CEIC News@lert: Can Japan Strengthen its Fiscal Position Without Losing its Growth Momentum?
October 1, 2014 THEME After experiencing two decades of slow growth and mild deflation, the Japanese economy has gradually showed signs of recovery since the launch of “Abenomics”, the signature economic policy of the present Abe administration in early 2013. While one of the three prongs of Abenomics (alongside monetary easing and structural reforms) is to increase government spending to revitalize the economy, this Keynesian approach may endanger the country’s fiscal position which was already fragile before the government took office in late 2012. THE FISCAL IMBALANCE To understand Japan’s high government debt, which is double the size of its nominal GDP, it is worth focusing on the public finance of Japan over the past two decades. This may provide us with more clues on how government revenue and expenditure have evolved over this period. Over the past two decades, general government expenditure exceeded general government revenue in most years, while the deficit widened considerably since the downturn from the global financial crisis of 2008-09. This deficit has so far been financed through the purchase of Japanese government bonds by Bank of Japan (BOJ), but BOJ’s balance sheet cannot continue to expand indefinitely without raising concerns about its implication on fiscal discipline of the country. Taking a closer look at the government’s revenue sources may be useful to develop a more sustainable solution to address the problem of the weakening fiscal position. Previously, in fiscal year 1994 (ending March 1995), tax revenue was the primary source of government revenue, with taxes on income, profits and capital gains (TIPC) amounting to half of the total revenue. However, as shown in the next pie chart, the government revenue structure has undergone some changes after two decades. While taxation continues to be the primary source of revenue, its importance fell from 44.04% to 36.35%. In absolute terms, tax revenue dropped by 6.8% over the period. The drop in the share of tax revenue to total government revenue was mostly explained by the significant decrease in the tax on TIPC, by 16% over the period. This may be attributed to the ageing demographics of Japan, hence resulting in the lower income tax collected, and to the lower earned profit by Japanese large corporations in recent years. On the other hand, tax revenue from goods and services has been more stable and has acted as an increasingly important source of government income, increasing by 15% over the same period. It should be noted that the amount of tax received increased significantly after the implementation of the national sales taxes in 1997. Against this backdrop, the Abe administration has announced a two-phase sales tax hike from 5% to 8% in April 2014 and a proposed further increase to 10% in 2015. THE ECONOMIC IMPACT Prior to the sales tax hike, front-loaded household consumption caused sharp growth in retail sales and household expenditure in 2014Q1, but the buoyant domestic consumption was soon replaced by a slump in 2014Q2 as the sales tax hike took effect on April 1. Department store sales, considered as one of the leading indicators for the official retail sales figures, recorded negative year-on-year (Y-o-Y) growth in the four consecutive months after the April tax hike, after adjusting for the number of stores. For durable goods, such as passenger cars, domestic sales also experienced a sharp correction starting from April 2014, with the number of cars sold falling from 1,590,110 units in 2014Q1 to 976,437 units in 2014Q2. Correspondingly, monthly real household living expenditure shared a similar pattern of development with a stunning increase in March 2014 (7.1% Y-o-Y growth), followed by negative Y-o-Y growth from April to July. At the corporate level, the latest official figures on corporate business performance show that retailers were hit hard by the sales tax hike, with total sales in 2014Q2 as low as the sales figures during the worst point of the financial crisis in 2009Q2. Given this, the profit margins of retailers were also eroded. Furthermore, the drop in profit led corporate decision makers to be more cautious in their investment plans. Total investment on plant and equipment by retailers has recorded a mildly decreasing trend since 2013Q4, amid the weakening domestic market and uncertainty surrounding the effect of the second round sales tax hike due in 2015. In terms of prices, whether Japan can lift itself out of the decade-long deflation trap is considered to be one of the criteria for evaluating the successfulness of Abenomics. Thanks to the weakening Yen since Abenomics was introduced, both the core consumer price index (CPI) and producer price index (PPI) are now registering inflation after adjusting for the upward effect on the indices from the sales tax hike. As at July 2014, Japan registered CPI inflation of 3.4%. In the labour market some improvement has been observed with the seasonally-adjusted unemployment rate below 4% since the end of 2013. However, given that employment figures are “lagging indicators”, more time will be needed to analyze the effect of the sales tax hike on the job market. The average 2.4% Y-o-Y rise in cash earnings across industries seen in the July revised statistics is the highest percentage gain since the data were first published in October 2007. While more time will be needed to assess its sustainability, the increase partially offsets the decrease in purchasing power of income earners from rising prices. *Core CPI (excluding direct effect on Sales tax) was estimated to be around 1.25% according to the BOJ’s Monetary policy meeting minutes on August 7 and 8. CAN THE ECONOMY SURVIVE ANOTHER SALES TAX HIKE? The revised national accounts show the country’s real GDP shrank by an annualized 7.1% in 2014Q2, with the percentage point contributions from each GDP component by expenditure as follows: *Latest figures as per official releases on Sept 8, 2014; data subject to further revision. Empirically, household expenditure and corporate capital spending account for 60% and 15% of Japan’s GDP, respectively, and the sharp fall in these two components was the reason why GDP shrank in the second quarter. On the other hand, while the contributions from inventories and imports kept Japan from falling into a double-digit GDP contraction, the consumption and investment figures implied that domestic demand was very weak in the quarter. The export sector also faced strong headwinds and recorded a negative contribution, despite the Yen depreciating. Overall, with the implementation of the sales tax hike, the economic performance of Japan in 2014Q2 was disappointing, and the key question is whether the economy can regain its growth momentum for the rest of 2014. Data collected from surveys of households and corporations’ expectations may shed some light on the short term economic outlook. The latest BOJ “Opinion Survey” on households in June 2014 illustrated that only 4.6% of surveyed households would increase their spending during the next 12 months, which is the lowest result since Prime Minster Abe took office in late 2012. Another key survey conducted by the BOJ over the same period, the “Tankan Survey” of business expectations, similarly showed that retailers were pessimistic in the wake of the sales tax hike with the business conditions index dropping from +19 in 2014Q1 to -13 in 2014Q2. The index is calculated by subtracting the percentage of firms with a negative outlook from the percentage of firms with a positive outlook. The next releases of the BOJ’s Opinion Survey and the Tankan Survey are due in early October and will provide more information on how the economy is likely to perform for the rest of the year. What is certain is that the Abe administration is facing a dilemma in trying to strengthen its fiscal position by introducing incremental rises in the sales tax rate without suppressing economic growth. Discuss this post and many other topics in our LinkedIn Group (you must be a LinkedIn member to participate). Request a Free Trial Subscription. Back to Blog