Fiscal Consolidation and Local Public Finances in Japan: Incentive Problems Associated with Intergovernmental Transfers and Their Political Roles

Abstract

Japanese local public finances are supported by large intergovernmental transfers from the central government. Intergovernmental transfers have two roles. The first is to guarantee fiscal standards at local levels. The second is to reduce the degree of fiscal inequality among local governments. However, both roles induce incentive problems. This chapter focuses on the incentive problems associated with intergovernmental transfers in Japan and explores how the behavior of politicians in terms of designing the transfer system affects this problem.

Comment Paper to Chapter 4

Takeshi Miyazaki

Kyushu University, 6-10-1 Hakozaki, Higashi-ku, Fukuoka 812-8581, Japan

e-mail: tmiyazak@econ.kyushu-u.ac.jp

This study discusses Japanese local public finance, focusing on the intergovernmental transfer system known as “Local Allocation Tax” (LAT), and its incentive problems and political roles. With respect to incentive problems, the study closely analyzes the calculation formula of LAT. In the formula, it is argued that the retention rate of “Standard Fiscal Revenues” (SFR) is 25 %, meaning it is equivalent to a very high 75 % marginal tax rate on taxable revenue. Moreover, problems such as discretionary adjustments in the components of “standard fiscal needs” (SFN) and SFR based on the economic situation, the existence of information asymmetry related to fiscal effort, and the effect of “soft budget constraints” (SBCs) are said to induce local governments to lower their fiscal efforts to raise tax revenue or to increase their tax base.

The main comments on this study follow. Regarding the function of LAT, although the author did not discuss this in any depth, it would be better to point out that some recent theoretical works have found that fiscal equalizing transfer can contribute to attaining economic efficiency as well as equity, in the presence of competition with mobile tax base (e.g., Köthenbürger 2002; Smart 1998). Moreover, to strengthen the argument of this study, another view to the one stated above concerning the effects of LAT on fiscal effort may also be discussed. That is, some researchers have stated that the LAT formula for the calculation of SFN is objective, and is measured on the basis of objective indices (e.g., Mochida 2006). Also, it is shown in this chapter that if the central government can commit to “no bailout”, then local government will choose to make fiscal efforts as its best course of action, and a socially optimal equilibrium can be achieved. As is well known, this form of equilibrium is reached under “hard budget constraints” (HBCs), so discussing HBCs will help readers understand the argument.

Although there are several articles that have attempted to demonstrate the function of LAT, many of them can only explain its framework and basic statistics. In contrast, this study aims at revealing what outcome LAT will yield on the basis of up-to-date economic theory. As a result, it could become one of the more useful studies to which later researchers who intend to learn about the Japanese intergovernmental transfer system can refer.