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Democracy on Trial: The Challenge of Fiscal Reform

Tags: Democracy , Consumption Tax , Social Security , Public Debt , Noda

Yakushiji, Katsuyuki

March 08, 2012

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Just over two years since the Democratic Party of Japan broke the Liberal Democratic Party's hold on power, Prime Minister Yoshihiko Noda has taken on a huge political challenge, one that the LDP was ultimately unwilling to tackle: integrated reform of the social-security and tax systems.

The meat of Noda's proposal is a fairly simple plan to raise the consumption tax rate from the current level of 5% to 10% by 2015 and apply all revenues from the hike to Japan's skyrocketing social security costs.

Lest anyone question the need for such a reform, a few simple statistics should suffice to put those doubts to rest.

First, under the government's draft budget for fiscal 2012, expenditures are set to reach 92 trillion yen. Incredibly, the government is relying on bond issues to cover 44 trillion of that, well in excess of the 41 trillion funded by tax revenue.

The expedient of floating more and more government bonds to foot the bill for rising government expenditures instead of cutting spending has been going on in Japan since the 1990s, with the result that Japan's total public debt (local government included) has soared to approximately 1 quadrillion yen, or twice the nation's gross domestic product.

The last time Japan shouldered such a debt-to-GDP ratio was in the mid-1940s, shortly before Japan's surrender in World War II, when the domestic economy collapsed as a consequence of the government's reckless adventurism.

Not only does Japan have the largest public debt burden of any country in the world but its debt-to-GDP ratio dwarfs Italy's 120 percent—and Italy has been hovering on the brink of default for months. Japan is sitting on a fiscal tinderbox that could explode at any moment.

Next, let's take a look at the social-security side of the equation. The current average life expectancy in Japan is 83 years (80 for men and 86 for women), the highest in the world. In addition, Japan's population is aging faster than any other country's, with the 65-and-over segment projected rise to 39% by 2050 (up from 24 percent in 2010).

This means that in another few decades, two out of every five Japanese citizens will be eligible for old-age pension benefits. As a consequence of this demographic shift, the social-security budget is automatically increasing by 1 trillion yen every year, placing an unsustainable burden on the government's finances.

Under Japan's current social-security system, pension and healthcare benefits for the elderly are financed primarily by the tax payments and contributions of the currently employed population. This system works fine as long as the population keeps growing at a healthy clip.

Back in 1965, when Japan's population structure was still a pyramid, there were nine productively employed people for every elderly person drawing a pension. But things have changed dramatically since then. That ratio will fall to three workers per pensioner in 2012 and 1.2 in 2050, assuming that the current system continues unchanged.

Taxes and social security contributions will swallow up a huge portion of younger workers' earnings, leaving a pittance to cover their own living expenses. Small wonder the government has finally decided to take action and raise the consumption tax.

The DPJ government's proposal for integrated reform of the social-security and tax systems is a rational plan, essential if Japan is to maintain social services for the elderly and prevent a fiscal collapse. Moreover, since the LDP—the DPJ's main rival—has called for a similar increase in the consumption tax as part of its own platform, it has no grounds for opposing Noda's plan from a policy standpoint.

Yet both the LDP and New Komeito have remained recalcitrant. The opposition has maintained that if the DPJ wants to raise the consumption tax in violation of its 2009 election manifesto, it should first call a general election and put the matter to the voters.

In addition, Noda is facing resistance from younger politicians in his own party, who worry that a tax increase will cost them their Diet seats. Rational, essential reforms are being sacrificed to partisan politics and the short-term imperatives of the election cycle—a situation by no means unique to Japan.

Another major obstacle to reform is the fact that the opposition parties currently control the House of Councillors, and under the Constitution, most bills must win the approval of both houses of the Diet (or else a two-thirds majority in a second vote in the lower house) to become law. Noda has said that he wants the Diet to enact reform legislation during the current ordinary session, but as things stand, his bills have little chance of passing the upper house, even if they make it through the lower house.

The Japanese government's inability to extricate itself from this fiscal quandary reflects a fundamental weakness of representative democracy when faced with the necessity of adding to the national burden.

As long as the economy continued to grow at a healthy pace, corporate and income tax revenues automatically increased each year, enabling each successive administration to adopt generous policies and programs without cutting spending elsewhere or seeking new sources of revenue. Such was Japan's situation from the 1960s all the way through the 1980s.

Moreover, since the population was growing as well, the government operated on the assumption that the contributions of currently employed workers would be sufficient to support the social-security system for the foreseeable future.

All of that changed in the 1990s. During the prolonged recession that followed the collapse of the 1980s bubble economy, tax revenues shrank. Meanwhile, the population was aging rapidly, resulting in a dramatic increase in government outlays for pension and healthcare benefits.

Instead of addressing the growing crisis through much-needed reforms, the LDP tried to ride out the storm with government bond issues, fearing that a serious push for higher taxes and spending cutbacks would trigger a fatal voter backlash. As a result, government debt ballooned, and Japan's fiscal health continued to decline.

In 2009, the public finally despaired of the LDP's leadership and handed the reins of government to the DPJ.

Unfortunately, the DPJ's lack of experience at the helm resulted in one misstep after another. Prime Minister Yukio Hatoyama resigned after less than a year, and his successor Naoto Kan fared little better. Now at last Yoshihiko Noda, Japan's third DPJ prime minister, is tackling the challenge of social security and tax reform.

Should Noda fail, Japan can probably look forward to another change in leadership before the year is out. The current government may be forced to dissolve the House of Representatives and call a general election, which could return the LDP to power. Japanese politics in 2012 is fraught with uncertainty, just when the nation is most in need of stable leadership.

But to blame this instability on some peculiarly Japanese political failure is unfair. The European debt crisis is testimony to the challenges facing developed countries worldwide as they attempt to address the problems of a post-growth era using political systems that have evolved and thrived in the context of social and economic growth.

Representative democracy has functioned primarily to effect the redistribution of wealth under such growth conditions. The dysfunction we are seeing in all likelihood presages the end of that system.

Demographic aging and economic stagnation have hit harder and faster in Japan than elsewhere, but these are structural problems all developed countries will have to face sooner or later. Under the circumstances, Japan's political instability should sound a warning for the developed countries of the West.

Under representative democracy, parties and governments have gained public support through policies that deliver immediate benefits. How can we maintain a stable political system while asking more from the people and delivering less? Given this fundamental dilemma, the fate of Noda's reform initiative could have profound repercussions in the years ahead—not only for Japan's fiscal health but also for the future of democratic government.

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