Japan Needs Paradigm Shift for the State

Masahiko AOKI (President, Research Institute for Economy, Trade and Industry, and Professor, Stanford University

Institutional Change Since 1993

Future historians will probably regard the period around 1993 as the beginning of an era of institutional change in Japan. That was when the bursting of the bubble was recognized widely and the LDP's one party rule came to an end. Since then, we have been witnessing some shake-ups in various social customs and contracts, which had been taken for granted before.

However, one might ask why we are not really feeling about a change in Japan's institution as a whole. My answer would be that the "framework of the nation" (the state), that consists of relationships among politicians, people and bureaucracy, still remains the same after all these years. Those relationships must be thoroughly reformed in order to facilitate various innovative efforts in the private sector and to develop a model for revitalizing Japan.

Problem with Fiscal Policy

Public finance forms the basis for any state, where the state is a framework for controlling government's discretionary power for provision of public services and taxation to finance them. In Japan, such a framework itself seems to be in question.

It is often said that, although the economy is stagnant, Japanese households still own financial assets as much as 1,400 trillion yen. Actually, however, its net value would be only half that amount if total government debt was subtracted from households' financial assets. Furthermore, most of the government debt should be repaid by our future generations and, therefore, we are facing a serious issue of intergenerational distribution.

While the adoption of a stimulus fiscal policy without regard for our future generations would be the old generation's egoism, we could not solve our problems by just crying for administrative restructuring or restrictions on the issuance of government bonds. The question is: what kind of arrangement enables citizens (taxpayers) to monitor the efficacy and fairness of government's activities.

Current Mechanism of Public Spending

First, let us look at the decision-making mechanism for public expenditures. Currently, it is based on intensive ex-ante evaluation of budget proposals by the Tax Bureau of the Ministry of Treasure and execution of approved budget within a current fiscal year. However, it is becoming more and more difficult to sustain such a mechanism, as the world is changing faster and becoming increasingly more complex.

Budget officers, however competent and neutral, find it difficult to inspect detailed budgetary demands by various ministries in an ex-ante, zero-base fashion. Therefore, they tend to settle the matter by negotiating with representative officers from various ministries over incremental changes in their routine budgetary items.

As a result, a representative officer's career prospect in his ministry is enhanced in accordance with his performance to bring about increases rather than savings in the budget for the ministry. On the other hand, it takes several years of lengthy negotiations and a period of preliminary expenditure for a brand new item to be admitted in the final budget. In other words, there is strong inertia built into the current mechanism for an expansion and rigidity of public spending.

Proposal for Reform in Public Finance

What we need here is a paradigm shift from ex-ante evaluation to ex-post assessment of public expenditures.　　For example, the following mechanism might be implemented. The Council for Economic and Fiscal Policy should set up a basic guideline for functional allocations of public expenditure according to the policy priorities determined by the Cabinet. Then, the Ministry of Finance should follow such a guideline to formulate a draft for budge allocations for various ministries, and submit it to the Diet for parliamentary scrutiny and decision. Based on such a decision, each ministry formulates its own budget in more concrete terms, but its actual expenditure could go beyond a current fiscal year for effective fine-tuning. And the Ministry of Finance, with the help of specialists in various fields, should rigorously assess the effects of each ministry's expenditure ex post, and report to the Diet.

The feedback mechanism of such an ex-post assessment system should help control the wasteful spending by various ministries, while politicians could shed their old-fashioned image as intermediaries for delivering rents to various interests groups by participating in more fundamental policy discussions in the budgetary process.

Reform in Taxation

Second, we need to reform the system of taxation. Japan's tax system has become an extremely complex and incomprehensible mesh of various tax codes in the name of neutrality and specialty in tax law stipulation. There seems to be increasing criticism against the exclusive and autocratic nature of the LDP's Tax Council. Given the rigidity of the tax system, the government has almost exclusively used fiscal spending measures in an attempt to stimulate the economy, but it has become clear that the multiplier effect of public spending on job creation is not very large. Instead, we should adopt such tax measures as a reduction in neutral corporate taxes to stimulate business investment and new employment. This kind of paradigm shift would also require the exercise of leadership by the Cabinet. Politicians' expertise on taxation should be utilized through a more transparent process of policy making in the Cabinet or the Diet than it has been in the past.

Furthermore, it is important to expand the tax base according to general rules. This is not just for the sake of increasing fiscal revenue, but for the sake of creating a new framework for a disciplined state without moral hazard in Japan. For that purpose, the income tax base should be expanded to include lower income brackets than it is now, and also some external criteria should be adopted to tax all the corporations that are receiving public services such as enforcement of private contracts and provision of public goods. This way we could enhance incentives to monitor wasteful government spending from taxpayers' standpoint.

Decentralization in Fiscal Management

Third, fiscal management should be decentralized. In providing such public goods as roads, education, medical and child care, etc., uniform administration by the central government is no longer able to respond to increasingly diversified public demands. The era of standardization and equalization policy by central administration has already come to an end.

For example, it has been argued that in order to avoid wasteful road construction, highways should be owned by a privatized corporation and its road investment should be restricted by toll revenues for that corporation. However, that is not the only available institutional arrangement for highway investment, and that might imply high toll levels for users and eventually lead to a decline in industrial competitiveness in Japan.

In some cases, roads as public goods should rather be financed by taxation. At the same time, however, we need some institutional arrangements to avoid excessive competition among local interests over the budget and to make investment decisions responsive to real economic needs. For that purpose, we should delegate decision-making power including the power of taxation to local governments, which are more directly accountable for taxpayers and beneficiaries than the central government is.

Judgment by Taxpayers Cum Voters

In order to carry out the reforms mentioned above, it is inevitable to radically realign the roles and relationships among the Cabinet, government ministries, and local governments. It would also require fundamental changes in the relationship between politics and bureaucracy as well as in citizens' attitude as taxpayers and voters. It will not be easy to come by and probably not emerge from the current political or bureaucratic circles, at least voluntarily.

Instead, the choice for the model described above eventually depends on the judgment by taxpayers cum voters, who will probably make such a choice consciously sooner or later. At least such a possibility seems to be indicated by a trend in the results of recent local and supplementary elections. This is what is implied by the new era, which began in 1993, as I mentioned at the outset.

(This is from Professor Aoki's original Japanese article in the January 7, 2003 issue of Nikkei Shinbun.)