Abeconomics, deflation and the consumption tax

by George Hatjoullis

Sales & Consumption Tax Rates from around the ...

Sales & Consumption Tax Rates from around the World (Photo credit: MatthewRad)

Abe is mulling raising the consumption tax. It is presently 5% and the plan is to raise it, in stages, to 10%. Peter Tasker correctly reminds FT readers (http://on.ft.com/1443CUp) that when the tax was raised in 1998 it presaged a lost decade for the Japan economy. The consumption tax is often assigned a causal role in this lost decade. This may well be correct but what was not appropriate in 1998 need not necessarily always be inappropriate. It all depends on the context.

The problem Japan faces, as has been explained at length in previous posts, is to break structurally negative inflation expectations. The expectations manifest in the form of continuous excess demand for fiat money and the holding of large cash balances by economic agents. The cash balances are built up by deferring expenditure. This has been the enduring characteristic of the so-called lost decade.

Does a consumption tax reinforce or help break this depressive pattern of behaviour? It could be argued that it helps break this pattern. The prospect of rising prices, however induced, should bring forward expenditure. If economic agents know that prices will rise with certainty over the next year then, other things being equal, they should bring forward expenditure. The cycle of deferral is thus broken, if only for a short while. However, given how entrenched this pattern of expenditure deferral has become any interruption could be cathartic and have longer term effects. If it helps boost the Japan economy over the next year it might help start a new phase of optimism.

The effect of a consumption tax could also be positive in broader terms. Too the extent that it calms the bond markets it is very beneficial. The risk to Abeconomics, as has been elaborated, is a bond market panic and abrupt jump in yields. Pressure on yields to rise is coming from the USA, as well Abeconomics itself, so anything that might weaken this correlation is to be welcomed. A higher consumption tax constitutes a structural improvement in the tax base of Japan. At 5% one can hardly argue that the tax is high, especially when one compares it with comparable taxes elsewhere (see table).

The most effective path to breaking inflation expectations is, of course, debt cancellation and this has been the constant theme of all my Japan blogs. However, Abeconomics has stopped short of this policy option. Debt cancellation is pure monetary financing of government expenditure and a consumption tax is as far from such a policy as one can get in conventional fiscal policy terms. However, the effect on the central problem may not be dissimilar. Both debt cancellation and a staggered increase in the consumption tax have the capacity to break the structurally negative inflation expectations and the constant cycle of deferred expenditure. It is an odd argument to offer but the situation in Japan is quite unique. The impact of a consumption tax, may perversely, be positive on this occasion.