How to solve Japan’s fiscal sustainability issues

Volume 3, no. 3, March 2015

Authors: Takashi Oshio, Hitotsubashi University and Kazumasa Oguro, Hosei University

Japan is facing a dual problem of an ageing population and increasing government debt. While pension payouts will balloon out in the next decade, a low tax base means that the government will struggle to finance this. In 2013 Japan’s gross debt-to-GDP ratio was 243 per cent, the highest among OECD countries. If the government does not implement strict reform, Japan risks a financial crisis similar to the European crash in 2009.

Whether or not Japan’s debt is actually sustainable depends in large part on whether the market believes that it is sustainable: if the investors buying Japan’s government bonds begin to believe that it may not be paid off, then they will demand a higher rate of interest on government bonds, and those higher interest rates will make the debt even less manageable. In other words, a debt crisis could be a self-fulfilling prophecy. But Japan’s government bonds have been steadily absorbed by markets and long-term interest rates have remained low. For now, it seems that market participants have confidence in the government’s ability to conduct fiscal management.

But how long can these expectations be sustained?

Social security expenditures are increasing by more than 1 trillion yen (US$8.2 billion) a year and that rate is expected to continue over the next decade. Even if Japan’s zero interest rates continue, interest payments on government bonds are projected to increase by approximately 8 trillion yen (US$66 billion) over the next decade.

If market participants expect that the future yield on bonds will be significantly negative, they will likely stop buying them, and the government will be unable issue any new bonds. The government would need to run a primary surplus (that is, a budget that is in surplus if you ignore interest repayments) in order to pay back the debt it has already acquired.
The yield on government bonds has remained stable, if extremely low, but the fiscal situation in Japan seems to be extremely poor, with governments running persistent budget deficits. The present low yield on debt therefore does not automatically mean that Japan can avoid a fiscal crisis in the future. Market expectations can change dramatically in the space of just one or two years.

For now, it seems that market participants have confidence in the government’s ability to conduct fiscal management.

To prevent Japan’s debt from exploding through spiralling interest rates, the amount of net debt needs to be less than the future stream of primary surpluses that can be used to pay it off. Japan’s net debt is estimated at approximately 140 per cent of GDP; a primary budget surplus would be needed therefore to prevent an explosion. But Japan’s primary balance is currently negative and would remain so even if the consumption tax was increased to 10 per cent. So, as social security expenditures increase, Japan needs further financial and social security reforms, and the government needs to tackle the politically sensitive hurdle of cutting expenditure.

If market expectations change as a result of a political or economic shock and the yield on Japan’s government bonds rises to 4–5 per cent, then Japan’s interest expenses — approximately 9 trillion yen (US$74 billion) — would increase four- or five-fold. While interest payments are slow to adjust to changes in rates due to the average length of government bonds, the impact of such a rise on finances would be prohibitive. If the yield on bonds increases to approximately 5 per cent, then the government would need to run primary surpluses of around 5.2 per cent of GDP in order to prevent a debt crisis.

Japan’s long-term interest rates are currently stable, despite an accumulation of government debt. But there is an undeniable risk that a change in market expectations could cause the government bond bubble to collapse.

With this in mind, Japan must carry out fiscal restructuring immediately. The government needs to provide its people with three choices: a high level of welfare with a high financial burden; a medium level of services at a medium financial burden; or a low level at a low financial burden. If there is insufficient discussion on the overall framework, the reform process will collapse. The government needs to prioritise.

If the government pursues a ‘high welfare, high burden’ model, Japan must first debate whether the increase in social security expenditures can be somehow curtailed. Japan’s financial responsibilities must be made clear. A solution may include increasing the consumption tax rate to around 30 per cent. But if the Japanese government is reluctant to increase the consumption tax above 8 per cent and instead chooses the ‘low welfare, low financial burden’ route, it must reduce its expenditure by approximately 42.5 trillion yen (US$340 billion). Only by reducing the ever-increasing social security expenditures could this sort of a figure be obtained.

Japan’s net debt is estimated at approximately 140 per cent of GDP; a primary budget surplus would be needed therefore to prevent an explosion.

So what about the ‘medium welfare, medium burden’ route? Even in this scenario it is highly likely that the consumption tax rate would have to increase to more than 20 per cent. Over the next 15 years, the Japanese government must increase the tax rate by 15 per cent and reduce government expenditure by 12.5 trillion yen (US$99 billion) to reach the effective 20 per cent tax rate.

Japan must advance its social security reforms. It should increase the pension age and increase pension taxation. The government needs to increase the share of healthcare and nursing costs that are borne by the individual rather than the state. And it should strive to curtail the natural increase in costs that will occur over the next 20 years.

The cost of benefits currently exceeds the financial capacity to pay for them, meaning that there is no balance in the system. Genuine political leadership necessitates a debate on the overall framework. Politicians must consider the financial burden that will be placed on future generations, while still helping people of the current generation. Japan’s politicians need to focus less on whether its fiscal strategy is popular and more on whether it’s right.

This commentary is based on an article written by the authors in Public Policy Review.

About the authors

_Professor Kazumasa Ogura is a Consulting Fellow at the Research Institute of Economy, Trade, and Industry (RIETI) and Professor in the Department of Economics at Hosei University. He was previously Associate Professor at the Institute of Economic Research at Hitotsubashi University. Positions he has held include Research Fellow at the Institute for International Policy Studies and Senior Economist at the Policy Research Institute at the Japanese Ministry of Finance.

Takashi Oshio is Professor in the Institute of Economic Research at Hitotsubashi University.He was previously the Professor at the Graduate School of Education, Kobe University. Position he has held include economist for J.P. Morgan and Associate Professor at Ritsumeikan University and Tokyo Gakugei University._

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