Points of Discussion over the Planned Consumption Tax Increase: Tax hike would not necessarily lead to slower economic growth
Consulting Fellow, RIETI
Prime Minister Shinzo Abe is expected to decide by early October 2013 on whether or not to go ahead with the planned consumption tax rate hike from the current 5% to 8% in April 2014, by evaluating the country's economic outlook. The government has begun studying possible effects on the Japanese economy of the planned tax hike as well as of some other possible options such as reducing the margin of the April hike from the planned three percentage points and postponing the tax increase. The move is believed to come in response to concern that the planned tax increase will negatively affect the domestic economy. In fact, the consumption tax hike from 3% to 5% in 1997, which translates into an increase of five trillion yen in financial burden on consumers, was blamed for further aggravating the already slumping Japanese economy.
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Typically, the economic impact of a tax increase can be evaluated in two dimensions, namely, in terms of its effects on a country's economic growth and tax revenue. Higher taxes will lower household disposable income, which in turn will dampen consumption thereby resulting in slower economic growth. This mechanism for tax changes to affect economic growth is called the "income effect."
We tend to assume that higher taxes come in the form of a hike in the consumption or income tax rate. However, abolishing tax breaks, curtailing tax deductions, and raising social security premiums can be also defined as a form of tax increase. Consumers decide their consumption levels on the basis of their current and future income, taking into account the economic outlook. Therefore, what they perceive as their disposable income today reflects expected pension benefits in the future. In other words, an increase in pension benefits can be seen as a form of tax decrease while a decrease in pension benefits—a cut in the amount of benefits receivable and a rise in the minimum age for pension receipts—can be defined as a form of tax increase.
Given that, it is illogical to single out a consumption tax rate hike as something special and highlight concerns over its impact. For example, when the fixed-rate income tax cuts that were introduced in 1999 at the national and local levels were scaled down in 2006 and eliminated in 2007, the household tax burden increased by 3.4 trillion yen. But no strong concern was voiced over the possibility of hindering economic growth and a resulting decrease in overall tax revenue. Furthermore, as part of its pension and social security system reform in 2004, the government decided to raise social security premiums gradually over the period of 14 years between 2004 and 2017 by 0.4 trillion yen per year or 5.6 trillion yen in total. In addition, the government decided to decrease pension benefits by introducing a macro-economic slide. But little concern has been voiced over the possible negative effects on the overall economy.
What is unique with a consumption tax increase is a phenomenon known as the "intertemporal substitution effect," whereby consumption rises prior to the planned hike on last-minute demand typically for durable goods and falls afterward. The impact of a consumption tax hike on the economy appears to loom particularly large because of its intertemporal substitution effect in addition to the income effect. However, the intertemporal substitution effect is only temporal. According to estimates made by the government and private-sector think tanks, if the consumption tax rate is raised by three percentage points in 2014 as scheduled, Japan's real economic growth will be boosted by about 0.7 percentage points on last-minute demand in fiscal 2013 and pushed down by the same 0.7 percentage points in fiscal 2014 due to a reactionary downturn in demand. This indicates that the positive and negative impacts of the tax increase will be offset over the two years combined.
Therefore, what we should consider in terms of medium- to long-term impact is the income effect. The three percentage point increase in the consumption tax rate translates into an additional burden equivalent to 1.5% of the gross domestic product (GDP). The extent to which this will impact consumption through the income effect depends on the marginal propensity to consume (MPC), the ratio of the change in consumption to the change in income. Recent empirical studies show the MPC to be 0.3 to 0.4. If we assume that MPC is 0.5, the income effect of the tax increase will push down Japan's economic growth by about 0.7 percentage points (1.5% x 0.5). This decrease, however, may be offset to some extent if part of the revenue from the consumption tax increase is redistributed, which would have a positive income effect on the economy.
Projections by the government and private-sector think tanks for the negative impact of the 2014 consumption tax hike on real economic growth, excluding the impact of a temporal boost and subsequent fall in consumption before and after the hike, range from 0.4 to 0.8 percentage points. The 0.7 percentage point decline calculated above is consistent with those projections.
In considering the relationship between real GDP growth rates and consumption tax increases in the past, it is important to take note of the difference between the two major occasions, namely, the introduction of the consumption tax in 1989 at a rate of 3% and the raising of the consumption tax rate to 5% in 1997.
First, take a look at the three-year period from before to after the consumption tax rate hike in 1997. Japan's real GDP growth rate fell consistently throughout the period from 2.6% in 1996 to 1.6% in 1997 and then to negative 2% in 1998. In contrast, during the three-year period from before to after the 1989 consumption tax introduction, the real GDP growth rate dropped from 7.2% in 1988 to 5.4% in 1989 but rebounded to 5.6% in 1990. Meanwhile, with regard to the aforementioned scale-back and elimination of the fixed-rate tax cuts in 2006 and 2007, the GDP growth rate rose consistently from 1.3% in 2005 to 1.69% in 2006 and then to 2.19% in 2007.
These facts stand as evidence that a tax hike does not necessarily lead to slower economic growth. Rather, it is fair to say that the primary cause of the recession in 1997 and 1998 is the abnormal economic environment that surrounded Japan at the time. Following the wake of the Asian currency crisis in July 1997 and the domestic financial crisis in November 1997, the impact of banks' disposal of nonperforming loans and credit squeeze was beginning to be felt in the real economy. In fact, Japan's consumption recovered in the July-September quarter of 1997, providing further evidence that the financial crisis and its aftereffects had a greater impact on the economy than the tax increase in April 1997.
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Let's look at some overseas cases. In the graph below, created by using data on the member countries of the Organisation for Economic Co-operation and Development (OECD) member countries, the vertical axis represents the year-to-year change in the per-capita real GDP growth rate. This measurement is used so as to exclude the influence of population changes and inflation. Data on changes in the per-capita real GDP are plotted only when they coincide with some sort of tax increase, which is deemed to have taken place when a country's revenue from the value-added tax, an equivalent to the consumption tax in Japan, increased by a minimum of one percentage point as a share of its GDP.
Dots representing cases where an increase in the value-added tax slowed economic growth appear in the third or fourth quadrants of the graph, whereas those in the first and second quadrants represent cases where value-added tax hikes did not lead to slower economic growth. We can see that in roughly half of the cases where revenue increased by a minimum of two percentage points against GDP, a tax hike comparable to a four percentage point increase in Japan's consumption tax rate, did not lead to slower economic growth.
Some critics argue that Japan could expect higher tax revenue by postponing the planned consumption tax hike and ensuring "economic growth." But the graph shows that their argument is invalid if they are talking about increasing tax revenue by boosting real economic growth. Or if they are focusing on nominal economic growth and thus talking about a tax revenue increase by means of inflation, revenue-boosting effects will be only temporal.
Meanwhile, what is little recognized is the fact that the decline in Japan's tax revenue in fiscal 1997 and thereafter mainly resulted from a series of tax cuts implemented to date. Along with the aforementioned fixed-rate income tax cuts introduced in 1999, the transfer of tax revenue sources from the central to local governments effective from fiscal 2004 and a series of income tax breaks for companies contributed significantly to the decline in revenue to the central government. A comparison between the total amount of individual and corporate income taxes collected by the central government for fiscal 1997 onward and the amount that would have been collected in the absence of tax hikes and breaks according to my estimation show that a series of income tax reduction measures implemented since fiscal 1997 resulted in a permanent decrease of approximately nine trillion yen in annual tax revenue to the central government. If it were not for this, the government's tax revenue in fiscal 2007 would have exceeded that in fiscal 1997.
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While the current consumption tax debate is focused so much on how the tax rate should be raised, little attention—if any—is being paid to the prospect that postponing the planned consumption tax hike would necessitate a tax rate increase of five percentage points or more in the future to achieve the same fiscal reform effects. Also lacking in the debate is the discussion of the maximum allowable level to which the consumption tax rate could be eventually raised in order to ensure fiscal stability.
A study by R. Anton Braun, a senior economist at the U.S. Federal Reserve Bank of Atlanta, and others analyzed a scenario in which Japan raises the consumption tax rate by five percentage points every five years. In order to ensure fiscal stability under this scenario, the study suggests that the consumption tax rate would have to be raised to as high as 32% even if the country successfully pulls out of deflation and achieves its 2% inflation target. This scenario is predicated on the implementation of drastic spending cuts, including a reduction in public pension benefits. Thus, in the event of a delay in the planned tax increase, the peak tax rate required to ensure fiscal stability would be sharply higher, further increasing the burden on the younger and future generations. The same study also points to the possibility of Japan falling into fiscal collapse around 2028 in the case of a scenario in which the government postpones the tax hike. The biggest difference between now and 1997 is that there is very little time before the fiscal crisis is set to explode.
"Time is the scarcest resource and, unless it is managed, nothing else can be managed," said Peter Drucker. In order to avoid fiscal collapse, Japan must carry out drastic social security reform and implement further tax hikes. It is hoped that political leaders will make relevant policy decisions by fully taking into account the time resources available and the interests of the future generations.
* Translated by RIETI.
September 2, 2013 Nihon Keizai Shimbun
September 25, 2013
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