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Japan: Lower Public Debt, Structural Reforms Critical, says IMF

Businessman shops for clothes. The IMF supports increasing the consumption tax to help bring down public debt (photo: TWPhoto/Corbis)

ECONOMIC HEALTH CHECK

Japan: Lower Public Debt, Structural Reforms Critical, says IMF

IMF Survey online

July 19, 2011

  • Japan must consolidate its fiscal position, says IMF
  • Recovery has started after earthquake, but uncertainties remain
  • IMF advocates modest increase in consumption tax to pay for recovery

The massive earthquake in northeast Japan earlier this year has led to additional government spending which is pushing the country’s public debt to higher levels. The world’s third largest economy must consolidate its fiscal position over the medium term if it is to continue being a positive force in the region, says the IMF in its regular assessment of the country’s economy.

“Japan needs to implement fiscal and structural reforms to strengthen the resilience and growth prospects of its own economy if it is to continue with its existing important, positive role,” said Mahmood Pradhan, the IMF mission chief for the northeast Asian country.

Japan’s public debt is over 220 percent of the country’s GDP in gross terms―the highest level among advanced economies. In their “Article IV” report on the state of the Japanese economy, IMF economists proposed reforms to bolster confidence in public finances, including reining in social security spending, increasing the country’s tax revenue, and boosting growth through structural reforms.

An uncertain near term

Economic activity has started to recover following the March earthquake and tsunami, but a high degree of uncertainty remains with the recovery dependent on the easing of supply bottlenecks, a stable long-term supply of electricity, and the recovery of sentiment.

Reconstruction spending is likely to further increase Japan’s sizable public debt, and the report predicts GDP growth is likely to slow to -0.7 percent this year before rising to 2.9 percent in 2012.

The IMF report suggests reconstruction spending could be financed by a modest increase in the consumption tax from 5 to 7–8 percent in 2012, with a greater and continued increase up to 15 percent thereafter. This is also needed to bring down Japan’s high level of public debt.

“Bringing down public debt over the medium term will require a sustained and significant adjustment of the primary balance,” says the report.

Reform of taxation

Given the limited scope for spending cuts, fiscal adjustment depends on limiting existing spending and finding new sources of revenue. Tax revenues could provide one such source.

This island nation has one of the lowest tax revenue levels in the world—about 17 percent of GDP—and this gives the northeast Asian country ample space to use taxes as a way of consolidating the country’s fiscal position.

The country’s authorities have already outlined plans to double the sales tax to 10 percent by the mid-2010s to help meet its target of halving the primary deficit (in percent of GDP). This forms part of a package of measures unveiled in June which included reforms to social security spending, a proposal to raise the retirement age, and adjustments to pension benefits.

An opportunity in the face of disaster

The IMF economists welcomed the government’s plan for fiscal consolidation, but called for more vigorous action to reduce public debt levels at a faster rate within the next five years. They believe the economic slowdown prompted by the Great East Japan earthquake provides an opportunity to kick-start much-needed structural reforms.

“Notwithstanding the large but temporary shock, the earthquake provides an opportunity to broaden and accelerate reforms in several areas.”

Although in the short term, fiscal adjustment could reduce domestic demand, over the longer term, lowering the level of public savings would help improve confidence, spur investment and boost household incomes, suggests the report.

“Fiscal consolidation would also benefit Japan’s partners by releasing a pool of savings for other countries to borrow and reducing risks from a disruption in the Japanese government bond market,” it adds.

The Japanese economy is battling a shrinking labor force, and the priorities identified by the economists include boosting employment by raising labor participation among the elderly, young, and women, pursuing trade liberalization, and promoting SME restructuring.

Despite Japan’s economic slowdown in recent years, and the disaster in March, the report says that as one of the largest and richest economies in the world, Japan remains an important contributor to regional growth and stability. “To maintain these positive spillovers, fiscal and structural reforms are essential,” it concludes.