The number of people in Japan aged 65 or older has reached 30.74 million, or 24.1 percent of the population, according to a government estimate released on the Respect for the Aged Day last Monday. The numbers are record highs and warn of snowballing health and welfare costs the country will soon have to face. Will Japan have enough political willpower to enforce the upcoming tax hikes and will they have a positive effect on the economy?
The major political parties enacted social security and tax reform laws in August that raise the consumption tax rate to 8 percent from 5 percent in April 2014, and to 10 percent in October 2015. Despite political wrangling, the legislation was passed with support from the opposition-leading Liberal Democratic Party and ally New Komeito.
The Cabinet Office estimates that the extra revenue will allow the government to achieve its target of halving the primary balance deficit of the central and local governments combined in fiscal 2015 from fiscal 2010 levels. However, a series of political events must take place before the tax hike actually takes effect, including a general election that could lead to the change in government.
During a public debate held by candidates running for president of the ruling Democratic Party of Japan, Prime Minister Yoshihiko Noda himself acknowledged that the DPJ will need to promise to follow through on the implementation of the tax hike in its manifesto for the next election. Meanwhile, the European debt crisis illustrates how difficult it is to legislate cuts in government spending.
Even if the primary balance deficit is halved as forecast, it does not automatically reduce outstanding debt because the government will still need to issue bonds to pay off the portion reaching maturity. Given the need for more spending on disaster and welfare measures to cover the rapidly growing elderly population, further tax hikes are likely in the years ahead. With the global economy still under pressure and turbulence expected in China’s development, the fallout from the 2014-15 tax hikes will likely be more serious than in the one in 1997.
As we contemplate the impact of the upcoming hikes, let’s review the economic changes that took place when the consumption tax itself was introduced and when it was raised in 1997 to the current rate of 5 percent.
A consumption tax of 3 percent was levied in April 1989 with the primary purpose of correcting the imbalance between direct and indirect taxes. At that time, the macroeconomic impact of the new tax was limited because it was combined with the abolition of the excise tax (which included levies of 23 percent for cars — 18.5 percent for compacts and 15.5 percent for minivehicles), as well as a reduction in the maximum income tax rates for households.
Japan logged real GDP growth rates of 5.37 percent in 1989 and 5.57 percent in 1990, with bubble economy wage hikes more than offsetting the rise in retail prices caused by the tax hike. Last-minute demand for expensive goods before the tax — and the subsequent dent in sales — did not materialize because consumers opted to wait for the abolition of the excise tax, which was much bigger than the consumption tax.
Following the collapse of the bubble economy in the early ’90s, the consumption tax rate was hiked to 5 percent in April 1997, creating a major negative impact as GDP growth sank from 1.6 percent in 1997 to minus 2 percent in 1998.
Along with the tax hike, the government raised social security premiums to increase the public’s share of the burden for rising medical expenses, and terminated special household income tax breaks. All of these took place just as the Asian currency crisis hit and Japan was still mired in its own emergency triggered by the collapse financial giants that included Yamaichi Securities and Hokkaido Takushoku Bank, which signaled the beginning of the prolonged “jutaku” housing loan crisis.
Meanwhile, wages stopped rising as quickly as before as firms reigned in manpower costs to survive rising competition from overseas. As a result, real household purchasing power declined.
Today, economic conditions are even worse. First, Japan’s economy is under pressure from the continuing global slump, including the European debt crisis. Last year, GDP shrank 0.75 percent in real terms.
Second, public debt has mushroomed to twice the size of the GDP. Despite the Bank of Japan’s zero-interest-rate policy, there is a risk of long-term rates rising. Furthermore, any significant depreciation of the yen could reverse the steady stream of overseas funds flowing into the country.
The third problem is the continuing lack of political leadership needed to make quick policy decisions and cut spending. None of the candidates for DPJ and LDP leadership races this month were able to spell out concrete ways to reduce government expenditures.
Furthermore, the trade surplus, which used to drive Japan’s growth, has been replaced by deficits. This will naturally cause labor uncertainties in export-related industries. Japan’s official unemployment rate stands at around 5 percent, which is much lower than in United States and many European economies. But this is only because companies have been retaining surplus workers protected by labor laws and government subsidies. If those labor woes materialize, the unemployment rate is projected to jump into the 9 percent range — which is about the same as in many Western economies.
Under such circumstances, the upcoming tax hikes will likely have a more dire effect on Japan than the 1997 hike. The only consolation would be that Japan imports much more than it used to, now that Japanese firms have expanded overseas production and that division of labor with other Asian economies has progressed. As a result, any drops in domestic consumption and investment would partly be offset by a reduction in imports, mitigating some of the negative impact of the tax hikes on GDP growth.
Teruhiko Mano is an international economics analyst.