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Japan Chair Platform: Japan to Raise Consumption Tax
For additional graphs please see the PDF of this essay here.
Prime Minister Shinzo Abe announced on October 1 that his government would go ahead with the planned consumption tax increase to 8 percent next April from the current 5 percent. A second increase to 10 percent is scheduled for October 2015. The two-stage tax hike became law in August last year under then–Prime Minister Yoshihiko Noda with the support of all the major political parties, but implementation was to be contingent on the state of the economy. The hike would raise approximately 7 trillion yen in new revenues, 1.5 percent of GDP. According to press reports, the prime minister had decided in September to go ahead with the increase, but concerns about the likely negative economic impact convinced him to develop a stimulus program that would counter the short-term downward effects of the higher tax rate.
Government debt motivates tax rise: Japan has the highest ratio of government debt to GDP among the advanced economies. Many academic papers have concluded that this debt trajectory is unsustainable. Credit ratings agencies have downgraded Japan’s public debt several times in recent years. However, bets that Japan will face a sovereign debt crisis have been wrong. Interest rates on Japanese government 10-year bonds, at 0.65 percent, are hovering just above their historic lows. Nevertheless, neither the academic research, nor the ratings agencies, nor those betting against Japanese debt are totally wrong.
Table 1 shows various ways of measuring the debt level. The figure usually cited includes the gross debt of both central and local government: 234 percent of GDP. This is indeed a scary amount, exceeding the debt of the most profligate southern European economies. Excluding local governments does not improve matters much, as the central government still owes twice the value of GDP. However, in addition to liabilities, the government’s balance sheet includes financial assets. Temporary cash shortages and surpluses arise on the government’s books due to differences between daily receipts and payments. To cover these gaps, the Finance Ministry issues short-term financing bills that generate liquid assets; these funds tend to balance short-term borrowing. Net debt, therefore, subtracts out these assets, leaving an amount approximated by the value of outstanding Japanese government bonds (JGBs). However, even after these various adjustments, the net central government borrowing is still a very scary 150 percent of GDP.
Table 1: Alternative Measures of Japanese Government Debt (% of GDP as of March 31, 2013)
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Source: Bank of Japan, Flow of Funds
It is the last line of the table that changes our appreciation of the debt problem. Government or quasi-government agencies own more than half of outstanding JGBs, showing up on their books as assets; a consolidated balance sheet would net these holdings. The bonds held by nongovernment actors are less than 70 percent of GDP. As recently as 2010, though, this amount was below 40 percent.
Table 2 suggests that one reason JGBs have defied gravity is that the amounts being sold did not strain private market demand because government buyers were purchasing these assets for their own purposes. However, as shown in figure 1, the rapid rise of bonds now having to be sold to private buyers could finally prove the investment managers correct.
Concerns over raising taxes: As worrying as the reality of rising deficits are to markets and policymakers, the possibility
that a consumption tax increase could send a fragile economy back into recession is even more frightening, especially to a prime minister who has assigned himself the job of ending Japan’s deflation.
Table 2: Holder of Japanese Government Bonds (% of outstanding JGBs as of March 31, 2013)
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Source: Bank of Japan, Flow of Funds
The main piece of evidence is what happened the last time the tax was raised, from 3 percent to 5 percent, in April 1997. By the end of that year, the economy was plunging downward. The problem of interpreting this event is that many other things were occurring at the same time, including a rise in the income tax, the addition of copayments to the national health insurance program, and tightening on the spending side; the consumption tax change represented only about one-third of the package. The combined hit from all the tax measures was an estimated 2 percent of GDP over two years. Not only did fiscal policy squeeze the economy, but also the Asian financial crisis began that summer and several major Japanese financial companies failed that November.
The main area affected by the consumption tax in 1997 was consumer durables, which first jumped almost 10 percent over the two quarters preceding the increase in a wave of anticipatory purchases and then proceeded to fall 22 percent over the next year as both the higher tax and weakening economy took their tolls. Total household consumption is almost 60 percent of GDP, but spending on durable goods is only 5 percent. Therefore, the effect on total output of a slowdown in durables is muted. I estimate that the effect of the 1997 consumption tax rise was somewhat less than 1 percent of GDP.
The current finance minister, Taro Aso, keenly recalled that earlier attempt to rein in the deficit in an appearance at CSIS (April 19, 2013), when he noted that not only did the economy fall into recession, but that consumption tax revenues actually fell. Mr. Abe has had to convince his finance minister that this time will be different.
Stimulus added to tax increase: Prime Minister Abe’s private economic advisers had recommended a slower trajectory of increases, 1 percent a year for the next five years, with the goal being the same final figure as the current law. However, the legislative challenges to such a course, plus the fact that the current plan had been supported by the major parties, derailed that suggestion. As an alternative, the cabinet agreed to compile a new economic stimulus package worth about 6 trillion yen to cushion the blow, the details to be worked out by December. The prime minister pushed for corporate tax reductions as a way to promote wage increases, although the economic reasoning behind this rationale is murky. Among the other pieces of the package: 1 trillion yen in tax breaks to encourage capital investment and wage increases, as well as terminating a year early a special corporate tax for rebuilding from the March 2011 disaster.
The government plans to halve the ratio to GDP of the primary balance deficit (which excludes debt-servicing costs) by 2015 from the level in 2010 and to run a primary surplus by 2020. If the economy continues its recent growth for another four years or so, this should be achievable because of the automatic revenue expansion and spending declines that growth produces. As shown in figure 2, the central government deficit disappeared during the bubble period in the late 1980s and then again during the six-year expansion ending in 2008. Fiscal policy was dormant in both periods, meaning that growth alone produced such wonders. The same forces generated a surplus in the U.S. budget in the late 1990s.
So far, Mr. Abe’s economic policies are bringing about the growth he seeks; if this lasts, his budgetary goals will become considerably easier. Stimulus details and his further efforts to open the economy will be closely watched.
Arthur Alexander is an adjunct professor with the Asian Studies Program at Georgetown University. He spent 10 years as president of the Japan Economic Institute in Washington, D.C.