Fiscal Reform and Government Debt in Japan: A Neoclassical Perspective Gary Hansen and Selo İmrohoroğlu UCLA Economics USC Marshall School June 1, 2012 06/01/2012 1 / 33
Basic Issue Japan faces two significant challenges High debt to output ratio Aging population Projected Inreases in Government Expenditures View issue through lens of neoclassical growth model. How big is the problem and what are the consequences of possible solutions? 06/01/2012 2 / 33
Two Significant challenges faced by Japan 1. High Debt 1.1 Net Debt to GNP Ratio 1 0.9 0.8 0.7 0.6 0.5 0.4 0.3 0.2 0.1 1980 1985 1990 1995 2000 2005 2010 Figure 1. Net Debt to GNP Ratio 06/01/2012 3 / 33
Two Significant challenges faced by Japan 2. Aging Population Dependency Ratios 0.9 0.8 0.7 0.6 0.5 0.4 0.3 0.2 65+ to 21 64 70+ to 20 69 2010 2020 2030 2040 2050 2060 2070 2080 2090 2100 Figure 2. Dependency Ratios 06/01/2012 4 / 33
Two Significant challenges faced by Japan Implications of the Aging Population: Fukawa and Sato (2009) 0.25 Government Purchases to GNP Ratio 0.2 0.15 0.1 1980 1990 2000 2010 2020 2030 2040 2050 2060 2070 2080 0.25 Transfer Payments to GNP Ratio 0.2 0.15 0.1 1980 1990 2000 2010 2020 2030 2040 2050 2060 2070 2080 Figure 3. Government Expenditures to GNP Ratio 06/01/2012 5 / 33
What We Do Use Hayashi and Prescott (2002) 1 Measure the size of fiscal adjustment needed 2 Calculate the effects of two alternative fiscal policies designed to achieve fiscal balance 06/01/2012 6 / 33
Methodology Economic actors know the future, including futures changes in government policy. Exogenous: total factor productivity, tax rates, government spending, transfer payments, and population levels. Actual values for 1981-2008, forecasts (Fukawa and Sato (2009)) after. Model determines: Output, hours, investment, consumption, capital stock, interest rates, and government debt. 06/01/2012 7 / 33
More on What We Do Implement a debt sustainability rule. Once an ad hoc threshold is reached, debt is reduced toward assumed long run level. Compute required revenue to reduce debt given projected government expenditures. Compute two alternative fiscal policy transitions Consumption tax Labor income tax 06/01/2012 8 / 33
Why These Alternative Policies The policies considered are not "optimal" policies. two considerations: We are motivated by 1 Politically there is likely an incentive to put off any reform as long as possible. This is why we use a debt to output trigger. 2 We focus on consumption and labor income tax rates because of their simplicity. Further research should explore things like increasing the retirement age, other reforms of entitlement programs, encouraging immigration, encourage female labor supply, etc. 06/01/2012 9 / 33
Main Findings Very large additional revenues needed to finance the projected increases in government expenditures due to aging About 30% of aggregate consumption each year If the government uses the consumption tax to finance the expected burden due to aging, then the consumption tax rate needs to increase from its current level of 5% to about 35%. If the labor income tax is used, then the tax rate will nearly double from its current level of 30% to about 60%. The welfare cost of using the labor income tax is 3.22% of consumption, which is more than twice that of using the consumption tax to restore fiscal balance. 06/01/2012 10 / 33
Model Endogenous: Hours worked (h t ), per capita consumption (C t ), output (Y t ), the stock of capital (K t+1 ), tax revenues, government debt (B t+1 ), and the price of government bonds, (q t ), from 1981 into the infinite future Population: N t+1 = η t N t. Exogenous: Tax rates τ h,t, τ k,t, τ b,t, τ c,t Government purchases G t Transfer payments TR t Working age population N t TFP A t, Use actual time series 1981-2008; forecasts and assumptions for 2009 and beyond. Eventually, the tax rates, G t /Y t, TR t /Y t, growth rates of N t and A t are all constant; economy converges to a balanced growth path. 06/01/2012 11 / 33
Revenue Required to Stablilize Debt Government Budget Constraint: G t + TR t + B t = η t q t B t+1 + τ c,t C t + τ h,t W t h t (1) +τ k,t (r t δ)k t + τ b,t (1 q t 1 )B t. Debt Sustainability Rule: D t = κι t (B t B t ), { 1 if Bs /Y ι t = s b max for some s t, 0 otherwise Replace TR t with TR t = TR t D t 06/01/2012 12 / 33
Calibration Tax Rates Tax rate on Capital Income: Updated version of Hayashi and Prescott (2002) Tax Rate on Labor Income: Updated version of Mendoza, Razin, and Tesar(1994) Tax Rate on Consumption: 0% 1981-1988 3% 1989-1996 5% 1997-2008 For 2009 and beyond, we assume that tax rates are constant at their 2008 levels. 06/01/2012 13 / 33
Calibration Tax Rates 0.5 Tax Rates 0.45 0.4 0.35 0.3 0.25 0.2 0.15 0.1 0.05 Consumption Tax Rate Labor Income Tax Rate Capital Income Tax Rate 0 1980 1985 1990 1995 2000 2005 2010 Figure 4. Tax Rates 06/01/2012 14 / 33
Calibration TFP, Population Growth Rates, Expenditure Ratios Actual Values used for 1981-2009 Table 3. Calibration of TFP and Population Growth Rates 1981 2009 2010 2050 2051 γ t Actual Values 1.02 (1 θ) 1.02 (1 θ) η t Actual Values Government Projections 1.0 Projections by Fukawa and Sato (2009) Table 4. Calibration of G /Y and TR/Y 1981 2009 2010 2050 2051 G /Y Actual Values linear increase from 0.198 to 0.238 0.238 TR/Y Actual Values linear increase from 0.148 to 0.188 0.188 06/01/2012 15 / 33
Calibration TFP, Population Growth Rates, Expenditure Ratios 90 Working Age Population 300 TFP (Normalized) 80 250 70 200 60 150 50 1980 2000 2020 2040 2060 2080 100 1980 2000 2020 2040 2060 2080 0.25 Government Purchases to GNP Ratio 0.25 Transfer Payments to GNP Ratio 0.2 0.2 0.15 0.15 0.1 0.1 1980 2000 2020 2040 2060 2080 1980 2000 2020 2040 2060 2080 06/01/2012 16 / 33
Calibration Parameters for Fiscal Balance: κ, b max, and b { 1 if Bs /Y ι t = s b max for some s t, 0 otherwise D t = κι t (B t B t ), For the debt to output ratio along the balanced growth path, b, we use a value of 60%. For b max, the debt to output ratio that triggers tax increases, we used 150% and 200%. For κ, see next slide. 06/01/2012 17 / 33
Calibration Revenue Requirements: b max = 150% Consumption Tax Equivalent Revenue Requirement, (B/Y) max = 1.5 0.5 0.4 κ = 0.15 κ = 0.2 κ = 0.25 0.3 0.2 0.1 0 1980 1990 2000 2010 2020 2030 2040 2050 2060 2070 2080 3 Debt to GNP Ratio, (B/Y) max = 1.5 2.5 2 1.5 1 0.5 0 1980 1990 2000 2010 2020 2030 2040 2050 2060 2070 2080 Figure 6. Revenue Requirement 06/01/2012 18 / 33
Calibration Revenue Requirements: b max = 200% Consumption Tax Equivalent Revenue Requirement, (B/Y) max = 2 0.5 0.4 κ = 0.1 κ = 0.15 κ = 0.2 0.3 0.2 0.1 0 1980 1990 2000 2010 2020 2030 2040 2050 2060 2070 2080 3 Debt to GNP Ratio, (B/Y) max = 2 2.5 2 1.5 1 0.5 0 1980 1990 2000 2010 2020 2030 2040 2050 2060 2070 2080 Figure 7. Revenue Requirement 06/01/2012 19 / 33
Quantitative Findings Benchmark Results 0.4 Hours Worked 0.35 0.3 Data Model 0.25 1980 1985 1990 1995 2000 2005 2010 1.5 x 10 6 Capital Stock 1 0.5 1980 1985 1990 1995 2000 2005 2010 6 x 10 5 GNP 5 4 3 2 1980 1985 1990 1995 2000 2005 2010 Figure 10. Capital, Labor and Output 06/01/2012 20 / 33
Quantitative Findings Benchmark Results 3.5 x 10 5 Consumption 3 2.5 2 Data Model 1.5 1980 1985 1990 1995 2000 2005 2010 1.5 x 10 5 Investment 1 0.5 1980 1985 1990 1995 2000 2005 2010 3 Capital Output Ratio 2.5 2 1.5 1980 1985 1990 1995 2000 2005 2010 Figure 11. Consumption, Investment, and Capital-Output Ratio 06/01/2012 21 / 33
Quantitative Findings Benchmark Results 1 0.98 Data Model Bond Price 0.96 0.94 0.92 1980 1985 1990 1995 2000 2005 2010 1 Debt to Output Ratio 0.8 0.6 0.4 0.2 0 1980 1985 1990 1995 2000 2005 2010 Figure 12. Bond Price and Debt to GNP Ratio 06/01/2012 22 / 33
Using a Distorting Tax Instead of Lumpsum Reduction in Transfers Transition Policy Fiscal policy is assumed to follow τ x,2009 if B s /Y s b max for all s t τ x,t = τ x + π if B s /Y s > b max for some s t and B t /Y t > b τ x if B t /Y t b. 06/01/2012 23 / 33
Using a Distorting Tax Instead of a Lumpsum Tax Consumption Tax 0.35 Consumption Tax Rate 0.3 0.25 0.2 0.15 0.1 0.05 0 1980 2000 2020 2040 2060 2080 2100 Figure 13. Consumption Tax Rate 06/01/2012 24 / 33
Using a Distorting Tax Instead of a Lumpsum Tax Labor Income Tax 0.65 Labor Income Tax Rate 0.6 0.55 0.5 0.45 0.4 0.35 0.3 0.25 0.2 1980 2000 2020 2040 2060 2080 2100 2120 Figure 14. Labor Income Tax Rate 06/01/2012 25 / 33
Transition Comparison 0.5 Hours Worked 0.4 0.3 0.2 0.1 1980 2000 2020 2040 2060 2080 2100 2120 6 x 10 6 Capital Stock 4 2 Lumpsum Tax Consumption Tax Labor Income Tax 0 1980 2000 2020 2040 2060 2080 2100 2120 3 x 10 6 GNP 2 1 0 1980 2000 2020 2040 2060 2080 2100 2120 Figure 15. Labor, Capital, and Output 06/01/2012 26 / 33
Transition Comparison 12 x 10 5 Consumption Lumpsum Tax 10 Consumption Tax Labor Income Tax 8 6 4 2 0 1980 2000 2020 2040 2060 2080 2100 2120 6 x 10 5 Investment 5 4 3 2 1 0 1980 2000 2020 2040 2060 2080 2100 2120 Figure 16. Consumption and Investment 06/01/2012 27 / 33
Transition Effective Tax Rates (1 τ) = (1 τ h )/(1 + τ c ) which implies τ = (τ c + τ h )/(1 + τ h ) 0.65 Effective Tax Rate 0.6 0.55 0.5 0.45 0.4 0.35 0.3 0.25 Labor Income Tax Adjusts Consumption Tax Adjusts 0.2 1980 2000 2020 2040 2060 2080 2100 06/01/2012 28 / 33
Transition Debt to GNP 3 Bond to GNP Ratio Lumpsum Tax Consumption Tax Labor Income Tax 2.5 2 1.5 1 0.5 0 1980 2000 2020 2040 2060 2080 2100 2120 Figure 17. Debt to GNP Ratios 06/01/2012 29 / 33
Transition Output Effects 0.4 0.2 Consumption Tax Labor Income Tax Output Loss 0 0.2 0.4 1980 2000 2020 2040 2060 2080 2100 2120 Figure 18. Output Effects 06/01/2012 30 / 33
Welfare Costs What percentage decrease in consumption each period would give someone in the benchmark (lump sum tax) economy the same lifetime utility as someone living in an economy where increases in the consumption tax or labor tax is used to achieve fiscal stability? λ c = 1.41% λ h = 3.22% 06/01/2012 31 / 33
Conclusions This Paper Fiscal day of reckoning is soon 2017-2022. A nearly PERMANENT increase in consumption tax rate of about 30 percent. A nearly PERMANENT increase in labor income tax rate of about 30 percent. 06/01/2012 32 / 33
Conclusions Other possibilities: social security reform immigration fertility encourage female labor force participation reduce spending 06/01/2012 33 / 33