Will Abe's fiscal consolidation work?
When Shinzo Abe was first elected to be prime minister of Japan, he promised to end deflation and kick-start growth. His methods, in the short-term, involved fiscal and monetary stimulus.
Now a daunting demand management challenge of sustaining good growth and achieving fiscal consolidation confronts the Japanese government. Abe has already made a major decision: he will allow the consumption tax increase from 5 to 8 percent, scheduled from April 2014. Consensus is widespread that such a large increase will reduce growth by 0.7 percent (the government’s optimistic estimate) or as much as 1.5 percent (private-sector estimates). A major debate ensued over the summer whether to have the consumption tax increase proceed as scheduled, to delay it, or replace it with annual 1 percent increases for five years.
It was also indicated that the government will provide a supplementary budget stimulus package of ¥5 trillion (US$50 billion) later this fiscal year to cushion about two-thirds of the impact.
Assuming that offsetting demand stimulus will only partially offset the consumption tax increase, fiscal consolidation will begin next spring with the fiscal 2014 budget. Demand management in both the near term and the longer run will require a careful balancing of fiscal and growth policies. One risk is that fiscal consolidation will proceed prematurely, that is, before deflation has been terminated and a good growth path achieved.
Growth and fiscal policies are deeply intertwined. The demand management challenge is how both to sustain good growth and achieve fiscal consolidation. For the foreseeable future fiscal consolidation means achieving a stable, if extraordinarily high, ratio of government debt to GDP.
The Cabinet Office growth strategy scenario states that stability will be achieved within a few years, certainly by 2020. But it is not clear how its projection is derived; it seems too optimistic. The scenario projects that the government, which borrowed 11.2 percent of GDP in 2012,in 2020 will have to borrow 5.6 percent of GDP, and that the primary balance (excluding government interest payments) will decline from a negative 6.4 percent of GDP in 2012 to a negative 2 percent.
The scenario projects a stable ratio of government debt to GDP of 186 percent, less than the present ratio because the government will receive about ¥6 trillion from the sale of Japan Post. These projections exclude the special Tohoku reconstruction expenditures, taxes and temporary government debt.
In its 2013 annual spring consultation with the Japanese government, the IMF concluded that, to be able to reduce its government debt-to-GDP ratio, Japan will have to raise taxes and reduce expenditures by 11 percent of GDP, a huge reduction in domestic demand.
In a cogent analysis of the Cabinet Office August report, Robert Feldman estimates that to stabilize the ratio, even with 2 percent growth, the consumption tax will have to rise substantially beyond 10 percent and per capita expenditures for those over 65 will have to decrease significantly in real terms. His analysis shows that the growth-strategy scenario implies that government expenditures per elderly person would decrease by 17 percent in real terms, but because further consumption tax increases are not projected, the government debt-to-GDP ratio would continue to rise.
Feldman calculates five alternative policy choices. At one extreme, a consumption tax of 10 percent, as now legislated, requires reducing per capita support of the elderly by more than 40 percent. At the other extreme, no reduction in real per capita expenditures for the increasing number of elderly requires a consumption tax rate of 31 percent. The middle option, putting the fiscal adjustment burden half on consumption taxpayers and half on the elderly, implies a consumption tax rate of 16.7 percent and a reduction in elderly support per capita of 26.9 percent.
These stark choices indicate that achieving a stable government debt-to-GDP ratio by 2020 will be extraordinarily difficult. If growth averages only 1 percent or so in the coming decade, fiscal stability will be even more difficult. But what probably is more important is that investors and others perceive that the government has developed a credible program for eventual fiscal consolidation, even if the time frame is longer. That perception, and reality, will be essential to prevent an eventual crisis in the Japanese government bond market.
Japan’s most challenging longer-run economic problem is to resolve the deep tension between sustaining full employment growth and engaging in fiscal consolidation. The evidence from the 2007–08 global financial crisis is that austerity policy is very costly and not very successful, despite the needs for structural reform and improved incentives. Simply stabilizing Japan’s government debt-to-GDP ratio at a high level will require major reductions in the budget deficit, with some combination of significantly reduced benefits for the elderly and further consumption tax increases. Fiscal consolidation will take many years. There is no quick fix.
As for my final comment on Abenomics? Although it has been proceeding well so far, it is too early to determine its eventual success. My view is a mixture of concern, caution, and — optimist that I am — hope.
(Hugh Patrick is Director of the Center on Japanese Economy and Business and the Robert D. Calkins Professor Emeritus of International Business at Columbia University. This is reprinted with permission from the East Asia Forum)