January 24, 2011 / 9:24 AM / in 7 years

Q+A-Japan's prospective sales tax hike, impact on economy

TOKYO, Jan 24 (Reuters) - Japanese Prime Minister Naoto Kan has put social security and tax reform at the top of his policy agenda, seeking to increase the politically sensitive consumption tax to fund welfare costs in a fast-ageing society.

Economists say raising the consumption tax, now 5 percent and among the lowest in major economies, is vital for Japan, whose public debt is about twice the size of its $5 trillion economy, but if done immediately it could undermine a fragile recovery.

Following are some questions and answers on prospects for Japan’s sales tax hike and its potential impact on the economy.

HOW WILL KAN APPROACH SALES TAX HIKES?

Kan’s cabinet aims to lay out a roadmap in June to fix Japan’s creaking social welfare system, which could include the extent and timing of sales tax hikes. It also hopes to pass a tax reform bill by the end of the fiscal year starting in April.

The bill would lay out reform plans but not necessarily raise taxes immediately, Economics Minister Kaoru Yosano said, adding that a tax hike should be timed to match the economy’s ability to absorb it.

Kan, facing a split parliament and doubts about his political survival, has called for multiparty talks on welfare and tax reforms, but the main opposition has turned a cold shoulder, saying the ruling party must first show a concrete reform plan.

Kan is also likely to have a hard time gaining consensus on a reform plan within his ruling Democratic Party of Japan (DPJ), whose members are wary of alienating voters, making the outlook on tax reform highly uncertain.

Having floated the idea of raising the sales tax when he took office in June, Kan backed down after the DPJ badly lost an upper house election the following month.

HOW WOULD TAX HIKES HURT THE ECONOMY?

It depends on how the economy is doing when a tax hike is implemented.

Economists warn that announcing plans for a tax increase could trigger a rush or purchases before the tax hike is implemented, followed by a subsequent slump in consumption to levels that, during times of weak demand, could be less than what prevailed before the announcement.

To avoid big fluctuations, analysts are calling for incremental tax hikes, which some say could also boost inflation expectations. But government officials are wary of taking such an approach as it would involve complicated and time-consuming procedures at government offices with each increase.

Nomura Securities says doubling the sales tax rate would cut 0.5 percentage point from Japan’s real GDP growth in the year the increase was implemented, and another 0.8 percentage point the following year. Mitsubishi Research Institute estimates it would knock as much as 2 percentage points off the real growth rate.

That could be a considerable blow to the economy given that Japan’s real growth averaged 1.3 percent over the decade up to the financial crisis in 2008 and the government aims to achieve 2 percent expansion per year over the coming decade.

HOW DID PAST TAX HIKES AFFECT GROWTH?

Historic precedents suggest that an increase in the sales tax would undermine growth initially, rather than boost it.

When Japan adopted a 3 percent consumption tax in 1989 the economy was booming.

Growth slowed after the tax was introduced to 4.6 percent in fiscal 1989/90 from 6.4 percent the previous year. Growth in private consumption slid to 4.1 percent from 5.3 percent.

When the tax rate was raised to 5 percent in the year to March 1998, the economy stalled after growth of 2.9 percent the year before. A banking crisis also weighed on the economy, which slipped into a recession the following year.

Analysts say the sales tax played a large part in the economic slowdown in both cases, although the direct impact is hard to calculate as the increase was accompanied by changes to other tax rates.

HOW WOULD THE TAX IMPACT INFLATION?

The introduction of the tax in 1989 and its subsequent increase a decade later raised prices, although such taxes generally do not have a long-term inflationary impact.

Core consumer inflation excluding fresh food but including oil product prices jumped to 2.8 percent in fiscal 1989/90 from 0.6 percent the year before.

It increased to 2.1 percent in fiscal 1997/98 from 0.3 percent a year earlier.

Nomura says increasing the sales tax to 10 percent would raise core consumer inflation by 3 percentage points. Japan Research Institute says such a rise would boost core inflation by 4.5 percentage points.

To offset the impact of a higher sales tax, Kan last year proposed refunds for lower-income earners and applying different rates to food and some other necessities as many other developed countries do. That could complicate the impact a sales tax hike would have on inflation.

WHAT SALES TAXES DO OTHER COUNTRIES APPLY?

Japan’s 5 percent consumption tax rate is among the lowest in major economies and compares with 20 percent in Britain and 23 percent in Portugal -- which raised the tax rate by 2.5 and 2 percentage points respectively this year to tackle debt issues. The rate is 19 percent in Germany and 10 percent in South Korea.

The impact seems to have varied from country to country.

Germany raised its value-added tax, similar to a sales tax, by 1 percentage point in 1993 to 15 percent, which came amid an economic slowdown and led to a slide in personal consumption.

France increased its value-added tax by 2 percentage points in 1995 to 20.6 percent. But it managed to avoid a sharp downturn in consumption, partly because the tax hike came after the economy’s steady growth above 2 percent in the previous year.

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