Economic Analysis Series No.163
Government Deficit and Economic Activity:
Medium and Long-Term Analysis

March 2002
Toshihiro Ihori
(Executive Research Fellow, Economic and Social Research Institute, Cabinet Office;
Professor, The University of Tokyo)
Ryuta Kato
(Visiting Fellow, Economic and Social Research Institute, Cabinet Office;
Associate Professor, Shiga University)
Hideo Nakano
(Visiting Fellow, Economic and Social Research Institute, Cabinet Office;
Associate Professor, Senshu University)
Toru Nakazato
(Visiting Fellow, Economic and Social Research Institute, Cabinet Office;
Assistant Professor, Sophia University)
Takero Doi
(Visiting Fellow, Economic and Social Research Institute, Cabinet Office;
Assistant Professor, Keio University)
Hiroki Kondo
(Visiting Fellow, Economic and Social Research Institute, Cabinet Office;
Assistant Professor, Shinshu University)
Masakazu Sato
(Department of Information and Research Cooperation, Economic and Social Research Institute, Cabinet Office)

The full text is written in Japanese.

(Abstract)

This research stems from ESRI's economic analysis "A series of Policy Research" N 16, released in September 2000, and examines some problems concerning Japan's government deficit from medium and long-term points of view.

This research includes both theoretical and empirical analyses of the accelerating increase in government deficit, of the correlation between future macroeconomic policy and Japan's aging population, of the productivity of public investments, of household budgets and reactions of enterprises, of the lobbying activities of special interest groups, and of the maturity structure of bonds and public finance. The research consists of six chapters, summarized as follows.


Chapter 1 "Government Deficit, Public Investment, and Public Capital in an Aging Society"

Outlines several scenarios concerning the possible effects of an aging population on future public capital investment, budget deficit, national contribution ratio, capital accumulation, and social welfare of future generations. The chapter explores the effects of an aging population based on data from "Japan's Future Stochastic Population" (estimation of January, 1997). We reexamine the effect of future budget deficits and public investment by introducing the effect of public capital on private production into a simulated model used in the above-mentioned economic analysis "A Series of Policy Research."

The most important points in the first chapter are as follows. First, the policy of reducing outstanding government bonds by cutting public investment has a negative effect on income and output. However, in terms of utility-depending on the level of consumption-it is preferable to maintain the outstanding amount of government bonds at a low level, even through that reduces public investment, which contributes to private production. Second, comparing the social security contribution and benefits based on the methodology of generational accounting, we found redistribution of the benefits from the generation born after the last half of the 1940s to those born before. Third, public investments that are "wasteful" in the sense of not contributing to long-term private productivity have a negative effect on future income and production levels. Twenty-five percent of "wasteful" investments reduce output by 6.5 percent in a stationary state. Moreover, 50 percent of "wasteful" investments reduce output by 15 percent, and 100 percent of investments not contributing to the private production reduces output by 30 percent. GDP declines in proportion to the "wasteful" amount of public investment.

Chapter 2 "Non-Keynesian Effects of Fiscal Policy: A Survey"

Overviews the previous studies on the non-conventional effects of fiscal policy and proposes a policy alternative to improve the performance of fiscal policy in Japan on the basis of the empirical results. The "Non-Keynesian effect" is a possibility that a fiscal consolidation may induce a boom, or conversely a fiscal expansion may reduce private demand under some conditions. Several recent studies suggest that the effect of fiscal policy on private demand is non-linear, depending on the conditions under which the fiscal impulse occurs and its characteristics.

Our empirical results show that the cut in public expenditure during the period of fiscal consolidation in the 1980s stimulated private consumption. The finding suggests that the fiscal reform scheme of "fiscal consolidation without tax increase" may be expansionary. The success of a fiscal reform, however, depends on how the reform affects expectation of private sector, and thus it depends on the credibility of the government implementing the fiscal reform. The government should implement fiscal reform with this in mind.

Chapter 3 "Debt Neutrality Proposition and Private Consumption"

Focuses on a normative analysis of Barro's neutrality proposition, especially whether the neutrality of government bonds holds in Japan, where the amount of government bonds reached unprecedented levels, both in historical terms and compared to other developed countries. The essence of Barro's neutrality proposition is that, provided the individual cares enough about his children, he will also calculate the tax liability that falls on them due to debt issued in his lifetime; thus, issuing bonds will not affect consumption or other economic activity. Barro's neutrality proposition holds on the following strong assumptions: 1) there are competitive markets and no borrowing constraints, 2) there is a transparent tax system, 3) there is a perfect foresight for future fiscal policy, and 4) households as well as government have infinite planning periods. Assumptions 1, 2, and 3 are necessary conditions for Ricardian equivalence to hold; assumption 4 is vital for Barro's result. An infinite planning period of finite-living agents is considered an unselfish intergenerational altruism, causing people to care about the utility of their offspring.

Using the methodology of permanent income hypothesis, Chapter 3 tries to verify on the basis of Japan's data whether the generational permanent income hypothesis and intergenerational altruism are supported and, thus, whether Barro's neutrality proposition holds. It also tries to verify whether, even if the generational permanent income hypothesis holds, the intergenerational altruism fails to hold and, thus, whether issuing bonds will become a heavy burden for subsequent generations. The conclusion: the permanent income hypothesis and altruism do not hold simultaneously, implying that Barro's neutrality proposition is not valid. However, we cannot completely reject the hypothesis that generations make their consumption and saving decisions by taking into account their permanent income; but they either have no or insufficient altruism. Hence, it becomes obvious that the current government debt has some real effect, and that the debt burden could be transferred to subsequent generations.

Chapter 4 "Analysis of Reconstruction of Fiscal Deficit Within the Framework of a Non-cooperative Dynamic Game Among Local Governments: Attempts of Reconstruction of the Fiscal Deficit and Its Consequences"

Develops an analytical model that analyzes the reconstruction of the fiscal deficit within the framework of dynamic non-cooperative game theory. The model consists of the central government having tax revenue sources and plural local governments or interest groups receiving transfers of fiscal resources. We assume that the central government has weak leadership and that the decisions on the level of government spending completely depend on power relationship of local governments and interest groups. The local governments behave non-cooperatively to receive as many transfer payments as possible after observing the tax revenue of the central government and decisions of other local governments. Moreover, the implementation of the transfer payment from the central government requires some cost; the cost is especially higher for those transfers that bring profit only to that region.

The results of the theoretical analysis are as follows. When the outstanding amount is at a relatively low level, each local government competes for maximizing the transfers of fiscal resources. As a result, government deficit increases and eventually reaches the maximum sustainable level at the ongoing level of tax revenues. In this case, even if there is an increase in taxes to reduce the outstanding amount of bonds, the local governments will claim for increases in transfers. As a result, the outstanding amount of bonds will increase to new sustainable levels, taking into account the increase in tax revenues. Besides, if the cost of implementing the transfer declines, political pressure by local governments on the central government becomes even stronger. Transfers of fiscal resources increase, and the speed of increase in outstanding bonds accelerates, causing the expansion of long-term outstanding bonds.

Chapter 5 "Analysis of Bond Management Policy Concerning the Maturity Structure of Japanese Bonds"

Focuses on the theoretical analysis of the maturity structure of bonds and an exploration of future alternatives based on numerical analysis. According to the theoretical model, the term of expiration affects neither the inflation rate, the tax rate, nor fiscal expenditures in the "second-best sense", 1 but affects the desirable in the second-best sense level of issued bonds in every period. To maintain the neutrality of bonds toward social welfare (social loss), it is necessary to issue bonds to cover the part of fiscal expenditures and redemption that cannot be covered from tax revenues and re-coinage profits while maintaining budget constraints and not distorting the inflation rate, tax rate, and fiscal expenditures. Given the maturity, issuing bonds should act as a buffer in the budget.

Given the present structure of bonds by maturity (structure centering on 10-year maturity bonds), the future schedule of issuing bonds should be as follows. As the termination date concentrates within a ten-year period, it is preferable not to raise taxes or the inflation rate or to cut expenditures in this period but to reserve the fiscal resources to a certain extent even if the reliance on government bonds will rise. However, it is necessary not to cut taxesor increase expenditures but to reduce reliance on the government bonds when there are relatively few expiring bonds. Moreover, it is indispensable to restrain the increasing trend of reliance on government bonds.

Chapter 6 "Debt Management Policy and the Role of Public Finance"

Explores the government's debt management policy with respect to public finance (here, we refer to the Bank of Japan and government institutions such as the Trust Fund Bureau, the Debt Consolidation Fund, and the Postal Life Insurance Fund). The public sector of Japan holds a large amount of government bonds. Compared to other countries, the structure of holdings of Japan, where the public sector underwrites government bonds and invests in them, is unique. Besides, the investment policy of the public sector takes the form of "buy-and-hold": bonds bought by the public sector are held until maturity and are rarely sold on the secondary market. Here we examine how the holding of government bonds by the public sector affect private expectations of repayment risk, the price of bonds, and the rate of return.

Based on the assumption of the lower risk aversion of the public sector compared to households, our theoretical analysis shows that the holding of government bonds by the public sector increases the price of bonds (reduces the rate of return). Moreover, there is asymmetry of information between the borrower (government) and lender (household). Taking this into account, the amount of government bonds held by the public sector, buying operations affect the expectations of risk repayment. The public sector decides on optimal policy after observing how its behavior signals repayment risk. The optimum policy for the private sector is to maintain the fixed level of market absorption of bonds, even if the environment changes, leading to an increase in repayment risk, and to keep the price of bonds stable. Using the terminology of game theory, this means the existence of a pooling equilibrium when households accept misleading signals; as a result, the price of bonds deviates from fundamentals.


1 The income tax and changing individual preferences of leisure and labor affect the production level of the nation. Optimal taxes are those not causing distortions to the production level, but they are impossible. Given the distortions to the allocation of resources, the decision of choosing the optimal policy is called the second-best sense.

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