Column  Finance and the Social Security System  2014.02.28

In the end, by how much does Japan need to increase taxes?

On the 2nd of December 2013, the CIGS Policy Conference titled "Abenomics and sustainability of the public debt" was held. At the conference, possible scenarios of Japanese public finance based on three different types of economic modelling were presented. The idea, "Even if the consumption tax is increased to 10% in October 2015, it won't be enough to maintain healthy Japanese finances." featured in each scenario, so this can be regarded as a consensus. All of the attendees agreed about the necessity of a further tax increase and additional expenditure cuts including social security costs.

However, I could see that three speakers (Dr Takatoshi Ito, Dr Selahattin Imrohoroglu, and Dr R. Anton Braun) had different ideas about the extent of tax increases and expenditure cuts eventually needed for Japan. I'd like to elaborate on those differences in this essay.

The report by Dr Takatoshi Ito (Hoshi and Ito 2013) said that a consumption tax increase to 20% or 25% will be necessary and sufficient to maintain a manageable level of public debt. On the other hand, the report by Dr Imrohoroglu (Hansen and Imrohoroglu 2013) said that consumption tax would have to be increased to around 60% from 2019 to 2087 and then stabilized at 47% to maintain manageable levels of public debt if consumption tax is the only thing to be changed. Finally, Dr Braun (Braun and Joines 2013) found that the consumption tax would have to be gradually increased to around 53% by around 2070 to maintain a stable level of government debt (It could subsequently be decreased little by little in the first half of 22nd century to an eventual terminal level of 40%.).

Dr Ito's report implies that the fiscal sustainability can be maintained by relatively low tax increase (25% consumption tax), while both Dr Imrohoroglu's and Dr Braun's seem to imply that the debt problem of Japan is much more severe than what Dr Ito's analysis implies. Although Dr Imrohoroglu and Dr Braun also suggested various policies other than a consumption tax increases (for example, the expansion of women's participation in the workplace and acceptance of immigration to increase tax revenue, or increasing the rate of individual contributions to health expenditure for old people from 10% to 30%, gradually over 40 years.) I suggest you read their essays if you need more information.

Now, I will examine the difference methodology, focusing on the differences in their perceptions of the severity of the situation in Japanese public finance. (There are many points in common between Dr Imrohoroglu and Dr Braun, so I'd like to focus on the differences between Dr Ito and Dr Braun.)

1. Differences in how to estimate social security expenditure

In the Hoshi and Ito essay, the amount of social security benefit is calculated by regression analysis, using GDP and population of the elderly (over 65 years old). These factors have a linear relationship. On the other hand, in the Braun and Joines essay, they consider that the amount of medical expenditures will change depending on age, and will be especially high in old age. Accordingly, the amount of social security expenditure is estimated, based on the changes in the age pyramid calculated down to a precise level. It wasn't clear in the presentation, but in the Braun and Joines essay social security expenditure is expected to increase rapidly, in a non-linear fashion. If this actually happens, the predicted amount of government expenditure in Braun and Joines seems to be much higher than in Hoshi and Ito. As the result, there is a difference between Braun and Joins and Hoshi and Ito in the predicted required level of tax increase needed for fiscal reconstruction.

The forecast of social security expenditure in Hansen and Imrohoroglu (2013) is taken from Fukawa and Sato (2009) estimates. They estimate that the social security expenditure will increase by 7% GDP from 2010 to 2050. Imrohoroglu, Kitao and Yamada (2013) also estimate the same number for the increase in the aging-related expenditure. An increase by 7% of GDP is quite a large amount to be financed.

2. The difference in the inflation rate

In the Braun and Joines essay, the inflation rate is taken as fixed at 2%. On the other hand, in Hoshi and Ito, it's forecast that a 1% increase in consumption tax will cause an inflation rate increase of 2/3%. In Hoshi and Ito, it is predicted that consumption tax will continue to increase by 1% a year for 15 years up to an eventual level of 25%. In this case, the inflation rate will be around 3.7% for 15 years. That means the predicted inflation rate in Hoshi and Ito is 1.7% higher than in Braun and Joines, and will continue for some time. In the Hoshi and Ito essay, high inflation makes tax revenue and expenditure increase simultaneously, so it is difficult to see whether it would make a better fiscal balance. However, since inflation reduces the amount of debt in real terms, I predict that it will be a help in maintaining manageable levels of public debt. Therefore, the difference in the inflation rate predicted in each essay seems to be a cause of the difference in how much tax increase they estimate would be needed in the end.

3. Differences in the interest rate

In the Hoshi and Ito essay, using the rate in 2010 as a starting point, the long term interest rate is calculated to increase 2 basis points for every 1% increase in the ratio of public debt to GDP. In Braun and Joines, the interest rate is calculated by using the first order conditions and the transversality conditions in the general equilibrium model. Using these calculations the general equilibrium effect (the increase of government debt crowed out private investment) is also taken into account. Therefore, the increase in interest rates caused by increases in public debt may be a bigger factor in Braun and Joines than in Hoshi and Ito. This can be a cause of the difference in the predicted levels of tax increase required.

4. The difference in the growth rate

For a 2% growth rate in whole economy, the increase in productivity per worker needs to be about 3.6% to compensate for the decrease of economic growth caused by the decrease in population. At the time of Dr Ito's report, a 2% growth rate was presented, implying 3.6% productivity growth per worker. In Braun and Joines, the increase in productivity per worker is fixed at 2%. This difference in the predicted growth rate is likely to be a cause of difference in suggested level of tax increase. In addition to the high productivity growth, the effect on the growth rate of the consumption tax increase is small according to Hoshi and Ito. (1% tax increase causes a 0.1% decrease in productivity). On the other hand, In Braun and Joines, the consumption tax increase has a distortionary general-equilibrium effect on growth. So this point too is possibly a reason for the difference in the predicted levels of tax increase required.

In summary, Hoshi and Ito conclude that the combination of a high growth (2% aggregate growth or 3.6% per capita productivity growth) and a high inflation and 25% consumption tax can maintain the sustainability of the Japan's public debt, whereas Braun and Joines (and Hansen and Imrohoroglu) argue that a moderate growth (2% per capita productivity growth) and a moderate inflation necessitates a combination of severer policies, such as 29% consumption tax and a high copayment (30%) for elderly medical expenditures.

As I pointed out above, I think, each essay proposes important models for fiscal reconstruction. Their complexity causes the differences in how seriously they view the Japanese public finance situation and whether or not they think healthy Japanese public finances can be maintained by comparatively simple policies.

I will summarize the lessons from the three reports as the following.
•It is important for academics to examine various models and debate possible ways to maintain healthy Japanese public finances over the next century.
•They also need to compare and judge the plausibility of the assumptions and methodological frameworks of those models.
•We should admit that these fiscal problems cannot be solved without a long-term commitment to contentious policies e.g. further tax increases, cuts in expenditure, changes in immigration policy etc.

I hope this conference will prove to be an opportunity to encourage more public dialogue on the direction of the Japanese economy and Japanese public finance.

■Please refer to the event report

CIGS Policy Conference: Abenomics and sustainability of the public debt