Japan needs a new economic miracle

TOKYO — HasJapan’spolitical paralysis finally lifted? The agreement last week between the government and leading opposition parties to double the consumption tax — the sales tax — from 5% to 10% by 2015 suggests that it has. But there is a real risk that the government will mistake this measure for the end of the economic reform process. In fact, it is — or should be — only the beginning.

By virtually any measure, official Japanese debt is the highest in the world. The total outstanding volume of Japanese government bonds is an almost unfathomable $9 trillion, just below the $10.5 trillion in outstanding debt for the 17-country Eurozone, which has more than triple the population.

So grim hasJapan’sfiscal position become that bond issuance now exceeds tax revenue. Taxes cover less than half of government spending. And last year’s earthquake, tsunami and nuclear disaster only made a grim fiscal picture worse by requiring huge new spending on reconstruction. Japan issued a record $693.5 billion, or 12% of nominal GDP, in government bonds during the last fiscal year.

Japan’s fiscal problems, of course, have been mounting for decades. Indeed, annual tax revenue has fallen 30% since the country’s property bubble burst in 1989, owing to slow growth and deflation. Tax cuts implemented as stimulus measures during the 1990s recession also played a subsidiary role.

The reason Japan has been able to sustain its fiscal position as the world’s third-largest economy is that 93% of its debt is domestically held. Indeed, in contrast to the foreign capital flight that has so damaged Europe, willing foreign buyers of Japanese government bonds are plentiful, pushing interest rates to their lowest level ever.

Moreover, Japan’s private sector — its households and companies — sits atop a mountain of savings, which is mostly used to purchase government bonds. Because the government can still borrow mainly from the Japanese people, its balance sheet remains stable. But how long can that continue, given the aging of Japan’s population?

Most leading Japanese economists believe that the situation cannot be sustained, given that the large number of households consisting of pensioners is increasingly drawing down savings. The share of those age 65 and older has nearly doubled over the last two decades, to 23%, compared with 13% for the U.S. and more than 16% for Europe. If this trend continues, as seems likely, the market that government bonds have had for decades will begin to shrink dangerously. At that point, foreign purchasers are unlikely to pick up the slack.

In reaching the agreement to raise the consumption tax, the opposition Liberal Democratic Party insisted that one of the biggest contributors to the budget deficit — the amount spent on social security benefits for Japan’s retirees — be addressed. But the agreement actually does nothing to fix that problem.

The large number of aged and retired people means that spending on healthcare and social security now consumes 29.2% of the budget, a one-third increase since 2000. To meet these demands, the government has been slashing spending on education and research, the two areas that powered Japan’s postwar economic rise. And the old jibe that Japan can’t resist building bridges to nowhere if the government is paying rings less true nowadays. Public works and pork-barrel spending fell to 5.1% of the budget this year from 13% in 2000. So just cutting spending is not the answer.

Of course, the tax system does need to be addressed. Japanese income earners are clearly undertaxed. Even after the proposed doubling of the consumption tax, the rate will remain nearly half the 20% or more that almost all European countries levy. Overall tax revenue is roughly 27% of GDP, putting Japan in 28th place among the 34 countries in the Organization for Economic Cooperation and Development.

The government must not overestimate how much revenue the tax increase will generate. Moreover, it has so far shrugged off any concern that the tax increase may have a chilling effect on consumption, and thus on economic growth.

Despite two decades of malaise, Japan’s economy will grow by about 2% this year and 1.5% in 2013. Given the global economic doldrums, that may not seem so bad. But if Japan is ever to address its fiscal dilemma effectively, it will need to sustain faster growth than that.

Such growth presupposes a credible strategy to pare the deficit, one that recognizes the reality of the growing cohort of pensioners. Japan will also need bold liberalizing reforms, including greater workforce participation by women, inducing corporations to invest more at home and improving competition in cosseted sectors.

If any country has the political tools to undertake a program of comprehensive reform, it is Japan. The unity with which the Japanese population met last year’s disaster demonstrated once again that, when called upon, the national spirit can work miracles. And Japan’s “greatest generation” — the men and women who rebuilt a war-shattered country into an economic powerhouse — should not be deemed unwilling to sacrifice for the greater good. After all, they saved their country once; they are more than capable of doing it again.

Yuriko Koike, a former defense minister, national security advisor and chairwoman of Japan’s Liberal Democratic Party, is currently an opposition leader in the Diet. This piece is adapted from a longer version for Project Syndicate.