Getting rid of state-to-local subsidies

Tomohiko Taniguchi (Editor at Large, Nikkei Business Publications)

Most of Japan's public works projects are undertaken jointly between the central government and local, municipal governments. Suppose a bridge to nowhere costing 100 million yen is under construction. This is of course another squandering of tax payers' money. But how small local governments can afford to continue such lavish spending is the crux of the matter.

Few municipalities are financially healthy. Some, like Hokkaido, would be nearing bankruptcy if they were private entities. And yet why they can continue public works projects is a question that has seldom been fully addressed either by the Japanese press or by curious foreigners. The answer is that it costs them remarkably little thanks to a cunningly embedded state subsidy scheme: in the case of the bridge to nowhere the local government would cover just less than half of the total cost of 100 million yen. And it is this subsidised public works system that Prime Minister Junichiro Koizumi wants to get rid of.

Figure A shows how. At a glance, while one third of the total cost is covered by the central government subsidy, or Hojokin, the rest, called in bureaucrats' jargon Hojo-Ura (the opposite side of the subsidy), appears to be shouldered by the local municipal government, although in reality this is hardly the case.

Of the 66.66 million yen the local government is supposed to bear, only 10 % comes from local tax payers' money. The rest is divided into two, as is shown, each half of which is to be funded by two kinds of bond issuances. If this were the end of the story, the municipal government would still have to pay back the principal and the interest.

The truth is that a substantial portion of the debt incurred by the bond issuances (30 % of part "C" and 50 % of "D") will be covered later by central government subsidies - what I call TTCMG, or Tax Transfers from Central to Municipal Government. As a result the net amount that the municipal government must shoulder in the end will be reduced to a mere 47 % of the total. This is a perfect invitation for local governments to conduct morally hazardous investments, for a bridge of 100 million yen comes with a flashy tag of "53 % OFF". It is precisely because of this concealed subsidy scheme that bridges, highways, and empty concert halls in the middle of rice pads have emerged all over Japan.

Prime Minister Koizumi surprised the nation and especially central and local government officials by announcing soon after the November general election that in the next fiscal year the total amount of state-to-local subsidies will be reduced by 1 trillion yen - a huge amount of money indeed. The outright subsidy that in Figure A makes up one third of the entire cost would surely be reduced. Supposing that the subsidy will make not one third but only 10 % of the total, and that TTCNG functions will remain the same, the municipal government would end up having to pay 63% (100 – 10 - 20.25 - 6.75), instead of 47%. What appeared a bargain price would all of a sudden look expensive, which is exactly what Koizumi aims at achieving, bureaucrats close to his decision maintain.

The reduction of state-to-local subsidies will continue beyond the next fiscal year, and amount to 4 trillion yen, or 37 billion US dollars, equivalent to approximately 10 % of the Dutch or Australian economies. In the meantime, by the end of fiscal year 2005, central government's control over the issuances of municipal bonds will have ceased to exist, so will financial support in the form of TTCMG. Thereafter each municipal bond issuer, namely local government, will be examined by credit rating agencies in exactly the same way that corporate bond issuers are. Sandwiched in between, municipal governments cannot help but give up many of their extravagant investments.

Figure A