Japan’s Tax-Hike Test

TOKYO – As October began, Japanese Prime Minister Shinzo Abe announced that his government would raise the country’s consumption-tax rate from 5% to 8% next April, and presumably to 10% 18 months after that. The contrast with what is now happening in the United States could not be sharper. As US President Barack Obama’s domestic opponents resist his signature health-care legislation, owing to the wealth transfers that it implies, Japanese bureaucrats are trying to recover the authority to administer tax revenue to support social-welfare programs.

There are many arguments for raising Japan’s consumption-tax rate. Japan’s government has a huge debt burden, and its consumption-tax rate is far lower than the value-added-tax rates that prevail in Europe. At the same time, the effective corporate-tax rate in Japan is higher than it is elsewhere, making it difficult for Japan to attract investment, foreign or domestic. In order to survive international tax competition – and thus be able to rely on corporate taxes as a source of revenue – Japan’s corporate-tax rate should be lowered in the long run.

Nonetheless, with Japan’s economy just beginning to recover from more than 15 years of stagnation, such a steep consumption-tax hike is not advisable. In fact, such a large increase has seldom – if ever – been attempted, owing to the risk that it would spur consumers to spend before it takes effect, thereby reducing future consumption. Moreover, any sudden rise in the tax burden results in deadweight losses.

A consumption-tax hike should be timed in such a way that it does not suffocate the economic recovery that Abe’s bold economic program, dubbed “Abenomics,” is facilitating. Western economists typically favor gradual tax increases; Jeffrey Frankel, for example, recommends a pre-announced plan to increase the tax rate by, say, one percentage point annually for five years. But Japanese policymakers, media, and academics largely continue to favor a sudden and substantial hike.

Last year, when Japan’s Diet passed the legislation to raise the consumption tax, it included a provision calling for the plan to be reevaluated if economic conditions required it. When the Cabinet Office called upon 60 business leaders, academics, and economists (including me) to perform such an evaluation, more than 70% favored the hike.

But the selection of experts reflected a clear bias toward the finance ministry’s views. In fact, the ministry has used its “informational campaign” to shape public discussion, convincing scholars, business economists, and the general public to be more concerned about keeping the budget deficit under control than about the effects of a negative demand shock. This is a typical example of what economists like Joseph Stiglitz call “cognitive capture.”

For more than two decades – a period characterized by chronic recession and deflation – Japan has retained its position as the world’s richest country in terms of net wealth abroad. At the end of last year, Japan’s net international wealth amounted to ¥296 trillion ($3 trillion). But Japan’s government is believed to be the world’s poorest, with the finance ministry reporting that the gross debt/GDP ratio exceeds 200%.

That is an exaggeration. For example, Ichizo Miyamoto, a former senior finance-ministry official, claims that, accounting for the government’s assets, Japan’s net debt/GDP ratio is below 100%, similar to that of the United States.

The validity of the finance ministry’s position on the tax increase was called into question by the decline in Japan’s Nikkei index of stock futures after Abe’s October 1 announcement. To be sure, the budget crisis in the US caused most stock futures to decline on that day. But, if the ministry’s view of the consumption tax was correct, Nikkei futures would have gained more – or at least lost less – than futures in other countries. Instead, the index declined three times more steeply than others.

And yet, while the consumption-tax increase is not ideally timed, I am not entirely pessimistic about its impact. The Mundell-Fleming framework – which describes the short-run relationship between the nominal exchange rate, interest rates, and output in an open economy – indicates that, under Japan’s flexible exchange-rate regime, the post-hike decline in demand could be addressed relatively easily with more expansionary monetary policy.

That is why Bank of Japan Governor Haruhiko Kuroda should respond accordingly if the tax increase has a deflationary impact. In doing so, he would avoid the criticism that former Bank of England Governor Mervyn King faced for supporting a consumer-tax hike in 2011 but failing to use monetary policy to offset its recessionary effects.

Just a year ago, former Prime Minister Yoshihiko Noda attempted, despite a deep recession, to raise the consumption tax without monetary easing – a strategy that could have brought only continued economic stagnation. Abe must not make the same mistake. If Japan’s government can overcome a demand setback after the tax increase takes effect – leaving the economy functioning smoothly and initiating a recovery in government revenue – Abe will be able to declare Abenomics an unequivocal success.