Abe’s Growth-First Fiscal Policy

Tobias Harris

Publications Abe’s Growth-First Fiscal Policy


On June 30, 2015, the Council on Economic and Fiscal Policy (CEFP), the Japanese government’s leading economic advisory council, issued the 2015 version of its Basic Policies for Economic and Fiscal Management and Reform (henceforth referred to as the “basic policy”). The basic policy is a blueprint for the government’s economic policy agenda for the current fiscal year and the following fiscal year’s budgetary process, which starts in the summer. While drafting the basic policy is often a contentious process, drafting the FY2015 basic policy was an especially challenging exercise for Prime Minister Shinzo Abe’s government.

The reason is that when Abe announced in November 2014 that he would delay raising the consumption tax from 8% to 10% in October 2015, he also promised that by summer 2015 his government would issue a new fiscal reform plan to demonstrate its commitment to fiscal sustainability despite the postponed tax hike. However, the process of drafting a new fiscal plan quickly became the setting for the latest battle between two schools of thought within the Abe government and the Liberal Democratic Party (LDP), the fiscal reconstructionist school and the growth-first school, which have been fighting over the LDP’s guiding economic philosophy for more than a decade.

In this instance, the growth-first school won: while the fiscal plan retained the government’s pledge to achieve a primary fiscal surplus—more revenues than expenditures when interest payments are excluded—by FY 2020, the government will rely heavily on boosting growth and trimming “wasteful” spending to achieve this goal instead of pursuing fundamental reforms to pension and healthcare spending and additional tax increases.

However, it is unlikely that this will be the last fight over Japan’s long-term fiscal plans, not least because the five-year program calls for a mid-term review in 2018 that could result in additional measures if it appears that the government is not on pace to achieve a fiscal surplus. More fundamentally, although Abe successfully pushed back against the fiscal hawks when he decided to postpone the second consumption tax hike, the main actors favoring more substantive tax and spending reforms remain no less committed to the belief that Japan needs to take aggressive steps to avert a financial crisis in the future.

“No fiscal health without economic revitalization”

The Abe government’s basic policy has as its motto the phrase, “No fiscal health without economic revitalization.” Reminiscent of the Koizumi government’s slogan “No growth without reform,” the Abe government’s new slogan confirms that while senior leaders have previously referred to the need to balance the twin goals of economic recovery and fiscal consolidation, economic growth over the short and medium runs is increasingly seen as the necessary precursor to solving Japan’s fiscal issues. To this end, the first pillar of the five-year fiscal program included in the basic policy is “Breaking free of deflation and economic revitalization.” The implication is that boosting incomes, consumption, investment, and profits will redound to the benefit of the Japanese state both through higher tax revenues and new innovations that will boost the productivity of the public sector. As such, the basic policy emphasizes the need for reforms to boost private-sector productivity—outlining what would amount to a “productivity revolution”—through investment in infrastructure, technology, and human capital. To realize these changes, the basic policy and the accompanying growth strategy provides a lengthy list of proposals for reforming the education system, building links between universities and venture capitalists, promoting the use of “Big Data” in the private and public sectors, improving opportunities for women, the elderly, and non-Japanese, and additional reforms to corporate governance and agricultural production.

The government hopes to extend the productivity revolution to the public sector, and the plan’s second pillar—expenditure reform—makes enhancing public-sector productivity the explicit goal of the government’s fiscal policy. Instead of a firm target for spending cuts, particularly in social security and healthcare, the administration calls for changing how the national and local governments spend their money. Direct central government subsidies are the second-largest budget item after social security expenditures (excluding interest payments), amounting to more than ¥15 trillion in the FY2015 general budget. This figure does not include the nearly ¥25 trillion in subsidies paid to local governments for eldercare, child subsidies, education, and public works. Accordingly, the Abe government hopes to at least limit the growth in these figures by encouraging local governments to use resources more efficiently, develop public-private partnerships (PPP) to deliver healthcare and eldercare, and outsource the provision of certain services to the private sector.

To the extent that the government will try to limit the growth of social security-related expenditures, it has a soft target of capping the increase of social security expenditures at ¥1.5 trillion yen through FY2018 (roughly ¥500 billion per year). It also calls for expanding the use of generic drugs by the healthcare system to at least 70% of total prescriptions by FY2017 and more than 80% by FY2020. These cuts are considerably less stringent than the controversial budget constraints called for by the Koizumi administration’s 2006 fiscal consolidation plan, which, in order to realize a primary fiscal surplus in FY2011, called for restricting the growth of social security spending to ¥220 billion annually.

The fiscal plan’s revenue reforms are similarly cautious: the plan mainly relies on economic growth to broaden the tax base and boost tax receipts, and touts the importance of the “My Number” system, which will unify tax and social security systems into a unified system for collecting taxes and premiums, as a means for improving revenue gathering instead of stressing new reforms. The government has also ruled out additional rate hikes beyond increasing the consumption tax from 8% to 10% in April 2017.

The bottom line is that Abe government believes that a strong commitment to boosting productivity and economic growth can spare Japan’s leaders from having to make politically difficult decisions to cut spending and inflict pain on Japanese citizens.

Remaining obstacles

Perhaps there is reason for optimism about Japan’s fiscal future. After plummeting to 38.4% in FY2009, tax revenues as a percentage of government spending is expected to rise to 54.5% in FY2015. Thanks to rising tax revenues, the finance ministry expects that the total amount of new bond issuance in FY2015 will be approximately ¥37 trillion, the lowest level in seven years.

However, there is reason to believe that Abe government will struggle to meet its FY2020 target. Japan’s Cabinet Office, which released its mid-term economic and fiscal forecasts in July, projects that even under the government’s best-case scenario, in which real GDP and nominal GDP rise by 2.2% and 3.6% respectively in FY2020, the primary deficit will still be 1% of GDP (as opposed to 3% in FY2015). The International Monetary Fund (IMF) also has its doubts about the credibility of the Abe government’s fiscal plan; its 2015 Article IV consultation with Japan projected that medium-term real growth would be 0.7%, well below the Abe government’s optimistic scenario. As the Nikkei Shimbun concluded in an editorial on July 1: “It is correct to boost the potential growth rate, which shows the economy’s true strength, by means of structural reform. However, in a mid-term plan for an uncertain future, one should refrain from optimistic assumptions.”

As the IMF stressed, the deciding factor will be whether the Abe government is able to follow through on structural reforms. The decision to implement a fiscal plan that did not include new tax increases or significant spending cuts was effectively a decision to commit the Abe government ever more strongly to structural reform, policies that the Abe government and its predecessors have struggled to implement. Promising a “productivity revolution” may be better political message than social security spending cuts or tax increases, but there is no guarantee that the administration will be able to follow through on these proposals.

Building a growth-first LDP

Abe’s decision to delay the second consumption tax hike, his outmaneuvering of the LDP’s tax commission to secure a large corporate tax cut in FY2015, and now his government’s adoption of a growth-first fiscal plan despite pressure from within the LDP to include more substantial cuts to social security expenditures suggests that the prime minister has succeeded at nudging the LDP away from fiscal consolidation. In this respect, Abe has reversed the path his party took in the post-Koizumi era (2006-2012), when the LDP was riven by a dispute between the fiscal reconstructionists and the growth-first school (which then went by the name of the “rising tide faction”). The “rising tide faction,” led by Hidenao Nakagawa, LDP secretary-general during the first Abe government and Heizo Takenaka, former Prime Minister Junichiro Koizumi’s economy czar, these policymakers and advisers were proto-reflationists, advocating a growth strategy to promote innovation, aggressive monetary easing by the Bank of Japan (BOJ), and fiscal policy focused on trimming “wasteful” spending, instead of more aggressive measures to reform social security or raise tax revenues by raising the consumption tax rate. With allies in key positions within the administration, they briefly had the upper hand within the first Abe government, but were unseated when Yasuo Fukuda succeeded Abe as prime minister in September 2007, who favored fiscal reconstructionists like Kaoru Yosano, Sadakazu Tanigaki, and the late Nobutaka Machimura. The post-Koizumi LDP would run on a fiscal reconstruction platform in its 2009 landslide defeat by the Democratic Party of Japan (DPJ) and, in opposition, the Tanigaki-led LDP successfully maneuvered the Noda government into agreeing to raise the consumption tax rate even at the price of splitting the DPJ.

Since returning to power, Abe has sought to move the LDP back towards a growth-first strategy, though arguably it took the recession that followed the April 2014 consumption tax hike to convince him that economic revitalization had to precede fiscal consolidation. Accordingly, when Abe decided to postpone the second tax hike, he did so despite pressure from fiscal hawks like Tanigaki (now LDP secretary-general) and Takeshi Noda, head of the party’s tax commission, who, along with Finance Minister Taro Aso, BOJ Governor Haruhiko Kuroda, and much of the business establishment, argued that Abe had to follow through on the prevailing plan or else Japan’s credibility would suffer. The prime minister’s victory in the debate over the second tax hike, which was followed shortly thereafter by his government’s general election victory in December 2014, gave the Abe administration considerably more latitude to adopt a growth-first fiscal plan.

However, it is possible that Abe’s triumph could prove to be temporary. First, the fiscal plan calls for a mid-term review in FY2018: if the primary deficit has not fallen to 1% of GDP, additional measures will have to be undertaken in order to achieve the FY2020 target. This will give fiscal hawks another opportunity to press for tax increases and spending cuts. Meanwhile, the debate over the fiscal plan within the LDP saw the reemergence of a third approach to the growth vs. fiscal consolidation debate, what can best be described as an aggressive, small-government approach to spending cuts reminiscent of the Koizumi government. A special committee on fiscal sustainability under the leadership of Tomomi Inada, the LDP’s policy chief and a close ally of the prime minister, issued a set of recommendations that shared the government’s views on growth as a precursor of fiscal consolidation but which nevertheless demanded more aggressive measures to control spending not just on social security but on other budget items.

For the time being, neither group can unseat Abe’s growth-first approach to fiscal consolidation, which will remain predominant as long as rising profits and incomes boost tax revenues. But if tax revenues level out and if the government fails to boost potential growth, fiscal policy will likely be a subject of contention between the administration and the LDP again.

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