A New Era Carved by Fiscal Consolidation and Tax Reform

2019/04/22

Japan's government debt (total for national and local governments) was approximately 250 trillion yen at the end of March 1989 (the end of fiscal year 1988), but it is expected to have accumulated to approximately 1,100 trillion yen by the end of fiscal year 2018, swelling approximately 4.4 times during the Heisei era. While Japan's nominal GDP (Gross Domestic Product) grew from 412 trillion yen in 1989 to 549 trillion yen in 2018 (preliminary figures), government debt grew significantly more than that.

After the collapse of the bubble economy, large-scale public works projects were carried out by issuing more government bonds under the guise of economic stimulus, but the prosperity of the Showa era could not be recovered. In the end, the economy did not improve, and only debt remained.

Public finances during the Heisei era deteriorated to the point of no return through repeated cycles of fiscal stimulus and fiscal consolidation. It was as if someone repeatedly dieted and rebounded until they could no longer return to their original weight. Fiscal stimulus would be implemented as an economic measure, only to be criticized as wasteful, leading to efforts in administrative and fiscal reform to cut spending. While the fiscal balance would improve temporarily, an economic crisis would unfortunately occur, bringing everything back to square one and leading to yet another round of fiscal stimulus. Then came the criticism of wasteful spending. It was a cycle of repetition.

It was around this time that, faced with the economic difficulties of the bubble's collapse, economic measures were taken but proved ineffective, and the construction of hot spring resorts in rural villages was criticized.

Subsequently, the Hashimoto Cabinet embarked on administrative and fiscal reforms and planned to reduce the fiscal deficit. However, immediately afterward, a financial crisis triggered by the failure of major financial institutions occurred in Japan, and the Hashimoto Cabinet's fiscal structural reforms were forced to a halt.

The succeeding Obuchi Cabinet issued more government bonds for public works projects as crisis measures, to the extent that the Prime Minister himself joked about being the "world's biggest debtor." Even so, the disposal of non-performing loans did not progress, and the economy remained stagnant. Since the problem lay in the financial sector, it was something that fiscal policy could not solve.

Amidst this sense of stagnation, the Koizumi Cabinet, which took power vowing to "destroy the LDP," worked on administrative and fiscal reforms during its long tenure, leading to progress in spending cuts and a reduction in the fiscal deficit. At the end of the administration, a fiscal consolidation goal was set to achieve a primary balance surplus by fiscal year 2011 before handing over the reins. The primary balance is an indicator of whether this year's policy expenses can be covered by this year's tax revenue; if policy expenses cannot be covered by tax revenue alone and the government must rely on debt for funding, it results in a deficit.

However, due to the global financial crisis exacerbated by the Lehman shock in 2008, Japan's economy also fell sharply, forcing the withdrawal of the fiscal consolidation goal and a return to focusing on economic stimulus measures.

In the Abe Cabinet, the last cabinet of the Heisei era, although it could not be said to be as enthusiastic about fiscal consolidation as previous administrations, the primary balance deficit has been steadily decreasing. That said, while the target year for achieving fiscal consolidation set by the second Abe Cabinet was 2020, the target year was postponed to fiscal year 2025 because it was decided to use the financial resources obtained from the consumption tax hike for increasing social security costs rather than for improving the balance.

Turning to the consumption tax, it was established in April 1989 at a rate of 3%. It was truly meant to be the tax that symbolized the Heisei era. At the time, the burden of income tax was strongly felt among the public, and the "review of the direct-to-indirect tax ratio"—the idea that it would be better to distribute the tax burden not only to direct taxes like income and corporate taxes but also to indirect taxes paid at the consumption stage—was a strong motivation for tax reform. Major tax reforms were carried out during the transition from Showa to Heisei under the Nakasone and Takeshita Cabinets.

In fact, no large-scale tax reform surpassing this was ever carried out during the Heisei era. While some administrations sought tax reform, perhaps due to the trauma of being unable to implement consumption tax hikes, politicians did not actively attempt to persuade the public.

During that time, the environment surrounding the Japanese economy changed significantly. The Cold War ended, and globalization progressed. As the birthrate declined and the population aged further, and social security costs became increasingly necessary, the population of the working generation bearing those costs began to decrease. Reform of the social security system was also slow, and benefits for the elderly remained preserved.

Under such circumstances, even if one tried to cover financial resources by increasing corporate taxes, it is difficult to impose heavy tax payments on Japanese companies exposed to fierce international competition. Even if one tried to increase income tax, under the current tax system, the heavy tax burden would fall only on the working generation, while the elderly would pay almost nothing. The intergenerational gap between benefits and burdens could widen further. Inheritance tax only generates a little over 2 trillion yen in current tax revenue, which cannot support the entire budget.

Consequently, among the core taxes, the consumption tax is the one that can minimize the damage to the Japanese economy. Academic research suggests that to obtain the same tax revenue, the consumption tax is less likely to lower the economic growth rate than income or corporate taxes. Since the consumption tax is not levied on exports, export competitiveness can be maintained even if the tax rate rises. It can also demand a burden from the elderly generation as well as the working generation, contributing to the correction of intergenerational inequality.

Of course, since correcting income inequality through income tax is also important, a balanced imposition of both consumption tax and income tax is required.

In the fiscal management of the Heisei era, no politician appeared who could carry out tax reform in a timely and appropriate manner. Along with fiscal consolidation to prevent the accumulated government debt from expanding, a major homework assignment has been left for the new era.