Waiting for the stars to align: Japan's Consumption Tax increase

Japan, as does much of the world, has long-run fiscal challenges. Its population aged faster than anticipated. No mechanism was put in place to automatically adjust pension and healthcare revenues.^{Note 1} In addition, the slowdown of economic growth and the late 1980s bubble and its collapse both meant that revenues plummeted, leaving the economy with a one-time buildup of debt as the aging process commenced. The result was a large initial buildup of debt, and an inexorable subsequent rise.

...right now the stars are aligned around the consumption tax...

Addressing the issue required however the proper alignment of stars. First, the political system had to be configured so as to allow decisionmaking. A long era of prime minister of the season meant that doing much of anything has been a challenge. Then there's the economic system: even deficit scaremongers recognize that raising taxes in a recession is a bad idea.^{Note 2} So Japan also needed to have the economic stars align. For the initial decade or so, the aftereffect of their bubble muted discussion of tax hikes. External shocks – the Asian financial crisis in 1997, worries about spillover from the end of the US dot.com bubble, then 9/11 and 3/11 [the Tohoku megaquake], and more recently the sharp recession touched off by what is known in Japan as the "Lehman Shock" provided excuses to postpone, from the perspective of politicians if not economists.

Then came Abe. He is only the second prime minister in many, many years to not face a constant risk of losing his majority support in the Diet; the political stars aligned. Likewise the economy has been recovering bit by bit from the Lehman Shock and 3/11. While the reality may be something less, weak labor markets that kept youth from launching careers, headlines trumpted the rise of GDP and diminishing deflation. The denoument was that on April 1, 2014 Japan increased the consumption tax (消費税) – its national sales tax – from 5% to 8%. That had a predictable negative impact on growth, and so it remains an open question which way Abe and his cabinet will lean for authorizing the next increase in the consumption tax, a 2 percentage point bump scheduled for October 2015. The legislation is in place, but there is still an opt out.

One metric is inflation. Unfortunately a disadvantage of a large bump – in this case 3 percentage points – is that while it will produce a correspondingly large jump in the price level, the base effect will wear off if the underlying wage and other cost dynamics (and firm pricing power) remain unchanged. So we are now at the point where inflation is trending down. The depreciation of the yen helped hide that, particularly as higher import prices have been sufficient to offset lower global energy prices. But that effect too will wear off. Global headwinds now threaten; China, not the US, is Japan's largest trading partner. (Japan's exports to China of computer chips and the like are incorporated into iPhones and similar goods that are promptly re-exported to the US and ... whoops ... Europe. No out there!) So my sense is that if the economic stars are aligned, that is temporary.

All this begs one question on the nature of the tax increase: why large jumps? Instead of raising taxes by 3 percentage points in one fell swoop, why not raise rates by 0.75 percentage points every 6 months over two years? or (given the 10% end point) raise rates in increments of 0.5 percentage points every 6 months for 5 years?

That would have multiple advantages:

1. Incremental bumps would lessen the surge of big-ticket purchases just before the rate increase went into effect, and the subsequent negative rebound. Such volatility serves no good macroeconomic purpose.
2. Maxi bumps make sales data hard to interpret for the private sector – how much of the March 2014 sales surge was because the economy was doing well and how much was due to consumers pulling purchases forward? Such uncertainty serves no good business purpose.
3. Volatility makes macro data hard to interpret for us economists. Yes, readers are shedding crocodile tears in sympathy, but some economists do have politician's ears (such as Koichi Hamada, a friend of Abe and former University of Tokyo and Yale professor whom I've known for 30 years). If such economists are honest – Hamada is not a mere political hack – then they are surely tempering their advice.
4. Frequent mini bumps would add to inflation for some time to come. Surely that would be better if the goal of policymakers is to shift expectations away from deflation.
5. Mini bumps ought to be more robust politically. You can with good reason argue that, in the midst of a slowing global economy, now is not the time to bump the consumption tax to 10%. It would be harder to argue that going from 8.5% to 9.0% should be postponed.
6. Mini bumps ought to be easier to extend. From a fiscal perspective, even at 10% Japan's deficit will remain large, and at 10% the consumption tax is much lower than in many OECD countries. So why stop at 10%? That's surely much easier to sell if it's a continuation of mini bumps rather than a maxi jump.

Tightening loopholes through strict implementation of a national tax ID system may be the most desirable step. Right now though the stars are aligned around the consumption tax.

 

1. Money is fungible and there is no particular economic reason to run retirement programs on a stand-alone budgetary basis. Having separate retirement and healthcare accounts and taxes to match is however to my knowledge universal.
2. Cutting retirement benefits would have the same net budget impact and the same short-term contractionary impact as a tax increase, though with 25+% of the population already benefitting from Japan's programs, that's politically infeasible. It's also morally objectionable, as the twenty-five-percenters paid taxes during their working lives and so fulfilled their end the social contract. Extending the retirement age is a compromise: those near retirement may be treated unfairly, paying in more and taking out less than they anticipated, but at least the ex post adjustment is muted.