Commentary / Japan

Structural reform must follow tax hike

by Jesper Koll

For the 2019 Japan economic outlook, the hike in the consumption tax is causing headaches among economists and businesspeople alike. After all, the track record has been a perfect three out of three: Whenever taxes were hiked in the past, a recession followed. In fact, on all three occasions, the frantic front-loading of consumer purchases ahead of the price hikes forced a boom-bust cycle so disruptive that policymakers scrambled to compile countermeasures within three to six months of taxes going up.

The good news is that history may not repeat itself after the hike from 8 percent to 10 percent in October 2019. This is because Team Abe is actually trying to be proactive. Credible programs designed to cushion next year’s blow to the purchasing power of the people will become a mainstay of the 2019 national budget. The creative energy of designing the countermeasures is amazing. In my view, although all the details are still to be finalized, the positive impact of exempting fresh foods from the tax hike as well as raising transfers to households for education and elder care together with some other policies should do the trick. The 2019 tax hike will be felt but won’t choke off the economy like the previous increases did.

The bad news is that the current policy scramble to counter the expected negative impact on the 2019 economic cycle is coming at the cost of neglecting much-needed structural policy initiatives and changes that are vital for Japan’s longer-term prosperity. It’s almost as if Team Abe has decided to trade strategic vision for tactical gains.

To be sure, there is a pragmatic reason for doing so. While the previous 2014 tax hike was part of a legacy package Prime Minister Shinzo Abe inherited, this one is openly endorsed and advocated by Team Abe, so a slip back into recession will not just cut into its popularity and economic leadership credentials, but become a black spot on Abe’s legacy. Say what you will, he is an ambitious leader who wants to go down in history as having been a better economic policymaker than his predecessors.

So the real issue for the Japanese economy in 2019 is not the tax hike, but how quickly and how determined Team Abe will reassert its promised focus on structural reform. Chances are good this will be sooner rather than later, for two reasons. First, Japan will be the chair and host of the Group of 20 meetings. Team Abe will not want to miss this global stage opportunity to assert exemplary leadership by presenting a credible structural growth agenda that showcases Japan’s coming progress. Second, the next Upper House election is due by next July or August and Abe’s Liberal Democratic Party will have to have a policy agenda that goes beyond promising the tax hike won’t force a recession. All said, by April or May at the latest, structural pro-growth policies are poised to be back on center stage in Japan.

Specifically, there is one domestic growth policy agenda item I am focused on to verify — or falsify — my optimism. Will Team Abe commit to a strategic refocusing of fiscal policy priority, away from tax hikes toward expenditure cuts? After all, the worst that can happen is that as soon as taxes are hiked, the government calls for the next hike. Nothing is more demoralizing for consumers than being told that the future tax burden must go up and up. It’s bad for both the cycle and the structure of the economy because it basically forces an never-ending rise in pre-cautionary balances, i.e. excess savings: Save more now to pay for future tax hikes.

In contrast, if, as I expect, Team Abe and the LDP make a clear-cut commitment to freeze future consumption tax hikes and keep rates stable at 10 percent for the foreseeable future, the basic political incentives of real structural reform will come into sight: Politicians will have to get serious about public expenditure reform in general and social security in particular. Voters will like it, not just because of the assured future tax cost stability, but also because the LDP can get creative. I expect a policy agenda that aims to redistribute public spending away from the rich and wealthy pensioners to those lower on the wealth and income ladder.

Expect the unexpected. In a country where by 2025 almost one in three people will be living on pensions, implementing means-testing for the eligibility of public funds and services is poised to be not just rational economic policy but also popular with voters. While perhaps unthinkable in America, Japan’s strong focus on equality of outcome and its sense of national unity makes means-testing a totally viable policy option in Japan. It’s a de facto tax on accumulated wealth that can be sold politically as being “fair” — of course the wealthy should pay more (and we from the LDP look out for the little guy …). It would also accelerate the generational transfer of household wealth as the rich elderly will have to pay out of their own savings for their health care rather than the young paying for it with their taxes. And more fundamentally, means-testing for public entitlements is a clear way to reduce excess savings, which are, after all, Japan’s single most dominant macroeconomic structural problem.

Trial balloons are being discussed already, like, for example, an idea to raise out-of-pocket medical expenses from the current top rate of 30 percent to 100 percent if your household net financial assets exceed ¥10 million and your mortgage has been paid off. Working out the details — who is eligible for what benefits given what threshold of wealth — would give the post-Abe generation of LDP leaders and Finance Ministry officials plenty of room to earn their policymaking credentials.

There is much room for creativity here. Make no mistake: Managing entitlement cutbacks in a fair, effective and politically feasible way is exactly what will make or break Japan’s credentials and global reputation from here. The next generation of LDP leaders will make its mark by showcasing how to successfully manage a rapidly aging society within the context of a parliamentary democracy.

Am I too optimistic? For starters, we’ll know whether a structural reform agenda will indeed be back as the mainstay of Team Abe’s ambitions by mid-2019. Either way, sooner or later the fundamental shift away from tax and spend will have to start. At the same time, do not underestimate Japan’s ability to answer the question of how to cut expenditures while at the same time raising voters’ sense of adding greater “fairness” to the system. The combination of great private sector financial wealth, a rapidly aging voter base and a growing sense of unfairness allows for much greater policy flexibility than business-as-usual suggests. The post-Abe agenda will be shaped by younger leaders who seize the opportunities offered, with means-testing a probable centerpiece driving entitlement reform and expenditure cutbacks.

Based in Tokyo, Jesper Koll is WisdomTree’s head of Japan. Researching and investing in Japan since 1986, he’s been consistently ranked as a top Japan strategist/economist. He publishes blogs at www.wisdomtree.com/blog.