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Briefing Report

Basic Policies for Economic and Fiscal Management and Structural Reform (Large-boned Policy) 2006

Professor, The University of Tokyo; Member of the Council on Economic and Fiscal Policy
Dr. Hiroshi Yoshikawa

[Economy] July 13 , 2006

Basic Policies for Economic and Fiscal Management
and Structural Reform 2006


Today I would like to talk about the government’s Basic Policies for Economic and Fiscal Management and Structural Reform 2006 [commonly known in Japan as the “large-boned” or “big-boned” policy]. These Basic Policies were decided on July 7. When they were decided on July 7, I hear that Prime Minister Junichiro Koizumi said, “On the day of Tanabata [Star Festival]. That’s good.”

This is a digression from the main topic, but for the foreigners in the audience, let me explain about Tanabata on July 7. In the East, there seems to be a tradition that odd numbers are lucky and even numbers are not so lucky. July 7 sees the combination of two odd numbers. The same thing happens on January 1, which is New Year’s Day; March 3, which is the Doll Festival; May 5, which is Children’s Day; and September 9, which is the Chrysanthemum Festival. These are all lucky dates on which the same odd numbers come together. July 7 is Tanabata, and it is an extremely auspicious day, too.

To return to the main theme of the Basic Policies, as shown in the leaflet that has been distributed to you, these Basic Policies of the government consist of three pillars. The first pillar is the raising of the economic growth rate. I will talk about this in detail later on. But in Japan a population decline has begun, so this pillar involves how to raise the economic growth rate under a situation of population decline. The second pillar is the restoration of fiscal health. And the third pillar is the realization of a safe and secure society.

Looking back, the Japanese economy was in a very serious condition five or six years ago. From around that time there was recognition that the fiscal problem was very severe. At that time, though, the debate on economic policy in Japan was whether fiscal administration should be managed expansively, since the economy was in a poor state, or whether we should be patient, since there was the problem of the fiscal deficit. This was a major point of contention. During these five years the policy stance of the Koizumi cabinet has been one of struggling to maintain a balance, arguing that both the economy and fiscal administration are important.

Specifically, the government could not manage fiscal administration as a whole in an expansive manner. The reason is that the problem of the fiscal deficit is serious. Accordingly, the government sought to review the content of the budget on the expenditure side. Also, on the taxation side, in a sense the government has shuffled the contents around. Overall the tendency has been one of restraint, but the content has been changed for both expenditures and taxation.

Since this might perhaps be easier to understand if I give a specific example, let me cite one example in the revision of taxes. This is related to the policy of economic growth, but since research and development is very important for the future of Japan, the government reduced the tax on R&D investment. However, since tax revenue would decrease if only this measure were implemented, the government also had to increase taxation somewhere, so it raised the tax on tobacco. There are probably some people among you who smoke, so this would be bad news for you. But anyway, that’s what happened. The government raised the tobacco tax and thereby also contributed to the nation’s health. Raising the tobacco tax led to an increase in tax revenue. But on the other hand, the tax on R&D investment was lowered. That is one example.

In the meantime, fortunately the Japanese economy began to improve. You know the present situation. The economy has got better, and we have reached the state where it is now being discussed whether the Bank of Japan will lift its zero interest-rate policy, maybe even today or tomorrow. The Koizumi cabinet has said from the start that both the economic problem and the fiscal problem are important. When the economy was in a poor state, we really did have a hard time. But now the economy has improved, so the government naturally believes that it must give due consideration to the remaining issue of fiscal reconstruction. Accordingly, this became the important theme of this year’s Basic Policies.

So, I would like to begin by talking about fiscal reconstruction. I would like to explain how the government drew up the scenario for fiscal reconstruction in the latest Basic Policies. In considering this issue of fiscal reconstruction, the Japanese government thinks in terms of three phases, including the past that has already ended and the future. These are the first, second, and third phases. Specifically, the first phase lasted from 2001 until this year, 2006. In other words, it was the era of the Koizumi cabinet. Needless to say, this phase already belongs to the past. The second phase is from 2007 until 2011, and the third phase is from about 2011 until the middle of the 2010s --- that is, around 2015. These are the three phases that the government has in mind.

I have already spoken about the first phase, the era of the Koizumi cabinet. Amid severe economic conditions, the fiscal deficit worsened at one time, but since then it has steadily shrunk. That is the first phase. The future, of course, is phase two and phase three. The target of the second phase is to reduce the current deficit, the primary balance, to zero by 2011. With the primary balance having been brought down to zero, the target of the following third phase is to steadily lower the ratio of outstanding debts to gross domestic product, which at present is rising, so that it does not expand. Fiscal reconstruction cannot be achieved only by bringing the primary balance to zero. That is not the final target. The reason is that at present Japan’s ratio of outstanding debts to GDP is 150 percent. I am sure there are some Europeans among you. Well, the Maastricht Treaty sets a level of about 60 percent for membership of the European Union, so in the present circumstances, if Japan were an island floating in the Mediterranean, it would not be able to join the EU.

Going back to the target of the second phase, as I said just now, the goal is to achieve a primary balance of zero by 2011. The first problem here is that we must clarify how much the fiscal deficit must be reduced for this purpose. In macroeconomic discussions in Japan, the unit is trillion yen. The Basic Policies state that it is necessary for us to plug a fiscal deficit of \16.5 trillion. There are two methods of eliminating this fiscal deficit of \16.5 trillion. We can either cut expenditures or increase taxes. They are the only methods. In its basic policies, the government recognizes that behind the current fiscal deficit lies some bloated and excessive spending. Accordingly, the basic policy of the government first of all is to cut expenditures.

Under the Japanese political system, expenditure reduction means the budget, so in the end any cuts have to be endorsed by the ruling parties. Given that situation, Minister of State for Economic and Fiscal Policy and Financial Services Kaoru Yosano and Prime Minister Koizumi instructed the ruling parties to come up with concrete suggestions for expenditure cuts. Traditionally ruling parties have been eager to increase the budget as much as possible, but this time, because of this reform, interestingly enough, they sweated about how to restrain the budget as much as possible. As a result, they came up with a plan to cut expenditures by \11 trillion to about \14 trillion by 2011. In other words, the plan is to slash from \11 trillion to around \14 trillion of the \16.5 trillion fiscal deficit through expenditure cuts. The rest is a subtraction problem. Subtract the expenditure cuts from the \16.5 trillion, and the remaining sum will have to be covered by increased tax revenue.

As I said earlier, however, reducing the primary balance to zero through these reforms is only an interim target; it is not the final goal. As the final goal, the government clearly states that it is necessary to continue efforts to lower the ratio of outstanding debts to GDP until around 2015. I have already spoken about expenditure cuts. Regarding increased tax revenue --- that is, increasing taxes --- as you know, in Japan the consumption tax is attracting a lot of attention. So, that is what I have to say about fiscal reconstruction.

In order to advance fiscal reconstruction in accordance with the scenario that I have described, a necessary condition, naturally, is that the Japanese economy continues to steadily grow from now on also. Fiscal reconstruction cannot be achieved if the economy registers negative growth and falls into a serious condition. So another pillar of the Basic Policies is the issue of economic growth policy. Regarding economic growth in Japan, because the population is beginning to decline, pessimism is dominant. How can economic growth be achieved when the number of working people is declining? Surely it is only natural that growth will be negative in such a situation? Even if every individual works hard, zero growth is the best that can be hoped for. Such views have become mainstream.

Enter economics. To jump forward to the conclusion, the main factor in economic growth in developed countries is actually not growth of the labor force. Increase of productivity plays a far more important role. When they hear about productivity increases, many people tend to imagine a certain morale or individual efforts, but this is mistaken. Productivity increases in developed countries are brought about mainly by capital accumulation and technological progress.

For example, this can best be understood if we remember the period of high economic growth in Japan. In the 1950s and 1960s, like China today, Japan, as is well known, achieved an annual average growth rate of 10 percent. I am sure that you all know about this. So, let me give you a little quiz. In the 1950s and 1960s, when Japan achieved growth of 10 percent, what do you think was the growth rate of the working population in Japan? . . . The answer is no more than 1 percent. Where did the remaining 9 percent come from? From the increase of productivity. Moreover, that 9 percent productivity was created through capital accumulation and technological progress. In other words, the general image that people have of labor is the image of each worker carrying a single shovel and engaged, for example, in road construction. In that case, of course, if the number of workers declines, then production will probably fall as well.

I am sure that you have got the point by now. What I want to say is that the decline of the working population in Japan itself is of course a negative factor for growth of the Japanese economy, but quantitatively it is not a decisive factor. Rather, the important factors are capital accumulation and technical advances --- technological progress and innovation. What are the thoughts of the Japanese government regarding this point? Well, we are definitely not pessimistic. Japan is certainly facing several challenges, such as the population decline and aging. But we also recognize that these challenges are opportunities as well. Aging and environmental problems, for example, are challenges for Japan, and at the same time they are global challenges. As you know, even China will face this issue of aging in the twenty-first century. And regarding environmental problems, Japan is the most advanced country in the world in the field of environmental preservation technology. We believe that such technologies are important not only for Japan but for the world as a whole and will become the source of the Japanese economy’s strength as well.

To continue the examples a little more, the working population is shrinking in Japan. As measures and policies that can be considered as ways of resolving this problem, one, naturally, is the acceptance of foreigners. Another is robots. I think that people have a tendency to underestimate robots and associate them with the world of science fiction. But many outstanding engineers have told me that robots will probably become as common in the twenty-first century as cars are today in the automobile societies of the major developed nations. Whatever the case, Japan stands on the front line of robot technology. This is just one example, but as I have been saying, these technologies will respond to not only domestic but also global problems. For that reason, we believe that they will become the source of the Japanese economy’s strength.

Anyway, I hope that you have understood that the role of technological progress and capital accumulation in economic growth, including that of Japan, is more important than that of population trends. However, this technological progress will not be realized if we just sit back and do nothing. Private-sector companies play the leading role, but we believe that it is necessary to support their efforts through government policies, such as deregulation and policies to support various research and development. Such measures are listed in the section on growth policy, which is one of the pillars of the Basic Policies.

Now let me move on to the third pillar, that is, measures for building a safe and secure society. Several problems are cited in this section. A safe and secure society has various meanings. One important theme is social security. Another is our response to the declining birthrate amid the shrinking population. And finally there is what you might call security in the narrow sense --- that is, we must solve the problem of rising crime. That is another theme. In other words, within the framework of the safe and secure society there are several themes, such as social security, measures to halt the declining birthrate by making it easier for people to have children without anxiety, and building safe and crime-free communities.

I would like to begin by talking about social security. Actually, this problem is closely related to the issue of fiscal reconstruction, which I have already spoken about. I think some Japanese-language materials have been distributed to you. Let me explain these diagrams(*).

(*) Please refer to the diagrams on page 6 of the following
document.

http://www.mof.go.jp/jouhou/syukei/sy014_1803.pdf

In the 1990s the fiscal deficit expanded year by year. These diagrams analyze several factors to explain why the fiscal deficit expanded. The upper diagram shows the increase of expenditures, and the lower diagram shows the slump in tax revenue. The slump in tax revenue shown in the lower diagram is of course important, but here I would like to draw your attention to the upper diagram showing the increase of expenditures.

In the 1990s Japan increased expenditures so as to combat the economic recession. People often say that the government increased wasteful public works investment. The white portion in the upper diagram shows the increase of public works spending. Looking at this diagram, we can see that the increase of public works spending certainly contributed to the expansion of the fiscal deficit up to the middle of the 1990s --- in other words, in the first half of the period shown in this diagram. From the end of the 1990s into the 2000s, however, the contribution of the black portion is much larger. This black portion is social security. So it is no exaggeration to say that in the present situation the core of the problem of the fiscal deficit, and in particular the problem of expenditures, is social security. Specifically this means public pensions and health insurance. And given also the issue of aging, which is going to advance from now on, we can say that social security is the core of the fiscal problem in Japan. The recently announced Basic Policies state that we must think squarely about this matter. Incidentally, the problem of the consumption tax, which I mentioned just now in connection with fiscal reconstruction, is being discussed in relation to social security in Japan.

Finally, I would like to talk briefly about measures to combat the declining birthrate. In Japan the birthrate and the total fertility rate are extremely low, but for a long time the policy of the government was that it was not a good thing for the state to intervene in this matter. One of the reasons, I imagine, is that this was a legacy from the prewar years, when the state in Japan encouraged people to have children. Since the number of children was directly related to the number of soldiers, the state encouraged people to produce as many children as possible. Because of that legacy, for a long time after the war the state and the government of Japan refrained from intervening to deal with the declining birthrate and the drop in the number of children. However, the Koizumi cabinet has clearly reversed this stance and adopted a position that the declining birthrate is a problem and the state should take appropriate measures to tackle it.

To avoid misunderstanding, however, I should explain that appropriate measures do not mean that the state is encouraging people to have children. Japanese people who want to give birth are not doing so because of various constraints. The question of whether to have children or not is a private one. But the government is also aware that a situation has arisen in which, because of the constraints, it is difficult for people to have children even if they want to. So, based on this understanding, the basic policy of the government is to eliminate these constraints.

My time seems to be up. I have explained about the three pillars that constitute the Basic Policies recently approved by the cabinet. Thank you for your attention.


QUESTIONS AND ANSWERS

Q: I have several questions. First, when the consumption tax rate is raised from now on, what will be the impact on small and medium-sized companies? Will it become impossible to exempt small and medium-sized companies from the consumption tax? What are your thoughts on this matter? Second, I think the government in Japan is becoming quite slim. If that is the case, from now on it will become necessary to expand the tax base and collect social insurance premiums from as many people as possible. In these Basic Policies you said that the nominal economic growth rate is estimated to be around 3 percent, but in relation to social security, what is the estimate for the inflation rate? Third, regarding capital accumulation, I believe you said it would be 1 percent of GDP by 2015. If that is so, I think a ratio of 40 percent or 50 percent will be necessary. What scenario do you have in mind for capital investment? Also, what is the estimate in the Basic Policies for the productivity increase rate required to make the economy grow even amid the population decline?
A: First of all, let me speak about the basic philosophy. Regarding the scale of social security, as I am sure you are well aware, comparing Japan, the United States, and Europe, it is extremely large in Europe and small in the United States, and Japan comes right in the middle of the two. As a philosophy, Japan believes that social security is important, but we do not aim to be on a par with Sweden, which is an extreme example. We are thinking of a scale between Europe and the United States, which is indeed the actual case.
Second, regarding the growth outlook, including inflation, the Japanese government is thinking in terms of a real economic growth rate of a little over 2 percent. We see the nominal growth rate as being around 3 percent. Accordingly, in reply to your question about what the inflation rate will be, it will be about 1 percent. However, to go into a bit more detail, if the real economic growth rate is 2 percent and the nominal growth rate is 3 percent, the difference gives an inflation rate of 1 percent, but this means inflation as seen by the GDP deflator. In all countries, inflation as seen by the consumer price index is about 0.5 points higher than the inflation rate as seen by the GDP deflator. In that sense, we estimate an inflation rate as seen by the CPI of around 1.5 percent. I hope you understand this point.
Finally, I think you said that the ratio of capital investment to GDP must be more than 40 percent, but I do not think that will be the case. Capital investment in Japan is about one-sixth of GDP --- around 16 or 17 percent, I think. To give an example that is easy to understand, looking back at the Japanese economy in the year of fiscal 2005, which ended in March, the real economic growth rate was 3.2 percent. Although the working population continued to decline, Japan achieved growth of 3.2 percent. The level of 3 percent is almost too good to be true, but over the last five years the average has been about 2 percent. We want the Japanese economy to continuing growing as it has done over the last three or four years. We want the conditions that we see before us today to continue for the next 10 years. And we are now discussing what is necessary for this purpose.

Q: When these Basic Policies were being decided, was it a very tortuous debate in the Council on Economic and Fiscal Policy? Also, these policies have been developed under the Koizumi administration. When this administration comes to an end, is there any possibility of a reversal of this economic and fiscal policy?
A: Very intensive discussions took place before these Basic Policies were finally approved on July 7. However, following the cabinet decision, the cabinet is fully committed to achieving the contents. At the present time, there is a 100 percent consensus in the current Koizumi cabinet. To repeat myself, though, a very intensive exchange of opinions took place in the council in the process of reaching this point.
Regarding your second question about what will happen after the Koizumi administration comes to an end, we of course do not want the Basic Policies to be reversed, and we do not expect them to be reversed. But be that as it may, I think that tax reform is going to be a major topic for the next administration. As I explained, specific measures for expenditure cuts until 2011 have been decided, so the next major theme will be tax reform. In this plan, we have set our sights up to 2015. In the second and third phases, first of all the primary balance will be reduced to zero by 2011, and then the ratio of outstanding debts to GDP will be lowered by 2015. Through these two phases, finally the question will be how much we will have to increase tax revenue. I think Japan’s policy leaders understand well that fiscal reconstruction is a very important issue. However, as you know, there will be an election for the House of Councillors next year. It will be in this situation that, as I said just now, the next administration will have to tackle policy management with tax reform as an important theme. To return to your first question, I do not think that the contents of the Basic Policies will be reversed, but we will have to wait and see what kind of policy management takes shape. We hope that the contents of the Basic Policies will be steadily implemented.

Q: Could you please say a little more about the consumption tax and what you expect? In the 1990s many people were saying that the government should promote the combination of multiple policies in order to stimulate the economy, but recently some people have been arguing that this was not the best thing to do after all. I am very interested to see how Japan’s policies will evolve. So my first question is: How much will the consumption tax be raised by and when? And my second question is: What might be the focal point of tax reform? Will the tax reform be centered on large corporations, or will it be aimed at the general public? What are your forecasts on this point?
A: Regarding the consumption tax, I think that it is naturally going to rise. An easy way to understand the present situation in Japan is to take a look around the world. The consumption tax rate in Japan is 5 percent. How many other countries have a consumption tax of 5 percent? Probably only Singapore and a few others. So the starting point is the fact that there are almost no countries with a consumption tax of 5 percent. However, when we think about tax reform in Japan, the consumption tax is an important point, but it is not everything. We must also think about the income tax. In Japan recently there has been a lot of talk about income inequality. The problem of inequality has become a political issue. The consumption tax is a regressive tax. From an international view, Japan’s income tax rate has become quite flat. In connection with the income inequality debate, when the consumption tax rate is increased, I think there will also be a lot of discussion about the income tax. In that sense, I think the next administration is going to have to hold discussions about a full-fledged revision of the tax system.

Q: I have a couple of questions. One is that I understand that the government is committed to try and prevent the birthrate from declining further. But it was not quantified in a number how much the government is expected to spend on active policies in favor of families and working women, day-care infrastructure, and so on. Does that mean there is not yet a consensus within the government on how much to take away from social security spending earmarked for the elderly in order to give it to children? And my second question concerns the matter of the interest rate. Do you think the interest rate hike tomorrow will be good for the economy? And can you give us some hint about the position of the government with regard to monetary policy?
A: Regarding your first question, various discussions are being held in the government now about how to use money for measures to combat the declining birthrate and what are the best ways of use --- for example, subsidies or tax cuts. As for your second question about monetary policy, the Bank of Japan decides on this policy, and I do not know whether the government will issue any statement tomorrow. If you ask me what I think personally, rather than wondering whether an increase in interest rates will be good for the economy or not, I think that it is a matter of course: if the economy gets better, then naturally interest rates will rise as well. In terms of the logic of economics, it is only natural that if the economy improves and continues to grow, interest rates will increase. In that sense, I think that zero interest rates are unnatural. That is what I think as an economist. After all, interest rates are one price that is determined by the market.

* Given on July 13, 2006, at the Foreign Press Center/Japan. This paper is reserved for internal use; any reproduction or quotation is forbidden without prior permission from the FPCJ. 　 ©FPCJ 2006