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Japanese Economy Update

Time Inconsistent Fiscal Consolidation

Jun SAITO
  Senior Research Fellow

2016/06/07

Postponement of the second consumption tax rate hike

Prime Minster Abe announced that he will postpone, for the second time, the consumption tax rate hike to 10 percent that was planned to take place in April 2017: Now it is expected to take place in October 2019, just before the Tokyo Olympic and Paralympic Game in 2020. When he postponed the consumption tax rate hike for the firsts time in November 2014, he declared that the consumption tax rate hike will now take place in April 2017, no matter what unless some unexpected disastrous events like the Lehman Shock and the Great East-Japan Earthquake take place. Therefore, it was a surprise that the consumption tax rate hike was postponed this time in an environment where, even though it is not so favorable by any means, there is no evident crisis breaking out.

Time inconsistent policy commitment

The postponement of the consumption tax rate hike is a typical outcome of a policy commitment that is time inconsistent.

Discretionary policies that determines policy by maximizing the social welfare at each point of time is “time consistent” in a sense that the government faces no contradiction over time. While it may seem reasonable, the outcome may be inefficient: There may be a better outcome if the government commits itself to a rule that determines the path of the policies in the coming future. That is because the households and the firms would expect the impacts of the policies and take them into account when deciding their actions, that is, if the government’s commitment is considered credible. For example, the fiscal consolidation plans that has been announced in the crisis affected Euro-zone countries is designed to persuade the market that the default risk is under control.

However, Government’s engagement to prior commitments has a problem: it is “time inconsistent:” There is always a temptation for the government to depart from the commitment. That is because, once the private sector has made decisions on the assumption that the government would carry through its commitment, a new option emerges for the government at a later time that would maximize the social welfare at that point of time.

While it may seem a sensible thing to do for the government, it would undoubtedly harm the credibility of the government. The government would no longer be able to enjoy the positive reactions by the private sector when the government makes another commitment in the future. If the government is to have a long time horizon, it is not appropriate for the government to depart from the commitment.

In order to make the commitment binding, so that the commitment would be credible, arrangements that make it difficult for the government to depart have been introduced: In some cases, the commitments are made into legislation, and in other cases, it is designed so that departures face punishment. An example of the latter in the case of crisis affected Euro-zone countries is the arrangement by the Troika (ECB, EU, and IMF) that would suspend further financial assistance if the program country is judged to have departed from prior commitments.

Little negative reaction in the financial market

So much for the general theory. How can the decision to postpone the second consumption tax rate hike be seen in the context of the “time inconsistency” of policy commitments? Wouldn’t the departure from the prior commitment create a problem in an economic sense?

First, it should be noted that the situation in Japan makes it difficult to see the benefit of prior policy commitment, particularly in the financial market. As it was suggested earlier, one of the benefits of committing to a future policy path in the area of fiscal consolidation, is to persuade the private sector to calm down by showing that the default risk is under control; it is expected to bring down the long-term interest rate that had surged in anticipation of the growing risk of a sovereign default. However, in Japan, the long-term interest rate has been significantly low for some time. It makes it difficult to see the positive effect of the fiscal consolidation commitment.

Second, it is also difficult to see the negative reaction to the departure from the commitment in the financial market. The long-term interest rate has shown no significant changes after the postponement announcement. It continues to stay negative in the recent days. The rating companies, that should take into account the long-term implications of the postponement have only shown very limited reactions so far.

The limited reaction to the commitment, and also to the departure from it, is partly due to the fact that the Japanese government bonds (JGBs) are, for the most part (about 90 percent), held by domestic investors that are also long-term holders, and partly due to the fact that the Bank of Japan has been actively purchasing JGBs (currently holding more than 30 percent of the total outstanding).

It suggests that the limited reaction may change only when the current account balance turns deficit, implying that a bigger role will be played in the financial market by foreign investor in the future; and when the Bank of Japan starts to exit from the current unconventional monetary policy relying on purchase of large amount of JGBs.

Possible impact on consumer behavior

What should deserve more attention is the reaction by the households. In the above, the focus was in the reaction in the financial market whose reaction is quick and visible. Compared to the reaction by the financial market, the reaction by the households will be slow and hard to observe.

The postponement of the consumption tax rate hike is expected to have a negative effect on the planned initiatives in social security reform. Households would be affected by the decision. If the credibility of the commitment on the fiscal consolidation itself is harmed, it could have a large negative impact on households: The households would put less confidence in the sustainability of the social security and the consolidation of the fiscal situation, and could strengthen efforts to prepare for themselves for the future, by consuming less and saving more.

One of the worst scenarios for the fiscal consolidation efforts that may realize in the future is that next commitment to fiscal consolidation will not be rewarded by any positive reaction by the private sector because of the loss of credibility of the government. The government at the time may stress the firmness of its commitment: However, it may not be believed because of the prior experience. It is an unfortunate consequence, but that is the cost that it has to pay for giving in to the temptation that accompanies time inconsistent policy commitment.