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Japan: Will Tokyo Stay Focused On Reform?

At some point, Japan will have to get serious about fiscal reform. Already, the government is looking at proposals for lifting taxes and cutting spending. But are the politicians and the economy up to it?

The Japanese government has dug itself into a deep hole. Its ratio of debt to gross domestic product is 1.45, the highest in the industrialized world, and the budget deficit is running at 7% of GDP, about twice that in the U.S. This is why Japan's sovereign debt rating is now the lowest in the industrialized world.

Economy Minister Heizo Takenaka is beginning to develop a reform agenda, starting with a proposal to repeal the broad 1999 tax cuts. A public opinion poll taken by Takenaka's commission on reform revealed that many Japanese favor reform, but the task is daunting.

Given the necessary adjustment, with one-fourth coming from tax hikes and three-fourths from cuts in spending -- similar to the proportions indicated in the opinion poll -- Morgan Stanley (MWD) analyst Robert Feldman estimates that the consumption tax would have to double, from 5% to 10%. On the spending side, he says that public works outlays would have to be cut by more than half, in addition to very large cuts in social spending.

But how much will Japan's powerful Liberal Democratic Party support the reform effort? With the 2005 budget process about to begin, the betting is that the LDP will look for compromise on the rollback of the 1999 tax breaks.

One reason: New figures on economic growth, based on new statistical methods, show much slower growth for the past year and a half, compared with earlier data. Japan has made scant progress in righting the long-term problems that have crippled its domestic economy. Now, a global slowdown, costlier oil, and a soaring yen are hitting exports, which grew last quarter at the slowest pace in more than a year. Based on soft October data and slippage in the December Tankan survey of business sentiment, the economy weakened further this quarter.

Even Takenaka recently said that reform needs to be "flexible" based on the economy's health. Meanwhile, the government's hole is getting deeper.

By James C. Cooper & Kathleen Madigan

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