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.