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Budget Deficit and Fiscal Discipline:

Budget Reform in US and Japan

Kousuke SHIRAISHI

Research Center for Policy and Economy Mitsubishi Research Institute, Inc.

February 19, 2003

Abstract Institutional reforms concerning budget discipline, budget making process and transparency in the

budget, restrain the expansion of budget deficit. However, in Japan, budget ceilings, supplementary budgets,

the Fiscal Structural Reform law of 1997, and the inter-governmental fiscal relations did not effective ly

manage the fiscal position. This paper examines institutional problems in the fiscal sector and compares

them to the system in the United States. With respect to the role of fiscal rules, there only exist few rules

based on statutes which restrict the budget deficit and debt level. Japan establishes centralization in budget

process. The institutional arrangements attain an equal level with other countries. However, the strategic

examination of the entire budget, target setting, budget examinations are not conducted well in Japan. With

respect to the transparency of budget, they do not show the medium-term fiscal projections and the fiscal

impact of economic packages.

The article is organized as follows. Section 1 reviews OECD data and recent economic

controversies in Japan. Thee roles of fiscal institutions are examined in Section 2. I examine Japan’s fiscal

failures from the view point of fiscal institutions in Section 3. Concluding remarks are presented in Section 4.

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1. Introduction

1.1 Fiscal Position in the United States and Japan

1.1.1 Comparison of the Fiscal Indicators In this paper, the influences of fiscal institutions on the budget deficit are studied.

Institutional reforms concerning budget discipline, budget making process and transparency in the budget, restrain the expansion of budget deficit. However, in Japan, budget ceilings, supplementary budgets, the Fiscal Structural Reform law of 1997, and the inter-governmental fiscal relations did not effectively manage the fiscal position. This paper will examine the institutional problems in the fiscal sector and compare them to the system in the United States.

General Government Fiscal Balances

OECD (2002) "OECD Economic Outlook no.71." reports the fiscal balances in major countries from 1985 to 2003. With respect to the general government financial balances, the U.S. economy the experienced fiscal deficits from 1985 to 1997. While the U.S. government instituted fiscal reform in the 1980s, the budget deficit did not decrease. The fiscal balance improved starting the second half of the 1990s when business conditions recovered. On the other hand, in Japan, the fiscal condition was good in 1990 when the fiscal surplus was at 1.9% of nominal GDP. Since then it has worsened, falling to -7.4% in 2000. While the fiscal situations in major countries improved in the late 1990s, Japan’s fiscal position worsened.

Graph: General Government Financial Balances

Source: OECD (2002) “OECD Economic Outlook no.71”2002 June

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General Government Gross Fiscal Liabilities Aside from the fiscal balance, government debt is another commonly-monitored fiscal

data. The debt ratio in the U.S. was 59.0% in 1985. It became 75.8% in 1993, rising by 16.8% in eight years. However, in the next seven years, this ratio fell by 16.4% to 59.4% in 2000. Over this 15-year period, the increase in the first half was reversed in the second half. It can be said that the U.S. government debt was managed well. On the other hand, in Japan, the debt ratio rapidly rose to 123.5% from 61.1% during the 1991-2000 period.

Graph: General Government Gross Financial Liabilities


General Government Primary Balances

The primary balance is the difference between tax revenue and expenditures excluding for interest payments. While the fiscal balance worsens with increases in interest payments, the primary balance is not affected. It only accounts for the fiscal situation for that year. In the past 18 years, the highest levels of the U.S. primary balance are -2.2% in 1992 and -2.0% in 1986. It can be said that the deficits arising from current year’s activities were controlled well. The U.S. primary balance worsened in the depression year of 1992. However, it has since been maintained at about -2% of nominal GDP. As for Japan, the primary balance was kept in surplus during the 1980s. This, however, was turned into a deficit in 1993. By 1999, the ratio exceeded -5%. This situation continues to prevail until now.

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Graph: General Government Primary Balances


General Government Structural Balances

The structural fiscal balance is the budget deficit adjusted for the business cycle. Since traditional Keynesian principles, such as built-in stabilizers and expansionary fiscal policy, influence the expenditure policy during depressions, the structural budget deficit provides a better measure. The U.S. structural balance was kept at around -4% till 1992. The situation continued to worsen in major countries during the period. Structural balance in Japan exceeded the level of the U.S. in 1999, and has reached -7.4% in 2000.

Graph: General Government Structural Balances


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General Government Net Financial Liabilities

There is an argument that government debt should be evaluated not by the gross level but by the net level. Gross level is satisfactory when the government holds property on the other hand.

In 2000, the U.S. net ratio is 43.4% and 50.5% in Japan. Both countries do not have so much difference. However, in the U.S., due to fiscal reforms, the net debt was gradually reduced starting 1990. In Japan, the net debt ratio contracted in the second half of the 1980s at a pace exceeding current U.S. rates. However, the net debt increased rapidly in the 1990s.

Graph: General Government Net Financial Liabilities Source: OECD (2002) “OECD Economic Outlook no.71”2002 June

1.1.2 Fiscal Performances in the U.S. and Japan Government Consumption and Investment

Following the SNA, government expenditures are divided into government consumption and investment. There are differences for these data in the U.S. and Japan.

Using U.S. data, the ratio of government consumption to the real GDP was 17.1% in 1990. It fell to 13.9% in 2000. The ratio of government investment was 3.6% in 1990, falling to 3.3% in 2000. The U.S. public finance improved its fiscal position by controlling the growth of government consumption as compared with GDP growth.

In Japan, the ratio of government consumption to the nominal GDP increased from 13.7% in 1991 to 17.4% in 2000. This is due to the social security costs arising from the recession and the medical expenses for the elderly. The tendency of government consumption to increase accelerated the widening of the fiscal deficit in Japan. As for

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government investment, after rising until 1995, it has since been declining. The level of public investment is two times larger than that of the U.S.

Graph: Governmental Expenditures in the U.S. and Japan USA JAPAN Source: Statistics of each country

Central and Local Government Expenditures

Public expenditure can be divided into central and local government spending. The local governments are independent bodies in both countries, hence local governments should implement their own fiscal reforms.

In 1990, the U.S. federal government spent 9.0% of the real GDP and the U.S. local governments spent 11.6%. On the average, it appears that both governments spent 10% of real GDP. Federal expenditures fell to 5.9% in 2000. Most U.S. state governments follow the balanced budget principle strictly, while the federal government accumulated huge deficits. Therefore, public finance can be improved with federal government efforts. The

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reduction in social security expenses arising from the economic recovery also contributed to this. In Japan, local government expenditures amount to three or more times that of the central government expenditures. Government Bond Yield

When the fiscal situation gets worse, the credibility of government bonds fall, and the long-term interest rate increases. Even if interest rates do not go up, the interest payment of the bonds will increase. Thus, the management of interest rates becomes an important policy issue.

The yields of 10-year Treasury securities tended to fall starting 1985. In the 1980s, tight monetary policy relieved inflation and this contributed to interest rate reduction. On the other hand, the bond yield fell as a result of fiscal reform in the 1990s. Since inflation fell gradually, the real interest rate, which nets inflation from the nominal interest rate, is falling discretely. The fall in real interest rates contributes not only to fiscal reforms but also to the prevention of crowding out effects. A desirable cycle of reduced interest rates and increased private investment was developed.

In Japan, although fiscal difficulties followed in 1990s, the bond yield shows a downward trend like that of the U.S. Japan can endure the rise in government debts with the low interest rate, and the pain of fiscal difficulties is not felt until the present. While deflationary recession continues and the investments are reduced, the investment in government bonds by public corporations and private banks continues. This supports low yields.

Graph: Government Bond Yield and CPI USA

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JAPAN Source: Statistics of each country

1.2 Why Economic Policies are Supported Keynesian Principles are no longer influential in the United States

In the U.S., the 1950s and the 1960s were the golden age of the traditional Keynesian economics. Fiscal policy as a means of fine tuning the macroeconomy in times of depression was accepted. However, when the 1970s came, problems such as rise of inflation due to the widening budget deficits emerged. Support for the traditional Keynesian economics eroded during this period. While various policies for the rehabilitation of the economy were tried in the 1980s, it aimed to regain fiscal discipline and large-scale fiscal policy stimuli were not adopted in spite of the recession. It is because the pitfalls of Keynesian principles, such as an interest rate increase, inflation, and fiscal deterioration, became conspicuous. The situation is same in the U.K. and Germany. Fiscal policy keeps its position as a policy measure in recessions; however, its scale as a policy tool is kept to a minimum. Fiscal order becomes an important issue while the importance of fiscal policy in the macroeconomic policy is reduced.

On the other hand, in Japan, the general public continues to support spending policies during depressions. It is interesting why the view already abandoned in the U.S. and other OECD countries continues to be a leading idea in Japan. The policy difference in Japan may be due to a unique economic situation arising from the heavy recession after the Second World War, which may be in contrast to other countries. Current disputes on fiscal policy will be discussed in this section.

Keynesian Principles are strongly practiced in Japan

When an economic package is implemented, public opinion, including that of the

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political circles, the business community, and economists, strongly demands government activities A famous notion from Keynes's “General theory” which proposes digging a hole in recessions and covering it is not to be taken literally. The pump-priming effect on economic growth provides the basis. Since the multiplier effect exists in the macroeconomy, an increase in government expenditure will result in an expansion beyond the initial increase to the whole economy. Revitalizing the macroeconomy is the objective of the economic measures that were adapted in the 1990s. According to the econometric model of the former Economic Planning Agency (EPA), while the government investment multiplier in Japan is falling gradually, the level still exceeds one. Government expenditure definitely increases GDP.

However, economists cannot conclude whether or not a supplemental budget brings about economic expansion. Looking back on the series of fiscal policies in the 1990s, in spite of the economic package of 100 trillion yen or more, the Japanese macroeconomy is still ailing. We cannot avoid concluding that the pump-priming effect of the fiscal spending is low. On the other hand, the critics who supported the spending policies argue that if there is enough infusion (c.f. a series of defense expenditures) of public funds, the low pump-priming effect can be counteracted. Furthermore, a large amount of additional governmental expenditures does not cause crowding out effects. Uncertainty arising from the excessive increases in public debts does not bring about a heavy reduction in the household consumption. The pain of deficit finance is not realized and these gains also support to the spending policies.

The typical pattern for the making of supplemental budget in the 1990s is as follows. Fiscal year starts in April in Japan. Since the initial budget is not intended to boost the economy, some economists have already pointed out a shortage of spending at this stage. The news flashes of quarterly GDP statistics (Quarterly Estimates) are released in June and September. At this time, the slowdown of business and the difficulty of achieving the government targets become clear. The general public is concerned about business conditions entering into a deflationary spiral should the macroeconomy be left alone. Spending policies are demanded to pump-prime the economy. In response, the government decides to make a supplementary budget between October and December and will move towards its implementation.

Practical Use of Unused Resources

Demand deficiency is keenly realized in Japan since the deflationary depression continues. Concern for how to stimulate the aggregate demand is a key issue in Japan. Fiscal policy is supported in this regard. Ono (1998) discusses that the real social cost of employing jobless people is zero and he insists on spending policies during times of recession. Jobless people cannot produce anything under this hypothetical situation without public spending. The critical point of this argument is that the labor force cannot move across different times and the debt finance does not matter. It is impossible to utilize the unemployed in the future since labor force cannot be saved. Therefore, the utilization of the unemployed has an impact. In addition, since government is an organization with an infinite life, government should not care about an increase in short-term public debt. It is not a

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problem to employ jobless people by issuing bonds. This argument provides the basis for governmental activity during depression.

Ono, however, does not propose the use of public spending at all times. He points out the existence of a crowding out problem. When a resource which is to be used by the private sector is employed by the public sector, this spending policy cannot be permitted. Moreover, while his own view is not known, Ono should attach a reservation for the view that considers a country as a single entity. The present jobless people and the future generation are different. A burden problem among generations may occur when the future generation pays for the current fiscal expenditure by the bond finances.

Aggregate Demand for the Economic Growth

Yoshikawa (2000) presents a persuasive idea on macroeconomics under the demand deficiency. Yoshikawa doubts the theory that supply factors such as capital, labor, and TFP (total factor productivity) will determine long run economic growth. His new view is as follows: economic growth can be realized by encouraging new demands, such as IT products, and improvements in social welfare will emerge through time. Since the product cycle takes the S-style shape, the macroeconomy cannot grow without a new product cycle. Fiscal policy to create these new types of goods and service is desired. Since the economic depression has continued for more than ten years, existing product cycles are in their stage of maturity and the demands for these products are diminishing. He suggests that new products can restore economic growth over the short and long run. It is hard to achieve growth solely by strengthening the supply side. Therefore, the government should create a market in advance.

Saito (2002) is another economist who desires demand creation and addressing areas with social needs. When there is a mis-identification of demand deficient sectors, competition with private demand occurs. Saito suggests that this brings about the preservation of low productivity sectors. Public funds should be spent in areas where there are social needs. Although Saito's argument does not support the fiscal policy in recession, his view opposes the notion of pursuing fiscal control to prevent a budget deficit. Expenditures for the required areas should be implemented regardless of the fiscal condition.

How to Cope with a Fiscal Crisis

Existing studies conclude that the Japanese public finance is sustainable in the 1990s, however, the fiscal condition worsened in 2000. The possibility of a fiscal collapse is presented. While public finance scholars are concerned about this possibility, macroeconomists are not as interested.

Takemori (2002) thinks that the present state of Japanese public finance is reaching the critical level of bankruptcy. He also argues that it is premature to discuss a breakdown based only on the trend for the past ten years. Government continues infinitely, and 95% of government bonds are held inside Japan. Even if a crisis arises from public debt, a change occurs only in the capital flow. Saito is also of the same view—that the sustainable debt level and the taxation system should be maintained in the long run.

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2. Roles of Fiscal Institutions 2.1 Fiscal Rules and Fiscal Discipline 2.1.1 Comparison of Fiscal Reforms in Major Countries

Japanese fiscal conditions deteriorated in 1990s. The need for fiscal reforms, such as expenditure cuts and taxation, has been repeatedly emphasized. The Fiscal Structural Reform Law was crafted by Prime Minister Hashimoto in 1997. Moreover, in response to rising concerns for fiscal reform, a comparative study on fiscal reforms is warranted. Medium Term Fiscal Plan

Mitsubishi Research Institute (2000) studies the medium term fiscal plans of the major countries. In Japan, "Reform and Economic Prospect" which can be called as the first medium term fiscal plan was released by the Council on Economic and Fiscal Policy (CEFP) in January 2002. According to the study of the Mitsubishi Research Institute (2000), U.S., U.K., Germany, and Italy made plans which show their medium term fiscal strategies. The fiscal plans in the U.K., Germany, and Italy have a binding effect on the actual budget.

Although a policy framework equivalent to a medium term fiscal plan does not exist in the U.S., two policies similar to the latter can be pointed out. First, there was the deficit target in 1980s. The U.S. government made several fiscal reforms focusing on the deficit target and curbing expenditures. Fiscal reform was promoted by restraining the annual budget. The Gramm-Rudman-Hollings Act (1985, 1987) aimed at the gradual curtailment of budget deficit over five years. Second, expenditure targets were set over a period of 10 years. The Omnibus Budget Reconciliation Act (OBRA, 1990, 1993) changed the fiscal target from the budget deficit to an annual expenditure cap. In order to check expenditures the Congressional Budget Office (CBO) and the Office of Management and Budgeting (OMB) estimated baseline projections three times every year. These baseline projections consist of revenue and expenditure prospects for ten years under the present taxation and expenditure programs. With these, influences of new programs on the medium term public finance are evaluated. Under the OBRA, when a new program brings about the increase in annual expenditure more than the baseline, that program is refused if it is not accompanied by a separate source of revenues. (i.e. sequester)

In Germany, under the 1967 Economic Stability and Growth Act, the German government formulates the medium term fiscal plan for five years, and this fiscal plan is rolled every year. While this plan does not bind the annual budget, the law requires an analysis of the past budget. The fiscal plan is submitted to the National Diet and is utilized for budget making, thus achieving its goal of restraining the annual budget.

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Table Medium term fiscal plans in major countries Medium term fiscal plan Binding

U.S. - deficit targets in five years (GRH) - caps in expenditures (OBRA) - baseline projections

- GRH and OBRA binds the congressional budget making - baseline projection is referred

U.K. - economic and financial strategy : fiscal policy over three years - Spending review

- reference of pre budget - each program is checked form the basics

Germany - medium term fiscal plan : five year plan, rolled over every year with ex post analysis

- law of 1967 orders the plan and rolling, but the plan does not bind National Diet - however, it influences on budget

Italy - economy and fiscal plan : four years plan

- the first year’s plan becomes the upper limit of the budget, the limit is voted at the congress

Japan - medium term fiscal plan : five years plan

- no numerical target, no binding role

Source: Mitsubishi Research Institute (2000)

New Public Management (NPM)

One of the issues brought into the limelight in Japan in the second half of the 1990s is New Public Management (NPM). NPM is an administrative reform technique used in Anglo-Saxon countries, such as New Zealand and Britain in the 1980s, and is characterized by a performance-based system and market orientation.

A study of the Ministry of Finance (2001) analyses the private management idea and business technique in NPM by examining how it is applied to reforming budget and financial management. According to this study, there exist legislations that build a legal framework for transparency and accountability. For example, the New Zealand Fiscal Responsibility Act enacts a governmental obligation on the report. By making the fiscal target defined independently and these are interlocked with, accountability serves as a fiscal order and fiscal reconstruction. Performance management of the central ministries clarifies the policy target which the government at that time regards as strategically important, and the objective of leading the entire government into a single direction is achieved. The establishment of an agency was also widely adopted in each country. Other key results are the public appointment of the director general, the adoption of the term-of-office system, the setting of targets, and the creation and monitoring of plans. Extensive discretion is given to the agency director with respect to resources, budget making, personnel affairs and the like.

Though a country with an Anglo-Saxon system, it was uncommon to apply NPM in the United States. The United States was not included in the study of the Ministry of Finance (2001). Vice-President Gore of the Clinton Administration led the U.S. administrative reforms in the 1990s. His idea was a direct introduction of the performance-based system and the business technique. Since it was rare in the U.S. for a government institution to engage in profit making, compared with Japan and the European countries, neither outsourcing nor privatization could become a focus of discussion. The introduction of the private sector management style to the governmental is aimed at. Specifically, the Business Process Reengineering (BPR) which was practical in business administration was an option for this. The 1993 GPRA (Government Performance and Result Act) is line with

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the flow of administrative reform in the United States. The volition and incentive to reform were greater than ever before, and bureaucratic reform was actually realized.

Table New Public Management in major countries Budget management Performance management

U.K. - Fiscal stability discipline (1998) - golden rule (construction bond), sustainability rule (debt/GDP ratio of 40%)

- public service agreement (PSA) - business plan at the agency

New Zeeland - fiscal responsibility act (1994) - gross debt/GDP ratio of 30%, net ratio of 20%

- governmental and departmental strategies - business contract between minister and director - business plan at the agency

Australia - net debt/GDP ratio of 10%

- governmental and departmental strategies - specification of outcome and output

Canada - Two years fiscal plan (1995) - budget deficit of 3% in 1996, the debt will be reduced in the long run

- departmental business plan - business plan at the agency

Source: Ministry of Finance (2001)

2.1.2 Fiscal Rules in the United States and Japan

Cross-cuntry comparison among foreign countries is widely adopted in Japan. Although much knowledge has been gained, a comparative study can help draw out experiences that are applicable to the Japanese case. In this section, the purpose of the fiscal rules in the U.S. and Japan are reexamined. Definition of Fiscal Rules

IMF (1998) "Fiscal Policy Rules" defines the fiscal rules “as a permanent constraint on fiscal policy, typically defined in terms of an indicator of overall fiscal performance.” Fiscal rules can be classified into three: (1) balance-budget or deficit rules; (2) borrowing rules; and, (3) debt or reserve rules. Balance-budget rule restricts budget deficit. Borrowing rule restricts finance of public money. Debt rule restricts the level of public debt accumulation. These restrictions are specified in many cases by constitution, domestic statutory law, or international law like the Maastricht Treaty.

With the evolution of fiscal rules over the past 20 years in major countries, the IMF concludes the following four facts. First, most countries experienced fiscal expansion until the 1970s. However, expenditure contracted with the introduction of fiscal rules in the 1980s. Second, there are few countries which attained fiscal control by the use of discretionary policy over the short period and medium terms. Third, even if the fiscal rules controlled government expenditures, there are few examples that the economic package will be introduced in recession. Fourth, the key for success is a commitment to fiscal rules over the long run.

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Table Major Types of Fiscal Policy Rules Balance-budget or

deficit rules

- Balance between overall revenue and expenditure; or limit on government deficit as a proportion of GDP - Balance between structural revenue and expenditure; or limit on structural deficit as a proportion of GDP - Balance between current revenue and current expenditure

Borrowing rules - Prohibition on government borrowing from domestic sources - Prohibition on government borrowing from central bank; or limit on such borrowing as a proportion of past government revenue or expenditure

Debt or reserve rules - Limit on stock of gross government liabilities as a proportion of GDP - Target stock of reserves of extrabudgetary contingency funds as a proportion of annual benefit payments

IMF (1998) "Fiscal Policy Rules"

Rationale for Fiscal Rules

According to IMF (1998), fiscal rules are considered as the second best solution in the management of the macroeconomy. Keynesian discretionary macroeconomic policy remains prevalent in economics. Spending-policies with bond finance in depressions and the budget surpluses in boom times are excellent examples of actual policy bringing about fiscal expansion. Therefore, fiscal policy which restrains budget deficits by fiscal rules is adopted as a second best solution. IMF (1998) also points out three rationales for fiscal rules: (1) to make a credible reduction in the fiscal deficit; (2) to maintain long-run fiscal sustainability; and (3) to reduce or remove the influence of short run political expediency that leads to a deficit bias. Budget deficit causes inflation and uncertainty. To curtail these, government should control the deficit and fiscal rules can strengthen public confidence. The sustainability of the budget deficit over the long run is another issue and fiscal rules can pursue it using debt and reserve rules. The political pressure for the fiscal expansion in short run is a common problem in most countries. Fiscal rules become an effective measure to prevent this.

Now, when the research results by IMF (1998) are applied to current Japan, what arguments can be considered? With regard to the fiscal deficit, currently Japan is not suffering its negative effects. In spite of exceeding the deficit levels experienced in foreign countries, inflation has not occurred. Moreover, in relation to the second argument, the primary balance has deteriorated sharply. Even if the budget deficit continues for ten years or more, amid the heavy economic recession, some economists accept this kind of fiscal policy. The short run political pressure relevant to the third argument is remarkable also in Japan. That is, in spite of the serious fiscal situation as compared with foreign countries, since there are minimal problems, the necessity for fiscal rules is not recognized by the general public. On the other hand in the U.S., while traditionally the balanced budget was strongly supported, the fiscal burden was sizeable in the 1970s. The curtailment of budget deficit and the rationales for the sustainable public finance were studied. The long-run fiscal target was enacted in the GRH Act in 1985 and in the OBRA method in 1990. Statutory Basis

The constitution, laws, regulations, policy guidelines, and international treaties provide the statutory basis for fiscal rules. By law, the U.S. federal government set the

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budget deficit targets and annual expenditure limits and this restrains the actual budget. The U.S. state governments and the German central government aim for balanced budgets in their statutes. Policy guidelines, though not legislated, substantially function as fiscal rules in the Netherlands and Indonesia.

In Japan, the Public Finance Law of 1947 prohibits the bond finance by the Bank of Japan and implements the construction bond principle. It is hard to say that this public finance law controls the budget deficit effectively. This law only defines the borrowing rules. That is, it only restricts the method of bond finance and it does not restrict the level of budget deficit or the amount of debts. On this regard, the budget deficit can be left as is. In U.S. states, the balanced budget is specified by the state’s constitution, and it contributes to sound public finance at the state level compared with the federal and municipal governments. Even if the public choice school asserts the strength of the constitution, the constitutional amendment for the federal balanced budget was not realized. It is because there was a counterargument that the credibility will fall when a fragile rule like deficit target is introduced. The GRH Act and the OBRA provide the statutory basis for the federal government. Authority

In the monitoring of fiscal rules, an organization that supervises the budget and forces the government and Parliament into a consensus is needed. A court takes part in monitoring in countries where fiscal rules are specified in the constitution. The European Commission and the ministerial council of EU engage observers under the Maastricht Treaty scheme. According to the IMF study, the validity of authority depends on the conditions and traditions of each country even if an agency inside government can monitor fiscal rules effectively. However, it is said that an independent body is more useful for enforcing fiscal rules. Surveillance capability and analytical method are also desired for the backing of authority.

In Japan, the Ministry of Finance (MOF) controls the budget, and enforces fiscal rules. While the monitoring by MOF is granted by law, the authority of MOF is traditionally high in Japan. This tradition contributes to fiscal discipline. However, there is no legal basis for fiscal targets like the budget deficit and debt limit. Also, since the MOF is a department inside the government, issues pertaining to the lack of independence exist. The problem of Japan is that the surveillance of the fiscal position is not validated by a semi-independent organization that has statutory basis. While the newly created Council on Economic and Fiscal Policy (CEFP) is an independent body, it has three weaknesses. First, the council is a body for research and is only recommendatory. The installation statute defines its roles and this dose not give the role of budget inspection. Second, the new body lacks in tradition and authority. Lastly, although it conducts the medium-term fiscal plan and gives policy proposals on the economic reform, its surveillance capability is inadequate. They cannot scrutinize each program. MOF’s inspection capability at the budget process is high. However, since multi-year fiscal targets do not exist in Japan, the MOF’s task remains in the assessment of annual budget.

The surveillance of fiscal position is carried out by two organizations in the U.S., i.e. the Office of Management and Budget (OMB) and the Congressional Budget Office (CBO).

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When the appropriation exceeds expenditure cap, OMB can warn the congressional committees. This authority is guaranteed by the OBRA. The CBO also examines baseline projections to prevent this sequestration by the executive branch. The analytical capability of the CBO is high. According to Schick (2000), the number of the personnel in the OMB reaches 500 persons. Moreover, according to an OECD study, the number of research staff of budget committees in OECD countries, including Japan, does not exceed 10 persons. The number of staff at the U.S. congress budget committee is over 200 persons. Implementation

Discussion on implementation revolves around the ex ante and ex post application of fiscal rules. There exist three areas of concern during implementation: (1) availability of automatic or discretionary contingency measures during budget execution; (2) provision for safeguards or escape clauses; and (3) effectiveness of sanctions for non-compliance with the rules. The U.S. and Switzerland adopted a method of adjusting annual expenditures when the budget does not satisfy the fiscal rules. A regulation for fiscal rules exists in EU’s Growth and Stability Pact.

In the case of Japan, the fiscal rule for debt finance is flexible. The Public Finance Law of 1947 does not restrict construction bonds and public investment can be pursued under this system. The deficit bond is also available as a special case under the law. Currently, the Japanese government passes a special law for the deficit bond every year and the basic law does not function as a method for implementing fiscal rules. Moreover, a rule that calls for the automatic reduction of annual expenditures to restrict the budget deficit or a sanction rule for budget deficit do not exist. Thus, the implementation policy which enforce fiscal rules does not exist under the Japanese fiscal system. The U.S. federal budget process has two methods for ex ante warning and the OMB can implement ex post sequestration. 2.2 Centralization in Budget Process 2.2.1 Study by Von Hagen and Harden (1996)

Research that followed von Hagen (1992) pointed out that one of the causes of fiscal expansion lies in the process of budget making. Ministers, government officials, and members of parliament are solely concerned in increasing their individual budgets, and they do not care for the whole expenditure. This argument was pointed out by Niskanen et al. Von Hagen et al. divides the budget process (government, parliament and implementation) into several stages and examine whether or not the fiscal order in each process is the mechanism to reduce budget deficit. According to von Hagen, there are two mechanisms to strengthen fiscal discipline: (1) centralization which enhances authority; and (2) a contract on the budget targets. The parliament government tends to choose the centralization. The analysis of the budget process in von Hagen (1996) covers the EU countries. In this section, their analytical tools are applied to the United States and Japan. The discussion on the U.S. budget process follows Schick (2000) while that for the Japanese fiscal system follows Kono (2001) and Jinno (2002).

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Main Steps in the Budget Process

According to von Hagen, the budget process is divided into three stages namely : (1) Government Stage, (2) Parliamentary Stage, and (3) Implementation and Revision Stage. Each stage consists of at least steps.

Table Main steps of budget process

Source: von Hagen and I Harden(1996) “Budget Processes and Commitment to Fiscal Discipline” IMF

working paper

The Government Stage consists of five steps. The formulation of budget targets and

guidelines (G1) provides the technical guidelines for budget documents and macro economic estimates. This preliminary framework determines the fiscal targets such as total expenditures and the budget deficit. Under preparation of budget bids (G2), priorities are set by the spending departments. In G3, the Ministry of Finance compiles proposal into the first draft of the budget. Negotiations between the Ministry of Finance and each department are conducted during reconciliation (G4). Furthermore, a meeting is held among cabinet members with the Prime Minister as the arbitrator, to assess the budget. The budget proposal is finalized and is submitted to parliament in G5.

There are three processes in the parliamentary stage. P1 consist of debates, amendments and the vote on the budget proposal. Reconciliation between upper and lower houses is done in P2. P3 is the approval by the government. The forms of deliberation at the parliamentary stage differ among countries depending on factors such as the constitution and the predominance of the lower house in parliament. Italy and Belgium adopts the equality of both houses in the budget deliberation. Predominance of the lower house is established in France and Germany. The U.K. lower house dominates in budget making. A deliberation of budget passes through several meetings from the first reading. The House of Commons votes on a budget bill and enacts into an Appropriations Act.

In the implementation and revision stage, I1 is the execution of the budget by the Ministry of Finance and the spending departments. I2 consists of the in-year changes of the budget done through the supplementary budget. The supplementary budget follows the

<Government Stage> G1 Formulation of budget targets and guidelines G2 Preparation of budget bids G3 Compilation of budget draft G4 Reconciliation G5 Finalization of budget proposal

<Parliamentary Stage> P1 Debate, amendment of, and vote on budget proposal P2 Reconciliation between upper and lower houses P3 Approval by government

<Implementation and Revision> I1 Execution of the budget act I2 In-year changes of the budget

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same budget cycle.

Government Stage The following table is taken from von Hagen (1996). The EU case studies indicate

three types of procedures: (1) strategically centralized; (2) guided decentralized; and (3) decentralized. In strategically centralized procedures, the Ministry of Finance enjoys relatively strong control in budget making and setting of the fiscal targets like program expenditures and the budget deficit. Guided decentralized procedures set less binding budget standards, and the Ministry of Finance exercises restricted leadership in budget negotiation. Decentralized procedures do not set a budget standard. The Ministry of Finance only implements the compilation of the draft and no reconciliation is performed. Centralization instills more fiscal order.

The type of the budget process in the U.S. is a mix between strategically centralized and guided decentralized procedures. The Budget and Accounting Act of 1921 mandates that the U.S. President submits the President’s budget to Congress. Currently, the Office of Management and Budget (OMB) at the executive branch compiles the President’s budget. The president is the person in charge of the formulation of budget targets and guidelines (G1). Since the OMB issues the policy guidelines to the departments, a strategically centralized procedure is institutionally established. However, it is uncommon for the President to exercise his control on the budget at the start of the budget process, and the strategic nature of budget process is actually weak. In budget bids (G2), spending departments send to OMB their desired appropriations. This process is the same as other countries. The compilation of the budget draft (G3) is conducted by the President with the assistance of the OMB. President can make his intentions reflected in budget at this stage. The spending departments can demand more budget allocation from OMB in during the period of reconciliation (G4). However, departments and agencies make their budget requests conform with the President’s intentions after his budget plan is determined.

Unlike other countries, under the government stage, in the U.S., the executive branch cannot make the budget draft. They also cannot present a budget draft to Congress. President submits the President’s budget to Congress in February every year, but under the Congressional Budget and Impoundment Control Act of 1974, this is only for reference. The U.S. Congress will make its own Appropriations Act. Government departments including the OMB attend the congressional hearings to explain President’s budget and President can veto to congressional budget in the final stage. The contents of President’s budget are fully respected in Congress. It can be said that the authority of President supports the centralization at the government stage even if the U.S. system does not have a cabinet committee for the budget.

The formal budget process in Japan can be classified as strategically centralized, but the actual process is guided decentralized. In Japan, the cabinet is the organization for budget preparation and the Ministry of Finance (MOF) is in charge of the budget compilation. In the first phase of the budget process, the cabinet and MOF formulate the budget guideline and each ministry and agency starts budget making based on this. Preparation of budget bids (G2) is undertaken between the MOF and the ministries. The MOF assesses the government budget. It is unusual that the cabinet exercises leadership

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in budget negotiation, i.e. in reconciliation (G4). The direct assessment by the cabinet committee which is common in the EU budget processes, does not exist.

The Council on Economic and Fiscal Policy (CEFP) is within the Cabinet Office and they take charge in the deliberation and study of the general guidelines for the budget. CEFP cannot enforce the strategy for the entire budget. Moreover, due to weak reconciliation (G4), the examination of the budget by the Finance Minister is strong. The authority of the Finance Minister is strong although he is not legally the Deputy Prime Minister like in other countries. Therefore, centralization in Japan is established by the MOF’s scrutiny. However, since the total budget strategy is ambiguous and the contribution to budget making by the whole cabinet is relatively small, the centralization in Japan has weaknesses. Jinno (2002) suggests the strategic budget determination fails. The budget principles and the quantitative guidelines are determined between July and August, during the initial stage of the budget process. The cabinet formally approves this guideline in December. Strategic determination has failed.

Table Centralization at the government stage


working paper Parliamentary Stage

There exist three criteria to access the centralization in the parliamentary stage. First is the scope of amendments, which is whether amendments can confine the increase in spending. For example, in the British House of Commons votes on the budget initially ( i.e. vote of confidence on the government). Second is the relation of upper and lower houses, which is whether the lower house has prerogative over the upper house. In the Netherlands

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and Ireland, the upper house has no budgetary powers and only the lower house deliberates on the budget. Centralization is put into practice. Third is the relation of government and parliament, which is whether a vote on the budget has the character of vote of confidence on the government. In this case, since the rejection of the budget means the collapse of political power, the easy adjustments to the budget will be eliminated. It can be called centralization from a reverse viewpoint.

The U.S. Congress enjoys a high degree of centralization. As for scope of amendments, Congress enacts a budget bill and budget amendments does not exist under the U.S. system. Various kinds of restrictions are imposed on the budget process in Congress. First, Congress passes a resolution that determines 20 budgetary limits immediately after the presentation of the President’s budget. The congressional committees in the Senate and the House of Representatives start to deliberate on the appropriation for each expenditure item. Since the aggregate budget amount is determined first, budget increases are prevented. Second, when the pay-as-you-go principle is incorporated in the budget resolution, the new legislation which brings about an obligatory expenditure or tax reduction must secure an offsetting source of revenue so that the budget deficit will not increase. This system was enshrined in the 1974 law. In addition to this, the 1990 law enacted the sequestration process. When Congress does not prepare the offsetting revenue, a compulsory sequestration of the entitlement programs is carried out. That is, the legislator who proposes the increase in obligatory expenditure needs separately to look for a new source of revenue to fund, and when it is impossible, uniform curtailment including other budgets is imposed. Third, a cap on discretionary budget does exist. This was introduced in 1994. It defines annual expenditure upper limits for five years. Congress does not accept budget proposals that exceed the cap. It is not in a government budget but rather in Congress that quantitative targets over the long run are set by independent laws. This is the structure of budget process in U.S.

The relationship between the upper and lower houses remains at the level of guided decentralized procedures. Although the House of Representatives has the right to first debate on the budget, both houses have equal powers in passing the budget bill. When the bicameral views differ, the joint committee will revise it.

As for the relation of government and parliament, the President can veto the budget bill passed by Congress. All Presidents orient fiscal reforms in past, and he can deny the demand for budget expenditure increases by Congress. However, since President can only the veto the entire budget, and he cannot veto any specific program, the centralization of budget process depends on whether he can influence budget formulation in Congress. Although President's veto and the vote of confidence in EU countries are different their functions are similar. When there is increasing pressure from the budget, one can raise fiscal discipline through the procedure of confidence or refusal.

The control of the Japanese National Diet on the budget process is relatively low compared with U.S. and European countries. First, as for the scope of amendments, the budget is not the laws of appropriation and revenue but budget is a parliament approval. The budget is a distinguished system in Diet procedure compared with ordinal law makings, the government gets the recognition of annual expenditure and revenue from the Diet. In other words, the intention of budget by the Cabinet is strongly respected in Japan. Although

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amendments to the budget by the Diet is accepted under this system, it is made possible within the limits that do not spoil the budget initiative. The concrete standards for the amendments by the Diet are not clear and this is a problem. Kono (2001) defines amendments as containing a completely new budget with substantial increases. However, he also admits that amendments be judged individually.

The relation of upper and lower houses is dominated by the lower house. The lower house starts the discussions followed by the upper house. As for the relation of government and parliament, the budget resolution is passed by the Diet. Rejection does not signal non-confidence in government. It is a system on where centralization does not work in the parliamentary stage.

Table Centralization at the parliamentary stage


working paper Implementation Stage

The centralization at the implementation stage can be evaluated by the following criteria: (1) expenditure management which pertains to spending control by the Ministry of Finance (MOF) during budget execution; (2) transfer of appropriation which is the diversion of expenditures across programs. (3) substantive revisions through a supplementary budget.

In the United States, although expenditure management is left to each department, the OMB and the Treasury Department have a handle of the whole situation at any time. Transfer of appropriation is restricted. Since President may not implement the

22

congressional budget, the restrictions are imposed by the statute. As for substantive revisions, it is very unusual rare that a supplementary budget is drawn. While supplementary budgets were required for reasons like the increase of salary during the 1980s, the introduction of the system for discretionary spending in the 1990s makes it difficult.

In Japan, expenditure management and transfer of appropriation are likewise strictly managed by the MOF. However, substantive revisions are not kept in check. The shortage of revenue and legislated expenditures or a contingent event permit a supplementary budget. However, supplementary budget are used frequently in recessions.

Table Centralization at the implementation stage


working paper A Comparative Study of the U.S. and Japan

The United States and Japan are unique cases for the centralization of budget processes and for the relation of government and parliament in terms of European standards. However, when the interaction of institutional rules is examined, U.S. attains centralization while Japan’s degree of centralization is inadequate.

In the U.S., although Congress makes the budget, a number of rules that prevent the increase in spending are in place, and they are working effectively. Although the system institutionally differs from European countries there are many similarities such as the structure which initially decides the entire budget and the structure which restricts amendments. The President executes the budget and he exercises strong control (i.e.

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centralization) inside government and in the relationship with Congress. Therefore, the intention of a President who desires fiscal reforms can easily be reflected in the budget. Furthermore, since Congress is required to obtain approval from the executive branch in the final stage of the budget process, centralization is working. In the relationship with Congress, President can veto the budget bill. It is rare that a supplementary budget is drawn up.

Japan has a budget process similar to European countries, but the degree of centralization is quite low. In the government stage, it lacks the fiscal rule that controls the entire budget, and since the budget process is entrusted with the Finance Minister, the curbing of expenditures by the cabinet is hardly demonstrated. One may opt to introduce the Cap System and the pay-as-you-go principle into the government stage. However, the applicability of these parliament rules remains controversial.

From the view point of restricting annual expenditures, a budget guideline exists in the government stage in Japan. However, the ability to effectively enforce it is questionable. Budget examination by Diet is not effectively performed. The frequent use of supplementary budgets in the implementation stage manifests the failure of centralization in Japan. The MOF takes charge of fiscal control inside government. The MOF cannot deny requests because the cabinet (i.e. politicians) is in charge of budget making in the executive branch. 2.2.2 Analysis of the Parliamentary Stage in OECD Database Features of the Parliamentary Stage in Japan

OECD collects information on parliamentary budget procedures in the OECD countries. This is carried out using questionnaires from the member countries.

The result of questions shows that the type of budget deliberation in parliament in Japan is within the average for OECD countries. It is because Japan belongs to a category with the highest reply ratio from OECD countries. Japan differs from other OECD countries in the area of revising the budget proposal. In the question, “In practice, does the legislature generally approve the budget as presented by the government?,” the countries which answered "With no changed" are Japan, Australia, Canada, Greece, New Zealand, and Britain, i.e. only six countries. Budget revisions are made in many countries.

A more detailed look of countries which responded "With no changed," four nations, Australia, Canada, New Zealand, and Britain, answered affirmatively to the question "Is a vote on the budget considered a vote of confidence in the government?" Thus, in a country where the parliament does not change the budget proposal, an amendment of government budget actually means non-confidence in the government. These four countries follow the British parliamentary system and the authority of the Prime Minister and the cabinet is very high. Under the parliamentary system, the ruling party and the executive are the same. The authority of the Prime Minister and cabinet means that fiscal reforms can be pursued using the strong leadership in government.

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Table Budget Deliberation in Legislature (OECD)

OECD average

USA Japan

Any restrictions on the amendment No No No Role of each house Lower Equal Lower Vote of confidence No No No Change of budget Minor significant No

Prior budget debate No No No First vote No Yes No Number of appropriation laws Single 13 3 Committee structure Single Multiple Single Minister attendance Yes Yes Yes Number of staff of the budget committee 5-10 245 5-10 Special budget research organization No 25- 5-24 Vote on the entitlements Yes No Yes

Source: OECD(2002) “OECD Journal on Budgeting, vol.1, no.3” 2.3 Improvement in Transparency 2.3.1 Fiscal Transparency Objectives in Transparency

In addition to fiscal rules and centralization Fiscal transparency attracts academic interest Poterba (1996) suggest three goals for transmitting precise fiscal-related information to voters and politicians: (1) to inform the budget debate; (2) to structure the debate on government programs; and (3) to affect fiscal policy outcomes. The Argument of Alesina and Perotti (1999)

According to Alesina and Perotti (1999), there are two objectives in the transparency of the budget: (1) to prevent fiscal illusion; and (2) to prevent the maneuvers by politicians. If precise information is transmitted, a correct fiscal decision will be realized. The bad examples of budget lead are as follows: (1) overestimate the expected growth of the economy, (2) project overly optimistic forecasts of the effect on the budget of various policies, (3) keep various items off budget, (4) use budget projections strategically, and (5) strategic use of multiyear budgeting. They propose three possibilities to enhance transparency in the budget. First is to adopt a legal approach (but complicated rules might be introduced). Second is to have an entity in charge of evaluating the transparency (but it depends on the political independence). Third, is to have a respected private institution conducts the verification thus assuring accuracy and transparency. 2.3.2 Comparative Study Ministry of Finance (2002)

IMF prepares guidelines for the improvement of transparency in budget and fiscal system. OECD also makes guidelines for the transparency in budget system. The Ministry of Finance (2002) evaluates the transparency of actual budget systems in major countries based on a checklist in these guidelines. The items in the checklist are divided roughly into

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four categories: (1) scope of government and budget; (2) overall budget and fiscal information; (3) micro budget and fiscal information; and (4) report and auditing. According to the study, the United States and Japan have satisfied the basic requirements of guidelines. Although the United States has reached the level that satisfies a superior norm than the basic requirements, Japan hardly satisfies the superior norm. U.S. - Japan Comparison of Transparency

The checklist for the scope of government and budget consist of following: the coverage of the parliamentary resolution, the types of public sector entities covered by budget documents and the coverage of the budget position. Although the coverage of the budget resolution is narrow in U.S., the types of public sectors entities covered and the coverage of the budget deficit released is relatively large. In Japan, the types of public sector entities which budget document covers is wider, but the fiscal position covers only for the general account of the central government. The central governments in Japan are divided into the general account, the special accounts (social security fund is included), the government institutions, and the public corporations. All, except public corporations, are covered by parliamentary approvals, and budget documents are shown from each organization. However, the budget does not consolidate financial positions, for the budget deficit and debt level. Therefore, the consolidated budget position of public sectors in Japan is unavailable.

The checklist for overall budget and fiscal information contains items that help determine whether the full fiscal outlook is understood. This consists of eight items.

(1) Long-term framework - while the U.S. budget prepares baseline projections, it is only starting 2002 that the Japanese government initiated this kind of planning.

(2) Sustainability – while the U.S. fiscal system conducts projections of 70 years, long-term estimation is restricted to the field of social security in Japan.

(3) Fiscal rules and targets - the fiscal rules like the GRH Act and the OBRA exist in U.S., it is only the Public Finance Law of 1947 that forbids the issue of bonds for deficit financing.

(4) Macroeconomic projection – the U.S. fiscal system forecasts an economic outlook and the quality of this is always verified ex post, while in Japan, the government economic prospect is only for the next fiscal year.

(5) Fiscal position - both governments publish the budget deficit. (6) Fiscal outcome – this is the change in fiscal outlook; the reason and magnitude

of change are shown clearly in the U.S. fiscal documents; although changes in the main budget and the comparison of settlement with budget are also reported in Japan, it is hard to say that ex post verification of the past budget is fully performed.

(7) Effect of the new policy - the U.S. budget examines the influence of new policy in detail.

(8) Fiscal risk - sensitivity analysis of fiscal indices is carried out both in Japan and the U.S.

Micro budget and fiscal information refer to the checklist for individual budget

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programs and budget documents. These are: (1) Program evaluation - the system of program evaluation is established in the

U.S.; in Japan, policy evaluation was just started. (2) Taxes and expenditures - a detailed analysis and prospect of the tax revenues

are released with the annual budget in U.S; Japan does not conduct this analysis.

(3) Debt and asset - periodical reports are published in both countries; the U.S. government announces the balance sheet and the property of the entire public sector, while Japan is inadequate in this regard.

(4) Accounting policy - while the accrual basis is adopted in U.S., it is on cash basis in Japan.

The checklist for report and auditing are as follows: (1) Types of reports - the report of budget and fiscal position are published in both

countries; the U.S. system, which has monthly reports and long-term projections, is superior to the Japanese system.

(2) Auditing - the Board of Audit is established and the internal audit is performed for Japan and U.S. within departments; however, the Inspector General inside U.S. departments is institutionally superior.

Transparency in Japan

With respect to the transparency of public finance in Japan, the Ministry of Finance (2002) recommends the following: (1) the need to formulate a medium term framework for fiscal management; (2) the need to have a comprehensive measure of the fiscal position which permits the analysis of fiscal policies and the budget situation; and (3) the system of fiscal reporting is desired. The budget document in the budget process and SNA statistics data are well prepared in Japan. However, since medium-term viewpoint, comprehensive study, and ex post evaluations are not prevailed, and these problems jeopardize the transparency.

From viewpoints of fiscal rules and the budget process, followings can be concluded. The fiscal rules for Japan is relatively loose compared with U.S. and European countries. Therefore, fiscal indices and the tools of analysis to judge fiscal situation do not exist, and this has brought about the decline in transparency. In the U.S., the OMB and the CBO concentrate on producing the fiscal documents necessary to decide on excess expenditures as required by law. In connection with budget process, Japanese centralization lacks this strategic nature. This problem has caused the dearth of comprehensive analysis and review.

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Table International comparison of transparency of budget and fiscal system

USA Japan A. Scope of government and budget Scope: large

Position: large Scope: large Position: only central government

B. Overall information 1) Long-term framework

Baseline projection

Start from 2002

2) Sustainability 70 year projection Social security only 3) Fiscal rule, target 1985 GRH, 1990 OBRA Debt rule 4) Macroeconomic projection Medium-term in economic

cycle, ex post evaluation Next year only

5) Fiscal position Budget balance Budget balance 6) Fiscal outcome Comparison with the

former ones Estimate and actual figure

7) Effect of the new policy Numerical analysis for the pay as you go

Qualitative explanation

8) Fiscal risk Sensitivity analysis Sensitivity analysis C. Micro information 1) Program evaluation

Program evaluation, GPRA

Ex post policy evaluation

2) Tax, expenditure Tax expenditure report - 3) Debt and asset Monthly statement on Debt

Balance sheet, national wealth

Quarter statement on Debt Limited balance sheet

4) Accounting policy Cash based with accrual Cash based D. Report 1) Types of reports

Monthly treasury statement Long-term projection

-

2) Auditing Inspector general General accounting office

National audit office

Source: Ministry of Finance (2002) “Budget and Fiscal Transparency”

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