Battle Lessons from a Fiscal Warrior

Former State Minister for Economic and Fiscal Policy Hiroko Ota shares some operational lessons learned in her own battles for fiscal and social security reform.

*     *     *

I would like to offer some insights into the challenges of fiscal and social security reform from the standpoint of the policymaking process, drawing on my own experience as a Cabinet Office economist in the administration of Prime Minister Jun’ichiro Koizumi (2001–6), and later as state minister for economic and fiscal policy under Prime Minister Shinzo Abe (first cabinet, 2006–7) and Prime Minister Yasuo Fukuda (2007–8). I focus here on two policy initiatives in which I was directly involved: the 2004 reform of the public pension system and the 2007–8 “integrated reform of expenditures and revenues.”

The 2004 Pension Reform

I took part in the deliberative process leading to the 2004 pension reform in my capacity as a senior member of the Cabinet Office’s economic policy research staff (director of policy analysis and subsequently deputy director general and director general for economic research). The aim of the reform was to adapt the pension system to the requirements of an aging society to ensure its long-term financial sustainability. While the pension system is under the jurisdiction of the Ministry of Health, Labor, and Welfare (MHLW), the official arena for deliberation was the Council on Economic and Fiscal Policy.[*] The council was composed of policymaking officials from the Cabinet Office and the relevant ministries, as well as scholars and other experts from the private sector.

MHLW submitted the initial reform proposal, which entailed the adoption of a fixed contribution schedule (raising the contribution rate each year until it reached a specified fixed final rate), accompanied by an automatic balancing mechanism called the “macroeconomic slide,” which would limit growth in pension payouts by indexing benefits to shifts in the demographic structure, as well as to wages and prices (demographically modified indexation).

The private-sector members of the council voiced no objections to this scheme. Rather, the disagreement centered on the final contribution rate. MHLW recommended a final rate of 20%, which it argued was needed to fund adequate benefits in the years ahead. The council’s private-sector members, backed by the Ministry of Economy, Trade, and Industry (METI) and the Ministry of Finance (MOF), felt that such a burden was unsustainable and called for a final rate of 18%. The two camps were unable to reach agreement.

In August 2003, the Cabinet Secretariat shifted the deliberations to a “forum on pension reform” chaired by Deputy Chief Cabinet Secretary Teijiro Furukawa and consisting of vice-ministerial-level bureaucrats from the Cabinet Office, MOF, MHLW, and METI, together with economist Masaaki Honma, one of the council’s private-sector members. It also set up a working group comprising bureau-chief-level officials from the same government units, myself included.

One key contribution of this forum was to get all government ministries to embrace MHLW’s fiscal projection model. Until then, the Cabinet Office, MOF, METI, and MHLW had their own projections of future burdens and benefits, since MHLW . With everyone using the same model, policymakers from the different government agencies were finally able to debate the issue from the same premises.

In its initial proposal, MHLW had provided the council with two financial projections, one based on the recommended 20% rate and the other on a 19% rate. Under the old policymaking process, the government would have had little choice but to go with one of the two alternatives. Under the new process, the Cabinet Office was able to generate three different projections based on final contribution rates of 16%, 18%, and 20%. With that information, senior policymakers in the ruling Liberal Democratic Party (who made the final decision) settled on a maximum contribution rate of 18.3%.

In addition, by holding the deliberations within an inter-agency body with private-sector experts leading the discussion, the new process fostered open debate on the basic question of whether pension reform should focus on maximizing benefits or holding down the national burden. That is to say, it facilitated a meaningful discussion of the fundamental issues involved in designing a sustainable pension system. The Council on Economic and Fiscal Policy continues to function as a key government policymaking body, and I am hopeful that it will inject a realistic and balanced perspective into the five-yearly review of the pension system’s financial status.

Incidentally, it was only after the pension reform plan was passed into law in 2004 that a provision was added restricting the application of the macroeconomic slide to prevent it from reducing benefits in nominal terms. This tacked-on provision has resulted in a discrepancy between the initial projections and the actual balance of contributions and payouts. But such a provision was never on the table during the reform deliberations. Under the circumstances, I regard the enactment of the 2004 pension reform, with its automatic balancing mechanism, as a major policy achievement

Integrated Reform of Expenditures and Revenues

The second example I would like to take up is the “integrated reform of expenditures and revenues” (IRER) carried out from 2007 to 2008. This was an ambitious program for fiscal consolidation first outlined in the 2006 Basic Policies for Economic and Fiscal Management and Reform, the last such plan approved by the Koizumi cabinet. When I took over as minister of state for economic and fiscal policy in the autumn of 2006, under the first Abe cabinet, my predecessor Kaoru Yosano entrusted me with enforcement of the plan, which he characterized as the Koizumi cabinet’s last will and testament.

The program’s goal was to eliminate the central government’s ¥16.5 trillion primary deficit by fiscal year 2011. Spending cuts were to account for ¥14.3 trillion of that sum, with the remainder covered by tax increases. For years, each proposal to balance the budget by raising taxes had been vigorously opposed on the grounds that the government should first do what it could to cut spending. However, when it came time to implement the spending cuts, these too came under attack. In this way progress was stymied again and again. The IRER sought to resolve this conundrum by establishing clear spending limits that would minimize the need for tax increases. It was probably the first Japanese government program to integrate spending and revenue reforms in this manner.

However, it was clear from the beginning that adhering to the spending limits would be extremely difficult. For example, with the Tokyo International Conference on African Development looming in May 2008, an increase in foreign aid spending seemed unavoidable. It also seemed likely that Prime Minister Abe would want new funding for his pet education initiatives. Still, my feeling was that if we started yielding on this or that item, the whole plan would unravel, and for that reason I took the position of adhering staunchly to the prescribed cutbacks.

Social security proved especially difficult. The plan called for cutting ¥1.1 trillion from the central government’s baseline projection for social security spending over five years, taking into account the natural growth in spending caused by the aging of the population and so forth. The media divided the ¥1.1 trillion by five years and reported, inaccurately, that the social security budget was going to be slashed by ¥220 billion each year, though the plan only mandated slower growth. That fueled fierce criticism not only from the opposition parties but from politicians in the ruling bloc as well. Defending the plan in the Diet was a grueling ordeal. Enforcing the IRER was my toughest job as minister of state for economic and fiscal policy. And there are still some LDP politicians who blame the program for the July 2007 electoral defeat that put the opposition in control of the House of Councillors.

That was the situation when Yasuo Fukuda took over from Abe as prime minister in September 2007. Faced with a divided government, the Prime Minister’s Office was less than enthusiastic about adhering to the IRER in fiscal 2008. I managed to keep the program alive, but when it came to social security cuts, the criticism was intense. At the time, moreover, Japan was grappling with a shortage of doctors, particularly pediatricians and obstetrician/gynecologists. With such issues in mind, we hammered out a detailed plan that specified which social security programs were to be expanded and which were to be cut back and made sure that all increases in social security spending were financed by cuts elsewhere.

The IRER can be thought of as the first blueprint for “comprehensive reform of taxes and social security,” though in this case, spending cuts took precedence. After the Democratic Party of Japan came to power in 2009, the new government took up the banner of comprehensive tax and social security reform, but this was framed in a way to justify higher taxes. I think it is fair to say that more remains to be done in terms of integrated tax and social security reform.

In the end, the fiscal 2007 and 2008 budgets were both drafted within the framework of the IRER. I stepped down at the beginning of August 2008. The global financial crisis hit a few weeks later, and that was the end of the IRER.

Any effective fiscal consolidation program needs three key components: clear-cut targets, a plan for limiting expenditures, and a schedule for tax increases. In this sense, the IRER was a model fiscal consolidation plan, featuring all three elements.

The second Abe cabinet, while ostensibly committed to fiscal consolidation, has failed to produce a comparable three-point program—owing in large part, I suspect, to indecision over the scheduling of the planned consumption tax increases. I think the government needs to begin by drawing up a firm medium-term fiscal consolidation plan and implementing it faithfully.

Drafting such a plan will not be easy, but the bigger challenge will be sticking with it for a full five years. The fiscal restructuring bill submitted by the cabinet of Prime Minister Ryutaro Hashimoto was shelved indefinitely after the 1997 Asian financial crisis hit, and the 2008 global meltdown effectively killed the IRER. An economic crisis certainly calls for flexibility in the implementation of spending cuts, but it should not be allowed to derail the plan altogether. To ensure that the consolidation process continues, we need to adopt clear rules governing the temporary curtailment or postponement of spending cuts under specified economic conditions.

It should also be noted that any meaningful fiscal and social security reform must be premised on a clear view of the future, based on sound fiscal projections. The economic assumptions used in these projections are critical. Government policymakers need to start with shared assumptions, incorporating the viewpoints of various agencies, as seen in the 2004 pension reform. The process should also incorporate a mechanism for independent verification by economists outside of government.

Let me add a final observation. It seems to me that one crucial element lacking from the approach to fiscal and social security reform today is a focus on intergenerational distribution of burdens and benefits. I would strongly urge the government to incorporate the viewpoint of different age groups when drafting reform policies going forward.

[*] The Council on Economic and Fiscal Policy is an advisory body to the prime minister, established under the Cabinet Office in 2001 as part of a package of administrative reforms designed to counter bureaucratic sectionalism and strengthen the prime minister’s leadership in the policymaking process.—Ed.

 

Hiroko Ota

  • Senior Professor, National Graduate Institute for Policy Studies