Policy School

By Heizo Takenaka
Senior Research Fellow
Japan Center for Economic Research

Parsing Japan's latest fiscal and economic blueprint

(August 3, 2015)

The Japanese government makes major policy decisions every year in late June, and this year was no exception. On June 30, the cabinet approved an economic and fiscal management blueprint and a growth strategy, which are the revised fiscal 2015 versions of the Basic Policy for Economic and Fiscal Management and Structural Reform, and the Japan Revitalization Strategy.

These documents, written in flawless bureaucrat-ese, are difficult to understand. This often leads the media to criticize them from beginning to end as mushy or lacking teeth. Public interest in economic issues is particularly low at the moment, given the logjam in parliament in connection with controversial security bills. Nevertheless, the economic and fiscal management blueprint and the growth strategy contain a number of points that deserve attention:

Getting specific

The blueprint has two positive points. One is the position taken by the cabinet of Prime Minister Shinzo Abe that there can be "no fiscal health without economic revitalization." Vague expressions, such as "the compatibility of the economy and public finance," and "the inevitability of fiscal health for economic revitalization," appeared frequently.

In terms of macroeconomic policy, the government often gave priority to fiscal health over economic revitalization. The consumption tax hike in April last year illustrates this. The Finance Ministry's role as keeper of the keys to the safe prevailed over broader macroeconomic management. But it has become difficult to put Japan's fiscal house in order because the sales tax increase in April has weakened the economy. Getting the economy back on track should be the priority.

Therefore, the general concept of the blueprint is appropriate.

The other point deserving attention is the blueprint's call for an overhaul of the tax system. Although Japan's corporate tax rate is higher than that of many countries, the effective rate is due to be lowered to around 31% in two years. But the planned cut is still inadequate by international standards. To ensure the competitiveness of Japanese companies, a reduction to around 25% is necessary.

Between the lines

One of the fundamental problems with the tax system lies in the income tax, which is low for middle-income earners in Japan. It must be raised, although politically that is extremely difficult to do. Despite the challenges, a fundamental re-evaluation of the tax system cannot be avoided. The blueprint was correct to mention it.

On the other hand, the blueprint leaves many important issues unaddressed, the biggest being limits on spending. The government must do its utmost to curb spending, while promoting economic revitalization. Rather than a patchwork effort, a fundamental rethink of the social security system is indispensable. Social security accounts for one-third of public expenditures in Japan.

The bureaucratic language of the blueprint is interesting on this point: There are eight sentences dealing with medical and nursing care, seven of which end with pledges to "study" the issue. On pension reforms as well, there are many long sentences concluding with vows to "continue studying" the problem.

The Liberal Democratic Party's Council for the Promotion of Social Security System Reform is tasked with deliberating on these issues, having effectively taken over the task from the National Council on Social Security System Reform set up by the previous Democratic Party of Japan government. Changes to the structure of the LDP council, including reorganization, may be necessary.

The blueprint says the Government Tax Commission will discuss an overhaul of the tax system. But issues of this importance should be taken up by the Council on Economic and Fiscal Policy, which directly reports to the prime minister, rather than the Tax Commission, which is strongly influenced by the Finance Ministry. That is how former Prime Minister Junichiro Koizumi's government dealt with this question. Abe's team should do the same.

At stake is how to bridge the gap between the blueprint's general concepts and the specific policies needed to put these ideas into practice.

Question everything

The Cabinet Office announced an estimate of the government's fiscal position in 2020 in February to establish a basis for discussion of medium-term reform, specifically moving from a primary deficit to a surplus. In July, the office released a revised version of the estimate. But the forecast is biased, making the deficit look larger than it is likely to be. This calls the discussions themselves into question.

The original estimate said that Japan will have to overcome a revenue shortfall of 9.4 trillion yen ($75.1 billion) to attain the 2020 fiscal reform target. Although the revised version cut the projected shortfall to 6.2 trillion yen, it still paints a dire picture. This may strike some people as odd; the government's estimate has been widely criticized for forecasting economic growth of 2%, a number many consider too high.

But Abenomics is aimed at achieving a high rate of growth. It is therefore natural to adopt a fiscal reform plan based on the idea that the target can be met. Critics who call the 2% growth target unrealistic should go all the way and criticize Abenomics as well.

The problem is not the assumed growth rate of 2%, but two other factors. One is the elasticity of tax revenue versus gross domestic product, which is set at a low 1. Although the elasticity is around 1 in the long run, it rises to about 3 or 4 during an economic recovery.

The other factor is the estimated 2% rise in the consumer price index, which is based on the assumption that the Bank of Japan will hit its inflation target. But the estimate also assumes an increase of a little more than 1% in the GDP deflator. While the GDP deflator is lower than the CPI under deflation, the two measures show comparable growth rates when an economy leaves deflation behind.

The Cabinet Office revised its tax revenue shortfall estimate of 9.4 trillion yen when government departments began submitting budget requests for fiscal 2016. The revised estimate is 6.2 trillion yen. But the revision will not drastically change the basis of deliberations on fiscal reform. It is simply fine-tuning that factors in the current increase in tax revenues, and envisages restraining the growth of fiscal 2016 expenditures by around half the current rate of inflation.

In other words, moderate adjustments to current conditions can cut the deficit by as much as 3 trillion yen in 2020, suggesting the medium-term outlook for fiscal management can be readily changed by altering the assumptions for GDP elasticity and the GDP deflator.

Productive discussions on fiscal reform for 2020 are impossible without objective and reasonable estimates. One can always argue that an optimistic economic estimate makes policymakers less sensitive to the need for spending cuts, but such cuts will be necessary. On the revenue side, government should not have raised taxes to increase revenue last year. What is needed now is steady spending cuts based on a reasonable macroeconomic scenario.

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Heizo Takenaka is a Senior Research Fellow in Japan Center for Economic Research (JCER).
He is alsoa professor and director of the Global Security Research Institute at Keio University in Japan and was formerly Minister for Internal Affairs and Communications (2005-2006). In his capacity as an economist and as part of his social activities, he also serves on several advisory boards and committees including: Director, Academyhills and Board Member, Pasona Inc. He was named to the Foundation Board of the World Economic Forum in 2007. Professor Takenaka's research interest is in economic policy.

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Japanese Economy Update

By Jun Saito
Senior Research Fellow
Japan Center for Economic Research

Deregulation of the Energy Sector:Its Achievements and the Remaining Agenda

(April 6, 2017)

Full liberalization of the retail energy market achieved

Of the three arrows of Abenomics, the third arrow has often been accused of been slow in showing progress. However, one apparent exception would be the deregulation of the energy sector. Following the full liberalization of electricity retail market in April 2016, full liberalization of the city gas retail market has become effective in April 2017. In the two retail markets, consumers can now freely choose their energy provider which offers different rates for their products.

Traditional regulatory framework

Relative high cost of energy has long been a problem in Japan. In order to address the problem, deregulation of the energy sectors started in the mid-1990s.

Until then, both the electricity and city gas was provided by companies which enjoyed regional monopoly. National market of electricity was divided into ten regions where there was only a single supplier in each of the regions (e.g. TEPCO for the Kanto region). The national market of city gas was divided into much smaller regions, each also dominated by a monopoly supplier. Among them, four large suppliers stood out (e.g. Tokyo Gas for the Kanto region).

Regional monopoly was given to the suppliers because the energy industry was considered to have the features of natural monopoly. In order to secure stable supply of energy at reasonable rates to the customers, the government allowed regional monopoly in exchange for government regulation on rate setting: the energy suppliers had to submit requests to, and get the approval of, the government before being able to change their rates. The government required that the rates be calculated on the basis of full cost principle (i.e. estimated efficient cost plus appropriate profit).

Deregulation process started in mid-1990s

Deregulation of the energy sector has been gradually introduced since mid-1990s in both regional monopoly and rate setting area. It took place in both of the electricity and city gas industries.

In 1995, the electricity wholesale generation was liberalized to allow non-original electricity companies to generate electricity and sell them to electricity companies. Also, non-original electricity companies with its own generation and distribution system were allowed to sell electricity in the retail market. With regards rate setting, in order to provide incentive to be efficient, rates became subject to horizontal comparison of costs across the companies in the industry (i.e. yardstick competition). As an exception to government regulation on rate changes, automatic fuel cost adjustment system was introduced to allow full pass-through of changes in fuel cost to rates. City gas industry underwent a similar deregulation in 1995 when non-original city gas companies were allowed to supply gas to customers who purchased large volume of gas (those purchasing more than 2 million cubic meters per year). Yardstick competition and fuel cost adjustment system were also introduced to the industry.

In 1999, the electricity retail market was partially liberalized when non-original electricity companies were allowed to generate and sell electricity to super high-voltage customers (those receiving electricity at more than 20,000V and have contracts for more than 2000kW) at rates freely set among the parties concerned. Since these new market entrants required access to transmission and distribution system owned by the original electricity companies, rules for wheeling service (which allows access to and to make use of the system) were formulated. In the regulated area, rate setting was partially relaxed by allowing rate cuts (but not rate increases) to come into effect without government approval. The city gas retail market was further liberalized (expanded to cover customers purchasing more than 1 million cubic meters a year), rules for the wheeling service were also formulated, and procedure for rate reduction was relaxed.

Electricity retail market underwent further liberalization in 2004 and 2005 when non-original electricity companies were allowed to supply to high voltage customers with contracts of more than 500kW and 50kW, respectively, at prices freely set by the parties concerned. City gas market followed suit when retail deregulation was further expanded to cover customers covering more than 0.5 million cubic meters a year in 2004. In addition, threshold of the liberalization of the retail city gas market was further reduced to 0.1 million cubic meters a year in 2007.

Impact of the full liberalization of the retail energy market

The full liberalization of the retail energy market that took place in 2016, for electricity, and 2017, for city gas, was the final step in the deregulation process. While the impact of the liberalization is still to be seen, particularly with regards the city gas retail market which only started this April and some main competitors are still yet to enter the market (e.g. TEPCO is expected to enter the business in July), some partial information in the electric retail market is available.

According to the Electricity and Gas Market Surveillance Commission (EGC), a body in the Ministry of Economy, Trade and Industry, those who have switched from regulated rates to deregulated rates at end-2016 was an accumulated 7.2 percent of the total contracts in 2015; 3.6 percent between the original electricity companies and the new entrants, and 3.6 percent within the original electricity companies, i.e. from regulated to unregulated rates (Fig.1).

Figure 1: Switching made to unregulated electricity rates in 2016

(Data source) Electricity and Gas Market Surveillance Commission

The impact of the changes in prices can be approximated by the average rate charged per unit. Data provided by EGC shows that rates charged by the new entrants have gradually fallen to below the regulated prices of the original electricity companies (Fig. 2). The lowest rates, however, seems to be provided by the unregulated rates offered by the original electricity companies.

Figure 2: Averages electricity rates offered by new entrants and incumbents in 2016

(Data source) Electricity and Gas Market Surveillance Commission

The limited information above shows that the impact is only slowly evolving. We seem to require more time before being able to make more firm assessment of the full liberalization.

Remaining agenda

While the retail energy market is fully liberalized, there is still a large portion of the energy sector that is still subject to regulation. That is the transmission and distribution system of the electricity and city gas industry (e.g. the electricity cables and gas tubes) owned by the original electricity companies. Since they are considered to be essential facilities (or bottleneck facilities) of the industry, they are given regional monopoly. However, in view of the need for the new entrants to be able to access the transmission and distribution system at fair rates, incumbents are obliged to accept the request of the new entrant to access the system, and the access charges need to be approved by the government. Full cost principle is applied to the access charges when the government examines the requests.

Separation of the transmission and distribution system from the rest to become independent companies is expected to take place in 2020, in the electricity industry, and in 2022, in the city gas industry. It would help in securing fair access to the system by new entrants and original companies alike, and in improving the transparency of the cost of the system. However, it would not eliminate the more difficult problem that full cost principle has: It provides only a limited incentive to the owners of the essential facilities to be efficient. Further innovation needs to be made in that respect.

The mission to achieve an efficient energy sector is yet to be accomplished.

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Jun Saito is a Senior Research Fellow in Japan Center for Economic Research (JCER).
After receiving Bachelor and Master of Economics degrees from the University of Tokyo, he joined the Economic Planning Agency in 1978. He held a number of senior positions in the Government before serving as the Director-General of the Cabinet Office's Economic Research Bureau between 2007 and 2012. He also has spent some time outside the Government; studying at the University of Oxford, and working as economists in the International Monetary Fund (IMF) and the JCER. He is currently a Visiting Professor at the International Christian University (ICU), and also teaches at Aoyama Gakuin, Keio, and Tokyo Universities. He assumed the current position at the JCER in 2012.

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