To Hike or Not to Hike?

The prime minister, Shinzo Abe, must decide soon whether or not to go ahead with a planned rise in the national consumption tax. Many think that raising the tax is vital to cutting Japan's enormous public debt, which now exceeds 220% of GDP. But Mr Abe faces a dilemma over whether fiscal tightening of this kind will disrupt his reflationary economic policy (dubbed "Abenomics") by hitting private consumption at a time when the recovery is still fragile, and by causing interest rates to jump.

Raising the tax is not part of Abenomics. Mr Abe inherited the policy from the previous government, which passed legislation in 2012 mandating two successive increases: from 5% to 8% in April 2014, and to 10% in October 2015. The law contained riders to the effect that the government would be able to take the strength of the economy into account before proceeding and could modify or postpone the plan, but any changes would nevertheless require new legislation. Although troublesome, this would be possible, given that the ruling coalition led by Mr Abe's Liberal Democratic Party has majorities in both houses of parliament. The real issue is the need to determine whether the economy—and the government's economic policies—can withstand the planned tax hikes.

With this in mind, Mr Abe will wait for revised GDP growth data for the second quarter of this year, due to be published on September 9th, before making a decision. It is likely that he will also take into account national inflation and production data for August, as well as the results of the most recent quarterly Tankan survey of corporate sentiment produced by the Bank of Japan (BOJ, the central bank). All of these statistics are due for release at the end of September, meaning that a final decision will probably be made in the first week of October. In the meantime, the government is consulting an army of economists, academics, business leaders and other experts on the advisability of the plan.

Advocates of caution

A number of prominent figures have advised caution, on the grounds that the impact on consumption of raising the tax rate would be too severe. Among them are Koichi Hamada, a Yale professor and economic adviser to Mr Abe who helped to design Abenomics. Professor Hamada favours either postponing a rise in the tax for at least a year or, if possible, a more gradual series of increases in the tax rate of 1 percentage point per year.

Many opponents of the plan cite historical precedent: in 1997, amid flickering signs of an economic recovery, the government raised the sales tax from 3% to 5%, bowing to pressure from those who were worried about rising public debt (then equivalent to 102% of GDP) and upward pressure on bond yields. Shortly afterwards, the economy fell back into recession. In the years that followed, tax revenue fell steeply and government borrowing snowballed—even while Japanese government bonds (JGBs) enjoyed a long bull run.

Don't delay

The historical comparison is not especially strong, though. It is difficult to separate the effects on the economy of fiscal tightening in 1997 from the impact of the financial crisis in Asia that began in that year. At the time, Japan's banks were also still labouring under mountains of non-performing loans left over from the bursting of the country's asset-price bubble years earlier. Moreover, many argue that the fact that public debt was then only a fraction of what it is today makes the need to increase revenue now even more urgent; otherwise, they say, Japan faces financial apocalypse when international investors start to doubt its ability to repay its borrowings.

The degree to which Japan is at the mercy of its bondholders is, however, open to question. Most of the country's debt is owned by domestic investors and financial institutions, many of which would see losses on their colossal holdings of JGBs if interest rates started to rise. They would hesitate to contribute directly to this state of affairs. But there is an issue of credibility at stake: if creditors suspect that the BOJ's massive monetary-easing programme is really intended to monetise public debt and that the government has no intention of reducing public borrowing, interest rates will inevitably rise, undermining a key part of Mr Abe's economic programme.

Such is the view of the current central bank governor, Haruhiko Kuroda, who has come out strongly in favour of raising the tax as planned. In a press conference in early August, he warned that it was "extremely important for the government to clarify the path of fiscal rehabilitation and to move ahead with fiscal and structural reforms". Others agree. The IMF, for example, recently described the tax hikes as an "essential first step" in fixing Japan's fiscal problems that should not be delayed.

Then there is the issue of Mr Abe's own credibility. To turn back on the tax rises now would be to admit that his economic policy has not produced a strong enough recovery to enable him to proceed with a policy that his party supports. A delay might also undermine confidence in the government's willingness to take tough decisions to restore Japan's public finances to some semblance of sustainability. Along with the core goals of boosting economic growth and restoring inflation, Mr Abe has promised to eliminate the deficit in the central and local government primary balance (which indicates whether spending is covered by tax revenue) by 2020. Postponing or watering down planned tax rises would necessitate a corresponding cut in public spending in order to achieve these goals.

Another factor to consider is that any revision, including to the increment in the tax rate or the timing of a rise, would require new legislation and would therefore distract attention from the economic agenda planned for the next parliamentary session. The political energy needed would be drawn from the reserves that Mr Abe needs to press on with more controversial structural reform—such as social security reform or labour market liberalisation—that is equally essential in order to revivify the economy.

Sweetening the pill

The pressure would therefore appear to be on Mr Abe to proceed with the consumption tax rise next April as planned, and The Economist Intelligence Unit expects him to do so. However, we also believe that the government will offset the impact of the tax through compensatory fiscal easing of some kind. There is consensus that such compensation will be necessary. According to the Nikkei newspaper, of 60 experts participating in a week-long consultation with the government on the issue at the end of August, 44 backed raising the tax as planned, provided that compensatory measures are introduced. Just 11 called for a review of the timing or pace of tax increases, and three opposed any kind of rise (two did not make their positions clear).

Although recent economic data have been reasonably strong, there is little doubt that raising the sales tax would hit private consumption and corporate earnings. Wages have not grown as rapidly as prices, meaning either that many consumers would cut spending to compensate or that companies would feel compelled to absorb some of the impact. Offsetting measures could therefore include supplementary spending: some have mentioned a figure around ¥5trn (US$51bn), around one-half the size of the supplementary budget announced earlier this year. An alternative might be to cut Japan's corporate tax rate, which is currently high at around 35%, although Ministry of Finance officials will be worried about losing tax revenue.

Either way, Mr Abe faces an unenviable choice. He will be damned by Japan's creditors, the finance ministry and the BOJ if he waters down the plan to raise the tax, and damned by everyone else if he goes ahead and the country's nascent economic recovery stalls as a result. Proceeding but offsetting the measure with plenty of spending—and with compensatory tax cuts elsewhere, if possible—may be the only way forward.

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