REPORT CARD ON THE KOIZUMI REFORMS

A year has passed since Prime Minister Koizumi Jun’ichirô took office and launched his program of structural reforms. Koizumi announced early on that implementing the reform program might result in a temporary economic slowdown. Ironically, despite the lack of progress on the reform front, the prime minister’s warning of a slowdown came true. For three consecutive quarters starting in April–June 2001, real gross domestic product registered negative growth. The unemployment rate also got worse, rising from 4.8% when Koizumi took office in April 2001 to 5.6% at the end of the year. The picture improved in the first quarter of 2002, with real GDP expanding at a 5.7% clip in annual terms, but you could not find anybody proclaiming that this marked the start of a recovery sparked by the Koizumi reforms.

There had been talk of a possible “March crisis” involving major bankruptcies and maybe even a financial-sector meltdown at the end of the 2001 fiscal year this March. When the fiscal year ended without such a crisis, a certain degree of optimism began to spread. But the situation remains severe. Little progress has been made toward cleaning up the bad-loan mess, though this was one of the key objectives the Koizumi administration set for itself. The problem has changed in nature and, in fact, become even harder to resolve. The original source of the bad-loan problem was the sharp drop in asset prices following the collapse of the bubble economy a decade ago, which resulted in a wave of bankruptcies and also lowered the value of the collateral provided to back earlier loans. But what is weighing down the major commercial banks these days is not so much these bubble-related loans as loans that have soured more recently because the stagnation has become so prolonged. Though the problem is a massive one, when the Financial Services Agency completed a round of special inspections of banks’ loan portfolios earlier this year, it decided that no further infusion of public funds was required to shore up banks’ capital at that point. And when stock prices rose before fiscal 2001 drew to an end in March, the position of the banks became healthier, making the bad-debt problem look smaller. But critics have charged that this was no more than a cosmetic improvement, with higher stock prices concealing the true extent of the major banks' nonperforming assets.

As much as half of the strong GDP growth in the first quarter of 2002 was due to exports. Consumer spending and corporate investment, the main domestic components of demand, are marking time or contracting. No self-sustaining recovery has begun. Now more than ever bold reform is needed to rebuild the economy and get it back on a growth track. But the economic policymakers do not seem to realize that this is the time to act. On the monetary policy front, the Bank of Japan seems inclined simply to wait for results from the substantial quantitative relaxation it has already introduced. The administration has recently come out with an additional package of measures aimed at countering deflation and promoting structural reform, but it was basically just a showpiece prepared for display at the June 26–27 Group of Eight summit in Kananaskis, Canada.

The government and the ruling parties have not even made up their minds about how the tax system should be reformed, a subject I will return to later. Should the emphasis be placed on reining in the massive budget deficit, or should reviving the economy take priority? Debate on the subject is getting nowhere because of a power struggle among the actors, which include the Ministry of Finance, the Council on Economic and Fiscal Policy, the Tax Commission, and the Liberal Democratic Party’s Research Commission on the Tax System. Prime Minister Koizumi is absent from the control tower, where he is supposed to be directing this debate, with the result that the discussions are going around in circles. Much the same can be said of the move to open up the postal services to participation by private-sector actors, one of Koizumi’s major priorities. The country’s leading parcel delivery company has announced that the proposed legislation on postal deregulation will in fact not promote the entry of private enterprise.

The so-called postal services reform has been turned into a vehicle for preserving and enhancing vested interests within the existing postal system. In the absence of top-down leadership on policies and reforms, the mandarins have reverted to form and are jealously guarding their powers. Heartened by Koizumi’s decline in popularity, the forces of resistance in the bureaucratic establishment are even seeking to strengthen their powers in the name of reform.

PROBLEMS AND TASKS Takenaka Heizô, minister in charge of economic and fiscal policy in the Koizumi cabinet, likens the first year of the reform program to an approach run, a period of gathering speed prior to a big jump. Over the next two years, he says, the reform measures should start to take effect. His position is that the economy can be invigorated through a combination of measures to stop deflation, revise the tax system, and roll back regulation, all premised on the strengthening of the financial system. Takenaka has not, however, clarified his thinking on the chances for meaningful reform in these various areas or on the specific steps to be taken. Perhaps his vagueness is due in part to the constraints on what a public figure can say, but the fact remains that the Koizumi administration's economic strategy remains hard to see even as it enters its second year.

In his article below, Kobayashi Keiichirô presents a lucid analysis of the fix the Japanese economy finds itself in. The 1990s were a period of fiscal stimulus and monetary relaxation aimed at propping up the economy. Neither banks nor ordinary companies were compelled to undertake drastic restructuring, and the writing off of nonperforming loans, which kept right on piling up, was held within the limits of what banks could pay for from their profits. But this policy approach can no longer be sustained, Kobayashi declares. He comes down hard on the government’s economic policy, asserting that the public’s loss of confidence in it has exacerbated the sense that Japan is at an impasse. In order to clear away bad loans, overcome deflation, and establish a new business model in the financial sector, he argues, the government must come up with long-term measures designed for the next 10 to 20 years.

The financial reforms South Korea has implemented provide an instructive contrast to the Japanese pattern of procrastination on writing off bad loans and restructuring the financial sector. I recently had the opportunity to discuss this subject with Korean policymakers and economists, and I was favorably impressed by three aspects of the Korean response: the bold infusion of public funds, the choice of a hard landing that reduced employment in the banking sector by 32%, and the adoption of policies to revitalize industry. On a more fundamental level, the responsible Korean officials had a firm understanding of principles to apply and directions to move in, and they were enthusiastic about translating their ideas into practice and willing to put considerable effort into persuading the public of the correctness of their approach. All these are weaknesses of the policymaking process in Japan.

Kobayashi points to the importance of reforming the financial sector and devising a new business model for it, arguing that public funds should be used for such purposes. South Korea drew heavily on public funds in piloting the financial sector to a hard landing, after which it sought to establish new practices in bank management while introducing capital from overseas. By comparison, Japan has taken a backward-looking and piecemeal approach to injecting public funds into banks. The big banks bear part of the responsibility for this, since they themselves have consistently downplayed the scale of the bad loans on their books. The upshot of the Japanese approach has been a loss of confidence in the Financial Services Agency and a delay in the recovery of banks' ability to function as financial intermediaries.

One person who has taken the task of crafting a new financial business model into his own hands is Matsumoto Ôki, the founder of Monex Inc. Matsumoto gave up his job as an executive at an American investment bank in order to try out a business model he had devised. In the interview with him that we include in this section, he unfolds the following argument: Japan’s institutions, systems, and ways of thinking are simply too different from what can be found elsewhere. It is wrong to get carried away by past successes and assume that Japan’s old institutions and systems can still be used for economic activities around the world. To some extent the Western way of business must be embraced. The Western model has the flexibility to change course and renew itself in response to shifting conditions and uncertainty. But in Japan, even the basic economic mechanisms are no longer working properly. Accordingly, the first thing on the agenda should be to make Japan a more “normal” country.

The debate in Japan over reform of the tax system provides one example of discussion on institutional reform. Let us therefore consider next the problems in Japan’s tax system and the tasks to be addressed, reviewing the direction of the reform, the status of the debate, and the policymaking process.

THE WEIGHT OF TAXES On May 19 a group of business executives and scholars headed by Kôsai Yutaka, chairman of the Japan Center for Economic Research, released its proposal for tax reform. Kôsai’s Tax Reform Study Group, which sees tax reform as pivotal to structural reform of the Japanese economy, advocates making “fairness, vitality, and simplicity” the catchphrase of the reform drive, thus slightly modifying the traditional dictum that a tax system should aim for equity, neutrality, and simplicity. It is because both individuals and companies have lost their vitality, the group feels, that Japan has become bogged down in a long slump and is seeing its competitive power decline. Pointing out that an age of globalized business activities is one in which companies are free to pick the countries they operate in, the group feels that bringing Japanese taxes into line with global norms is a matter of considerable urgency. The centerpiece of the reform, the group’s members say, should be a reduction in corporate taxation to enhance the competitive position of companies. They want the tax burden to be made lighter at the production stage of creating value and heavier at the stage of paying out the profits and consuming.

How heavy are Japan’s taxes in international terms? I attach a table and graph that shed some light on this question. In the case of personal income taxes, the bill paid by people in the middle- and low-income categories—the great majority of all taxpayers—is comparatively light, while the bill paid by those in the high-income category is on a par with that in other major industrial countries. The effective tax rate on earned income amounts to no more than 5% after deductions are taken for spouses, dependents, and the like. The tax threshold (the minimum annual income subject to taxation) is ¥3.84 million for a standard family (a wage earner, a spouse, and two children). This is almost ¥700,000 more than the ¥3.15 million threshold for a comparable American family.

A fairly steep schedule of graduated rates and generous deductions for dependent spouses act as disincentives for work by both wage earners and spouses. The study group accordingly proposes that the minimum taxable level of earned income be lifted and that the graduations be made less progressive. It further recommends separate taxation at a low, flat rate for income from sources like financial assets, thus creating a dual system of income taxation.

The effective rate of corporate taxes (national and local corporate income taxes and the corporate enterprise tax imposed by prefectures) has come down to 40.87% after cuts in the national corporation tax in 1998 and 1999. This is on a par with the American corporate tax rate of 40.75% (for California-domiciled corporations) but considerably above Britain’s 30.00% and Germany’s 38.44%. In an age when companies pick countries, the group observes, any country needing to recover competitive power will want to be a step ahead of other countries in lowering its corporate taxes. In order to encourage the renewal of production facilities, the group proposes the use of accelerated depreciation and preferential treatment for research and development outlays. It also proposes a major expansion in deductions for losses in order encourage start-ups. This would involve broadening the scope and extending the length of deductions from income for “angels” (investors who put up risk capital for new business ventures).

The group emphasizes that the reform process should start with tax cuts for plant and equipment investment and R&D spending, since these can provide immediate stimulus, and it advocates that a broadening of the tax base should be combined with a lowering of tax rates for individuals. Steps must eventually be taken to hike taxes in order to trim the government deficit, but they should be deferred until a recovery has kicked in, the group feels.

NEUTRALITY VERSUS VITALITY The economists and industrialists on the Council on Economic and Fiscal Policy—a relatively new advisory body created in January 2001, headed by the prime minister and also including the relevant government ministers—tend to share the thinking of Kôsai’s Tax Reform Study Group on how taxes should be reformed. But an entirely different view is prevalent in groups like the Tax Commission (a long-established government advisory panel) and the LDP’s Tax System Research Commission. To begin with, there is disagreement over whether to aim for “neutrality” or “vitality” in tax reform, and even the principle of neutrality is understood in different ways. The Ministry of Finance and the LDP want any tax cuts to be balanced with tax hikes of equivalent size, which they say will produce a revenue-neutral tax reform. But their critics charge that this simple formula cannot achieve a more important goal, which is to enhance the economy’s vitality.

Quite a few business executives echo an opinion expressed in the Nihon Keizai (Nikkei) Shimbun on May 9 by Toshiba Chairman Nishimuro Taizô. This is that cuts in the effective tax rate on corporations are needed to lift the competitive power of companies relative to their counterparts in the United States and other countries. Among economists, meanwhile, some have underlined that it is impossible from the start to maintain neutrality in the distribution of resources using the tool of taxes. For instance, University of Tokyo Professor Itô Motoshige asserts in a column in the June 3 issue of the Nikkei that the proper objective of taxes should be to correct distortions in the economy so as to enhance its dynamism.

Itô-Yôkadô President Suzuki Toshifumi waded into the debate with an article in the May 11 Nikkei characterizing the changes being considered as a patchwork without any guiding principles, and pointing to the need to come up with tax rules that people will accept and comply with. One more voice is that of Ogura Masao, director of the Yamato Welfare Foundation, who in the May 10 Nikkei asserted that reform of the tax system should be discussed only after first undertaking to slash government spending. To start with discussions of tax reform that include revenue-enhancing measures aimed at balancing the budget is to put the cart before the horse. The first order of business in his view is to eliminate the waste in fiscal expenditures.

BACK TO BUSINESS AS USUAL? The dynamics of the policymaking process have changed over the course of the past year. When Koizumi took office against a backdrop of enthusiastic public support, the Council on Economic and Fiscal Policy was able to take the lead over the bureaucracy and the ruling parties on the strength of Koizumi’s approval of its proposals. But in one year the power balance was reversed. These days it is the senior bureaucrats and powerful figures in the LDP who are calling the shots.

On June 21 the CEFP released a second edition of the Koizumi administration’s basic reform plan. In it, the council echoes the Tax Reform Study Group’s catchphrase of “fairness, vitality, and simplicity” as the principles for taxation. But it is revealing that in the section on specific tax measures, the document consistently limits itself to saying that particular changes should be “considered.” The CEFP has revealed its inability to go beyond generalities; the specifics are out of its hands. Most of its ideas are for the 2003–6 period, when the council says steps should be taken to reform national government spending and local administration and finances, to lower the effective rate of corporate taxes, and revise the tax deductions for spouses. Thought is also to be given to the introduction of “pro forma” corporate taxes based not on profits but on the size of businesses (capital, sales, number of employees).

Earlier in the same week, on June 17, the government announced a package of extra antideflationary measures for presentation to the Kananaskis summit. This featured three tax-cutting measures to go into effect from January 2003, before the end of the current fiscal year. Two involve companies, which will get cuts designed to stimulate R&D spending and capital investment. The third involves individuals, who will get lower rates for inheritance and gift taxes.

In this way the government has announced that it is putting tax relief first in order to reduce deflationary pressures and perk up businesses. The immediate impact will be minimal, however, since firms and families will not realize any benefits from the proposed tax cuts until after the start of fiscal 2003 in April next year. The government was constrained by its self-imposed cap of ¥30 trillion on annual bond issues, and evidently it was unable to exercise the flexibility required to revitalize the economy through bolder tax cuts. The limits of the Koizumi administration’s economic policymaking capacity have come into view. And no road map has been drawn up for the reforms ahead, since the lead actors in the bureaucracy and the ruling parties are still ironing out their differences. Clearly the policymaking process predating Koizumi’s arrival has reasserted itself.

The confusion in the tax debate was further highlighted by the differences between the June 17 package and the report released just three days earlier by the government’s Tax Commission. Pointing out that corporate taxes are now down to the American level, the commission advised against further action on that front. And unlike the CEFP, which positioned the recovery of vitality at the center of tax reform in its June 21 reform plan, the commission focused on balancing the budget in the future as a major goal. As the drafting of a tax reform for fiscal 2003 goes forward over the remainder of this year, Koizumi will have his hands full getting all concerned to point the reform in the right direction. (Nariai Osamu, Professor, Reitaku University)

© 2002 Japan Echo Inc.