NIRA REPORT

2011.4

The Path to Fiscal Reconstruction
Overcoming Disaster and Bequeathing Sound Public Finances to Future Generations

NIRA Report
The Path to Fiscal Reconstruction:
Overcoming Disaster and Bequeathing Sound Public Finances to Future Generations

Copyright Ⓒ 2011 by
National Institute for Research Advancement (NIRA)
Publisher
National Institute for Research Advancement (NIRA)
Yebisu Garden Place Tower, 34th Floor
4-20-3, Ebisu, Shibuya-ku, Tokyo 150-6034, Japan(URL:http://www.nira.or.jp/english)
For more information： info:nira.or.jp
Tel +81-3-5448-1735

Fax +81-3-5448-1743

April 2011

NIRA Report

The Path to Fiscal Reconstruction
Overcoming Disaster and Bequeathing Sound Public Finances to Future Generations

Executive Summary

Motoshige Itoh
President, NIRA
Professor, Graduate School of Economics, University of Tokyo
Against the background of a long-term economic slump and the rapid aging of the
population, the state of Japan’s public finances continues to worsen, and concern overthe effect that this will have on the government bond market is increasing. It is also
important at the present juncture to consider how Japan’s fiscal problems will betransformed in the wake of the recent earthquake and tsunami disaster. This reportorganizes points of discussion in relation to these issues, and offers policy proposals
concerning the form and the method of implementation of the fiscal reconstruction
necessary to enabling us to bequeath sound public finances to future generations.
(1) Reconciling recovery from disaster with fiscal reconstruction
Prioritizing recovery from disaster necessitates the expenditure of enormous sums,
and this will increase the pressure on Japan’s already severely burdened publicfinances. We must consider the following three directions if we wish to reconcile thesecuring of funds for recovery with fiscal reconstruction.
1) Reexamination of existing government expenditure
Large-scale

reexaminationofexisting

government

expenditure,including

expenditure forming part of the ruling party’s Manifesto, in order to enable theurgent fiscal expenditure represented by funds for disaster recovery.
2) Use of reconstruction bonds
Creation of a mechanism that will provide an incentive to encourage as many
citizens as possible to invest funds in reconstruction bonds, enabling us to mobilize
the efforts of citizens who seek to make a contribution, no matter how small, to thenation’s recovery.
13) Introduction of a reconstruction tax
Introduction of a reconstruction tax, not as a temporary measure to secure funds
for reconstruction, but in a form which links it to a desirable long-term tax system
for Japan. For example, if the rate of consumption tax were to be increased or acarbon (or electricity) tax introduced, when these measures had fulfilled their
purpose as reconstruction taxes, they could remain in place as an increase in
consumption tax to provide funds for social security, or an environment tax toprovide funds for the protection of the environment.
(2) Evaluation of the risk of a dramatic decline in the price of Japanese government
bonds
The stability of the market for Japanese government bonds despite the high level ofthe nation’s outstanding debt is due to the fact that against a background of low
growth and deflation, excess funds from the household and corporate sectors are
flowing into the market via financial institutions. Fiscal problems are problems in
the long-term balance between government income and expenditure, but at thesame time, they are also short- and medium-term macroeconomic problems andfinancial market problems. In considering future trends in the government bondmarket, it will be necessary to focus on the following points.
1) Signs of global inflation
Concerns are developing over increases in commodity prices in advanced nations
against the background of factors such as economic overheating (in particular inemerging nations) and spiraling prices of primary products. It will be essential toconsider the effects on Japan in the event that an inflationary tendency becomesconspicuous globally and long-term interest rates increase.
2) Effect of the earthquake and tsunami disaster on the government bond market
The increase in government expenditure necessary for disaster recovery will placea new burden on the government bond market. In addition, if constraints on supply
and the stimulation of demand by recovery efforts relieve deflationary pressure,
upward pressure will be placed on long-term interest rates. Because interest rates
would presumably be affected by predictions of future increases in commodity
prices and increase earlier than commodity prices, it is possible that this would
place a considerable burden on public finances.
3) Will and ability on the part of the government to achieve fiscal soundness
The prior history of measures instituted to achieve fiscal soundness, i.e. theirimpasse in the face of economic slowdowns, suggests that the will and ability ofpoliticians and the public in this area are not especially strong. The question iswhether the government will develop policies designed to realize fiscal soundness
before we reach a situation in which there is a precipitous fall in the price ofgovernment bonds, and whether such policies will be supported by the public.
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(3) Fiscal reconstruction: Form and method of implementation
Given that the time available for Japan’s fiscal reconstruction is extremely limited,
it will be important to rapidly delineate a path towards the achievement of thisgoal and win the confidence of the markets. Reform in the area of social security
and reevaluation of the taxation system will be key factors in enabling this, and thefollowing should be points of particular focus.
1) Selection and focusing of public sector involvement in the area of social security
As the nation’s birth rate declines and its population ages, the radical prioritizationof the social security system will be essential in order to ensure the maximal
functioning of public assistance using tax resources. In addition, it will benecessary to maximally utilize self-help and mutual assistance by citizens, and toprovide policy support to mobilize private sector economic activity.
2) Design of systems to avoid moral hazard
It will be necessary to consider system design to ensure that the public support
system does not generate moral hazard in the form of excessive consultations or
use of services in the areas of healthcare and nursing care.
3) Bequeathing sound finances to coming generations
In order to prevent an excessive burden being passed on to future generations, itwill be necessary to rapidly effect social security and taxation reforms, and torealize a sound social security system and financial base as much as possible in thepresent generation.
(Overview of chapters)
Chapter 1

Organizing Points of Discussion concerning Government Bond Issues – Is

Anxiety over a Fall in the Price of Government Bonds a Case of Crying Wolf?
Anxiety over the state of Japanese government bonds and fears of a precipitous decline
in their price have been discussed for more than 10 years now, but nevertheless thebond market has continued to function stably. In the background here is the fact thatamid ongoing adjustment of the balance sheet and deflation since the latter half of the
1990s, loans to the corporate sector have declined despite quantitative easing by thecentral bank, and financial institutions have invested their excess funds in the bondmarket. In addition, the fact that despite the enormous scale of Japan’s fiscal deficit,
its current account balance remains in the black, and essential funds can largely besourced in the country itself, can also be pointed to as a factor in this stability.
The reason that financial institutions have continued to invest in Japanese
government bonds despite the staggering government debt is that Japan’s tax burden
is extremely low in comparison to the international standard, and they can therefore
3anticipate the potential for improvement of the government’s fiscal position throughthe imposition of increased taxes in order to generate increased tax revenue. However,with uncertainty over whether it will actually be feasible to increase taxes, and themarket aware of the limits to the ability to consume government bonds as theoutstanding amount of debt increases, it has become impossible to simply dismiss
anxiety over government bonds as crying wolf.
In order to ensure the sustainability of Japanese government bonds in such a situation,
it will be essential to focus on “the three Cs”: communication (dialogue with themarket), credibility (the formulation of a “Government Bond Manifesto” that outlines
medium- and long-term paths to fiscal reconstruction), and coordination (cooperation
between the market, the government, and the Bank of Japan to form a “government
bond triumvirate”). In addition, the adjustment of the outstanding debt, rather than adrama involving a collapse in bond prices, should be conducted steadily by means offiscal reconstruction and the creation of resources for bond redemption via theformulation of growth scenarios.
(Hajime Takata)
Chapter 2

What can We Learn from a History of Failures? – A Case Study of Major

Sovereign Debt Crises and Defaults and Lessons for JapanAs the state of Japan’s public finances grows steadily worse, there is a certain
significance from a crisis management perspective in considering the potential triggers
that might plunge Japan into a fiscal crisis and lead to a debt default, the effect that
this might have, potential policy responses, and related issues. Given this, the author
has attempted to derive lessons for Japan from a comparative consideration of majordomestic and overseas examples of sovereign debt crisis and default.
The main lessons to be learned from this study can be summed up as follows.
1) The situation in Japan with regard to unchecked burgeoning expenditure and the
postponement of essential reforms is either similar to or worse than the situationsin the examples considered
2) In the majority of examples considered, the trigger for the crisis was the market’s
loss of faith in economic and fiscal sustainability, indicating the importance ofconstant efforts to maintain or increase market confidence
3) For Japan, where holdings of government bonds are concentrated in domestic
financial institutions, the risk of a fiscal crisis or default becoming a financial
system crisis is high; enhancement of risk management and spreading of bondholdings by financial institutions is therefore essential
4) The cost of resolving problems increases enormously in the event of a fiscal crisis or
default and it is therefore essential to persist tenaciously in effecting orderly fiscal
reconstruction
45) A correct awareness of the situation on the part of the public and the politicalleadership is an important factor in overcoming a fiscal crisis
While it is not possible to make simple comparisons between the examples considered
and contemporary Japan, overconfidence could lead the nation into the same errors.
Learning from these examples, it will be important for us to pursue autonomous fiscal
reconstruction efforts, rather than waiting for pressure from the market.
(Tetsuo Ota)
Chapter 3

Fiscal Reconstruction: Concept and Method of Procedure – Deficit Ceilingand Deficit Taxation
In order to study mechanisms for effective setting of ceilings in proceeding with fiscal
reconstruction within a political economy framework, the author compared two cases –hard budget constraints and soft budget constraints – and analyzed their effect on
economic welfare. This analysis showed that a commitment to hard budget constraints
has the potential to produce cases in which not only future generations and membersof present generations with an interest in fiscal reconstruction, but also members ofpresent generations with no interest in fiscal reconstruction, are able to benefit. By
contrast, under soft budget constraints, when there are numerous individuals with nointerest in fiscal reconstruction and moves to secure vested interests are inefficient,finances might deteriorate significantly due to the increase in vested interests,
resulting in negative effects for both individuals with and individuals without interest
in fiscal reconstruction. This suggests that the timing of ceiling-setting is important forthe success of fiscal reconstruction, and that it is also important to make a thoroughcommitment to ceilings set in advance, and not to easily revise these ceilings.
In addition, in order to proceed effectively with fiscal reconstruction, in the event of anincrease in the fiscal deficit, the adoption of fiscal reconstruction rules (after a specified
period of time) providing for reductions in expenditure and increased taxes would also
represent a benefit. Because economic actors would predict that taxes, etc. would
increase in line with increases in the fiscal deficit, under this scenario not only would
the attempt to secure vested interests be controlled, but the incentive to voluntarily
cooperate in fiscal reconstruction would increase because postponing the burden until
the future would generate greater pressure for tax increases.
As this indicates, the application of constraints by means of financial rules isimportant to the process of fiscal reconstruction, but whether this functions effectively
or not is dependent on how far politicians and their constituents are prepared to follow
the determined constraints. The question is whether we are capable of implementing
policies that adopt a long-term perspective and take future generations into
consideration.
(Toshihiro Ihori)
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Chapter 4

Fiscal Discipline for Success in Fiscal Reconstruction – Examples from

Other Countries and Implications for Japan
In a democracy, governments frequently experience pressure leading towards the
expansion of the fiscal deficit through increases in expenditure or reductions in taxes,
and fiscal reconstruction therefore necessitates a strong commitment. For this reason
governments in Europe and the U.S. have conducted budget system reforms whichhave included the incorporation of appropriate fiscal discipline in the budget
formulation process.
Fiscal discipline can be either rule-based or discretion-based, but in the 1990s fiscal
management based on the setting of rules became the dominant trend. In addition to
the introduction of cap systems and the pay-as-you-go principle, EU member nations
set upper limits on fiscal deficits and the ratio of outstanding debt to GDP based on the
Maastricht Treaty, and this has had a significant effect in ensuring fiscal soundness.
In Japan also, targets for fiscal soundness were set by the 1997 Act on Special
Measures concerning the Fiscal Structure Reform and the “Big-boned Policy” put into
effect from 2001, but in both cases the targets were retreated from due to the rapid
worsening of the national economy. The Fiscal Management Strategy formulated by
the DPJ administration also includes targets for fiscal soundness such as returning the
primary balance to the black and reducing the ratio of outstanding public debt to GDP,in addition to elements of fiscal discipline such as the pay-as-you-go principle, but
provides insufficient indication of concrete measures for the achievement of these goals.
Transparency of targets, flexibility in relation to changes in the economic situation,and the guarantee of feasibility can be pointed to as the desirable conditions for fiscal
discipline. The Fiscal Management Strategy is in particular need of a radical overhaul
in relation to the last of these.
(Naoki Shimoi)
Chapter 5Integrated Reform of Social Security and Tax Systems – Combining

Pension Reform with Individual Self-help Efforts
The achievement of consistency between the enhancement of social security and fiscal
reconstruction is an important factor in conducting integrated reform of the social
security and tax systems, and it is necessary to proceed while attempting to achieve
increased efficiency in the social security system. In European countries, reform of thepension system has involved enhancement and reform of private pensions (company
pensions and individual pensions) at the same time as reform of the public pension
system. Japan should refer to these cases in considering the introduction of a new
system predicated on individual self-help efforts.
In specific terms, the author proposes the establishment of a system which exempts
6pension funds accumulated by individuals from taxation (a Japanese IRA), in order tosupplement public and company pensions and to support asset formation for old age by
self-help efforts. By means of reasonable preferential tax measures, such a system
would support asset formation by citizens’ own self-help efforts without reliance on thegovernment or companies. In addition to supplementing the shortfall of public andcompany pensions, it could also be expected to have the effect of easing the impact ofcompany bankruptcies and resolving issues of portability, and also of eliminating
inequalities between companies and within generations. With regard to the pension
taxation system, given its simplicity and clarity, and the fact that it offers advantages
including a low fiscal burden due to the lack of a tax reduction upon entry to thesystem, a taxed-exempt-exempt (TEE) system, which taxes contributions but not gains
or benefits, should be adopted as the system of taxation for savings.
It is essential that we reduce the burden on citizens and ease inequalities between
generations by optimizing a private pension system through measures such as theintroduction of a Japanese IRA in order to enable the effective use of limited publicresources.
(Shigeki Morinobu)
Chapter 6

Simulation Analysis of Fiscal and Social Security Reform

The author conducted simulations using a macroeconometric model in order toquantitatively examine how the enhancement of social security can be made consistent
with fiscal reconstruction. Because there were upper limits to the rates of increase in
consumption tax that could realistically be expected, the simulations also examinedthe choices available for fiscal reconstruction and the introduction of a guaranteed
minimum pension(GMP) within these ranges (here, considered as an increase to 10%
for the short term and to 15% for the medium- to long-term).
The analysis showed that in order to achieve the targets of the Fiscal Management
Strategy – the achievement of equilibrium in the primary balances of the national andlocal governments in fiscal 2020 and, further, the reduction of the ratio of outstanding
public debt to GDP thereafter, it would be necessary to increase consumption tax to
16% in respect of the first goal, and to 22% in respect of the second. Given this, theachievement of fiscal reconstruction under the upper limits for consumption tax will
necessitate additional efforts on a significant scale to improve the fiscal balance.
The level of benefits of a GMP financed by the increase in revenue generated byincreases in the consumption tax within the same limits was calculated in the sameway. In the case of provision of a uniform pension irrespective of income, thesimulation indicated that benefits would fall well below the level of the current basic
pension. However, when a large-scale clawback was introduced to the GMP, the level ofbenefits for individuals qualifying for full benefits exceeded that for the current basic
7pension.
This indicates that the achievement of fiscal reconstruction and the introduction of a
GMP within the scope of the tax burden that can realistically be expected to be applied
will be no easy matter, and will necessitate additional improvement of the fiscal
balance and a greater focus on pension benefits.
(Itaru Sato)

Projections of ratio of outstanding national and local government debt to GDP

（％）

350
Benchmark caseAchievement of equilibrium in primary balance from fiscal 2020
Reduction of public debt to GDP ratio from fiscal 2020

Consumption tax
rate remains 5%

300

Consumption tax
rate increases to
16% by fiscal 2020

250

Consumption tax
rate increases to
22% by fiscal 2020

200

150
2010

2012

2014

2016

2018

2020

2022

2024

2026

2028

2030

（FY）

(Note) Extract from results of simulation using macroeconometric model (Chapter 6)8Research Members
Toshihiro Ihori

Professor, Graduate School of Economics, The University of Tokyo

Shigeki Morinobu

Professor, Chuo Law School

Itaru Sato

Researcher, National Institute of Population and Social
Security Research

Hajime Takata

Operating Officer / Chief Strategist, Mizuho Securities Co. Ltd.

Motoshige Itoh

President, NIRA/Professor, Graduate School of Economics,
The University of Tokyo

Naoki Shimoi

Visiting Researcher, NIRA/ Associate Professor, Department ofManagement and Information Sciences, Tama University

Tetsuo Ota

Director and Senior Researcher, NIRA

Masatoshi Jinno

Senior Researcher, NIRA

What’s NIRA?
The National Institute for Research Advancement (NIRA) is an independent, private-sector
research institute which defines urgent policy issues and formulates bold and timely policy
proposals, seeking to contribute to the revitalization and further development of Japanesesociety and the Japanese economy.
Utilizing a network of scholars, researchers, and specialists in a wide range of subjects,
NIRA works for the public benefit from a fair and neutral perspective, attempting to
reinvigorate policy debate and contribute to the process of policy formation in Japan. The
institute focuses on domestic social and economic policy, international relations, and regional
issues in Japan as its principal areas of research.
Established in 1974 as a government-authorized independent research institution, NIRA
became an incorporated foundation in 2007, and since February 2011 has been recognized asa Public Interest Incorporated Foundation.

National Institute for Research Advancement (NIRA), Japan
Yebisu Garden Place Tower, 34th Floor
4-20-3, Ebisu, Shibuya-ku, Tokyo 150-6034, Japan
Tel: 81-3-5448-1735

Fax:81-3-5448-1743

E-mail: info@nira.or.jp

URL:http://www.nira.or.jp/english

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