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National finances face a dark future

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A shopper holds Japanese 10,000 yen bills.   © Reuters

TOKYO -- Prime Minister Shinzo Abe's decision to put off the second stage of the sales tax hike, slated for October 2015, has provoked debate over the Japanese economy's long-term prospects.

     Postponing the scheduled increase, from 8% to 10%, by 18 months may prove a short-term boon for the economy but is likely to significantly delay efforts to restore the health of state finances. This augurs ill for the nation's fiscal future: Social security spending is bound to grow rapidly in the coming years. The move makes substantial spending cuts even more important for the nation over the long term.

     An advisory panel of experts set up by the government to discuss whether the sales tax should be raised as planned held its final meeting Nov. 18. Abe announced his tax postponement decision after that. One of the members of the panel said he felt the group's hard work had been for nothing.

     Media had been abuzz since early November with reports that Abe would soon announce postponing the tax increase and call a snap election.

Contraction woes

Preliminary gross domestic product data, released Nov. 17, shows the Japanese economy contracted at an annualized rate of 1.6% in the July-September quarter. The weak GDP data provided strong support for delaying the tax hike.

     That day, the expert panel met at the prime minister's official residence in Nagatacho, Japan's political power center. The area was almost deserted as politicians had gone to their electoral districts to prepare for their election campaigns. Deputy Prime Minister Taro Aso, who also serves as finance minister, is a leading champion of the tax hike. He was absent from the meeting as he was at the Group of 20 conference of finance ministers in Australia.

     A majority of the panel members called on the government to go ahead with the tax hike as planned. Their arguments sounded irrelevant at that stage.

     In explaining the Bank of Japan's move to fatten its already aggressive monetary expansion program in a Nov. 12 session of the lower house finance committee, Gov. Haruhiko Kuroda said the central bank had taken the step on the assumption that the sales tax rate would be raised to 10% as planned. Policymakers who prioritize curing the budget ills were also dismayed by Abe's decision.

     Even so, keeping from further burdening consumers with another tax increase seems to be a plus for the economy, which is in a technical recession after shrinking for two consecutive quarters. The postponement will push up Japan's real GDP growth rate by 0.3 of a percentage point in fiscal 2015, which starts in April, and by 0.2 of a point in fiscal 2016, according to UBS economist Daiju Aoki.

     A 2-point increase in the consumption tax rate would translate into 5 trillion yen ($42.5 billion) in fresh annual tax revenues for the central and local governments. Since the tax will not be raised next October, some 70% of the amount will be spent by consumers. As a result, the core consumer price index, which excludes volatile food prices, will rise at a 0.2-point higher rate, according to Aoki's, estimates.

     Delaying the tax hike, however, stalls any progress toward healthier national finances.

     The government has set a fiscal reform goal of lowering the ratio of the primary deficit -- government receipts minus all outlays other than net interest -- to GDP by half from the current 6.6% during the five years to fiscal 2015. It aims to realize a surplus by fiscal 2020. This is regarded as an effective international promise.

     Abe's decision will slice 1.5 trillion yen from the state's estimated fiscal 2015 tax revenue. But the 2015 target of reducing the primary deficit by half is still within reach.


There is good news for the government: Corporate tax payments are expected to increase in line with growing profits. In addition, long-term interest rates, which determine the government's debt-servicing cost, are expected to remain low.

     These factors will make it possible for the government to achieve the primary deficit target for fiscal 2015, at least in the original budget for the year, predicted Yasuhide Yajima, a senior researcher at the NLI Research Institute.

     But getting into a primary surplus by fiscal 2020 seems out of reach. The Cabinet Office had admitted the target would be a long shot even if the sales tax hike went ahead as planned.

      If the consumption tax rate is raised to 10% in April 2017, as is now planned, Japan will post a primary deficit equivalent to 2.5% of GDP in fiscal 2017, according to an estimate by Barclays Securities Japan. While the ratio would fall to 1.3% in fiscal 2020 under this scenario, a primary surplus would still be a long way off.

     Responding to concerns that the consumption tax hike could be put off again and eventually dropped off the agenda altogether, Abe said the rate will be raised to 10% in April 2017 regardless of economic conditions at that time. The decision will not be affected by the provision in the tax hike law that allows for delays depending on economic conditions, he argued.

     His comment was welcomed by some economists, including Hideo Kumano, chief economist at Dai-Ichi Life Research Institute. Abe showed he is commited to fiscal reform as a top policy priority, Kumano said. One analyst at a foreign brokerage was not convinced. He said the government will make a political decision on the tax increase again based on its economic assessment, whether there is a provision to do so or not.

     Raising the sales tax rate from 5% to 8% in April 2014 choked economic growth. Nevertheless, the employment situation has improved, and expectations of pay growth are high.

     Abe made the decision despite these positive signs.

     Some pro-reflation economists have interpreted Abe's decision as a signal of continued fiscal and monetary expansion. Abe sent out "a message that the government will keep providing powerful fiscal and monetary stimuli to stoke economic growth at least until April 2017," said Takuji Aida, chief economist at Societe Generale Securities.

Austerity questions

Effective efforts to trim government spending are as important for fiscal reform as measures to ramp up tax receipts. Social security expenditures total about 30 trillion yen, accounting for some 30% of overall government spending. Aging pushes up social security outlays at an annual rate of 1 trillion yen as more of the nation's population requires costly, cutting-edge medical treatments.

     The then-opposition Liberal Democratic Party, its junior coalition partner, Komeito, and the Democratic Party of Japan in 2012 reached a three-party agreement on integrated tax and social security reform, including the two-stage sales tax hike. Struck when the DPJ was in power, the agreement calls for substantial cuts in social security expenditures.

     There has been little progress toward this goal. The government has embarked on only a small number of relatively mild reforms, such as the introduction of a so-called macroeconomic slide formula to curb pension benefits automatically as the population shrinks. This slide mechanism has collapsed due to the sales tax postponement and lower house dissolution.

     Pressure for spending cuts could now weaken even further.

     Kyohei Morita, a Barclays Securities Japan economist, calls for measures such as raising the pension age and increasing the elderly's out-of-pocket payments for hospital bills.

     Fiscal reform is a race against the clock. Health care spending in particular will balloon in the coming years as the youngest baby boomers turn 65 next year, and 75 in 2025. A special medical care net is available for people aged 75 or older.

     The government's per-capita health care spending for this age group will rise to 326,000 yen, according to a projection by the Finance Ministry.

     To avoid disaster, the government's new fiscal reform plan, to be worked out by next summer, needs to effectively slash expenditures.


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