A Downturn Not Much Different from Those in the Past
OGURO Kazumasa Consulting Fellow, RIETI
Japan's biggest domestic concern is the sustainability of its public finance. The government debt to gross domestic product (GDP) ratio is at the highest level since the prewar days and continues to expand. This is simply delaying an excessive debt burden for future generations. Because the primary cause is the rapid rise in social security costs and the shortfalls in revenue, both of which are associated with the rapid aging of the population, the painful reforms, such as curbing social security costs and increasing taxes, cannot be avoided.
Under such circumstances, in August 2012, legislation relating to comprehensive reform of social security and taxation systems, including consumption tax increases, was enacted. The legislation includes a two-stage increase of the consumption tax rate, and the first increase—from 5% to 8%—was implemented in April 2014. If everything goes as scheduled, the next tax increase—from 8% to 10%—will take place in October 2015.
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If the consumer price pass-through associated with the consumption tax increases takes place all at once, a rush demand to purchase durables and housing and the downturn from that demand both will be amplified, temporarily causing a large distortion of the economic growth rate. Furthermore, except for affecting the timing of purchases of durables and other goods, theoretically speaking, a consumption tax increase differs little from an increase in income tax or social insurance premiums, but there are strong concerns that the size and speed of the tax increases will have a certain impact on the economy.
With regard to the tax increase in October 2015, the government plans to take into account comprehensively factors such as economic conditions and to make an assessment during 2014, with Prime Minister Shinzo Abe planning to make the final decision by the end of the year. One of the bases for making the decision is economic performance after the first tax increase, and the GDP statistics for the April-June 2014 quarter have attracted much interest in the market.
While the real GDP figure in the first preliminary estimate, released in August 2014, indicated a quarter-on-quarter decrease of -1.7% (an annualized rate of -6.8%), in the second preliminary estimate, released on September 8, 2014, the figure was revised downward to a quarter-on-quarter decrease of -1.8% (an annualized rate of -7.1%). This is a larger downturn than the one in the January-March 2011 quarter, when the Great East Japan Earthquake occurred. The main factor is that the recoil from the last-minute rise in demand before the tax increase led to the largest-ever decline in consumer spending.
The downturns in the growth rate following the introduction of the consumption tax (from 0% to 3%) in 1989 and the increase in the consumption tax (from 3% to 5%) in 1997 were -1.3% and -0.9%, respectively. Because the downturn this time will likely be larger, voices of concern over the economic outlook have begun to be heard in some markets. Nonetheless, this particular viewpoint should be given a little thought.
This is because the size of a downturn arising from a consumption tax increase must be assessed by taking into account the level of the trend growth rate of the economy (the real GDP growth rate achievable in the long run), and, from that point of view, the recent downturn cannot be considered as excessively large.
If negative growth results from a temporary negative shock to the economy, the true size of that negative growth must be measured by also including the fall from the trend growth rate of the economy. In other words, the size of a downturn after a tax increase is determined by subtracting the trend growth rate from the actual growth rate of the economy, which increases the size of the negative growth.
Let's consider two cases: a high-growth case where the trend growth rate of the economy is 1.2%, and a low-growth case where the trend growth rate of the economy is 0.5%. As a result of a tax increase, even if the real growth rate temporarily falls to -2% in both cases, it is appropriate to make the assessment that the downturn is -3.2% in the former case and -2.5% in the latter case.
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What is the actual situation now? The real growth rate (average annual rate of change) was 4.3% in the 1980s, 1.5% in the 1990s, and 1.4% in the 2000s (To exclude the impact of the collapse of Lehman Brothers, the 2000s means the average rate from 2000 to 2008. If 2009 is also included, the rate is 0.7%). Expressed as quarter-on-quarter changes, the real growth rate was approximately 1.1% in the 1980s, approximately 0.38% in the 1990s, and approximately 0.35% in the 2000s. Accordingly, we assumed these rates to be the trend growth rates of the economy and calculated the value of "real growth rate" minus "trend growth rate" for each of the years in question. (See the figure.)
From this analysis, based on the size of the downturns in the April-June quarters associated with the consumption tax increases, the order is: 1989 (-2.4%), 2014 (-2.15%), and 1997 (-1.3%). We can appreciate that the recent downturn is larger than that in 1997, but a little smaller than the one in 1989.
Some may argue that the trend growth rate of recent years is too low. However, even if the yen keeps weakening with a new phase of monetary easing while export amounts grow slowly due mainly to a decline in domestic production capacity, imported inflation due to the weaker yen will erode the real income of households. On the supply side, because of the population decrease and savings rate decline associated with the rapidly aging population, a decrease in the labor force and sluggish growth in the private net capital stock are becoming clear. Unless productivity improves, a drop in the trend growth rate of the economy is inevitable.
In addition, attention should be paid to the difference between nominal tax burdens and real tax burdens. At the time of the introduction of the consumption tax in 1989, while the increase in the nominal burden was 5.4 trillion yen, due to tax reductions including the repeal of the commodity tax, the increase in the real burden on the household sector was 3.1 trillion yen. Conversely, in 1997, besides the increase in the nominal tax burden (5.2 trillion yen), the burdens of the discontinuance of temporary tax cuts and the pension and health insurance reforms overlapped, and the increase in the real burden on the household sector reached 8.5 trillion yen.
Meanwhile, although the increase in the nominal burden this time (eight trillion yen) exceeds that in 1997, as the size of the tax increase exceeds that of 1997, the real burden on households should be less this time with such measures as an expansion of tax credits for salary growth and direct payments to lower income groups having taken in a total of one trillion yen.
Although there is some concern that the recent downturn is larger than that in 1997, unlike in the past, 5.5 trillion yen in economic measures have been taken this time. In the April-June 2014 quarter, the increase in public fixed capital formation was negative, and considering that the government attempted to front-load spending in the budget for the current year, sufficient progress clearly has not been made. However, this is because time lags occur in the GDP statistics that are viewed as the value of work done corresponding to the progress in construction projects, which means that the effects of the measures will not appear until in or after the July-September 2014 quarter.
In addition, viewed from the perspective of the index of consumption expenditure level in the Family Income and Expenditure Survey conducted by the Ministry of Internal Affairs and Communications, consumption marked a sizeable drop in May 2014 after the tax increase but has been gradually recovering since June 2014. Moreover, with the industrial production index for July 2014 increasing by 0.2% from the previous month, the industrial production index exceeded the previous month's figure for the first time in two months. Although we cannot determine it until the preliminary GDP data for the July-September 2014 quarter are released, the recoil of the rush demand is abating, and the gradual economic recovery is basically expected to continue in the months ahead.
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Be that as it may, actual policy decision has to be made amid uncertain outlooks and imperfect information. In particular, real GDP in the July-September 2014 quarter is expected to register positive growth through a rebound from the downturn following the consumption tax increase, and economic performance will become even more difficult to predict.
Although calls for a supplementary budget for fiscal 2014 and additional monetary easing have already begun, even while preparing various policy responses, making an actual decision after assessing the economic trends in the July-September 2014 quarter will not be too late. Rather, the most important factor in determining policies under these circumstances is to focus fully on economic trends and correctly grasp the true state of the economic changes by paying the utmost attention to them. In that process, an assessment of the divergence from the trend growth rate of the economy is indispensible.
There may be criticism that the economy may slow down even more if a tax increase is implemented when the trend growth rate of the economy is low. However, the point of view that economic agents make decisions while keeping an eye on the policy outlook is also crucially important. If a consumption tax increase and social security reform are unavoidable, theoretically speaking, more than being a problem from the perspective of the economy, the real problem is that, by throwing the intertemporal consumption and savings optimizations chosen by economic agents into confusion, the efficiency of the allocation of economic resources will be distorted.
For example, because a gradual consumption tax increase will impose an even higher tax rate when savings are diverted to consumption in the future, such an increase has the same effect as savings tax. Delaying the tax increase will further increase the tax rate necessary for fiscal stability, and if savings falls in an adverse reaction, there will be various side effects on the economy, such as a slowdown in the pace of capital accumulation for future growth.
If there is a great deal of uncertainty about when measures such as a consumption tax increase will be implemented by policy makers, then the negative impact on allocation of resources will be even larger. Considering this uncertainty and the current fiscal conditions, no time can be lost in undertaking fiscal reconstruction. Excluding abnormal circumstances, such as the collapse of Lehman Brothers and the Great East Japan Earthquake, further delaying of the tax increase and thereby creating a problem for the future should be avoided.
* Translated by RIETI with some additional information.
September 15, 2014 Nihon Keizai Shimbun
October 21, 2014
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