Prime Minister Abe’s medium-term plan to bring government deficit spending under control by 2020 is nothing short of an Olympic challenge. Leading economist Takatoshi Ito said it likely involves raising Japan’s consumption tax to European levels with possible deep cuts to socialized health care and pensions. With good leadership, he said, the country could avoid a serious crisis. In an exclusive interview with Beacon Reports, Professor Ito explained his proposed road map to achieving fiscal sustainability by 2020 and the hurdles to be overcome.
Prof. lto is noted for his early and outspoken support for the Bank of Japan’s (BOJ) 2% inflation target policy, designed to enliven Japan’s ‘animal spirits’ and end 15 years of deflation. He recently led a task force to reform the ¥130 trillion ($1.2 trillion) Government Pension Investment Fund. The former policy advisor will shortly join the faculty at Columbia University after 12 years as a University of Tokyo professor and dean.
Prof. Ito believes a rise in the consumption tax to 10% in Oct. 2015 is just a start of further tax hikes to come. “That rise is a done deal unless something terrible happens between now and December,” he said. To close the nation’s primary balance by 2020, he added, a hike to 15% is needed “with good economic growth” or to 20% “without a spurt of growth.” His proposed road map includes the adoption of new tax legislation in 2017, with rate increases scheduled for 2018 or 2019. The expected construction and tourist boom in the run up to the 2020 Olympic Games, he thinks, makes for an ideal time to hike the tax rate further from 15% to 20%.
A hike to 20% may still not be enough. Each year the government issues roughly ¥40 trillion of new debt to cover deficit spending which so far has caused the national debt to swell to 2.4 times GDP. Each one percentage point tax hike equates to ¥2.8 trillion of additional tax revenue. Prof. Ito estimates a consumption tax rise from 10% to 20% still leaves the annual deficit in the ¥10 – ¥15 trillion range.
To fill the gap, the professor reckons the government could raise the consumption tax to 25% or cut health care and pension costs (social entitlements) which amount to ¥30 trillion and consumes 1/3rd of the national budget. When asked if it was realistic to cut social entitlements in half from ¥30 trillion to ¥15 trillion, he responded, “I think cutting them in half would be politically impossible,” highlighting the challenge the Administration faces.
A key problem is that social entitlement schemes were devised in the 1960s and 1970s when the country was growing at the average rate of 10% each year and life expectancy on average was only about 70 years. “Japan’s pension plan assumes a 2% or higher growth rate when the new normal potential growth rate is between .5% and 1%”, Prof. Ito noted. So long as there was sufficient growth, the government could afford to be generous with pensions. “But when the growth rate declines and population growth turns negative,” as is happening to Japan, said Prof. Ito, “the infinite Ponzi scheme ceases to work.”
In fact Japan’s labor force on a per person basis is as productive as in other advanced nations. By that measure, productivity growth is roughly 2% every year. What sets Japan apart is its shrinking workforce and aging population, which drags the overall growth rate down by 1% or 1.5%. “It’s that subtraction that’s tough,” said Prof. Ito, because “Japan must pay for mounting debts, growing social entitlements, national defense and so forth.”
Meanwhile, social entitlements are growing by ¥1 trillion each year and are expected to explode in 10 years’ time when the first baby boomers turn 75 years old. These increased costs could be covered by raising the consumption tax a further 1% every other year, said Prof. Ito, but he feels it would be wiser if the Administration were to consider cutting social expenditures instead. “The consumption tax is a powerful weapon,” he said, warning that, “Once you exhaust it, it’s ‘game over’.”
To contain entitlement costs, the professor suggests reforming the old-age pension system by slowly increasing the retirement age at which people are first allowed to draw on their full pensions (now 65 years of age). Health-care benefits could be means-tested and co-payments to receive them increased. “The Administration needs to pick and choose” the best options, he said.
Prof. Ito predicts the government will be forced to claw back pensions from those already retired and to downsize those nearing it. Also, young people won’t receive a 1:1 distribution on what they paid into the system over their lifetimes. The shortfall will go to pay pension costs already accrued to previous generations. He advises today’s youth to enroll in a private pension scheme, even though that means bearing a double pension burden.
The professor believes Japan has a ten year window to achieve fiscal consolidation during which there is little risk of capital flight. Currently household savers and corporations are indirect owners of most of the nation’s debt. Banks and other financial intermediaries take their deposits and buy government bonds. “As long as they continue to pour money into those financial institutions,” he said, “then intermediaries are happy to continue buying bonds.” But as baby boomers begin to draw down their life savings, the inflow of deposits to financial intermediaries will shrink and so will their capacity to hold bonds. “In 10 years this will become a serious constraint,” Prof. Ito added.
However, there is risk of a bond crash which “may happen at any time,” he said. The risk is mitigated by the Administration’s monetary policy called quantitative and qualitative easing (QQE). Under QQE, the BOJ is buying huge amounts of debt from financial institutions. This lowers bond returns, causing the value of the yen to fall and forcing investors into higher yielding, riskier assets. It also shifts the risk of plummeting bond prices onto the public sector. “QQE socializes bond-crash risk,” Prof. Ito said, adding, “That’s okay because the central bank does not need to maximize profits. They don’t have to mark-to-market and can endure a crash. We only have to worry if the government becomes complacent by issuing debt to pay for an expanding structural deficit.”
Provided there is proper leadership from the Administration, Prof. Ito thinks a serious crisis is avoidable. That entails Abe pushing through ‘third arrow’ reforms and not falling afoul of moral hazard when pursuing stimulative ‘first arrow’ QQE measures. Overall, he believes the Administration’s policy of monetary easing and fiscal tightening should contribute to the expansion of Japan’s economy.
Read the full interview here.
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