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Japanese Economy Update

Consumption Tax Rate Hike : What Will It Bring To the Japanese Economy

Jun SAITO
  Senior Research Fellow

2014/04/02

As of April 1, the consumption tax rate has been raised from 5 to 8 percent. While there was a spending spree in anticipation of the tax rate hike in late March, the hike itself came into force without much confusion. At this conjuncture, this month’s column is going to examine what consumption tax rate hike will bring to the Japanese economy.

Implications on the budget and fiscal policy

Consumption tax rate hike is expected to raise extra revenue of 5.0 trillion yen for the Government. While it consists of revenue of both the central government (4.3 trillion yen) and the local government (0.7 trillion yen), extra revenue will all be spent for improving and maintaining the current social security system.

In order to further contribute to the sustainability of the social security system, additional burden is going to fall on the shoulders of the households. From April, premiums and over-the-counter payments for healthcare are going to increase for some categories and age-groups. Pension benefits are also going to be cut in order to make up for the over-payment during the deflationary period.

Undoubtedly, increase in consumption tax rate and other measures mentioned above mean a decline in disposable household income. Consumption tax rate hike will also bring a big drop in sales of goods that saw a big surge of sales just before the tax rate hike. As a result, private consumption is expected to fall after the consumption tax rate hike in April.

In order to offset the negative impact, Government has introduced a supplementary budget for FY2013, most of which is going to be spent in early 2014. The magnitude of the supplementary budget is 5.5 trillion yen, and includes such measures as lump-sum payments to low income earners as well as increase in expenditures for reconstruction of the areas affected by the Great East-Japan Earthquake.

On the tax side, taxes paid by households on house and car purchases are reduced from April for certain categories. Tax burden on companies is also reduced by an early abolishment of the special tax for the reconstruction of the areas affected by the Great East-Japan Earthquake.

Impact on the economy

While fiscal measures that have been employed to offset the negative impact of the consumption tax rate hike will show their effect, it will not be enough to offset all of the negative impact, especially the drop of sales caused by the forward shift of demand in anticipation of the tax rate hike.

There are, however, different views as to the severity of the negative impact. Among those that are relatively pessimistic are the taxi-drivers and shop-owners who respond to the Cabinet Office’s Economy Watchers Survey. According to the February Survey, the business outlook for the coming 2~3 months has deteriorated from 49 in January to 40 in February (as seen by the DI for Future Economic Conditions), particularly in the retail industry.

Firms themselves also seem to be pessimistic. According to the Bank of Japan’s Tankan for March, the large enterprises in the manufacturing sector expect the business condition to deteriorate from 17 in March to 8 in June (as seen by the Business Conditions DI). If smaller enterprises and enterprises in the non-manufacturing sector are included, it is expected to fall from 12 to 1 over the same period.

Economists also see a slowdown of the economy. According to the average rate for the ESP Forecaster as surveyed by the JCER, after achieving real growth of annualized 4.6 percent over the previous quarter in the 1st quarter of 2014, real growth rate is expected to fall in the 2nd quarter by 4.1 percent.

However, the same survey shows that economists expect the growth rate will recover to around positive 1.5-2.0 percent in the following quarters. While the real growth rate for the FY2014 as a whole is expected to be low as 0.72 percent, down from 2.25 percent in FY2013, majority of them do not see a recession coming. The probability of a recession coming in the following twelve months is, on average, 26.3 percent.

The recent outcome of the Spring Wage Round was positive in that the basic wage payments will be raised (“base-ups” achieved) for the first time in six years. However, if it remains in the large companies and do not spread to smaller companies, it will only help in preventing the average wage per worker from falling. It is still uncertain whether it has established a firm enough base for the economy to be able to resist the negative shock coming from the consumption tax rate hike.

On the other hand, it should also be noted that the situation is different from the last consumption tax rate hike in 1997. At that time, May 1997, only a month after the tax rate hike, turned out to be the peak of the expansionary phase. But it had much to do with the Asian Crisis that broke out in July, and the very fragile state of the banking sector which had massive non-performing loans in their portfolio. The recession in 1997 cannot be blamed solely on the tax-rate hike.

Implications for fiscal consolidation

The consumption tax rate hike was deemed necessary to sustain our social security system and to bring a halt to the deterioration of the fiscal situation. However, it is important to reconfirm, at this point, what consumption tax rate hike actually means for fiscal consolidation.

The current medium-term fiscal consolidation program of the Government consists of three targets; (a) halving the primary deficit (of the central and local governments combined) which existed in FY2010 by FY2015; (b) achieving primary surplus by 2020; and (c) bringing government debt to GDP ratio down after 2020. The consumption tax rate hike is part of the response to achieve this program.

The consumption tax rate hikes, even if we include the second hike to 10 percent which is yet to be confirmed, is only just enough to achieve the first target (a) under favorable circumstances. According to the Cabinet Office’s “Projections on Economic and Fiscal Situation in the Medium to Long Term” published this January, the primary deficit will be 3.2 percent of GDP at 2015 under Economic Revitalization Case (medium to long term average growth rate of 2 percent), against the target of 3.3 percent. If the growth rate is lower or the second hike postponed, even this first target will not be achieved.

It shows that the tax rate hike to 8 percent is only the first step towards fiscal consolidation. Even if we achieve the first target, the measures needed to achieve the second and the third targets are yet to be determined. The remaining primary deficit is still significant.

Economic environment for fiscal consolidation

The fiscal situation of Japan has been the worst in the developed economies. However, long-term interest rate has surprisingly remained low. The reason for this lies in the fact that Japan had a current account surplus. It enabled government bonds to be purchased by domestic investors, commercial banks in particular. Banks attracted much of household savings but found little opportunity but to invest in government bonds. Banks’ purchase, so far, have supported the price of the government bonds.

The situation was expected to remain as it is until around 2020 when many forecasted that the current account would turn into deficit. However, there is a sign that the situation may be changing much earlier than expected. The current account has turned into deficit last October and has remained so until January (the latest data available). During the period, foreign investors have become more influential as government bond holders. The share of foreign holders of short-term government bonds has risen to 31.2 percent by end-December 2013. While there could be a debate whether the trend of the current account has actually changed, the situation has undoubtedly become more unfavorable than in the past.

Weighing the risks

The next decision to make would be to whether the consumption tax rate should be raised to 10 percent in October next year.

The discussion above suggest that the economic growth is somewhat stronger than before though there is still a risk that household income is not that strong to support the sustained growth in private consumption. On the other hand, the environment has become worse so that there is more risk of the government bond market incorporating higher risk premium.

The decision as to whether to go for the hike to 10 percent has to be made by weighing these risks.