Has Abenomics, Japanese Prime Minister Shinzo Abe’s blend of audacious fiscal and monetary stimulus, already run its course? Japanese GDP grew just 2.6 percent in the second quarter, a full percentage point lower than the consensus forecast. It wasn’t all bad news. Consumer spending grew 3.1 percent during the quarter, while real exports increased 12.5 percent. Net exports, helped along by a weak yen, grew enough to contribute 0.7 percentage points to GDP growth.
There’s no question that Abenomics has provided a jolt to the Japanese economy. But there’s a spoiler lurking in the background: the plan to raise Japan’s consumption tax by five percentage points over the next two years, topping out at 10 percent in 2015. The first of two planned hikes, bringing the rate to 8 percent, is scheduled for next April, with the second increase to follow in 2015. The consumption levy, a type of value-added tax, imposes a fee on goods at every step along the supply chain, but to consumers who ultimately foot the bill, the fee is effectively a sales tax. In light of Japan’s disappointing growth figures, a debate has erupted over whether the tax increase could derail the government’s efforts to both boost economic growth and nudge inflation higher.
Those who support the tax hike say that it’s necessary to address another big problem: the country’s growing debt. This week, Japan’s public debt surpassed ¥1 quadrillion. (That’s 15 zeroes, in case you were wondering.) Although in dollar terms, that’s “only” about $10.3 trillion, it’s still more than twice the size of Japan’s economy. Japan’s rapidly aging population ensures that the country will soon be faced with a growing pension burden and fewer working-age people to pay income taxes. Policymakers argue that the time to start tackling the debt problem is now. At the very least, they add, the country needs to convince investors that Japan does intend to tackle it. Bank of Japan Governor Hirohiko Kuroda warned this week that if the debt keeps rising, it could unnerve investors in Japanese government bonds, pushing yields higher as a result. And an increase in debt servicing costs would deprive the government of funds now being used for stimulative effect via open-market asset purchases and other means. The International Monetary Fund has warned Japan that even though 90 percent of Japanese government bonds are owned domestically, the country’s ageing population will not be able or willing to invest in bonds the way they used to, reducing the country’s ability to issue new debt in the future. In other words, Japan needs to start deleveraging. That’s where the consumption tax comes in.
But even those who support the long-term rationale for the hike are beginning to worry about the timing. In a note last week entitled “How Will the Planned Consumption Tax Rate Hikes into FY 2015 Affect Key Variables?” Credit Suisse’s Japan Economics Research analysts predicted that increasing the consumption tax as planned will cause sharp declines in key economic indicators between fiscal 2013 (ending on March 31, 2014) and fiscal 2014. They estimate that GDP growth would fall from 2.9 percent to just 0.7 percent, household spending would slump from 2.3 percent to -0.4 percent, and the growth in investment in new residences would plummet from a strong 5.7 percent to -1.7 percent. “Household and corporate sentiment improved dramatically in late FY2012/early FY2013 as the yen weakened and stocks surged, but we see little prospect of ‘Abenomics’-driven optimism being sufficient to sustain demand growth [after fiscal tightening kicks in],” the analysts wrote in the Aug. 13 edition of Credit Suisse’s regular publication, “Japan Economic Advisor.”
Given its potential to set the economy back, there’s also the issue that the consumption tax will likely undercut other sources of tax. So the open question is whether raising the consumption tax will even do enough to help close Japan’s budget deficit and lighten its debt burden to make its contractionary effects worthwhile. Credit Suisse believes that the consumption tax hike would bring in new government revenues of ¥10.5 trillion, but the resulting economic moderation would reduce the tax take from all other sources by ¥1.9 trillion, for a net increase of just ¥8.6 trillion. That wouldn’t be enough to bring Japan’s budget deficit to its 2015 budget target of 3.3 percent. Instead, the consumption tax would merely reduce the deficit from an expected 6.2 percent of GDP in fiscal 2015 to 4.9 percent. Without the benefit of strong economic growth to strengthen the government’s balance sheet, policymakers would likely need to take additional measures to narrow the budget gap. “Assuming that there is little room to hike taxes on corporate and household income flows, an insistence on meeting fiscal reform targets may leave the government with no alternative but to increase the consumption tax rate even further, cut pension and medical insurance benefits and/or increase taxation of wealth,” the Credit Suisse analysts wrote.
What’s more, the tax won’t do a thing for Japan’s debt load, which Credit Suisse expects to reach 256 percent of GDP by the end of the 2016 fiscal year. “Debt will continue to accumulate even if the consumption tax rate is doubled as planned,” analysts wrote. “We must therefore conclude that the proposed consumption tax hike will do nothing to improve the Japanese government’s solvency.”
The tax could also bring about the very thing the government wants desperately to avoid – a lower inflation rate. That’s because what’s known as the output gap, or the difference between actual economic output and what output could be if the economy were going full steam, would likely shrink with a consumption tax in place. That difference between the economy’s actual performance and its potential is the key indicator of how much room there is for further growth, and a higher gap tends to signal higher inflation ahead. Credit Suisse forecasts that inflation would reach just 0.5 percent in 2016 with the tax, compared to 0.8 percent without it.
There’s also the issue that a consumption tax hike wouldn’t hit all Japanese citizens equally. Young people, an increasingly scarce demographic in fast-graying Japan, would naturally absorb the heaviest blow. That’s hardly a plus on the list of reasons to stay put in Japan.
The Japanese government is expected to decide in October whether or not to implement the first of the consumption tax hikes in April 2014, Credit Suisse noted. A decision to delay or scrap the tax increase could protect Japan’s economic health far more than the increase in revenues that would be gained from implementing it. It’s a tough call, but no one said running an economy was easy.