How to Succeed in Fiscal Reform without Tax Increases

Yutaka HARADA (Chief Economist at Daiwa Institute of Research)

There seem to be more and more politicians loudly voicing the opinion that fiscal reform could not be pushed any further and some tax increases would be inevitable, because substantial cuts in social security expenditures are out of question. However, I will argue in this paper that no tax increases are necessary, at least until the baby boomer generation reaches 75 years old or so, if realistic reductions in public expenditures are made on the basis of the "Basic Principles of Budget Formulation," adopted by the government in 2006 and 2008.

According to the Basic Principles in 2006 (similarly in 2008), there are four major expenditure categories, "social security," "personnel expenditures," "public investment," and "other expenditures (except interest payments)," where fairly large cuts are proposed, not based on actual expenditure levels, but rather on projected levels including natural increases in expenditures. In spite of strong objections to those proposals, it seems to me that such reductions are realistic and even more cuts are possible in some cases. The reasons are as follows.

First, in the category of social security, the actual expenditure in FY 2006 is 31.1 trillion yen, while the projected expenditure for FY2011 is 39.9 trillion yen, including the additional government support of 2.3 trillion yen for the national pension system, effective FY 2009. The proposed cut is from this projected expenditure 39.9 trillion to 38.3 trillion yen. Excluding the additional government support, this means that the proposed expenditure level for FY2011 is 36.0 trillion yen, that is, an increase of 4.9 trillion yen and an annual growth rate of 3.0 per cent from 2006 (i.e., the real growth rate being 2.0 percent, given the 1.0 percent inflation rate). Since elderly population above 65 years old is increasing at the annual rate of 2.2 per cent, this proposal should be considered reasonable and acceptable, even to elderly people.

Second, in the category of personnel expenditures, the projected level for FY2011 is 35.0 trillion yen, compared to the actual level of 30.1 trillion for FY2006. Needless to say, the projected level is unacceptable, but even the proposed level of 32.4 trillion for FY2011, that is a 2.3 trillion yen reduction from the projected level, seems excessive. This is because the proposal amounts to a 7.6 percent increase from FY2006 to FY 2011, which means almost 13 percent increase per person (the annual rate of 2.7%), given the planned reductions in public employees around 5.7% by FY2010. Clearly, this would be too much in favor of public employees, compared to their counterparts in the private sector.

Third, in terms of public investment, the projected level for FY2011 is 21.7 trillion yen, compared to the actual level of 18.8 trillion yen for FY2006. This projected increase is out of question and, therefore, the proposed level for FY2011 is 16.1 trillion yen, that is, an annual reduction rate of 3.1 percent, approaching to the average ratio of public investment to GDP among advanced countries. This seems perfectly feasible and reasonable.

Finally, in the category of other expenditures, the proposal is virtually no increase in the total expenditure, in contrast to the projected increase of more than 3 trillion yen from FY2006 to FY2011. This proposal should be accepted without modifications, although political pressure is mounting to increase educational expenditures these days.

It must be added that tax increases would have a negative effect on the economy as a whole. A one-percentage-point increase in the consumption tax is likely to decrease the real economic growth rate by 0.25 percent in the second year after the tax increase, according to an estimate by using an econometric model developed at a governmental research institute. It appears that the bad effect of the increase in the consumption tax is small. Actually, however, the result could be much worse than that, leading to virtually no increase in tax revenue, if taxes are raised in a recessionary period, which we seem to be in now.

What has been happening in the recent history of the economy and government budget in Japan is such that public expenditures tend to increase when tax revenues increase during economic booms, while budget deficit tends to worsen when tax revenues decrease due to economic downturns. In other words, public expenditures will increase or decrease as tax revenues increase or decrease. This means that public expenditures could not be reduced, but rather likely be increased, if taxes are raised now. The Japanese economy will be strengthened and the government budget can be reformed, if public spending is rationalized and reduced, rather than increasing taxes.

(The original Japanese article appeared in the October, 2008 issue of Voice)