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Sales tax hike postponement raises questions about Japan's fiscal reform

Prime Minister Shinzo Abe's decision to push back the scheduled hike in the country's consumption tax from April 2017 to October 2019 has raised questions over whether Japan will be able to put the economy on a steady recovery track and rein in public debt.

Despite citing some good results from his "Abenomics" policy mix, Prime Minister Abe announced his decision to put off the planned consumption tax hike again on June 1. He stressed that the ratio of job offers to applicants across the country rose to more than one for the first time in April since February 2005 when the government started to collect data, the number of corporate bankruptcies dropped to levels seen during the period of the "bubble economy," wages for workers have been rising, and so on. But a senior Finance Ministry official showed a feeling of enervation and said, "If we cannot raise the tax under the current circumstances, when can we do it?"

The Finance Ministry, which is supposed to take steps to lay the groundwork for a tax raise, had not been able to do so. A Finance Ministry official said, "I was instructed by a senior official 'not to move.'" Before Prime Minister Abe initially decided to postpone the consumption tax hike in November 2014, Finance Ministry officials aggressively "explained" behind-the-scenes the need for the consumption tax hike to legislators from the ruling Liberal Democratic Party (LDP) and others. But in the eyes of the prime minister's office, "It was like a move to apply pressure," said a government source.

The Finance Ministry officials' efforts had an adverse effect as they came under fire from top government officials, including Chief Cabinet Secretary Yoshihide Suga. Therefore, they decided not to do the same thing this time around. They suggested to Prime Minister Abe about the possibility of taking large-scale pump-priming measures to uphold the economy ahead of the planned consumption tax hike. But the prime minister did not respond to the suggestion.

Abe's concerns are understandable. If the consumption tax is raised to 10 percent, a household with an annual income of 5 million yen will have to shoulder an extra tax burden of about 50,000 yen a year. That could offset the effects of wage increases achieved during the last spring labor offensive. At a news conference on June 1, Prime Minister Abe emphasized, "We will shake off the risks." He drew a scenario in which the government would raise the sales tax after putting the economy on a firm recovery track so that it would be able to catch "two hares" -- economic recovery and fiscal reconstruction.

What is feared is that the risks that the government should have contained would eventually be amplified and come back in different forms. Major ratings agency Fitch Ratings warned on June 1 that the postponement of the sales tax hike would "undermine the credibility of the political commitment to fiscal consolidation." When the government decided in November 2014 to put off the sales tax hike, Moody's Investors Service downgraded the Japanese government's debt rating by one notch to A1 -- the fifth from the top. In September 2015, Standard & Poor's downgraded Japan's sovereign debt rating to the same level designated by Moody's Investors Service, as it raised questions about the effectiveness of Abenomics in shoring up the economy.

Abe's latest decision to postpone the sales tax hike means that the government has broken its promise to reconstruct its finances twice so far. If Moody's Investors Service were to downgrade Japan's sovereign debt rating by two notches, Japan's credit status would fall below the level assigned in 2002 -- a rating below that of Botswana. A situation could emerge that there are no buyers of Japanese government bonds, resulting in a sharp upswing of interest rates (while bond prices would plummet).

For the time being, the Bank of Japan (BOJ), which is sticking to an ultra-easy monetary policy, is to continue to buy up Japanese government bonds to hold interest rates down. Ironically, as the economy is moving further to emerge from deflation, the Japanese government and the BOJ will face the risks they have contained. When the BOJ stops buying government bonds in a bid to end its easy monetary policy and if Japan's fiscal conditions have not improved, there could be no buyers of Japanese government bonds and interest rates could rise sharply accordingly.

If long-term interest rates rise by 1 percent, Japanese banks that hold Japanese government bonds will suffer a total loss of 7.5 trillion yen, which is more than double the combined total net profits earned in fiscal 2014 by all Japanese banks. A senior BOJ official said, "The hurdle for exiting from the ultra-easy monetary policy will become all the higher."

If the government lacks stable financial resources, it will face budget rigidity. Debt repayments and social security spending, that are hard to cut back on, already account for about 70 percent of the government's total spending. A senior Finance Ministry official said that it would be difficult to secure sufficient budget to rebuild ageing infrastructure across the country such as roads and bridges. The official said, therefore, that the government would have no option but to be selective in working out infrastructure projects. At the same time, the postponement of the consumption tax hike will make it impossible for the government to secure annual tax revenue of 4.4 trillion yen, which is about double the amount needed to finance measures to tackle the falling birth rate in fiscal 2016.

Randall Jones, who oversees Japan's policy at the Organization for Economic Cooperation and Development (OECD), said at a news conference on June 1 that Japan should work out specific plans to reduce its debts in order to maintain its credibility. Suspicions have already been spreading within the government over whether it will actually be able to raise the consumption tax in October 2019. Etsuro Honda, special adviser to the Cabinet, said on a TV program on May 30, "No one knows if two years and a half (of the postponement of the consumption tax hike) will be enough."

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