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Where Next For Japan As Kan Falls On His Sword?

By Editorial
September 5, 2011

Yoshihiko Noda has become Japan's sixth Prime Minister in six years since Junichiro's Koizumi's five-year spell as PM ended in 2006, a revolving door of leaders indicative of the political elite's failure to get to grips with the country's deep-seated fiscal problems which have piled up following two decades of economic stagnation.

It appears that the latest PM will persist with the tax-raising stance he took when Minister of Finance in the previous Naoto Kan government, in order to resolve Japan's reconstruction and budget deficit problems. Whether he has the courage of his convictions - or indeed the necessary backing - to carry them through after the suggestion of tax hikes in a weak economy contributed to the departure of so many of his predecessors, remains to be seen.

Japan is the most heavily-indebted nation in the developed world. Indeed, its debt-to-GDP ratio now stands at 225%, above St Kitts and Nevis, Lebanon, Zimbabwe and Greece. Its budget deficit, at about 7% of GDP, is not especially high compared with some European Union countries, or even the United States for that matter. However, the need to raise new sources of revenue has become ever more urgent, with a rapidly ageing population expected to exacerbate the debt problem and put the country's social security system under huge strain in the medium- to long-term; about one quarter of the population is of pensionable age, up from 12% twenty years ago, and according to Japan's statistics bureau, people aged 65 or older will account for about 40% by 2050.

Last month, Moody's Investors Service reduced Japan's sovereign long-term credit rating, partly as a result of the government's on-going inability to agree a comprehensive tax reform plan. Frequent changes in administrations have prevented the government from implementing long-term economic and fiscal strategies into effective and durable policies, said Moody's.

For many years now, successive governments have been fixated with Japan's consumption tax as a potential solution to the crisis. At 5%, Japan's sales tax is much lower than equivalent levies in other developed nations, such as Europe, so there would appear to be scope for this tax to be increased. However, this proposal is proving to be a very unpopular one, not only with parliament, but also with the voting public. This has, to some extent, accounted for the frequent changes in administrations cited by Moody's.

While Japan's medium-term policy target of a halving of the primary budget deficit (excluding interest payments) to approximately 3% of GDP by 2015 is seen as feasible, assuming the government doubles the consumption tax to 10% by the middle of the decade, Moody's concludes that its ultimate goal of achieving a primary surplus by 2020 "would require additional, and yet unidentified, fiscal measures".

In July, the International Monetary Fund waded into the debate, suggesting in its annual review of the Japanese economy that a moderate increase in the consumption tax, to 7%-8% in 2012 when a cyclical recovery is underway, is achievable. However, the IMF agreed with Moody's that further unspecified tax increases would also be needed to bring down Japan's high level of public debt. The IMF has been a particularly vocal supporter of a consumption tax increase though, and in a staff discussion note published in June, entitled 'Raising the Consumption Tax in Japan: Why, When, How?', it was suggested that the Japanese government should begin a gradual increase in consumption tax from 5% to 15% over several years.

Of course, the budgetary situation in Japan has not been helped by the twin tragedies of the earthquake and tsunami that struck the northeast of the country in March. The total cost of the reconstruction efforts is expected to run into billions of dollars, and the government has had to issue supplementary budgets in order to finance the clean-up costs.

For now, the Japanese government has settled on the solution of borrowing yet more money from its citizens in the form of reconstruction bonds to help pay for the reconstruction and relief efforts, as recommended by the government-appointed Reconstruction Design Council. Until the government can agree on tax policy, it probably has little choice but to do this in order to cover short-term financing needs. Besides, any new or increased taxes would take time to be introduced and for the new revenues to replenish the budget. Nonetheless, the reconstruction panel did conclude that a temporary increase in a mix of the country's 'core taxes', which was taken to mean personal income tax, corporate income tax, and consumption tax, was probably unavoidable.

Until recently, Japan had actually been planning to cut the corporate tax rate, which, at more than 40%, is the highest in the OECD - another league table that the government is keen that the country doesn't top. This and other tax proposals were included in the fiscal policy framework agreed last December, but March's events look to have knocked the government's reform agenda off course and it is unclear if, or when, such proposals will see the light of day, at least in the short-term, as the country deals with the aftermath of the natural disasters.

As to the longer-term, unless a government comes along with a strong mandate and parliament can unite around a comprehensive tax and spending reform agenda, the revolving door at the top of Japanese politics looks set to continue rotating.


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