Lessons from Japanese Tax Policy

November 18, 2014

Today, Japanese Prime Minister Shinzo Abe announced a delay in the implementation of the second phase of his own tax hike plan, seeking a mandate for his decision by calling for snap elections in December.

Back in April, Japan’s VAT increased from 5 to 8 percent in the first of two planned sales tax hikes orchestrated by Prime Minister Abe as part of his three-pronged economic reform plan, widely termed “Abenomics.” (The three prongs, or “arrows,” of Abenomics are fiscal stimulus, monetary easing, and structural reforms, the latter of which includes tax hikes designed to address growing budget deficits.) A further increase to 10 percent was slated for October 2015, but has been postponed in the wake of the economy shrinking a disastrous 7.3 percent in the second quarter and slipping a further 1.6 percent in the third quarter as the nation fell into recession.

Few doubt the reason. Even the plan’s patron is now expressing caution, with the Prime Minister telling the Financial Times, “By increasing the consumption tax rate if the economy derails and if it decelerates, there will be no increase in tax revenues so it would render the whole exercise meaningless.”

For many in Japan, there’s a feeling a déjà vu. Japan fell into recession following its last tax increase, when the consumption tax was raised from 3 to 5 percent in 1997. At the time, the tax increase came in for some of the blame, but falling as it did in the midst of the Asian financial crisis, determining the extent to which tax increases were responsible was all but impossible. Not so this time.

Etsuro Honda, an economic advisor to Prime Minister Abe, was remarkably candid in an interview with the Wall Street Journal: “Abenomics and the sales-tax increase are policies facing in opposite directions. If you step on the gas and hit the brakes at the same time, you know what will happen? The car will go into a spin.”

The most optimistic outlook came from Akira Amari, the minister of state for economic and fiscal policy, who could only argue that “the effect of the sales tax hike is subsiding” because the economy is no longer declining as rapidly.

Initially, many observers doubted warnings of substantial economic consequences. Back in April, a Reuters survey of sales estimates suggested that the tax increase would not be nearly as economically damaging as critics had predicted, though their poll of economists proved prescient, with economists projecting a decline of 7.1 percent. That quarter ended with an economic contraction of 7.3 percent.

After these alarming numbers came out, analysts expected a modest recovery in the third quarter, predicting growth of 2.2 percent. The economy shrank a further 1.6 percent quarter-on-quarter on an annualized basis. Few view a further increase as benign now.

On the contrary, a top government official is proposing that the second stage of the sales tax increase be delayed, and Honda, one of the architects of Abenomics, warned, “There’s a great danger from the next sales tax hike given the current situation where the positive effects of ‘Abenomics’ and the negative impact of April's sales tax hike are offsetting each other.”

Meanwhile, Prime Minister Abe has called a snap election seeking a vote of confidence in his administration and the proposed VAT hike delay against poll results showing 71 percent of respondents opposed to implementing the second phase of the sales tax increase.

How this tax-engineered recession will register in Japanese elections and whether it will derail the other planks of “Abenomics” remains to be seen, but today’s decision, and the reflections of the architects of the tax hike, underscore just how much tax hikes effect behavior and economic growth.

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