JAPAN: FROM GROWING THE PIE TO HANDING OUT PORK?

C O N F I D E N T I A L SECTION 01 OF 03 TOKYO 005196

SIPDIS

SIPDIS

TREASURY FOR IA/DOHNER, HAARSAGER, WINSHIP, POGGI

E.O. 12958: DECL: 11/08/2017
TAGS: ECON EFIN JA
SUBJECT: JAPAN: FROM GROWING THE PIE TO HANDING OUT PORK?

REF: TOKYO 5090

Classified By: Ambassador J. Thomas Schieffer for reasons 1.4 b and d


1. (C) Summary: Prime Minister Fukuda, though initially
reiterating former Prime Minister Abe,s fiscal goals of
achieving a primary deficit surplus by FY 2011 and reducing
the debt-to-GDP ratio by the mid 2010s, appears to have
turned away from the Abe pro-growth strategy. Since the
disastrous Upper House election in July, tensions have been
building within the LDP among fiscal conservatives, who want
to cut expenditures and raise taxes to put Japan on a
fiscally sustainable path, the pro-growth camp, and a third
group who want to return to pork-barrel public spending in
order to build support with voters prior to the next
election. Intra-LDP tussles on fiscal policy have been
complicated by the DPJ,s new role as the largest party in
the Upper House and the influence that this accords them.
The DPJ can affect tax reform directly through submitting
their own tax bills in the Diet or failing to pass
government-submitted tax bills, and can influence the
disbursement of spending measures by blocking budget-related
bills in the Upper House. End Summary.

Where does Fukuda stand?


2. (C) Immediately following his selection as Prime
Minister, press reports speculated that Prime Minister Fukuda
would carry on the fiscal reconstruction policies of former
Prime Minister Abe. During the LDP presidential campaign,
Fukuda told the press that &since the budget is limited, we
must use our resourcefulness.8 Fukuda,s appointment of
several noted fiscal conservatives, namely Sadakazu Tanigaki
as the LDP,s Policy Affairs Research Council chairman and
Kaoru Yosano as the LDP Tax Commission subcommittee chair
confirmed this impression for many. However, these
appointments also fuelled discussions about whether the
Fukuda administration was abandoning the pro-growth rhetoric
of the Abe government, which aimed to expand the economic pie
through structural reform measures that would boost economic
growth and raise tax revenues organically, while continuing
to pursue expenditure cuts before tax increases.


3. (C) On October 17, the Council on Economic and Fiscal
Policy, chaired by the Prime Minister, discussed Cabinet
office projections, laying the groundwork for a consumption
tax hike by showing a number of scenarios with varying growth
and expenditure cut assumptions. Almost none of these,
however, could achieve the GOJ,s stated objective of
reaching a primary budget surplus by FY2011 without a
consumption tax hike. The low-growth projections led many
observers to conclude a consumption tax hike is an inevitable
policy choice. Some analysts further suggested the GOJ is
turning away from the pro-growth approach toward fiscal
policy based on higher taxes, and may indicate an abandonment
of further structural reform efforts.


4. (C) In practice, the pro-growth reforms outlined by the
Abe administration did not come to fruition for the most
part. The readmission to the party of the former LDP rebels
who had opposed postal privatization, as well as the
mishandling of the proposal to reorient the use of revenues
from gasoline-related taxes currently dedicated to road
construction and maintenance to the general fund, convinced
many that Abe was not serious about continuing the
Koizumi-era reforms.

But What about the Rest of the LDP?


4. (C) In contrast to the initial perceived stance of fiscal
conservatism evinced by the Fukuda government, there are
clearly voices within the LDP clamoring to increase spending
to shore up support in traditional LDP strongholds for the
next election. Indeed, Fukuda himself has sought to reassure
reform-weary constituencies and has talked about the need to
address regional and income disparities. How a balance will
be struck remains to be seen. In an initial indication
pointing to some increase in fiscal spending, the LDP and
Komeito agreed in early September and PM Fukuda confirmed at
the end of October that plans put into law in June 2006 to
increase health care payments by the elderly would be
postponed. Continuing to fund the same level of payments by
the GOJ will cost the taxpayers an additional 150 billion
yen in FY08.

Is the DPJ a Threat to the LDP,s Plans for Fiscal Policy?


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5. (C) As the largest party in the Upper House, the
Democratic Party of Japan (DPJ) aims to achieve political
gain by foiling the Liberal Democratic Party,s (LDP)
attempts at legislative policymaking. Regarding fiscal
policy, the DPJ is better placed to affect tax legislation,
which requires the concurrence of the Upper House, than
budget, which does not. Necessary implementing legislation
for the budget, however, will need to be agreed by the Upper
House or overridden by a two-thirds majority in the Lower
House. In seeking a deal on tax reforms and the budget
implementing legislation, the ruling LDP-Komeito coalition
may have to make concessions to the DPJ on the budget side as
well. Recent events, however, may weaken the opposition
party's ability to utilize any of these parliamentary
maneuvers


6. (C) During the Upper House election campaign, the DPJ
promised to boost public spending by 15 trillion to deal
with the disparities regarded as results of the LDP,s
Koizumi-era reforms, including measures to create a new child
allowance program, use all consumption tax revenues to
support the basic pension program, support small and medium
sized enterprises, eliminate highway tolls, provide income
support to farmers, and eliminate public high school tuition.
The DPJ has opposed raising the consumption tax and has
suggested somewhat unrealistic plans to raise revenues to
fund the additional proposed spending, such as realizing cost
savings from eliminating bid-rigging and amakudari,
abolishing special public corporations, reducing expenses for
central government employees and reducing central government
subsidies to local governments by adopting a lump sum
program. In addition, the DPJ has said it will carefully
examine the elimination of 43 temporary tax measures slated
to expire.


7. (C) The DPJ could submit its own tax reform bills to the
Diet. Such a move could lead to a conflict scenario where
the Upper House approves DPJ tax bills, while the Lower House
approves the tax bills submitted by the government. In that
case, the ruling coalition parties may need to overrule the
Upper House decision with a two-thirds vote. Action on tax
bills will need to be completed by end-March 2008 to provide
financing for the regular FY08 budget, and due to the expiry
of many temporary tax measures at that time. The strategy
would be the same that has been expected to handle the
restoration of Japan,s participation in Operation Enduring
Freedom in the Indian Ocean.

The Supplemental Budget is the Thing to Watch


8. (C) The result of the fiscal negotiations is not easy to
predict at this point, even more so because of the changing
dynamics in the DPJ resulting from Ozawa,s resignation, but
some likely aspects can be surmised from the process itself.
The parameters of the FY08 regular budget were set when the
Cabinet approved the budget guidelines in August. The MOF is
now negotiating with the various ministries to whittle back
the budget requests to within the Cabinet approved
guidelines, and while there is wiggle room on the allocations
of the spending within ministerial budget caps, there is no
process for amending the overall regular budget guidelines.


9. (C) The FY07 supplemental budget, however, is a different
story. Virtually every year, the GOJ compiles a
&housekeeping8 supplemental budget to fund all the items
that have cropped up since the previous regular budget.
Examples include reconstruction spending for natural
disasters, overseas commitments for aid or development
spending in response to unforeseen events, or necessary
adjustments to allow increases in mandatory spending items,
such as social security. During the post-bubble period,
supplemental budgets were frequently used to fund public
spending aimed at spurring economic growth. Whatever
pork-barrel spending the LDP decides to propose will end up
in the supplemental. The overall size of the FY07
supplemental will give a better indication of the Fukuda
government,s commitment to fiscal consolidation.

Whither the Consumption Tax


10. (C) Following his election, PM Fukuda reiterated his
predecessor,s plan for a discussion by the LDP of
comprehensive tax reform, including corporate, income,
consumption, and special tax measures. Sensitivities to
concerns about disparities seem to have pushed consideration
of changes to the corporate and income taxes from the agenda.
The hot topic for the fall tax debate is the consumption

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tax. The GOJ has committed to find a stable funding source
for the increase of the government contribution to the basic
pension scheme in FY09 from a third to a half, a funding
requirement of 2.5 trillion that is roughly equivalent to a
1 percent rise in the consumption tax. Prime Minister Fukuda
stated during his campaign to be LDP President he would
consider boosting the consumption tax. But there is a high
degree of skepticism as to whether LDP can make a concrete
recommendation this year to increase the consumption tax
given the possibility of national elections in spring 2008.
It usually takes three calendar years to implement a
consumption tax hike ) a formal decision is taken in the
year-end tax deliberations (December),the change needs to be
legislated in the following year,s budget Diet session
(spring of the following year),and implementation occurs at
the start of the next fiscal year. So a decision made in
this year,s tax discussions to hike the consumption tax rate
would be implemented just ahead of Lower House elections in
September 2009, assuming an early election is not called.


11. (C) Election timing notwithstanding, the Cabinet office
projections discussed at the CEFP on October 17 pointed to
the difficulty of meeting GOJ fiscal goals without a
consmption tax increase. Following that meeting PM Fukuda
stated, &If we delay even further, our options will become
even more limited. We need to quickly pursue discussions
about these issues in a way that is easy to understand from
the public,s perspective.8 As noted previously, the DPJ
has already stated its opposition to raising the consumption
tax.


12. (C) Besides a heated debate on the consumption tax,
there are 43 tax measures that will expire by the fiscal
yearend of March 2008 if no action is taken. In total, the
net effect of the expiration of all 43 measures would be a
loss of about 3 trillion in tax revenue, according to
calculations by Deutsche Securities. The end of the
temporary gasoline surcharge tax would have the largest
single effect and cost the GOJ 1.4 trillion in tax revenues
should it expire.


13. (C) LDP officials have indicated that they will recommend
renewing the gasoline surcharge tax, whose revenues are used
for road construction and maintenance. As noted above, Abe
had argued use of the gasoline surchage revenues should be
reoriented from road maintenance and construction to general
budget purposes. This proposal met with stiff resistance
last fall from LDP members with rural constituents, who
benefit disproportionately from road construction projects.
Given the current concerns about regional disparities and
lagging regional economies, a reorientation of the use of the
revenues appears to be off the table.


14. (C) Comment: Developments on these issues will unfold
over the next two months as the government compiles its
budget and tax bills, and will come to a head early in the
ordinary Diet session, which will begin in January 2008. The
disarray in the major opposition party only adds to the
confusion. At this point, the most likely outcomes are that
the FY08 regular budget will be relatively restrictive
following the budget guidelines approved by the Cabinet in
August, with the FY07 supplemental budget being the real
bellwether for the Fukuda Administration,s fiscal policy
direction. If there is pork-barrel spending to be had, here
is where it will show up. The most contentious tax area is
the consumption tax, which is likely to end up with an LDP
acknowledgement that a consumption tax hike will be needed
sometime in the future without specifying a concrete
recommendation for timing or amount, thus pushing that
decision into the future. End Comment.
SCHIEFFER