Oct. 26 (Bloomberg) -- The Japanese government is cutting spending and increasing taxes to deal with its long-term budget and debt woes.

It's far from certain it will work as Japan nurtures a fragile economic recovery and tries to end a stubborn decade-long bout of deflation.

The higher levies include a gradual rise of 5 percentage points in Social Security payroll taxes and the roll back of a personal income-tax cut enacted in 1999.

Contrast that with the actions of President George W. Bush, who has rejected higher taxes to close the long-term gap in Social Security finances. Meanwhile, the Bush administration is still concentrating on trying to extend a variety of temporary income tax cuts in the face of serious projected long-term fiscal imbalances.

Bush has proposed some spending cuts, though most have been rejected or ignored by Congress at the same time spending has soared for many domestic programs, the wars in Afghanistan and Iraq, and in response to the destruction caused by a series of hurricanes.

Japan's problems are as big or bigger than the U.S.'s. Its budget deficit is about twice as large relative to the size of its economy as that of the U.S. The country's debt is equal to about 160 percent of gross domestic product, or more than four times the level of the U.S.'s debt.

That daunting reality is partly mitigated by Japan's high personal savings rate, which allows its government debt to be financed domestically. Much of the U.S. debt is held by foreigners, including the central banks of Japan, China and other East Asian nations.

Dogged Deflation

The key problem is the deflation that has dogged the economy for much of the past decade.

It is not just that real economic growth has been stagnant or worse over the past 10 years. With prices falling, nominal GDP has also gone down, and with it, the incomes and spending on which taxes are based.

Paul Sheard, Lehman Brothers Holdings Inc.'s chief economist for Asia, noted in an interview that since the end of 1997, nominal GDP in Japan has declined 2.5 percent while real GDP has increased 7.3 percent.

Over the same period, nominal GDP rose 46 percent in the U.S. and real GDP climbed by more than a fourth.

``At the moment, Japan remains in a deflationary trap,'' Sheard said. ``It needs a real kick in the pants to get it out of deflation.'' Instead, the country ``is only edging slowly toward an exit.''

Devastated Budget

The deflation has had a devastating impact on the budget.

For instance, government tax receipts, which were running around 60 trillion yen ($522 billion) in the early 1990s, had fallen to just over 40 trillion yen by 2004 and are not expect to be much higher this year. With spending expected to exceed 80 trillion yen this year, the government will have to finance more than half its budget with borrowing.

The government's goal is to achieve a so-called primary balance in its budget seven or eight years from now. That is, to have tax receipts at least equal to spending on everything other than interest payments on its debt.

At that critical point, if the average interest rate paid on the outstanding government bonds is lower than the growth rate of nominal GDP, the debt-to-GDP ratio would begin to fall.

Big Assumption

The government assumes that deflation ends soon and that real growth will be strong enough that nominal GDP will be increasing at a 3.5 percent to 4 percent annual rate within a couple of years and continue at that pace indefinitely. Even if that assumption turns out to be correct --- and some analysts in Japan regard it as overly optimistic --- tax receipts might still be too low to achieve the target of a primary budget balance.

Mikihiro Matsuoka, a senior economist at Deutsche Securities, said in an interview that it would take a ``minimum of a 2 percentage point increase in the value added tax'' and more spending cuts, in addition to the other actions planned, to reach a primary budget balance on the government's timetable.

Kiichi Murashima, an economist at Nikko Citigroup Ltd. agreed with that assessment, and added that Prime Minister Junichiro Koizumi ``has promised not to increase the consumption tax.''

The issue of a VAT increase will have to be decided late next year, presumably by Koizumi's successor, if he steps down from his post next fall, as he has said he will, according to Murashima. Any increase would become effective in 2008, he said.

Uninterrupted Growth

This sort of timetable assumes that the economic expansion, which has run for several years, will continue without interruption. In particular, that the planed tax increases won't lead to cutbacks in consumer spending large enough to cause a recession.

Japanese economic growth also remains vulnerable, in Murashima's opinion, to an economic slump in the U.S.

``If U.S. growth slowed to 2.5 percent next year, Japanese growth would slow to 1 percent,'' he said. ``The yen likely would appreciate and exports would not grow strongly in that case.''

Matsuoka is more optimistic. He expects Japanese growth next year and the year after to be about 2.5 percent, only slightly less than the 2.7 percent increase last year. And that should be fast enough to lift prices, as measured by the GDP deflator, in 2007.

So even if all goes really well for Japan, it is going to be a long slog before the government begins to fill the huge hole in its budget and halt the rapid rise in its debt. If things take a notable turn for the worse, they might just explode.

To contact the writer of this column: John M. Berry in Washington at jberry5@bloomberg.net.

Last Updated: October 25, 2005 17:30 EDT