The 2007 budget process from Daiwa Research Institute

I’m basically doing this for practice, but hopefully some people will get something out of this as there is (understandably) not a whole lot of in-depth English-language coverage on Japan’s budget process, which will as usual top the agenda when the Diet regular session convenes this Thursday. Enjoy:

Perspective on the Fiscal 2007 Budget and Midterm Fiscal Management

The regular Diet session will begin shortly. Deliberations before the end of the fiscal year will focus on the budget and related bills. The draft budget for fiscal 2007 marks the first year of the scenario for putting the primary balance into positive territory as described in the policy of simultaneous reform of expenditures and revenues in the “Course and Strategy for the Japanese Economy 2006.” It is also the first budget put together by the Abe administration. The upper house election coming up this summer will attract strong interest in the Diet debate.

The figure of 16.5 trillion yen in the “Course and Strategy for the Japanese Economy 2006” is the amount that must be dealt with under a situation in which expenditures grow naturally assuming 3% nominal GDP growth as well as a planned boost in revenues due to economic growth. That means that a primary balance deficit of 16.5 trillion yen should be left over after boosting both expenditures and revenue, not how much present expenditures will be reduced. Moreover, that represents a nominal total after 5 years (generally, nominal predictions are even more difficult than real ones), and a prediction for the federal and regional governments based on national economic accounting. That’s a bit hard to understand.

I cannot tell how much this scenario is being followed even after looking at the government’s budget for FY2007. According to what I see in the various materials for the draft budget, generally it looks like reform of expenditures is being promoted in accordance with the goals. For expenditures as a whole, even looking sector by sector, it is said that the “Course and Strategy for the Japanese Economy 2006” is progressing on the lean side of the equation (necessary expenditure cuts are given in a broad range from 11.4-11.3 trillion yen).

What catches my attention at the same time are the “pathways and strategies” that have replaced the “reforms and outlook.” These will be decided shortly. If projections for midterm real and nominal growth rates are revised, then tax revenues and expenditures will change, causing the scenario to be revised. According to news reports, the timing for meeting the goal of making the primary balance positive will not be pushed ahead, but rather a scenario for avoiding an increase in the consumption tax will be unveiled. (tr: see this news report for details)

What are the risks of a scenario that lives or dies by mid-term growth? First of all, tax revenues may not increase as expected due to changed in the economic cycle. The FY2007 budget contains an increase in revenues of 7.6 trillion yen more than the FY2006 budget, so the recognition that growth is key has strengthened. Of course economic growth is important. But of that amount 4.6 trillion yen was appropriated in the supplementary budget, signaling a discrepancy in the original projection. Also, it includes 1.2 trillion yen from the full elimination of fixed-rate tax cuts that was decided a year ago, making the increase in revenue on a realistic basis for FY2007 only 1.5 trillion yen.

Second would be the interest rate hikes that come with economic growth. The ratio of interest payments in the general account is trending downward after peaking in FY1986. The below chart indicates the planned interest payments according to the initial budget from FY2000 in a dotted line, and it shows clearly that the budget drafting has been conservative each year. However, after the long-term interest rate hit bottom in FY2003, the dotted line direction changed while its significance became more profound. One must note that the effects of the debt succession from the local allocation tax special account play a major role in the boost in Japanese Government Bond servicing costs. If interest payments rise, then even if the primary balance improves the fiscal deficit won’t shrink. Interest payment costs will likely receive more attention once the growth strategy is specified in more detail.