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(Project of the Kajima Institute of International Peace)

Expanding Social Security Expenses and Fiscal Reforms

Lectured by Kazumasa Oguro, Professor at Hosei University

It is quite natural that economic issues are taken up at the SSDP, because Japan's economic capabilities are a major factor in discussions on diplomacy and security. At present, supply side problems constitute a bottleneck for the Japanese economy.

(Present status of Japan's economic growth)

Various growth strategies and economic measures have been implemented since the collapse of the bubble. According to Figure 1 "Japan's Nominal GDP Growth Rate and Projection Assumptions," during the period from 1995 to 2016, annual growth of nominal GDP averaged just 0.3%. The GDP gap is now being eliminated. The question is how to raise the potential growth rate through reforms of the supply side. If we failed to raise it, a limit to further economic growth would emerge. Meanwhile, the trend of the business cycle is important, and as shown by Figure 1 in professor Itoh's handout, there is a possibility that the business cycle will cause Japan's economic slowdown from 2019 or 2020 after the completion of the Tokyo Olympic Games.

Fig. 1 Japan's Nominal GDP Growth Rate and Projection Assumptions

Which option should be given priority, fiscal reconstruction or measures to raise the potential growth rate through growth strategies and regulatory reforms, is a hard-to-answer question, amidst the situation where the potential growth rate hardly rises due to supply side constraints. If the pace of fiscal reconstruction were to slow down, and as a result the economic growth rate failed to rise, the fiscal situation could be disastrous.

(Stagnant price rise)

Although it is not wrong to try to raise prices in accordance with the BOJ's monetary policy, yet, we should note the reason for stagnant price rise is that service prices do not rise. Fig. 2 "The US-Japan Comparison of CPI on Year-on-Year Basis" well illustrates this situation. Compare CPI values for August 2016 with those for the previous year. US total CPI is 1.1%, whereas Japan's total CPI is -0.5%; and US services CPI is 3.0%, whereas Japan's services CPI is just 0.2%. US CPI values for public services charges like water and sewerage charges are rising, besides those for charges for hospital services and nursing care. Particularly the US CPI value for hospital services has increased by 6.2%, while as for Japan where medical expenses are controlled by official rates for health care fees, CPI value for hospital services has risen by only 1.1%. It is likely that various regulations for the service industry as well as Japan's peculiar economic structure are deeply related with price increase rate. Furthermore, US CPI value for nursing care fees has risen by 3.7%, whereas that of Japan has not risen. The same is true with CPI values for college tuition fees. These data account for the necessity of such regulatory reforms as utilization of private sector services to promote mixed-billing medical treatments and nursing care, and multiage child care.

Fig. 2 The US-Japan Comparison of CPI on Year-on-Year Basis

(Trends in social security benefit expenditures-to-GDP ratio)

As shown in Figure 3 "Trends in Social Security Benefit Expenditures-to-GDP Ratio", the Japanese economy has been in a period of expansion since the end of 2012 when the Abe administration was inaugurated, and social security benefit expenditures-to-GDP ratio seems to be considerably controlled. The current social security benefit expenditures amount to some 120 trillion yen, but their ratio to GDP has almost been flat since 2011.

Fig. 3 Trends in Social Security Benefit Expenditures-to-GDP Ratio

However, it is questionable if the expansion of social security benefit expenditures can be continuously suppressed. Figure 4 is a projection of social security benefit expenditures until 2040 released by the Cabinet Office. Social security benefit expenditures for 2018 are 121 trillion yen, while those for 2040 are estimated at some 190 trillion yen. The SSBE-to-GDP ratio will increase to around 24% from 21.5%. Thus the rise of the ratio during this period is 2.5% points. There is an opinion that 2.5% points could be controlled. On the other hand, as shown in Figure 5 "Transition of Age-related Expenditures (MOF projection)," the ratio to GDP of age-related expenditures including medical expenses and nursing care expenses will grow mildly until around 2030; but it is projected to increase to 27% by 5% points in 2060. For 2040 --- a half way point to 2060 --- the ratio is estimated at around 25%, which is quite consistent with the Fig. 4 projection.

Why is the ratio to GDP of age related expenditures expected not to rise during the 2020's? As illustrated by the right-hand side graph of Figure 5, a service category-wise analysis --- pension, medical care, nursing care, and education --- indicates that under the premise that macroeconomic slides will be implemented, the pension-to-GDP ratio will initially decline and then level off, while the medical and nursing care-to-GDP ratio will continue to rise steadily. Consequently, the ratio to GDP of all the services is projected to stay flat in the 2020's and then turn to increase.

Fig. 4 A Projection of Social Security Benefit Expenditures until 2040 (The Cabinet Office)

Fig. 5 Transition of Age-Related Expenditures (MOF projection)

An impact of a 5% point increase in age-related expenditures-to-GDP ratio would be enormous. As GDP is over 550 trillion yen, its 5% value is about 28 trillion yen. The fiscal deficit is generated some 20 trillion yen annually. The said amount of 28 trillion yen will exceed it. To address both this increase and the fiscal deficit by consumption tax hikes, consumption tax rate should be raised to no less than 20%. What measures should be taken to cope with these difficulties? How should expenditure cuts, tax increases and economic growth be combined to each other? Is it possible that the current administration that places emphasis on economic growth will come up with a scenario to help boost economic growth drastically; or can it afford to implement fiscal reconstruction at all? Needless to say, this is a matter of political judgment. Various growth strategies and economic measures were executed in the past, but none of them has succeeded in increasing the economic growth rate.

(An outlook for economic growth rate)

Assumptions for a 2040 projection in terms of population and economy are as shown in Figure 5. Since the nominal economic growth rate (baseline case) for 2018 is estimated at 2.5%, and for 2040 at 1.3%, respectively, its growth range during this period is projected to be over 1.5%. Meanwhile, the past average of the growth rate is 0.3%. Taking into account recent good achievements, an average growth rate may be lifted to 0.5% at most. Realization of a 1.5% growth rate looks quite severe.

(Public debt and the fiscal deficit-to-GDP ratio)

The question of future public debt can be judged by use of "Domar's proposition," which is expressed by the following equation:

The convergence value of public debt-to-GDP ratio = the average fiscal deficit-to-GDP ratio (q) / the average growth rate of nominal GDP (n)

If (q) is given as -2.8% for baseline case, according to a medium- to long-term projection by the Cabinet Office (July, 2018 ), and (n) given as 0.7% by adjusting the past average growth rate 0.3% with recent high economic growth rate, the convergence value of public debt-to-GDP ratio will be more than 4 times, or over 400%. This indicates a very tough situation. In order to maintain the same public debt-to-GDP ratio as at present, the nominal GDP growth rate should be raised to 1% by taking every possible measure and at the same time the fiscal deficit-to-GDP ratio should be lowered to some -2%. This is what reality requires.

Fig. 6 Yields of Major Assets under Management of BOJ

The BOJ's asset-side yield is about 0.3% in total (Figure 6). There is nothing to worry about this now. If, on the other, liability-side cost exceeds 0.5%, its capital may be reduced. Such is an abnormal situation. However, even if the BOJ falls in deficit, there still may be an option that the government ultimately compensates the deficit.

(Fiscal reforms or economic growth?)

The vital problem to tackle is how to control public finances. The politicians must decide whether to seek a certain degree of economic growth or to steadily restore fiscal integrity and implement social security reforms. Prime Minister Abe seems to respond by coupling pension issue and employment extension beyond the retirement age, but it is uncertain whether the administration can step further to such a tough reform program of raising the pension age.

Flanked by the two Pacific super powers --- the United States and China ---, Japan is obliged to pursue its own diplomatic and security policies, maintaining its economic power as diplomatic and security resources. If its public finances fell into disarray, Japan's presence would be compromised. Whereas the Abe administration is seemingly pushing forward with its economic growth policy, the present author believes that the restoration of Japan's fiscal integrity should claim priority.

(This paper is prepared by the SSDP secretariat.)

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