Japan: Worrying about rising taxes

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Japan: Worrying about rising taxes

Japan: Worrying about rising taxes

Asia Pacific Economic Outlook, May 2014

Japan raised the national consumption tax for the first time in 14 years, which many fear may throw a wrench into the economy’s recent growth momentum.

Japan_shopperJapan raised the national consumption tax for the first time in 14 years, from 5 percent to 8 percent, which many fear may throw a wrench into the economy’s recent growth momentum. After growing at a slower pace than expected in Q4 2013, Japan’s economy may not improve substantially in Q1 2014 either. The bigger concern is that growth in the coming quarters may stall or may even fall substantially due to a rise in the national sales tax.

Signs of economic weakness before tax hike

A few monthly releases in Q1 2014 indicate that the impacts of the tax rise on demand and production are probably in effect already. After a strong rise in January, some indices weakened in February.

On the demand side, the seasonally adjusted trends in total commercial sales indicated strong growth of 2.2 percent month over month in January, but growth fell in February to an eight-month low of -1.3 percent. Similar patterns were seen in the monthly consumer spending index, which rose 1.6 percent month over month in January and fell -1.5 percent in February (figure 1).

Figure 1. Signs of weakening demand and resulting weakening production

Similar patterns were observed in the production side of the economy (figure 1). In January 2014 the industrial production index for mining and manufacturing registered the highest month-over-month growth, 3.8 percent, in over two years. But the growth fell sharply, by 2.3 percent, in the subsequent month, primarily due to a decline in the production of transport equipment, business-oriented machinery, and electronics equipment. Production in large passenger cars and auto parts experienced the biggest fall.

Surveys point to weak second quarter

According to the Bank of Japan’s (BOJ) Tankan survey in March 2014, domestic demand conditions for products and services surpassed the December 2013 forecast, as consumers rushed to make purchases prior to the rise in sales tax. However, demand is expected to fall post the sales tax hike that came into effect on April 1, 2014, as shown in figure 2.1 Consumer confidence too has been on a steady decline since December 2013, as consumers worry about the impact of taxes on their purchasing power.

Many companies are wary about prospects amid fears of weakening demand after the consumption tax hike. The BOJ’s Tankan index in March 2014 indicates that business sentiments among large manufacturers improved for five straight quarters. However, sentiments are expected to deteriorate for the industry in the next three months (figure 2).2

Figure 2. Surveys point to an expected fall in demand and prodution in Q2 2014

While some of the weakness in economic activities in February could partly be due to bad weather, the probable impact of the tax rise cannot be ruled out entirely. As consumers cut spending after they have built up inventories in advance of the tax hike, companies will likely cut down production to keep inventories low in anticipation of a fall in demand. The production data for March may marginally gain 0.9 percent month over month to support a last-minute rise in consumer spending, as forecast by the Ministry of Economy, Trade, and Industry, though the production number for April is forecast to be -0.6 percent.3 The ministry is upbeat about the economy and predicts that the fall in production will be limited in coming months since companies are making long-term demand projections and keeping production and inventory under control. However, the fall in growth will likely be substantial in the second quarter. What remains to be seen is whether or not the economy can bounce back in subsequent quarters.

Can Abenomics help?

The anticipation of poor growth and weaker-than-expected business sentiments in the coming quarter has heightened market expectations of the BOJ further easing monetary policies in the coming months. According to press reports, the governor of the BOJ has expressed confidence about Japan’s growth ability post the tax hikes. However, he also added that the BOJ will adjust policy if necessary.4 An aggressive monetary policy will likely be implemented later this year to support economic recovery.

Any further rise in debt will impact investors’ sentiments and impact growth in the long term.

The government passed a supplementary stimulus package of 5.5 trillion Japanese yen in December 2013 to soften the impact of the tax rise. The government has already indicated that consumption tax rates for daily necessities will be reduced. It also aims to speed budget spending for 2014 to cope with any downside risks stemming from a planned sales tax hike.5 However, with public debt hovering above 227 percent of GDP and a fiscal deficit of 10 percent of GDP in 2013, the government may not have much flexibility in spending. Any further rise in debt will impact investors’ sentiments and impact growth in the long term.

More importantly, the pace of structural and regulatory reforms will have a significant impact on business sentiments. So far the pace of reforms has remained sluggish—which may not change much this year. That said, deregulations will help the labor market as well as business investment.

Tax hike could be beneficial

On the plus side, the rise in taxes is expected to contain the deficit and debt. In addition, the tax rise bodes well for prices. Recent data suggest that inflationary pressures have re-emerged in Japan; seasonally adjusted consumer prices went up 1.5 percent year over year in February. According to a survey conducted by the Cabinet Office in March, about 72 percent of respondents believe that prices will go above 2 percent in a year.6 The tax hike will accelerate the price rise, though it will take time to reach the BOJ’s target of 2 percent.

The price rise will also incentivize businesses to increase wages. So far wages have remained stagnant as businesses lack confidence to raise wages for their workers. Prime Minister Shinzo Abe has failed to persuade companies to raise wages despite rising corporate profits in response to a weaker yen and recent policy initiatives. Price acceleration will strengthen his case to persuade businesses to increases wages.

However, if the government fails to convince businesses, a rise in prices will result in a decline in real wages. This will further dampen consumption spending. Global demand holds the key for the trade-dependent economy: Stronger demand from the United States, China, and Eurozone will likely help Japan’s current account and compensate for the fall in domestic demand.

Endnotes

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  1. The “demand minus supply” estimate for products and services rose in March 2014 to its higest (less negative) since the pre-crisis period and is expected to rebound to low levels (more negative) in the next three months. “Less negative” suggests a fall in excess supply. This time the fall has been due to rise in demand. Business conditions above zero imply a greater percentage share of the number of respondents who choose favorable over unfavorable business environment alternatives.
  2. Only business conditions for manufacturing are reported here.
  3. Ministry of Economy, Trade, and Industry, “The survey of production forecast in manufacturing,” Indices of industrial production: Preliminary report, February 2014, http://www.meti.go.jp/english/statistics/tyo/iip/index.html.
  4. Reuters, “BOJ’s Kuroda voices confidence of meeting 2 percent inflation target,” March 19, 2014, http://www.reuters.com/article/2014/03/19/us-japan-economy-kuroda-idUSBREA2I09720140319.
  5. Forty percent of budget is to be spent focusing on public works by the end of June, and another 60 percent by the end of September.
  6. Cabinet Office, “Price expectations,” Consumer confidence survey, March 12, 2014, http://www.esri.cao.go.jp/en/stat/shouhi/shouhi-e.html.

About The Author

Dr. Rumki Majumdar

Dr. Rumki Majumdar is a macroeconomist and a manager at Deloitte Research, Deloitte Services LP.

Asia Pacific Economic Outlook, May 2014: Japan
Cover Image by Jessica McCourt (Cover), Stephanie Dalton Cowan (Japan)