Friday, September 27, 2013

Japan's consumption tax

US fiscal deadlines aren’t the only significant fiscal issue worthy of attention right now.  Japanese Prime Minister Abe will soon make a call on whether to proceed with the scheduled increase in the consumption tax from 5% to 8% in April next year.  Media reports suggest he is waiting for the results of next week’s Tankan survey before making a final decision.

Our expectation is the Government will proceed with the increase.  Any plans to delay or shelve the increase will be viewed negatively by markets given the implications for medium-term fiscal outcomes.  The consumption tax increase is correctly viewed as a small step along the long road towards Japanese fiscal sustainability.

The questions right now are, firstly, whether the Government go ahead with the full 3% increase or phase it more gradually (e.g. 1% per annum).  The second issue is the extent to which they will attempt to offset the economic impact with other fiscal measures and, if so, what impact they will have.

The tax increase will raise an estimated ¥8 trillion and add around 2% to inflation.  The impact on the economy will be significant.  Before the tax is implemented there will be the inevitable bringing forward of expenditure leaving a deep hole following the increase.  And in an environment of muted wage growth, higher inflation will be a hit to real household incomes.

It is therefore not surprising the Government is looking at options to mitigate the negative impact on economic growth.  These options appear to include further measures to increase public works investment, tax breaks for capital investment, tax incentives to increase labour compensation and reductions in the corporate tax rate.

Efforts to stimulate business investment are well intentioned but the impact could be disappointing.  While much of the recent revision up in Q2 GDP was due to stronger investment, I think businesses will maintain a caution approach to investment, largely because there is yet little confidence that the current better growth will prove sustainable.  Sustainably higher growth needs stronger investment which in turn requires greater confidence that Prime Minister Abe will make more progress on his “third arrow” of structural reform.

Furthermore, it appears likely firms would take a cautious approach towards investment given the uncertainty about how the economy will perform after the tax increase.  Also there is a second increases in the consumption tax scheduled for 2015 (from 8% to 10%).

Our current Japan GDP forecasts incorporate the increase in the consumption tax, but don’t allow for any offsetting measures yet.  I’ll wait for the detail.  Of course there is also the possibility of further monetary stimulus should the new tax burden prove too great.  Our forecasts have annual average calendar year GDP growth of 2.0% this year, 1.5% in 2014 and 0.6% in 2015.