diverge over time. Specifically, whether a government debt to GDP ratio diverges or not can be judged from a formula known as the Domar Formula. According to the formula, 1) under the condition where the primary balance is in equilibrium, if nominal GDP growth rates are higher than nominal interest rates, the government debt to GDP ratio will decline gradually, but if nominal interest rates are higher than nominal GDP growth rates, the government debt to GDP ratio will diverge over time and 2) when nominal interest rates are higher than nominal GDP growth rates, it is necessary to achieve a surplus in the primary balance in order to stabilize the government debt to GDP ratio(29). The Domar Formula has its limitations in that nominal GDP growth rate and nominal interest rates do not necessarily change at a constant rate and that it does not imply at what level the government debt to GDP ratio enters a cautionary zone. Still, it is widely used as a criterion of fiscal sustainability.

(Comparison of conditions for fiscal sustainability of OECD countries)
    Therefore, we have examined to what extent the conditions for fiscal sustainability, as defined by the Domar Formula, were satisfied in Japan and other major countries. Specifically, based on analyses made by OECD(30), we first calculated the primary balance which is required to stabilize the government debt to GDP ratio from the relationship between nominal interest rates and nominal GDP growth rates and then examined whether the actual primary balances satisfy the conditions for sustainability (Figure 1-4-4).
Figure 1-4-4 Public Debt Sustainability Indicator (OECD) : Deviation of the actual primary balance from the balance which is required to stabilize the pubic debts-to-GDP ratio
    First, as to Japan, the sustainability conditions were satisfied from the mid-1980s to the first half of the 1990s but were not thereafter. As to the relationship between nominal interest rates and nominal GDP growth rates, GDP growth rates were higher than interest rates until late in the 1980s. In and after the 1980s, interest rates were generally higher than GDP growth rates, except for the bubble period. Meanwhile, the primary balance posted a surplus from 1984 to early in the 1990s but deteriorated sharply thereafter. For these and other reasons, Japan's public debt to GDP ratio is extremely high among the OECD countries(31).
    By contrast, many of the other G-7 countries failed to satisfy the sustainability conditions from the latter half of the 1980s to the early 1990s due to growing budget deficits, but have come to satisfy the conditions since the mid-1990s. Behind this is the fact that, although nominal interest rates have tended to be higher than nominal GDP growth rates since the 1980s, they have come to satisfy the sustainability conditions by achieving a surplus in the primary balances.

(Integrated reform of expenditure and revenue and the enhancement of growth potential and international competitiveness)
    The government is addressing two major challenges of achieving sustained economic growth led by private demand and achieving fiscal consolidation. In "Basic Policy 2006," the government has laid down specific measures concerning the integrated reform of expenditures and revenues and the Economic Growth Initiative in order to promote efforts to enhance growth potential and international competitiveness and continue efforts to achieve fiscal consolidation as the foundation of reform under the concept of the integrated reform on economic and public finance.
    With respect to achieving fiscal consolidation, the government has been promoting fiscal reconstruction with the aim of achieving a surplus in the primary balance of the central and local governments in the early 2010s as the first step to prevent a divergent increase in public debts and make public finance sustainable. In order to reinforce the foundation to preserve the vitality of the economy and society into the future and unrelentingly promote necessary reforms to achieve fiscal consolidation, the government has formulated measures for integrated reform of expenditures and revenues.
    In the integrated expenditure and revenue reform, measures taken by the Koizumi cabinet are positioned as "Fiscal Consolidation Advancement - Phase I" (FY2001~2006). In Phase II (FY2007~early 2010s), the government aims to achieve a surplus in the primary balance, and in Phase III (early 2010s~mid-2010s), the government intends to prevent the divergence of the government debt to GDP ratio and ensure stable reduction of the ratio in order to make public finance sustainable. A roadmap and specific targets are as follows.

Fiscal Consolidation Advancement - Phase II (FY2007 to early 2010s)
The government will make the same extent of efforts for advancing fiscal consolidation as in Phase I, and achieve a surplus in the primary balance of the central and local governments combined by FY2011.
With the aim to restore the primary balance of the financially-pressed central government as much as possible, the Government will promote financial reconstruction while securing a central and local balance.
The local governments will maintain a surplus trend by reducing their expenditure while keeping the reduction pace with that of the central government and, in terms of revenue, securing the total amount of general revenues required.

Fiscal Consolidation Advancement - Phase III (early 2010s to mid-2010s)
Even after achieving a surplus in the primary balance, the central and local governments will continue their efforts to improve the primary balance, and secure a certain amount of surplus. In doing so, while maintaining steady economic growth, they will ensure the prevention of a divergence in the ratio of debts of the central and local governments to GDP, and stable reduction of the ratio.
With respect to the central government alone, as well, the Government will aim to prevent a divergence in the ratio of debts of the central government to the GDP and reduce the ratio in a stable manner.

    When promoting fiscal reconstruction, it is important to steadily promote integrated reform of expenditures and revenues, while making utmost efforts to maximize the growth potential and international competitiveness. In other words, it is important to realize "a virtuous cycle in which the enhancement of growth potential and the advancement of fiscal consolidation effect and strengthen each other." To this end, the government has formulated the Economic Growth Initiative so that the basic concept and strategic targets of the Initiative will be shared by the whole government and consistent measures will be implemented. Specifically, in order to promote sustainable, stable growth led by private demand, the government will construct "a new growth model to overcome declining population" by using the following three as leverage.
Productivity improvement: Promotion of productivity improvement of the service industry which accounts for about 70% of the Japanese economy but whose productivity is low compared with manufacturing industries and by international standards
Technical innovation: Enhancement of labor productivity by leading the creation of innovations and IT innovations through promotion of science and technology to productivity improvement and economic expansion
Asia's dynamism: Enhancement of Japanese industries' added value and upgrading of Japanese industrial structures through division of labor with Asian countries
    In addition, in order to promote the "enhancement of the quality of labor force and manpower," the government will realize a society where young people, women, and the elderly can exercise their abilities, and thus overcome the constraining factor of the decreasing work force.
    In order to make the initiative effective, the government has prepared a "time table" for short-term, medium-term and long-term measures to be implemented in 10 years ending in FY2015, when the population decrease begins to take full effect. Moreover, the government will check the progress of measures every year by using the PDCA cycle and revise the measures quantitatively in the process of preparing a "Basic Policy."

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