The Scenario for Restoring Fiscal Health - Stronger Growth or Higher Taxes?

Below, calculations are made based on various assumptions in order to examine which scenarios may be realistically possible. The calculations are based on the starting point of Japan's FY 2005 primary balance, with a 3.3 percent debt in general treasury funds as a percentage of GDP, and a government debt of 731 trillion yen.

First, let's assume a case in which the nominal growth rate from FY 2006 onward is a low rate of 2 percent. Let's also assume that the long-term interest rate remains at a conservative level of 2 percent in FY 2006, but rises above the nominal growth rate to 3.5 percent from FY 2007 onward. This is to reflect the average gap of 1.5 percent between nominal growth rates and long-term interest rates during the 1990s, before the zero-interest rate policy was adopted.

When designing a policy for restoring fiscal health, the relationship between nominal growth and long-term interest rates is an extremely important element. If nominal growth rates are above long-term interest rates, then the rate of increase of nominal GDP will be comparatively higher than the rate of increase of government debt, thereby lowering the ratio of government debt to nominal GDP by that amount. It is from this relationship that the Growth-Oriented Faction argues the necessity of achieving the highest possible growth rates and the lowest possible long-term interest rates. However, looking at historical trends in developed countries, nominal growth rates are higher than long-term interest rates during high growth periods, but when the economy matures nominal growth rates fall below long-term interest rates. With this relationship in mind, this report uses the recent average gap of 1.5 percent between nominal growth rates and long-term interest rates in its calculations.

Meanwhile, let's assume that from FY 2007 onward, the level of general government expenditure shrinks at a rate of 0.5 percent of GDP per year, meaning that after FY 2016-ten years later-expenditure will be shrinking at 5 percent of GDP compared with the present. On the revenue side, let's assume a two-stage process by which the consumption tax is increased from 3 percent to 8 percent in FY 2008, with a further increase of 2 percent three years later in 2011 to a total consumption tax rate of 10 percent. This rate was drawn from a recent public opinion poll regarding the acceptance of a consumption tax increase, in which an increase of 10 percent was the highest level accepted. In order to earn the public's understanding regarding a tax increase, the increase should be delayed by one year from the start of the government's reduction of expenditures.

Given these conditions, calculations predict that the primary balance will reach a surplus by FY 2010, and by FY 2016 the surplus will be 4.4 percent of GDP. Government debt as a percentage of GDP will decline from FY 2013 onward, reaching 68 percent of GDP in 2049-on par with early 1990s levels where the percentage remained in the 60s. According to these calculations, the current primary balance debt of 3.3 percent of GDP will be improved to a 4.4 percent surplus by FY 2016, but close to 70 percent of this total improvement of 7.7 percentage points is calculated as resulting from the reduction of government expenditures.

High Nominal-Growth Case

In summation, the above scenario posited a low nominal growth rate of 2 percent where the long-term interest rate is at a reasonably natural level of 3.5 percent. This scenario predicts that in order for government debt to be reduced to an early-1990s level of 60-69 percent of GDP by the year 2050, it is necessary to improve the primary balance by 7.7 percent. Further, in order to achieve this improvement while keeping the level of tax increase from rising above 10 percent, it will be necessary to reduce expenditures as a percentage of GDP by 5 percent.

How does the scenario change if the growth rate is estimated at a higher level? In the case of a nominal growth rate of 3 percent (and a long-term interest rate of 4.5 percent), tax revenue will increase naturally with economic growth, and thus government debt as a percentage of GDP will reach the 60-69 percent level more quickly (i.e. 69 percent by 2045). An even higher growth rate (a nominal growth rate of 5 percent, and long-term interest rate of 6.5 percent) has the potential to reach a government debt of 69 percent of GDP by 2053, with a consumption tax increase of only 8 percent. Though a high growth rate achieves a natural growth in tax revenue with a minimal increase in consumption tax, on the other hand the cost of interest payments also increases with the rise in interest rates, and thus the effects cancel each other out. In order for nominal growth rates and long-term interest rates to be held equal at 5 percent, calculations show that it is possible to achieve this with only a 5 percent increase in the consumption tax.

The above calculations assumed that all expenditure reductions (to a final total of 5 percent of GDP) were conducted in phases, but what would happen if expenditures were not reduced at all? In the case of low economic growth (i.e. a nominal growth rate of 2 percent) where there are no reductions in expenditures, government debt will not fall within the 60-69 percent of GDP range by around 2050 unless consumption tax rates are increased by 22 percent (in which case debt reaches 66 percent of GDP by 2053).

In this way, future scenarios for improving fiscal health are greatly influenced by macroeconomic predictions (nominal growth rates and long-term interest rates) as well by revenue and expenditure estimates. From a policy perspective, under conservative macroeconomic assumptions it is necessary for the government to propose a plan for reducing expenditures in order for the consumption tax increase to be as small as possible. Scenarios that are over-dependent on accelerating growth rates and suppressing interest rates or that rely too much on increasing taxes both lack realistic persuasiveness. Though the calculations given here are no more than rough estimates, it is the government's duty to pursue more detailed and nuanced calculations so as to present the public with policy choices, and to earn the public's understanding in restoring the country's fiscal health.