Does Japan have a fiscal space?

A call for a concerted fiscal action

As the G7 Ise-Shima Summit draws near, international policy coordination is attracting interest as one of the main topics to be discussed by the leaders of the advanced economies. Because of current weakness of the global economy and the growing uncertainty surrounding its future path of the global economy, an aggressive concerted action to address the situation is called for. In particular, considering the discussions that has taken place in the G20 finance ministers and central bank governors meeting in Shanghai this February, the message would be to ask economies with “fiscal space” to engage in more expansionary fiscal policy. As a member of the Summit, and especially as the host of this year’s meeting, one of the options that the Japanese government needs to consider is whether to go ahead with the second hike of the consumption tax rate or not.

The second consumption tax rate hike was initially planned to take place in October 2015. However, in view of the weakness of the economy, Prime Minister Abe decided to postpone the tax rate hike to April 2017. At the same time, he said that next tax rate hike would take place unless something drastic happens; something similar to a Lehman Shock or a major earthquake. Also, in order to show his firm commitment to fiscal consolidation, an intermediate target (containing the primary deficit to one percent of GDP by FY2018) was introduced in addition to the three targets already set as part of the medium-term fiscal consolidation strategy. It is clear that the postponement of the tax rate hike would extremely harm the credibility of the government in terms of its commitment to fiscal consolidation.

Japan’s limited fiscal space

Putting credibility issue aside, what can be said about Japan’s fiscal space?

In consideration of the already large primary deficit and high government debt to GDP ratio, there is a risk that holdings of JGBs would become subject to more caution. So far, since the majority of the JGBs are held by domestic investors, financial institutions in particular, the risk has not materialized. However, aging of the population has lowered the household savings rate, and a prospect of current account surplus vanishing in the medium-term is increasingly becoming a reality. Relying more on foreign investors would raise the possibility of fiscal risk premium to be reassessed.

In this respect, it is difficult to think that there is a fiscal space in Japan to support the postponement of the second consumption tax rate hike. In this connection, a few points is worth commenting on.

First, while low interest rate may increase fiscal space in the short-run (cf. OECD, Interim Economic Outlook, February 2016), low interest rates will not help the financial balance of the government in the long-term.

It is true that low interest rate would enable the government to raise funds at lower cost for the time being. Since, at such a circumstance, nominal interest rates would usually be lower than nominal growth rate, government debt to GDP ratio would also decline in the short-term. However, if the debt is refinanced by issuing government bonds in the future, the higher interest rate at that point of time would apply, and the debt to GDP ratio would tend to rise in the long-term. The fiscal balance would eventually suffer from the burden carried over from the borrowing made at a low interest rate environment.

Second, while it may seem that having its own currency makes a difference (cf. Krugman, March 2016), depreciation of the currency would not help the situation either.

It is true that Greece had to go through tough times partly because it had surrendered its own currency. However, even if it had the drachma, the depreciation of the currency would have increased the burden of the foreign currency denominated debts. In the case of Japan, it may not have a high level of external debts at present. However, there is a high possibility that the reassessment of the fiscal risk will follow the shift of the current account balance to deficit mentioned earlier. At such a circumstance, Japan should be relying more on foreign financing. The depreciation of the currency that would follow a capital flight would provide a negative influence on the domestic economic activity.

Third, postponing consumption tax rate hike would not stimulate the economy enough to raise tax revenues so as to allow it to finance itself.

For instance, the results of a simulation using a short-term macroeconomic model show that a sustained reduction of the consumption tax rate by one percent (about 0.5 percent of GDP) leads to a worsening of the general government fiscal balance by 0.37 percent of GDP in the first year, and by 0.41percent and 0.40 percent in the second and third year, respectively (for details of the simulation, see Cabinet Office, Economic and Social Research Institute Discussion Paper Series No.314, January 2015). It implies that increasing public investment always leaves a larger government debt behind.

Fiscal space can only be created by a bold structural policy

If the postponement of a second tax rate hike can be justified at this point of time, it is only when its multiplier effect can be expected to be significantly higher so that any addition to the government debt would be suppressed to the minimum in the long-term. In the current situation, that kind of a situation can only be created by engaging in a bold structural reform.

In this respect, reforming the labor market should be given a high priority. It is difficult to expect a better environment to reform the labor market than at present when the labor market condition is tight, and any redistribution of the labor force can be made with relatively low adjustment cost.

More specifically, achieving more equal treatment of regular and non-regular workers by increasing mobility in the labor market, supporting the less favorable with higher minimum wages, can be an important initiative to implement. It is in line with the government’s pursuit of an employment system based on “equal pay for equal work” principle.

It is only when it is accompanied by such a bold economic reform that an enough fiscal space could be created to justify the postponement of the second consumption tax rate hike.