Japan’s Tax Reforms and its Blockbuster GDP Growth

Japan has been implementing some substantial economic reforms lately. This year might be a good experiment in tax policy, where a country trades an increase in one sort of tax for a decrease in another.

The tax hike happened earlier this year. As of April 1st, Japan's sales tax has risen from 5% to 8%. In the quarter prior to the tax increase, the growth was rate was extremely high. After revisions, the Cabinet Office determined that Japan's economy grew at a ludicrously-fast 6.7% rate – a number that almost certainly includes consumption-shifting in order to get big purchases in before the April 1st deadline. Consistent with that hypothesis, Japan had poor retail sales in April. Over the long term, of course, the consumption-shifting opportunity will no longer be available. Purchases from now on will have to deal with the 8% tax.

Taken completely in a vacuum, this tax increase would be bad for Japan. The tax increase essentially takes away 3% of Japanese citizens’ purchasing power on a static basis, and even more once one considers the deadweight loss from disincentive effects.

However, put in context, the tax increase looks a lot better. Japan’s public debt is well over 200% of GDP; it has to raise some revenues to keep that debt under control. The government also looks set to increase the consumption tax again, to 10%, in October 2015.

Consumption taxes are the most neutral tax base of all; all economic activity is done for the eventual purpose of consumption. A broad-based consumption tax taxes all economic activity exactly once.

The good thing about this tax hike is that it may allow Japan to reduce far more damaging taxes, like its 35% corporate rate. That rate is the second highest in the developed world, behind only the United States at 39.1%. Japan is eyeing a reduction to 30% or even 25%.

Paired together, theory would predict that these two tax changes create a structural shift in the Japanese economy; the more favorable corporate tax climate would encourage investment, and some income would be spent on that new investment instead of immediate consumption. Over the long term, this will boost Japanese wealth and productivity, and eventually allow for a higher standard of living than before.

The data fit this theory so far; private nonresidential investment grew at a “blockbuster” rate of 7.6% in the first quarter of 2014. We will continue to watch Japan’s progress because it has a tax situation very similar to our own; it is a very large, wealthy economy with low consumption taxes, high corporate income taxes, and moderate individual income taxes. If Shinzo Abe’s reforms are successful, they can serve as road maps for the United States. So far, so good.