Japan: Conflicted Policy

Updated 05 July 2013 at 3:08 am EST, to correct computational errors.

Econontersect:  The government of Japan under Shinzo Abe is following policies that are self-contradicting.  The recent headlines have focused on monetary expansion with that will put the U.S. to shame for sheer size of the effort.  Less attention has been given to the seemingly draconian tax increases on consumption.  Taxes will increase by 60% in April 2014 and a total of 100% from current levels by October 2015.  While pouring money into the financial system with one hand Abe will be draining it from consumers with the other.

Japan introduced a consumption tax (CT), the equivalent of the European Value Added Tax (VAT), in 1989.  Initially the tax was  3%.  In 1998 the tax was increased by 67% to 5% where it remains currently.  The two tax dates coincide with the start of serious economic disruption in Japan:  (1) 1989 was the peak of the Japanese expansionary bubble and (2) 1998 was the start of Japan’s most serious post-peak recession until The Great Recession of 2007-2009.

The CT changes may not have “caused” the two contractions, but it would be hard to argue that they did not exacerbate them.

Now the government is planning to introduce a negative consumption shock even greater than the first two over an 18-month time span, up from 5% to 8% CT in less than a year (April 2014) and another hike to 10% in October 2015.

Perhaps it could be argued that consumption will be spurred over the next 10 months as consumers anticipate the tax hike.  But that would largely be “selling forward” consumption that would otherwise have been seen after the tax hikes start.  Just when the impact of QE could be waning the consumer could be withdrawing.

Note: The CT has a far bigger impact on consumption costs than the nominal percentage because it is applied at every transfer step in the economy.  Looking at the goods portion of the economy, Econintersect proposes a hypothetical example.  Consider a five step economy:  (1) raw materials, (2) processing, (3) assembly, (4) distribution and (5) retail.  If each step has a 10% profit margin and a 10% added expense cost, a 10% CT would result in an added cost to the consumer of 8.4% above the cost of a 5% CT (and 17.9% above no CT).  The actual impact will be different than derived from these assumptions (and the model for services would be different) but it is clear that the impact of each 1% CT (or VAT) is larger than 1% on retail prices, even if the model used here  overestimates the burden of the tax.

Note 2: Consumer spending in Japan is about 50% of GDP.  The current CT is dragging 7.4% (approximately, based on hypothetical applied) of that spending out of the economy with the 5% CT.  Much of the CT amount is spent back into the economy but the question remains what frictional losses occur in the economy.  And how much of the CT proceeds amount to a transfer from Peter (real economy) to Paul (the financial economy).

Japan is presumably undertaking a massive QE program to counter years of depressed consumer demand.  Here is how financial analyst John Brown put it in the Pittsburgh Tribune-Review:

Responding to a decade of depressed consumer demand, Haruhiko Kuroda, governor of the Bank of Japan, announced this spring a program of quantitative easing of about $1.4 trillion by 2014 to boost the island nation’s economy.

The magnitude of the Japanese QE relative to GDP is equivalent to the U.S. Fed continuing the $85 billion per month asset purchases for almost four years, or until  well into 2016.  Unless the talk of taper is a smoke screen the Fed will be out of this liquidity program well before then.  Japan is headed for uncharted territory, even more so if their QE continues beyond 2014.

And if this is aimed at stopping deflation by increasing consumer demand, what is the logic of increasing the “take” of the government from the consumer by increased taxation in the amount of about $30 billion a year in increased consumption taxes by the end of 2015?  When the current tax is included the CT will be decreasing demand by more than $60 billion a year if the amount of spending remains constant.  At constant spending for 20 years the total taken out of the economy will be $1.2 trillion.  Of course Japan wants spending to increase so the total could be hgher.

How conflicted can you get?

John Lounsbury

Sources:

• Japan Consumption Tax (International VAT and GST Services)

• Japan Consumer Spending (Trading Economics)

• Japan GDP (Trading Economics)

• Japan taking big gamble with QE program (John Brown, Pittsburgh Tribune-Review, 08 June 2013)