Shouldn’t We Raise the Consumption Tax Rate?

The time limit for deciding whether to raise the consumption tax rate in April 2014 to eight percent from the current rate of five percent is coming near. The tax-rate hike, which is scheduled to be followed by another hike to ten percent in October 2015, is laid down in the legislation which was an outcome of an agreement between the then-ruling party DPJ (Democratic Party of Japan) and the then-opposition parties LDP (Liberal Democratic Party) and the New Komeito. In addition to the tax raising schedule, however, it also included a provision requiring the government to check the economic situation beforehand in order to be sure that the tax-rate hikes are appropriate.

In order to fulfill the requirement, the Prime Minister Abe has asked academics, economists, business representatives, local government heads etc. to express their opinions which would be taken into account when he makes the final decision. Sixty people have expressed their views over a six-days meeting. It is expected that the Prime Minister would be making the final decision by early October.

This column will discuss some of the issues that are considered to be crucial in making the final decision.

What is the alternative to tax increase?

While there are a number of proposals that, while agreeing to raise the consumption tax rate, suggest different time profiles (e.g. one percent raise for five consecutive years), we will be comparing, in the following, the impacts of raising tax as scheduled or suspended altogether, considering the political difficulty of realizing a third option.

Even so, there is still a need to make clear what we mean by the case where tax-rate hike is suspended altogether. Will the expenditure be reduced at the same time so that the budget deficit is left unchanged? If so, it would have a negative multiplier effect which will be greater than the positive effect resulting from the suspension of tax increase (for a given amount of fiscal resources, government expenditure multipliers are always larger than tax-cut multipliers). Contrary to the common impression, the postponement of tax increase in this case will have a negative impact on the economy on a net basis.

Of course, the usual discussion takes place on an implicit assumption that expenditures are maintained so that that budget deficits widens. In this case, it may seem to involve no negative impact on the economy. However, it may have an important negative influence on the economy in the following sense.

First, it would add to the already high public debt that has been accumulated to reach 200 percent of GDP. If the consumption tax-rate hike is suspended, even the first target of the fiscal consolidation program that is in place, namely the halving of the primary deficit by FY2015 will become impossible (cf. the second is reaching primary surplus by FY2020). The fiscal consolidation program will have to be reestablished altogether.

Second, suspension of the tax-rate hike that was considered optimal at the time of the legislation, and which was committed by the government to achieve, is a typical example of the time inconsistency problem. The suspension of the tax increase would seriously harm the credibility of the government. It may be difficult for the Government to persuade the nation when it argues for a need of similar tax-rate hike in the future.

These considerations imply that the suspension of the tax increase would undermine the credibility of the government in consolidating the fiscal condition, and that there is a possibility that it may ignite downgrading of JGBs by the rating firms, which in turn would lead to a steep rise in the long-term interest rates.

What are the impacts on the economy?

Next issue that warrants discussion is the impact of the rise in consumption tax rate on the economy. There are clearly two distinct impacts.

First is the income effect of the fall in real disposable income which would lead to fall in private consumption. Since the tax increase is going to be a permanent one, the impact would be larger compared to a temporary one, and can lead to a relatively large drop in consumption level over the long-term. In addition, to the extent that the economic agents are forward-looking and rational, the negative impact of the tax increase should be witnessed well before the increase itself.

Second is the intertemporal substitution effect leading to a front-loading of demand in anticipation of the tax increase, and an offsetting fall thereafter. The large fluctuation of demand as such takes place since legislation needs to be enacted, deliberated, and approved by the Diet, with additional notification time, which leaves ample room for manipulation of purchasing decisions to minimize expenditure by the agents.

It can be argued that such fluctuation of demand would not necessarily imply fluctuation of the total output if firms try to smooth production and meet the fluctuation of demand by first running down inventories, and then rebuilt them thereafter. Such behavior may dampen the fluctuation of the GDP. Having said that, it can also be argued that the past experience shows that there have been large fluctuations before and after April 1989 (when consumption tax was introduced) and April 1997 (when the consumption tax rate was raised from three percent to five) which can be considered as a proof that such a behavior is not taken by the firms in general.

If there is going to be a large decline in private consumption, especially immediately after the tax increase, the important question is whether private consumption can endure such decline. If not, the tax increase implies that we may have to sacrifice the steady growth of private consumption and the success of the fight against deflation.

How strong is private consumption?

It is true that private consumption at the moment is showing steady increase. The quarterly GDP estimates show an increase in private consumption for three consecutive quarters. The problem, however, is that the increase is not necessarily supported by a solid growth in compensation of employees.

First, the increase in private consumption has been supported by consumption by the elderly whose main income is pensions, which are less vulnerable to economic fluctuations. With aging of the population in progress, this “silver” consumption has been a positive factor for consumption.

Second, the increase in private consumption has also been supported by wealth effect. The rise in share prices since late last year is considered to have stimulated consumption, especially in those households which have large financial assets.

Third, improvement in consumer confidence about the economic environment must have contributed in the increase in spending behavior of households. As can be seen in the consumer confidence survey, consumers are more optimistic about the economy, which should allow them to increase their spending.

However, there is a risk that these factors may not sustain. The consumption by the elderly may be discouraged by the cut in public pension that will take place this October, aiming to make a downward-adjustment of the level that has been maintained during the deflationary period despite the price-indexation clause. The wealth effect may be limited because of the increased volatility of share prices since this May, and because of the facts that shares (both direct holdings and indirect holdings through mutual funds) are only a small portion of the total financial assets of the households. Improvement in confidence could also be overturned by the lagging improvement in wages and employment. Increase in basic wages (those other than overtime pay and bonuses) is limited, and increase in employment can only be seen in non-regular workers.

Historically speaking, the recent Japanese expansionary phase has been very vulnerable to external shocks because of the fact that the improvement in the corporate sector failed to feed into the improvement in the household sector because of the absence of sustainable improvement in wages and employment. This situation has been described as “the failure to pass the baton,” by the analogy of relay races. In comparison, the current expansionary phase is unusual in the sense that household sector looks better together with the corporate sector. But if one looks into the factors that support the performance in the household sector, it is not necessarily sustainable as we have seen. By the same analogy of relay races, the current situation can be described as a situation where the households are “running without receiving the baton.”

The above consideration leads us to think that increase in private consumption may not be so solid as one may think. Therefore, there is a risk that households cannot endure the extra burden of a tax increase, and that private consumption may lose momentum as a result. If that actually tales place, sales of domestic business is going to decline and most probably affect private investment. Such a situation could also make the Japanese economy very vulnerable to external shocks.

How should the tough decision be made?

The above implies that the Government has to make a very tough decision. On one hand, to suspend raising consumption tax rate is to lose the Government’s credibility in trying to manage fiscal conditions, and could possibly invite upset in the financial market. The conclusion that leads from this consideration is to raise the consumption tax rate as scheduled. On the other hand, to raise the tax-rate is to take the risk of burdening the households so that private consumption would weaken. In this sense, tax increase should be avoided in order to keep the economy on the path to overcoming deflation.

In making the tough decision, I think is very important that we remind ourselves of the lesson that the Great East Japan Earthquake has taught us. It has taught us that, even if the possibility of the event taking place is very small, if it is going to incur huge cost once it does take place (“a tail risk”), we should not neglect it but to prepare for it. In that sense, avoiding sovereign debt crisis (and probably also an economic and financial crisis) taking place in Japan should be given a highest priority in making the decision. It means that we should follow what has been decided, and keep the track towards fiscal consolidation. The consumption tax rate should be raised as scheduled.

The difficulty I envisage is more serious that the difficulty some suggests. In many cases, those who argue for raising tax believes that economy is strong enough to endure the burden, while those who argue for the suspension of tax increase thinks that the economy is vulnerable. The difficulty I see is that we have to raise the tax rate even though private consumption is vulnerable.

Of course, even if we raise the tax rate, we still can give considerations to private consumption by improving the environment for household income to increase. However, the important thing is that it should not be made by increasing public expenditures for transfers and/or public works. It should be done by implementing growth strategy in an aggressive and effective way. It should be achieved by redesigning labor and financial systems so that incentives are provided to agent to contribute in raising potential growth rate (please see the Japanese Economy Update of June 2013, “Waiting Eagerly for the Growth Strategy,” for my view on the growth strategy). It is certainly vital for the sustained improvement of the business conditions in general, but it is also an urgent task if the consumption tax rate is to be raised as scheduled.