RIETI Report June 2016

Estimating the harm Japan's next VAT rate increase will inflict on the economy

One of the most important political issues that the Japanese government has faced is when to implement the planned consumption tax rate hike, which was announced recently by Prime Minister Shinzo Abe to be postponed to October 2019. Although the first tax increase from 5% to 8% occurred as planned in April 2014, the second increase from 8% to 10% originally scheduled for October 2015 was postponed initially to April 2017, and, now legislation is being initiated to delay it once again to October 2019. In the June issue of the RIETI Report, we present the column "How much harm will Japan's next VAT rate increase inflict on the economy?" originally published on VoxEU by David Cashin of the Federal Reserve Board of Governors and Faculty Fellow Takashi Unayama, where the authors discuss the response of household consumption to Abe's announcement and the April 2014 tax rate increase, as well as what these responses may imply for the next tax rate increase.

While the tax rate increase is viewed as critical to Japan's pursuit of fiscal consolidation, the government is concerned about the potential harm to the economy due to reduced household consumption. Cashin and Unayama first look at the past responses to tax increases under a theoretical framework that analyzes household decisions which posits that a household's consumption depends solely on its "permanent income," or the expected average real income over its lifetime. The implication is that a shock to household income induces a change in consumption once it is recognized regardless of whether it has yet been realized. They then analyze the 2014 tax increase and find that household consumption fell by around 4% upon Abe's announcement and 1% upon implementation in April 2014, indicating that most of the negative impact of the tax rate increases indeed occurred at the time of announcement. Accordingly, Cashin and Unayama suggest that the harm to the economy from the next tax rate increase will not be as great as was the case in 2013-2014 as households have already reduced their consumption in anticipation of a future tax rate increase.

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Estimating the harm Japan's next VAT rate increase will inflict on the economy

UNAYAMA TakashiFaculty Fellow, RIETI

David CASHIN Economist, Federal Reserve Board of Governors

One of the most important political issues facing the Japanese government is when to further increase its value added tax (VAT) rate. In fact, Japan's prime minister, Shinzo Abe, recently announced the postponement of the tax rate increase planned for April 2017 until October 2019. The law for the subsequent VAT rate increase originally passed the Diet (legislature) in 2012, and in October 2013, Abe officially confirmed that the VAT rate would increase from 5% to 8% in April 2014, and from 8% to 10% in October 2015. Although the government increased the VAT rate from 5% to 8% as planned in April 2014, it shortly thereafter postponed the second increase until April 2017. And now, the government is initiating legislation to delay the VAT rate increase once again.

While the VAT rate increase is perceived as being critical to Japan's pursuit of fiscal consolidation (Japan's debt to GDP ratio of more than 200% is the highest among major industrialised countries), the government is concerned that the tax increase may harm the economy by reducing household consumption. To investigate this concern, in this column we consider the response of household consumption to the October 2013 announcement and the April 2014 rate increase. We further examine what these responses might imply for the next VAT increase.

To read the full text
http://www.rieti.go.jp/en/columns/v01_0061.html

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