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Increasing Japan’s consumption tax: is this really the best time?

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In Brief

In the last week of December 2011, Prime Minister Yoshihiko Noda gathered together reluctant members of his Democratic Party of Japan (DPJ) to endorse a doubling of the country’s consumption tax.

Politically, the increase is enormously risky.


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The ink had barely dried on the accord — which will raise the tax from its current level of 5 per cent to 10 per cent by 2015 — before nine DPJ legislators defected from the party to forge a rival outfit partly based around opposition to the tax hike. Certainly, the promise of an increased consumption tax has been among Japan’s most enduring electoral curses, with a great many governments losing popular support because of this very issue. Yet the economic case for a tax increase counterbalances its political risks for three central reasons.

First, Japan’s medium-term fiscal horizon appears bleak by any reckoning. Unique among G7 countries, Japan runs a persistent primary budget deficit, and erasing this will take time. Recent Cabinet Office estimates reveal that the planned tax hike to 10 per cent will fail to generate a primary balance any time before 2020. By contrast, crisis-stricken Italy, a slow-growth G7 economy with a net government debt position comparable to Japan’s, ran an average annual primary surplus of 2.8 per cent of GDP from 1992 until 2007.

That Japan’s relatively strong net international asset position (56 per cent of GDP in 2010) will, in the meantime, inoculate its government bond market from financial turbulence, is not a given. Belgium, for example, is another politically challenged OECD country but one, like Japan, with persistent current account surpluses and a healthy net international investment position in excess of 50 per cent of GDP. But it still faced 10-year bond yields as high as 5.25 per cent in 2011. And although the extreme, risk-averse home bias in the asset portfolios of Japan’s household sector may still keep interest rates low and stable (averaging between 1–2 per cent over the past decade), this needs to be weighed against the reality that gross public debt will exceed household financial assets in under 10 years. Japan clearly needs to adjust its current trend line of receipts and outlays to protect its government bond market from the financial markets’ unpredictable tendencies. This cannot be accomplished without revenue-raising measures such as tax increases

Second, contrary to prevailing caricatures, pork-barrel spending is not the villain of Japan’s fiscal problems. Over the past decade, non-social security discretionary spending has been flat and capital spending in trend decline. In fact, this type of spending is among the lowest in the OECD if measured as a share of GDP — standing at 16 per cent. Rather, the increase in government expenditure since 1996 is overwhelmingly due to transfers to the elderly; spending on social security benefits has risen 60 per cent over the past 15 years. With this spending now cutting to the bone, efforts to raise revenue are essential.

Third, an increase in Japan’s consumption tax is perhaps the most efficient and inter-generationally equitable means of closing the country’s fiscal black hole. Its impact is less distortive than a tax on incomes because it is levied on a broader base (that is, final sales). It is also a more stable source of revenue, with private consumption generally growing faster than labour income by around 0.5 percentage points per year. Raising Japan’s consumption tax will equally allow for a more equitable and long-overdue distribution of the tax burden across generations; the elderly are often bigger consumers, as they are likely to have built up more assets. In the meantime, targeted direct transfers to the young and low-income households could partially remedy the tax’s regressive element. Yet the negative impact of a tax rise on an economy still mired in deflation should not be discounted — despite the fact that Japan has among the lowest consumption tax rates in Asia. The Japanese economy contracted by 2.8 per cent in 2011 alone (in nominal terms; 0.9 per cent on a real basis), and growth prospects hang in the balance.

This means the pace and scale of the tax increase need to eschew pre-ordained timelines. The current plan anticipates raising the tax rate to 8 per cent in April 2014 and to 10 per cent by 2015. The Noda government should replace this with a plan framing any tax hike within a broader growth and macroeconomic management strategy that links potential increases to two variables. First, progress toward an unequivocal end to deflation and second, a consolidation of growth during the current business cycle.

Meanwhile, the Noda government should avoid resorting to the extra-budgetary shenanigans it used to bridge various financing gaps in its 2012 draft fiscal budget. The government should instead make a concerted effort to promote a flexible implementation plan for the tax increase during Japan’s upcoming national elections. This would help convince a sceptical but amenable population of the tax’s necessity, and would also prove both economically prudent and politically wise.

Sourabh Gupta is Senior Research Associate at Samuels International Associates, Washington, DC. He is an EAF Distinguished Fellow for 2012.

2 responses to “Increasing Japan’s consumption tax: is this really the best time?”

  1. It would be good to know what statistics the author has used to conclude that contrary to prevailing caricatures, pork-barrel spending is not the villain of Japan’s fiscal problems. Over the past decade, non-social security discretionary spending has been flat and capital spending in trend decline.

    Relying on figures for Japan’s main budget (the General Account or GA budget) alone can be misleading because they do not provide the full picture of Japanese government spending. The Japanese national budget for any one year also includes supplementary budget(s), the Special Account (SA) budget and the budget for independent administrative corporations and public interest corporations. Looking at the 2011 Japanese budget, for example, in addition to a General Account budget of ¥92.4 trillion, there were four supplementary budgets (principally to deal with the after-effects of the earthquake and tsunami disaster). Just the first of these amounted to ¥11.6 trillion, almost 13per cent of the size of the GA budget. There was also an SA budget of ¥384.9 trillion in terms of total gross expenditure, which was more than four times the size of the GA budget; plus a relatively modest budget for government administrative agencies.

    It’s certainly true that public works spending in the GA budget may have been on a gradually declining trend since the Koizumi administration of the early-to-mid 2000s, but these other budgets have traditionally provided important additional sources of pork barrel (including public works) spending. Subsidies to the agricultural, forestry and fisheries industries, for instance, have figured heavily in Special Account budget expenditure.

    The point I’m trying to make is that pork barrel spending, including public works, still figures large in budget expenditure in Japan, and when drawing general conclusions about Japan’s fiscal problems, and which factors are responsible for them, it’s important to look at the whole government fiscal allocation system, not just a small segment of it.

    • Yes, these are General Account figures, which is the basis for calculating the revenue shortfall and consumption tax rise requirement.

      And yes, some spending is routed through the Special Accounts system. Though the sums in the revenue and expenditure columns of the Special Accounts is HUGE, how large (and wasteful) the surpluses are is a matter of conjecture. The DPJ’s Government Revitalization Unit has tried to “unbury” some of this wasteful “hidden treasure” for the past three years but has come up exceedingly short!

      Anyways, the Special Accounts are in a long overdue process of rationalization (by way of the special accounts law of the mid-2000s) … but time will tell that there is not as much waste (or budgetary windfall) to be had once the sunlight fully seeps through.

      Best, Sourabh

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