A Missing Link in Decentralization Reform in Japan:Trinity Reform Package

In June 2003, the Koizumi administration created the "Trinity Reform Package." In this context, "trinity" means the decentralization reform process that involves three factors: local tax, local allocation tax grant and national government disbursement. There is, however, a missing link in the reform. This is local bond, which is one of major revenue source for local governments. In particular, system of local bond has a very close relationship with local allocation tax system. Local allocation tax grant also covers debt service expenditure at the local level. Hence, the system itself undermines the sound issuance of local bonds. Moreover current local bond system does not result in awareness as debtors. In this paper, we build a simple theoretical model describing the Japanese local system, and propose a comprehensive decentralization reform including local bond. JEL Classifications: H71, H77, H63 * I thank participants of seminars held at Policy Research Institute, Ministry of Finance, the Japanese Government and Ministry of Finance, the Kingdom of Thailand, the international symposium on the Legislation of Fiscal Transfers, Dali, Yunnan, People's Republic of China, and the microeconomics workshop held at University of Tokyo for helpful comments. The remaining errors are my own. ** Associate Professor of Keio University and Special Researcher of Policy Research Institute, Ministry of Finance, the Japanese Government. e-mail: [email protected]. URL: http://www.econ.keio.ac.jp/staff/tdoi/. 1 1. Japan's local fiscal system and its current status In June 2003, the Council of Economic and Fiscal Policy (CEFP) created the "Trinity Reform Package," which is one of main reform schemes launched by the Koizumi Administration. In this context, "trinity" means the decentralization reform process that involves three factors: local tax, Local Allocation Tax grant and national government disbursement. This decentralization reform is necessary because Japan currently has an excessively "centralized" governance structure. For example, central government grants a significant amount of its fiscal funds to local governments and financially controls local government revenue. Revenue sources for Japan's local governments consist of local taxes, Local Allocation Tax grant, national government disbursement and local bonds, making up the most of their total revenue. Local taxes are the largest revenue source for local governments. In principle, local governments are not allowed to freely determine tax items or tax rates, since the Local Tax Law, a national law, sets specific tax items and tax rates. In addition, the law involves a penalty that limits local bond issuance for local governments that levy a lower tax rate than stipulated by the national law. As a result, most local governments levy local taxes in accordance with the Local Tax Law, rather than establishing their own tax items/rates. (Recently, some local governments have started levying their own particular taxes. See Section 2 for more information.) Local Allocation Tax grant is a public finance transfer scheme in which central government allocates a certain percentage of national tax revenue to local governments without specifying the purpose of expenditure. The Ministry of Public Management, Home Affairs, Posts and Telecommunications (MOHA, hereafter, formerly the Ministry of Home Affairs) unilaterally determines this quota for each local government. National government disbursement is a subsidy allocated by central government to local governments, determining expenditure purpose in terms of central-local government joint projects or other projects that central government deems desirable. Under this scheme, local governments have almost no discretion in deciding expenditure purposes. Local government bonds are local government borrowing for a specific expenditure purpose; however, local governments cannot freely issue bonds. When issuing bonds, they need permission from the prefectural governor or the Minister of Public Management, Home Affairs, Posts and Telecommunications. (This system is called the local bond issuance permission system). As a matter of practice, MOHA controls almost every local bond issuance. Central government is deeply involved in local government revenue sources. In addition, these