Waiting for the stars to align: Japan's Consumption Tax increase

Japan, as does much of the world, has long-run fiscal challenges. Its population aged faster than anticipated. No mechanism was put in place to automatically adjust pension and healthcare revenues.^{Note 1} In addition, the slowdown of economic growth and the late 1980s bubble and its collapse both meant that revenues plummeted, leaving the economy with a one-time buildup of debt as the aging process commenced. The result was a large initial buildup of debt, and an inexorable subsequent rise.

...right now the stars are aligned around the consumption tax...

Addressing the issue required however the proper alignment of stars. First, the political system had to be configured so as to allow decisionmaking. A long era of prime minister of the season meant that doing much of anything has been a challenge. Then there's the economic system: even deficit scaremongers recognize that raising taxes in a recession is a bad idea.^{Note 2} So Japan also needed to have the economic stars align. For the initial decade or so, the aftereffect of their bubble muted discussion of tax hikes. External shocks – the Asian financial crisis in 1997, worries about spillover from the end of the US dot.com bubble, then 9/11 and 3/11 [the Tohoku megaquake], and more recently the sharp recession touched off by what is known in Japan as the "Lehman Shock" provided excuses to postpone, from the perspective of politicians if not economists.

Then came Abe. He is only the second prime minister in many, many years to not face a constant risk of losing his majority support in the Diet; the political stars aligned. Likewise the economy has been recovering bit by bit from the Lehman Shock and 3/11. While the reality may be something less, weak labor markets that kept youth from launching careers, headlines trumpted the rise of GDP and diminishing deflation. The denoument was that on April 1, 2014 Japan increased the consumption tax (消費税) – its national sales tax – from 5% to 8%. That had a predictable negative impact on growth, and so it remains an open question which way Abe and his cabinet will lean for authorizing the next increase in the consumption tax, a 2 percentage point bump scheduled for October 2015. The legislation is in place, but there is still an opt out.

One metric is inflation. Unfortunately a disadvantage of a large bump – in this case 3 percentage points – is that while it will produce a correspondingly large jump in the price level, the base effect will wear off if the underlying wage and other cost dynamics (and firm pricing power) remain unchanged. So we are now at the point where inflation is trending down. The depreciation of the yen helped hide that, particularly as higher import prices have been sufficient to offset lower global energy prices. But that effect too will wear off. Global headwinds now threaten; China, not the US, is Japan's largest trading partner. (Japan's exports to China of computer chips and the like are incorporated into iPhones and similar goods that are promptly re-exported to the US and ... whoops ... Europe. No out there!) So my sense is that if the economic stars are aligned, that is temporary.

All this begs one question on the nature of the tax increase: why large jumps? Instead of raising taxes by 3 percentage points in one fell swoop, why not raise rates by 0.75 percentage points every 6 months over two years? or (given the 10% end point) raise rates in increments of 0.5 percentage points every 6 months for 5 years?

That would have multiple advantages:

1. Incremental bumps would lessen the surge of big-ticket purchases just before the rate increase went into effect, and the subsequent negative rebound. Such volatility serves no good macroeconomic purpose.
2. Maxi bumps make sales data hard to interpret for the private sector – how much of the March 2014 sales surge was because the economy was doing well and how much was due to consumers pulling purchases forward? Such uncertainty serves no good business purpose.
3. Volatility makes macro data hard to interpret for us economists. Yes, readers are shedding crocodile tears in sympathy, but some economists do have politician's ears (such as Koichi Hamada, a friend of Abe and former University of Tokyo and Yale professor whom I've known for 30 years). If such economists are honest – Hamada is not a mere political hack – then they are surely tempering their advice.
4. Frequent mini bumps would add to inflation for some time to come. Surely that would be better if the goal of policymakers is to shift expectations away from deflation.
5. Mini bumps ought to be more robust politically. You can with good reason argue that, in the midst of a slowing global economy, now is not the time to bump the consumption tax to 10%. It would be harder to argue that going from 8.5% to 9.0% should be postponed.
6. Mini bumps ought to be easier to extend. From a fiscal perspective, even at 10% Japan's deficit will remain large, and at 10% the consumption tax is much lower than in many OECD countries. So why stop at 10%? That's surely much easier to sell if it's a continuation of mini bumps rather than a maxi jump.

Tightening loopholes through strict implementation of a national tax ID system may be the most desirable step. Right now though the stars are aligned around the consumption tax.

 

1. Money is fungible and there is no particular economic reason to run retirement programs on a stand-alone budgetary basis. Having separate retirement and healthcare accounts and taxes to match is however to my knowledge universal.
2. Cutting retirement benefits would have the same net budget impact and the same short-term contractionary impact as a tax increase, though with 25+% of the population already benefitting from Japan's programs, that's politically infeasible. It's also morally objectionable, as the twenty-five-percenters paid taxes during their working lives and so fulfilled their end the social contract. Extending the retirement age is a compromise: those near retirement may be treated unfairly, paying in more and taking out less than they anticipated, but at least the ex post adjustment is muted.

The Crisis Yet to Come

The Atlanta Fed's blog from October 27, 2010 has a chilling piece on the source of the downturn in revenue at the state level (and by implication the local level, too). Quite simply, they note and then back with data that (duh! - with hindsight) real estate assessments lag the market. Hence the downturn has to have other sources, specifically declines in individual income tax receipts and sales tax receipts. Real estate tax receipts have actually continued to rise, as higher assessments from the era of peak prices continue to track up.

That's chilling, because it implies that state and local governments will continue to see revenues fall as assessments are updated to track the market down. Now the level of dependence on real estate related revenue varies widely. But on average it suggests that even if incomes begin to recover, government revenues will continue to fall.

Indeed, a recent paper by Cogan and Taylor quantifies the magnitude of the downturn: budget cuts by state and local governments fully offset the much-maligned Obama stimulus package. They had earlier taken a stand on the "multiplier" (the extent to which an expenditure increase or tax cut would stimulate activity). [Look for a discussion of multiplier estimates by Brad de Long.] But when they went to check what ex post performance might show, they found a problem that rendered that discussion moot: ex post, there was no multiplicand to be multiplied. Of course that's not reassuring going forward, because in 2011 there won't be a stimulus package to offset what state and local government are doing. When teachers are fired next summer, and as road maintenance crews are axed and parks closed, there won't be anyone stepping in to hire them or pay for them to be rehired. Now Cogan and Taylor think the multiplier is small; I'm not convinced by their arguments. But small multiplier or large, the job losses will be real.

John F. Cogan and John B. Taylor, "What the Government Purchases Multiplier Actually Multiplied in the 2009 Stimulus Package." National Bureau of Economic Research Working Paper No. 16505, October 2010. http://www.nber.org/papers/w16505

If we thought banks were too big to fail, what of the government of the 10th largest economy in the world, California? They are starting their 2011 budget cycle with a $25 billion deficit and a long period of underfunding state and local pension funds. I doubt there's enough available for cutting on the expenditure side, and while I've never lived there, my sense is that there is no ability to enhance revenue, given the demonstrated ability of vocal citizens' movements to impede government via referenda. Pundits may be comparing us to Greece to argue that we need to cut the Federal deficit, but they really don't understand the dynamics of bond markets. But they can and should look at California, and ask whether we will feel compelled to bail them out as the EU did with Greece.

Mike Smitka

Addenda

Readers might see a contrarian position at Slate Moneybox, Default Position: Why we needn't worry too much about municipal bankruptcy by Annie Lowry. She argues first that the incentives are strong to avoid bankruptcy, while a crisis increases policy options. Second, though only implicit in her argument, bond holders can be forced to renogotiate without bankruptcy. While she does not mention it, many bonds are very close to private placements, and that facilitates renegotiating debt. (I handled sovereign debt renegotiations during a banking career decades back.) Third, and again less explicit, the biggest obligations are not formal bonds but retirement systems. It may be possible to renege on those -- tell retirees "no more pension." That may not need Chapter 9. In sum, all of those lessen the role of formal bankruptcy.

Elsewhere I calculated the numbers for California. Their accounting is arcane, but at the state level the budget is around $100 billion with a projected $25 billion deficit. That means tax receipts of $75 billion, so that closing the gap via revenue enhancement would in the extreme require a 33% increase in taxes (and more in tax rates, given exemptions). But in the background California's GDP is approximately $1 trillion, so the gap is on the order of 2.5% of personal and corporate incomes. Of course the state has perhaps $500 billion in unfunded pension obligations. Now in most places where I've lived government salaries are below market so these pensions are in effect part of the total package. I don't believe it ethical to adjust those retroactively. But in any case the magnitude of the problem is well within the taxing ability of the state, without leading to exorbitant rates. The problem is one of politics, not economics.