Fiscal Policy Effectiveness in Japan

Journal of the Japanese and International Economies16,536–558(2002)

doi:10.1006/jjie.2002.0512

Fiscal Policy Effectiveness in Japan1

Kenneth N.Kuttner

Federal Reserve Bank of New York,New York

and

Adam S.Posen

Institute for International Economics,Washington,DC

Received January18,2002;revised August30,2002

Kuttner,Kenneth N.,and Posen,Adam S.—Fiscal Policy Effectiveness in Japan

The effectiveness of?scal policy in Japan over the past decade has been a matter of great

controversy.We investigate the effectiveness of Japanese?scal policy over the1976–1999

period using a structural V AR analysis of real GDP,tax revenues,and public expenditures.

We?nd that expansionary?scal policy,whether in the form of tax cuts or of public works

spending,had signi?cant stimulative https://www.wendangku.net/doc/1115908419.html,ing a new method of computing policy

multipliers from structural V ARs,we calculate that the multiplier on tax cuts is about25%

higher at a four-year horizon than that on public works spending,though both are well

in excess of one.A historical decomposition reveals that Japanese?scal policy was con-

tractionary over much of the1990s,and a signi?cant proportion of the variation in growth

can be attributed to?scal policy shocks;accordingly,most of the run-up in public debt

is attributable to declining tax revenues due to the recession.Examining savings behavior

directly,we?nd limited evidence of Ricardian effects,insuf?cient to offset the short-term ef-

fects of discretionary?scal policy.J.Japan.Int.Econ.,December2002,16(4),pp.536–558.

1Correspondence should be addressed to Adam Posen,Institute for International Economics,1750 Massachusetts Avenue N.W.,Washington,D.C.20036.Fax:202-454-5432.E-mail:aposen@https://www.wendangku.net/doc/1115908419.html,. An earlier version was presented at the CEPR-NBER-TCER Conference on Issues in Fiscal Adjust-ment,December13–14,2001,Tokyo,Japan.We are grateful to Stanley Fischer,Fumio Hayashi, Takeo Hoshi,Richard Jerram,John Makin,George Perry,Mitsuru Taniuchi,and Tsutomu Watanabe for helpful comments and advice.Samantha Davis provided excellent research assistance during the revisions.The views expressed here and any errors are those of the authors,and not necessarily those of Federal Reserve Bank of New York,the Federal Reserve System,or the IIE. c Federal Reserve Bank of New York and Institute for International Economics.2002.

536

0889-1583/02$35.00

c 2002Elsevier Science(USA)

All rights reserved.

FISCAL POLICY EFFECTIVENESS IN JAPAN537 Federal Reserve Bank of New York,New York,and Institute for International Economics,

Washington,DC.c 2002Elsevier Science(USA)

Journal of Economic Literature Classi?cation Numbers:E62,E65,E21.

The effectiveness of?scal policy in Japan in the1990s has been at least as controversial as the currently more public disputes over monetary policy.There has been open debate over the degree to which expansionary?scal policy has even been tried,let alone whether it has been effective,along with widespread assertions about the degree of forward-looking behavior by Japanese savers.The highly visible and rapid,more than doubling of Japanese public debt in less than a decade speaks for itself to a surprising number of observers:the?scal de?cit has grown sharply,yet the economy has continued to stagnate,so?scal stabilization failed.No less an economist than Milton Friedman recently wrote,”[D]oes?scal stimulus stimulate?Japan’s experience in the‘90s is dramatic evidence to the contrary.Japan resorted repeatedly to large doeses of?scal stimulus in the form of extra government spending....The result:stagnation at best,depression at worst, for most of the past decade.”2

But it is easy to demonstrate from just charting publicly available data that the bulk of the increase in Japanese public debt is due to a plateau in tax revenue rather than to increased public expenditure or even discretionary tax cuts.This of course re?ects the inverse cyclical relationship between output and tax revenue.If one applied a plausible tax elasticity of1.25to reasonable measures of the widening output gap(e.g.,those estimated in Kuttner and Posen(2001)),the result would be a much-reduced estimate of the structural budget de?cit.In fact,using the measure of potential based on a constant productivity trend growth rate of2.5%a year all but eliminates the non-social security portion of the de?cit.Moreover,as measured by the?scal shocks derived from our estimates in this paper,?scal policy has been generally contractionary since1997.

More tellingly,the massive increase in Japanese government debt outstanding over the period has had little apparent effect to date on either the level of long-term interest rates or the steepness of the yield curve,or the yen–dollar exchange rate. This is commonly attributed to the passivity of Japanese savers,and there surely has been no sign of crowding out or of in?ation fears.This fact has not gone unremarked upon in the?nancial press.3Nevertheless,citing the eventual need to pay obligations,including those off of the government balance sheet(such as pen-sions),the ratings agencies downgraded Japanese local currency sovereign debt to 2Friedman,“No More Economic Stimulus Needed,”Wall Street Journal,October10,2001,p.A17. See also Ian Campbell,“Friedman Opposes Stimulus Package,”UPI Newswire,October9,2001.

3The Economist observed,“[government bond yields]fell as the government pumped the economy with...?scal stimulus,as the yen plummeted by40%from its high in the middle of1995,and even as the government’s debt climbed to100%of GDP.By late[1997]the Japanese government was able to borrow more cheaply than any other government in recorded history.”“Japanese Bonds:That Sinking Feeling,”The Economist,February21,1998,pp.74–75.

538KUTTNER AND POSEN

AA-(by Standard and Poor’s,April15,2002)and A2(by Moody’s,May30, 2002).4But with the exception of a brief panic-induced spike in rates in Jan-uary1999,more than half of which was reversed within two months,holders of Japanese government bonds have yet to take any signi?cant capital losses. Against this background of declining tax revenues and relatively stable long-term nominal interest rates,the actual course of Japanese?scal policy has been almost tumultuous,rather than one of unremitting spend-spend-spend,as often assumed.The divergence of common perceptions from reality may be due in part to the fact that Japan has a centralized,if arcane,?scal system.5Every year since 1994has brought announcements of various tax reforms,but their actual impact is dif?cult to ascertain.6On the public spending side,estimating the mamizu(“true water”)of any Japanese?scal stimulus requires great care,given institutional complications.7Meanwhile,in terms of revenue collection,the Japanese tax base is rather small by developed economy standards,especially on the household side, where salaried urban workers pay a disproportionate share of the taxes,and small business owners and rural residents pay almost none.8

The absence of obvious interest rate,in?ation,or crowding out effects from the ?scal measures undertaken leads us to examine what really happened with?scal policy in Japan in the1990s.If standard theory tells us that expansionary?scal policy drives up interest rates,limiting that policy’s effectiveness,then perhaps the absence of an interest rate rise is indicative of the opposite.Our?rst considera-tion therefore is simply whether the?scal impulses had Keynesian countercyclical signs and what impact those impulses had.As many observers have stressed,tra-ditional public works in Japan more closely approximate the building of pyramids in hinterlands,famous to macroeconomics undergraduates,than do those in any other OECD country.9Some have indicated that they would expect the multiplier on such wasteful expenditures to be less than one.10Of course,although Keynes 4See Arkady Ostrovsky and Christopher Swann,“Japan hit by downgrade in credit rating,”Financial Times,April16,2002,p.13,and David Ibison,“Japan’s sovereign debt rating downgraded,”https://www.wendangku.net/doc/1115908419.html,, May31,2002.

5See Ishi(2000)for a historical perspective;Balassa and Noland(1988),Bayoumi(1998),and OECD Economic Survey:Japan(1999),for institutional descriptions;and Schick(1996)for a com-parison of U.S.and Japanese budget processes.Tax Bureau(2000)gives the of?cial account of the tax system.

6See Watanabe et al.(2001)and Tax Bureau(2000).

7See Posen(1998).

8See Balassa and Noland(1988).

9Sixty percent of the Japanese coastline is today reportedly encased in concrete(Ian Buruma,“The Japanese Malaise,”New York Review of Books,July5,2001,p.5).Similar examples are easy to come by:see,for example,Martin Wolf,“Japan’s Economic Black Holes,”Financial Times,January17, 2001,p.21,and Bergsten,Ito,and Noland(2001,pp.64–65).

10In June1998the then—Vice Minister of Finance for International Affairs Eisuke Sakakibara (1999,p.45),expressed a contrary point of view:“Concerning the current?scal package,I know that there have been various criticisms of it,but I think there is now a wider acceptance,even in the international community,of public works as a more effective means than tax cuts.In addition,under current circumstances,a strong multiplier effect can be expected....”

FISCAL POLICY EFFECTIVENESS IN JAPAN539 maintained that even overtly wasteful public works projects were an effective source of?scal expansion,several observers have stressed that in the Japanese context tax cuts are likely to be more effective.

We then turn to historical decompositions of the effect of?scal policy on the Japanese economy in the1990s.The ample variation in Japanese?scal policy,mov-ing from contractionary to expansionary and back to contractionary,with some tax measures temporary and others permanent,provides a rich basis for econometric investigation.Upon that investigation,it becomes clear that?scal policy provides an apparent explanation for a surprisingly large amount of the variation in Japanese economic growth over the period.Meanwhile,on the tax side,all tax cuts were preceded and accompanied by loud declarations by government of?cials that even-tually taxes would have to go up—whether due to the looming demographic threat, to the unsustainability of Japanese public debt,or to the supposedly declining po-tential growth rate.Even though we?nd that these well-publicized dangers from debt did not have any obvious short-run effect on multipliers,we also directly examine the possibility of Ricardian equivalence.Finally,we conclude by consid-ering some of the questions raised by the apparent?scal power granted through savers’passivity in Japan.

The analysis here builds on earlier work applying a structural V AR approach to?scal policy in Japan(Kuttner and Posen,2001),but extends that paper’s in-vestigations in four important ways.First,impulse response functions and their standard errors are calculated,allowing a clear sense of the signi?cance and inter-action of?scal policy shocks.Second,?scal shocks and their contributions to GDP growth in the1990s are computed and plotted,yielding an analysis of the historical record.Third,a new approach is introduced to compute“pure”policy multipliers from structural vector autoregressions(V ARs)in order to give a clearer picture of the effects of tax and expenditure changes in isolation.And fourth,throughout the paper,a variety of robustness checks are considered,especially with regard to the results’sensivity to the identifying assumptions.

1.THE SHORT-RUN EFFECTS OF FISCAL POLICY

To assess the impact of?scal policy on the economy,we employ a structural three-variable V AR model adapted from Blanchard and Perotti(1999),which is designed to identify the impact of?scal policy while explicitly allowing for con-temporaneous interdependence among output,taxes,and spending.The one-lag version of the structural V AR can be expressed succinctly as

A0Y t=A1Y t?1+Bεt,(1) where Y t=(T t,E t,X t) is the vector of the logarithms of real tax revenue,real expenditure,and real GDP,andεt is interpreted as a vector of mutually orthogonal shocks to the three jointly endogenous variables.

540KUTTNER AND POSEN

Following Blanchard and Perotti,a key identifying assumption is that real GDP is allowed to have a contemporaneous effect on tax receipts,but not on expenditure. (As discussed below,however,plausible changes to this assumption make no substantive difference to the results.)The model also assumes that taxes do not depend contemporaneously on expenditure(or vice versa)although tax shocks are allowed to affect spending within the year.This assumption re?ects the institutional setup for?scal policy in Japan,where taxes are mostly collected from withholding and consumption,spending is mostly implemented with a lag,and both automatic stabilizers and the size of the public sector are limited.With these assumptions imposed,the model can be written as

T t=a130X t+a111T t?1+a121E t?1+a131X t?1+εT t

E t=a211T t?1+a221E t?1+a231X t?1+b21εT t+εE t(2)

X t=a310T t+a320E t+a311T t?1+a321E t?1+a331X t?1+εX t,

where a i j

0,a i j

1

,and b i j represent the i,j th elements of the A0,A1,and B matrices.

Thus a13

0captures the within-period elasticity of tax receipts with respect to GDP,

b21is the effect of tax shocks on expenditure,and a31

0and a32

allow taxes and

expenditure to affect real GDP contemporaneously.

With seven parameters to estimate from the six unique elements of the covariance matrix of reduced-form V AR residuals,the model in(2)is not identi?ed,however.11 Our strategy,like that of Blanchard and Perotti,is to use independent information

on the elasticity of tax revenue with respect to real GDP(i.e.,a13

0)to identify

the model.Drawing on Giorno et al.(1995),we set this parameter equal to1.25, yielding an exactly identi?ed model.

Reliable comprehensive quarterly?scal data for Japan are not available to the public or to the international?nancial organizations,unfortunately,and so we ?t the model instead to annual consolidated central,state,and local?scal data, compiled by the IMF,spanning?scal years1976through1999.12Tax receipts are de?ned as direct and indirect tax revenue,excluding social security contributions. Expenditure corresponds to the sum of current and capital expenditure,less so-cial security and interest payments.13The estimated model also includes a linear trend and a trend interacted with a post-1990dummy to capture the post-1990 11See Hamilton(1994,chapter11)for a complete discussion of identi?cation and estimation of structural V ARs.

12This lack of timely higher frequency data is of course of policy signi?cance,as well as presenting a dif?culty for research.As Stanley Fischer(2001,p.163)observes,“Indeed,there is a general problem of?scal transparency in Japan...the key issues are lack of consolidation among different?scal units and the absence of quarterly data,which means that?scal information is on average about eight months out of date.”

13As noted by Blanchard and Perotti(1999),estimating the third equation in the structural V AR is equivalent to using a measure of“cyclically adjusted”tax receipts(and a similarly adjusted measure of spending)as instruments for taxes and spending in a two-stage least squares regression.

FISCAL POLICY EFFECTIVENESS IN JAPAN541

TABLE I

The Relationship between Taxes,Spending,and GDP:Estimated Parameters of the Structural V AR

Equation

Independent variable Lag Tax Expenditure GDP Tax receipts t——?0.03 Expenditures t——0.17??Real GDP t 1.25——Tax receipts t?10.71????0.12?0.25??

Expenditures t?10.030.78???0.02 Real GDP t?1?0.58??0.66?0.59???Tax shock t—?0.03—Trend?0.004?0.0020.033???Trend×(t>1990)?0.018?0.010?0.038???Adjusted R20.9960.9950.997 Durbin–Watson 1.66 2.30 1.85 Source.Authors’calculations,based on trivariate structural V AR including real tax revenue,real government expenditures and real GDP,estimated on24annual observations spanning?scal years 1976through1999.

Note.Asterisks indicate statistical sign?cance:???for0.01,??for0.05,and?for0.10.The coef?cient of1.25on real GDP in the tax equation is imposed a priori as an identifying assumption.The adjusted R-squared and Durbin–Watson statistics are from the reduced form V AR equations.Further details can be found in the text.

slowdown in trend GDP growth.14The estimated parameters are displayed in Table I.Interpreting individual coef?cients of a simultaneous equation model is dif?cult,of course,but it is worth noting that expenditures have a positive,statis-tically signi?cant impact on real GDP.

Figure1plots the impulse response functions for the four-year time-horizon relevant for policy analysis,along with90%con?dence bands associated with the estimates.As shown in the?rst two panels of the last row of the?gure,tax cuts and expenditure increases both have expansionary effects.Moreover,the estimated effects are statistically signi?cant at a one-to two-year horizon,as well as for the current year in the case of expenditure shocks.The estimated magnitudes of both tax and expenditure effects are comparable as well.The upper left-hand panel of Fig.1shows that tax revenue shocks tend to be relatively transitory,effectively vanishing after one year,notwithstanding the characterization of most Japanese tax law changes as permanent in intent.15,16In contrast,the center panel of the 14The model makes no explicit distinction between temporary and permanent tax and expenditure changes,in part because the temporary tax changes enacted in Japan have been much smaller in magnitude than the permanent ones(see Watanabe et al.,2001).Many of the supposedly permanent tax changes were offset by subsequent tax legislation,however,and this pattern should be picked up by the model’s dynamics.

15This pattern is documented in Watanabe et al.(2001).Because of the feedback between tax revenues and GDP,and the greater-than-unit elasticity of tax revenue with respect to GDP,the impact of a10%tax shock on tax revenue is slightly less than10%.

16The lack of a signi?cant response of expenditures to tax shocks may appear at?rst to contradict the results of Ihori et al.(2001),who found Granger causality from the taxes to expenditures,expressed

542

KUTTNER AND POSEN years after shock

p e r c e n t effect of tax shock on tax 0

1234-14

-7

7

14

effect of tax shock on spending 0

1234-10-5051015

effect of tax shock on GDP 01234-5

5

1015

effect of spending shock on tax 01234-14-70714effect of spending shock on spending 01234-10

-5

5

1015effect of spending shock on GDP 01234-5051015effect of GDP shock on tax 01234-14-70714effect of GDP shock on spending 01234-10-5051015effect of GDP shock on GDP

01234-5051015FIG.1.Estimated impulse responses from structural V AR.Standard errors were computed via Monte-Carlo.Dashed lines represent 90%con ?dence intervals.No standard errors are given for the contemporaneous effects of GDP and spending shocks on spending,as these are ?xed by assumption.The tax shock represents a tax cut,and the spending shock represents a spending increase.

?gure shows that public works spending shocks are highly persistent,in keeping with institutional and journalistic accounts of government behavior in Japan (and elsewhere).

The dynamic effects of tax and spending shocks,including the expansionary effect of tax cuts on GDP,are easier to interpret (and more dramatic)when put in yen terms,as is done in Table I.To do so requires scaling up the response by the inverse of the share of taxes in GDP,which averaged 19%during the 1990s.This adjustment results in a cumulative Y =484increase in GDP in response to a Y =100tax cut.One explanation for the size of the response is that,over the sample period,tax cuts have tended to be associated with spending increases;in fact,the cumulative increase in spending is roughly equal to the decrease in taxes (although this effect as a share of GDP.A closer look shows that the results are consistent,however:in our model,positive tax shocks decrease the level of real GDP in our model while leaving expenditures largely unchanged in the near term,which leads in turn to an increase in expenditures as a share of GDP.

FISCAL POLICY EFFECTIVENESS IN JAPAN543 is estimated rather imprecisely).17Overall,GDP rises by more than twice the sum of the spending and tax effects.

The immediate impact of a10%positive spending shock on GDP is1.6%, however,which translates into Y=84for a Y=100spending increase,and the stimulus builds only slightly over time.One reason for the smaller estimated effect of spending than of tax shocks is that taxes tend to rise in response to positive spending shocks in this sample,partly offsetting the expansionary impact of the spending increase.This can be interpreted as evidence of the expensive maintenance of unproductive Japanese public works projects.Overall,the increase in GDP is about1.75times the net effect of the spending minus the tax increases—smaller than the effect of tax shocks,but still a respectable economic impact.

Deriving a model with suf?cient structure to assess the impact of?scal pol-icy clearly requires a number of strong identifying assumptions.As noted above, three such assumptions are embedded in a Blanchard–Perotti framework:?rst,that current taxes do not depend directly on current expenditures;second,that current expenditures to not respond directly to current GDP;and third,that the within-year elasticity of tax revenues with respect to GDP is1.25.Since the model is exactly identi?ed,these restrictions are not formally testable,of course,but the reported results are robust to plausible changes in all three of these assumptions.18 In particular,allowing for a contemporaneous effect from spending shocks to tax revenues(instead of the other way around)has virtually no effect on the results. The results are slightly more sensitive to changes to the assumed elasticity of tax revenues,but for plausible values of the parameter(i.e.,ranging from1.0to 1.5),the estimates are qualitatively similar to those reported above.And it turns out that assuming a plausible,negative elasticity of expenditures with respect to GDP(re?ecting a presumed countercyclical use of?scal policy)actually increases the estimated effects of?scal shocks.These robustness checks therefore indicate that the?ndings are not merely an artifact of the model’s identifying assump-tions.

This analysis shows that,when it has been used,discretionary?scal policy in Japan has in fact had the effects predicted in standard closed-economy macroe-conomic analyses.Both tax cuts and spending increases lead to higher real GDP, although the tendency for taxes and spending to move together has reduced the impact of spending increases.19The commonly held perception of?scal policy’s 17Blanchard and Perotti(1999)found a qualitatively similar pattern in the U.S.data.

18The full results obtained under these alternative assumptions are available from the authors upon request.

19Further work is needed to reconcile our results on the sizable effects of?scal policy in Japan with the?ndings(using very different econometric approaches)of Bayoumi(2001)and Perri(1999) that?scal policy had the expected sign but very small effects,and of Ramaswamy and Rendu(2000) that“public consumption had a dampening impact on activity in the1990s.”A likely explanation is that these analyses did not take full account of the dynamic interactions among GDP,tax revenue, and expenditure in the way that we were able to.

544KUTTNER AND POSEN

ineffectiveness in all likelihood stems from a failure to recognize the dependence of tax receipts with respect to GDP:as GDP falls,tax revenue shrinks,but to conclude from this that changes in the de?cit have not affected growth would be incorrect.

2.MULTIPLIERS ON TAX CUTS AND PUBLIC SPENDING

The dif?culty in reading off a simple multiplier from our estimations is that in the data(and therefore in Japanese reality over the period)tax cuts generally have been accompanied by spending increases;expenditure increases,on the other hand, have generally been accompanied by tax increases.So,for example,in Table II, where we list the Y=484estimate of the effect on GDP of a Y=100tax cut,we are actually reporting the four-year cumulative effect of the tax cut and of the accompanying expenditure increase seen in the data.A fair comparison of the effects of(or multiplier on)tax cuts and expenditure increases therefore requires taking into account any correlation between taxes and expenditures.

To do this,we examine the responses to linear combinations of tax and spending shocks calculated to generate a cumulative1%change in the variable of interest, and a cumulative zero response to the other variable,measured at a four-year hori-zon.The response of GDP to this combination of shocks is then used to calculate a “pure”multiplier on tax or spending shocks.For example,a?0.66%(expansion-ary)tax shock combined with a?0.21%(contractionary)spending shock gives a1%reduction in tax revenues over four years,with no cumulative impact on spending,and a net0.47%increase in real GDP.

Scaling this response by the inverse of the share of taxes in GDP(using the 1990–1999)average of19%)yields a multiplier for tax cuts of2.5;a similar calculation for spending increases gives a multiplier of2.0.As a result of this difference in magnitudes,the cumulative four-year gain to Japanese GDP from a revenue neutral shift of Y=100from public works spending to tax cuts is Y=47.

TABLE II

The Dynamic Impact of Fiscal Policy:Estimated Yen-Denominated Impulse Responses

(Effects of expansionary Y=100shocks,in yen)

Impact of?Y=100tax shock Impact of+Y=100spending shock

Taxes Spending GDP Taxes Spending GDP Year0?963162010084

Year1?32161583487105

Year2036168377789

Four-year cumulative?111104484127332353

Source.Authors’calculations based on the estimated structural V AR.

Note.The impact of Y=100tax and spending shocks are computed assuming taxes and

spending represent19%of GDP.

FISCAL POLICY EFFECTIVENESS IN JAPAN545 These estimates also understate the bene?cial effects of tax cuts,because they do not directly capture the allocative ef?ciency gains from changes in Japanese tax code,just the immediate macroeconomic impact.Though such gains can be exaggerated,there is good reason to believe that such supply-side effects would be large in Japan today.

These effects at?rst glance may seem rather large,relative to other published estimates;in fact they are quite close to comparably calculated multipliers for the United States,such as those of Blanchard and Perotti(1999).The“multipliers”reported there,however,are de?ned differently from those we calculate.Blanchard and Perotti reported multipliers de?ned as the ratio of the peak response of GDP to the size of the initial shock to taxes or spending.That method can be misleading, however,as it fails to take into account either the dynamics of the response or the tendency for taxes and spending to move together.20Using our method to calculate comparable multipliers from Blanchard and Perotti’s trend-stationary estimates, we obtain a multiplier of roughly4.0for tax shocks—considerably larger than our estimate for Japan.Our estimated spending multiplier for Japan is somewhat higher than the comparable multiplier for the United States calculated from the Blanchard–Perotti results,but quite close to similar calculations based on their estimated response to military spending shocks.

In contrast to these results,the Economic Planning Agency(EPA)of the Japanese government(now the Cabinet and Fiscal Of?ce)has published declining esti-mates of the multiplier on?scal policy for the past several years.In May1995, the EPA World Economic Model5th Version reported cumulative multipliers on government investment of1.32in the?rst year,1.75in the second year,and2.13 in the third year(down from1.39,1.88,and2.33in the4th Version),and far lower multipliers on income tax reductions(0.46,0.91,and1.26,down from0.53,1.14, and1.56in the4th Version).21In October2001,the EPA released the multipli-ers from the1998revised version of the model,with the cumulative multipliers on government investment declining to1.12,1.31,and1.10,and on income tax reductions of0.62,0.59,and0.05.22Leaving aside the question of whether these changes represent statistically signi?cant differences,given the dif?culties of esti-mating these multipliers,it is worth considering the source of this divergence from our results.

The dif?culty in making a strict comparison lies in the unavailability(at least publicly,in English)of the details of the EPA’s large-scale macro model,partic-ularly with regard to the assumed response of monetary policy built in.As the discussion in OECD(2000,pp.60–64)makes clear,while there are a number of

20Basing the multiplier on the peak response could,for example,yield a nonzero multiplier even if the effect on GDP were completely reversed in subsequent periods.

21See“The EPA World Economic Model5th Version:Basic Structure and Multipliers,”Economic Analysis Series139,May,1995,www.esri.cao.go.jp/en/archive/bun/abstract/139-e.html.

22See“The ESRI Short-Run Macroeconometric Model of Japanese Economy:Basic Structure and Multipliers,”October2001,www.esri.cao.go.jp/en/archive/e-dis/abstract/006-e.html.

546KUTTNER AND POSEN

candidate explanations for why the multiplier might have declined over time in Japan—sectoral shifts in the weight of public works intensive industries,increased interest elasticity of demand,increased capital mobility,increased price elasticity of import demand,increased price elasticity of consumption,and decreased sensi-tivity of investment to demand?uctuations—there is little direct evidence of any of these.In fact,as documented in Kuttner and Posen(2001),the relative share in Japanese GDP of industries bene?ting from public works has increased over the past20years,and the sensitivity of investment to demand remains strong,both of which work in the opposite direction.The absence of any capital mobility on the part of Japanese savers is self-evident,and we return to this troubling point that is a major source of?scal policy’s continuing effectiveness in our conclusion. In any event,it is worth noting that in the publicly available FRB/Global model, another large-scale macro model,the estimated?scal multipliers for Japan are comparable to those of our estimates here,as well as being the highest among major economies,whichever of a range of monetary response rules is built into the model.23

Still,one factor potentially affecting the size of our estimated?scal policy mul-tipliers is the omission of monetary policy.It would,of course,be good to have a model that included monetary policy explicitly,but the annual frequency of ana-lysis(forced upon us by limitations of Japanese?scal data)renders untenable the conventional(if problematic)identifying assumption that monetary policy does not affect the economy contemporaneously.24Still,even though monetary policy does not enter our structural V AR explicitly,it does implicitly,in the sense that the estimated response to tax and spending shocks includes any accommodation of those shocks by the central bank.In that sense,the multipliers estimated from the trivariate structural V AR do not correspond to the standard textbook IS/LM multipliers,in which the LM curve remains?xed(i.e.,no monetary accommoda-tion)in response to a shift in the IS curve.Instead,our multipliers represent the effect of the?scal policy induced IS-curve shift plus any tendency for the monetary authority to shift the LM curve in response.Therefore,to the extent that monetary expansions tended to accompany?scal expansions,the estimated effect of?scal policy would be overstated.The more natural tendency,however,would be for ?scal expansion to be partially offset by tighter monetary policy,in which case our estimated multipliers would understate the true impact of?scal policy.In the case of Japan in the1990s,given the limited movement in the Bank of Japan’s policy instrument interest rate,and then its reaching the zero nominal bound,the most realistic assessment is that monetary policy did not respond to?scal developments in any signi?cant,systematic way.

23See Ahearne et al.(2002),Exhibit V.3.

24Simply including the money supply,rather than a representation of monetary policy(presumably in terms of effects on credit conditions),would be unlikely to have any effect on our estimates except to add a noisy regressor,since the link between money growth and real outcomes has been weak to nonexistent(Kuttner and Posen,2001).

FISCAL POLICY EFFECTIVENESS IN JAPAN 547

p e r c e n t 1990919293949596979899

-7.5

-5.0

-2.5

0.0

2.5

5.0

7.5

FIG.2.Estimated tax and spending shocks.The tax shock represents a tax cut and the spend-ing shock represents a spending increase.The vertical axis scale represents the percentage deviation from the predicted path of spending or taxes in the absence of any shocks.The shocks are zero in 1996,as the model includes a dummy variable for this year to capture the impact of the announced increase in the consumption tax.

3.HISTORICAL DECOMPOSITIONS OF THE EFFECTS

OF FISCAL POLICY

Despite the institutional complications mentioned above,one can give a fair picture of the timeline of Japanese ?scal policy since the bubble burst in 1990.25The purpose of this section is to link those policy developments with the tax and spending shocks estimated in our V AR,and then with their cumulative impact on GDP over time.These are reported in the bar charts of Figs.2and 3,respectively.In both charts,the light gray bars depict the tax shocks (de ?ned so that positive values

25

Posen (1998,chapter 2),OECD (2000),IMF (2000),and Bergsten et al.(2001)give more detailed accounts of the policies undertaken over this period.Asako et al.(1991)provide an excellent account of “the rise and fall of [the]de ?cit in Japan,1965–90.”

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p e r c e n t 1990919293949596979899

-2.0

-1.5

-1.0

-0.5

0.00.5

1.0

1.5

FIG.3.Estimated historical impact of tax and spending shocks on real GDP growth.The estimated impact is from the historical decomposition of the ?uctuations of real GDP around its trend into the cumulative impact of the model ’s shocks.

are stimulative,i.e.,tax cuts)and the dark gray bars correspond to spending shocks (positive values are spending increases).Figure 2plots the shocks themselves;the scale represents the percentage deviation from the tax revenues or expenditures that would have been predicted,given the deterministic trends and lags in the model.Figure 3shows the contribution of those shocks to real GDP growth,expressed as the annualized percentage change.

Following the asset price collapses of 1990–1992,the Japanese government introduced the ?rst of a series of stimulus packages of public works in August 1992and April 1993,but the net incremental expenditure was small:2.2%of GDP in total,versus an announced combined size of 5%of GDP.A second stimulus package was issued in September 1993,with an announced 6.2trillion yen sup-plementary budget,and the mamizu (of 1.5trillion yen,or 0.3%of GDP)was mostly comprised of social infrastructure investment.As seen in Fig.2,however,these were quite stimulative,with the spending accumulating over the two years.The Diet passed a special income tax reduction in November 1994,to take ef-fect in ?scal year 1995,amounting to 0.6%of GDP,but as seen in Fig.2,the

FISCAL POLICY EFFECTIVENESS IN JAPAN549 effects were felt already in1994.26Interestingly,this tax cut was accompanied by an almost offsetting spending cut.The effects on GDP growth of this sequence were as to be expected,as shown in Fig.3:the tax cuts were felt particularly in 1993and1995,but with little persistent effect,while the effects of the spending cut in1994was more than enough to offset the tax cut of that year.In1995,the Japanese government implemented its?rst relatively large scale tax cut–public spending combination,which had a double-barreled impact on GDP that year;the greater multiplier on tax cuts,however,can be seen in the over1.0%effect on GDP from the tax shock,despite that shock being smaller in initial magnitude than the spending increase.

As is now well known,from the time of its passage,the1995tax cut was supposed to be reversed at the start of?scal year1997,and that tax increase was to be accompanied then by an increase in the national consumption tax(a value-added tax)from3to5%.At the time,Prime Minister Tomiichi Murayama and senior budget of?cials cited concern about the looming demographic threat as the primary reason for the tax consolidation and the shift to indirect taxes.Some belief in the power of an expansionary consolidation,due to Japan’s debt situation,was also invoked as a reason for the planned tax increase.27In June1996the Tax Commission(an advisory body to the prime minister)and then the Diet reaf?rmed the commitment to the tax increase.In April1997contribution rates to social security were increased along with the promised repeal of the temporary income tax cut and the implementation of the consumption tax increase.The tax burden rose by nearly2%of GDP,more mamizu of contraction than any of the?scal stimulus packages implemented up to that time.

This sequence of measures would in principle have had two competing effects. The?rst would have been an increase in savings(for standard permanent-income reasons),offsetting a tax cut which,because of the looming budget burden as well as the government rhetoric about that burden,was certainly perceived as temporary.The second would have been an intertemporal substitution effect,with households moving purchases forward before the consumption tax increase took effect.Neither of these forward-looking effects can be measured directly in our V AR by the?scal components,so we include a dummy variable for the year1996, where a positive effect on GDP would indicate a predominance of the intertemporal substitution effect.28We?nd that there was a positive impact of the1996dummy on GDP,of about3%,signi?cant at the10%level.Thus,it appears that despite 26The Japanese government?scal year runs from April1to March31.

27See Holley(1994,p.D1);“Editorial:Drastic Reforms Must Be Carried out,”Daily Yomiuri, June21,1996,p.13;William Dawkins,“Japan Con?rms Sales Tax Increase,”Financial Times,June26, 1996,p.6;and the account in Posen(1998,p.50).

28The V AR used to generate the results in Sections2and3did not include the1996dummy variable, but its inclusion has little effect on the estimated coef?cients or impulse response functions.The limited availability of Japanese?scal data unfortunately does not allow us to match the dummy variable more precisely to the date of the measure’s introduction.

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the announcements and warnings accompanying the tax cut,Japanese consumers in1995–1996did respond to a tax cut with expanded demand.29

The contractionary?scal impulse and its extremely sizable effect on GDP are strikingly obvious in Figs.2and3(in1997for spending,and in1998for the tax increase).30A recession and a series of?nancial failures hit Japan in the months following the April1997tax increase.In response to these events,as well as to international pressures stemming from the Asian?nancial crisis and an electoral setback for the Liberal Democratic Party in July1998,apparently large stimulus packages were announced in both April and November.These included front-loaded public works to make up for the falloff in public spending in the second half of1998(thereby merely moving that shortfall into the second half of1999),as well as a combination of permanent income tax rate cuts,primarily for corporations and the top personal income tax bracket.According to the IMF,these initiatives contained4%of GDP in“real water”measures felt mostly in1999.31

It is clear from Fig.2,however,that after the cumulative effect of previous spending cuts were taken into account,the1998stimulus package was smaller than that of1995,and once the lingering tax effects were put in,the net impact on the economy of this policy combination was nearly zero.More important,the cumulative impact of1997’s?scal contraction persisted through1998and into 1999,taking away an additional more than2.5%of GDP growth.There was no expansionary impact of this contraction through con?dence or any other channel.

4.TAXES,PUBLIC EXPENDITURE,AND SAVINGS IN THE LONG RUN On many a priori criteria—the connections of households across generations, the rapid aging of the Japanese population,and the repeated public statements by of?cials and commentators about future budget dif?culties,not to mention the obvious rapid rise in public debt—it would appear that if forward-looking savers were to offset?scal expansion anywhere,and to respond to?scal contraction with increased con?dence,it would be in Japan in the1990s.In the words of Allan Meltzer(1998),“There is no way to?nance these present and future[government] liabilities that will not involve higher future tax rates.The U.S.Treasury may not

29Of course the dummy variable would also pick up the cumulative effect of past?scal measures as well as any other factors idiosyncratic to1996,such as the effects of the pre-crisis expansion elsewhere in Asia.

30Because the?scal impulses are measured relative to long-term trends,the dummying-out of1996?scal policy is not a source of exaggeration of these within1997effects.While some might argue that the1997contraction was in part due to the?nancial problems of fall1997,particularly the surprise closure of Hokkaido Takusyoku Bank,it is dif?cult to?nd direct evidence of this in the https://www.wendangku.net/doc/1115908419.html,ing micro credit data,Hori and Takahashi(2001)establish that the effects of that bank closure on client ?rms were minimal.In any event,with the bank closure coming as a surprise in November,the timing would be suspect.

31“The implementation of these packages was mostly felt in calendar1999,however,due to the3–6month gestation period for public works projects,and owing to the fact that most of the tax measures were implemented through the FY1999initial budget.”IMF(2000,p.29).

FISCAL POLICY EFFECTIVENESS IN JAPAN551 understand it,but the ordinary Japanese citizen has been told the truth about this problem for years.”In one of his last public speeches to the Diet,on March8, 2001,then-Finance Minister Kiichi Miyazawa announced that Japan’s?nances “are very close to collapsing.We need fundamental?scal restructuring aimed at rebuilding our?nances in the21st century,looking10,20years into the future.”32 Asher(2000)asserts,“Overall,consumption in Japan is‘rationally suppressed’by structural factors outside of the range of monetary policy in?uence....Moreover, with public anxiety over the ballooning government debt growing it seems that this is generating a fair degree of Ricardian‘precautionary saving.’”

Such fears would have a surface plausibility,given reasonable concern for on-coming demographic shifts as well as the apparent decline in the government’s ?scal position.It is well documented that,on current trends,Japan faces a greater demographic challenge from its aging work force and increasing social security burden than any other developed economy.Smithers(1999)adds to the picture evidence of widespread weakness of local government balance sheets.Asher and Smithers(1998)point out that the government of Japan is potentially liable not only for local and central government debt,but also for the liabilities of the Trust Fund Bureau(to postal savings account holders)and of the state pension scheme. As early as1998,the OECD concluded that the rate of increase in net Japanese government debt(that is,debt outstanding after accounting for public assets and government holdings of its own bonds)“must soon be brought down for the dy-namics of the debt not to become explosive,even if the pensions’problem is separately resolved.”33Demographic-based simulations,such as those of Faruqee and M¨u hleisen(2001),yield daunting estimates of the policy changes and trade-offs that need to be addressed if Japan is to restore?scal sustainability.34

Yet,perhaps because it seems so self-evidently logical,the actual extent of the Ricardian offset to?scal expansion in Japan has not been confronted with the data.The apparent Keynesian response of GDP to?scal policy documented in the last two sections,however,would seem to be prima facie evidence that large Ricardian effects were not present.We look for Ricardian effects directly through an adaptation of the saving regressions in Hutchison(1992).A key bene?t of this approach is that it allows us to break out the differential effects on saving behavior of taxes,transfers,and public spending;these effects may indeed differ,especially in the Japanese context.The regression results are based on the equation

S t=α+D tβ+x tγ+e t,(3) where S is saving measured as a percentage of GNP,net of taxes,plus social security

32“Japanese Finance Minister Says Nation’s Finances‘Near Collapse,’”Associated Press Newswires,March8,2001.

33OECD(1998,p.85).

34Ihori et al.(2001)also raise concerns about sustainability,based on the apparent lack of a systematic response of the primary de?cit to debt levels in recent years.

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payments;D is the old-age dependency ratio(de?ned as the ratio of the65-and-older population to the population between15and64years of age);and x is a vector of?scal variables,each expressed as a percentage of GDP.35Since S,as well as many of the regressors,appears to be difference stationary,this regression can be interpreted as a long-run cointegration relationship;as such,it abstracts from the dynamics of the relationships between?scal policy and the rest of economy,which are modeled more explicitly in the framework used in Section2.36Accordingly, Phillips–Ouliaris statistics are reported for the test of the null hypothesis that the residuals from the estimated regression are nonstationary(that is,that there is no cointegration).

Following Hutchison,we start with the simplest measure of?scal policy—the overall?scal balance,or government net lending—and proceed from there to dis-aggregate that balance into its components.Table III displays the results.The simplest regression,containing only the old-age dependency ratio and the?scal balance,reported in column1,displays a positive coef?cient on the old-age de-pendency variable.This is inconsistent with the usual life-cycle interpretation, in which old people are dissavers,and suggests that this hypothesis does not adequately capture the behavior of Japanese elderly.37The estimated coef?cient on the balance is signi?cant but quantitatively small:it implies that a10%in-crease in the overall budget de?cit is associated with a1.2%decrease in private saving over the long-run.Adjusting for the dependent variable’s smaller denom-inator(income net of taxes plus social security payments is79%of GDP over the1990s),the effect in terms of yen is smaller still:only0.9%of GDP for a 10%increase in the de?cit.The Phillips–Ouliaris statistic of?5.23is suf?cient to reject the null hypothesis of no cointegration among the three variables at the 1%level.

Column2replaces the overall?scal balance with the two measures of spending and tax revenue used for the structural V AR in section1:expenditure net of interest and social security payments,and revenue excluding social security contributions. The coef?cient of?0.31on the tax revenue variable is signi?cant and suggests a somewhat larger,but still modest,degree of saving offset.(The coef?cient on

35Following Hutchison(1992),we also tried including real GNP growth but found it to have no signi?cant effect on saving.This is a logical result:because real GNP growth is stationary,it should have no long-run impact on saving.

36As in the earlier analysis,the lack of comprehensive quarterly?scal data forces us to use annual data,but since the relationship focuses exclusively on the long run,this is not a major handicap.

37Using microlevel data,Horioka(1990,1991,1993,1995,1997),Horioka and Watanabe(1997), and Horioka et al.(1996)come up with results more supportive of the life-cycle hypothesis,although the later studies give a more mixed picture than those at the start of the1990s.This may indicate rising precautionary saving motives as the Great Recession dragged on and the prospect of unemployment or lost pensions rose.Doi(2001)offers evidence that the Japanese savings rate is positively correlated with the risk of unemployment(but not income risk)per se,consistent with a particular form of precautionary savings.

FISCAL POLICY EFFECTIVENESS IN JAPAN553

TABLE III

The Long-Run Relationship between Saving and Fiscal Policy:Results from Savings Rate Regressions

Equation

(1)(2)(3) Constant30.6???38.4???37.9???

(0.62)(4.98)(5.39) Old age dependency ratio0.11???0.12???0.17?

(0.036)(0.033)(0.096) Fiscal balance(revenues-expenditures)?0.12??——

(0.045)

Tax revenue—?0.31???0.32??

(0.113)(0.133) Government expenditure—?0.10?0.09

(0.159)(0.172) Social security balance——0.30

(0.556) Net interest expenditure——0.13

(0.418) Adjusted R20.4810.5780.585 Durbin–Watson statistic1.251.511.48 Phillips–Ouliaris Z t test statistic?5.23????5.46????5.10??Note.The dependent variable is private saving,as a share of GNP net of taxes,plus social security payments.The old-age dependency ratio is de?ned as the above-65population divided by the population aged15–64.Fiscal variables are expressed as a percentage of GNP.Estimation is by OLS on annual data spanning?scal years1976through1999.Parentheses contain the coef?cients’standard errors. Asterisks indicate statistical sign?cance:???for0.01,??for0.05,and?for0.10.

expenditure has the“wrong”sign but is statistically insigni?cant.)Adjusting for the relative sizes of the variables’denominators,the revenue coef?cient implies a Y=24increase in saving in response to a Y=100tax cut over the long run.(Given the de facto transitory nature of tax changes in Japan,some saving offset is to be expected,concerns about demographics and future obligations aside.)There is some apparent tension between this long-run response and the short-run multiplier on tax cuts estimated in the previous analysis,but this should not be overdrawn. In essence,the results in Table I are net of these offsetting saving effects to the degree they are incurred within the three-year horizon.

The?nal speci?cation,in column3,adds to the previous speci?cation the two remaining elements in the overall?scal balance:the social security balance and net interest expenditure.Collectively,these four variables make up the overall ?scal balance(except for a very small“other revenue”category,which is omitted). Neither the social security balance nor net interest seems to bear a systematic relation to saving in Japan over the period:both are insigni?cant,and together they increase the adjusted R2only marginally.

One potential lacuna in this analysis is the failure to incorporate off-budget liabilities,such as pension shortfalls,debts of semipublic institutions,and likely

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insurance company failures.38These are omitted largely for lack of dependable time-series data.Still,since these liabilities and their implications for future tax liabilities are even more opaque than on-budget taxes and expenditure,evidence of a large Ricardian offset in the past decade from these sources seems unlikely, given that the more obvious factors had only a small impact on saving.Should these contingent liabilities become overt on the Japanese government’s balance sheet, say through the failure of a major life insurer or bankruptcy of a local government, that situation could change a great deal very quickly.In the data to date,however, our results provide little support for the Ricardian equivalence hypothesis under perhaps the most propitious conditions ever seen for it to hold:a rapid and large increase in public debt contemporaneous with a widely publicized projection of demographic dangers to social security bene?ts,in an economy already prone to high rates of saving.

5.DYSFUNCTIONAL SAVERS AND FUNCTIONAL FISCAL POLICY Our examination of the effects of?scal policy in Japan in the1990s has taken us on what seems to be a tour of macroeconomics’past:when economies were closed,savers were myopic,and consequently?scal stabilization was effective. Thus,Japan’s experience would appear to offer evidence that one can join Ball and Mankiw(1995)and Buiter and Kletzer(1992)in asking,“Who’s afraid of the public debt?,”at least in the short-term.If this is indeed the case,the short term can be separated from the long term:responsible stabilization policy today to maximize growth today is not harmful and indeed is perhaps the optimal response to long-run sustainability issues.39

Alternatively,given the dependence of tax revenues upon economic growth, restrictions on expenditure or even tax increases could back?re.On our estimates, were the Japanese government to maintain a limit on debt issuance in the face of a growth shortfall,the?scal contraction necessary to maintain a steady budget de?cit would have a sizable negative impact on growth and therefore on?scal position.As a numerical example,we considered the case where there was a shock of?1.5%to GDP,meant to capture the larger end of differences seen between of?cial Japanese government growth forecasts and actual growth outcomes.In such a case,the direct four-year cumulative effect on GDP in our model is?2.3%.This leads to a within 38See Asher and Smithers(1998)and Asher and Dugger(2000)for lengthy descriptions of these mounting contingent claims on the Japanese government,as well as Kotlikoff and Leibfritz(1998)for a generational accounting assessment of Japan’s demographic imbalances.

39Interestingly,Thomas Byrne,the senior credit of?cer at Moody’s credit rating agency responsible for Japan,recently advised the Japanese government in a manner consistent with this analysis(rather than demanding immediate contraction):“Japan can’t consolidate its way out of this[debt problem], it has to grow its way out....A?scal policy that didn’t include a lot of wasteful spending may present near-term anxiety but,if it really did stimulate growth,it would be good over the long term.”Quoted in Pilling(2002).

FISCAL POLICY EFFECTIVENESS IN JAPAN555 year decline of1.3%of total tax revenues,which expands the budget de?cit by roughly0.3%of https://www.wendangku.net/doc/1115908419.html,ing our multipliers,if taxes were raised to make up the revenue shortfall,GDP would decline an additional0.9%cumulative over four years;if public works were cut to make up the revenue shortfall(and maintain level debt issuance),GDP would decline an additional0.7%cumulative over four years.

Yet this is a very discomforting place to end up as economists even if it might be pleasing to policymakers.We are all familiar with the real-world example of Mundell–Fleming in France in1980–1981,where Francois Mitterand tried“so-cialism in one country”with?scal expansion that was almost completely reversed by rising interest rates,an appreciation of the franc,and capital in?ows.Of course, France was and is more globally integrated than Japan,but it is not as though French households circa1981were signi?cantly more likely to move their savings abroad than Japanese households circa1999—and certainly from the point of view of regulatory and product options,if not mores,Japanese savers today have an eas-ier time of moving money than their French counterparts of20years earlier did. In addition,French savers then had far less prospect than Japanese savers do now that their government might be forced to renege upon social security commitments or to con?scate savings in some manner.

Currently,the around$10trillion in Japanese national private savings(as com-pared to a$4.5trillion GDP)reside almost solely domestically—and almost50% of that total is kept in savings accounts of one form or another.These accounts earn well under1%interest annually;when the much higher yielding$1.5trillion in CD-equivalents in the postal savings system came due in2000–2001,most of them were rolled over into similarly low yielding accounts there rather than sent out to pursue new higher-yielding investment opportunities.Merrill Lynch and Charles Schwab contracted or closed their Japanese consumer operations,which were built on the expectation that some of this rollover money would roll their way, only to be disappointed.Clearly there is an absence of intermediation or at least of arbitrage taking place of the pool of Japanese savings.Meanwhile,there are now over$6.5trillion in Japanese government bonds(JGBs)outstanding versus under $3trillion a decade ago,and real interest rates are around only100basis points higher on JGBs on average.So captive savings do translate into?scal power. The institutional and cultural factors explaining such vast and costly risk aver-sion and home bias are beyond the scope of this paper,but it is interesting to contemplate the macroeconomic consequences of this apparent bias,or of its dis-appearance.To understand these consequences,consider the thought experiment in which one morning a signi?cant fraction(say20%)of bank savings account holders in Japan woke up and decided to reallocate their portfolios towards higher-yielding assets.With no domestic assets paying an attractive rate of return,this would mean a signi?cant?ow of savings($1trillion in our example)out of yen-denominated assets and into assets denominated in foreign currencies.What would be the consequences of such a massive reallocation?