Since taking office last month, Prime Minister Naoto Kan has dramatically shifted the focus of political and economic debate in Japan to the nation’s shocking finances.
Japan is in danger of financial collapse, Kan warned, as he called for a hike of the 5 percent consumption tax. Coming just before an important upper house election on Sunday, it was a bold move to touch a traditional ‘third rail’ of politics. And in doing so, he has turned the poll into something of a referendum on increasing the sales tax.
Broaching the subject has suddenly become possible in part because of the Greek debt crisis and its repercussions in the Eurozone and beyond. Scenes of public unrest in Greece on TV news shows and the rapid escalation in the scale of the bailouts needed by Athens have made the Japanese public more aware of the potential consequences of national debt problems.
And when it comes to debt, Tokyo has plenty of it. In fact, Japan has the highest proportion of outstanding debt in relation to GDP among major economies. The Ministry of Finance officially calculates Japan’s gross national debt in 2010 at 181 percent of GDP (though the latest figures suggest it’s closer to 200 percent), far in excess of the Eurostat figure for Greek national debt of 115 percent (2009). Meanwhile, to pay for this year’s 92.3 trillion yen budget, Japan needs to issue 44.3 trillion yen’s worth of new government bonds. That’s more than the 37.4 trillion yen it expects to raise from taxes for the year. Servicing the national debt now uses 22.4 percent of that budget, well in excess of spending on public works, education, science and defence spending combined.
Could Japan be the next Greece?
A glance at the figures suggests a real predicament for the government. But just how bad is Japan’s debt problem? Is Tokyo really in imminent danger of a financial meltdown similar to that of Athens? And if it does need to repair its finances, will raising the consumption tax be enough?
Economists and analysts suggest that while the Greek debt crisis has opened eyes in Japan and served as an important example of what can happen to a nation that turns a blind eye to its debt problems, there are important differences.
Takahira Ogawa, director of sovereign ratings at Standard & Poor’s, points out that Japan has the advantage of independent monetary policy unlike Greece, which is a member of the Eurozone. He also points out that Greece shot itself in the foot by possibly trying to ‘cook the books,’ fuelling a crisis in confidence. Ogawa said he can’t imagine Tokyo using derivatives to conceal its debt problem anytime soon.
Japan also has deep pockets, which means on paper at least it has the potential to pay off a lot of that outstanding debt.
‘The Japanese government has a lot of financial assets,’ Ogawa says. ‘Of course, the extent to which they can actually be used is a very serious question. But if you use the OECD or IMF’s definition, Japan’s net general government debt level is slightly less than 100 percent.’
While that moves Japan’s debt problem toward the scale of Italy’s rather than Zimbabwe’s, observers warn against complacency.
‘To properly understand the seriousness of Japan’s debt problem, net debt probably gives you a better picture than gross debt does,’ says Takero Doi, professor of economics at Keio University. ‘But if you’re asking what the Japanese public will have to pay back in the future, it’s gross debt that’s the correct figure.
‘So what’s being netted out? It’s mostly money in public pension funds. To take an extreme example, if investors suddenly demanded all their money back from Japan tomorrow, would Japan use the pension funds it has ready for pension benefits 20 to 30 years in the future? Of course not.’
Another important feature of Japan’s national debt is that it is almost entirely held by Japanese.
‘The situation is different in Japan because here domestic investors hold 95 percent of government bonds,’ Akihiko Inoue, chief strategist at Mizuho Investors Securities said. ‘This makes Japan a difficult country for hedge funds around the world to attack.’
While Greece is reliant on foreign investors buying a significant part of their debt issues, Japan enjoys plenty of domestic demand for its bonds, keeping prices buoyant and yields low.
Ministry of Finance statistics from December 2008 give a breakdown of Japan’s bond ownership: Japanese banks hold 41 percent, Japanese life and non-life insurers have 19 percent, Japanese public pension funds hold 12 percent, and the Bank of Japan has 8 percent.
‘About 60 percent of Japan’s government bonds are held by Japanese financial institutions, including the postal life and postal savings [companies],’ Ogawa says, adding that the problem with Japanese investors is that they’re risk averse. ‘They’re not lazy, but they don’t take risks. If they were to take calculated risks they would be like professional investors. But most of the institutional investors, maybe because of company policy or because of agreements with certain customers or clients…invest in almost nothing but traditional bonds and equities. Basically risk taking or new activities in the financial sector are weak points.’
Japan’s financial institutions, it seems, are flush with cash, aided by the Bank of Japan's accommodative monetary policy. Without sufficient corporate demand for loans and given the risk-averse nature of Japanese investors described by Ogawa, there’s an apparently never-ending demand for government bonds—a cushy environment for a government spending beyond its means.
‘If you look at the yen, with the US dollar trading at less than 90 yen, the Japanese currency is not showing any weakness at this juncture. Also the yield on Japanese government bonds is quite close to its six-year low. So for the near future at least, investors in general don’t seem all that worried about the Japanese government’s ability to repay its debt,’ Ogawa says. ‘But right now the Japanese general government is producing the equivalent of 10 percent of GDP in new debt. That’s clearly not sustainable. So at some point the market will start to think that it will be very difficult to absorb this amount. Japan probably still has more time. But the longer it takes for a medium-term solution, the more nervous the market will become about future increases in new lines to finance the government.’
As for S&P’s assessment of Japan, Ogawa says: ‘We have a negative outlook attached to Japan. That means there’s more than a 30 percent chance we’ll cut the rating. We are basically monitoring the situation. Our view is that Japan’s sovereign credit is slowly deteriorating but not to the extent to which we need to downgrade it at this stage.’
Inoue of Mizuho Investors Securities agrees that for the time being there seems to be no danger, but he, like other bond analysts, will keep a close eye on bond yields:
‘It’s a sudden rise in the yield that’s the indicator of trouble. You may not know what the trigger has been, but it suddenly comes. At the moment in this country, the biggest factor that is keeping rates at their present level is demand for bonds among major investors and investment institutions. They want to buy bonds even though the returns are not attractive. If those people stop buying, then unsold bonds will start to stack up. Currently they all vanish in an instant and there’s no sign whatsoever of demand weakening. But at some point that time will come.’
In other words, this is no time for the nation to feel comfortable with its burgeoning debt just because its citizens and institutions are still willing to purchase it all.
A Tale of Two Frogs
Spooked by events in Athens, European nations from Spain to Germany have been tightening their belts. While these countries don’t have anything like the accumulated debts of Japan, there are some pretty dramatic budget deficits. Britain’s 13.3 percent budget deficit for 2010 dwarfs Japan’s 8 percent, leading David Cameron’s new coalition government to raise Britain’s equivalent of the sales tax to 20 percent and slash public spending. But Britain’s national debt of 83 percent of GDP is still relatively low compared with Japan’s.
Comparing the two nations, Doi uses the boiled frog analogy. Thrown into a tub of boiling water, the British frog has reacted by jumping out quickly, Doi says. By contrast, the Japanese frog is sitting in a tub of cool water, unaware that it is gradually getting hotter and hotter. As it relaxes in the comfort zone of its slowly heating waters, the Japanese frog risks being boiled alive before it even realizes the danger.
Akio Makabe, professor of economics at Shinshu University, says that understanding government finances just requires you to think of yourself in a similar position.
‘Imagine you’re earning 20 million yen a year, and you borrow 20 million,’ Makabe says. ‘I earn 5 million and I borrow 2 million, but I already have a 30 million housing loan. Who’s in the worse situation, you or me? It’s me with the housing loan.’
Someone at the Ministry of Finance appears to share Makabe’s approach, since Japan’s national debt situation has been set out with a household analogy on the ministry’s website. The site indicates that if Japan were a household with a monthly income of 400,000 yen, it would need to borrow an additional 370,000 yen every month to pay for everything and would have accumulated debts of 63.7 million yen.
Can Kan Grasp the Debt Nettle?
Despite years of politicians brushing the nation’s debt issue to one side, Kan, after a short stint as finance minister, including a salutary meeting with his G7 counterparts in February, has become a convert to the fiscal consolidation cause. Alarmed by Japan’s fiscal situation and perhaps sensing a window of political opportunity to raise taxes provided by the sovereign debt crisis in Europe, Kan has embraced the idea of tackling the nation’s debt problem. Arguably this was also an astute move for quickly redirecting attention away from the problems of the previous administration of Yukio Hatoyama and appropriating the opposition Liberal Democratic Party’s somewhat ironic election card of ‘the fiscally responsible party.’
On June 22, the Cabinet unveiled a medium term plan for bringing the nation’s finances under control. The plan calls for halving the budget deficit by 2015 (2 years later than agreed by the other G20 nations in Toronto last month), and putting the government’s primary balance (essentially the budget deficit excluding debt servicing) into the black by 2020.
To achieve this, Kan has called for nonpartisan debate on raising the consumption tax, with the LDP’s proposal of 10 percent to be used as a reference figure. A report in the Asahi Shimbun on July 3 said that a provisional calculation by the Cabinet Office indicated that a rate of 15 percent would be needed to achieve Kan’s 2020 primary balance goal. But in opting to mention the main opposition party’s figure, Kan appears to have entered the debate with an astute opening gambit, even if his later attempts to allay the fears of the sales tax’s regressive nature have been less adept.
So would a hike in the consumption tax to 10 percent be enough to tackle the problem, or would it just be a first step?
Analysts and economists suggest that whatever level the sales tax is raised to, it will need to be done as part of a package of measures to deal with the issue of Japan’s debt. Japan needs a growth strategy and it needs to make better use of its spending by slashing waste. Other ideas include greater deregulation, and an overhaul of the tax system.
‘A GDP growth strategy is needed to boost the economy and get a natural increase in tax receipts from corporation and income tax, because it’s difficult to realistically expect to fill the gap with just the consumption tax,’ Inoue says.
‘At the moment there’s no demand for money, figures for investment in plants and equipment are not improving and banks can’t find borrowers. These are the biggest problems.
‘The latest strategy announced by the Bank of Japan—giving private banks money so that they can go out and find people to lend to in growth industries—is a step in the right direction, but whether it works or not remains to be seen. Maybe private banks need to try a bit harder.
‘As for the consumption tax, in global terms, it’s low, and the market definitely sees scope for raising it to international levels.’
Sales taxes in many European countries hover around the 20 percent mark. Britain’s VAT has just been raised from 17.5 percent to 20 percent. Italy’s is also 20 percent, with France’s rate of 19.6 percent, and Germany’s of 19 percent not far behind. Sweden’s rate is higher at 25 percent. By comparison, Japan’s 5 percent level does seem very low.
‘The consumption tax probably needs to be 15 percent,’ Inoue suggests. ‘But perhaps it should go up to 10 percent at first, that’s already twice the current rate. I think this is best done in one go, not in increments. Then wait five years or so, look at the situation, and then if possible raise it to 15 percent,’
Shinshu University’s Makabe suggests a three-pronged approach of drastic spending cuts, increased taxes and growth.
‘[Do nothing and] Japan will have a problem with its debt within 10 years. To avert this, spending needs to be cut and taxes have to go up to increase revenue. The other point is to boost GDP growth and increase nominal GDP. If GDP goes up, our debt situation in comparison with GDP improves.
‘To boost growth we need to strengthen Japanese competitiveness. By lowering the effective rate of corporation tax, for example, the savings can be invested in plant and equipment, improving productivity and global competitiveness and boosting exports.
As for the sales tax, Makabe recommends a more gradual approach to raising it.
‘At this stage we’ve got to be looking for at least ten percent. I don’t think it’s feasible to suddenly raise the tax by five percentage points, so we should have gradual increases of two percentage points and then one percentage point each year.
‘Whether that is enough will depend on the prevailing economic situation. If there’s four percent growth in nominal GDP, ten percent might even be enough.’
While Japan is unlikely to be enjoying 4 percent GDP growth anytime soon, growth would have a large impact on tax receipts, as seen during the ‘rising tide’ of the Koizumi administration.
‘But no one believes that economic growth alone can solve the problem. Realistically, it’s got to be a combination of measures,’ Makabe says.
S&P’s Ogawa would also like to see growth.
‘The most important issue is how to achieve macroeconomic growth. If you take nominal GDP, the Japanese economy is no bigger than it was 17 years ago. So the denominator [of the debt equation] says no growth, while the numerator has skyrocketed.’
‘The fiscal condition would be somewhat better if we had nominal GDP growth of several percent. But it is likely to be very difficult from this point on to achieve something like 5 percent growth, given deflation.
Ogawa suggests deregulation as a cheap way of stimulating the economy, while suggesting the Bank of Japan could do more to help by buying bonds. Monetizing debt, he concludes, is better than allowing decades of deflation.
‘The conundrum is how to stimulate growth without spending any more money,’ he says.
The Ghost of Hashimoto
There’s also the question of the impact a sales tax hike would have on growth. Many economists believe raising tax the consumption tax from 3 percent to 5 percent under the administration of Ryutaro Hashimoto in 1997 sparked a return to economic recession, echoing the effects of Franklyn D. Roosevelt’s budget balancing moves in 1937. After Hashimoto’s tax reforms, the LDP went on to lose its majority in the upper house election of 1998, spelling the end of Hashimoto’s tenure as leader. (The main beneficiary in that election was the newly formed DPJ led by none other than Kan, in his first spell at the helm of the party.)
This is the experience politicians have wanted to avoid repeating, hence the long-running taboo on mentioning a consumption tax increase before elections.
‘To start [increasing the sales tax] next year is impossible because we don’t have recognized economic growth in nominal GDP,’ warns Makabe. ‘The (1997 Hashimoto) tax reform really messed up Japan’s economy. It was one of the most important factors in what happened. In the analysis of most economic scholars, including myself, the Hashimoto tax reforms were a mistake.’
‘Deflation is one of the most important problems Japan is facing at the moment. Growth in real GDP doesn’t help us because our debts are held in nominal terms. But it will not be easy for Japan’s economy to achieve nominal growth soon.’
Ogawa, too, is wary of the effects a tax increase now would have on the economy.
‘We need to look at the macroeconomic condition on the ground level. Because the wrong time and the wrong implementation could actually reduce public revenue.’ Ogawa says.
Keio University’s Doi, however, is far more bullish about getting on with a sales tax hike. He dismisses the idea that the sales tax rise led to the return to recession in 1997.
‘My understanding of the situation in Japan in 1997 was that the increase in consumption tax didn’t cause the recession. That was a financial crisis. Raising the sales tax didn’t trigger the bankruptcies of Yamaichi Securities or Hokkaido Takushoku Bank. The problem lay with the delay in tackling the bad loan problem, which should have been sorted out earlier. This coincided with the Asian financial crisis in the summer of ‘97, which exacerbated the situation, leading to the failure of the two major financial institutions. I think the increase in the consumption tax was a minor factor in all of this.
‘Now an increase in the consumption tax does have a negative effect on the economy, but that’s not enough to justify putting off a tax hike into the future. If we do that, the financial situation will get worse and we’ll end up having to raise the tax even more in the future. Taking an extreme example, if we raise the sales tax to 15 percent and keep it there for 20 years, that might be enough. But if we wait 5 years with the rate at 5 percent and then only gradually increase it, we might end up having to take it up to 25 percent.’
Doi argues that in any case a sales tax rise won’t be politically possible until after the next general election.
‘Realistically, it won’t be possible politically to raise the consumption tax until 2013. By then the influence of the global financial crisis will have almost gone. I don’t know what the growth rate will be like then, but the situation should be better than it is now. So raising the sales tax in 2013 will be almost our last chance to avoid heading toward a debt crisis like Greece,’ explains Doi, who says the tax should be increased to 10 percent in 2013 and to 15 percent before 2020.
But that’s not the only tax change Doi would like to see. Doi and a group of like-minded economic scholars published a book last month on the need for a general tax overhaul in Japan. In the book, Doi and his co-authors call for an increase in the consumption tax, a lowering of corporation tax and a widening of the income tax base.
Doi claims that when it comes to income tax, in particular, only 40 percent of income is actually taxed, the rest being removed from the taxable base in the form of deductions. These deductions need to be scrapped, he says, and a preference for tax credits adopted instead.
One Tax Goes Up and Another Goes Down?
As for corporation tax, he believes lowering it in line with European nations, for example, will help put Japanese businesses on a more level playing field with their global competitors, and will ultimately increase tax receipts and improve competitiveness.
‘The semiconductor industry is quite a famous example. There are firms making quite a lot of profit such as Toshiba and NEC that are paying up to 40 percent in taxes. But the rate for rival Samsung (in South Korea) is nothing like that,’ Doi says. ‘It pays about 20 percent and can use the difference to invest in plant and equipment or a next-generation chip factory. Under those circumstances can you beat Samsung? It’s not the same in every industry, but in some particular ones, the situation is pretty serious.’
As for the future swelling of tax receipts, Doi claims that in Europe, countries have seen an increase in tax receipts after five years after cutting the tax rate. The current corporation tax rates effectively add up to 40 percent in Japan. Doi argues that this is a sufficiently high level to benefit from this rate-receipts paradox.
Ogawa, however, warns against a lowering of corporate tax before or at the same time as an increase in the sales tax.
‘Before cutting corporation tax or income tax, the government has to have its house in better order. It can’t afford to continue with a deficit of this size,’ he says. ‘It’s issuing more debt than it’s getting in tax revenue. I don’t think that is sound. I agree the corporate tax rate needs to be cut, but by cutting the tax you are giving away the money faster, then waiting for it to come back. But it might not come back.’
Meanwhile, raising the sales tax while cutting taxes for business will send mixed signals to the electorate, fitting in with claims that the real agenda of Kan’s talk of increasing the sales tax is to pay for a tax cut for big business.
The Japanese Communist Party and other groups flatly opposed to any increase in the sales tax point out that it’s regressive in nature and that it isn’t as insignificant as the 5 percent figure implies. Most European sales taxes exempt or impose lower rates on food and other daily essentials, but Japan’s does not.
At the same time this means that the tax generates far more income than its 5 percent figure suggests. A quick comparison of revenue shares reveals that the UK’s 17.5 percent VAT was estimated to raise £81 billion in fiscal 2010, or 30 percent of the combined projections for income, sales and corporation tax. In Japan, the sales tax is estimated to raise 9.6 trillion yen and this is 34 percent for the three combined taxes—a surprisingly high proportion.
A Poll to Vanquish or Re-establish the Taboo
Kan has already talked of the need to lower the sales tax burden on low-income households, but what kind of solution will he come up with? How will he achieve growth and tax hikes at the same time, as he claims is possible? Will the DPJ be able to cut back on spending while maintaining at least some of its previous election pledges? How will Kan stimulate growth without adding to Japan’s fiscal problems? And how will he convince voters that it’s fair to lower the corporation tax alongside an increase in consumption tax?
There’s a lot to sort out and his ability to tackle these issues will depend to a large extent on Sunday's election, which could leave him with an outright majority (and something of a sales tax hike mandate), needing coalition partners or even case-by-case cooperation with other parties just to push legislation through the Diet.
What is for sure is that while the European sovereign crisis has helped make it easier for Japanese politicians to talk about raising the consumption tax, a lot more debate will be required before any tax hike becomes reality. In the meantime, Japan’s mountain of debt will continue to grow.