Economic Insight: Folly of the income tax reduction triggered the “Kishida shock”

SATO Motohiro
Faculty Fellow, RIETI

The Kishida administration came up with an income tax reduction plan as part of a new economic package announced in November, with the proclaimed aim of “achieving a complete exit from deflation.”

Coming against the backdrop of an increase in government tax revenue to a record high (in the general-account budget) above 71 trillion yen, the tax reduction has been characterized as a means to “return” the tax revenue increase to the people. Specifically, each household is eligible for tax cuts worth 40,000 yen, including 30,000 yen as an income tax reduction and 10,000 yen in resident tax reduction, per household member, including dependents. The measure is expected to be implemented in June 2024, when Japanese workers receive semi-annual bonuses, in order to bring about synergy effects between the tax cuts and wage increases. The tax reduction is expected to be a one-off measure.

However, the tax reduction has been viewed unfavorably by the people, perhaps because they have seen through the façade to the true nature of the measure—being a vote-winning gimmick, rather than an economic stimulus measure. In each of the recent opinion polls conducted by the Yomiuri and Asahi newspapers, more than 60% viewed the income tax reduction unfavorably. In opinion polls conducted by media organizations in November, the approval rating for the cabinet fell into the 20-30% range across the board, hitting the lowest level since the inauguration of the Kishida administration in October 2021.

Will the Return of the Tax Increase to the People Deliver Positive Effects?

This situation is reminiscent of the “Truss Shock,” which shook the United Kingdom in the autumn of 2022. The administration of then Prime Minister Truss announced an expansionary fiscal policy package, including both a spending increase and tax cuts, without securing the necessary funds to undertake the measure. Due to concerns over a possible expansion of the budget deficit, financial markets were thrown into turmoil, with interest rates soaring and the U.K. pound plunging. Although the administration later made a policy change, the turmoil continued, forcing Prime Minister Truss to resign. In Japan, where the Bank of Japan has maintained monetary easing (low interest rates), the people, rather than the market, showed a negative reaction to the government’s policy course, delivering the “Kishida Shock.”

It is doubtful in the first place whether the tax cuts are “sure to increase disposable income, expand consumption, and realize a virtuous circle” as Prime Minister Kishida asserts. From the perspective of economics, personal consumption depends not only on current income but also on expectations for future income. The tax reduction will not significantly change future income as long as it remains a one-off measure, rather than a permanent one. Like in the case of the universal provision of benefits of 100,000 yen per person (special fixed-amount benefits) that was implemented during the COVID-19 crisis, most of the additional disposable income generated in this case may be set aside as savings.

However, continuing tax cuts for two years or longer is not desirable. If a multi-year tax reduction aggravates the government’s fiscal position, leading the people to anticipate austere fiscal consolidation measures, such as future tax increases, it would merely result in more savings being set aside in preparation for such austerity, as suggested by the Ricardian equivalence theorem. For that matter, the tax revenue increase that was already received does not exist as a surplus for free use, but is already needed to finance social security expenditures.

Raising the Economic Growth Rate Is Important

Into the future, in addition to social security expenditures increasing due to the aging of society, pressures for increasing spending on defense and measures to raise the low birth rate will continue. Japan’s fiscal position has no room left for implementing tax cuts under the pretext of returning the tax revenue increase to the people. The fall in the approval rating for the Kishida administration may be reflecting the negative reaction of people who expect that the current pork-barrel policy measures, including the tax reduction, far from eliminating the sense of social and economic helplessness, will only heighten concerns over the future.

The important thing to do is to increase supply capacity and raise the economic growth rate in the medium and long terms. The government should carry out structural and regulatory reforms to raise the growth rate, including promoting the digitalization and rejuvenation of the economy. A higher economic growth rate will lead to sustainable wage increases, resulting in an increase in the people’s disposable income without tax cuts, and removing concerns over the future. As for the return of the benefits of economic growth to the people, the government should take the long-term perspective of returning the benefits to future generations by creating fiscal room for dealing with future crises through the consolidation of its weak fiscal position.

>> Original text in Japanese
* Translated by RIETI.

December 16, 2023 Weekly Toyo Keizai

January 30, 2024

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