Japan’s economic recovery might be put at risk by tax increases

Japan’s prime minister is popular, but he may have to trade in his popularity for an unpopular policy — and that policy might not be the right one anyway

By Hiroko Tabuchi  /  NY Times News Service, TOKYO

Thu, Sep 19, 2013 - Page 9

Japan is on a roll. Its economy is growing at a robust 3.8 percent, the stock market is up by 40 percent this year, and the country is on the cusp of overcoming 15 years of deflation. Adding to the positive trend, Tokyo just won its bid to host the 2020 Summer Olympics, raising hopes of an investment and construction boom.

What could possibly go wrong?

A plan to raise taxes at the worst conceivable moment, economists say.

“It’s nonsense. Japan is only midway to recovery and hasn’t fully escaped deflation,” said Goushi Kataoka, chief economist at Mitsubishi UFJ Research & Consulting, which is affiliated with Japan’s largest bank, Mitsubishi UFJ Financial Group.

“Just as we are beginning to see the light, we’re threatening to snuff it out,” Kataoka added. “We’re trying to roast the pig before it’s fat enough to eat.”

After weeks of debate, Japanese Prime Minister Shinzo Abe appears ready to go ahead with a plan to raise Japan’s national sales tax rate in April next year to 8 percent from 5 percent — part of his bid to rein in the country’s public debt, which has surged to more than twice the size of its economy.

However, opponents say raising taxes on spending is premature, especially because it could dampen consumer spending, considered the weakest link in Japan’s nascent recovery. If spending slumps, Japan could slide back into the deflationary morass that has dogged it for 15 years.

Such a misstep threatens to bring down the curtain prematurely on Japan’s economic revival this year, led by Abe’s bold set of monetary and economic policies, called “Abenomics,” which has brought about one of the most unexpected turnarounds in recent years. Japan is now one of the most promising engines of growth this year among the world’s developed economies.

Still, proponents of raising the tax are pushing for action now because they fear a return to the dysfunction that has marred Japanese politics for several years through a succession of prime ministers, said Noah Smith, an assistant professor of finance at Stony Brook University in New York.

Abe, with solid support, could be the last prime minister in a while to be able to push through unpopular changes, he said.

“The optimal policy is to wait to raise the consumption tax, maybe a year. But given Japan’s political dysfunction, many people are afraid that if you wait too long, that will never get done,” Smith said. “The idea is that if we see a chance to make unpopular structural reforms, we need to take it now, even though it’s not the optimal time.”

To soften the blow, the Japanese government is considering putting together a stimulus package of as much as ¥5 trillion (US$50 billion), a sum that would return the equivalent of 2 percentage points of the tax rate increase to consumers and companies, local news reports have said. Abe has said he will not a make an official decision until early next month. Japan’s business lobby has also called on the government to slash the country’s relatively high corporate tax rates to make up for an anticipated drop in consumption.

Speaking at a government panel on economic and fiscal policy on Friday last week, Abe suggested Japan’s recovery was robust and its economy was escaping deflation. He also said that government and private-sector spending before the 2020 Games would further bolster economic recovery.

The Games “will be a catalyst that will clear away 15 years of deflation and shrinking,” he said.

Supporters of a higher sales tax, including Japan’s powerful Finance Ministry, say the move is necessary to rein in public debt. By all measures it is gargantuan, in large part because of the costs of caring for Japan’s increasing elderly population. This year, national debt topped 1 quadrillion yen for the first time — more than twice the size of Japan’s economy, and larger than the economies of Germany, France and Britain combined.

The size of Japan’s debt worries many economists and investors, who say any loss of confidence by markets in Japan’s fiscal

sustainability — brought about, for example, by postponing plans to raise taxes — could cause interest rates to rise, which might cripple Japan’s ability to service its debt.

Even supporters of a tax increase, however, acknowledge that a 3 percent rise in the consumption tax will not go very far in addressing Japan’s debt. It is expected to generate about 8 trillion yen in additional tax revenue a year. However, it was still important to “at least give the appearance” that the country was doing something about its mounting obligations, said Hajime Takata, chief economist of Mizuho Research Institute, in a statement after he took part in the government’s forum this month.

“The reason why we don’t see bonds issued by a government more than ¥1 quadrillion in debt go into nosedive is because of an unspoken trust the Japanese people hold in Japanese bonds and its government,” he said.

That trust, Takata warned, could be broken if Japan reneged on plans to start putting its finances in order by taking the tough step of raising the consumption tax.

The tax — which would be levied equally on all goods and services — is considered easy to collect, causes less distortion to the overall economy and is a more stable source of revenue than an income tax even in aging Japan, because everyone must consume. And at 5 percent, Japan’s sales tax is among the lowest in the world.

A second stage, laid out by the previous government of Yoshihiko Noda, would raise the rate to 10 percent in October 2015.

Public opinion has been divided. A survey of 1,658 voters published by the Asahi newspaper last month showed 43 percent of respondents in favor of initially raising the sales tax to 8 percent as planned, and 49 percent opposed.

Koichi Hamada, professor emeritus of economics at Yale University and a confidant to Abe, has called for a more gradual tax increase that would raise the consumption tax rate by 1 percentage point a year to limit adverse effects on the bond market and economic growth.

Such economists are less concerned about any imminent risks posed by Japan’s fiscal woes to the bond market. For more than a decade, Japanese bond prices have withstood numerous downgrades by credit ratings agencies, as well as the debt crisis in Europe. In fact, global financial turmoil has tended to lower yields on Japanese government bonds, as Japan became a safe haven.

The bigger risk as these economists see it is a slowing economy that would hurt tax revenue, and in that way, imperil Japan’s finances. The naysayers have historical precedent to back up their fears.

The last time Japan raised its consumption tax, to 5 percent from 3 percent in April 1997, its economy soon plunged into recession. Retail sales rose significantly in the months before the tax increase, as consumers loaded their pantries and made big-ticket purchases, but plummeted in April and never quite recovered. Consumer prices, adjusted for the tax increase, plunged afterward and have hardly grown since.

Still, Japan has something now that it did not have then, said Nicholas Smith, a strategist at CLSA Asia-Pacific Markets: An aggressive central bank willing to do “whatever it takes” to prop up the economy should a higher sales tax start taking its toll. The aggressive action of Bank of Japan Governor Haruhiko Kuroda has helped the country’s current expansion.

A year ago, Smith wrote in a note published on Friday last week, he was concerned that a consumption tax increase would kill growth.

“Abenomics has changed that picture entirely,” he said.