The Effect of Hiking the Consumption Tax

Fierce debate over the proposal to raise the consumption tax rate continues to rage. Those who are against the hike put forward the following arguments:

1. Raising the consumption tax now, in a weak economy, will stall economic growth.
2. The general public will never accept the tax rise if the government does not thoroughly review wastefulness in public finances first.  The government must make far better use of its so-called buried treasure: the huge amount of money that could be recovered from reserves and surpluses in the special accounts.(*1) Demanding an increase in the consumption tax in order to reduce government debt levels overestimates the debt problem and makes no sense.
3. In a deflationary environment, raising the consumption tax rate will not improve public finances. The priority should be to eliminate deflation first by demanding that the Bank of Japan implement a monetary policy capable of stopping prices from falling. Doing so should significantly improve the state of government finances. 
4. Even if the rate of the consumption tax is hiked by 5 percentage points to 10%, the resulting revenue would be a drop in the bucket, especially given our aging society.

It would not be true to say that these arguments are mistaken. However, they are an extremely weak justification for delaying a rise in the consumption tax rate. Raising taxes is never something that the public enjoys. Avoiding a hike now merely pushes the day of reckoning into the future.

What Market Participants Are Looking For

As the fourth criticism above correctly states, raising the consumption tax rate by 5 points will not solve the public finances problem by itself. In the light of Japan’s aging society, however, reforming social security and revising taxes are projects that we will have to deal with for decades to come. Hiking the consumption tax now is no more than one step in a much longer journey. If we cannot take even this single step, the journey will never happen.

How will the market react if there is a belief that raising the consumption tax rate will be politically difficult or impossible? Rather than looking at the immediate future of public finances, market participants are more interested in whether Japan has the ability and the will to achieve fiscal soundness over the long term. Whether the government has or lacks the determination to implement the proposed consumption tax hike will be part of the basis for deciding the answer to this question.

Ways Not to Solve the Problem

Politicians who wish to avoid the bitter medicine of the consumption tax rise are looking to take the easier path. It is not unreasonable to imagine that some of them think that if the BOJ prints a tremendous amount of money, the result will be a modest amount of inflation. And rising prices will then ease the management of fiscal deficits. Regrettably, there is no magic wand that will fix the problem. It is hard to believe that the BOJ can easily instigate intentional inflation, and if it goes too far and applies too much pressure with its monetary policy, there could be a wide variety of adverse effects. Even in the case that some inflation does come about, the idea that Japan’s public finances will improve beyond recognition is unthinkable when the burden will only increase with an aging population.

With regard to those who say that a consumption tax hike should take place only after wastefulness in public finances and government expenditure has been brought under control, their argument seems too late. The ruling Democratic Party of Japan itself was one of the voices demanding the elimination of wasteful spending and exploitation of buried treasure to free up additional revenue, but now it has been forced to agree that the consumption tax needs a higher rate. Rooting out wastefulness in government finances is important, but it cannot be used as an excuse for postponing a tax hike.

No Immediate Risk to the Economy

The argument that the consumption tax rate must not be increased until business is prosperous has been around for years. By that logic, it may never be possible to raise the rate. Leaving public finances as they are will only put the economy in even worse shape. When we talk about raising the tax rate, we are not talking about doing so next year. The proposed rate change from 5% to 10% will be a two-stage process, and in anticipation of the higher taxes, consumers are sure to be rushing out to shop before the new rate takes effect.  For the time being, accordingly, hiking the consumption tax is hardly likely to have a seriously detrimental effect on the economy.

The most important thing to realize is that increasing the consumption tax rate is not a short-term policy measure but part of long-term economic planning. Denmark and Sweden have value added tax rates in the vicinity of 25%, but they have far more lively economies and higher per capita income than Japan, with its modest 5% consumption tax. Saying that the economy will only get worse the higher the consumption tax goes is, accordingly, incorrect, at least in the medium to long term.

Comparison of Consumption Tax Rates/Value Added Tax Rates by Country

Source: From the “Fuka kachi zeiritsu (hyōjun zeiritsu) no kokusai hikaku” (Comparison of Value Added Tax Rates [Standard Rates] by Country, January 2012) report on the Ministry of Finance website. These are G20 countries, with Denmark and Sweden added.

(Originally written in Japanese on May 10, 2012.)