The easy part is done. The Bank of Japan is pumping money and officials have delivered a generous fiscal kick. Preliminary numbers suggest Japan was the fastest growing advanced economy over the first half of the year. The question now is whether Prime Minister Shinzo Abe can seal the deal by taking the third arrow out of his quiver and firing off structural reforms.
Among these, a pressing issue is sales taxes. Current law stipulates a doubling of the rate by 2015. But this could knock back growth as it has in the past. The temptation is thus to back off tax reform. That would be a mistake. It needs to be implemented as planned.
Consumption taxes are a thorny issue in Japan. The country boasts the lowest sales tax rate, or VAT, in the developed world at 5 per cent. After scrapping an early version and going for decades without one, the government reintroduced a sales tax at the height of the bubble in 1989, setting the rate at 3 per cent. Collapsing growth soon thereafter made officials nervous about tweaking it again. But by 1997, ballooning debt prompted Prime Minister Ryutaro Hashimoto to push the sales tax up to 5 per cent. The economy slid into a recession, pushing Japan deeper into deflation.
In truth, the reasons for the collapse after 1989 and the recession of 1997 do not lie with the hike in sales taxes. Huge domestic deleveraging pressures and the recessions first in the US and subsequently in emerging Asia were probably the real causes. Still, the impression sits deep. At the very least, the increase in consumption taxes prompted a sharp spike in household spending.
The first time around, spending roared by an annualised 12.6 per cent immediately before its implementation and contracted 7 per cent in the quarter thereafter. Similarly, in 1997, it jumped 8.8 per cent and then fell 13.2 per cent.
If anything, the issue of raising revenue is even more pressing today. Japan’s gross public debt is by far the highest among advanced economies, standing close to 240 per cent of GDP. Without a boost to revenues, that will only get worse amid a rapidly ageing population. Mindful of this, the previous government pushed through a law in June 2012 stipulating that the consumption tax will be hiked to 8 per cent in April 2014 and to 10 per cent in October 2015.
Strong, stimulus-fuelled growth over the first half of 2013 should make this easier to implement, one might think. Alas, risks have crept back in. The latest data point to a deceleration in growth: consumer spending unexpectedly contracted in June and business surveys reveal deteriorating sentiment. Investment spending by companies has also been lacklustre over the course of this recovery, despite the handsome profits delivered to Japan’s manufacturers by a tumbling yen.
It is no surprise, then, that doubters about the scheduled tax hikes have come out of hiding. Even within Mr Abe’s own government, calls erupted at least for a postponement after the self-imposed restraint in the run-up to the recent Upper House election. The prime minister has put off a final decision, indicating that he might make his final call as late as October.
A number of options are on the table. The obvious ones include indefinite postponement or full implementation. Next is the idea to raise the consumption tax rate by 1 percentage point per year over the next five years. This would presumably be less of a psychological blow to consumers than bigger, more immediate hikes, but it would also push out revenue gains further into the future. A complementary idea is to stick to the current schedule but add another fiscal stimulus – perhaps around Y4tn-Y5tn (roughly 1 per cent of GDP), about half the boost delivered in the January package – to cushion the blow.
Twist and turn the proposals as you wish, it comes down to two choices: start consolidating Japan’s huge fiscal imbalances as soon as possible or put off the pain and push up debt yet higher for years to come. The hike in sales taxes would only mark a first, tentative step on a long and arduous journey. The Cabinet Office itself projects that even with the scheduled changes Japan would still miss its target of achieving a balanced primary budget balance by 2020.
Markets have shown remarkable patience at official prevarication in recent weeks. That may not last. Cancelling, or even just delaying, the proposed rise in the sales tax would rattle bonds especially – and rightly so: Mr Abe would thereby reveal that he is no different than his many predecessors, wilting in front of the urgent task of pressing ahead with unpalatable reforms. The consequent damage to confidence and growth would then comfortably exceed any squeeze a tax hike would deliver. Time to load the bow.
Frederic Neumann is co-head of Asian economics research at HSBC