JAPAN MUST BE BRAVE -- IT IS TIME TO PUT UP TAXES / THE FINANCIAL TIMES COMMENT & ANALYSIS

September 9, 2013 5:37 pm

 

Japan must be brave – it is time to put up taxes

 

By Takatoshi Ito

 

Raising consumption tax to 20-25 per cent would resolve the fiscal situation, says Takatoshi Ito

 

©EPA

It is hardly a secret that Japan’s fiscal situation is much worse than that of some European countries that fell into crisis. In the past few years, less than half of the central government budget has been financed by taxation. The volume of new bond issuance has exceeded tax revenues. It is as if a family were to use credit cards for half of their monthly expenditure. The ratio of gross debt to gross domestic product is more than 200 per cent – the highest among the OECD countries. The situation is clearly not sustainable.

Given the dire financial situation, many economists and investors have been mystified as to why Japanese government bonds have maintained their exceptionally low yield, currently at about 0.7 per cent for 10-year paper. Takeo Hoshi and I have an answer. Since the rate of consumption tax (a value added tax) is a lowly 5 per cent, there is ample room for a tax rise.

 

Suppose that the Japanese government raised the consumption tax rate to the European level of 20-25 per cent. At that point, Japan’s fiscal situation would become perfectly sustainable. Hence, we conjecture that Japanese investors trust that at some point in the future, some wise political leaders will persuade the public to accept higher consumption tax rates.

 

They have reason to do so: in 2012, the three major parties agreed to raise this tax. Under the law, passed by both houses of parliament last August, the tax would first move from its current 5 per cent to 8 per cent in April 2014 and, from there, to 10 per cent in October 2015. The legislation was a turning point, the first step towards fiscal sustainability – and one largely accepted by the Japanese public.

However, a year after the legislation and six months before implementation, there are signs that the Liberal Democratic party government of Shinzo Abe is having second thoughts. The prime minister’s personal economic advisers openly oppose the scheduled increase. They have put forward an alternative plan to raise the tax 1 percentage point a year for each of the next five years.

 

Opponents fear that an abrupt increase would risk repeating the experience of 1997 when an increase of 2 percentage points in the consumption tax was followed by a big recession. They argue that today’s Japanese economy, on the verge of escaping longstanding deflation, is insufficiently strong to withstand the demand shock that a hefty tax increase might imply.

Mr Abe has an escape clause. The law passed in 2012 stipulates that the tax increase should only go ahead if the economy is considered sufficiently robust to merit it. Opponents are arguing that it is not. There are worrying signs that Mr Abe’s resolve is wobbling.

Late last month, 60 representatives of the economic profession, business, consumers, labour and younger generations were interviewed about the likely impact of the tax rate increase. Mr Abe received a report summarising the discussions last week and is scheduled to make his ruling on whether to press ahead with the tax rise shortly after.

The arguments of those who advocate going ahead with the tax increase, including myself, are centred on four main points.

First, the economy is firmly in an expansionary phase. The Japanese economy grew in the first two quarters of this year, at annualised rates of 4.1 per cent and 3.8 per cent respectively. It is very unlikely that the economy would fall back into stagnation or deflation as a result of a 3 percentage point increase in the tax rate next April.

Second, there is no connection between the April 1997 tax increase and the recession that followed. The Sharp economic downturn of 1998 had its roots in the Asian currency crisis and Japan’s own banking problems. The tax rise was irrelevant.

Third, if the current law were to be suspended, a new one would have to be written and argued over in parliament. The tax rise itself is unavoidable. Expending political capital over rescheduling its implementation would be a colossal waste of time and effort. Rather than doing that, Mr Abe should spend the next several months implementing regulatory reform – the so-called third arrow of Abenomics. If he gets distracted on a fruitless round of negotiations over the consumption tax, structural reform vital to Japan’s long-term growth prospects would take a back seat.

 

Fourth, suspension would probably be interpreted by the markets as a lack of political will. That would be very bad news for the JGB and equities markets. The very real gains accrued through aggressive monetary policy – namely a sharp increase in stock prices and a fall in the yen – could be unwound.

It is important for Mr Abe to keep the momentum. Being assured by the new strong growth numbers, he should quickly put the debate to rest by announcing his intention to press ahead with the tax increase as planned. It would be a great mistake if he lost his nerve now.


The writer is dean of the Graduate School of Public Policy at the University of Tokyo and was an economic adviser to the 2006 Abe government

 

Copyright The Financial Times Limited 2013.