Ezrati’s Economic Outlook: Japan’s Sales Tax Risk

The need to address Japan’s budget situation is beyond cavil. Japan has the distinction of facing the worst fiscal situation in the developed world. This year, the country will likely see deficits rise to about 10% of its gross domestic product (GDP). Huge deficits plagued Japan for years as the government tried to prop up the economy’s meager growth prospects. Now Japan also faces a huge debt overhang. According to the Ministry of Finance, outstanding bond obligations of the central government equal close to 150% of GDP. Including local governments, the outstanding debt is almost double GDP. Debt servicing costs have roughly doubled as a percent of total outlays since 1980 and this fiscal year, even with interest rates as low as they are in Japan, will amount to about 25% of all government expenditures. There is a real concern that matters have reached a point when these expenses will crowd out other necessary and legitimate government functions and bring on the untenable situation in which government goes deeper into debt largely to meet the obligations on its existing debt.

But if the need for fiscal reform is obvious, questions nonetheless remain over whether a sales tax hike is the way to go about it. History would argue otherwise. Back in April 1997, then-Prime Minister Ryutaro Hashimoto went this route despite a lot of opposition within Japan’s Diet (parliament) and the public. A recession began immediately after he raised the national sales tax from 3% to 5%. Consumer spending, which had been growing at better than a 4% annual rate, fell during the second half of that year and into the middle of 1998. At the slowdown’s worst, the Japanese consumer made real cutbacks at a yearly rate of over 4%. Though the Japanese consumer is a less significant part of Japan’s economy than the American consumer is of the U.S. economy, the economic effect was profound. Japan’s real GDP sank, and knock-on effects kept it declining. The country did not show positive growth until late 1999, more than two years after the tax went into effect. Because of the economic shortfall, the budget deficit, rather than shrinking, about doubled from its 1996 level.