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In search of a Grand Design
for the Economy and Public Finance

October 2, 2000

Japan Federation of Economic Organizations

  1. Declining birth rate, population aging, and structural reform
    1. Japan's economy today and the impact of a falling birth rate and aging population
    2. Although, in the run-up to the 21st century, Japanese economy remains in the throes of a stock adjustment, the self-sustainable recovery in terms of the flow of economic activity is gradually gathering momentum. The pace of economic structural reform centering around the IT revolution, area in which Japan fell a long way behind the US in the 1990s, is increasing in both public and private sectors, as evidenced by the recent formulation of the Basic Law for the Promotion of an Advanced Information and Telecommunications Society (provisional abbreviation: "Basic IT Law").
      However, the protracted recession after the bursting of economic bubbles and the successive implementation of economic measures, tax cuts and spending policies to stimulate economic recovery have left Japan's public finances in very poor condition. Based on the initial FY2000 budget, the combined long-term debt of national and local government by the end of FY2000 will be ¥ 645 trillion, equivalent to approximately 130% of GDP. To date, moreover, the government has yet made a start on the radical reforms of the social security system such as pensions and health provision, whose future reliability is far from certain.
      As the nation is about to enter the 21st century, not only is Japan's public sector burdened with a massive debt for future generations, it has also failed to establish a clear vision of the social security system.
      The most frightening prospect as we head into the new century is that of a society in which the birth rate is falling and the population is aging more quickly than any other country on earth. Median estimates made by the National Institute of Population and Social Security Research point to an increase in the ratio of the aged population (65 years of age or more) to the working population (15-64 years of age) -- sometimes referred to as the Aged Population Index - from 25.3% in 2000 to 46.0% in 2025.
      The declining birth rate and population aging will affect Japan's socioeconomic infrastructure in a variety of ways, as shown in Figure 1 below. However, the greatest concern has been generated by the increase in the ratio of public to national income (national burden rate) implied by a slower rate of economic growth, deteriorating public finances, and a growing social security burden.

    3. The need for structural reform
    4. An examination of the data demonstrates a clear reverse correlation, as shown in Figure 2 below, between increases in the national burden rate and the rate of economic growth. There is thus a strong possibility that problems such as a declining savings rate, a declining labor supply and crowding out resulting from an excessive rise in the national burden rate would sap the economic vigor.
      There is strong support for the argument that taxes should be increased as a means of improving the balance of Japan's public finances. However, even in such a case, any easy change should not be introduced to the target of containing the national burden rate below 50%, which has become a national consensus since the Provisional Council for the Promotion of Administrative Reform presented its final report on the subject in April 1990.
      Our objective must be to minimize growth of the national burden rate by implementing a series of structural reform measures designed (1) to maximize economic growth through the effective use of economic resources, (2) to realize "small government" by securing a more rational, efficient, and focused application of public funds at both the national and local level, and by optimizing social security benefits, and (3) to create the sort of tax and social security burden mix that will have the least detrimental effect on economic growth.

  2. Basic direction of structural reform by sector
  3. Keidanren has been issuing recommendations on various sectors regarding the ways of structural reform. The basic thrust of the recommendation is as follows.
    Clearly, no amount of structural reform will be sufficient to ward off failure in national economy unless the decline in the birth rate is stemmed. It also goes without saying that action to slow the decline in the birth rate will be the country's most pressing issue in the new century. In an opinion paper entitled "Finding specific answer to the problem of declining birth rate" (March 1999), we proposed a number of practical measures such as amplifying and reviewing the child care and education system, creating urban environments in which people live closer to their work, and securing the more active involvement of fathers in housework and child care. It is essential for us to work together in a steadfast manner at government, industry, community, and family level to ensure that these measures are duly implemented.

    1. Growth strategy
    2. Despite the progressive decline in the birth rate and population aging, the Japanese economy is expected to have a potential economic growth rate of about 2.7% annually up to 2025. To realize this potential, the public and private sectors will need to work together to achieve comprehensive and strategic implementation of policy measures designed (1) to increase job opportunities for women and the aged, and to secure the size of the working population by, for example, actively recruiting foreign workers to fill posts in specialist and technical fields, (2) to promote capital investment by enhancing the efficiency of capital and improving the financial and capital markets, and (3) to stimulate an increase in TFP (total factor productivity), particularly in the non-manufacturing sector, by encouraging the IT revolution, regulatory reform, and the like.
      For a more detailed discussion of the above points, refer to the Keidanren opinion paper "Towards the establishment of new growth strategies to cope with the declining birth rate and population aging" (May 2000).

    3. Reform of the structure of public expenditure
    4. To contain spending at both national and local government level, we will carry out a thorough across-the-board review of the efficiency and effectiveness of all policies and systems while at the same time taking steps to further rationalize and improve the efficiency of spending by encouraging privatization, outsourcing, and the computerization of administrative systems (electronic government at both national and local level). At the same time, the budget has to be allocated with an emphasis on policies relating to the IT revolution and other new growth strategies.

      1) Public works reform

      The role expected of public works will change to incorporate functions such as the creation of a new foundation for growth and maintenance of the existing social capital stock. With this end in view and with a view to ensuring a proper division of role between the public and private sectors for the provision of fixed social capital, we should be more selective and cost conscious in our management of public works. We should also make use of PFIs (Private Finance Initiatives) and the like to make the implementation of public works more efficient.
      For the time being, we should seek, among other things, to enact the Administrative Assessment Law (provisional name) at the earliest possible timing to make public works project evaluation (cost benefit analysis) obligatory, to establish a close linkage between administrative assessment and budget preparation, and to strengthen the functions of the Policy Evaluation and Independent Administrative Corporation Evaluation Committee. At the same time, to reduce the costs of public works, we should seek the early enactment and rigorous implementation of the Law to Promote the Rationalization of Public Works Tenders and Contracts (provisional name), correction of the tendency to give priority to local businesses for local projects, and a review of the Law on Ensuring the Receipt of Orders from the Government and Other Public Agencies by Small and Medium Enterprises (Public Agency Order Law) and the joint venture system.

      2) Reform of local government finance

      We should establish a fiscal framework that will encourage local public agencies to be independent and self-reliant and to make spontaneous endeavors toward administrative and fiscal reforms.
      To this end, we should undertake the comprehensive reorganization of local public agencies in such a way as to ensure that the check and control by local residents work effectively. At the same time, we should seek to clarify the relationship between benefit and burden at local government agency level by augmenting local sources of tax and abolishing local grant tax and national treasury disbursements. We should also improve disclosure and policy evaluation with respect to local government finance. With the help of these measures, we will make vigorous efforts to restructure public spending at local level.
      For a more detailed discussion of the above points, refer to the Keidanren opinion paper "Towards the establishment of an independent, self-reliant system of local public finance" (April 2000).

    5. Social security system reform
    6. We should establish a social security system that is capable of being sustained in the face of a declining birth rate and population aging and that does not overburden either the current working population or future generations, by securing a suitable mix of self-help and social provision, and by ensuring the integrated and efficient provision of benefits based on a relationship of mutual support and substitution between pension, medical treatment for the aged, and long-term care insurance.

      1) Pension system reform

      We should seek to secure the reliable funding of pension benefits by, for example, excluding people with income above a certain level as a means of confining the payment of pensions to those who really need them, while at the same time steadily improving the balance of burden between generations.
      To this end, we should limit the basic benefits to a level sufficient to guarantee minimum living standards and increase the proportion paid out of the public fund. In the case of the earnings-related benefits we should carry out a thorough review of both the benefits and the burden, the ultimate aim being complete privatization at some point in the future. We should also seek to secure a fairer balance between the generations by reducing deductions for public pension benefits.
      At the same time, to encourage the formation of an independent, self-reliant attitude, we should also facilitate the development of private pension provision by, for example, introducing defined-contribution pensions as soon as possible, by redesigning the defined-benefit pension system to make it more flexible, and by abolishing special corporation tax.

      2) Medical treatment for the aged and long-term care insurance system reform

      We will undertake the comprehensive adjustment of benefit provision, including pensions. More specifically, we should establish a new system of medical treatment for the aged, the main beneficiaries of which will be determined on the basis of their income. We should also seek to minimize waste by replacing so-called "social hospitalization" with long-term care insurance and reviewing terminal medical care.
      With regard to funding, we should carry out a radical review with the aim of using existing assets to increase the emphasis placed on the intra-generational insurance element while at the same time increasing the proportion paid out of public funds, bearing in mind the rising morbidity due to aging. In the interim, we should increase the proportion of the medical treatment system for the aged funded by the individual (out-of-pocket expenses) as soon as possible and, assuming an increase in the proportion funded out of the public purse, we should abolish contributions for medical expenditures for the elderly, which are currently supported by inter-generational funding by the working population.

    7. Tax reform
    8. To accommodate population aging, we will establish a tax system which combines the new principle of "vitality" with the existing principles of fairness, neutrality and simplicity.
      By imposing an obligation to pay tax and social insurance premiums, we force individuals and firms to act differently from the way they would have acted if such a burden had not been imposed, thereby reducing the efficiency of the economy as a whole. Estimates by Keidanren suggest that in order to raise the same amount of funds for social security, indirect taxation would have less adverse effects on the economy than the current system of funding out of income tax and social insurance contributions (divided 50/50 between labor and management). (See Figure 3.)
      Generally speaking, the funding of public finance and social security calls for the establishment of a suitable mix among various component taxes and social insurance premiums, bearing in mind factors such as differences in the tax base, problems associated with capturing income, non-payment and non-participation, and various uses of funds. The present system, however, leans too heavily on direct taxation and social security contributions. We should therefore seek to establish a more appropriate ratio of direct and indirect taxes based on a suitable functional division between tax and social insurance premiums by introducing an invoice-based tax system and reviewing the simplified consumption tax system to eliminate the "beneficial tax element" as well as by promoting the establishment of multiple tax rates, tax-inclusive pricing, and the like. From the standpoint of enhancing international competitiveness, we should reduce corporation tax rates and, as for individual income tax, we should seek to mitigate the steep progressive structure of taxation while at the same time lowering the minimum taxable income.
      For a more detailed discussion of the above points, refer to the Keidanren opinion paper "Recommendations for revision of the FY2001 tax system" (September 2000).

      Figure 3: Impact of tax and social insurance premiums on the economy
      - Differences in "deadweight loss" depending on fund procurement method -
      Tax, insurance contribution collection method
      Revenues from tax
      (and insurance contributions)
      Income tax Social insurance
      (divided 50/50 between
      labor and management)
      Consumption tax
      ¥ 10 trillion¥ 78.7 billion¥ 12.7 billion
      ¥ 20 trillion¥ 78.7 billion¥ 51.2 billion
      ¥ 30 trillion¥ 325.9 billion¥ 115.7 billion
      ¥ 40 trillion¥ 1,397.4 billion¥ 206.9 billion
      ¥ 50 trillion¥ 2,269.6 billion¥ 324.9 billion
      * "deadweight loss"
      By requiring people and firms to pay income tax and social insurance premiums, we distort their behavior and, in so doing, we generate inefficiencies that would not have arisen if those requirements had not been imposed. This loss is called the "deadweight loss".

  4. Need for a Grand Design for economic and fiscal policy
    1. Experience gained from the six major reforms of 1997
    2. The basic thrust of structural reform in the various sectors is as described above. The question now is how this might be realized in terms of specific objectives, schedule and combination.
      The experience of the six major reforms of 1997 should serve as useful reference in this regard.
      The six major reforms initiated in 1997 (administration, fiscal structure, social insurance structure, economic structure, financial system and education) were regarded as pioneering structural reforms. Of these, reform of the financial system was incorporated in the Law Regarding the Preparation of Related Laws for Financial System Reform (Financial System Reform Law), which came into force in December 1998. In the case of administrative reform, the complete reorganization of Japan's ministries and government agencies is scheduled to take place in January 2001.
      In the case of reform of the fiscal structure, on the other hand, despite the enactment of the Fiscal Structure Reform Law in November 1997, the target year for implementation had to be changed in May 1998 and, in December of the same year, action for implementation was suspended.
      A start has yet to be made on the drastic reform of social security system.
      An examination of the reasons for the setback in fiscal structure reform points to three main problems.

      1. There were no links between this and other closely related reforms such as administrative reform, social security system reform, and economic structural reform.
      2. The practicable potential of specified goals and schedules was not given sufficient thought. For example, achievement of the twin objectives of "Eliminated deficit covering bond issuance" and "Fiscal deficit equivalent to 3% of GDP or less" shown in Figure 4 would necessitate the attainment of nominal growth in the middle of the 5% range throughout the term of the plan (FY1998-2003).
      3. The economy was in the grip of severe problems such as financial system uncertainties and a rapid worsening of Asian currency crisis, unforeseen at the time of enactment of the law.

    3. The Grand Design
    4. 1) Conditions that must be met by the Grand Design

      Based on our experience of 1997, in undertaking the necessary structural reform, the Grand Design to be formulated must meet the following requirements:

      1. Comprehensive (in particular, there must be consistency between the various system reforms and the economic growth strategy)
      2. Well-planned (goals must be achievable and clearly scheduled)
      3. Flexible (it must be flexible enough to accommodate unforeseen developments, changes in the economic and business environment, etc.)

      2) Planning and establishing the Grand Design

      Under the new central administrative system due to be put in place in January 2001, the Economic and Fiscal Consultative Council will be established in the Cabinet Office to discussion of important economic and fiscal policy measures. Under the Prime Minister's leadership and with the cooperation of other organizations concerned, the Council should become the pivot in the planning and establishment based on the Grand Design and periodic review of its progress.

      3) Possible options

      Keidanren has estimated the effects of various combination of structural reforms on economic growth and the fiscal balance between now and 2025. The results of these simulations are shown in Figure 5.
      If the series of structural reforms envisaged in the simulations in Case 3 or Case 4, both of which are close to the basic thrust of Keidanren's recommendations, were to be implemented, the national burden rate could be kept below 50% between now and 2025. Primary balance (balance of "Expenditure excluding national debt service payments" and "Revenue excluding receipts from government bonds") equilibrium - the goal of the Economic Strategy Council - is achieved in FY2004-2005, and the "outstanding government debt/GDP" ratio is reduced. Stable management of the social security system also is made possible.
      These are, of course, nothing more than simulations based on a given set of assumptions. However, we would strongly urge that by using these simulations as reference the Economic and Fiscal Consultative Council and other bodies should examine further the goals of structural reforms, starting dates, schedules and a suitable mix of policy initiatives, and should formulate a Grand Design at the earliest possible timing.
      The cases we simulated are discussed in more detail below. The starting date for the implementation of structural reform in each case is assumed to be FY2002.

      Case 1

      The aim in this scenario is to achieve the requisite equilibrium between revenue and expenditure by imposing steep increases in consumption tax and social insurance premiums but without reforming the structure either of government expenditure or of the social security system. Under this scenario, the consumption tax rate has to be hiked straight to 25.5% in FY2002 and the employees' pension insurance premium rate is increased in stages from its present 17.35% to 34.5%, thereby causing a 1.4 fold increase in the medical insurance burden. As a result, the rate of economic growth falls below 2% to 1.7% a year and the national burden rate is driven up to 71.8% by FY2025.

      Case 2

      Under the scenario in Case 2, it is assumed that only the structure of national and local government expenditure is reformed. If these reforms are actively implemented in respect of both public work and final consumption expenditure of government, the consumption tax rate in FY2002 will be 14.5% lower than Case 1 by 11 percentage points. However, since nothing is done to reform the social security system, the increase in the employees' pension insurance premium rate is more or less on a par with Case 1 and the medical insurance burden continues to grow. As a result, the economic growth rate is little better than that in Case 1, and while the national burden rate at 59.8% in FY2025 is better than it is in Case 1, it nevertheless remains high in absolute terms.

      Case 3

      As is clear from Case 2, the national burden rate cannot be kept below 50% without implementing radical social security system reform. In Cases 3 to 5, therefore, we have assumed reform not only of the structure of government expenditure but also of the social security system.
      In addition to the expenditure structure reforms envisaged in Case 2, the scenario in Case 3 also assumes the establishment of appropriate benefit levels for both pensions and medical insurance. In this case, it is possible to confine the FY2002 increase in the consumption tax rate to 5 percentage points. The employees' pension insurance premium rate also remains on a par with current rates and the medical insurance burden can be reduced from the level based on the current system. As a result, the economic growth rate improves to 2.4% per year, and the national burden rate in FY2025 will be 46.5%,i.e. below 50%.

      Case 4

      The Case 4 scenario is similar to that of Case 3 except that it assumes that the whole of the basic pension is paid by the national treasury and that all the costs of medical treatment for the aged and long-term care other than out-of-pocket expenses are paid out of public funds. In this case, the consumption tax rate has to be raised to 15.8%, more than three times its current level, in FY2002. On the other hand, the employees' pension insurance premium rate can be lowered to 14.5%, and it is also possible to reduce the medical insurance burden below the level in Case 3. Consequently, the economic growth rate rises to 2.7% and the national burden rate is confined to 46.3% in FY2025.

      Case 5

      In Cases 1 to 4 above, the national and local government fiscal deficit is eliminated in the 2020s. The scenario in Case 5 is based on Case 3 except that greater emphasis is placed on fiscal consolidation with the result that the fiscal deficit is eliminated in 10 years along with the pension shortfall, thereby enabling the reserve to start growing again. In this case, however, the consumption tax rate has to be raised to 17.5% in FY2002 and the employees' pension insurance premium rate has to be raised in stages to 33.5%. As a result, the annual rate of economic growth falls to 1.9% and the national burden rate rises to 61.3% in FY2025.

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