Nov 14, 2014 | 01:49 GMT

6 mins read

Japan's Economic Strategy Hits a Snag

It can be difficult to separate the important from unimportant on any given day. Reflections mean to do exactly that — by thinking about what happened today, we can consider what might happen tomorrow.

Reports in Japanese and Western media on Thursday appeared to confirm that Japanese Prime Minister Shinzo Abe will delay plans to raise the country's sales tax from 8 to 10 percent in October 2015. Abe has not yet officially canceled the sales tax hike. However, recent data showing weak consumer sentiment and economic activity have spurred worries across markets and within the Japanese government that the tax hike would cripple consumer spending and the economy irreparably. At the very worst, in a repeat of the debacle that followed former Prime Minister Ryutaro Hashimoto's 1997 decision to raise the sales tax from 3 to 5 percent, another tax hike could send Japan's economy back into a protracted recession. Needless to say, a recession probably would mean the end of Abe's plan to revitalize the Japanese economy and nation — at least for now.

Apocalyptic visions of Japan's economic implosion notwithstanding, it is worth considering the significance of the consumption tax hike and the implications of Abe's (highly likely) decision to delay it. To do this, an understanding of the tax's role within Abe's strategy for economic revitalization is necessary.

The Basics of 'Abenomics'

The premise of "Abenomics," as the strategy is popularly known, is that Japan's economy has been caught in a cycle of gradual economic decline caused by two major factors. The first is Japan's aging, declining population, which leads to naturally falling aggregate consumer spending, and thus falling prices for domestic consumer goods. The second is the world's continued perception of the Japanese economy as a stable haven for investment, leading to strong demand for — and thus an increased value of — the yen. In this deflationary cycle, declining consumer spending combined with an increasingly valuable currency creates the perception of perpetually falling prices at home, causing consumers to save their money rather than spend it (because goods will always be cheaper later). This behavior undermines corporate profits and investment and pushes wages down, further suppressing consumer spending.

Abenomics seeks to cut through this cycle with a two-stage plan of attack. First, it aims to trigger temporary inflation by massively expanding the money supply and ramping up government spending. Inflation is meant to begin shifting consumer expectations away from falling prices and toward rising prices, kick-starting stronger domestic consumption. In theory, these expectations would then start a cycle in which stronger consumer spending leads to higher corporate profits, wages and consumer spending. Monetary easing also seeks to stimulate stronger Japanese manufacturing and exports by depreciating the yen's value and reducing the cost of Japanese goods on the global market. According to the plan, once this government-driven inflation put consumer spending and exports back into gear, the second stage — structural economic reforms designed to foster long-term growth — would kick in.

Abe's Planned Tax Reforms

Key among the structural reforms promised by Abenomics was a package designed to change the way Japan's corporate sector works and, for the most part, to make it easier for businesses to operate profitably in Japan. One of those changes involved lowering Japan's corporate tax rate, which was greater than 42 percent for most of the 1990s and early 2000s and which, at its current 35 percent, is one of the highest in the world. Lowering the corporate tax, however, leaves the government with less revenue — revenue that Tokyo needs to maintain high levels of government spending and to meet other recurring obligations, such as the rising costs of caring for Japan's elderly and of servicing Japan's enormous government debt.

Moreover, there is a perceptional concern: Given Japan's already enormous government debt levels, any move by the Japanese government to lower corporate taxes while increasing spending without finding other means of boosting government revenue could, in theory, lead to a loss of faith in the Japanese government's ability to manage its economy. This development would drive up rates on Japanese government debt further and put Tokyo in even more of a funding bind. Either way, the message was clear: In order to implement corporate tax reforms while ramping up government spending, without incurring the wrath of the market, Tokyo would have to raise taxes somewhere. Japan's sales tax, historically one of the lower sales taxes globally, was deemed the best option.

But raising taxes on consumers while lowering them for the corporate sector, in addition to being a politically volatile move, stifles consumer spending and thus negates the original premise of Abenomics. Hashimoto's attempt to raise the tax in 1997 triggered a drop in consumer spending that led to a recession, and Abe's previous tax hike, from 5 to 8 percent this April, has led to six months of weak spending and economic activity that appear poised to end his hopes for another tax hike.

The Potential Effects of a Delay

What will happen if Abe delays the consumption tax hike? Probably not very much, at least in the short term. Japanese government bond yields could rise as some foreign investors cash out, theoretically raising the cost of servicing Japan's government debt. But virtually all of Japan's debt is domestically held and denominated in yen, and the majority of that debt is owned by a single entity: the Bank of Japan. This means that the owner of debt is also the printer of money and setter of rates, giving the entire situation a counterintuitive but deep stability. And what will a delay do to the government budget, especially if the Abe administration continues to increase spending — as seems likely — and goes forward with a corporate tax cut? Certainly it will drive budget deficits further up in the near term, but to what end is much less clear.

The unknowns surrounding the developments in Japan are expected, given that Japan is in many ways charting new social, political and economic territory as the country at the forefront of demographic decline and population aging. What Stratfor can say, however, is that to a degree remarkable among the world's major states, Japan has shown a capacity throughout its history to reshape itself — rapidly, if traumatically — to overcome new and seemingly insurmountable constraints. For this reason, we will continue to watch Japan and the progress or failure of Abenomics closely.

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