Many people likely believe that mild inflation is favorable for Japan’s fiscal management. It’s true that rising prices and wages lead to increased tax revenues. Furthermore, as GDP rises with inflation, the debt-to-GDP ratio tends to decline. Compared to the deflationary era—when reducing government debt was extremely difficult—keeping the debt-to-GDP ratio in check is far easier under mild inflation.
Against this backdrop, the government has in recent years taken an aggressive stance toward fiscal spending. Some use the term “inflation tax”—the idea that when prices rise, the real value of citizens’ currency erodes, effectively becoming government revenue. However, this argument has some questionable aspects.
It is true that if long-term interest rates (government bond yields) remain unchanged even as prices rise, inflation works in favor of fiscal management. In reality, however, as inflation progresses, long-term interest rates also rise, increasing the interest payments on government debt and placing a burden on fiscal operations.
The Ministry of Finance has published simulation results showing how much interest payments would increase as interest rates rise. According to these projections, the long-term interest rate is assumed to reach 3.0% in fiscal 2026, rising to 3.6% by fiscal 2029, and remaining at that level thereafter.
Under this scenario, interest payments would grow from ¥13 trillion ($89.7 billion) in FY2026 to ¥24.3 trillion ($167.6 billion) in FY2030, and further to ¥35.9 trillion ($247.6 billion) in FY2035—a 2.8-fold increase compared to FY2026. Such a surge in interest payments would leave little fiscal room for other expenditures.
A Ticking Debt Bomb
A key point in this simulation is that there is a time lag between inflation’s impact and its effect on government interest payments. Even if long-term interest rates rise, the interest payments on already-issued bonds do not increase immediately. However, as time passes and bonds are refinanced, the interest burden gradually grows.
For some time after inflation begins, this increase in interest burden does not occur. Japan is currently enjoying this temporary relief—the easing of fiscal burdens brought by inflation—and does not yet feel the fiscal strain of rising interest rates.
However, this temporary benefit cannot last forever. The continued rise in long-term interest rates, driven by expectations of sustained future inflation, foreshadows the difficult fiscal situation Japan will face five to ten years from now.
That said, for currency—on which no interest is paid—the benefit of the inflation tax remains. But its scale has limits. It is not enough to offset the rising interest costs on government bonds, which amount to around 200% of GDP.
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(Read the article in Japanese.)
Author: Motoshige Itoh, Professor Emeritus, University of Tokyo