Shinzo Abe will shortly reach a defining moment of his second premiership with the announcement on whether to raise the consumption tax next April. Reports suggest that, encouraged in part by the upward revision to Q2 GDP, which showed annualised growth in H1 close to 4%, he is set to confirm that the tax rate will rise by the full planned 3ppts to 8%. All that possibly stands in his way is would be a terrible Tankan on 1 October. But that looks unlikely.
The tax hike would represent the first attempt by Abe to move Japan to a more sustainable fiscal path. But many commentators, including some of Abe’s advisors, fear that it would prove counterproductive, snuffing out the recovery before it has become self-sustaining. Given the lasting economic malaise which followed the 2ppt hike in the consumption tax rate to 5% in April 1997 – a time when the Japanese economy was also growing strongly – those fears are hardly surprising. On that occasion, consumption declined 3½%Q/Q during the quarter the hike was implemented. And given persistent weakness thereafter (see charts below), it took just over four years for consumption to return to its pre-tax hike peak, while GDP took three years to do likewise, by which time Japan had slid into the deflation from which it has yet to emerge.
But pinning all of the blame for the post-97 malaise on the consumption tax hike is wrong. The intensification of Japan’s own banking sector woes as well as the dramatic escalation of the East Asian financial crisis towards the back end of 1997 – after consumer spending had shown tentative signs of a revival – arguably played the principal role in explaining the subsequent lasting economic weakness. Certainly, the introduction of the consumption tax at a rate of 3% in 1989 demonstrates that, under a more favourable domestic and external environment, a sizeable hike in the consumption tax need not derail the recovery. On that occasion, private consumption and GDP took just one quarter to return back to their pre-tax levels, and within a year both indicators had increased by around 8%.
Of course, just as 1997 is far from a perfect guide to what may happen next year, neither is the 1989 experience. Then, growth was fuelled, among other things, by the wealth effects of Japan’s asset price bubble and robust global demand, while trend growth was well in excess of the present rate of roughly ½%Y/Y.
The effect of a 3ppt tax hike in April 2014 is likely to be somewhere between that of 1997 and 1989. We expect neither persistent slump nor subsequent boom. Although we would expect consumption to decline initially by almost 3%Q/Q in Q214, in large part thanks to a pre-tax hike splurge in spending, we would expect a modest recovery to resume thereafter. A reported supplementary spending package (of up to ¥5trn, roughly 1% of GDP) will help cushion the blow somewhat, and avoid repeating the counterproductive sharp decline in public spending in 1997 that also contributed to undermining recovery that time around. Further monetary easing would also help support asset prices and weaken the yen, which would give an additional boost to exports. Provided that rising inflation pressures and a tightening labour market translate into higher wages, consumer spending should eventually recover. So, if everything falls into place, GDP should return to its pre-tax hike peak by the start of 2015, a scenario consistent with the assessment of the Bank of Japan, which has for some time advocated the 3ppt hike in full. As such, the BoJ’s forecast of GDP growth of 2.8% in FY13 and 1.3% in FY14 – above potential in both years and hence further chipping away at deflationary spare capacity – looks plausible.
Impact of consumption tax hike on GDP*Dotted line is illustrative forecast of GDP before and after a 3ppt hike in April 2014. t is the quarter in which the consumption tax was/is increased. Source: Cabinet Office and Daiwa Capital Markets Europe Ltd.
Impact of consumption tax hike on private consumption*Dotted line is illustrative forecast of private consumption before and after a 3ppt hike in April 2014. t is the quarter in which the consumption tax was/is increased. Source: Cabinet Office and Daiwa Capital Markets Europe Ltd.
Chris Scicluna, Head of Economic Research
Emily Nicol, Economist