An RIETI contribution organizes the mechanism by which inflation creates temporary fiscal headroom for the government and the risk that this will tilt toward fiscal dominance as a two-player game between the government and the Bank of Japan. It also discusses how the equilibrium changes under excessive debt.
As Japan’s economy transitions from deflation to inflation, tax revenues rise elastically with increases in nominal income, corporate profits and consumption. Meanwhile, expenditures such as pensions, medical care and public-sector salaries adjust more slowly because of institutional and budget-process lags, creating temporary fiscal headroom.
This fiscal headroom comes with a decline in real value and cannot become a permanent source of funding. It creates a conflict between redistribution, which directly appeals to voters, and fiscal consolidation viewed from a long-term perspective, with incentives in the political decision-making process colliding between the two. The article also points to the problem of time inconsistency, whereby desirable policies before the fact are unlikely to match the policies chosen afterward.
The government and the Bank of Japan have two strategic options. In normal times, the optimal combination is to use fiscal headroom for redistribution while pursuing monetary normalization. Under excessive debt, however, the Bank of Japan’s payoff structure changes, increasing the likelihood that the equilibrium will shift toward postponing redistribution and monetary normalization.
Treating the issue as an intertemporal (dynamic) game, the article suggests ways to avoid a situation in which market expectations shape policy responses as budget formulation and monetary-policy decisions are repeated, causing temporary fiscal headroom to be mistaken for a permanent source of funding.
The article also mentions its publication in the Nihon Keizai Shimbun’s “Keizai Kyoshitsu” on 11 September 2026 and the information that it was posted on 30 September 2026.