Japan sales tax hike masks bigger problem of welfare spending

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Prime Minister Shinzo Abe is poised to raise Japan's sales tax, but this bruising political decision leaves unresolved the bigger and much more complicated task of curbing runaway social-welfare spending.

The tax hike, Japan's first serious move in nearly two decades to rein in the worst debt burden in the developed world, looks like the easy part.

Attention has focused on the sales tax increase - still not formally decided - which is hugely politically sensitive in Japan after the last rise, in 1997, was widely blamed for tipping the economy into recession.

(Read more: Doubts over plan to raise Japan sales tax linger)

But any improvement in government revenue from the tax increase will be dwarfed by expenditures, where a rapidly ageing society and generous public services are blowing an ever-bigger hole in the budget.

Santelli on Japanese debt and taxation

"There is no real progress on containing welfare spending, so even if you raise the sales tax, the country's finances won't improve," said Norio Miyagawa, senior economist at Mizuho Securities Research & Consulting.

"We know what needs to be done. But the government is pushing back important decisions."

With the most rapidly aging society in the world - a quarter of the population is already over 65 - welfare is the biggest and fastest-growing category of spending. The shrinking workforce is crimping payments into the welfare system while the boom in the number of retirees swells government payouts.

(Read more: CNBC's special report on aging in Asia)

The government has taken some steps, such as raising the retirement age - decided before Abe took office in December. But there is scant progress to show on such contentious issues as cutting benefits to the wealthy, adjusting pension payouts to prices or getting local governments to bear more of the burden.

Fiscal balancing act

Abe is attempting a tough fiscal balancing act, boosting the economy with massive spending and easy monetary policy while promising to balance the budget over the medium-term. Unless he can start to get spending under control, Japan's debt will continue to balloon, eventually threatening a crisis of confidence that could send interest rates soaring.

The prime minister, who returned to power for a rare second term promising to revive Japan with a radical economic policy that has been dubbed "Abenomics", is set to announce around Oct. 1 that he will raise the sales tax to 8 percent from 5 percent in April, people familiar with the process told Reuters this month.

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To offset much of the resulting drag on the economy, he ordered his government to craft a stimulus package that sources said was likely to amount to about 5 trillion yen ($50 billion).

The tax increase, meant to be the first of a two-step doubling of the levy, is part of a package agreed last year to begin righting the public finances of the world's third-biggest economy.

But the government has little to show on welfare reform. The cabinet last months approved the outlines of a bill, to be submitted to the next session of parliament, that is largely a list of promises to craft "necessary measures" over the next several years.

Abe's government aims to halve the annual budget deficit - excluding debt service and income from debt sales - by the fiscal year to March 2016 and balance it five years later.

That target, already considered unrealistic by many economists, will be derailed entirely if the government does not aggressively tackle spending such as pension payouts and nursing home costs.

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Quadrillion yen problem

Japan's public debt has just topped 1 quadrillion yen - 1,000 trillion yen, or about $10 trillion. At more than twice Japan's GDP, it is the heaviest debt burden among industrialized nations. Simply servicing the debt pile eats up nearly a quarter of the budget.

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For now, Japan's welfare program appears well within international norms. It amounted to 22.3 percent of GDP in 2010, versus 19.8 percent for the United States, 23.8 percent for Britain and 27.1 percent for Germany, according to the Organisation for Economic Cooperation and Development.

But welfare spending is exploding as the population ages. Moreover, the official figures may under-represent the problem, as Japanese companies, due to strict labor regulations, keep on their payrolls millions of employees whose skills are no longer of use.

It is difficult to measure the number of these "hidden unemployed", but a government scheme to support companies that have fallen on hard times subsidized salaries for 4.6 million people last fiscal year - just over 7 percent of the workforce.

Assuming Abe decides to raise the sales tax next year and then carries through with the second increase to 10 percent in 2015 - a big if - the levy will bring in 13.5 trillion yen a year, the Finance Ministry reckons.

Against that, the government is spending 29 trillion yen this fiscal year on welfare. That could balloon to almost 35 trillion yen in three years, according to the ministry.

Policymakers have taken some steps, but they appear at best only likely to slow the spending growth a bit.

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The government wants to use 10.8 trillion yen of the annual sales tax revenue to pay for welfare costs for the elderly and plug a shortfall in the pension system.

Seniors will see the out-of-pocket burden of their outpatient costs double to 20 percent in April, just as the unpopular tax hike hits. And the government is raising the retirement age in steps to 65 from 60, although the shift won't be complete until 2030.

While many analysts worry that the pace is too leisurely, there is no indication the government has the appetite to change things more quickly.

"The worry is that the government will lose its incentive to cut spending once it sees a pick-up in tax revenue," said Hiroshi Miyazaki, senior economist at Mitsubishi UFJ Morgan Stanley Securities.

"The government is focused more on higher economic growth and higher tax revenue. I don't expect reforms to focus on contributing greatly to fiscal discipline."

Indeed, the fiscal-reform plan allocates around 2.7 trillion yen in new tax revenue to improving daycare facilities and pensions for the poor, an attempt to soften public opposition to welfare cuts.

The government also wants to expand the pension system to cover more part-time workers, but there are not enough details about the plan to estimate how much this could offset the expected savings.

If Abe tries to have it both ways, he could hamper progress in reducing the pension burden, hamstringing his long-term budget goals.