Fiscal medium- to long-term simulation: tax reductions and fiscal sustainability

Summary

Japan faces a massive debt outstanding, yet public interest in tax reductions remains strong. In the summer House of Councillors election, opposition parties advocating tax reductions forced the ruling coalition to lose its majority, and there were moments in financial markets when concerns about fiscal health deepened. Moreover, in the Liberal Democratic Party presidential election, Ms. Takaichi, a proponent of expansionary fiscal policy, won. She has expressed her intention to review the income tax system.

• This paper focuses on the impact of tax reductions on fiscal sustainability. 
Fiscal sustainability is assessed using the debt-to-GDP ratio. A sustained rise in the debt-to-GDP ratio means that there is no brake on the decline in debt-servicing capacity. Avoiding such a situation is defined here as fiscal sustainability.

• For tax reductions, we consider: 
(a) raising the income tax threshold to 1.78 million yen (scale of 
reduction: approximately 6.3 trillion yen), 
(b) introducing a refundable tax credit (approximately 3.6 trillion yen), 
and 
(c) implementing both (a) and (b) (approximately 9.9 trillion yen). 

In the stable interest rate case, all of (a)–(c) result in a continued decline in the debt-to-GDP ratio, and fiscal sustainability is maintained. In contrast, in the higher interest rate case, (c) causes the debt-to-GDP ratio to turn upward, meaning fiscal sustainability is lost.  We estimate the tax reduction threshold—where the debt-to-GDP ratio remains flat—at about 15 trillion yen in the stable interest rate case and 8 trillion yen in the higher rate case.

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