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Japan sales tax hike: Ready to take the pain?

Publication Date: 05 Jul 2019 - By Continuum Economics By Continuum Economics
Actionable
Differentiated

FX & Rates Investment Strategies Macro Multi Asset Asia ex-China

By Jiaxin Lu and S. Pinar Darendeli

• The Japanese government is trying to press ahead with the planned sales tax hike this year. While the previous sales tax hike tipped the economy into a temporary recession, Prime Minister Shinzo Abe’s government is hoping that this time will be different.  
• Bottom line: The planned sales tax hike could deal another blow to the economy, but the impact is likely to be smaller this time. Our simulation results show that, while Japan’s output growth in 2019 will still be positive (0.5%), 2020 will see drop down to -0.4%. However, various government support measures may help cushion the potential blow to household consumption. 
• Market implications: USDJPY has tended to rally ahead of government announcements of a delay in the tax hike. However, due to the complications arising from the U.S.-China trade war and other geopolitical events, a further delay in the tax hike may not necessarily push USDJPY higher. 

Figure 1: Increase in Tax Revenue From Previous Sales Tax Hikes Helped Improve Fiscal Deficit (% of Nominal GDP)

(Source: CEIC, Continuum Economics)

A sales tax hike is crucial for Japan as it struggles with a large fiscal deficit (Figure 1) and rising social welfare costs due to an aging population. Japan’s consumption tax was introduced in 1989 at a 3% rate and it has been raised twice since—first to 5% in 1997 and then to 8% in 2014. There has been heated debate in the markets about the implementation of the next sales tax hike, as the previous one resulted in a sharp contraction in Japan’s economy. 

A tax hike from 8% to 10% was originally planned for October 2015, but it has been delayed twice due to the unfavorable economic situation. The Japanese government is now trying to pull the trigger on a tax hike this October, unless a global slump hits Japan. 

Japan’s economy still lacks strength in our view. The better-than-expected growth in Q1 came as a relief at first glance, but a closer look reveals some weakness in domestic demand. The planned sales tax hike could deal another blow to the economy, but the impact is likely to be smaller this time than in the first two instances. 

How Is it Different This Time?

Although the previous tax hike in 2014 resulted in a temporary recession, the Abe government is hoping that the impact will be different this time. For one, the degree of the planned tax hike is smaller this time around (from 8% to 10% compared with 5% to 8% previously). Additionally, this would be the first time that a split rate is implemented: The current rate of 8% would still apply for food and drinks (excluding dining-out services and liquors) and subscribed newspapers published twice or more a week. By excluding these frequently purchased necessities, we believe that it may help to alleviate the impact on household consumption.

In addition to free early childhood education and benefits for low-income pensioners, the government is considering introducing further supportive measures in the form of expanding housing loan tax credits and subsidies for purchasing automobiles and other large consumer durable goods. 

Estimating the Impact of a Sales Tax Hike

Figure 2: The Tax Hike Is Estimated to Negatively Affect Japan’s Consumption and Growth (%)

(Source: Continuum Economics)

Our analysis* (using our global macro-econometric model of choice, NiGEM) suggests that Japan will end 2019 with an average annual growth rate of 0.5%, affected by the drop in consumption growth following the fall in real wages due to higher taxes. However, the negative impact of the tax hike on consumption and GDP growth is greater in 2020, with GDP growth declining to -0.4% (Figure 2).

However, our analysis does not capture the effect of mitigating measures by the government, which are likely to help reduce the negative impacts. According to estimates by Japan’s Ministry of Finance, measures to stimulate consumer spending amounting to approximately ¥2.3 trillion, or 0.4% of GDP, are believed to be more than enough to offset the adverse impact of the tax hike. 

Figure 3: The Previous Tax Hike Did a Number to Household Consumption (% y/y) and GDP Growth (% q/q SAAR)


(Source: CEIC, Continuum Economics)

The previous tax dealt a heavy blow to the economy. Household consumption, which accounts for about 60% of Japan’s economy, was badly hit; it slowed down to 0.3% y/y in Q2 2014 when the tax was increased and only started to recover about a year later (Figure 3). Household spending continues to grow, but at a much slower pace due to weak wage growth. The global slowdown has dampened external demand this year, so stronger consumption growth is needed to prop up overall growth this year. 

The tax hike impact on household consumption is estimated to be smaller this time around, not only because the tax rates of some daily necessities will be kept constant, but also because various forms of support are available for low-income households. 

However, since most of the implementation period only lasts for six months to two years after the tax increase, there are still concerns over the longer-term impact on household spending once various support measures are withdrawn and the Olympics-related boost winds down. 

While the Japanese government is trying to press ahead with the sales tax hike, poor economic data could still cause another delay in our view. The Japanese economy continues to face various challenges on both domestic and external fronts. The main risk factors stem from the intensification of U.S.-China trade tensions, a slowdown of the Chinese economy and the continued decline in global IT-related demand. In the event of a further escalation of trade tensions, the adverse effects on business, consumers and the financial market could amplify the downside risks to growth. Under these circumstances, Japan’s economy would be in an unfavorable situation. 

Key Data Points to Watch

There are several events and data releases that we will be closely monitoring, which will shed some light on the state of the economy ahead of the sales tax hike. Meanwhile, Japan will hold its Upper House election in July, and the imminent sales tax hike will likely be at the center of the discussion. 

Figure 4: A Calendar of Key Events and Data Releases Before the Planned Sales Tax Hike


(Source: Bloomberg, Continuum Economics)

Market Implications

If past experience is any guide, USDJPY has a tendency to rally ahead of the government’s announcement of any delay of the sales tax hike. However, given that the yen is also inclined to move with the general tone of risk appetite driven by international events, a delay in the tax hike may not necessarily push USDJPY significantly higher this time. 

NOTES:

Continuum Economics assumes that tax rates will be kept at 10% permanently, and the Bank of Japan (BoJ) will keep the short- and long-term interest rates constant until the effects of the tax hike diminish. The research firm also assumes that, just like in the previous tax hike of 2014, consumers will frontload their consumption by increasing their spending in the quarter before the tax hike by around 1%.

More from Continuum Economics

Podcast: Latin America economic overview, 28 June 2019
Global outlook overview: Running into headwinds, 15 March, 2019
Continuum Economics Q1 2018 Global Outlook (Free sample), 4 March 2019

Disclosure:

I have no positions in any of the securities referenced in the contribution

I do not use any non-public, material information in this contribution

To the best of my knowledge, the views expressed in this contribution comply with UK law

I agree with the terms and conditions of ReachX

This contribution is for informational purpose and does not constitute investment advice nor is it an offer to sell or buy, nor is it a recommendation for any security.

Continuum Economics

 

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