Is it the right time to fire Shinzo Abe’s fourth arrow? There has been so much emphasis on arrows number one to three that many have forgotten about the fourth altogether. This entails doubling the consumption tax in two stages, starting in April next year, to 10 per cent. By some accounts, the fourth arrow, the opening shot in an effort to repair Japan’s finances after years of deficits, is the most important of all. Deciding when to fire it could be the trickiest decision the prime minister has had to make.
First, the story so far. Soon after he came to power in December, Mr Abe released arrow number one: a $110bn stimulus package, worth 2 per cent of gross domestic product, to upgrade roads and bridges. Arrow number two, shot with the most fanfare, was a pledge to escape years of deflation, backed up with the appointment of a central bank governor definitively committed to a 2 per cent inflation target. Arrow number three, which many consider the flimsiest, is a bevy of structural reforms aimed at lifting the long-term growth rate. Strictly speaking, the fourth arrow – doubling the consumption tax – is part of arrow number one. Mr Abe has promised not an expansionary fiscal policy but a “flexible” one. If he presses ahead now with legislation to raise consumption tax (initially to 8 per cent) from next April, we will know what “flexible” means: fiscal expansion followed by contraction. The question for Mr Abe is whether this is the right approach.
The consensus among those paying attention is that it most certainly is. More, they see it as Mr Abe’s test by fire. If “Abenomics” is to be taken seriously, they argue, the prime minister must not balk at this vital first step in repairing Japan’s crumbling finances.
There are several reasons to support this view. First, Japan’s gross debt is more than 240 per cent of GDP, even if net debt is a marginally less alarming 150 per cent. Since the early 1990s, Japan has been adding to its debt pile with primary deficits (before interest payments) running at about 4 per cent of GDP. In the years after the Lehman crunch, which hit Japan’s exports, and the 2011 tsunami, which hit just about everything, the deficit rocketed to almost 8 per cent. That situation has improved a bit, with the primary deficit expected to drop to 4.8 per cent this fiscal year. Still, sooner or later Japan will need to get its fiscal house in order. Raising more tax is bound to be part of that.
The second argument is that Mr Abe should make a start while his approval rating is at almost 70 per cent. If, as expected, he leads his party to a big victory in upper house elections next month, proponents of a tax rise say he should use his political capital to make an unpopular – but necessary – decision.
Third, bond markets are watching closely. If they sense a lack of resolve, they could become jittery. That could push interest rates up sharply, raising the cost of debt service, or provoke capital flight. Even consumers, some argue, might take heart from a consumption tax rise. An economic theory known as Ricardian equivalence hypothesises that people are more likely to save if they figure that public finances are unsustainable and that they will be called on to plug the gap later. Conversely, if they sense that finances are in decent shape, they may take out their wallets. These are all good arguments – with the probable exception of the last. To argue that people with less money in their pockets are likely to spend more requires too big a leap of faith. More likely, they will spend less.
For that reason, Mr Abe has reason to pause. If his priority is to reach his goal of 2 per cent inflation, there is a strong case for delaying the tax rise. Otherwise, Japan will be applying the monetary accelerator with one foot and stamping on the fiscal brake with the other. Paul Sheard, chief economist at Standard & Poor’s, thinks that would be a mistake. He and others recall the 1997 consumption tax rise that has been blamed – unfairly according to some – for plunging the economy into recession.
The argument is far from clear-cut. At root is a fundamental division. In one camp are those who see the monetary and fiscal arrows as basically superficial efforts to improve the economy. Far more important, they argue, are structural reforms aimed at improving productivity and repairing public finances. In the second camp are those who argue that achieving nominal growth – principally via inflation – is far from superficial. Japan’s debt looks huge because, thanks to deflation, nominal GDP has stalled at 1990 levels and tax revenue has shrunk. With inflation of 2 per cent and real growth of, say, 1-2 per cent, Japan would achieve nominal growth of 3-4 per cent. That would start to make the debt pile look more manageable. In other words, Japan might do better trying to inflate away its debts rather than cut or contract its way out of them.
At some stage, Japan will probably have to raise sales tax from its hardly onerous level of 5 per cent. Mr Abe should think long and hard, however, about whether that time is now.
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