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How Did the Abe Cabinet Attempt to Mitigate the Economic Pain From Its Tax Hike?

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How Did the Abe Cabinet Attempt to Mitigate the Economic Pain From Its Tax Hike?

Japan’s GDP fell by 6.3 percent after the sales tax hike. The Abe government must have seen that coming.

How Did the Abe Cabinet Attempt to Mitigate the Economic Pain From Its Tax Hike?
Credit: Pixabay

On February 17, the Cabinet Office announced that Japan’s Gross Domestic Product (GDP) from October to December 2019 fell by an annualized rate of 6.3 percent. The shrinking of the Japanese economy was obviously the result of the consumption tax hike from 8 percent to 10 percent as of October 1, 2019. Japan’s GDP previously shrank by 7.2 percent after the sales tax was raised from 5 percent to 8 percent in April 2014.

The government plans to use the increased revenue to provide free childcare and early education. At the same time as the tax hike, the Japanese government introduced a so-called “reduced tax rate system,” under which the tax rate for foods and beverages (except for alcohol) remained at 8 percent. Also, a new cash-back reward was introduced for cashless payments. It seems that the introduction of multiple tax rate systems and the cashless payment system led to temporary confusion at stores to a certain extent. Was the sales tax hike to 10 percent, along with the introduction of a multiple tax rate system, the right decision for the Japanese economy?

Looking back on the history of Japan’s sales tax, the policy has long been unpopular among the Japanese people. In fact, there were controversies over the necessity of introducing a sales tax during administrations of Prime Ministers Masayoshi Ohira (1978-80) and Yasuhiro Nakasone (1982-87), but the attempts ended up in failure. Through a trial and error process, however, the Noboru Takeshita government introduced a sales tax system for the first time on April 1, 1989 with a rate of 3 percent. Unsurprisingly, the sales tax on foods and other necessities increased the burden on low-income earners, and eventually, Takeshita was forced to step down from the prime minister position.

After the resignation of Takeshita, the new tax became a central issue in the upper house election, which took place in July 1989 during the Sosuke Uno administration. Due to the dual impact of a corruption scandal and the new sales tax, the Liberal Democratic Party (LDP) lost its majority in the upper house for the first time since its initiation, whereas opposition parties, especially the Japan Socialist Party (JSP), earned a large increase in their number of seats in the Diet.

In the so-called “twisted Diet,” the opposition parties attempted to abolish the sales tax system, although the attempt failed in the end. In the lower house election during the Toshiki Kaifu administration, the LDP promised to reconsider the sales tax system, and successfully won the election, but could not fulfill its campaign pledge due to the twisted Diet.

In order to tackle a budget deficit following the collapse of the bubble economy, the Japanese government, especially after the Kiichi Miyazawa Cabinet, began considering the necessity of tax system reform. After similar discussions during the administrations of Prime Ministers Morihiro Hosokawa (1993-94), Tsutomu Hata (1994), and Tomiichi Murayama (1994-96), Prime Minister Ryutaro Hashimoto adopted a tax hike policy at a Cabinet meeting in June 1996, and finally raised the sales tax to 5 percent in April 1997. The tax hike by the Hashimoto government caused a long period of deflation in Japan, and the following prime ministers did not dare to tackle a sales tax hike for a long time afterward.

However, the Yoshihiko Noda administration facilitated the tax system reform, and the Democratic Party of Japan (DPJ), the LDP, and Komeito agreed on a further sales tax hike in June 2012. On April 1, 2014, the Shinzo Abe government raised the consumption tax to 8 percent. Moreover, the LDP-Komeito coalition government decided on a further tax hike to 10 percent and introduction of reduced tax rate system. On January 14, 2015, the Abe Cabinet decided to reschedule the timing for the tax hike from October 2015 to April 2017. A few months later, on March 31, 2015, tax revision legislation was enacted with support of the LDP, Komeito, and the Party for Future Generations in the Plenary Session of the upper house. The legislation decided on the sales tax hike to 10 percent regardless of the economic environment.

Yet some politicians and economists showed their opposition to the tax hike planned by the Abe government. Domestically, opposition parties, such as the Japanese Communist Party (JCP) and the Socialist Democratic Party, were against the plan. Sayumi Iwamoto, affiliate professor of Osaka University of Economics, pointed out that the sales tax hike could decrease domestic consumption and would have a negative impact on the Japanese economy.

Internationally, Nobel laureate economists showed “conditional opposition” to Japan’s sales tax hike. Paul Krugman highly evaluated the short-term success of “Abenomics,” but he argued that the sales tax hike would be better coming after the Japanese economy became more stable, to the extent that inflation replaces deflation. For the same reason, Joseph Stiglitz criticized Japan’s sales tax hike plan as “premature” and a “risky strategy.”

In spite of the domestic and international criticism, after two postponements, the Abe government indeed raised the sales tax rate to 10 percent on October 1, 2019.

Why was the additional sales tax hike necessary in Japan? According to the Japanese Ministry of Finance, the primary reason was, of course, to secure revenue, especially for social security in an aging society with fewer children. The Ministry also explained that, unlike personal income tax or corporate income tax, the consumption tax is stable, and therefore, a sales tax hike was considered to be appropriate.

The Ministry of Finance then referred to a comparative analysis of value added tax (VAT), equivalent to the consumption tax in Japan, and pointed out that VAT tax rate in Japan is obviously low. Indeed, the VAT rates of most member states of the European Union (EU) and the Organization of Economic Cooperation and Development (OECD) are more than 20 percent on average. Even compared to neighboring countries in Asia, such as China (17 percent) and South Korea (10 percent), the VAT rate in Japan has been relatively low. Given the domestic and international factors above, the Abe government decided on the second sales tax hike.

Nevertheless, the so-called “regressive” nature of a consumption tax remains a fundamental problem. Generally, a consumption tax is considered to be regressive, because the burden ratio of low-income earners tends to be larger than that of high-income earners. Therefore, measures to help low-income earners have been considered alongside the consumption tax hike.

In order to counteract the regressive nature of the consumption tax and its impact on low-income earners, Komeito, as a coalition partner of the LDP, advocated the introduction of the “reduced tax rate system” for daily necessities in reference to the multiple tax rate system in European countries. European countries, in which the VAT rates are approximately 20 percent on average, have introduced lower tax rates on groceries, books, newspapers, medicine, etc. as a measure against the regressive nature of the VAT.

Following the example of European countries, the introduction of the reduced tax rate system in Japan was necessary when the sales tax was raised to 10 percent. In other words, the introduction of the multiple tax rate system was viewed as an effective way to mitigate the pain of the sales tax hike on Japanese customers.

Meanwhile, the International Monetary Fund (IMF) on February 10 called on Japan to raise the sales tax to 15 percent by 2030 and to 20 percent by 2050 so that the Japanese government could deal with its budgetary deficit amid an aging society. From the perspective of the IMF, therefore, the sales tax hike to 10 percent in Japan was appropriate at this stage, but not at all sufficient in the longer term.