Toward Financial Reconstruction —Growth first, then tax increase—

Naosumu Atoda
Professor,

Faculty of Business and Commerce, Department of
Business and Commerce,
Keio University

Is it possible to bring the primary balance into the black in fiscal 2011? To assess the feasibility of that achievement, we developed a forecasting model to use in simulation, with economic growth rate, inflation rate and long-term interest rate as exogenous parameters. According to the simulation results, even if an economic growth rate of 3% is achieved, the primary balance would be a deficit of 600 billion yen in fiscal 2011, due to recent economic stagnation. The deficit would be kept at such a low level because low rates of inflation would hold down government expenditure, despite tax revenue declines caused by the present growth rate of as low as 1.3%. A deficit of 600 billion yen or so can be eliminated to achieve a surplus primary balance by stepping up expenditure cuts, without raising taxes. Moreover, as banks are pressing ahead with disposal of bad loans, an approximately 2.5 trillion yen increase in tax revenues from financial institutions is expected. Therefore, it will clearly be possible to achieve a primary balance surplus in fiscal 2011.

If the growth rate remains at 2% or so, however, the primary balance will be back in the red in fiscal 2012 and beyond, mainly because most baby boomers will turn 65 and begin to receive pension benefits. To avoid this scenario, it is absolutely necessary to increase the growth rate. First, economic pump-priming measures, such as tax credits for investment in plant and equipment, are effective in raising economic growth rates even in the short term. Second, promotion of technological advances by introducing tax credits for research and development investment will have positive effects on potential growth rates. It is imperative to achieve a growth rate of 3% or higher by taking these measures.

Even if a surplus primary balance is maintained by increasing the economic growth rate as described above, additional sources of revenue will be needed to achieve a budget surplus, with the aim of reducing the accumulated debt. Even if spending cuts of 14.3 trillion yen are carried out by fiscal 2011, revenue shortfalls ranging from 12.5 trillion yen to 22.5 trillion yen are expected for fiscal 2012 onward. It would be emotionally exhausting to consider carrying out additional spending cuts in such amounts, which comprise approximately 10% of the combined central and local government expenditures, on a net basis. Given this perspective, a tax increase may be unavoidable. Specifically, it will be necessary to raise the consumption tax from 5% to 9%.

In doing so, the budget balance of central and local governments should be taken into consideration. While the central government is in deficit, local governments are in surplus. In addition, the Tokyo Metropolitan Government accounts for 60% of the local government budget surplus. The primary balance simulation described in this section is based on the assumption that spending cuts are carried out. In view of the Tokyo government's bid to host the Olympic Games, we cannot expect Tokyo to make an earnest effort to reduce expenditures. It is therefore urgently necessary to consider the possibility of incorporating the Tokyo government's surplus into the central government's budget.

April 21, 2008