Pity the Japanese economic policymaker. Even before the triple whammy of earthquake, tsunami, and nuclear crisis struck in March, Japan was facing the mother of all fiscal headaches. With public debt climbing to new heights, the government was facing an increasingly urgent dilemma: should it try to improve public finances with fiscal austerity measures, or continue to spend in the hope that the persistently weak economy would rebound.
That dilemma is even more pressing now. Japan faces the most expensive recovery bill in history and a serious setback to its economy. Under the circumstances, fiscal hawks will need to wait. But at some point, Japan will have to combine deficit reduction with fiscal expansion. Orthodox approaches that put one before the other haven’t worked so far, and given demographic trends they are unlikely to help in the future.
The Road to Crisis
It’s customary to blame the economic bubble era of the late 1980s for Japan’s current fiscal mess, but in fact the bubble was merely a symptom of an underlying condition: Japan’s postwar hyper-industrialization policy. Widely written about at the time, the policy turbocharged Japan’s reconstruction and industrialization. By the 1980s, though, it had reached the end of its effective life—Japan had caught up and was at full industrial capacity.
That left business looking for new places to put its money. Always a combustible situation, the Bank of Japan (BOJ) added a match when it cut interest rates to combat a rising yen. The cheap money encouraged speculation, called zai-tech (literally, ‘financial technology’), a curious term designed to sound cutting-edge and sophisticated, but which really signalled companies getting in way over their heads with ill-advised investments.
Noted Tokyo-based economist Richard Koo estimates that the inevitable collapse of the bubble wiped out 1.5 quadrillion yen in wealth—about three years’ worth of Japanese GDP. This compares to about one year’s worth of GDP lost by the United States during the Great Depression. Yet Japanese economic activity never experienced anything like the collapse seen in 1930s America. In fact, GDP never dropped below its bubble peak, even though private-sector borrowing and investment contracted sharply as corporations and banks struggled with a mammoth debt hangover.
Japan was able to avoid the soup kitchens because the government responded throughout the 1990s with the classic Keynesian approach of vigorous fiscal spending, which plugged the gap created by the collapse in corporate investment. Combined with dwindling tax revenues from the reduced private-sector activity, this spending expanded the public debt throughout most of the 1990s, albeit to still manageable levels. The approach had the same effect as US spending during World War II, which finally ended the Great Depression.
A Pernicious Problem
Now, had Japan been enjoying the same population growth as 1940s America, the Keynesian approach would have sufficed. A rising population would have created fresh demand for houses, cars, washing machines, TV sets, and other products, and as soon as corporate Japan had paid down its debt—and it mostly had by the 2000s—it could have returned to investing in productive assets once again.
But Japan entering the 2000s was in a very different position: the working population was already in decline, and this was soon to be followed by overall population contraction. Long-term population decline is unprecedented for a modern industrialized economy, and conventional economics really doesn’t have an answer for it, because a shrinking population busts important assumptions about investment and borrowing. And yet the demographic impact on Japanese business is often overlooked by economists, including Keynesian spenders who are still waiting for the private sector to pick up the reins.
The consequence of population decline was that even when Japanese companies had paid down their bubble-era debt, they saw little reason to invest domestically and even less reason to borrow. Why would you, if your market is shrinking? So they began to save instead. With nobody borrowing, conventional monetary policy was ineffective. The BOJ slashed interest rates to near zero and flooded the financial system with cash, but it never entered the real economy because banks couldn’t lend it out. The only entity borrowing was the government, and so that’s where the largesse went. By the end of the decade, almost half of listed Japanese companies had more cash than debt, with cash alone of about 200 trillion yen.
Individual Japanese have been going in the opposite direction: an aging population is just now beginning to draw down its savings, and individual savings rates in Japan are now at the levels of other developed nations. Still, that comes after a long period of thrift, and household savings have reached about 1,500 trillion yen ($18 trillion).
This lack of aggregate demand has created a deflationary environment, which makes the situation much worse, especially for the indebted government. Nominal GDP contracted along with tax revenues, while the real value of the debt increased. Deflation encourages savings and discourages investment and consumption, further weakening the economy.
A modest rebound in the middle of the last decade as companies made some long-delayed productivity investments and exports performed solidly couldn’t hide the fact that the Japanese economy was already struggling for a second decade in the 2000s. The weakness was exposed in the global financial crisis, when Japan was one of the countries hardest hit by the fallout, with industrial output and stock prices plunging to unprecedented lows. The government did its best with fiscal spending, but it was increasingly constrained by further falls in tax revenues, and public debt began to climb to even more worrying levels.
Heading into this year, the lack of tax revenues has been the key to Japan’s fiscal problems. According to the OECD, Japan took in nearly 66 trillion yen in individual and corporate income taxes in 1991. By 2009, that had fallen to 36 trillion yen. Demographic and economic trends, not to mention political realities, make it hard for the government to cut spending meaningfully. Bond issues make up the difference, producing the gargantuan public debt.
Fiscal Armageddon or Fiscal Utopia?
This mounting debt has prompted a vigorous debate. Is Japan on a fast train to collapse, or can it continue to issue new bonds indefinitely?
At the start of 2010, some doomsayers were predicting that Japan would default—or at the very least would face a severe fiscal crisis. Japan, they argued, was in worse shape than some of the European countries then receiving bailouts. Such claims were fuelled by headlines claiming that Japanese public debt was heading beyond 200 percent of GDP—more than any other country bar Zimbabwe.
But there are a number of problems with this argument, starting with that headline figure. The 200 percent or more of GDP is gross debt—all debt owed by all agencies of the Japanese government. Since many Japanese government agencies owe debt to each other, it’s double counting—like including money a husband owes his wife when calculating the total debt of a household. It also doesn’t consolidate the considerable Japanese government bond (JGB) holdings of the BOJ, which is effectively government controlled. For the purposes of assessing sovereign risk at least, net debt is the more realistic figure. In fact, net debt was heading to about 113 percent of GDP in 2011, not quite as much of an outlier.
Second, all but 6 percent of the debt is held by domestic investors. The Japanese government has enjoyed a captive market for its bonds, because there’s so little demand for private-sector borrowing (which also means that total debt, public and private, is far less worrying). With few competing demands, the government has been able to benefit from very low interest rates, although deflation makes real rates somewhat higher. With few foreign holders, it doesn’t have to compete with overseas interest rates to attract investors. Despite years of worries about Japan’s debt, there have been no signs of an increase in bond yields; there has just been too much cash parked in the financial system with too few places to go.
Third, unlike those European countries, Japan’s public debt is denominated in a currency that it controls. It can print yen at will. For this reason, it won’t default. Rather, the BOJ would monetize the debt (although that ultimately produces a frightening scenario of its own).
For these and other reasons, some observers are much more sanguine about Japan’s debt problem. They see Japan representing a new reality: an aging population saves money and demands low-risk assets and so provides an ongoing source of investors for government bond issues. This argument has strong support from Japanese bond yields, which haven’t shown any signs at all of responding to mounting debt levels. Rather than trying to raise tax revenues, these analysts argue that the government should continue spending to stimulate the economy while proceeding with structural reforms. In a worst-case scenario, they say, the government can turn to the central bank to buy the debt.
So, can the government really forget about debt? No. The problem with this argument is that it overlooks the costs of servicing. Net debt may be a better measure for overall default risk, but it’s gross debt that has to be serviced. Even at the very low interest rates that the government still enjoys (about 1.5 percent), annual interest payments already account for about 25 percent of tax revenues, while total debt service costs are double that. That puts Japan in an increasingly risky spot. If the day did come when investors baulked at buying new Japanese government bonds, or JGBs, and a spike in bond yields resulted, the government could very quickly find itself in considerable difficulty.
This is why the BOJ has been so cautious about being seen to be monetizing the debt—the fear of inflation expectations and an interest rate spike. A full-bore undertaking by the central bank to purchase the debt runs the risk of creating another Weimar Republic.
The other factor that lends urgency to the debt question is that in a country that’s aging and shrinking, household savings have their limits, and Japan’s appears to have peaked. This comes at a time when the trends are all in the direction of higher government spending and lower tax revenues. Japan’s rapidly aging population will placing increasing burdens on healthcare and social security, while its declining workforce and departing companies will produce less tax.
How should we assess Japan’s public debt level? The bottom line is that eventually it’s going to be unsupportable—demographics alone ensure that. It’s important to avoid the mistake of thinking that just because a fiscal crisis didn’t occur yesterday, that it won’t occur tomorrow. The problem isn’t the absolute debt level, but the cost of servicing it relative to revenues. Interest rates are low now, but even a very small rise could rapidly create considerable discomfort. The question is, when will the crunch occur? The consensus among local economists is that Japan probably has until the end of this decade. Yet political pressure is likely to demand action before then.
Few Good Options
So what’s a country to do? That’s the question now being debated in Japan. Fiscal hawks demand austerity measures, including cuts in ‘wasteful’ spending and tax hikes, with the consumption (sales) tax—low by international standards—the preferred target. In a country where aggregate demand is as weak as it is in Japan, spending cuts and a consumption tax hike are likely to be counterproductive, at least in the short term. In reality, it’s hard to see how Japan would be able to close its budget deficit without an eventual hike in the consumption tax, but it’s equally hard to see how fiscal austerity alone can solve Japan’s problems without it accepting a very painful economic contraction.
Fiscal doves, on the other hand, call for more demand-side measures. The idea is to use Keynesian spending and ongoing reforms to return the economy to growth, and get tax revenues back to where they were. That would restore a healthy economy and prove the ultimate fix to the fiscal crisis. The idea is appealing, and doubtless demand-side measures are needed in Japan.
The problem is that Japan has been trying to do exactly that for 20 years and it has yet to produce a truly sustainable recovery. That’s not surprising when the population is shrinking—the new normal for Japan is contraction, not growth. This can be offset for a time by productivity growth (the other factor in GDP), and indeed, Japan has outperformed certain OECD peers in that regard in recent years. But as the population declines, it becomes increasingly difficult to make up the gap with productivity improvements alone. With this approach, Japan runs the grave risk of another decade eking out meagre growth returns on massive spending, leaving itself even worse off in 2020 than it is today.
Breaking from Conventional Wisdom
Ideally, Japan would be able to combine new taxes with growth policies, but the two are mutually exclusive. Or are they? Certainly, raising taxes on private and corporate income and on spending (which includes capital spending) counteracts expansionary fiscal policies. But might there be another tax that doesn’t?
Perhaps Japanese policymakers should also be looking to base their tax policy on where the money actually is, rather than where they would wish it to be. In Japan, the money is in wealth, not incomes. According to the Statistics Bureau, Japanese financial sector and nonfinancial corporations hold a massive 3.6 quadrillion yen in gross domestic financial assets
The Japanese government is already tapping this money, but through borrowings, not taxation. As we’ve seen, the government needs more revenue, not more debt.
There are two ways to tax wealth. One way is through inflation. Inflation reduces the value of savings, like a tax, and simultaneously reduces the value of the money the government has borrowed. As an added bonus, it would weaken the yen (helping exporters) and encourage consumer to spend today, rather than postponing their purchase. Tax revenues would increase in nominal terms. For that reason, many pundits call for the Bank of Japan to up its efforts to trigger a healthy inflation rate (usually seen as about 3 percent).
Japan does indeed need to return to modest inflation, but that needs to happen after it has slashed its reliance on bond issuance, not before. An inflation rate tomorrow of, say, 3 percent, could mean that the government will face triple the interest rate on new bond issues. That would very quickly get nasty. If, on the other hand, the government was able to slash its bond issuance, then a modest inflation rate would be very helpful, raising nominal GDP and tax revenues against the fixed nominal values of outstanding debt.
A Balance Sheet Tax for Japan
The other way to tax wealth is with an asset tax. Asset taxes already exist in various forms—property taxes are an example. Countries such as France and Switzerland levy a tax on individual net worth. Pakistan, which has its own fiscal problems, has been weighing the introduction of a draconian-sounding ‘Gross Asset Tax’ on companies. Similar taxes have been proposed in recent years for the financial sector. The global financial crisis brought calls for a bank tax, or financial transactions tax, to generate revenue and rein in the runaway growth of the financial markets. (The taxes are actually on bank liabilities, which are mostly deposits.) Naturally, there was considerable resistance from financial institutions themselves. The most notable criticism is that banks would pass the costs on to regular customers, in the form of higher charges and interest rates.
Asset taxes do have problems with effectiveness, liquidity, and fairness. For a start, a wealth tax on individuals simply encourages offshoring of money. And a gross asset tax such as that proposed in Pakistan can create all sorts of liquidity problems. Consider heavy industry, with huge fixed assets such as plant and equipment relative to cash flow. It would be much more severely pressed to pay a gross asset tax than, say, a fabless manufacturer.
These problems can be alleviated with some modifications. First, to avoid money escaping offshore, impose the tax on the consolidated balance sheets of companies either incorporated or with their principal place of business in Japan (to avoid companies setting up overseas holding companies). This would make it much harder to remove assets from the taxman’s purview. Foreign companies operating in Japan would be subject to the tax on their Japan operations only. Since this would be fairly easy to minimize, it wouldn’t deter inward foreign direct investment, which Japan desperately needs. Yes, it would constitute an advantage for foreign firms, but no more so than special tax breaks many countries offer to entice FDI.
Second, limit the taxable assets to financial assets only, excluding plant and equipment. This would remove the unfairness for capital-intensive firms, and would attenuate the problems with liquidity.
Third, impose the tax on all companies, financial and nonfinancial, but tax financial companies, which naturally have much larger financial assets, at a lower rate. In reality, it would be two separate taxes.
Finally, although taxing financial assets alone does help alleviate the liquidity issues of an asset tax, it doesn’t solve them altogether. A firm that had financial assets, but which also had burdensome liabilities falling due, may not have the funds to pay the tax. Limiting the tax to net assets is one possibility, but it would encourage firms to try to inflate their liabilities. Linking the tax to profits is another possibility, but even before the financial crisis, only about a third of Japanese companies were claiming profits for tax purposes. A more effective approach might be to use a sliding scale of tax rates based on the size of the company, as measured by sales, and then allow for applications for exemptions based on criteria such as insolvency. (In an ideal world, the government would base an asset tax rate on return on assets, indexed to industry averages, and penalize companies with lower returns on assets by charging higher asset taxes.)
So how much revenue would this raise? It depends on numerous factors, most notably the tax rate(s) applied and the definition of ‘financial assets’ used. If the tax office managed to tax all 3.6 quadrillion yen in gross domestic financial assets in the hands of the private sector, then an average tax of 0.05 percent (higher for nonfinancial companies, lower for financial companies) would generate 1.8 trillion yen in tax revenue. A 0.05 percent rate is much lower than most wealth taxes. For every 100 million yen in financial assets you had, you’d have a tax bill of 50,000 yen, or in US dollar terms, $500 for every $1 million.
A Helping Hand from the BOJ
Additional tax revenue of 1.8 trillion yen would no doubt be welcome, but it wouldn’t solve Japan’s fiscal problems. Since most financial assets are held by the financial sector (2.8 quadrillion of the 3.6 quadrillion figure cited above), any additional increase would have to come predominately from that sector. However, raising a tax on gross financial assets of financial sector firms quickly becomes burdensome. Take the largest of them in Japan, the Mitsubishi UFJ Group. In has about 200 trillion yen in total assets, mostly financial, and in a good year will report somewhat less than 1 trillion yen in net income. A 0.05 percent tax on 200 trillion yen is 100 billion yen ($1.2 billion), which would represent a significant increase in its tax bill.
And no doubt financial institutions would be quick to pass on the costs to customers. To a certain extent, this might be viewed as replicating a wealth tax on individuals. Ultimately, everybody in Japan is going to have to foot the bill one way or the other. However, the burden could also be reduced with help from the BOJ.
The much-maligned BOJ has responded to political pressure to ‘do something’ about deflation with some remarkably aggressive quantitative easing. Unfortunately, the liquidity it supplies won’t reach the real economy as long as demand for borrowing is weak. Where the central bank does make a difference is in its purchase of JGBs in the secondary market. The BOJ now buys 1.8 trillion yen of the bonds every month in a move it insists is a fund provision measure (and not a debt monetization one; even though it has essentially monetized a significant chunk of the debt).
That money does reach the real economy, but at the cost of additional government debt. Perhaps the BOJ might then be willing to provide the liquidity to help the financial sector fund the government through tax, rather than through debt. It could provide additional zero interest-rate funds that financial institutions could invest for profit, or it could even become one of the relatively few central banks that issue their own bonds. The profits made by the financial institutions could be used to offset an asset tax at somewhat higher rates.
That would be inflationary, but no more so than supplying cash to the financial sector to purchase bonds. And that programme to date has had no impact on inflation.
Lowering the Corporate Tax Rate
The other sweetener that could permit a higher asset tax rate is a reduction in the corporate income tax. In fact, coming into 2011, the government of Prime Minister Naoto Kan had announced a 5 percent cut. The effective rate in Japan is 39.6 percent, significantly higher than its neighbours. After the March 11 disaster, the planned cut was put on hold. It needs to be reintroduced.
Corporate income tax revenue has been falling dramatically in Japan, from a high of 18.9 trillion yen in fiscal 1989 to a low of 6.3 trillion yen in fiscal 2009, at the height of the global financial crisis. This is the principal factor in the decline of overall tax revenues, and it reflects the steady erosion of private sector activity. So, even a steep cut in the rate isn’t going to represent a large loss of tax revenues.
Clearly, a dramatic gesture is needed. Japanese companies are increasingly shifting the focus of their operations to overseas markets, recognizing the lack of domestic growth opportunities. And Japan has always struggled to attract inward foreign direct investment—a task that will be much more difficult in the wake of the recent disasters. These trends suggest a gloomy outlook for economic activity in Japan, and they need to be reversed.
Assuming Japan did introduce an asset or balance-sheet tax, then a slashing of corporate tax revenues, to 25 percent or even lower (15 percent would make Japan very competitive within its region) could be nicely complementary. It would certainly help dampen corporate opposition to a new tax. It should also be accompanied with reforms to expand the tax base, since only about a third of Japanese companies actually pay corporate income tax.
Now, it’s a shibboleth of supply-side adherents that tax cuts always pay for themselves in the form of higher economic activity, but there’s ample evidence to support the concept of the Laffer curve with corporate tax. Many European countries have slashed corporate tax rates in recent decades, to find that corporate tax revenue as a percentage of GDP has risen. That’s unlikely to happen with a cut to 15 percent, but corporate tax in Japan begs for reform.
Assuming, as seems likely, that Japan has a few years until its fiscal situation becomes unsupportable, it could ease into this tax reform with a start that is only mildly revenue-positive: a steep cut in the corporate income tax rate more than offset by the introduction of a corporate financial assets tax at a modest rate, leaving just enough left over to fund some additional demand measures. The growth effect of the lower corporate income tax could subsequently make a hike in the consumption tax easier and more effective.
Something to Spend On
So assume for a moment that Japan actually did go ahead and adopt a balance-sheet tax, offsetting it with a major cut in the corporate income tax rate. As a consolidated balance-sheet tax, domestic Japanese companies would have to pay the tax, no matter where they parked their money. The incentive would be to move money out of financial assets such as cash, either investing it in non-taxable productive assets or returning it to shareholders—both actions good for the economy. For financial institutions, the incentive would be to avoid inflating their balance sheets, also desirable. (Tokyo’s goal of becoming a major financial centre is ill-advised.) The incentive to relocate offshore would be attenuated by the much lower corporate tax rate in Japan. Foreign companies may also begin to take another look at Japan.
That’s all well and good, but if the Japanese market is in decline, what incentive is there to invest? A lower tax rate alone won’t prompt companies to build new facilities if they are going to be over-capacity. Here’s where demand-side action is needed, to accompany the supply-side tax measures.
Fortunately, Japan already has the answer to this. In 2010, it introduced ‘eco subsidies,’ encouraging the purchase of energy-efficient cars and electronics. The programme was a major hit, the only problem was that it ended when the government ran out of money. It serves as a useful indicator of where Japan could find new demand: a green revolution that could touch on virtually every aspect of the economy. If Japan did ease its budget pressures somewhat with a new tax, this would seem the obvious place to spend to encourage demand.
The previous Japanese government already had a plan to reinvigorate the economy through environmental innovation (borrowing from US President Barack Obama, circa inauguration). The plan should be dusted off and reintroduced. For one thing, the appeal of alternative energy is greater now than ever, in the wake of the Fukushima I Nuclear Power Plant accident, and not surprisingly Kan announced on May 10 that his government was scrapping plans to boost its reliance on nuclear power from 30 percent to 50 percent, and will instead turn to alternative energy. There’s talk of rebuilding the disaster-stricken areas northeast of Tokyo as centres of solar and wind power. That would seem a particularly appropriate response, and could also stimulate substantial new investment. A new Japan indeed.
Another major area of potential new demand lies in the service sector, which significantly lags its OECD peers in productivity. Overregulation and a lack of competition discouraged the kind of investment in information technology that the US service sector made in the 1990s. This is why Kan’s plans to join the Trans-Pacific Partnership are so important: the competition would stimulate investment in service sector reforms. Japan has one of the largest service sectors in the world, as a percentage of GDP. Reform would have a powerful impact on the economy and could be done without government subsidies.
There are, of course, other possible ways to stimulate demand, all debated extensively in recent years: encouraging immigration, reducing the opportunity cost having children represents for Japanese women, and reforming the farm sector. The stumbling block has always been resistance from those whose interests would be threatened by change. Still, Japan has in recent decades slowly moved in the direction of reform, and that’s unlikely to change. In the meantime, a green revolution is a good way to start.
Japan as Innovator
Of course, some might find much that is wrong with these ideas. Indeed, the whole concept of a financial assets tax may strike some as ridiculous. But Japan is through the looking glass, and perhaps ‘ridiculous’ is needed. Clearly there would be concerns: the plan favours profitable companies (although that’s not such a bad thing), taxable assets would need to be defined, there’s concern about the impact on demand for JGBs and what might happen to interest rates. There would still be issues with companies trying to remove assets from the balance sheets. No doubt, the proposed role for the BOJ would be disturbing for some.
Of course, it would be nice if Japan could just announce a new tax that displeased nobody and solved all of its problems. The reality is likely to be much more complex. But the important thing here is not so much to present a neatly wrapped solution, but to underscore the need for Japan to get innovative about its tax policy and to switch from industrial-era macroeconomics to policies geared to a post-industrial nation: cash-rich, demand-poor. In such a nation, trying to squeeze additional tax revenues out of income and spending is like trying to get blood from a stone.
The other major challenge is that for as long as the Japanese population is in decline, it will always struggle to achieve growth. New taxes, green revolutions, and other technological (productivity) breakthroughs can buy time, but without immigration or a higher birthrate, Japan’s economy will always be tending to contract. The domestic reckoning for the corporate sector will always be shrinking markets. Lack of productive opportunities will always tend to prod companies to unwise investments; Japan was fortunate that the incipient J-REIT bubble of the mid-2000s was pricked early by the global financial crisis. Only through constant productivity innovation will Japan have a chance of managing its contraction gracefully.
For most of its modern economic history, Japan has been a follower. In both the Meiji era and the postwar economic boom, it succeeded by importing and modifying the practices and technologies of the world’s leading economies. Even in recent years, from the Japanese ‘Big Bang’ to J-SOX and J-REITs, the government has favoured reforms tried overseas first.
Now, for the first time, Japan finds itself with nothing to copy. It’s an outlier in statistical measures; its problems are unique. This is mostly a demographic issue, which explains much of the lag in its economic performance over the last two decades. Immigration has helped other industrialized nations postpone the post-industrial malaise. From the US budget crisis to Italian underperformance, there are indications, though, that the problems Japan faces today are problems that await its OECD peers.
That’s the other side of the coin, of course: the opportunity for Japan to define success in the post-industrial age. Only new thinking will do the job.
James Pach is the publisher of The Diplomat and the founder of Trans-Asia Inc., a Tokyo-based translation and investor relations company.