The right way to finance disaster recovery

In mid-October, as Japan was being battered by Typhoon Hagibis – the most powerful typhoon to hit the country in over six decades – it was also shaken by a magnitude 5.7 earthquake. As climate change progresses, Japan, like the rest of the world, will face increasingly frequent and severe natural disasters, necessitating costly recovery efforts. Tax hikes are not the way to pay for them.

Soon after the 2011 East Japan Great Earthquake and tsunami devastated much of Japan, two influential economists, Motoshige Ito and Takatoshi Ito, whom I highly respect otherwise, proposed in the Nikkei that, to avoid burdening future generations, the government should finance the recovery by raising taxes, rather than issuing debt. Hundreds of economists endorsed the proposal.

But the approach could not be more wrong. Indeed, it contradicts the theory of public finance, which states that the response to temporary shocks, such as natural disasters or wars, should be financed by temporary increases in the deficit.

Increasing government revenues enough to cover the additional expenditure without altering the fiscal balance would require major tax hikes. Beyond the direct cost to taxpayers, this would impose indirect costs on the economy by distorting the market mechanism, weakening incentives, and undermining efficiency at precisely the moment when the country can least afford it.

Raising taxes to finance disaster recovery is the equivalent of imposing fiscal austerity during a recession. As the experiences of Greece and others have starkly demonstrated, implementing deep spending cuts during a downturn depresses national income and undermines growth, thereby making it even more difficult for the government to repay its debts.

Just as you wouldn’t force an injured child to carry a heavy backpack, it is unwise to burden a battered economy with higher taxes. Because natural-disaster recovery, like a recession, does not last forever, a country is better off delaying fiscal consolidation until the economy is better able to weather it – that is, after a largely debt-financed recovery is complete.

When I made this argument in 2011, Japanese media were reluctant to publish it. They subscribed to the notion, pushed by Japan’s revenue-hungry finance ministry, that raising taxes will have the same effect, whether it happens now or in the future. This argument rests on the concept of Ricardian equivalence: a government cannot stimulate short-term consumer demand with debt-financed spending, because people assume that whatever is gained now will be offset by higher taxes in the future.

But even the concept’s author, David Ricardo, recognized that it is based on an idealized theoretical scenario, in which economic actors maintain the same objectives and awareness over a very long time horizon – longer than any human lifetime. Over a century later, Paul Samuelson showed that when individuals live for a finite period in a succession of overlapping generations – a far more realistic scenario – Ricardian equivalence does not hold, because at least some people know that current savings on taxes will not be matched by future payments. The burden will instead be borne by the next generation.

In the real world, tax cuts today have the intended wealth effects, boosting spending and growth. Samuelson also showed that, in countries with surplus savings, government borrowing improves national welfare.

Nor are sovereign default risks – the next concern that opponents of debt-financed recovery would probably raise – likely to be as severe as they seem. Modern Monetary Theory – which has lately been revived by US progressives such as Representative Alexandria Ocasio-Cortez, and economists like James K. Galbraith – argues that countries that issue their own currencies can never really run out of money, though they do face inflation risks. The fiscal theory of the price level supports a similar, though somewhat more cautious conclusion.

Mainstream economists now increasingly seem to be on board with deficit spending. For example, Olivier Blanchard, a former chief economist at the International Monetary Fund, has argued that “in countries where interest rates are extremely low and public debt is considered safe by investors … larger fiscal deficits may be needed to make up for the limitations of monetary policy.”

In Japan, raising taxes is all the more ill-advised today, because a 2% consumption tax hike went into effect this month. Japanese Prime Minister Shinzo Abe has emphasized the importance of the measure to boost social welfare programs, and half of the revenues will be earmarked for free preschool education – critical to feminizing the workforce and supporting human-capital development in a country whose population is aging rapidly.

Thus, Abe will not implement a further tax hike in the near term to fund natural-disaster recovery. He, unlike the finance ministry, understands that sometimes – particularly in the case of temporary shocks – governments simply need to spend.