The Impact of a Permanent Income Shock on Consumption: Evidence from Japan's 2014 VAT increase

Interviewee UNAYAMA Takashi (Faculty Fellow, RIETI)
Issue date / NO. Research Digest No.13
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When Japan's consumption tax rate, which is a value-added tax (VAT) rises, it causes the price of goods to increase proportionally, which in turn represents the proportional reduction in lifetime disposable income. In other words, according to the life-cycle/permanent income hypothesis (LCPIH), which posits that personal consumption behavior is determined by lifetime disposable income, we can expect that a VAT rate increase will cause consumption to fall proportionally. RIETI Faculty Fellow Takashi Unayama analyzed the impact on consumption of the April 2014 VAT rate increase from 5% to 8% and verified that this theoretical prediction holds true. He also focused on "hand-to-mouth" households, which do not follow the LCPIH, and identified how a VAT rate increase have impacted these households. ( Interviewer: Yoshiyuki Arata, Fellow, RIETI)

Overview of the research

Q: Could you outline your research?

Unayama: A VAT rate increase in Japan causes the prices of goods to rise proportionally. This means that if we take future income as a given, lifetime disposable income will fall. Following the standard LCPIH, a decline in lifetime disposable income should bring about an equivalent decline in consumption. In a recent joint research study with David Cashin, an economist with the Board of Governors of the U.S. Federal Reserve System, using the National Survey of Family Income and Expenditure data on Japanese household expenditures, we examined whether the 2014 VAT rate increase caused any changes in consumption as predicted theoretically.

According to the LCPIH, consumption should decline as soon as households become aware of the VAT increase. To determine whether consumption has changed as the theory suggests, it is necessary to know when households become aware of the increase. However, in general, it is challenging to identify the precise point in time at which households become aware of a tax increase (what we call the tax increase announcement time) because not every household is aware of the tax increase at the same time.

The policymaking process, starting with the government's recognition of a need for a VAT increase, takes a long time. In the meantime, people gradually share information, and under normal circumstances, everyone has already taken the VAT increase into account by the time it is actually implemented.

The 2014 increase, however, was decided under special circumstances that made it possible to identify the time of announcement. The special circumstances were the fact that Prime Minister Shinzo Abe had a free hand to implement a VAT increase as soon as he took office. This is to say that the increase was decided not by a complicated legislative process but merely by a decision of the prime minister. Under those circumstances, when Prime Minister Abe held a press conference on October 1, 2013 to unveil the increase, attention was highly focused on the event, and this became a clear declaration of a tax increase.

Changes in consumption were observed at the time, taking October 1, 2013 as the tax increase announcement time. The result was an approximately 4% decline in consumption in October 2013, along with a decline of about 0.5% in April 2014 when the increase went into effect. This roughly corresponds to the 5% tax increase that was initially planned, so, in large part, changes were observed that were in line with the theory.

Q: Do you mean the slowdown in consumption was just as predicted?

Unayama: Actually, I had not expected the drop in consumption to be quite that large. Although I thought there would be some impact from the drop in lifetime disposable income, I thought that it would be adjusted long before the increase went into effect, and that the observed change in consumption would be small. In fact, in another research study that I conducted with Cashin analyzing the impact of the 1997 VAT increase, we found hardly any change in consumption at the time set as the announcement time, and the change in consumption upon implementation of the increase was very small as well.

The results show, however, that Japanese households hardly took the effect of a drop in lifetime disposable income into account as they believed there was enough of a possibility that the increase would be postponed or suspended.

In other words, the change actually observed was as suggested by the LCPIH and could have been predicted by theory. What was not predicted, however, was that the effect of the increase announcement could actually be observable. In that sense, Prime Minister Abe's decision had a greater impact than predicted.

Q: So the cause of the recent economic stagnation is the VAT rate increase?

Unayama: What our analysis tells us is that the VAT rate increase had about a 5% effect on the decline in consumption compared to prior to the announcement of the increase; namely, the period through September 2013. Looking at subsequent trends, however, we see consumption declining again, starting at about the end of 2015. I don't really know the reason for this, but the timing makes it seem like it cannot be the effect of the VAT.

I believe there still is room for verification in the premise that a VAT rate increase deteriorates the economy. When the VAT rate increase occurred in April 1997, the preliminary figures that were announced based on economic indicators gave the impression that the economy had reached a turning point in April of that year, which exerted a traumatic influence on the Japanese households. Even if the impact of the VAT cannot be ignored, it is impossible to imagine that it has a catastrophic effect on the economy.

Figure: Impact of VAT Increase on Consumption
Figure: Impact of VAT Increase on Consumption

VAT increase postponement effect

Q: I understand your recent research looked into the first postponement of an increase in November 2014. Was the postponement effective in boosting the economy?

Unayama: The results suggest that the postponement announcement raised consumption by more than 1%. Delaying a 2% increase by a year and a half should be equivalent to a 2% tax break during those 18 months. Theoretically speaking, a tax break for a mere year and a half should not have much effect, so in consideration, it had a very great effect indeed.

One reason may be the possibility that it was perceived by some as a permanent tax cut. The increases in 1997 and April 2014 were implemented legislatively, but when an increase was postponed the first time, some households may have perceived this as meaning it was politically infeasible to increase the VAT again. This is a point I hope to fully consider going forward.

Q: There was also a second postponement. Do you think that was that the right thing to do?

Unayama: The reason for the postponement was probably to maintain consumption levels, but if the goal had been for the government to enhance predictability in consumption trends, they should have thought more carefully about how to announce the postponement.

A tax rate increase will inevitably have a negative impact on consumption, but that impact can be kept from showing itself if enough time is taken to allow the information to penetrate in and be digested. Sudden policy changes, such as declaring a postponement to a tax rate increase, may have a temporary positive effect, but it will always be coupled with a downturn that negates it. The government should take plenty of time to communicate its policy so that households can predict future trends more easily so as to minimize policy uncertainty.

A situation like this with many sudden postponements exacerbates policy uncertainty, making it unclear what things households are taking into account. The government cannot predict how consumption will react the next time it takes action. This is not a desirable situation for either households or the government.

Q: The government has not given up on its goal of turning Japan's primary balance to a surplus by FY2020. Is raising the VAT an effective way of achieving that?

Unayama: Several points come to mind. First, some would say that if a VAT rate increase leads to a corresponding consumption drop, tax revenues will not rise and therefore the tax rate increase would be meaningless. That is a major mistake, however, because what we are looking at is real consumption. If taxes rise by 5% and real consumption falls by 5%, then nominal consumption is flat, given tax-inclusive prices. In other words, in principle, a VAT rate increase raises tax revenue by as much as the tax rate increase. In that sense, a tax rate increase has a positive impact for getting the fiscal balance back in the surplus.

Also, if instead of a VAT rate increase, the government raised the expected value of future income, consumption would recover and tax revenue would rise as well. This means that the growth strategy should be raising the expected value of future income growth. Of course, if that can be achieved, tax revenue can be increased from sources other than the VAT, and this is an extremely desirable thing. But achieving it is difficult and does not necessarily contradict a VAT rate increase.

Table: Consumption Changes by HtM Status
Table: Consumption Changes by HtM Status
Note: This shows the deviation from the log of the average adjusted real monthly household income and non-storable, non-durable consumption. The adjusted ones are obtained from a regression of corresponding variables on month dummies and other control variables used in the regression analysis. *, **, and *** represent significance at the 10%, 5%, and 1% levels respectively.

Q: If the government were to raise the VAT rate to 10%, some reduced tax rates would be applied. Would this be an effective economic measure?

Unayama: This is somewhat off the topic of my recent research, but in general, applying reduced tax rates, which have a major impact on the relative price of goods, significantly distorts the market structure. Basically, this is not desirable. If we want to mitigate the impact of a tax rate increase on the macro economy, we should minimize the scale of the increase in the tax rate itself. On the other hand, if the purpose is to support households with certain attributes, such as the poor, transferring income instead of applying reduced tax rates has a lower administrative cost and would not, in my opinion, significantly distort the behavior of firms and households.

Existence of hand-to-mouth households

Q: In your paper, you talk about the behavior of hand-to-mouth households. How does this relate to the LCPIH?

Unayama: Many papers have already been devoted to testing the LCPIH. Some of these have made it clear that some households behave in ways inconsistent with the hypothesis. These are so-called "hand-to-mouth households."

In the context of the LCPIH, a hand-to-mouth household is one that lives by spending all of its expendable economic resources that are immediately available: monthly income, immediately available savings, and the like. The expression probably conjures up an image of the poor, but it is basically a separate concept. If a household which earns one million yen a month spends its entire income, that is a hand-to-mouth household. Another household may have an income of only 100,000 yen per month, but if it manages to save even a part of it, then it is not a hand-to-mouth household.

Hand-to-mouth households are thought to exist due to imperfect capital markets that keep households from borrowing appropriately and from practicing optimal consumption as determined by LCPIH. A household may appear to be restraining consumption due to a relatively low current income as well as an inability to borrow despite expectations of a higher income in future and thus increased consumption.

Q: How do hand-to-mouth households react to VAT rate increases?

Unayama: Consumption by hand-to-mouth households does not decline even if a VAT rate increase is announced, and households recognize that their lifetime disposable income will be reduced. The reason is that their optimal consumption level is higher than what their current income allows. So a VAT rate increase does not cause much change in household consumption even if optimal consumption level falls.

We actually observed changes in consumption by classifying households into "hand-to-mouth" and "non-hand-to-mouth." The results confirmed that hand-to-mouth households do not lower their consumption at the time of announcement of a tax rate increase. In that sense, the results show that changes in consumption are consistent with our verification of the LCPIH.

We do understand, however, that Japan has a lower percentage of hand-to-mouth households than other industrialized nations. Therefore, we saw a reaction to VAT rate increases that was closer to a simple LCPIH.

Future research themes

Q: Could you tell us about your research themes going forward?

Unayama: As far as VAT rate increases are concerned, having more hand-to-mouth households provides a more stable support for consumption. Conversely, when governments temporarily give out cash as an economic measure, hand-to-mouth households respond more faithfully to such stimulus measures, because these are households that would like to consume if only they had cash available. In that sense, hand-to-mouth households are a desirable thing for the government.

However, we do not intuitively think it is desirable to adopt policies that actively try to increase the number of hand-to-mouth consumers with some kind of constraint. On the other hand, it is conceivable that hand-to-mouth consumers will increase if there is an expectation of future income growth and a rise in interest in illiquid assets such as housing.

In that sense, when a growth strategy performs well, the government has more freedom to undertake policies. In the future, I would like to continue verifying the LCPIH as well as further addressing the role of hand-to-mouth consumers in economic initiatives.


UNAYAMA Takashi is an associate professor at the Institute of Economic Research, Hitotsubashi University. He has been a faculty fellow at RIETI since 2009. His research areas cover household behavior, applied econometrics, and the Japanese economy. His works include "Measuring Intertemporal Substitution in Consumption: Evidence from a VAT Increase in Japan," (with David Cashin), Review of Economics and Statistics, vol. 98, no. 2, pp. 285-297. (2016)