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Considering Social Security and Tax Reforms: What Will Become of Japan's Fiscal Reconstruction?

Kazumasa Oguro

The Significance of Fiscal Space to Address Emergencies

No end is in sight for the ongoing Russia-Ukraine war. This conflict has had a profound impact on the international community, which had believed that large-scale wars were a thing of the past in the post-Cold War world. On December 16, 2022, the Japanese government made a cabinet decision to secure 43 trillion-yen defense spending—more precisely, total expenses associated with the "Defense Buildup Program"—for the five-year period of fiscal 2023-2027.

This may be a move forward, but it is also crucial to strengthen the economic power and finances that form the foundation of defense capabilities. In times of emergency, the government must procure funds and resources necessary for carrying out warfare, even if it has to issue large-scale government bonds. Yet, if a country like Japan, encumbered with excessive government debt, attempts to issue government bonds in times of emergency, investors may demand extremely high yields. Additionally, if the country's finances collapse before or during an emergency, it cannot effectively respond to security threats.

When discussing the government and the Bank of Japan as a whole, the debt cost of the combined debt will fundamentally remain unchanged regardless of whether or not the Bank of Japan holds government bonds. Currently, due to the interest rate being nearly zero, the debt cost does not matter. However, once the country overcomes deflation and shifts to an inflationary economy and the interest rate normalizes, the situation that enables financing the fiscal deficit at no cost will end once and for all; the huge debt cost will gradually matter. Consequently, to increase Japan's capability to respond to security threats, discussing increases in defense spending does not suffice; even in peacetime, we should debate, from the perspective of fiscal security, reducing the excessive government debt to an appropriate level, thereby increasing the financial leeway (fiscal space) to issue government bonds on a large scale even in an emergency.

Inflationary Economy and the Current State of Finances

What is the current fiscal situation? Due to the effects of the weak yen and wage increases, the Japanese economy is steadily shifting from deflation to inflation. In this situation, an interesting phenomenon is emerging in the social security budget, which has been a long-standing concern for Japanese finances. The proposed General Account Budget for fiscal 2025 seems to symbolize this trend.

The proposed budget is worth approximately 115 trillion yen, of which the dominant expenditure item is social security-related expenses of 38 trillion yen (an increase of 560 billion yen from the previous year). Social security-related spending is composed of "pensions" of approximately 13.6 trillion yen, "health care" of 12.4 trillion yen, "nursing care" of 3.7 trillion yen, and "welfare, etc." of 8.3 trillion yen.

Among the key components of social security-related expenses, what then has scored the most prominent budgetary increase? 2025 marks a point where all baby boomers will become 75 or older. Unlike pensions, which, in principle, people 65 of age start to receive, more expensive health and nursing care costs are incurred for people 75 of age or over; therefore, many tend to think that health and nursing care costs contribute to budgetary increases given that people over 75 generally require more of these services. However, according to the Ministry of Finance's "Key Points of the Social Security Budget for FY2025," "pensions" score the highest increase (2.2%), followed by "welfare, etc." (1.9%), then "health care" (0.8%), and lastly, "nursing care" (0.2%).

The significant increase in pensions is because while the "macroeconomic slide" that curbs pension payout growth will be implemented in FY2025, pension payouts will be adjusted upward nonetheless. Health and nursing care fees are generally revised every two to three years. Since their last revision was in FY2024, they will not be in FY2025.

The Cabinet Office's Economic Outlook and Basic Stance for Economic and Fiscal Management (December 2024) estimates the real GDP growth rate for fiscal 2025 at 1.2% but the nominal GDP growth rate at 2.7% due to the effect of inflation. If this estimate is correct, pensions as a percentage of GDP will remain mostly level (-0.5%), while health care as a percentage of GDP will grow at -1.9%, and nursing care as a percentage of GDP at -2.5%—attributable to the effect of inflation.

Since the LDP-Komeito government is in a minority position in the ordinary Diet session in 2025, the ruling coalition will not be able to pass the budget independently. The ruling-opposition battle will intensify over the government's budget bill and its contents approved by the Cabinet last December. The LDP and Komeito plan to pass the budget bill by the end of the current fiscal year. They are continuing talks with the Democratic Party for the People on the "1.03-million-yen barrier" issue and with the Japan Restoration Party on free education. The outcome of these talks will affect the budget debates and budget contents. We must keep vigilant on the Diet sessions but, at the same time, look into the relationship between inflation and the budget.

Mid- to Long-Term Projections and Fiscal Outlook

Next, let us turn to the future fiscal outlook. What is useful in considering this is "Economic and Fiscal Projections for Medium to Long Term Analysis" (referred from here to as "Medium to Long Term Analysis") released by the Cabinet Office at the Council on Economic and Fiscal Policy meeting held on January 17, 2025. This document is released twice a year to discuss economic growth, the progress of fiscal consolidation, and the direction of future reforms. The latest analysis is a revised version of that released in July last year (2024).

As with the previous one, the latest Medium to Long Term Analysis presents three scenarios for nominal GDP growth rates and makes projections of the primary balance of central and local governments (ratio to nominal GDP) and the outstanding debt of the central and local governments (ratio to nominal GDP) throughout fiscal 2034.

The three scenarios are the "Higher Economic Growth (HG) Case," the "Transferring to a New Economic Stage (TN) Case," and the "Projection of Past Trend (PP) Case." The HG Case assumes that the nominal GDP growth rate will shift at just over 3% from fiscal 2025 to fiscal 2034, while the TN Case assumes that the same will shift at just under 3% during the same period. The PP Case assumes that the nominal GDP growth rate will remain around 0.7% during the same period.

Which scenario is the most appropriate is hard to determine at this point. The average nominal GDP growth rate from fiscal 1995 to fiscal 2024 is 0.64% per year, calculated using the SNA data released by the Cabinet Office. Fiscal consolidation is not something to achieve in one or two years; it takes decades. In addition, economic downturns such as the Lehman Shock are bound to occur periodically, affecting reform efforts. Therefore, if we were to make a conservative and careful assessment based on past trends, it would make sense to adopt the PP Case, which assumes a growth rate of around 0.7%.

What specific points can be gathered from the latest Medium to Long Term Analysis? The first is associated with the fiscal consolidation target. As part of the target, the government aims to achieve a surplus in the primary balance of the central and local governments by the end of fiscal 2025. Even in the PP Case mentioned above, the primary balance of the central and local governments is projected to be in the red by 4.5 trillion yen in fiscal 2025; yet, in fiscal 2026, it is projected to be in a surplus of 0.8 trillion yen, suggesting the possibility of achieving the fiscal consolidation target after one year delay.

Nowadays, we notice some optimistic opinions in TV and newspaper reports about the future fiscal situation. Yet, they misunderstand because as long as the primary balance of the central government is assessed, not that of the central and local governments combined, the deficit will continue. When checking the detailed results of fiscal projection in the PP Case, as shown in Table 1, the primary balance of the central government alone (ratio to nominal GDP) is projected to be in deficit by approximately 1% from fiscal 2026 to fiscal 2034. Despite that the primary balance of the central government alone will not be in balance, the primary balance of the central and local governments combined is projected to be almost in equilibrium from fiscal 2026 onwards because the primary balance of local governments (ratio to nominal GDP) is projected to be in surplus by around 1%.

Table 1

Source: "Economic and Fiscal Projections for Medium to Long Term Analysis" released by the Cabinet Office at the Council on Economic and Fiscal Policy held on January 17, 2025.

The Bank of Japan is currently normalizing monetary policy, planning to raise interest rates stepwise. If long-term interest rates rise, interest payments associated with outstanding government bonds and other public debt will also increase. In that case, it is necessary to watch what will become of the "fiscal balance," made up of the primary balance and the interest payments.

When checking this projection in the PP Case, the fiscal balance (ratio to Nominal GDP) of the central and local governments combined will be in a deficit of 0.7% in fiscal 2026, and the deficit will expand to 1.9% in fiscal 2034. Furthermore, as with the case of the primary balance, if the deficit width of the fiscal balance (ratio to nominal GDP) of the central government alone is assessed, not that of the central and local governments combined, the fiscal deficit (ratio to nominal GDP) of the central government alone is projected to expand from 1.8% in fiscal 2026 to 2.7% in fiscal 2034. Although Table 1 fails to indicate all projection results, the outstanding debt of the central government (ratio to nominal GDP) is estimated to rise from approximately 180% in fiscal 2024 to approximately 190% in fiscal 2034.

The Outstanding Debt of the Central Government (ratio to nominal GDP) Likely to Exceed 400%

Should this situation continue, what will become of the outstanding debt of the central government (ratio to nominal GDP)? This projection is calculable without difficulty by using the Domar proposition. The Domar proposition states that "in an economy with nominal GDP growth rates subject to non-negativity constraints, as long as the fiscal deficit (ratio to nominal GDP) shifts constant, the outstanding debt (ratio to nominal GDP) will eventually converge to a certain value." When the nominal GDP growth rate projection is ‘n,' and the fiscal deficit projection (ratio to nominal GDP) is ‘δ,' the outstanding debt (ratio to nominal GDP) will, theoretically, converge to ‘δ/n.' For example, if the fiscal deficit (ratio to nominal GDP) or ‘δ' is 5% while the nominal GDP growth rate or ‘n' is 2%, ‘δ/n' will be 2.5, or the outstanding debt (ratio to nominal GDP) will converge to 250%.

Let us take a practical example. In Table 1, the fiscal deficit of the central government (ratio to nominal GDP) in fiscal year 2034 is 2.7%; therefore, δ = 2.7%. The average nominal GDP growth rate between fiscal 1995 and fiscal 2024 is calculable to be 0.64% per year; therefore, n = 0.64%. Thus we get δ/n = 4.82. These signify that the outstanding debt of the central government (ratio to nominal GDP) will, over time, expand to 482%.

As noted above, in Table 1, the outstanding debt of the central government (ratio to nominal GDP) is approximately 180% for fiscal year 2024. For the outstanding debt of the central government (ratio to nominal GDP) to shift at almost the same level as at present, with the nominal GDP growth rate (n) being 0.64%, the fiscal deficit of the central government (ratio to nominal GDP) for fiscal 2034 must be reduced to about 1% instead of 2.7%, as indicated by the inverse calculation of the Domar proposition. In other words, if the Cabinet Office's projection is correct, the PP Case suggests that the fiscal deficit of the central government (ratio to nominal GDP) must be decreased by 1.7 percentage points (= 2.7%－1%).

To recapitulate the above:

(1) As part of its fiscal consolidation goal, the government aims to achieve a primary balance surplus of the central and local governments combined by fiscal 2025. According to the PP Case, the primary balance of the national and local governments is projected to be almost balanced from fiscal 2026 onward, albeit after one year delay.

(2) This projection appears to indicate the possibility of easing the fiscal discipline. Yet, this is not necessarily the case if assessing the primary balance and the fiscal balance of the central government alone, not those of the central and local governments combined. The central government's outstanding debt (ratio to nominal GDP) is projected to rise from 180% for fiscal 2024 to 190% for fiscal 2034.

(3) Rather, if assuming nominal GDP growth rates of the PP Case, to shift the central government's outstanding debt (ratio to nominal GDP) at almost the same level as now, it is necessary, as indicated by the inverse calculation of the Domar proposition, to curb the central government's fiscal deficit (ratio to nominal GDP) to around 1% and to improve the fiscal balance and the primary balance of the central government alone by 1.7 percentage points (ratio to nominal GDP).

If the 1.7 percentage point improvement is assessed in terms of the primary balance of the central and local governments combined (ratio to nominal GDP), it is necessary to achieve a just under 2% primary balance surplus (ratio to nominal GDP) of the central and local governments by fiscal year 20XX (e.g., FY 2034).

New Financial Rules Introduced in the Area of Health and Nursing Care

As noted above, the current fiscal situation is still alarming because social security costs for health and nursing care have, over the past few decades, increased due to the implications of declining population and birthrates and an aging population, resulting in a chronic fiscal deficit. Nonetheless, as the economy shifts from deflation to inflation and wage increases become a political agenda, new rules are being introduced for the financial control of health and nursing care in the budget formulation process.

This move is related to footnote 27 of the "Children's Future Strategy" that the Cabinet approved in December 2023 (referred from here to as "footnote 27"). The footnote states: "Due to the aging of the population, the increase of health and nursing care benefits have exceeded that of compensation of employees, based on which insurance contributions are calculated; due to this gap, insurance contribution rates are rising. To increase the take-home income of young people and households with children, this gap should be reduced through expenditure reforms and wage increases, thereby curbing increases in insurance contribution rates at maximum."

Footnote 27 is related to the "unprecedented measures to combat the declining birthrate," which former Prime Minister Kishida positioned as one of the centerpieces of his domestic policies. Although the contents of those measures were largely described in the "Children's Future Strategy" released by the government in June 2023, the specific measures for financing the policy (approximately 3.6 trillion yen) were left intact until the end of the same year. It was deemed politically difficult to finance the new policy by raising taxes, including the consumption tax; as a result, the government proposed the creation of a system to raise a certain amount of funds (e.g., 1 trillion yen) by raising social security contributions such as health insurance fees (referred from here to as the "support money system").

However, the Japan Business Federation and the Japanese Trade Union Confederation were quick to express concerns about creating the support money system because insurance contributions are equally shouldered between labor and management, and as a result, the burden on the working generation and companies would increase.

Looking at the minutes of the Children's Future Strategy Council (held on April 7, 2023), then-Chairman Masakazu Tokura of the Japan Business Federation stated as follows about financial resources for measures to combat the declining birthrate: "Increasing the social insurance burden to secure a source of funds would directly lead to a decrease in the disposable income of the working generation, undermining the effects of the wage hikes we have managed to realize and impeding the emergence of a virtuous cycle. I cannot support it. Rather, I think it would be desirable to use various tax revenue sources from a medium to long term perspective, while seeking the possibility of sharing the burden by all generations according to the ability-to-pay principle."

Chairman Tokura's remarks stemmed from his concerns that increasing the social insurance burden could reduce corporate competitiveness and increase the burden on the working generation raising children; given actually increasing social insurance contributions, his concerns are justifiable. Comparing the 1988 and 2017 outcomes of the Family Income and Expenditure Survey regarding "households with two or more workers" (national average), the burden of social insurance contributions increased by about 84% while the burden of direct taxes such as income tax decreased only slightly.

Health and Nursing Care Insurance Contributions to Rise by 50%

How high are social insurance contributions likely to rise in the future? This estimation requires a detailed analysis. The long-term projections of finances and social security presented by the Cabinet Office at the Council on Economic and Fiscal Policy (held on April 2, 2024) may serve as an informative reference.

The long-term projections in question (referred from here to as the "long-term estimate") were contained in a document titled "Toward a Medium to Long Term Sustainable Economy and Society (2)." The long-term estimate predicts macroeconomics, finances, and social security after the Medium to Long Term Analysis (from fiscal 2034 to fiscal 2060).

This estimate predicts finances and social security based on three scenarios: the "projection of current trend scenario," the "long-term stability scenario," and the "economic growth scenario." Of the three, the "projection of current trend scenario"―a 1% scenario considering past performance, such as medical advancements―may be the benchmark.

This scenario predicts that health and nursing care benefits (ratio to nominal GDP) will rise from 8.2% in FY2019 to 9.2% in FY2033, 10.2% in FY2040, 11.7% in FY2050, and 13.3% in FY2060. The Cabinet Office's long-term estimate also shows test calculations of health and nursing care insurance contributions and public contributions.

For example, health and nursing care insurance contributions (ratio to nominal GDP), which was 4.8% in FY2019, are estimated to rise to 5.2% in FY2033, 5.7% in FY2040, 6.4% in FY2050, and 7.2% in FY2060―1.5 times that of FY2019. These suggest that unless health and nursing care system reforms are implemented, the healthcare insurance contribution rate would have to be raised by about 50% by fiscal 2060 compared to fiscal 2019.

Use the Experience of the 2004 Pension Reform

Some solution is needed to this problem. Fortunately, we have experience addressing a similar challenge about 20 years ago regarding the pension insurance contribution rate. The pension system plays a crucial role in supporting the lives of elderly people. As the population aged and the birthrate declined, the pension insurance contribution rate has been raised many times. For instance, the employee pension insurance contribution rate, which was 5.5% in 1965, increased incrementally. By 2003, it was approximately 2.5 times higher than in 1965, at 13.58%. The reason for this is that the current pension system adopts a "pay-as-you-go" method, and the funds for pension payouts to elderly people have been outlaid from the insurance contribution income paid by the working generation.

However, there is a limit to the burden on the working generation. Under the Koizumi administration, which pursued a small government, pension reform was implemented in 2004 to curb the increasing burden on the working generation amid the declining birthrate and aging population. The upper limit of the employee pension insurance contribution rate was set at 18.3%.

According to Chapter 2 of the 2005 White Paper on Health, Labor, and Welfare, "if the employee pension insurance system previous to the 2004 reform had continued with the only modification of raising the contribution rate, the employee pension insurance contribution rate would have had to be raised from 13.58% to 25.9%." The government at the time considered raising the upper limit of the employee pension insurance contribution rate to 20% but faced opposition from the Japan Business Federation and others.

The Japan Business Federation's "On the Current Pension System Amendment" (September 10, 2003) states, "Raising the employee pension insurance contributions should not be done hastily, since it would sap many companies of their vitality, impede economic revitalization, and hurt corporate efforts to maintain employment. The government is considering setting the employee pension insurance contribution rate at 20% by law. Yet, given that the current system amendment is far from sufficient for curbing benefits and adopting an indirect tax method for basic pensions, setting the employee pension insurance contribution rate cap at 20% is tantamount to abandoning the three-pronged reforms―unacceptable at this stage. In the current system amendment, the government should realize reforms that focus on burden reduction in the light of preventing a bloated government, maintaining and expanding economic vitality, and rectifying intergenerational inequity. In other words, assuming curbing benefits and adopting an indirect tax method for the basic pension, the employee pension insurance contribution rate should be fixed for a long time at a level that does not exceed the current rate corresponding to 13.58% of the employee's annual income."

Ultimately, a political settlement was reached that the 2004 pension reform would increase the employee pension insurance contribution rate to 18.3% but not beyond that. Since 2017, the rate has stayed consistently at 18.3%. On the other hand, there has been no progress in discussing limits to the range of increases for the health and nursing care insurance contribution rate. There is no upper limit to the rate at present.

The recommendation of the Fiscal System Council (Fiscal System Subcommittee) in November 2023 states that "it is necessary to steadily advance the revision of medical fee and the reform of the health and nursing care system, and to keep increases in health and nursing care benefits, as a whole, within the range of increases in employee compensation." Following the Diet debates on the issue of the support money system and social insurance contributions, a footnote was added to the "Children's Future Strategy" decided by the Cabinet in December 2023, stating that "Due to aging and other factors, increases in health and nursing care benefits have exceeded those in employee compensation, which is the base for calculating the contributions; this gap has caused the health and nursing care insurance contribution rate to rise. To increase the take-home income of young people and households with children, this gap should be reduced through expenditure reforms and wage increases, thereby restraining the increase of the insurance contribution rate to the utmost."

There is questioning about what the phrase "to the utmost" means, but this footnote is also part of the Cabinet decision and is an official "government policy." In order to curb the increasing burden on the working generation responsible for raising children and to create a next trigger for health care financing reform, the government should swiftly present projections of the range of increases for social insurance contribution rates up to fiscal 2040 and 2050, while also considering setting a cap on social insurance contribution rates as a whole. The present author has been advocating a "healthcare version of macroeconomic slide mechanism" (for details, see Chapter 5 of Oguro (2020)). It is hoped that, in line with the policy of the above-mentioned "Children's Future Strategy" (footnotes), the government should begin to consider a mechanism for fine-tuning increases in social security benefits so that they do not depart from the medium to long term economic growth rate.

(Professor, Hosei University)

References

  • Kazumasa Oguro, Reconstructing the Japanese Economy, Nikkei Business Publications, Inc., 2020
  • Ministry of Finance, Fiscal System Council, Fiscal System Subcommittee, "Recommendations for the Formulation of the FY2024 Budget" (November 20, 2023)
  • Cabinet Secretariat, "Children's Future Strategy" (Cabinet decision, December 22, 2023)
  • Cabinet Office, "Toward Consideration of a Medium to Long Term Sustainable Economy and Society (2)" (Council on Economic and Fiscal Policy held on April 2, 2024)
  • Cabinet Office, "Economic and Fiscal Projections for Medium to Long Term Analysis" (Council on Economic and Fiscal Policy held on January 17, 2025)

[Supplementary Discussion] Defense Funding and Tobacco Tax Hike

Currently, many countries are taking complementary policy measures to address, among other problems, drug and alcohol addictions, taking into account the limitations and adverse effects of measures such as strengthening regulations and harsher penalties. This move aims to minimize the possible damage (including negative externalities) to individuals and communities, setting aside ethical judgment and pursuing the effectiveness of the policy. This is called "harm reduction."

With this trend as background, many countries are adopting policies that encourage shifting to alternative smoking products (e.g., heated tobacco products and electronic cigarettes), considered to reduce the user's contact with harmful substances than cigarettes. Meanwhile, the Japanese government does not take a harm-reduction approach. The 2023 Tax Reform Proposal, which featured increases in defense spending, decided to secure about 1 trillion yen as part of the resources for defense expenses by increasing corporate tax, income tax, and tobacco tax by about 200 billion yen. The government plans to raise the tax rate for heated tobacco products to the same rate as cigarettes in the fiscal 2025 tax reform.

In Japan, the tax gap between heated tobacco products and cigarettes ranges from 10-20%, narrow compared to other countries. In the UK, which promotes harm reduction, the tax gap is over 70%; it is likewise wide in Italy and France. In this situation, the Institute for New Era Strategy, where the author is a board member, has made recommendations on tobacco policy from the viewpoint of harm reduction. The recommendations emphasize the significance of enacting a basic law on harm reduction and present an estimate associated with tobacco tax increases. This estimate based on data about the prices of cigarettes and heated tobacco products makes two kinds of analysis following (1) a baseline scenario and (2) five variant scenarios with different taxation methods, respectively. Analysis based on scenario (1) confirms that raising the tax on cigarettes by 1.1 yen per cigarette and heated tobacco products by 3.3 yen per product would eliminate the tax gap between cigarettes and heated tobacco products and secure 200 billion yen in tax revenue.

The second analysis deals with (2) five variant scenarios. Here, the total tax increase stays consistently at 4.4 yen―the value obtained from the first analysis using the baseline scenario (1). In each of the five variant scenarios, the tax increase on cigarettes is raised while the tax increase on heated tobacco products is lowered. The chart above illustrates the results, as is apparent from which the effect of a 1-yen tax increase on heated tobacco products (approximately 34.3 billion yen) is only about half that of a 1-yen tax increase on cigarettes (approximately 67.5 billion yen). In the light of securing tax revenue, it is clear that raising the tax increase on cigarettes rather than on heated tobacco products will be more effective in increasing the revenue.

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