Higher Japanese Sales Tax: The Good and The Bad

Early this week, the yen got sold off across the board when better-than-expected capital spending data lessened the obstacles for Japanese Prime Minister Shinzo Abe to implement a sales tax increase. The data came in unchanged from a year earlier in the second quarter, which some analysts believe is enough for an upward revision of that period’s GDP.

If you remember, Shinzo Abe has been making headlines with his proposal to increase the country’s sales tax from 5% to 8% in April 2014 and up to 10% in October 2015. With 44 out of the government’s 60-man advisory panel already giving the thumbs up on the plan, it’s time to look deeper into the possible effects of the sales tax increase.

The good: Higher government revenue

Simply put, a higher sales tax would give the government more revenue. This means that it would have more budget to possibly add to its stimulus packages, pay off its ballooning social welfare costs, and even build confidence that the nation could pay off its debts, which is already worth twice its GDP.

Today, some are saying that even a delay in the sales tax increase would cause a surge in the 10-year government bond yields, which would make the government’s debt even more expensive. Yikes!

The bad: Weaker growth prospects

A couple of economic hotshots on Abe’s advisory team, namely Etsuro Honda and Koichi Hamada, opposed the large increase in sales tax and recommended only a 1% hike each year at most. For them, the government shouldn’t pump taxes higher while the Japanese economy is still stuck in deflation. After all, Japan just shifted into recovery mode earlier this year, as the BOJ’s massive easing efforts boosted spending and inflation.

If Abe insists on such a sharp increase in sales tax, the budget for the next fiscal year should have room for additional stimulus measures that might be necessary to keep the economy afloat. Number crunchers are projecting a 4.4% annualized contraction by the second quarter of 2014 if the sales tax increase pushes through. With that, Japan might need roughly 5 trillion JPY of extra stimulus to offset the negative impact of higher sales taxes on overall economic activity.

Don’t panic though! Nothing is set in stone yet, as Abe has announced that he will wait until next month to make the decision. He plans to take a look at the results of the Tankan business sentiment survey, which is set for release on October 1, before giving the go signal on the proposed tax increase.

For now, the government is also examining the potential effect of the tax hike on household spending and business investment. Some officials have come up with other suggestions to shore up the budget while keeping growth stable, such as reducing other taxes or coming up with alternative sources for government revenue.