How Much do the Government’s Fiscal Estimates Change Under Different Conditions?

Hidetaka Yoneyama
Senior Research Fellow

August 16, 2010 (Monday)

Outline of government estimates

The government has formulated its “Financial Management Strategy” (adopted on June 22 at the Cabinet meeting) and announced its “Economic and Fiscal Mid- and Long-term Estimates.” These estimates strongly suggest that it is essential to increase tax revenue to achieve a primary balance surplus and reduce government debt as a percentage of GDP.

The primary balance will reach a deficit of 21.7 trillion in the conservative scenario (nominal growth rate of around 1.5%) and 13.7 trillion yen in the growth strategy scenario (nominal growth rate of over 3%) by 2020. To achieve its goal of a primary balance surplus by 2020, the government must raise tax revenue or reduce expenditure. It goes without saying that a spending cut on this scale is unrealistic. Covering the deficit entirely with a consumption tax would require an 8-9% increase under the conservative scenario (a final consumption tax of 13-14%) and a 5-6% increase under the growth strategy scenario (a final consumption tax of 10-11%).

The government’s estimates are based on an econometric model, and do not use another mechanical method for fiscal estimates which sets the nominal growth rate and long-term interest rate, growth in expenditure, and value of elasticity of tax revenue (value that shows the percentage of tax revenue increase when the nominal GDP increases by 1%). Therefore, if the same econometric model isn’t used, it is impossible to predict the changes in the necessary amount of consumption tax increase when the conditions are altered. From the results of the government’s estimates, however, the value of the preconditions used in the mechanical calculations can largely be guessed. Based on these assumed conditions, we calculate how the necessary amount of consumption tax increase changes when the government estimates and conditions are altered.

Changing conditions under the “conservative scenario”

In the government’s conservative scenario, the average nominal growth rate from fiscal 2011 (to fiscal 2023) is 1.7%, the average long-term interest rate is 2.7%, and the average rate of increase in consumer prices is calculated at 1.1%. In terms of assumed expenditure, a cap (fixed at the level in fiscal 2010 excluding debt servicing costs and carryback of compensation for balance shortages) will be implemented from fiscal 2011 to fiscal 2013, and regarding 2014 and beyond, costs related to social security will increase as a result of the aging society while other spending will rise in line with the rate of increase in consumer prices. The rate of increase in social security-related costs is unclear, but we assume it to be an average of 3%. In terms of government revenue, the value of elasticity of the average tax revenue from fiscal 2011 (to fiscal 2023) is calculated at 1.9 based on announced tax revenues for each year.

Mechanical calculations are conducted below based on these conditions. Under a goal of achieving a primary balance surplus by around 2020, the consumption tax is first raised to 5% in fiscal 2013, and, if insufficient, is raised again five years later in 2018. Calculating with the conditions derived from the government’s conservative scenario, we find that a primary balance surplus is realized in fiscal 2022 by raising the consumption tax by 5% in fiscal 2013 and again by 4% in fiscal 2018 (final consumption tax of 14%; (1) in the table). This is similar to the result of the government’s conservative scenario.

We next see how the results of the mechanical calculations change when altering the conditions. First, how much will the necessary amount of consumption tax rate increase change in the absence of a spending cap from fiscal 2011 to 2013? When assuming that, from 2011, social security-related costs will increase by an average of 3% while other spending will rise in line with rate of increase in consumer prices (1.1% average), a primary balance surplus is realized in fiscal 2020 by raising the consumption tax by 5% in fiscal 2013 and again by 6% in fiscal 2018 (final consumption tax of 16%; (2) in the table). In the absence of a spending cap, it is necessary to raise the consumption tax 2% more compared to in the basic case ((1) in the table).

Next, we look at a case in which the value of elasticity of tax revenue is low ((3) in the table). The value of elasticity of tax revenue derived from the government’s conservative scenario is 1.9, but normally when such mechanical calculations are conducted the value of elasticity is set at 1.1. In times of rapid corporate tax revenue growth, such as during economic recovery, the value of elasticity of tax revenue can exceed 10 in the short-term. This, however, is a temporary phenomenon, and the long-term value is thought of as around 1.1 (this value is used in long-term fiscal estimates by the Fiscal System Council). Under these conditions, mechanical calculations show that a primary balance surplus is realized in fiscal 2018 by raising the consumption tax by 5% in fiscal 2013 and again by 7% in fiscal 2018 (final consumption tax of 17%). We find that this surplus, however, is only temporary, and the primary balance again returns to deficit and government debt grows as a percentage of GDP.

Lastly, we consider a case in which the rise of social-security-related costs is higher at 4% ((4) in the table). Here mechanical calculations find that a primary balance surplus is realized in fiscal 2021 by raising the consumption tax by 5% in fiscal 2013 and again by 5% in fiscal 2018 (final consumption tax of 15%). Due to the high growth of social-security-related costs, however, government debt as a percentage of GDP would not begin to fall even by fiscal 2100.

These findings show that, under the conservative scenario, fiscal reconstruction becomes quite challenging when the value of elasticity of tax revenue is low or the rise of social-security-related costs is high. In other words, even slightly altering conditions under the conservative scenario makes fiscal consolidation difficult.

Changing conditions under the “growth strategy scenario”

In the government’s growth strategy scenario, the average nominal growth rate from fiscal 2011 (to fiscal 2023) is 3.3%, the average long-term interest rate is 3.6%, and the average rate of increase in consumer prices is calculated at 1.9%. Government revenue is assumed to be the same as in the conservative scenario. The value of elasticity of the average tax revenue from fiscal 2011 (to fiscal 2023) is calculated at 1.5. Points of concern regarding the values of the growth strategy scenario when compared to the conservative scenario are the relationship between the nominal growth rate and long-term interest rate, and the value of elasticity of tax revenue. Regarding the relationship between the nominal growth rate and long-term interest rate, while the long-term interest rate exceeds the nominal growth rate by an average of 1% in the conservative scenario, the average is only 0.3% in the growth strategy scenario. The lower the long-term interest rate, which shows the speed of debt increase, the slower the speed of fiscal deterioration.

In other words, the relationship between the nominal growth rate and long-term interest rate is fiscally more favorable in the growth strategy scenario because the long-term interest rate exceeds the nominal growth rate by a lower margin than in the conservative scenario. On the other hand, while the 1.5 value of elasticity of tax revenue in the growth strategy scenario is lower than the 1.9 value in the conservative scenario, from a different perspective this means fiscal conditions should take a more favorable turn because of the condition that the value of elasticity is high in the conservative scenario. It was mentioned before that fiscal reconstruction becomes difficult when the value of elasticity of tax revenue is low in the conservative scenario, and it is even tempting to think that the value is high at 1.9 to avoid this situation (although this should not be the case as government’s estimates are values based on an econometric model). That the low-growth conservative scenario has a higher value of elasticity of tax revenue than the high-growth growth strategy scenario is also a point of concern.

Under these conditions, mechanical calculations show that a primary balance surplus is realized in fiscal 2022 by raising the consumption tax by 5% in fiscal 2013 (final consumption tax of 10%; (5) in the table). This is similar to the result of government estimates in the growth strategy case.

We next see how the results of mechanical calculations change when the conditions derived from government estimates are altered. In the absence of a spending cap from 2011 to 2013, a primary balance surplus is realized in fiscal 2021 by raising the consumption tax by 5% in fiscal 2013 and again by 2% in fiscal 2018 (final consumption tax of 12%; (6) in the table). It is necessary to raise the consumption tax by more when there is no spending cap.

Next, we look at a case in which the value of elasticity of tax revenue is low ((7) in the table). Using 1.1, the value used in normal mechanical calculations, a primary balance surplus is achieved in fiscal 2020 by raising the consumption tax by 5% in fiscal 2013 and again by 3% in fiscal 2018 (final consumption tax of 13%).

In the case where the rise of social-security-related costs is higher at 4% ((8) in the table), a primary balance surplus is realized in fiscal 2021 by raising the consumption tax by 5% in fiscal 2013 and again by 1% in fiscal 2018 (final consumption tax of 11%).

Lastly, in the case where the long-term interest rate exceeds the nominal growth rate by a high 1% ((9) in the table), a primary balance surplus is achieved in fiscal 2022 by raising the consumption tax by 5% in fiscal 2013 (final consumption tax of 10%). Though government debt as a percentage of GDP starts to decrease later, this result is almost identical to (5)—slightly raising the amount that the long-term interest rate exceeds the nominal growth rate has little effect on the result.

Importance of the growth strategy and eliminating waste

The above findings show that while the amount the consumption tax needs to be increased can be low in the growth strategy scenario compared to the conservative scenario (the final consumption tax is 11%-13%), even when the conditions are altered in the growth strategy scenario so that the value of elasticity of tax revenue decreases or costs related to social security increase, government debt as a percentage of GDP begins to fall in the 2020s. This suggests that fiscal reconstruction becomes more certain in this scenario. In contrast, fiscal reconstruction becomes difficult when conditions are even slightly altered in the conservative scenario.

These results reconfirm, in terms of future fiscal reconstruction, the importance of setting conditions similar to the growth strategy scenario with high growth. Moreover, a three-year spending cap starting in 2011 reduces the necessary amount of consumption tax increase by around 2% compared to a case without such a cap (in both the conservative and growth strategy scenarios). It is therefore also important to reduce wasteful spending to the extent possible before raising taxes.