Japan's Consumption Tax: Take it Slow and Steady

Japan’s consumption tax rate is scheduled to increase substantially in April (from 5% to 8%).  The motive is to address the long-term problem of very high debt.  (Takatoshi Ito has stated the case in favor of the tax increase.)  Prime Minister Shinzō Abe has apparently decided to go ahead with it.   Many observers, however, are worried that the loss in purchasing power resulting from the sharp increase in the sales tax rate will send the Japanese economy back into recession.

It is very reminiscent of April 1997.   I remember Larry Summers, who was then Undersecretary of the US Treasury, repeatedly warning the Japanese government that if it went ahead with the consumption tax hike that was scheduled for that date, Japan’s economy would go back into recession.  I was in the US government then too.  As the date drew near, I asked Summers why he persisted in offering Tokyo this unwanted advice, given that the prime minister of the day was clearly locked into the policy politically.    Summers told me that he knew he was unlikely to change their minds, but that he wanted to be sure the Japanese would realize their mistake when they went ahead with the tax increase and his prediction subsequently came true - as it did.

Japan’s fiscal problems in recent years have resembled those of the United States and many other countries.   The economy is weak, but the Bank of Japan can’t make monetary policy much more expansionary than it already is.  This calls for fiscal stimulus in the short run.  But the long-term fiscal outlook is troublesome, due to big debts that were run up in the past.    What is required is easy fiscal policy today together with plans to achieve fiscal rectitude in the long run.   The difficulty with this St. Augustine approach — “Lord make me chaste, but not yet” — is of course that announcements of future discipline are normally not at all credible.  Politicians often say that they will achieve budget surpluses in the future, but seldom do so.

What are wanted are steps taken today that are not mere words, but, rather, specific mechanisms to restore fiscal responsibility that are visibly likely to take effect when the time comes.  (Hints:    Raising the retirement age for future pension benefits qualifies as such a mechanism.   Legislating phony sunset provisions to tax cuts, as was done with the Bush tax cuts in the US, does not.)

For Japan, I like a proposal of Koichi Hamada (a Yale economics professor who has advised Abe) and others:  the planned jump in the consumption tax rate should be replaced with a gradual pre-announced path of increases, of 1% per year, for five years.  (The annual increases should probably even continue for more than five years).  A steady pre-announced set of small increases is a better path for fiscal policy than one jump, or two.  Because it establishes long-run fiscal discipline, it will not crash the bond market, as an outright cancellation of the tax increase might.  Yet it does not inflict damaging fiscal contraction in the short run, at a time when the economy is already weak.  Indeed, the expectation that tax-included prices will go up in the future can stimulate households today to buy autos, household appliances, and other consumer goods and thereby help speed the recovery.

The gradual path also has good implications for monetary policy too.  In normal times central banks want to get inflation down.  Pre-announced paths for taxes or administered prices can have the undesirable effect of building annual price increases into public perceptions, thus making it more difficult for the central bank to control inflation.  But current conditions are very different in this regard.  Interest rates and inflation rates in Japan lately have been, if anything, even lower than in the United States.  The most important cornerstone of Abenomics this year has been efforts by the Bank of Japan to ease money further, despite already-zero interest rates, and thus end the threat of deflation.  Under those circumstances, expectations of inflation are not worrisome.  Positive expected inflation would reduce the real interest rate, which is not a bad thing under current conditions.

There are useful analogies for policies in other countries.  The US could legislate a pre-announced path of slow but steady increases in energy or carbon taxes (accompanied by immediate short-term  offsets such as a reduction in the distortionary payroll tax or an end to the damaging spending sequester).    The same arguments regarding the time profile apply as to Japan:  enhancing long-run fiscal sustainability without imposing more fiscal contraction at a time when the economy has not yet fully recovered from the Great Recession.  In addition, the environmental and national security arguments in favor of discouraging fossil fuel consumption work better if the increase in energy prices is phased in over a long period of time, allowing people to plan ahead in making effective decisions about choice of automobiles, installation of home heating systems, construction of power plants, research into new technologies and so forth.

Emerging market countries like India and Indonesia are now being threatened with possible financial crises.  Part of the problem is large budget deficits, of which a major component has long been food and energy subsidies.  Trying to keep domestic prices for food and energy artificially low relative to world market prices has proven ruinously expensive, while yet very ineffective in the supposed goal of helping alleviate poverty.  Some leaders in these countries are aware of the need to reduce the subsidies (and the arguments that they can be accompanied by better-targeted anti-poverty innovations such as Mexico’s conditional cash transfers and India’s Unique ID system).  A credible pre-announced path of gradual phase-out in food and energy subsidies would provide much-needed immediate reassurance to skittish global investors, without imposing immediate hardship on the poor.  At the same time, the ability to plan ahead in anticipation of the price increases would allow more effective responses in decisions by farmers to plant new crops, energy-users to switch to more energy-efficient equipment, and so forth.

Slow and steady wins the race.

[This is an expanded version of a Project Syndicate op-ed.  Comments can be posted on that site.]

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