Chapter

12 Japan

Editor(s):
Teresa Ter-Minassian
Published Date:
September 1997
Share
  • ShareShare
Show Summary Details
Author(s)
Dubravko Mihaljek

After almost half a century of status quo, decentralization has become a major issue on Japan’s political and economic agenda in recent years. Soon after his inauguration in 1996, Prime Minister Ryutaro Hashimoto outlined four challenges that Japan must tackle: deregulation, administrative reform, devolution of authority, and relocating the capital city. These challenges are closely interrelated. The local public sector, which in 1995 accounted for about 16 percent of gross domestic product and employed over 3 million people, is one of the most regulated sectors in the Japanese economy. The central government exercises detailed and stringent controls over the revenues of local governments and a wide range of local expenditures. As a result, the degree of effective revenue and expenditure centralization in Japan is among the highest in industrial countries.

There seems to be broad agreement in both the government and the private sector that the rigid system of local public finance and intergovernmental relations needs to be reformed, but consensus on the direction of reforms has yet to emerge. Meanwhile, pressures for decentralization are on the rise, stemming from the need for fiscal consolidation and the process of deregulation and structural reform, as well as from the wave of decentralization efforts in other industrial countries. Fiscal decentralization is likely to improve welfare because central government control may interfere with the efficient supply of local public goods and services and not provide incentives for local governments to act responsibly. Local governments in Japan also show a high degree of “grant dependency,” which in the fiscal federalism literature has been associated with an inefficient size of the public sector and distortions in the allocation and financing of public goods. Empirical estimates of the relationship between historical changes in the degree of centralization and the size of Japan’s public sector presented in this chapter suggest that the tendency of general government to expand as a result of higher revenue and expenditure centralization is much stronger in Japan than in other industrial countries. These expansionary effects operate to an important degree through transfers to local governments.

This chapter analyzes the system of local public finance and intergovernmental relations in Japan, with a view to assessing the strengths and weaknesses of this system and identifying possible approaches to fiscal decentralization. Of special interest to the fiscal federalism literature are the unique features of Japan’s intergovernmental relations, such as the use of local borrowing as a tool of macrofiscal policy, the use of a local public finance program as a policy coordination tool, and the institutional representation of the interests of local governments in policy bargaining with other ministries, in particular the Ministry of Finance.

This chapter first provides a historical overview of the Japanese system of local government and describes the key constitutional, sociopolitical, and organizational aspects of the system that has emerged after World War II. Next, the basic structure of the present system of intergovernmental finances is analyzed, including the assignment of policy functions, expenditure responsibilities and revenue sources, and the grants system and local borrowing. The following section summarizes the views of Japanese policymakers and public finance experts on the problems of local public finances, reviews government reform initiatives, and elaborates on the need for fiscal decentralization on the basis of empirical evidence on the size and growth of the public sector in Japan. The chapter concludes with an outline of possible approaches to fiscal decentralization. An appendix summarizes the main statistical data on local public finance in Japan, compares them with the data on local expenditure and revenue in major industrial countries, and describes in more detail the local tax system and intergovernmental grants.

Intergovernmental Relations in Japan

Historical Background

Prior to World War II, local governments in Japan had little or no independence and were generally treated as administrative arms of the national government.1 There was no basic constitutional recognition of local autonomy, and the legal existence of local governments rested on a few basic statutes. Governors of prefectures were local agents of the national government, appointed by the Emperor and responsible to him. Local governments’ affairs were for the most part supervised by the Ministry of Interior and, where relevant, by other ministries (transport, education, agriculture, and so on).

Under a complex set of nationally established rules, local governments were responsible for sharing the costs of all national government programs, but had little or no say in the policies that defined them or even the manner of their implementation. Municipalities were fully subordinated to prefectural governors in all but the most minor local issues. The electoral base was very narrow, being primarily male land- or property owners.2 Political leadership tended to be an elite of minor nobility and landowners who viewed themselves not as public servants but as officials of the crown.

The process of urbanization fostered by the national government from the 1880s until World War II had an important impact on relations between the central and local governments. As millions of people left the countryside, the old-style concepts of paternalistic local government proved inadequate to meet the burgeoning demands for housing, sanitation, health care, transportation, electric power, and other elements of a modern infrastructure. Local authorities did not have the revenue resources to meet these growing needs, and they soon realized that they had to require the national government to pay for its own demands. At the same time, a broader base of educated people began to insist on a greater political voice in their own affairs, and were able to exert more direct influence on the political elite that ran the national government. These trends were interrupted by World War II, but they were a powerful influence toward democratization, which established a climate for the rethinking of Japanese government.

Constitutional Aspects

The new Constitution of 1947 emphasized the basic principle of democratic government and fundamental rights, drawing heavily from European and American traditions. It established for the first time the principle of a government of the people, in contrast to a government loyal to the Emperor. Japan committed itself to a structure that carried representative government down to the prefectural level and cities, towns, and villages. The Constitution itself gave a recognition to these bodies equal to that of the national government, and it further stipulated that: “Regulations concerning organization and operations of local public entities shall be fixed in accordance with the principle of local autonomy” (Article 92).

The Local Autonomy Law (1947) defined a two-tiered structure of local government consisting of prefectures and municipalities. While each level has equal status under the Constitution, national policies have continued to be paramount, and the national government retains a superior position: “Each local public body shall, in addition to its own community affairs, and the affairs required by national law or by cabinet order, perform other administrative affairs within its area insofar as such affairs are not reserved to the State” (that is, the national government) (Article 12).

Local authority in Japan is thus conveyed in a form directly opposite to the concept of residual states’ rights in federations—that is, specific authorities not given to the national government are reserved to the states. In contrast, the Local Autonomy Law makes specific designations of roles that the national government authorizes local governments to exercise.

In addition to its authorizing role, the Local Autonomy Law defines the authorities of local legislative bodies and local officials, establishes many uniform rules that must be obeyed, and final approvals that are retained by the national government.3 The Local Autonomy Law also cites some 550 other national laws that define an estimated 70-80 percent of all the activities of local governments.4 The system that emerged is very “public administration” oriented, in the sense that it contains many elements that also define how the administration or management of public functions is to be carried out (Bingman, 1989).

One of the more striking features of Japan’s system in this regard was the mandamus proceedings. Until 1991, when the Local Autonomy Law was revised, the relevant minister in the national government could directly order a prefectural governor—who is an elected official—to carry out certain actions, and if the governor did not obey such orders, he or she could be removed from office by the national minister, subject to certain legal appeals. 5

Sociopolitical Aspects

The defining characteristic of Japan’s system of intergovernmental relations is the strong collective preference for equal access to public goods. The Japanese people and government were willing to commit themselves after World War II to the evolution of autonomy for their newly defined structure of local government. However, they would not do so in a pattern that would reject their history and tradition of strong central government and allow for substantial regional differences to emerge. Equal access to public goods and fair sharing of the burden to finance these goods were viewed as essential for economic and social development. Hence, local governments were willing to sacrifice autonomy to maintain regional equity.

To implement these principles, local autonomy would have to function within a framework of uniform structure and ground rules defined by the central government. Interregional redistribution—the extent to which populations of different regions are supplied with the same level of public services and subjected to same burdens of taxation—is, therefore, the central issue for Japan’s system of intergovernmental fiscal relations. In this respect, Japan is similar to Germany, where the constitution guarantees “equality of living standards” to all Germans, and unlike the United States, where the federal government pursues a largely hands-off regional policy.

Organization

There are currently 47 prefectures and 3,281 municipalities in Japan. Forty-three prefectures and four equivalent bodies (Tokyo, Osaka, Kyoto, and Hokkaido) correspond to U.S. states, while three large cities have been given special authorities equivalent to prefectures. Municipalities include cities, “designated” cities (those with populations of 500,000 or more), towns, and villages. Currently there are 10 designated cities, 663 cities, 1,994 towns, and 577 villages. In addition, there are several thousand “special” local public entities, including the 23 wards of metropolitan Tokyo and over 7,000 functional associations of public bodies such as property wards and unions of local public enterprises.

The basic structure and authorities of local governments have not been defined by those governments themselves, but by a series of national laws that mandate essentially the same institutional setup at all three levels. Each prefecture has a bicameral legislative assembly, whose members are elected for four-year terms. In general, all activities of the prefecture are under the direct authority of the governor as chief executive. Governors submit a high proportion of new legislation each year (including the budget) and have veto powers on bills. Governors appoint and supervise all public employees, and organize and manage the departments of the government, including ownership and management of all public facilities. They may also let contracts or establish and supervise public enterprises to carry out the public’s business. The assembly may pass a resolution of nonconfidence by vote of two thirds of the membership. Governors, in turn, may dissolve the assembly.

Municipal assemblies have basically the same structure as prefectural assemblies, and mayors as chief executives have duties and powers similar to those of governors of prefectures.

Financial Relations Between the Central and Local Governments

Assignment of Policy Functions

In view of the unitary structure of government and a highly integrated national economy, stabilization policy in Japan is the sole responsibility of the central government. Redistribution policy in Japan is also centralized, given the high degree of homogeneity in preferences for core public services, the mix of taxes, and the degree of interpersonal and interregional redistribution that has evolved over time. However, even the allocation function in Japan remains highly centralized, although—as discussed below—there are strong efficiency arguments for a more decentralized provision of public goods and services.

Vertical Fiscal Imbalance

Like in other unitary states, financial relations between the central and local governments in Japan are marked by a substantial vertical fiscal imbalance—that is, revenues generally exceed expenditures at the central level and fall short at the local level. The central government receives tax revenue that typically exceeds by 15 percent the amount that it spends for its activities (Table 1). By contrast, the tax revenue of local governments amounts to less than 40 percent of the funds necessary to perform their functions.

Table 1.Japan: Ratio of Own Tax Revenue to Own Expenditure1(In percent)
19751985199019941975–94

Average
Central government119.3112.7134.7103.5115.6
Local governments32.141.943.342.439.1
Source: Ministry of Home Affairs (1994).

Own expenditure does not include transfers to local (central) governments. Own revenue includes all revenue collected by the central government (that is, before revenue sharing with local governments).

Source: Ministry of Home Affairs (1994).

Own expenditure does not include transfers to local (central) governments. Own revenue includes all revenue collected by the central government (that is, before revenue sharing with local governments).

To fill the financing gap at the local level, the central government transfers part of its “excess” tax revenue to local governments; these transfers amount to about 35 percent of local revenue (6½ percent of GDP). Prefectures and municipalities raise the remaining funds through nontax revenue and borrowing.

Division of Expenditure Responsibilities

The vertical fiscal imbalance results from the division of expenditure responsibilities and revenue-raising powers between the central and local governments. In Japan, the central government performs relatively few public functions directly. These include defense, national law and order, judiciary affairs, postal service, national hospitals and medical facilities, and institutions of higher education and research. Local governments are responsible for a major share of public spending, including that on education and culture, infrastructure, health and welfare, and public law and order. On average, central government expenditure accounts for about 10 percent of GDP, and local expenditure for about 18 percent of GDP (Table 2; see also Table 6 in the Appendix).

Table 2.Japan: Shares of Central and Local Expenditure1
19751985199019941975–94

Average
(In percent of total expenditure)
Central government32.438.437.641.237.2
Local governments67.661.662.458.862.8
(In percent of fiscal year GDP)
Central government8.010.710.811.410.5
Local governments16.717.217.916.317.6
Sources: Ministry of Home Affairs (1994); and national accounts.

Including expenditure financed by transfers from central or local governments.

Sources: Ministry of Home Affairs (1994); and national accounts.

Including expenditure financed by transfers from central or local governments.

Municipalities are responsible for slightly over half of total expenditure (Table 3). The share of municipal spending increased substantially between 1970 and 1980, but has remained stable at about 51 percent of local spending since.

Table 3.Japan: Shares of Prefectural and Municipal Expenditure1
1970198019851990Average2
(In percent of local expenditure)
Prefectures55.348.349.048.850.0
Municipalities44.751.751.051.250.0
(In percent of fiscal year GDP)
Prefectures7.28.69.08.58.6
Municipalities5.88.39.68.98.6
Sources: Jichi Sogo Center (1993); and national accounts.

Including expenditure financed by transfers from higher-level governments; expenditure by prefectures excludes transfers to municipalities.

For 1970, 1975, 1980, and 1985–90.

Sources: Jichi Sogo Center (1993); and national accounts.

Including expenditure financed by transfers from higher-level governments; expenditure by prefectures excludes transfers to municipalities.

For 1970, 1975, 1980, and 1985–90.

As regards the nature of local expenditure, about two-thirds is current spending and the rest is capital spending. The largest expenditures of local governments are on education and culture (26 percent of local spending), infrastructure (21 percent), health and welfare (17 percent), and law and order (9 percent).6

Although considerably more public spending takes place at the local level than at the central level, the central government remains heavily involved in almost every aspect of local public spending. Unlike in most unitary states and federations, the Local Autonomy Law does not clearly distinguish between the responsibilities of the central government and those of local governments. Rather, the law provides that prefectures perform those functions that “require uniformity in performance, cover a wide geographical area, are deemed too extensive for management by municipalities, or require efforts to coordinate two or more cities, towns, or villages.” Major programs (such as education, health, and infrastructure) are in practice formulated by national ministries and financed directly or indirectly by the central government. National ministries also retain numerous bureaucratic authorities with respect to local governments.7 Local governments in principle have large administrative responsibilities—over planning, construction and maintenance of facilities, regulation and zoning, management, inspection, and monitoring of compliance—but in practice national direction can be so detailed that it can severely constrain the authority of local officials and leave them with the job—but not the power—to satisfy public needs.

Revenue Assignment

As noted above, the main sources of local revenue are local taxes (on average, 37 percent of local revenue), transfers from the central government (35 percent), nontax revenue (20 percent), and bonds (9 percent). Excluding transfers, local governments’ own revenue accounts for about 42 percent of consolidated government revenue (11 percent of GDP) (Table 4).

Table 4.Japan: Shares of Central and Local Revenue1
1970198019851990Average2
(In percent of total revenue)
Central government58.061.459.357.158.6
Local governments42.038.640.742.941.9
(In percent of fiscal year GDP)
Central government11.217.916.716.616.0
Local governments8.111.311.512.411.3
Sources:Jichi Sogo Center (1993); and national accounts.

Includes tax revenue, nontax revenue, and borrowing; local revenue does not include transfers from the central government.

For 1970, 1975, 1980, and 1985–90.

Sources:Jichi Sogo Center (1993); and national accounts.

Includes tax revenue, nontax revenue, and borrowing; local revenue does not include transfers from the central government.

For 1970, 1975, 1980, and 1985–90.

At the local level, prefectures raise about 55 percent of revenue (9 1/2 percent of GDP) (Table 5). While the share of local taxes in revenues of prefectures and municipalities is about the same (35 percent of prefectural or municipal revenue), municipalities raise relatively more funds from nontax sources (20 percent of total revenue, compared with 15 percent for prefectures) and local bonds (10 percent, compared with 7 1/2 percent for prefectures). Prefectures receive more transfers from the central government (42 percent, compared with 36 percent for municipalities). Details of the assignment of major national and local taxes are provided in the Appendix.

Table 5.Japan: Shares of Prefectural and Municipal Revenue1
1970198019851990Average2
(In percent of local revenue)
Prefectures59.953.253.654.054.7
Municipalities40.146.846.446.045.3
(In percent of fiscal year GDP)
Prefectures8.010.19.510.09.6
Municipalities5.48.98.28.58.0
Sources: Jichi Sogo Center (1993); and national accounts.

Includes transfers from the central government. Municipal revenue does not include transfers from prefectures.

For 1970, 1975, 1980, and 1985–90.

Sources: Jichi Sogo Center (1993); and national accounts.

Includes transfers from the central government. Municipal revenue does not include transfers from prefectures.

For 1970, 1975, 1980, and 1985–90.

Although local taxes represent one of the most important revenue sources for local governments, the tax bases and tax rates cannot be determined by the independent initiative of local governments. The Local Tax Law—which was, significantly, enacted by the National Diet—prescribes in great detail the taxes that can be imposed by local government, defines the tax base in each case, and determines the tax rates. While local governments are given some flexibility with certain taxes, any discretion that local governments may have must be exercised with the approval or informal agreement of the central government.

Grants and Fiscal Equalization

To transfer its “excess” revenue to local governments, the central government uses revenue-sharing grants, referred to in Japan as the “local allocation tax,” and a large number of specific purpose grants, known as “central government disbursements.” The local allocation tax accounts for 50–60 percent of all transfers to local governments (15–20 percent of local revenue). Central government disbursements account for 45–60 percent of central government transfers (up to 15 percent of local revenue), while local transfer taxes account for 3–7 percent of all transfers (up to 2 percent of local revenue).8 Details of the grants system are described in the Appendix.

A major purpose of the local allocation tax is to equalize the fiscal capacity of local governments. The Japanese equalization model takes into account the inherent differences in both revenue-raising capacities and expenditure needs of local governments, an approach that is very similar to General Revenue Assistance in Australia. A prefecture or municipality that enjoys a high revenue-raising capacity and has a low cost of providing services is considered fiscally strong, and vice versa. The index of fiscal capacity and, hence, the amount of equalization payment depend on the ratio of “basic financial needs” over “basic financial revenue.” Where basic revenue exceeds basic financial needs (this is generally the case in large metropolitan areas), the local government receives no transfer but is entitled to retain its excess. By contrast, low-capacity governments (generally those situated in rural areas) receive large per capita equalization payments.

Basic financial need is not equivalent to the actual expenditure of a local government, but rather represents a standardized amount deemed necessary to provide public services at the level prescribed by the national government. The basic financial need for each public service is calculated according to the following formula:

Basic financial need = unit of measurement × unit cost × cost differential.

The total financial need of a local government is the sum of the basic financial needs for all expenditure items. The unit of measurement in the above formula is generally local population, or length and area of roads or other public facilities. Unit costs for public services are determined each year by the Local Finance Bureau of the Ministry of Home Affairs, taking into account price changes and changes in the demand for services. Finally, cost differentials depend on factors such as population density and growth, climate, area and geography, degree of urbanization, and industrial diversification.9 These factors reflect the differential costs of providing standard services that arise due to unavoidable circumstances in which local governments operate. The local allocation tax is on the whole administered in a fairly neutral manner, but inevitably there are occasional political pressures to include as many expenditures as possible in the unit of measurement when calculating standard fiscal needs.

Basic financial revenue is defined as general revenue that can be appropriated to meet the basic financial need. It is calculated as the sum of the local transfer tax and a prescribed percentage of the “standardized” local revenue—80 percent of such revenue for prefectures, and 75 percent for municipalities.10 Standardized revenue is the local tax revenue that can be obtained under the “standard” tax rate determined by the central government. If a local government levies taxes at lower rates and experiences a revenue shortfall, its basic financial revenue will not be considered inadequate (such a government may, therefore, receive no transfer). Conversely, if a local government levies taxes at higher-than-standard rates, it will not be penalized—the amount of transfer will be calculated as if the local government applied the standard rate.

The equalization impact of the local allocation tax is quite strong. For example, in FY 1992, per capita local tax revenue in Tokyo (the wealthiest prefecture) was ¥262,000, but only ¥61,000 in Okinawa, the poorest prefecture. After the transfer of the local allocation tax, however, per capita revenue in Okinawa rose to ¥217,000.

The main objective of specific purpose grants is to achieve uniformity in the provision of local public services. Unlike the local allocation tax, most of the national specific purpose grants are allocated among local governments at the discretion of the central government; there are only a few formula-based grants. Specific purpose grants are mainly designed as cost-sharing programs, that is, they subsidize a certain percentage of the standard cost prescribed by the national government. The rate of subsidy differs from program to program, depending on the financial burden of the program and the interest the central government has in the program. Almost 35 percent of the total amount of specific purpose grants are subsidies for public construction projects.

The system of specific purpose grants creates a close link between corresponding departments of national and local governments. For example, an officer in the public works department of a local government may come under the control of an officer of the Ministry of Construction, and that control may be more direct than that exerted by the head of the local government body itself. These links and the fact that similar subsidies are handled by different ministries often lead to administrative inefficiency. For example, a mayor of a small village may be forced to purchase two different makes of new buses simply because different ministries have different specifications for the use of buses.

Borrowing

Local borrowing accounts for about 9 percent of local revenue. The approach to local public finance in Japan has regarded borrowing as a source of funds to be resorted to only in case of special financial need (Yonehara, 1981; Ishihara, 1993). Because it gives rise to future financial claims against the local government, borrowing is generally limited to capital outlays. Local governments are prohibited from raising loans without the approval of the central government. The Local Loan Program, drawn up by the central government each year, lays down the rules governing approvals for local borrowing. This program is drawn up at the same time as the Local Public Finance Program, which determines local governments’ shares of the local allocation tax and specific purpose grants.

The main creditors of local governments are the central government, public enterprise loan funds, and the private sector. The central government funds, which provided finance for about 60 percent of local borrowing in the late 1980s, were provided through the Fiscal Investment and Loan Program (FILP), that is, indirectly from Post Office savings accounts, Post Office Life Insurance, and Annuity Systems (Ministry of Home Affairs, Local Autonomy College, 1995). The Japan Finance Corporation for Municipal Enterprises’ Fund (JFM) lends both short-term and long-term funds to local authorities that run public enterprises. It financed about 12 percent of local borrowing in the late 1980s, mainly by issuing its own bonds, which are held by either securities companies and other financial institutions, or organizations with special links to local governments (for example, the Local Government Employees Mutual Aid Corporation).

As for private funds, which financed about 28 percent of local borrowing in the late 1980s, a number of large local governments (including Tokyo Metropolis and Osaka Prefecture and City) sold their bonds in the open bond market, or floated loans in foreign countries. Most local authorities, however, borrowed long-term funds from commercial banks, insurance companies, and agricultural cooperatives (sometimes without issuing marketable bonds), as well as from the central government and the JFM. The FILP and the JFM usually lend to local governments at a lower rate and for a longer term than private financial institutions.11. Consequently, local governments generally see more advantage in borrowing from these sources. This is one of the reasons why an allocation of funds by the central government is necessary in connection with local loans (see below).

The use of local loans to assist in the implementation of fiscal policy has increased in recent years. Given the relative size of the local public sector, the central government must rely on local governments to implement its fiscal policy. It is impracticable to alter the local tax system or the local allocation tax to compensate for changes arising out of the business cycle. The local tax system and the proportion of national taxes allocated to local governments are fixed by statutes, which can be amended only by the Diet. The size of local borrowing, on the other hand, can be changed by executive action, and such changes are accompanied by an easing or tightening of fiscal policy. In view of this flexibility, the proportion of local loans in local revenue tends to increase in years when the national government adopts expansionary fiscal policy, and vice versa.

Local Public Finance Program

The involvement of the central government in the determination of local revenue and expenditure makes the budgets of the central and local governments in Japan much more closely linked than is the case in other unitary states. But the Local Public Finance Program links the central and local budgets even more closely together.

The Local Public Finance Program is assembled by the Ministry of Home Affairs, which bargains on behalf of local governments with the Ministry of Finance and the Cabinet. Each year, the central government makes an official estimate of the revenues and expenditures of local governments. On the revenue side, this estimate covers revenues from local taxes and nontax revenues, the local allocation tax, local transfer taxes, the national specific purpose grants, and local loans. On the expenditure side, the estimate covers wages and salaries, expenditure on goods and services, capital outlays, interest payments, and subsidies to public corporations. These estimates are then combined with an array of national policies and programs such as the FILP in order to produce, for each local expenditure program, an “acceptable” income-expenditure plan. The most important feature of this process is how revenues and expenditures are balanced through the local allocation tax and local borrowing. The Ministry of Home Affairs is responsible for ensuring that local governments have enough revenue to balance the program, and it bargains hard with the Ministry of Finance to secure the sources of revenue for local governments. The Local Public Finance Program is thus a unique mechanism for coordinating national and local fiscal policies.

From a public choice perspective, the Local Public Finance Program is subject to all the vagaries of the budget process. But when the program is approved by the Cabinet, it locks in local governments in terms of their own local taxes, their local loan programs, their employment and general administrative expenses, and most important, the levels of funding for almost all public programs.

Issues in Intergovernmental Finance

Views from Japan

Despite the slow progress toward fiscal decentralization, public debate in Japan on the reform of intergovernmental fiscal relations has been lively. In 1979, the Local Government System Research Council, an advisory organ of the Prime Minister’s Office, proposed decentralization for the first time in its 30-year history. The council noted that the Ministry of Home Affairs and the Ministry of Finance shared a common interest, although from different standpoints (Shindo, 1984). The Ministry of Home Affairs was keen on promoting decentralization in order to respond to the growing demands by the public for a more responsive and flexible local government that would be able to address such issues as urban congestion and environmental problems. At the same time, the Ministry of Finance, facing the urgent need to reduce the administrative expenses of national ministries, was searching for government organs and agencies to which national administrative affairs and projects could be transferred. In this context, the Ministry of Finance did not oppose decentralization initiatives.

Subsequently, the Ministry of Home Affairs has argued that the most significant theme for both central and local governments for the foreseeable future would be to obtain the cooperation and understanding of the general public for higher taxes (Ministry of Home Affairs, 1984). In the view of this ministry, the level of Japan’s public services compared favorably with that of other major countries; however, the average Japanese citizen’s tax burden was still one of the lowest among developed countries. The ministry therefore proposed measures to increase local tax revenue from existing taxes, reduce tax incentives for large corporations and capital income, and increase the reliance on user charges.

Opinions about fiscal decentralization have differed sharply at the local government level. Financially stronger governments have favored decentralization as a way of mobilizing larger resources for their growing expenditures. They have demanded greater flexibility to determine both revenues and expenditures, and have generally been in favor of greater freedom of initiative in policymaking. Financially weaker local governments have been concerned that any shift in the regime might decrease the local allocation tax to which they would be entitled in the future. Therefore, they were in favor of reforms that would result in either larger transfers from the central government or smaller expenditure responsibilities for local governments, noting that, for the public bodies lacking the ability to raise revenues, decentralization may mean the “freedom to go bankrupt.” Meanwhile, the central government, reflecting the resistance of the Japanese public to horizontal inequality, was concerned that fiscal decentralization might increase regional fiscal disparities, and eventually increase the need for resource transfers to local governments.

In contrast to the government, Japanese industry and financial institutions have generally associated decentralization with smaller, more efficient government, emphasizing the need to reduce the tax burden and improve public infrastructure. Opinions about fiscal decentralization among public finance experts have been sharply divided. While many have pointed to the need to restore local self-government as a means of enhancing government responsiveness to citizens’ needs and improving efficiency of resource allocation, others have questioned the emphasis on individual preferences and local accountability, given the widely shared ideas of fairness in Japan.12 Finally, the opposition parties recently raised the issue of decentralization in political debate, arguing that the clear division of responsibilities between different levels of government was essential for re reinvigorating the Japanese society and economy (Ozawa, 1996).

Government Reform Initiatives

Historically, government initiatives to reform intergovernmental finances have arisen largely as a result of macroeconomic pressures. Thus, in the mid-1950s, Japan’s local public finance system nearly collapsed under the burden of heavy borrowing to finance the rapidly rising local budget deficits, which prompted the central government to make a special temporary grant and create the system of fiscal equalization grants in 1954 (Mochida, 1997). Owing to buoyant economic growth and more stable revenues, the financial situation of local governments improved considerably between the mid-1950s and mid-1970s. Since then, however, both the central and local governments have been faced with declining revenue buoyancies and expanding expenditure requirements. Most recently, the recession of 1992–95 has led to a sharp slowdown in the growth of central and local revenues, while at the same time giving rise to the need for fiscal expenditures to stimulate the economy. As a temporary measure, the central government allowed local governments to issue far more bonds than in “ordinary” years, and encouraged them at the same time to increase their capital spending to offset weak private spending. To place the additional bonds, local governments had to tap private sector funds, hence raising their indebtedness. The reform of local public finances has thus become intertwined with and dependent upon the progress of overall fiscal consolidation.

Partly in response to the growing strains of local public finance, in 1993 the Diet passed a resolution calling for greater decentralization, and in 1995, the Murayama coalition government enacted the Decentralization Promotion Law, which obliged the government to draw up a five-year decentralization plan and set up a committee in the Prime Minister’s Office to advise on and monitor the decentralization process. While it represents an important step in political and administrative terms, the Decentralization Promotion Law remains vague on the overall objectives of decentralization and the methods for their implementation, Recent pronouncements by the government suggest that future reform initiatives are likely to focus on administrative reforms, in particular, further rationalization of expenditures.

Other recent reform initiatives include promotion of so-called hometown development projects (locally designed and implemented regional development projects); greater involvement of local governments in the design of social welfare programs that correspond to local needs and circumstances; and the debate on the relocation of the capital, which has highlighted the need to devolve authority to the local level and enhance the transparency, simplicity, and efficiency of government.13

Need for Reform

The need for fiscal decentralization arises not only from macroeconomic pressures but also from theoretical and empirical considerations of public sector efficiency. In particular, the decentralization hypothesis developed within the framework of public choice theory provides a strong efficiency rationale for fiscal decentralization. In addition, there is fairly strong empirical evidence on the tendency of the public sector in Japan to expand faster than in less centralized economies as a result of higher revenue and expenditure centralization.

One of the clearest statements of the decentralization hypothesis was provided by Brennan and Buchanan (1980): the greater the extent to which taxes and expenditures are decentralized, the smaller should be, ceteris paribus, the overall involvement of the government in the economy. One set of arguments in support of this hypothesis rests on the premise of greater political competition between various fiscal jurisdictions (Tiebout, 1956). Thus, in a centralized setting, the monopoly power to extract resources through tax legislation is less challenged than within a decentralized, multilayer government, where citizens’ access to comparative political “shopping” introduces a dimension of contestability on the political markets. This argument is believed to be particularly relevant at the local level (municipalities, counties) because of the influence of alternative tax-and-services packages on the locational choice of residents and businesses.

Another set of arguments focuses on the status of the budget constraint for different levels of government. In general, all levels of government are involved in allocation, but the opportunity for deficit spending through public borrowing and seigniorage creates a softer budget constraint for the central government than for lower levels of government. In a representative democracy, it is expected that the legislative representatives, after election, will articulate the fiscal preferences of their voters (including special interest groups) to safeguard their reelection. Under a soft budget constraint, the proportion of budgetary means available for discretionary use can generally be expected to be higher, and the political decision makers should, therefore, be able to give in more easily to the demands of interest groups and bureaucrats, as generally only a part of the tax bill has to be presented to voters or taxpayers. Therefore, one may expect that, other things being equal, the size of the public sector will be larger in a centralized setting.

The decentralization hypothesis has received fairly strong empirical support. In a recent study commissioned by the European Union, Moesen (1993) showed that an increase in the ratio of central government revenue to GNP by 1 percent raises the overall size of the public sector in industrial countries by 0.18 percent of GNP, while an increase in the ratio of central government expenditure to GNP of 1 percent raises the size of general government expenditure by 0.22 percent of GNP.14 As predicted by the decentralization hypothesis, the degree of centralization is also found to have a strong positive effect on expenditure for transfers and subsidies.

Estimates of the relationship between historical changes in the degree of centralization and the size of the public sector in Japan yielded the following equations:

where

  • TEG = total government expenditure (central plus local) in percent of GDP,
  • LDV = five-period moving average of the dependent variable, TEG,
  • CENR = a measure of revenue centralization, that is, total revenue of central government (before transfers to local governments) in percent of total revenue (central plus local), and
  • CENE = a measure of expenditure centralization, that is, total expenditure of central government (including transfers to local governments) in percent of total expenditure (central plus local).

Both equations were estimated by OLS on the FY 1970–93 (settlement) data;15 t-statistics are shown in parentheses.

The above regressions suggest that a 1 percent increase in the revenue centralization ratio increases the size of Japan’s public sector by 0.52 percent of GDP, while a 1 percent increase in the expenditure centralization ratio increases the size of the public sector by 0.72 percent of GDP. These results indicate that the tendency of general government to expand as a result of higher revenue and expenditure centralization is much stronger in Japan than in other industrial countries.

Subsidiary regressions, where the above explanatory variables are regressed on the transfers-to-GDP ratio, indicate that these expansionary effects operate to an important degree through transfers to local governments: a 1 percent increase in the revenue centralization ratio increases the size of transfers to local governments by 0.2 percent of GDP, while a 1 percent increase in the expenditure centralization ratio increases the size of these transfers by 0.36 percent of GDP. Again, these effects are considerably stronger than those obtained by Moesen (1993) and Moesen and Van Rompuy (1990) for industrial countries other than Japan.16

Options for Reform

The preceding sections identified several problems of local public finance in Japan: excessively tight expenditure controls, lack of freedom of local governments to determine local tax rates, and a relatively high dependence of local governments on grants and borrowing. This section outlines possible approaches to fiscal decentralization, taking into account the strengths of Japan’s system of intergovernmental fiscal relations, in particular, its effectiveness in horizontal fiscal equalization and implementation of macrofiscal policy.

Relaxing Expenditure Controls

It seems fair to say that the devolution of powers to local governments that occurred after World War II has been largely aimed at achieving the goals of the central government (that is, to improve national welfare as a whole). The alternative would, therefore, seem to be freeing local governments from central controls (that is, improving local welfare). As discussed above, economic analysis, as well as political theory, does provide a strong rationale for the establishment of local governments that are responsive to the wishes of their citizens, instead of being simply the agencies of the central government. So long as there are local variations in preferences and costs, there are clearly efficiency gains from carrying out public sector activities in as decentralized a fashion as possible. The only services that should be provided centrally are those for which there are no differences in demands in different localities, where there are substantial spillovers between jurisdictions that cannot be handled in some other way (for example, by negotiation or by grant design), or for which the additional costs of local administration are sufficiently higher to outweigh its advantages.

The assignment of expenditure responsibilities in Japan formally conforms, to a large extent, to these principles. Therefore, the issue is not so much to change the assignments themselves, as to redefine responsibilities for designing, implementing, and financing these assignments. One concern that is often expressed in this context is that local governments would allow the level and quality of public services to deteriorate below the standard considered desirable. This may be to a large extent a misplaced concern. If the service in question is of national importance (for example, health, education, or research) or one in which there is a strong national interest in maintaining standards (for example, poverty alleviation or some other distributional goal), such a service should remain nationally funded (at least in part) and its implementation monitored. If it is not a matter of national interest (for example, local roads or sewerage system), why should the national government be concerned? If the local electorate does not like what the local government does—or does not do—the government can be voted out of office at the next election. As is frequently emphasized in the public choice literature, the freedom to make mistakes and to bear the consequences of those mistakes is an important component of local autonomy (Bird, 1994).

A more effective devolution of spending responsibilities should be accompanied and supported by a strengthening of the capacities of the local authorities to manage expenditures. As in many countries, local government in Japan is generally considered to be less efficient than the central government. An important role in overcoming this efficiency gap could initially be played by local offices of the national administration, which in most cases possess the required skills and expertise—but not necessarily the sufficient workforce—to administer local spending programs effectively.

Managing Tax Diversity

As regards the local revenue system, prima facie there seems to be a strong case for allowing local governments more freedom in determining local taxes. In principle, local governments should not only have access to those revenue sources that they are best equipped to exploit—such as residential property taxes, income taxes, and user charges for local services—but they should also be both encouraged and permitted to exploit these sources without undue central supervision.

Local governments in Japan have relatively large receipts from what appear to be local taxes, but since they can neither set the tax rates nor determine the tax bases, it is difficult to see how they can be accountable to their constituents at the margin, as both efficiency and local autonomy require. As the economic role of local government is to provide to local residents those public services for which they are willing to pay, accountability is essentially the public sector equivalent of the “bottom line” in the private sector.

Large urban centers, which have a strong revenue base, usually also have much larger expenditure needs. Uniformity of the local tax code may thus prevent them from raising additional revenue that they need—and are able to raise. Although the central government allows local governments to vary the tax rate, the degree of flexibility is small: prefectures can raise the standard tax rate of the personal income tax up to 1.2 times the standard rate, and municipalities up to 1.5 times (up to 1.1 times and 1.2 times, respectively, in the case of the enterprise tax); but they cannot levy a tax rate lower than the standard rate (see the Appendix). Some flexibility in setting the consumption tax rate would also seem warranted. Such tax diversity takes account of different circumstances in which local governments operate, and different preferences over the mix of taxes and public goods.

It should be noted that most elements of the existing tax system—including the assignment of taxes, harmonized tax bases, and centralized collection and revenue sharing of certain taxes—can and should be preserved while allowing for the greater freedom of the local governments to determine the tax rates. In particular, the local allocation tax has proved quite effective as a tool of horizontal fiscal adjustment and should continue to be administered in as neutral a manner as possible. Finally, local governments should be encouraged to rely on user charges and fees for providing public services as much as possible.

A major concern that is expressed with respect to local tax diversity is that unharmonized tax structures can lead to distortions such as reduced tax neutrality, increased administrative and compliance costs, and tax exporting. However, recent empirical research has tended to reduce the validity of the case for tax centralization, partly because of a more favorable academic perception of the competitive process, and partly because more sophisticated empirical studies suggested that the quantitative importance of the potentially distorting effects from unharmonized tax structures was exaggerated in the traditional literature. In particular, the empirical work surveyed by Groenewegen (1988) indicates that differences in taxes were generally too small an element in business costs (or individuals’ locational decisions); that tax differentials reflecting differential quality and costs in local public services were not necessarily perceived as inefficient; and that subnational tax policymakers often had real fear of the potential effects of tax competition and, hence, were not keen on creating tax havens.

Reducing Dependency on Grants and Borrowing

Local governments raise about 50 percent of revenue from local taxes and nontax sources, while another 20 percent comes from the local allocation tax, a revenue-sharing grant that can be regarded as essentially local governments “own” revenue (albeit collected and distributed by the central government). Of the remainder, about 17 percent are specific purpose disbursements by the central government, designed to cover the costs of providing certain functions on behalf of the central government, and another 2 percent are earmarked revenue-sharing grants. Hence, if revenue-sharing grants are treated as local governments’ own revenue, the level of grant dependency is about 17 percent of local revenue, and the overall revenue deficiency, that is, the amount raised through local borrowing, amounts to about 10 percent of local revenue. These ratios are, indeed, high—about 2¼ percent and 1¼ percent of GDP, respectively.

It is largely a matter of structural fiscal reform how to reduce the dependency of local governments on grant money and borrowing. The fiscal federalism theory cannot offer much guidance on this issue, except noting that promoting local autonomy is likely to help reduce the inefficient size of the local public sector. It should be recognized, however, that the need for large local borrowing arises to a certain extent because of the way the central government conducts macrofiscal policy. Given the flexibility that such an arrangement allows the policymakers, it is not entirely clear that the revenue gap should be closed completely through, for example, larger permanent transfers from the central government. Another point to note is that local borrowing is used almost exclusively to finance capital projects. Hence, to the extent that these projects are cost-effective and raise the long-run productivity of social capital, they do not necessarily have to be financed by taxes on the current generation of taxpayers.

As for the design of specific purpose grants and the modalities of borrowing, a number of improvements could be achieved. The main problem with specific purpose grants, recognized for a long time by the Japanese experts (see, for example, Yonehara, 1981; and Jichi Sogo Center, 1993) is that, although (or perhaps because) they contain very detailed provisions, they do not sufficiently take into account local circumstances and needs.17 As noted earlier, the detailed nature of the these grants and their overall large volume can lead to inefficiency and frustration for both the central and local governments. The number of specific purpose grants should, therefore, be reduced to a few important expenditure areas. Other expenditures presently financed by specific purpose grants could be either devolved to local governments (and, hence, financed from their general revenue resources, including the local allocation tax) or, to the extent that they remain a central government responsibility, financed by grants-in-aid to local authorities, which would encourage local governments to take a more active role in implementing the activities deemed important by the national government.

From the perspective of the local authorities, the main issues concerning local borrowing are that procedures for loan applications are too complicated and time consuming, and that, in conducting counter-cyclical policy through variations in local borrowing, the central government does not take into account the burden of future interest payments by local governments. If local governments are to become more autonomous in their spending and taxation decisions, local borrowing should be facilitated through simplification of procedures for raising local loans. Given that financial markets in Japan are highly developed, there is no reason why the central government should be involved in almost every step of local loan raising.

The existence of ceilings on local borrowing has played an important role in maintaining the soundness of local government finances compared with the central government finances. However, such limits could be set more flexibly, for example, on the stock of debt at the local level rather than annual deficits, so as to allow local governments greater flexibility in responding to regional economic shocks. In this context, one should stress the need for transparent standing rules—linked, for example, to the projected ratio of debt service to revenue—for setting limits on the overall debt of local jurisdictions.

Given how tightly most aspects of local public finance in Japan are controlled, fiscal decentralization is not likely to produce exactly the pattern the central government—or local governments—would choose to implement if left to their own devices, except in the unlikely case that their goals precisely coincided. Conflicts between the central and local governments as to what should be decentralized are, therefore, inevitable. It should also be recognized that, in an economy as highly regulated as Japan’s, the overall public sector efficiency may not simply increase as a result of shifting the expenditure responsibilities to local governments. Fiscal decentralization therefore must be accompanied by overall deregulation of economic activity. But if accessibility, local responsibility, and the effectiveness of government are to be improved, it is of fundamental importance that governments that are responsible for expenditure decisions should be responsible for raising the revenue to fund them and should have control over—and responsibility for—revenue sources adequate to enable them to do so.

Appendix. Summary of Local Public Finance in Japan

Expenditures

Table 6 illustrates the scale of public expenditure and intergovernmental transfers effected by the central and local governments in FY 1992.

Table 6.Japan: Central and Local Government Expenditure, FY 1992
In Billions of YenIn Percent of TotalIn Percent of GDP
Gross expenditure167,700100.035.8
Central77,14146.016.5
Local89,56054.019.3
Transfers from
Central to local30,6226.6
Local to central1,2740.3
Net expenditure134,804100.028.9
Central46,51834.510.0
Local88,28565.518.9

On a net basis, the central government was responsible for about one-third of total expenditure (10 percent of GDP), and local governments for two-thirds (19 percent of GDP) in FY 1992. Transfers from the central to local governments consisted of the local allocation tax (52 percent), local transfer taxes (6 percent), and specific purpose grants (42 percent). Transfers from local governments to the central government were payments for certain public works carried out by the central government. Total transfers amounted to about 7 percent of GDP in FY 1992.

A standard classification of government expenditure by function in the IMF’s Government Finance statistics framework is not available for Japan’s local governments. Table 7 compiles such data on the basis of expenditure categories used in Japanese budgetary statistics. The entries for the central government are based on the initial budget for FY 1992; the entries for local governments are based on the settlement data. Both sets of data refer to gross expenditure (detailed breakdown on a net expenditure basis is not available). In view of these data limitations, the expenditure shares presented in Table 7 (as well as in Tables 9 and 10, which contain international comparisons of expenditure shares) should be regarded as illustrative only.

Table 7.Japan: Expenditure by Function and Level of Government, FY 1992
Central1Local2TotalCentralLocalTotal
(In billions of yen)(In percent)
General public services, public order, and safety34,57715,22819,80523.176.912.2
Defense4,5524,552100.02.8
Education5,68318,40624,08923.676.414.9
Health44,1045,6149,66442.257.86.0
Social security, welfare, and housing511,3519,93520,40853.346.713.2
Economic affairs69,01532,29441,30922.577.225.8
Debt service16,4477,11523,56269.830.214.6
Other716,12296817,09094.35.710.6
Total72,21889,560161,77844.655.4100.0
Sources: IMF staff estimates based on Ministry of Finance (1994); Ministry of Home Affairs, Local Autonomy College (1995); and Ministry of Home Affairs (1994).

Based on the initial budget for FY 1992; gross expenditure basis.

Based on settlement data for FY 1992; gross expenditure basis.

For central government, includes miscellaneous expenditure; for local governments, includes local assembly, general administration, fire protection, and police.

For central government, includes public health, government-managed health insurance, seamen’s insurance, and subsidies to National Health Insurance.

For central government, includes public assistance, social welfare, measures for the unemployed, employees’ pension insurance, national pension, “pensions and others,” children’s allowance, other social insurance, and housing expenditure from the public works budget.

For central government, includes public works (except housing), economic cooperation, and measures for small businesses, energy, and foodstuff control; for local governments, includes public works and measures for employment, agriculture, and trade and industry.

For central government, includes local allocation tax and contingency; for local governments, includes disaster relief and miscellaneous.

Sources: IMF staff estimates based on Ministry of Finance (1994); Ministry of Home Affairs, Local Autonomy College (1995); and Ministry of Home Affairs (1994).

Based on the initial budget for FY 1992; gross expenditure basis.

Based on settlement data for FY 1992; gross expenditure basis.

For central government, includes miscellaneous expenditure; for local governments, includes local assembly, general administration, fire protection, and police.

For central government, includes public health, government-managed health insurance, seamen’s insurance, and subsidies to National Health Insurance.

For central government, includes public assistance, social welfare, measures for the unemployed, employees’ pension insurance, national pension, “pensions and others,” children’s allowance, other social insurance, and housing expenditure from the public works budget.

For central government, includes public works (except housing), economic cooperation, and measures for small businesses, energy, and foodstuff control; for local governments, includes public works and measures for employment, agriculture, and trade and industry.

For central government, includes local allocation tax and contingency; for local governments, includes disaster relief and miscellaneous.

Table 8 presents a breakdown of expenditure by function at the level of prefectures and municipalities for FY 1990. The breakdown covers expenditure financed by central government transfers, as well as prefectural transfers to municipal governments.

Table 8.Japan: Local Expenditure by Function, FY 19901(In percent)
Composition by Level of Government
Share in Gross ExpenditureTotal local
PrefecturesMunicipalitiesgovernmentsPrefecturesMunicipalities
General public services, public order, and safety247.352.718.917.320.6
Social scurity and welfare29.071.010.66.015.5
Health33.566.55.73.77.8
Education64.235.820.125.014.8
Economic affairs354.945.134.036.231.7
Debt service46.753.38.07.28.8
Other486.413.62.84.70.8
Total51.648.4100.0100.0100.0
Source: Jichi Sogo Center (1993).

Based on settlement data for FY 1990; gross expenditure basis.

Includes local assembly, general administration, fire protection, and police.

Includes public works; employment and industrial relations; agriculture, forestry, and fisheries; and trade and industry.

Includes disaster relief and miscellaneous.

Source: Jichi Sogo Center (1993).

Based on settlement data for FY 1990; gross expenditure basis.

Includes local assembly, general administration, fire protection, and police.

Includes public works; employment and industrial relations; agriculture, forestry, and fisheries; and trade and industry.

Includes disaster relief and miscellaneous.

On the whole, prefectures had a slightly higher share in (gross) expenditure than municipalities in FY 1990 (52 percent, compared with 48 percent of total local expenditure). Prefectures carried out a higher proportion of expenditure on education and economic affairs than municipalities, while municipalities carried out a higher proportion of expenditure on social security, welfare, and health. Economic affairs were the main expenditure item for both prefectures and municipalities; education, general public services and public safety, and social security and welfare were the other major spending categories. Debt service accounted for a relatively high proportion of both prefectural and municipal spending.

To compare the composition of expenditure at the central and local levels of government in Japan with other countries, data from Table 7 were used along with the data from the IMF’ Government Finance Statistics Yearbook for two unitary states—France and the United Kingdom—and two federations—the United States and Germany. As the data for Japan were not compiled on the same basis, these comparisons only illustrate an approximate order of magnitude of central and local expenditure shares (Table 9).

Table 9.Japan: International Comparison of Expenditure Shares by Level of Government and Function1(In percent of expenditure on each function)
JapanFranceUnited KingdomUnited StatesGermany
CentralLocalCentralLocalCentralLocalCentralStateLocalCentralStateLocal
General public services, public order, and safety237774265446451837304723
Defense100100100100100
Education2476742615654257227523
Health4258982100503515731215
Social security, welfare, and housing534783177426751510721217
Economic affairs237771297426423622462726
Other831768141866249
Total445683187129591823612218
Sources: International Monetary Fund (1990); and IMF staff estimates based on Ministry of Finance (1994) and Ministry of Home Affairs, Local Autonomy College (1995)

Data for Japan are IMF staff estimates, based on Table 7. Data refer to the following years: FY 1992 for Japan, 1985 for France, 1988 for the United Kingdom and the United States, and 1987 for Germany.

Sources: International Monetary Fund (1990); and IMF staff estimates based on Ministry of Finance (1994) and Ministry of Home Affairs, Local Autonomy College (1995)

Data for Japan are IMF staff estimates, based on Table 7. Data refer to the following years: FY 1992 for Japan, 1985 for France, 1988 for the United Kingdom and the United States, and 1987 for Germany.

In interpreting the data in Table 9, it is important to note that, while the proportion of local government spending in Japan is relatively high for both total expenditure and individual spending categories (such as general administration and safety, education, health, and economic affairs), local governments have little effective control over the scope of spending that takes place at the local level. As discussed above, major programs (such as education, health, and public works) are in practice formulated by national ministries and financed directly or indirectly by the central government. Local governments in Japan execute these expenditure programs under detailed national direction, and, therefore, the degree of effective centralization of expenditure functions is higher than suggested by the above figures.

Table 10 compares the composition of expenditure at each level of government in Japan and four other industrial countries. As in Table 9, these comparisons are only an illustration of expenditure shares at each level of government, given that local government data for Japan are not available in the IMF’s Government Finance Statistics format.

Table 10.Japan: International Comparison of Expenditure Shares by Function and Level of Government1(In percent of central or local expenditure)
JapanFranceUnited KingdomUnited StatesGermany
CentralLocalCentralLocalCentralLocalCentralStateLocalCentralStateLocal
General public services, public order, and safety617813714791541811
Defense6712279
Education821914337119432710
Health66243141023819913
Social security, welfare, and housing161145423430301910512340
Economic affairs133661177617871113
Other245916221317121591213
Source: International Monetary Fund (1990); and IMF staff estimates based on Ministry of Finance (1994) and Ministry of Home Affairs, Local Autonomy College (1995).

Data for Japan are IMF staff estimates, based on Table 7. Data refer to the following years: FY 1992 for Japan, 1985 for France, 1988 for the United Kingdom and the United States, and 1987 for Germany.

For Japan, includes debt service, local allocation tax grants, and contingency.

Source: International Monetary Fund (1990); and IMF staff estimates based on Ministry of Finance (1994) and Ministry of Home Affairs, Local Autonomy College (1995).

Data for Japan are IMF staff estimates, based on Table 7. Data refer to the following years: FY 1992 for Japan, 1985 for France, 1988 for the United Kingdom and the United States, and 1987 for Germany.

For Japan, includes debt service, local allocation tax grants, and contingency.

Compared with other industrial countries, local governments in Japan spend a relatively higher proportion of their budgets on general public services, safety, and economic affairs and a relatively lower proportion on social security, welfare, and health. Also, spending on education as a proportion of local budgets is lower in Japan than in the United Kingdom, the United States, and Germany. At the central level, the government in Japan spends about the same proportion on administration, defense, and education as the central government in France. The share of health and social security spending in Japan’s central government budget is, however, lower than in the other industrial countries, while the share of expenditure on economic affairs (public infrastructure, agriculture, and energy) is higher.

Revenues

Total revenue of local governments consists of local taxes, central government transfers, nontax revenue, and local borrowing. The distribution of the main sources of revenue among prefectures and municipalities in FY 1990 is shown in Table 11.

Table 11.Japan: Local Government Revenue, FY 1990(In percent of total)
PrefecturesMunicipalitiesTotal
Local taxes39.938.741.6
Transfers from central government36.825.633.1
Local transfer tax1.82.12.1
Local allocation tax18.215.517.8
Specific purpose grants16.88.013.3
Charges and fees2.22.42.4
Other revenue113.725.515.1
Local bonds17.37.87.8
Total51.148.9100.0
Memorandum items:
Total revenue
In billions of yen143,45541,58280,410
In percent of GDP10.09.618.5
Source: Jichi Sogo Center (1993).

Transfers from prefectures to municipalities are netted out from the total.

Source: Jichi Sogo Center (1993).

Transfers from prefectures to municipalities are netted out from the total.

Prefectures and municipalities raised roughly the same proportion of their revenue from local taxes, charges and fees, and local bonds. Central government transfers represent a higher proportion of prefectural revenue because prefectures carry out more functions on behalf of the central government than municipalities. On the other hand, municipalities raise more revenue from nontax sources such as income from properties, shares, reimbursements, and contributions.

The major national and local taxes assigned to the three levels of government are shown in Table 12.

Table 12.Japan: Major Taxes
Local Taxes
National taxesPrefectural taxesMunicipal taxes
Income taxPrefectural inhabitants taxMunicipal inhabitants tax
Corporation taxEnterprise taxFixed assets tax
Inheritance taxReal property acquisition taxLight vehicle tax
Consumption tax1Prefectural tobacco taxMunicipal tobacco tax
Liquor taxGolf course usage tax
Tobacco taxSpecial local consumption tax
Gasoline taxAutomobile tax
Securities trade taxAutomobile acquisition tax
Stamp taxLight oil delivery tax

Twenty percent of the consumption tax is transferred directly to local governments.

Twenty percent of the consumption tax is transferred directly to local governments.

Local taxes are generally levied on an identical tax base as national taxes. Some representative tax rates follow.18

Prefectural Taxes

  • Prefectural inhabitants taxIf filing as an individual:
    • ¥700 a person (standard per capita tax)
    • For annual income of ¥7 million or less: 2 percent
    • For annual income over ¥7 million: 4 percent
    If filing as a corporation:
    • Standard per capita tax: ¥20,000–800,000 per corporation, depending on capital plus reserve funds
    • Standard tax rate: 5 percent of the national corporation tax
    • Maximum tax rate: 6 percent of the national corporation tax
  • Prefectural enterprise tax
For ordinary corporations:
Taxable incomeStandard tax rateMaximum tax rate
Less than ¥3.5 million6 percent6.6 percent
¥3.5–7.0 million9 percent9.9 percent
Over ¥7 million12 percent13.2 percent
For cooperative associations:
Taxable incomeStandard tax rateMaximum tax rate
Less than ¥3.5 million6 percent6.6 percent
Over ¥3.5 million8 percent3.2 percent
  • Real property acquisition taxStandard tax rate: 4 percent of the appraised value of land or house at the time of acquisition. Special deductions apply for certain residential properties.

Municipal Taxes

  • Municipal inhabitants taxIf filing as an individual:Per capita tax: ¥1,500-2,500 (maximum ¥2,000-3,200), depending on the size of municipality
Income taxStandard rateMaximum rate
For annual income up to ¥2 million3 percent4.5 percent
For annual income of ¥2–7 million8 percent12.0 percent
For annual income over ¥7 million11 percent16.5 percent
  • If filing as a corporation:
  • Lump sum tax: ¥50,000–3 million (maximum tax is 1.2 times the standard tax), depending on corporate capital plus reserve fund and the number of employees.
  • Standard tax rate: 12.3 percent of the national corporation tax
  • Maximum tax rate: 14.7 percent of the national corporation tax
  • Capital gains from the sale of property are taxed separately.
  • Municipal property tax: The standard tax rate is 1.4 percent (up to 2.1 percent maximum) of the cadastral value of land, houses, and depreciable assets. Special deductions and exemptions apply to certain residential properties.

Local governments are also assigned a large number of minor taxes, whose yield is small (0.1 percent of local tax revenue):

  • Minor prefectural taxes: Local entertainment tax, meals and hotel tax, mine lot tax, hunter’s registration tax, fixed assets tax, nonlegal ordinary tax, hunting tax, and water utilization and land benefit tax.
  • Minor municipal taxes: Electricity tax, gas tax, mineral product tax, timber delivery tax, special landholding tax, nonlegal ordinary tax, spa tax, business office tax, city planning tax, water utilization and land benefit tax, common facilities tax, land development tax, and national health insurance tax.

Table 13 describes the allocation of the tax revenue among the three levels of government in FY 1990.

Table 13.Japan: Central and Local Government Taxes, FY 1990
In Billions of YenIn Percent of TotalIn Percent of GDP
Total collections96,230100.022.2
Central62,78065.214.5
Local33,45034.87.7
Prefectural17,35318.04.0
Municipal16,09716.83.7
Transfers from
Central to local127,6006.4
Local to centra21,1320.3
Prefectural to municipal31,8680.4
Net allocation96,230100.022.2
Central36,31237.78.4
Local59,91862.313.8
Prefectural431,65732.97.3
Municipal528,43929.46.5
Sources: Ministry of Home Affairs, Local Autonomy College (1995); Jichi Sogo Center (1993); and IMF staff estimates.

Includes local allocation tax, local transfer tax, and specific purpose grants to local governments.

Contributions for central government projects.

Includes municipal taxes collected by prefectures.

Includes prefectural share of the local allocation tax, local transfer tax, and specific purpose grants.

Includes municipal share of the local allocation tax, local transfer tax, and specific purpose grants.

Sources: Ministry of Home Affairs, Local Autonomy College (1995); Jichi Sogo Center (1993); and IMF staff estimates.

Includes local allocation tax, local transfer tax, and specific purpose grants to local governments.

Contributions for central government projects.

Includes municipal taxes collected by prefectures.

Includes prefectural share of the local allocation tax, local transfer tax, and specific purpose grants.

Includes municipal share of the local allocation tax, local transfer tax, and specific purpose grants.

The breakdown of prefectural and municipal taxes in FY 1992 is illustrated in Table 14.

Table 14.Japan: Local Tax Collections by Source, FY 1992(in percent of total)
PrefecturalMunicipalTotal
Inhabitants tax33.051.643.6
Individuals19.837.730.0
Corporations5.513.910.3
Interest income7.73.3
Corpotation tax38.316.4
Property taxes14.637.223.2
Automobile taxes13.40.56.0
Other10.710.710.7
Total43.057.0100.0
Memorandum items:
Total taxes
In billions of yen14,88319,73534,618
In percent of GDP3.44.58.0
Source: Ministry of Home Affairs, Local Autonomy College (1995).

For prefectures, includes real property acquisition tax and prefectural fixed assets tax; for municipalities, includes municipal fixed assets tax and special landholding tax.

Source: Ministry of Home Affairs, Local Autonomy College (1995).

For prefectures, includes real property acquisition tax and prefectural fixed assets tax; for municipalities, includes municipal fixed assets tax and special landholding tax.

On the whole, the share of municipalities in local taxes was higher than that of prefectures in FY 1992 (57 percent compared with 43 percent). Municipalities raised a higher proportion of their tax revenue from personal income and property taxes, while prefectures raised more tax revenue from corporate income and automobile taxes. Taxes raised by local governments amounted to 8 percent of GDP in FY 1992. As discussed below, this represents a relatively high proportion of total revenue by international standards.

Unlike the expenditure data, the revenue data compiled in Japan are fully comparable internationally. Table 15 presents the shares of three main revenue sources—taxes, nontax revenue, and grants—at each level of government in Japan and five other industrial countries.

Table 15.Japan: International Comparison of Revenue Assignment by Level of Government1
Tax RevenueNontax RevenueGrantsTax RevenueNontax RevenueGrantsTax RevenueNontax RevenueGrants
(In percent, by source)(In percent, by level)(In percent of GDP)
Japan22.17.55.3
Central65.223.84.98810214.41.80.3
Prefectural18.030.849.24023374.02.32.6
Municipal16.745.445.93935263.73.42.4
France31.58.18.8
Central66.339.54.58513220.93.20.4
Local33.760.595.544213510.64.98.4
United Kingdom29.95.85.4
Central87.060.33.78812126.03.50.2
Local13.039.796.33420463.92.35.2
Italy24.62.217.1
Central97.240.94.7933323.90.90.8
Local2.859.195.347890.71.316.3
United States20.96.35.1
Central56.027.0871311.71.7
State26.841.339.25526205.62.62.0
Local17.231.760.84222363.62.03.1
Germany23.164.3
Central50.221.72.38910111.61.30.1
State35.525.041.97113168.21.51.8
Local14.353.355.83736273.33.22.4
Sources: Organization for Economic Cooperation and Development (1990); and Jichi Sogo Center (1993).

Data for Japan are for FY 1990, data for the United States are for 1987, and all other data are for 1988.

Sources: Organization for Economic Cooperation and Development (1990); and Jichi Sogo Center (1993).

Data for Japan are for FY 1990, data for the United States are for 1987, and all other data are for 1988.

The share of Japan’s local governments in total tax revenue is about one-third, the same as in France but significantly higher than in the United Kingdom and Italy. In terms of the share in total nontax revenue, Japanese local governments are comparable with states and local governments in the United States and Germany. Central governments in all industrial countries shown (except Italy) raise about 88 percent of their revenue from taxes. The share of grants in local revenue is roughly the same in Japan, France, and Italy. Finally, in terms of the GDP shares, local taxes in Japan amounted to about 7¾ percent of GDP in FY 1990, about one-third lower than in France (10½ percent of GDP in 1988), but higher than in the United Kingdom and Italy. The proportion of nontax revenue raised by local governments in Japan is highest among the countries shown (5¾ percent of GDP). Grants to subnational levels accounted for about 5 percent of GDP in all the countries shown except Italy.

Intergovernmental Transfers

Japan’s central government makes three basic types of grants to local governments;

(1) Unconditional, general purpose revenue-sharing grants, referred to in Japan as the local allocation tax. These grants are essentially mandatory transfers of revenue from a number of national taxes (in whole or in part) to local governments. Specifically, the local allocation tax consists of 32 percent of the yield of the income tax, the corporation tax, and the liquor tax; 24 percent of the yield of the consumption tax;19 and 25 percent of the yield of the tobacco tax.

The local allocation tax is divided into the ordinary allocation tax (94 percent of the total) and the special allocation tax (6 percent of the total), which is intended to compensate for shortfalls in the ordinary allocation tax. Local governments can spend the local allocation tax for any purpose, but the amounts transferred are designed so as equalize the fiscal capacity of local governments (see discussion below).

(2) Specific purpose grants, that is, transfers designed to finance (in whole or in part) the expenses related to specific local expenditure programs. The main objective of specific purpose grants is to achieve uniformity in the provision of local public services. Specific purpose grants are of two types: central government disbursements, which are further divided into: payments for “agency delegated tasks,” that is, for tasks that are essentially central government responsibility but their execution is entrusted to local governments (for example, administration of health insurance and the provision of national pensions); the central government’s obligatory share in certain local expenses (for example, salaries of public school teachers, contributions to construction work and disaster relief); and grants-in-aid to local authorities, that is, incentive subsidies used to encourage local governments to perform the activities deemed important by the national government.

(3) Local transfer taxes, which are essentially specific purpose, revenue-sharing grants, that is, taxes levied and collected by the national government on behalf of the prefectural and municipal governments (for example, vehicle tonnage and certain fuel taxes) and earmarked, for the most part, for specific purposes (such as local expenditure on roads).

Regression Variables and Data Sources

The variables used in the regressions reported in the section on Issues in Intergovernmental Finance were defined as follows:

  • TEG = the sum of: central government expenditure on general account (settled), minus expenditure on transfers (local allocation tax, local transfer taxes, and specific purpose grants), plus local government expenditure in local public finance program; divided by fiscal year GDP. This variable represents general government net expenditure.
  • CENR = central government revenue on general account (settled), divided by the sum of: central government revenue on general account (settled), minus transfers to local governments (local allocation tax, local transfer taxes, and specific purpose grants), plus local government revenue in local public finance program. This variable measures the revenue centralization ratio.
  • CENE = central government expenditure on general account (settled), divided by the sum of: central government expenditure on general account (settled), minus expenditure on transfers (local allocation tax, local transfer taxes, and specific purpose grants), plus local government expenditure in local public finance program. This variable measures the expenditure centralization ratio.

All variables were obtained from Nomura Research Institute’s 1994 database.

The following subsidiary regressions were also referred to in that section:

where the dependent variable, TRANS, is central government transfers to local governments (local allocation tax, local transfer taxes, and specific purpose grants) in percent of fiscal year GDP. Parameter estimates in the first equation are statistically significant at the 10 percent level (except the intercept); parameter estimates in the second equation are statistically significant at the 5 percent level.

The author is grateful to Teresa Ter-Minassian, Guy Meredith, Nobuki Mochida, Masatsugu Asakawa, and Kenji Okamura for helpful comments.
1This section draws on Bingman (1989). For a more detailed analysis, see Mochida (1985).
2Universal suffrage for men was achieved in 1927, and for women in 1947.
3For example, the law defines the powers and authorities of chief executives, including the number, name, and responsibilities of all major subdivisions of local governments.
4These laws are not just major statutes such as the City Planning Law or the Environmental Preservation Law, but also such acts as the Law for School Meals for Night Courses of Senior High Schools, or the Laundry Law, which sets forth detailed procedures for licensing, registration, and examination of laundries and their workers (Bingman, 1989, p. 52).
5National ministers are themselves elected officials: the Constitution requires that the prime minister and at least half of the cabinet come from either house of the Diet, In practice, almost all of them are Diet members, primarily from the house of representatives, whose 511 members are elected for four-year terms.
6For a breakdown of expenditure by function and level of government, see the Appendix.
7These authorities include the right to demand reports and evaluations of performance; the right to conduct investigations, inspections, and audits of local government activities; and the right to impose various corrective measures (Bingman, 1989).
8Local governments also make (small) payments for specific purposes to the central government, mainly toward improvements for public works carried out by the central government.
9For details, see Yonehara (1981 and 1993).
10The full amount of standardized revenue is not used in this formula in order to provide incentives to local governments to enlarge their tax bases, and also to take into account special local needs that require nonstandard amounts of revenue.
11In the past few years, the interest rate charged by private financial institutions has been lower than the FILP rate; however, the former is floating, while the latter is more or less fixed.
12For a review of the academic debate on decentralization, see Mochida (1995).
14The sample included five federations and ten European unitary countries during the 1980s. See also Saunders (1988) and Moesen and Van Rompuy (1990).
15For a detailed description of variables and sources of data, see the Appendix.
16Transfers include the local allocation tax, local transfer taxes, and specific-purpose grants to local governments. For details of these regressions, see the Appendix.
17In the case of construction works, for example, even the brands of construction materials and parts are sometimes specified by the central government.
19This percentage is applied to the central government’s share of the consumption tax (that is, to the 80 percent of the yield of the tax). Local governments get an additional 20 percent of the total yield of the consumption tax as a direct transfer; this portion, however, falls outside the scope of the local allocation tax.
References

    BingmanCharles F.1989Japanese Government Leadership and Management (New York: Macmillan).

    BirdRichard M1994“Threading the Fiscal Labyrinth: Some Issues in Fiscal Decentralization,”National Tax JournalVol. 46 (June) pp. 20727.

    • Search Google Scholar
    • Export Citation

    BrennanGeoffrey andJames M.Buchanan1980The Power to Tax: Analytic Foundations of a Fiscal Constitution (Cambridge, England: Cambridge University Press).

    • Search Google Scholar
    • Export Citation

    GroenewegenPeter1988“Taxation and Decentralization: A Reconsideration of the Costs and Benefits of a Decentralized Tax System,” in Taxation and Fiscal Federalism: Essays in Honour of Russell Matthewsed. by GeoffreyBrennanBhajan S.Grewal andPeterGroenewegen (Sydney: Australian National University).

    • Search Google Scholar
    • Export Citation

    HashiyamaReijiro1996“Whither the New Capital,”Look Japan (June) pp. 1415.

    International Monetary Fund1990Government Finance Statistics Yearbook 1990 (Washington: International Monetary Fund).

    IshiharaNobuo1993“The Local Public Finance System,” in Japan’s Public Sector: How the Government Is Financeded. by TokueShibata (Tokyo: University of Tokyo Press).

    • Search Google Scholar
    • Export Citation

    Jichi Sogo Center1989Statistical Abstract of Japanese Local Public Finance (Tokyo: Jichi Sogo Center).

    Jichi Sogo Center1993The Situation of Local Public Finance in Japan (Tokyo: Jichi Sogo Center).

    Ministry of Finance Budget Bureau1994The Japanese Budget in Brief (Tokyo: Ministry of Finance).

    Ministry of Finance Budget Bureau Tax Bureau1996An Outline of Japanese Taxes, 1995 (Tokyo: Ministry of Finance).

    Ministry of Home Affairs1984“Local Administration and Finance,” in Public Administration in Japaned. by KiyoakiTsuji (Tokyo: University of Tokyo Press).

    • Search Google Scholar
    • Export Citation

    Ministry of Home Affairs1994The Japanese Local Public Finance System (Tokyo: Ministry of Home Affairs).

    Ministry of Home Affairs General Affairs Office1995Source Material on the Bill on the Promotion of Regional Decentralization (in Japanese) (Tokyo: Ministry of Home Affairs).

    • Search Google Scholar
    • Export Citation

    Ministry of Home Affairs Local Autonomy College1995Local Public Finance in Japan (Tokyo: Ministry of Home Affairs).

    MochidaNobuki1985“The Role of Local Government Expenditures in Pre-War Japan,”Annals of the Institute of Social ScienceVol. 26March.

    • Search Google Scholar
    • Export Citation

    MochidaNobuki1995“Balancing Equity and Decentralization,”Social Science Japan (November) pp. 1011.

    MochidaNobuki1997“Revenue, Expenditure, and Intergovernmental Transfers in Japan,”paper presented at the World Bank/Economic Development Institute Workshop on Local Government and Economic Development in Japan, Kobe, Japan,January3–5.

    • Search Google Scholar
    • Export Citation

    MoesenWim A.1993“Community Public Finance in the Perspective of EMU: Assignment Rules, the Status of the Budget Constraint, and Young Fiscal Federalism in Belgium,”in Commission of the European Communities,The Economics of Community Public Finance European EconomyVol. 5.

    • Search Google Scholar
    • Export Citation

    MoesenWim A. andPaul VanRompuy1990“The Growth of Government Size and Fiscal Decentralization,” in Public Finance With Several Layers of Governmented. by RémyPrud’homme (Brussels: Foundation Journal of Public Finance).

    • Search Google Scholar
    • Export Citation

    Organization for Economic Cooperation and Development1990Revenue Statistics 1965–89 (Paris: Organization for Economic Cooperation and Development).

    • Search Google Scholar
    • Export Citation

    OzawaIchiro1996“Reforming Japan: The Third Opening,”The Economist (March 9) pp. 2123.

    SaundersPeter1988“Explaining International Differences in Public Expenditure: An Empirical Study,”Public FinanceVol. 43 pp. 27194.

    • Search Google Scholar
    • Export Citation

    ShindoMuneyuki1984“Relations Between National and Local Government,” in Public Administration in Japaned. by KiyoakiTsuji (Tokyo: University of Tokyo Press).

    • Search Google Scholar
    • Export Citation

    TieboutCharles1956“A Pure Theory of Local Expenditures,”Journal of Political EconomyVol. 64 (October) pp. 41624.

    YoneharaJunshichiro1981Local Public Finance in Japan (Canberra: Centre for Research on Federal Financial Relations, Australian National University).

    • Search Google Scholar
    • Export Citation

    YoneharaJunshichiro1993“Financial Relations Between the National and Local Governments,” in Japan’s Public Sector: How the Government Is Financeded. by TokueShibata (Tokyo: University of Tokyo Press).

    • Search Google Scholar
    • Export Citation

    Other Resources Citing This Publication