Current Japanese Fiscal Conditions and Issues to be Considered

Current Japanese Fiscal Conditions and Issues to be Considered 2007 Ministry of Finance

Table of Contents 1. General Account Budget for FY2007 2. Trends in General Account Expenditures and Tax Revenues 3. Accumulated Government Bonds Outstanding 4. International Comparison of Fiscal Conditions 5. Long-term Debt Outstanding and Financial Assets in the Household Sector 6. Declining Birthrate and Aging Population 7. Problems of Fiscal Deficit 8. Efforts to Fiscal Consolidation in Major Developed Countries 9. Integrated Reform of Expenditures and Revenues 10. Characteristics of FY2007 Budget (Flexibility Allocating Budget Fund) 11. Efforts toward More Efficient Budgeting 12. Review of Special Accounts 13. Asset and Liability Reform 14. Personnel Expenses Reform 15. Trends in Fiscal Conditions 1 4 5 7 9 10 11 13 15 17 18 19 21 22 23 Discussion 1 Social Security Discussion 2 Central and Local Governments Discussion 3 Public Works Discussion 4 Education Discussion 5 Science & Technology Discussion 6 National Defense Discussion 7 Official Development Assistance Discussion 8 Agriculture, Forestry and Fisheries Discussion 9 Measures for Small-and Medium-Sized Enterprises (SMEs) Conclusion 25 31 35 37 38 39 40 41 42 43

1. General Account Budget for FY2007 General account expenditures for FY2007 stand at approximately 83 trillion yen, of which the national debt service (expenditures allocated to interest payment and debt redemption for national government bonds), social security-related expenditures, local allocation tax grants, etc. occupy more than two thirds of the total expenditures. Breakdown of Expenditures Expenditures (Unit: billion yen,%) Of which, interest payment expenses 9,514.3 11.5 National Debt Service 20,998.8 (25.3) Local Allocation Tax Grants, etc. 14,931.6 (18.0) General Account Total Expenditures 82,908.8 (100.0) Others 8,814.3 (10.6) Social Security 21,140.9 (25.5) Public Works Education National & Science Defense 4,801.6 (5.8) 6,947.3 (8.4) 5,274.3 (6.4) Former Military Personnel Pensions (and others) 923.5(1.1) Energy 864.7(1.0) Economic Assistance 691.3(0.8) Food Supply 607.4(0.7) Promotion of SMEs 162.5(0.2) Transfers to Industrial Investment 20.3(0.0) Miscellaneous 5,194.6(6.3) Contingencies 350.0(0.4) 1

Tax revenues cover only a bit more than 60 percent of total revenues, while the remaining nearly 30 percent depends on government bond issues, which will pose burdens on future generations. Breakdown of Revenues Revenues (Unit: billion yen,%) Government Bond Issues 25,432.0 (30.7) Other Revenues 4,009.8 (4.8) Tax and Stamp Revenues Income Tax 53,467.0 16,545.0 (64.5) General (20.0) Account Total Revenues Corporation 82,908.8 Tax 100.0 16,359.0 (19.7) Consumption Tax 10,645.0 (12.8) Others 9,918.0 (12.0) Gasoline Tax 2,135.0(2.6) Inheritance Tax 1,503.0(1.8) Liquor Tax 1,495.0(1.8) Customs Duties 929.0(1.1) Tobacco Tax 926.0(1.1) Motor Vehicle Tonnage Tax 716.0(0.9) Petroleum and coal Tax 533.0(0.6) Other Taxes 462.0(0.6) Stamp Revenues 1,219.0(1.5) 2

Comparison of the Government Budget to a Household Budget Household Budget for a month FY2007 Government Budget Household monthly income 400 thousand Tax and Non-tax Revenues 57.5 trillion Household expenditures 330 thousand General Expenditures 47.0 trillion Monthly Allowance for Children 100 thousand Payment on Loans 150 thousand Local Allocation Tax, etc. 14.9 trillion National Debt Service 21.0 trillion Shortfall = Borrowing 180 thousand Government Bond Issues 25.4 trillion Result Loan Outstanding 46,000 thousand Bonds Outstanding 547 trillion Transportation expenses (public works) : Approximately 50,000 Public order (defense cost) : Approximately 30,000 Heating and lighting expenses (energy policies) : Approximately 6,000 Pension and medical expenses (social security) : Approximately 150,000 Education expenses (education, and S&T (science and technology) promotion) : Approximately 40,000 Food expenses (Food stable supply-related expenses) : Approximately 4,000 3

2. Trends in General Account Expenditures and Tax Revenues Fiscal deficit (annual spending less annual revenues) has been shrinking due to reduced expenditures and increased tax revenues for these years, but the deficit remains at a high level. It is necessary to further reduce fiscal deficit. (Trillion yen) 100 90 89.0 89.3 Total Expenditures 84.4 84.8 83.7 82.4 85.5 84.9 83.5 82.9 80 78.8 78.5 70 69.3 75.1 75.9 70.5 70.5 73.6 65.9 60 50 40 30 50.6 32.4 61.5 60.1 59.8 57.7 54.9 54.4 54.1 53.5 53.6 51.9 53.9 53.0 52.1 51.5 50.8 51.0 50.7 49.4 49.1 50.5 47.9 47.2 46.8 45.6 43.8 Tax Revenues 43.3 41.9 38.2 37.5 Construction Bond Issues 35.0 35.4 35.5 34.9 34.0 33.0 31.3 30.0 Special Deficit-financing Bond Issues 27.5 25.4 20 Ad-hoc Deficit-financing Bond Issues 16.2 16.5 21.2 21.8 18.5 13.5 12.8 12.3 11.3 10 9.4 7.2 6.6 7.3 6.7 9.5 0 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 (FY) 4

3. Accumulated Government Bonds Outstanding 1) Trends in Government Bonds Outstanding Japan s outstanding government bonds have been increasing year after year. The outstanding government bonds are estimated to rise to 547 trillion at the end of FY2007, which amounts to 10 times as large as Japan s annual tax revenues and will surely impose heavy burdens on future generations. (Trillion yen) 600 Accumulated outstanding long-term government debts at central and local government levels, which include indebtedness at the local government level, are estimated at 773 trillion, or 148% of Japan s GDP, at the end of FY2007. 550 500 531.7 240.6 526.9 243.2 247.0 499.0 241.4 547.1 450 457.0 226.4 400 350 Equal to approx 10 year s General Account tax revenues Tax Revenues in FY2007 General Account Budget: Approx. 53 trillion 421.1 222.0 392.4 216.3 367.6 209.1 331.7 197.2 300 250 200 150 100 50 0 For reference FY2007 Government bonds outstanding: approx. 547 trillion (projection) 174.9 244.7 167.8 225.2 157.7 206.6 142.4 199.1 Approx. 4.28 million per person 192.5 131.5 Approx. 17.13 million per family of 4 178.4 166.3 171.6 115.8 176.1 107.5 Average disposable income of a working family: 151.8 156.8160.9 101.8 91.4 approx. 5.29 million 96.8 158.4 145.1 86.5 Average family size: 3.46 134.4 81.4 134.5 75.2 121.7 109.7 68.6 Construction Bonds (Note) 62.6 107.8 Disposable income and family size are based on the FY2005 Survey of Household Economy 96.5 by the Ministry of Internal Affairs and Communications 56.2 82.3 83.1 49.4 76.9 70.5 42.3 56.3 59.2 63.7 65.3 35.2 42.6 47.1 53.1 65.4 64.1 64.5 64.1 67.5 61.1 64.2 62.6 28.0 40.3 31.9 32.9 22.1 21.6 28.3 Special Deficit-financing Bonds 0.2 0.9 1.6 2.1 2.5 2.8 4.0 5.8 7.6 9.7 15.0 16.6 21.1 12.9 14.6 10.3 2.1 5.5 65 66 67 68 69 70 71 72 73 74 75 76 77 78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 (FY) 258.0 295.2 187.4 230.6 257.6 279.9 306.4 288.5 5

2) Factors for Increase in General Bonds Outstanding In the 1990s, expenditure growth was mainly attributable to the increase in public works related expenditures. In contrast, expenditures have been recently growing mainly due to increased social security-related expenditures resulting from the aging of Japanese society. Government revenues have been shrinking mainly because tax revenues are falling due to the economic downturn and tax cuts. Increase in General Bonds Outstanding from FY1990 to FY2007: 380 trillion Contribution of Expenditures: 130 trillion 20.0 15.0 (Trillion yen) Public works related expenditures ( 60 trillion) Social Security related expenditures ( 100 trillion) 10.0 5.0 0.0 5.0 Other expenditures excluding debt redemption 90 91 92 93 9594 96 97 98 99 00 01 02 03 04 05 06 07 (FY) Effect of tax revenues decline: 140 trillion 20.0 (Trillion yen) 15.0 Tax revenues 10.0 5.0 0.0 5.0 Non-tax revenues 90 91 92 93 9594 96 97 98 99 00 01 02 03 04 05 06 07 (FY) Others (long-term debt transferred from Japan National Railway and disposal of nonperforming loans, etc.) 6

4. International Comparison of Fiscal Conditions 1) General Government Financial Balances (International Comparison) Japan s fiscal balance has been improving in recent years, but the balance remains at the worst level among major countries in the world. (Percent of GDP) 5.0 4.0 3.0 2.0 1.0 0.0 1.0 2.0 3.0 4.0 5.0 6.0 7.0 8.0 9.0 10.0 11.0 Japan GermanyGermany FranceFrance UKUK USUS CanadaCanada ItalyItaly Canada(0.8) Germany(-1.4) France(-2.5) UK(-2.7) Italy(-3.2) Japan(-3.6) US(-4.2) 12.0 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 (CY) (Source)OECD Economic Outlook 80 (December 2006) 7

2) General Government Gross Debt (International Comparison) In the terms of the ratio of general government debt to GDP, some developed countries were steadily implementing fiscal consolidation in the late 1990s. However, Japan s gross debt has rapidly worsened to reach the worst level among developed counties. (Percent of GDP) 180 Japan(177.6) 150 120 Italy Italy(121.0) 90 Canada 60 US Japan France(74.6) Germany(69.9) Canada(66.3) US(61.8) 30 France Germany UK 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 UK(49.0) (CY) (Source)OECD Economic Outlook 80 (December 2006) (Note) Debt includes Financial Bills (FBs) 8

5. Long-term Debt Outstanding and Financial Assets in the Household Sector Borrowing at the central and local government levels (long-term debt outstanding) have amounted to approximately half the financial assets in the household sector. In addition, also to be noted is that the savings rate has been taking a downward trend due to the aging population. (Trillion yen) 1,600 1,400 1,200 1,000 Financial assets in the household sector 2 800 600 Long-term debt outstanding 3 4 400 1 1 200 1 0 (%) 25.0 75 80 85 89 90 95 97 00 02 05 07 (FY) 20.0 15.0 10.0 Saving rate Elderly people aged 65 and over as a percentage to total population 19.1 18.5 18.0 18.0 17.0 16.3 16.2 16.7 17.4 16.0 16.1 15.7 15.2 15.0 15.1 14.6 14.4 14.1 14.2 12.9 13.2 13.6 13.6 13.1 13.1 12.1 12.6 13.1 12.9 10.8 11.4 10.9 11.2 11.6 10.4 10.7 10.3 10.6 10.0 9.1 9.3 9.6 9.8 9.9 7.9 19.5 20.2 5.0 5.2 4.6 3.9 3.4 3.1 0.0 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 (FY) Source: Cabinet Office, Annual Report on National Accounts ; Ministry of Internal Affairs and Communication, Population Estimates 9

6. Declining Birthrate and Aging Population In Japan, aging is progressing faster than in any other developed country and expected to progress in the further. ( (%) ) 40 1) Ratio of People Aged 65 and over to the Total Population Japan(40.5) 35 30 25 20 Germany(28.4) France(27.1) United Kingdom(23.2) United States(20.6) 15 10 5 0 1950 1965 1980 200520001995 2025 2050 (CY) (Source) 1. Figures for Japan from National Census ( the Ministry of Internal Affairs and Communications) and Japanese Future Demographic Projections (National Institute of Population and Social Security Research, December 2006) 2. Figures for other countries are based on UN projections. (Note) Upper right figure of Japan is estimated figure for 2055 and Upper right figures of other countries are estimated figures for 2050. 2) Changes in the Demographic Pyramid 2000 2025 2055 105 105 100 100 95 95 90 90 85 85 80 80 75 75 70 70 65 65 60 60 55 55 50 50 45 45 40 40 35 35 30 30 25 25 20 20 15 15 10 10 5 5 0 0 120 100 80 60 40 20 0 0 20 40 60 80 100 120 120 100 80 60 40 20 0 0 20 40 60 80 100 120 Male Population(10thousand) Female Male Population(10thousand) Female Male Population(10thousand) Female 100 95 90 85 80 75 70 65 60 55 50 45 40 35 30 25 20 15 10 5 0 120 100 80 60 40 20 0 0 20 40 60 80 120100 Ratio of population between the ages 20 and 64 to those aged 65 and over (Total population) 3.6 (126.93 million people) 1.8 (119.27 million people) 1.2 (89.93 million people) (Source) National Census ( the Ministry of Internal Affairs and Communications) and Japanese Future Demographic Projections (National Institute of Population and Social Security Research, December 2006) 10

7. Problems of Fiscal Deficit National burden ratio (the sum of total tax payments and social security contributions as a percentage of National Income) stands at a lower level in Japan when compared with other major developed countries. Under the current framework, the declining birthrate and aging population will pose a heavier burden on future generations. 1) International Comparison of National Burden Ratio National Burden Ratio = Total Taxes as a percentage of National Income(NI) (%) + Social security contribution as a percentage of NI 80 Social Security contribution Potential National Burden Ratio as a percentage of NI 70 Total Tax as a percentage of NI National Burden Ratio 60 The fiscal deficit as a percentage of NI 50 40 30 20 10 43.2 14.6 25.1 38.2 8.7 23.2 51.7 10.5 39.7 31.9 37.1 47.5 Potential National Burden Ratio = National Burden Ratio + fiscal deficit as a percentage of NI 56.2 23.8 27.5 51.3 65.9 24.2 36.8 61.0 70.2 20.2 49.9 70.2 0 3.5 6.2 4.1 4.9 4.9 0.0 10 Japan (FY2007) United States (CY2004) United Kingdom (CY2004) Germany (CY2004) France (CY2004) Sweden (CY2004) Note:In 2004, Japan saw the national burden ratio of 36.9%, and potential national burden ratio of 45.1%, while the ratio of fiscal deficits to national income stood at 8.2. 2) Lifetime Benefits and Burdens by Generation Under the current system, younger generations will face an increased excessive net burden. (Per family,10thousand yen) 25,000 20,000 Lifetime net benefit 15,000 Total benefit 10,000 5,000 1,598 4,875 0 5,000 10,000 4,585 1,660 1,202 28 15,000 20,000 Total burden 25,000 Future generations People in their 20s (born between 1974 and 1983) People in their 30s (born between 1964 and 1973) People in their 40s (born between 1954 and 1963) (Source) Cabinet Office/ Annual Report on The Japanese Economy and Public Finance 2005 People in their 50s (born between 1944 and 1953) People in their 60s and over (born in 1943 or earlier) 11

3) Interest Payments and Government Bonds Outstanding If economic recovery sends up interest rates, interest payments will rise sharply due to accumulated outstanding debts. (Trillion yen) 24 22 20 18 16 Government Bonds Outstanding 547.1 536.9 526.9 (Trillion yen) 600 500 400 14 12 Interest Payments 300 10 9.5 8 6 7.0 7.9 200 4 100 2 0 75 76 77 78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 0 (FY) Impacts of Fiscal Deficit Accumulation of fiscal deficit Policy actions become less flexible (increased interest payments) Higher interest rates will pose a negative impact on the Japanese economy Increased inequality among generations Major obstacle to the realization of a vibrant economy and society 12

8. Efforts to fiscal consolidation in major developed countries In the 1990s, major developed countries pushed ahead with restoring fiscal balance through raising taxes and reducing social security benefit payments. Efforts on the expenditure side Efforts on the revenue side United States Introducing the cap rule (setting upper limit on expenditures) and the pay-as-you-go rule (no expenditure growth without revenue source). Raising individual income tax, corporation income tax and estate tax. Putting a curb on defense expenditures and social security expenses. Raising social insurance premiums. United Kingdom Setting an upper limit on public expenditure growth rate for the next 3 years, and reducing expenditures through privatization. Enhancing fiscal discipline (The government is able Raising value-added tax and indirect taxes. to borrow funds only if it has an investment purpose). Germany France Introducing a new rule that a new expenditure would require reducing existing expenditures at almost the same amount. Raising value-added tax, solidarity tax and environment-related taxes. Reducing expenditures through restraining social security expenses. Restraining defense expenses and civil servant salaries under the government doctrine that expenditure growth should be restrained at inflation rate or lower. Raising general society contributions, valueadded tax, corporate tax and surtax. Restraining social security expenditures. Italy Strictly applying the rule that a request for new expenditures must accompany financial sources. Raising value-added tax and corporate tax. Reducing social security expenditures, and cutting Raising social security premiums. down interest payments through improving the fiscal balance. Strictly combating tax evasion. Canada Reducing and abolishing low-priority programs, and selectively allocating budget fund to policy actions with higher priority. Raising corporate tax. Reviewing the federal government s subsidy to provincial governments, and restraining social Raising social security premiums. security expenditures. 13

Foreign Country Targets for Fiscal Consolidation Major developed countries have set their targets to equilibrate fiscal balance (primary balance plus interest payments). Flow Stock United States Balancing the budget at the federal government level by FY2012 (i.e., zero-growth of outstanding US treasury bonds) EU Medium-range fiscal administration targets : Fiscal position (on the SNA basis) should be break even or register a surplus (France aims to achieve this target in FY2010 while Italy intends to attain this target in FY2011) Zero-growth for outstanding debts at the central and local government levels Excessive deficit procedure (EDP) : Fiscal deficit (on the SNA basis) should be 3% of GDP or smaller Excessive deficit procedure (EDP) : Debts outstanding should be 60% of GDP (In Japan, outstanding debts at the central and local government levels have amounted to 148% of GDP.) Golden rule Confining borrowing to investment purpose only United Kingdom (Comparable to breaking away from special deficit-financing bonds in the Japanese context) Sustainability rule Public sector s net debts outstanding should be 40% of GDP or smaller. 14

9. Integrated Reform of Expenditures and Revenues The government has launched the basic policy action on integrated reform of expenditures and revenues in the Basic Policies for Economic and Fiscal Management and Structural Reform 2006, as endorsed at the cabinet meeting in July 2006, and Prime Minister s policy speech in January 2007. In accordance with these policy actions, Japan intends to push ahead with fiscal consolidation. Roadmap and Targets of Fiscal Consolidation Phase (FY2001 FY2006) : Reforms by the Koizumi Cabinet Phase (FY2007 early 2010s) Achieve surplus in the primary balance as a first step toward fiscal consolidation. Continue fiscal consolidation as in the first period and ensure a surplus in the primary balance of the central and local governments combined by FY2011. Aim to achieve a primary balance for the central government as much as possible and promote fiscal consolidation, ensuring a balance between central and local governments. Phase (early 2010s mid 2010s) Stop the ballooning of the debt-to-gdp ratio and decrease it in a stable manner. Ensure surplus in the primary balance of the central and local governments. Aim to stop the ballooning of central government s debt-to-gdp ratio and reduce it in a stable manner. Primary Balance The situation where expenses, other than public debt expenses (debt servicing costs + redemption costs), are covered by revenues other than proceeds from the issuance of public bonds (mainly tax revenues) Revenues Expenditures When Primary expenditures and revenues are balanced Government Bond Issues Increase in fresh borrowing Debt Redemption Decrease in Debt National Debt Service Ratio of debt outstanding to GDP rises if nominal interest exceeds nominal GDP growth rate Interest Payment Ratio of debt outstanding to GDP remains constant if interest rate is equal to nominal GDP growth rate Tax Revenue, etc. General Expenditures, etc. Ratio of debt outstanding to GDP decrease if nominal GDP growth rate exceeds nominal interest rate Increase in Net Debt Outstanding 15

Reforms on the expenditure side from FY2007 to the early 2010s Target : Achieving a surplus in the primary balance of the combined budget of the central and local governments by FY2011 Fiscal gap to be filled : Approximately 16.5 trillion (necessary amount to attain the target), out of which expenditure reduction represents 14.3 11.4 trillion. Contents of expenditure reduction Social Security Personnel Expense Public Investment Other Expenditure Notes : Total FY2006 31.1 30.1 18.8 27.3 FY2011 Baseline 39.9 35.0 21.7 31.6 107.3 128.2 Fiscal gap to be filled 16.5 FY2011 Reformed 38.3 32.4 16.1 17.8 27.1 113.9 Reduction Also aiming to achieve the primary balance for the central government as much as possible. (In trillions of yen) Remarks Public works related expenditure 3% 1% Local government investment 3% 1% Social and technology expenditure 1.1% economic growth rate 1. The figures shown above represent the data both at the central and local government levels unless otherwise specified (on the SNA base). 2. The data in the Remarks column represent nominal growth rate (on a year-on-year bases as a percentage to overall GDP) of major general expenditures that correspond to expenditure reduction as well as nominal-based reduction rate for local government investment (based on local public finance program). 1.6 2.6 5.6 3.9 4.5 14.3 ODA 4% 2% Policy Speech by Prime Minister Shinzo Abe to the 166th Session of the Diet (excerpt) January 26, 2007 Regarding any possible increases in burden, even after thoroughly executing these reforms, we must secure a stable supply of revenue source in order to avoid shifting the burden onto the shoulders of future generations. We will start full discussions from fall this year, and endeavor to realize fundamental reform of the taxation system, including the consumption tax, from the viewpoint of being in line with the concept of sharing the burden equitably among all generations, while taking into account the forecast of the expenditures required for social security benefits and countermeasures for the declining birthrate, with FY2007 as a target. 16

10. Characteristics of FY2007 Budget (Flexibly Allocating Budget Fund) Ensure the implementation of the expenditure reform stipulated in Basic Policies 2006 4.5 trillion reduction of new bond issuance the larger-ever reduction Together with the 1.7 trillion debt redemption in the special account for local allocation tax grants, substantial fiscal consolidation of 6.3 trillion will be achieved. Prioritize budget allocation to such areas as: strengthening economic growth, giving those who have failed in business a second chance to build a career, addressing the declining birthrate and rebuilding education. Increase/decrease in major expenditures (FY2001 vs. FY2007) (The data incorporates the tax revenue sources transferred to local governments in a mechanical fashion.) Even with strict expenditures reform, social security-related expenditures have been rising sharply. [FY2001 vs. FY2007] Growth rate (%) Social security-related expenditures + 5.0 rillion ( 17.6 rillion Others 3.7 rillion ( 31.0 rillion General expenditures + 1.3 rillion ( 48.7 rillion 22.6 rillion) growth rate 28.5 27.4 rillion) growth rate 11.9 50.0 rillion) growth rate+2.7 30% Restraining expenditure growth through restructuring of the social security system 20% 10% 28.5% Social security-related expenditures + 5.0 trillion (+28.5 ) Defense-related expenditures 0.2 trillion ( 3.1 ) 0% 10% 20% 2.7% Growth rate of general expenditures Education and S&T (science and technology) promotion expenditures 0.1 trillion ( 1.2 ) Public works-related expenditures 2.4 trillion ( 25.0%) Others 1.1 trillion ( 11.0%) 30% 17

11. Efforts toward More Efficient Budgeting The government takes the following policy actions in order to further improve budget efficiency through enhancing the cycle consisting of Plan (formulation the budget), Do (executing the budget), Check (evaluating and verifying the budget) and Action (incorporating the evaluation results) processes for evaluating how budget funds are spent as well as what kind of results the budget has yielded, and then making use of evaluation results for future budgetary planning process. Plan (planning the budget) Budgetary PDCA cycle Action (incorporating the evaluation results) Do (executing the budget) Check (evaluating and verifying the budget) Budget Execution Survey Audit reports, etc. 1.Aiming to improving efficiency at a deeper level 1) Incorporating the results of Budget Execution Survey Thoroughly evaluating the necessity of projects or programs in the Budget Execution Survey process and, then, appropriately reflecting the evaluation results to the budgetary request/examination process. Based on the suggestions of the Budget Execution Survey, the government has decided to stop or suspend five projects. Cutting down unnecessary budgetary fund of 28.8 billion in the FY2007 budget (including the investi gations conducted by local finance bureaus). 2) Properly incorporating the settlements and audit-related reports Properly incorporating settlement-related parliamentary resolutions and Board of Audit s audit results into the budget Thoroughly reviewing programs and budgetary funds, paying due attention to cabinet decisions 2.Aiming to improve efficiency in a broader manner 1) Checking out budgets in a broader manner Expanding local finance bureau s Budget Execution Survey and disclosing the evaluation results 11 projects: Cutting down unnecessary budget fund of 2.3 billion for the FY 2007 budget Increasing projects subject to Budget Execution Survey Projects subject to Budget Execution Survey: 57 projects in FY2005 68 projects in FY2006 Number of field surveys: 542 locations in FY2005 816 locations in FY2006 (including investi gations conducted by local finance bureaus) 2) Listening to a wider variety of opinions In the Budget Execution Surveys conducted by local finance bureaus, examiners find new projects from the viewpoint of local residents. Setting up the opinion box on budget execution section on the MOF website (December 20,2006) http://www2.mof.go.jp/enquete/yosan-opinion.html 18

12. Review of Special Accounts What are Special Accounts? The accounts of the central government consist of general account and special accounts. Special accounts are designed to operate particular projects at the central government level and to manage specific funds. As of April 2007, the Japanese government has 28 special accounts. Expenditures from Special Accounts FY2007 Budget Total expenditures from special accounts : 362 trillion Net amount : 175 trillion (Total expenditures less duplicate entries) Local allocation tax grants, etc. 14.8 Transfer to Fiscal Loan Program Funds 18.8 Duplicate entries (Trillion yen) 11.6 ( 0.7) Social security benefit payments 51.4 Debt redemption and interest payment 78.9 Expenditures for repaying central government s debts Expenditures for pension benefits, health insurance benefits and other social security benefits payable in accordance with applicable laws Fund-raising for Fiscal Loan Program Funds selfsustaining loan programs (issuing fiscal loan bonds) Funds for local government finance Note : Clerical expenses, personnel costs and other program expenditures (such as welfare program expenditures) that would be considered special account s wasteful expenditures are all included in 11.6 trillion. 19

Reforms on special accounts Special accounts are separated from the general account in order to clearly indicate how a particular project or fund is managed. Analysts point out many problems: Many special accounts would lead to difficulty in understanding overall budgetary framework; and an excessive number of special accounts would result in insufficient monitoring, leading to wasteful expenditures. As a result of discussion on necessary reform, the government has decided to incorporate the basic philosophy of FY2006-FY2010 special accounts reforms into Administrative Reform Promotion Law. Outline of Act on Special Accounts (1) Abolishing and merging the current 31 special accounts into 17 special accounts (2) Reviewing special account s particular accounting procedures in a cross-sectoral manner, and reorganizing accounting procedures that are different from the general account (such as disposal of surplus fund) (3) Setting up appropriate rules to disclose special account-related information, such as preparation and disclosure of financial statements in accordance with corporate accounting practices Efforts for FY2007 budget Making use of surplus fund: 1.8 trillion The total 1.8 trillion funds are transferred to the general account in accordance with Act on Special Accounts. (1) Special Account for Foreign Exchange Funds : 1,629.0 billion (2) Special Account for Industrial Investment : 79.4 billion (3) Special Account for Trade Insurance : 49.2 billion (4) Special Account for Registration : 3.8 billion Thorough expenditure cuts: 0.7 trillion (5) Special Account for Motor Vehicle Inspection and Registration : 2.9 billion (6) Special Account for Patent Registration : 1.5 billion (7) Special Account for Urban Development Loan : 0.6 billion By reviewing related projects and further streamlining these projects, the government has reduced special accounts expenditures by total 0.7 trillion on year-on-year basis. The total expenditures from special accounts have decreased to 11.6 trillion. Examples of expenditure cuts (1) Cutting down fiscal expenditures through reviewing personnel cost and clerical expenses : 24.6 billion (2) Cutting down fiscal expenditures to independent administrative agencies and government-affiliated public corporations : 116.0 billion (3) Cutting down fiscal expenditures through abolishing/merging special accounts : 2.7 billion 20

13. Asset and Liability Reform To achieve small, efficient government and put a curb on debts growth, the government will reduce state assets by approximately 140 trillion in order to halve state assets as a percentage to GDP at the end of FY2015. In addition, the government will seek out an appropriate asset/liability management approach by actively employing private sector s expertise. Major actions in FY2007 budget Fiscal Investment and Loan Program (Reducing loan outstanding by more than 130 trillion in the next 10 years) Scaling down Fiscal Investment and Loan Program through selectively allocating funds to high priority programs and improving project efficiency FY2006 estimate: 15,004.6 billion FY2007 estimate: 14,162.2 billion (down 842.4 billion) Preparing for securitization of the FILP Loan Establishing applicable laws to put them into effect in FY2007. The FY2007 budget provides necessary fund ( 200 billion). Image of reducing the FILP Loan outstanding in line with the aforementioned framework At the end of FY2005: Approximately 233 trillion Outcome of fiscal loan reforms: Down 110 trillion In FY2007 : Under review Additional efforts Approximately 20 trillion More than 130 trillion (1) Selectively allocating funds to high priority projects and improring project efficiency (2) Selling and securitizing existing loans and securities holding to turn them into off-balance positions (3) Further making use of government guarantees Government-owned assets (The government intends to sell 12 trillion-worth assets in the next 10 years) 1. Housing for national public servants (Estimated gains on sale: Approximately 1.0 trillion) Housing in Tokyo 23 wards: 61 apartments will be abolished in FY2007. Housing outside Tokyo 23 wards: The expert panel launched an interim report in March 2007. 2. Government buildings (Estimated gains on sale: Approximately 0.5 trillion) In March 2007, the expert panel launched an interim report on how to sell government office buildings in Kasumigaseki, Otemachi or other locations in Tokyo 23 wards. 3. Unused state-owned land (Estimated gains on sale: Approximately 2.1 trillion) Accelerating the sale process by employing proper methods in accordance with the revised National Property Law The FY2007 budget estimates revenues of 216.5 billion (up 34.9 billion from the preceding fiscal year) 4. Investments in privatized enterprises (Estimated gains on sale: Approximately 8.4 trillion) Starting to sell Japan Alcohol Corporation shares within FY2007 The FY2007 budget estimates revenues of 14.0 billion by selling two thirds of Japan Alcohol Corporation shares owned by the government. 21

14. Personnel Expenses Reform Under extremely sever fiscal situation, the government must strictly review its personnel expenses and it has been steadily pushing ahead with reforms on the number and salary of civil servants. Personnel cost on national public servants (Net total of general account and special accounts) Net reduction of the number of national public servants FY2006 : FY2007 : 5,408.6 billion 5,370.9 billion * Reducing expenses by 194 billion, compared to no reform FY2006 : FY2007 : 331 thousand 328 thousand workers workers (1) Number of central government officials In FY2007, the government achieved net reduction of national public servants at a quicker pace than the FY2006 level (down 1,502 public servants), intending to attain the net reduction target of 5.7% or more of national public servants in the 5-year period.* * Net reduction of the number of national public servants as approved at the cabinet meeting on June 30, 2006. (2) Salary The budgets consider the salary reform for reflecting regional wage levels in the private sector as well as National Personnel Authority s new approach for comparing salary levels between the public and private sectors (e.g., comparable enterprises size: Private enterprises with 100 workers private enterprises with 50 workers). Reference Data #1:Local Public Servants (Outline of FY2007 Local Public Finance Program (salary-related)) FY2007 local public finance program salary-related expenditures : 22,511.1 billion (down 65.8 billion, or 0.3%, on a year-on-year basis) 1) Personnel cut: Net reduction of 34,000 civil servants (exceeding 1-year s reduction of the overall 5.7% personnel cut by 5,000 workers) 2) Salary: Expenditures are reduced by 400 billion through conducting salary structural reforms, introducing new method for comparing salaries between the public and private sectors and taking into considerations salary levels of regional private sectors. Reference Data #2: Number of Civil Servants per 1,000 People Japan 2.6 33.1 France 28.3 87.6 United Kingdom 7.4 79.5 United States 4.0 78.1 Germany 2.2 55.8 0 10 20 30 40 50 60 70 80 90 100 Source : Data prepared by Ministry of Internal Affairs and Communications (people) Note 1 : The figures represent the FY2005 data for Japan, the FY2004 data for the UK and US, and the FY2003 data for France and Germany. Note 2 : represents the number of civil servants at the central government level (excluding defense). 22

15. Trends in Fiscal Conditions (%) 50 45 40 35 30 Nominal GDP growth (68SNA for FY1964-1980, 93SNA for FY1981-2007) (Actual results for FY1964-2005, estimates for FY2006, projections for FY2007) Bond dependency ratio (ratio of bond issues to total expenditures) 25 20 15 14.2 10 5 7.2 0 64 65 66 67 68 69 70 71 72 73 74 75 76 77 78 79 80 81 82 83 84 85 5 (Trillion yen) 8.0 6.0 4.0 2.3 2.0 0.0 0.2 0.3 0.2 0.3 0.4 0.9 1.3 0.0 2.0 0.2 0.4 4.0 3.6 6.0 8.0 10.0 Tax Revenues Settlement minus Initial Budget 2.2 0.1 0.5 0.5 0.0 0.3 64 65 66 67 68 69 70 71 72 73 74 75 76 77 78 79 80 81 82 83 84 85 0.9 3.3 6.1 0.4 Promotion of fiscal reform Minus ceiling Goal set to end dependence on bond issues in 1990 Zero ceiling Global recession First step toward fiscal reconstruction Goal set to end dependence on bond issues in 1984 Second oil crisis Locomotive theory Active fiscal policy for 7 % economic growth at Bonn Summit Active fiscal policy backed by a current account surplus Goal set to end dependence on bond issues in 1980 Supplementary budget to launch special deficit-financing bonds 2 trillion in tax cuts First oil crisis First year of high-level social welfare Nixon Shock (August) Efforts to reduce bond dependency with tax revenue rise resulting from high economic growth Introduction of construction bonds FY1965 supplementary budget to issue revenue-covering bonds 23

Recession Bond issues (Trillion yen) 45 Construction bonds Special deficit-financing bonds Ad-hoc deficit-financing bonds Actual results for years up to FY2005, figures following supplementary budget for FY2006, and initial budget for FY2007 6.7 36.6% 31.3 32.9% 27.5 30.7% 7.8 25.4 6.4 5.2 21.1 23.5 20.2 40 35 30 25 20 15 10 1.0% 1.5% 2.2% 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 (FY) 5 0 1.3 5.6 5.7 3.9 2.1 0.7 0.1 2.1 1.5 3.8 5.1 4.6 2.0 8.1 7.2 2.6 1.8 In FY2006, Tax Revenues Supplementary Budget minus Initial Budget 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 3.9 9.1 2.8 3.0 (FY) New government bond issuance reduced by 4.5 trillion, hitting record-high reduction of government bond issuance The Abe cabinet formed 29.97 trillion-worth government in the initial budget bond issuance planned 30 trillion-worth government bond issuance planned in the initial budget The Koizumi cabinet formed Permanent national and local tax credits worth more than 6 trillion Suspension of the Fiscal Structure Reform Law 4 trillion in special tax cuts Consumption tax rate hike Enactment of the Fiscal Structure Reforms Law 6 trillion in income and other tax cuts Special deficit-financing bond issues resumed (Accumulation of government bonds ended) New goals for medium-term fiscal management Dependence on special deficit-financing bond issues ended Introduction of consumption tax Utilization of proceeds from NTT share sales 24

Discussion 1 Social Security In Japan, social security benefits and contributions are increasing in line with the rapid aging of the population. To provide a stable and efficient social security system that will be sustainable in the future, Japan must eliminate intergenerational inequality and secure a balance between social security benefits and contributions. 1)Trends in Social Security Benefits Trillion yen 150 141 125 116 65 105 100 75 1961 Universal Pension Coverage Universal Health Care Coverage 1973 First Year for Welfare Society (free medical treatment for the elderly, etc.) 78 90 54 59 65 47 50 47 48 36 Pension 32 37 25 25 28 28 21 17 18 12 Medical care 15 10 9 7 4 Long-term care 1 2 Welfare, etc. 1960 1965 1970 1975 1980 1985 1990 1995 2000 2006 2011 2015 2025 Social security benefits (A) National Income (NI) (B) Ratio of social security benefits to NI (A/B) 1970 4 61 5.8% 1980 25 203 12.2% 1990 47 348 13.6% 2000 78 372 21.0% 2006 90 376 23.9% 2015 116 461 25.3% 2025(Reference) 141 540 26.1% Sources: The data before FY2000 come from National Institute of Population and Social Security Research, The Cost of Social Security in Japan 2003 (September 2003); Cabinet Office, National Accounts, etc. The data from FY2006 onward come from Reviewing Social Security Benefits and Contributions (May 2006, Ministry of Health, Labour and Welfare s Case A (moderate economic growth)). 25

On average, elderly households do not face severer economic conditions than other age groups. Rather, their personal savings and assets substantially exceed those of other age groups. 2)Economic Conditions Surrounding the Elderly The average income at elderly households is not so much less than at other households Average income per household member (excluding three-generation households) (Thousand yen) 2500 2000 2,033 1,842 1500 1000 500 0 Average for all households Householders aged 65 or over (Source) Ministry of Health, Labor and Welfare Elderly households outperform working households in terms of assets including savings, holding about twice the level of saving on average (Million yen) 80 70 60 Assets 59.61 50 40 Savings 39.00 30 24.84 20 10 12.92 0 Working households Elderly households All households Householders aged 70 or older (Source) Family Income and Spending Survey(2005 average), Ministry of Internal Affairs and Communications (Source) National Consumption Survey(2004), Ministry of Internal Affairs and Communications 26

Medical Care With the aging of the Japanese population, medical care expenditures financed with premiums and taxes have been increasing faster than the economic growth rate. To provide sustainable universal health care insurance system under such conditions, it is necessary to restrain medical care expenditures by reducing and streamlining medical service delivery costs, selectively allocating funds to high-priority programs and improving efficiency in medical care benefits. 1) Breakdown of National Health Care Expenditures ( 32.1 trillion in FY2004) - Age bracket analysis: Citizens aged 65 or older (20% of overall population) occupy approximately 50%, and those aged 75 or older (10% of overall population) occupy approximately 30%. National health care expenditures (32.1) Citizens younger than 65 years old: 49% (15.7) Citizens aged 65 or older: 51% (16.4) [Citizens aged 70 or older: 41% (13.0); those aged 75 or older: 28% (9.0)] - Revenue source analysis: Patients are paying 15% of overall expenditures while the remaining 85% are financed with the public funds, such as taxes and premiums. Public funds (taxes): 35% (11.1) [Central government: 26% (8.4); local governments: 9% (2.8)] Premiums: 50% (16.0) Business owners: 21% (6.6); persons insured: 29% (9.4)] Patient charges: 15% (4.9) - Expenditures structure: Personnel costs for doctors, etc.: Approximately 50%; Drugs and medicines: Approximately 20%; and others: Approximately 30% Personnel costs for doctors, etc.: 48% (15.3) Drugs and medicines: 22% (7.0) Healthcare materials: 7% (2.1) Commission expenditures, Heating and lighting expenses: 24% (7.7) Note: The figures represent the FY2004 data. The figures in parentheses represent the data in 1 trillion. 2) Regional Gaps in Medical Care Costs There are wide gaps in per capita medical expenses for elderly people between different prefectures. Generally, per capita medical care expenses are higher in prefectures with more sickbeds. elderly for expenses medical in-patient capita Per Correlation between per capita in-patient medical expenses for elderly people and number of sickbeds per 100,000 people (Thousand yen) 600 is 2.8-fold difference between Kochi (No.1) and Kanagawa (No.47) peoplethere 550 500 450 400 350 300 There is 1.8-fold difference between Hokkaido (No.1) and Nagano (No.47) Coefficient of correlation:0.745 250 800 1000 1200 1400 1600 1800 2000 2200 2400 Number of sickbeds per 100,000 people (Excluding facilities for long-term nursing care) In-patient medical expenses include meal costs during hospitalization (actual data for FY2004)

Japan shows significant gaps with countries, particularly in terms of medical care expenditures for elderly citizens. Medical expenditures per elderly citizen stands at a significantly higher level than those for younger generations (approximately 5 times as large as medical expenditures for younger generations in Japan, while 2 to 4 times in foreign countries) Japanese elderly citizens occupy a greater number of hospital beds and tend to stay in hospitals for a longer period than elderly people in foreign countries (Number of hospital beds: 2 to 4 times as large as foreign countries level; number of days in the hospital: 3 to 6 times as long as foreign countries level) Japanese citizens visit hospitals more frequently (the highest level among OECD member countries; 2 to 5 times as frequent as foreign countries level) Japan has a greater number of advanced medical equipment types (CT: 6 to 13 times as many as countries countries level; MRI: 4 to 11 times as many as foreign countries level) 4) Share of Generic Drugs, and Gaps with Foreign Countries Sales volume of generic drugs in Japan stands at approximately a third of sales volume in the US, the UK or Germany. Country name Japan (2004) United States (2005) United Kingdom (2004) Germany (2004) France (2004) Volume 17 56 49 41 12 Share of generic drugs Monetary Amount 5 13 21 23 6 (Unit: %) Reference: Foreign countries efforts to finance drug-related expenditures France sets out the redemption prices for some drugs (for outpatient purposes) based on generic drug s price level. If the drug expenses exceed the generic drug s price level, patients need to pay for the excess portion. (2004-) In Germany, patients are supposed to pay 10% of their drug costs (for outpatient purposes). However, if the drug cost exceeds a certain price level (i.e., the reference price level set out between original drug s prices and generic drug prices), patients need to pay for the excess portion.

Public Pension System Paying attention to long-term population and economic trends, Japan needs to provide stable and equal public pension system. Outline of FY2004 Pension System Reform [Automatic adjustment of benefits based on fixed premium contributions and macroeconomic indexation] Introducing the new framework that sets out final pension premium levels and automatically adjusts pension benefit levels within a premium revenue level (i.e., macroeconomic-indexed framework that takes into considerations the lower premium revenues resulting from decreased labor population in the future). Welfare pension: Raising the pension premium by 0.354% every year since October 2004 (14.996% since September 2007) 18.30% from September 2017 onward National pension plan: Raising the monthly pension premium by 280 every year since April 2005 (based on the FY2004 price level) [ 14,100 from April 2007 onward] 16,900 from September 2017 onward (based on the FY2004 price level) [State Contribution s Share of Basic Pension Benefits] After fundamental tax reform to provide stable and necessary revenue sources in FY2007, the government intends to raise the state-contribution portion of basic pension benefits to half of the overall basic pension benefits at the latest in FY2009. Long-term Care As nursing-care insurance benefits are estimated to increase more than economic growth rate, it is necessary to restrain benefit expenditures by reducing/streamlining medical service delivery costs, selectively allocating funds to high-priority programs and improving efficiency in nursing-care insurance benefits. 1) Trends in Long-term Care Insurance Benefits and Premiums Nursing care insurance premiums have been increasing as nursing care insurance benefits have been rising substantially [Benefits] 3.2 trillion 4.1 trillion 4.7 trillion 5.1 trillion 5.6 trillion 6.0 trillion 6.5 trillion 6.7 trillion FY2000 FY2001 FY2002 FY2003 FY2004 FY2005 FY2006 FY2007 (Note) Actual results for FY2000-2004,and initial budget figures for FY2005-2007 2) Premiums Paid by over 65 Year Old [national average (monthly, weighted average)] First stage (FY2000 FY2002) Second stage (FY2003 FY2005) Third Stage (FY2006 FY2008) 2,911 3,293 (+13%) 4,090 (+24%)

Public Assistance As public assistance recipients has been increasing, it is necessary to carefully review the current framework from the viewpoints of providing an equal program and promoting self-help for public assistance recipients. Trend in Number of Public Assistance Recipients and the Central Government Contributions In line with an increase in the number of public assistance recipients, the central government contributions in the budget have been rising (Thousand pepole) 2200 (Billion yen) 2,200 2000 Assistance amount per recipient 2,000 1800 Average at approx. 1.8 million per year 1,800 1600 (Note) Calculated by dividing public assistance expenses in FY2005 (Actual expenses including medical assistance. Taking into account local government contributions) by the number of public assistance recipients Initial budget amount of public assistance 1,600 1400 1,400 1200 1,200 1000 1,000 800 Number of public assistance recipients 800 600 600 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 (FY)

Discussion 2 Central and Local Governments The central government has deficits both in the primary and fiscal balances while local governments enjoy surplus in the primary and fiscal balances. Outstanding debts at the central government level have been increasing because the central government has a fiscal deficit, while local governments will see decreased outstanding debts in the future, helped by their fiscal surplus. Central Government s Budget and Local Pubic Finance Program (based on the FY2007 data) Increase in debts outstanding Fiscal Balance -14.1 Primary Balance -4.4 (Central government (general account)) Revenues Expenditures 82.9 82.9 Bond Issuance 25.4 Tax Revenues 53.5 Debt Redemption 11.4 Interest Payment, etc. 9.6 National Debt Service 21.0 (Local public finance program) Revenues Expenditures 83.1 83.1 Local Bond Issues 9.7 Local Taxes, etc. 41.1 Local Allocation Tax, etc. 15.5 Debt Redemption 11.5 Interest Payment, etc. 3.5 Debt Service Expenditures, etc. 15.0 General Expenditures 47.0 General Expenditures 65.7 Fiscal Balance +1.9 Primary Balance +5.4 (Unit:trillion yen) Decrease in debts outstanding Others: 4.0 Local Allocation Tax, etc. 14.9 National Subsidies 10.2 Others: 6.7 Others: 2.4 Outstanding long-term debt of the central government is about three times as large as that of local governments. The ration of outstanding long-term debt to tax revenues (after adjusted for local allocation tax grants and other transfer) is 15.3 for the central government against 3.5 for local governments. Ratio of tax revenues to outstanding central and local government debt (estimated for the end of FY2007) (Trillion yen) 700.0 600.0 500.0 400.0 300.0 200.0 Central government Local governments 15.3 times about 607 100.0 0.0 39.8 Tax revenues (After local allocation tax and other transfer) 56.4 3.5 times about 199 Outstanding long-term debt (Projected for the end of the fiscal year) (Notes)1. Central government revenues include special account taxes. 2. Local tax revenues = Estimates in local public finance program + Estimates outside the program 3. Tax revenues after local allocation tax and other transfers are those after the local allocation tax and the local transfer tax are transferred to local governments.