Abenomics Japan Inflation Essay

Takeo Hoshi, left, and Tatsuo Hatta.

The government of Prime Minister Shinzo Abe is facing daunting challenges in 2017 as it continues its struggle to revitalize the Japanese economy. In the first half of a two-part discussion, two top Tokyo Foundation economists assess the government’s fiscal and monetary policies thus far and identify areas for improvement.

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TAKEO HOSHI: Two unexpected events jolted the world in 2016: the outcome of the Brexit referendum, in which British citizens voted to leave the European Union, and the election of Donald Trump as president of the United States. Today I’d like to consider what these global developments portend for our own economy and economic policies in 2017.

Let’s begin with a review of Japan’s economic situation. Over the past four years, the government of Prime Minister Shinzo Abe has adopted a package of economic revitalization measures called Abenomics. The “three arrows” of Abenomics are an aggressive monetary policy, a flexible fiscal policy, and a long-term growth strategy through structural reform. How should we rate each of these policies?

Waiting for Wage Growth

© Kyodo News
TATSUO HATTA: From a macroeconomic standpoint, an important outcome of the prime minister’s expansionary policies has been a drop in unemployment. A lot of people seem concerned about the fact that wages haven’t risen at the same time, but I don’t see this as a problem. During the recovery phase, we experienced a surge in nonregular employment, and the increased share of these lower-paying jobs in the overall job picture has pulled average wages down. But eventually, as the number of people in line for nonregular jobs dwindles, wages for those workers will rise as well. We’ve been in the midst of an adjustment, but it’s only a matter of time before wages start to rise again. In fact, we’re already beginning to see wage growth among part-time and temporary workers. I predict wages will soon be rising across the board.

HOSHI: Wages are on the rise among both regular and nonregular employees, as you mentioned, but the situation seems to vary from one industry to another. For example, while the share of nonregular workers has been growing at about the same rate in nursing-care services and in the construction industry, wages are rising for construction workers but not for care workers.

HATTA: That’s probably due to the fact that pay in the nursing-care industry is subject to government regulation, so wages don’t rise in response to excess demand for labor. It’s the same for childcare.

HOSHI: The government has decided to accelerate corporate tax cuts in hopes of encouraging companies to give workers pay raises. Based on what you’ve said, maybe it should be focusing on wages in the regulated industries that are shielded from the ripple effects of the economic recovery—either by raising wage levels or by easing regulations.

HATTA: Yes, the government could, for example, expand the range of optional nursing-care services for which providers can set their own fees. This would have the effect of raising average wage levels in the nursing-care industry.

Monetary Tightrope

HOSHI: How effective has the first arrow of Abenomics, monetary policy, been? Is there really much the Bank of Japan can accomplish to boost growth?

HATTA: It takes time for monetary policy to have an impact on the real economy. But land values are beginning to rise. And that will gradually push up the value of collateral and encourage more lending and investment. I think the Bank of Japan should keep doing what it’s been doing. Before long, things will start to heat up across the board. In fact we should start studying how to manage the expansion and keep it under control.

HOSHI: Milton Friedman talked about “long and variable lags” between the implementation of monetary policy and its impact on the real economy. That suggests that getting the timing right with monetary policy can be difficult.

HATTA: I agree. So we should be prepared for possible inflation. Back in the 1970s, during the Jimmy Carter administration, inflation and nominal interest rates both hit around 20 percent. What that meant was that in real terms, annual interest was down to around zero, but since taxes apply to nominal rates, the effective tax rate on interest income was well in excess of 100 percent. That severely dampened savings and investment.

That’s why Harvard Professor Martin Feldstein stressed the importance of taxing real interest income, adjusted for inflation. That became one of the tenets of supply-side economics. But in the 1980s, the Reagan administration, in response to this call, drastically lowered taxes on asset income by eviscerating the capital gains tax and slashing corporate taxes. Unfortunately, this overreaction led to a sharp drop in tax revenues. The correct course would have been to adjust for inflation, not to cut taxes on financial income to almost nothing.

Generally speaking, the worst effects of inflation can be attributed to the tax system. We need to head off such problems by preemptively instituting an inflation deduction for income from financial assets. If we do that, then inflation won’t cause serious damage to the economy even if shoots up to around 20 percent.

HOSHI: The cost of inflation is high because taxes and financial contracts are based on nominal values and not indexed to inflation. If they were designed to respond to inflation more nimbly, the economic damage would be limited to “menu costs” [the cost to businesses of changing prices] and “shoe leather costs” [the cost of going to the bank often to withdraw cash], which are minor by comparison. Shoe leather costs should be much less of an issue now, since online banking and electronic payment have become so widespread.

HATTA: The biggest hit comes from taxes.

HOSHI: Japan isn’t experiencing inflation at this time, of course. The BOJ has been working aggressively for several years to achieve a moderate level of inflation, but without much success. It may be too early to be talking about inflation; the priority at the moment is conquering deflation.

That said, if inflation does begin to take off, the government will need to respond quickly. So, even before that happens, there’s a need to start thinking about systemic tax reforms to limit the costs of inflation. We may be in that delicate transition phase right now.

Raising Taxes without Stifling Growth

HOSHI: Let’s move on to the second arrow of Abenomics, fiscal policy. As we’ve seen, monetary policy can take a long time to affect the real economy, but fiscal policy can have a more immediate impact, at least according to textbook economics. The Abe administration initially stressed a “flexible” fiscal policy that combined short-term, targeted stimulus with long-term fiscal discipline. How do you rate the government’s performance?

© Kyodo News
HATTA: I’d say it hasn’t done enough to restore fiscal discipline. On the revenue side of the budget, there are two main problems. The first is the spousal deduction, which gives a big tax break to taxpayers whose spouses earn less than 1.2 million yen each year. If this were eliminated and replaced with a spousal tax credit, it would boost government revenues substantially without adding to the burden of low-income, married couples. Unfortunately, in the final analysis, the ruling coalition decided, rather, to keep the current system and raise the deduction threshold. There was talk of holding another snap election early in 2017, and I suppose the party was worried about a backlash from families that would end up paying higher taxes. Given the frequency of national elections these days, it’s not surprising that the government is having a hard time reining in the deficit. With its stable majority, though, it should really do better.

The second issue concerns the consumption tax. If the government is going to rely on consumption tax increases to boost revenues, then it needs to make some basic changes to the way the tax is levied.

So far, both increases in the consumption tax—in 1997 and again in 2014—were followed by economic slumps. In 2014 the Finance Ministry insisted on raising the tax rate, citing Germany’s experience with the value-added tax in arguing that a consumption tax hike wouldn’t induce a recession in Japan. The fact is that the MOF has twice miscalculated the effect of such tax increases on the economy. Now people are saying, “That’s two consumption tax increases and two recessions. Before you raise the rate again, let’s hear how you plan to head off another downturn.”

One of the biggest issues with the Japanese consumption tax is its effect on the housing market. When a consumption tax increase raises prices, consumers generally try to offset the expenditure increase by reducing consumption of those goods. With goods like food or clothing, that’s a relatively straightforward adjustment. Let’s say someone spends 1 million yen on food annually, and the government decides to slap a 10 percent sales tax on food. That person can cover the cost of the tax by reducing food consumption to around 910,00 yen, so that tax-inclusive total food expenditures remains at 1 million yen. When it comes to buying a home, though, that’s not the case; a person who is planning to purchase a 100 million yen house, partially with a loan, wouldn’t be able to purchase a 91 million house when a 10 percent consumption tax is installed.

Most people need to take out a bank loan to buy a home, and to get the loan they need to come up with a down payment equal to a certain percentage of the loan—say, 25 percent. If there were no consumption tax on the house, a person with 20 million yen at his or her disposal would be able to purchase a 100 million yen home by taking out an 80 million yen loan.

Japan’s consumption tax applies to the full sales price of the property, excluding the land, in the year of the sale. Thus if a 10 percent consumption tax is levied in this situation, the buyer has to pay the tax up front along with the down payment, out of the 20 million at their disposal, since banks won’t loan the amount to cover the tax portion. So, it’s clear that a person with 20 million yen on hand can’t purchase a house of 91 million yen. In fact, she or he in this situation can only afford a house worth about 65 million yen. Just scaling back purchases proportionately, as you might with other goods, won’t do the trick.

This explains why increases in Japan’s consumption tax have such a big impact on the housing market, compared with other sectors of the economy. In fact, both the 1997 and 2014 tax hikes caused a long-term slump in home sales, and owing to the amount of money involved in those transactions, that was enough to trigger a recession. The reason Germany has been able to avoid this is because home purchases are basically exempt from the VAT.

The government could solve this problem by eliminating the consumption tax on home sales and at the same time setting the rate of the property tax on homes at the level consistent with the consumption tax rate. This would allow the government to raise the consumption tax rate on goods and services—with the exception of housing—without triggering a recession and without losing tax revenue in the long run.

Taxing Wage and Interest Income

HATTA: There’s also a lot of room for improvement on individual income taxes. The minimum taxable income in Japan is too high from an international perspective, and the top marginal rate is quite low by historical standards. Until the mid-1980s, Japan’s top marginal income tax rate was 88 percent. That was the rate that was levied on industrialists like Konosuke Matsushita, Soichiro Honda, and Akio Morita when they were building companies like Panasonic, Honda, and Sony into top global brands. So I really don’t think that raising the top rate a bit would significantly undermine the Japanese work ethic. Some high-income earners might be prompted to move overseas to avoid paying higher taxes, but for most Japanese families, educational and healthcare considerations, as well as nursing-care needs for parents, make that a very difficult step to take. Also, high-income earners tend to cherish Japan’s safe, clean cities. I can’t believe that emigration caused by an increase in income tax rates would result in a loss of tax revenue. On the other hand, I would advise leaving taxes on asset income at 20 percent.

HOSHI: Why is that?

HATTA: I think most people would agree with the idea that people with a similar standard of living should be similarly taxed. What determines a person’s living standard is utility. And the person derives his utility from his lifetime expenditure. So expenditure is a good indicator of his living standards.

One’s lifetime expenditure is the sum of the “present value” of his lifetime personal consumption and bequests over his lifetime, discounted by the interest rate on risk-free savings accounts. Within the limits of his own lifetime budget, a person adjusts his spending at each life phase through saving and borrowing in order to maximize his overall standard of living. So, lifetime expenditure functions as an indicator of his standard of living.

Let’s suppose we have two people who receive the same wages at every stage of their lives, but one of them puts a substantial portion of that income in a risk-free savings account when he’s young while the other saves nothing. They’re operating under the same lifetime budget constraints, so their lifetime expenditure should be the same, which means that their overall standard of living, averaged out over their lifetimes, will also be the same. If the government taxes their wage income only, then they’ll naturally pay the same amount in taxes. But if it also taxes interest from bank savings, then the one who is frugal and saves will end up paying more in taxes. The lifetime tax burden is higher for the saver, even though both have the same lifetime standard of living. It’s clear from this that it’s fairer to tax only wage income, which is the “primary income.” When you also tax interest income, which is a “derived income” from the earned income, this can be considered a form of double taxation.

HOSHI: One often hears the objection that taxing income from financial assets is double taxation. Does that mean we shouldn’t tax financial income at all?

HATTA: I think it depends on the type of financial income. Let’s say someone invests in the stock market in their youth and earns big dividends, well in excess of the rate on risk-free savings. In that case you need to add those “excess gains” to the present value of their lifetime expenditure treating it as “primary income,” just like earned income. It’s your compensation for smart investment decisions. If we base taxation on living standards, then we should exempt interest on risk-free savings accounts but tax any financial income in excess of that. Ideally, tax rates on financial income should be dependent on its type.

What Japan has done instead is to tax all financial asset income separately from earned income at a flat rate of 20 percent. This, actually, can be viewed as a bold approximation of the ideal situation; it’s clearly more reasonable than the comprehensive income tax idea, which adds asset and earned income and taxing them together. What we want is to uncouple the tax rates on financial income from increases in the personal income tax.

HOSHI: A moment ago you said that it was hard to raise taxes when national elections are held so frequently. And in fact, the government announced it would postpone a scheduled consumption tax hike before holding the past two general elections. Will it ever be able to raise the consumption tax?

HATTA: I think it could if it first puts in place the necessary policy measures to prevent a hike from triggering a recession. Until then, I think the government would do better to focus on reforming the income tax. An increase in the top marginal rate wouldn’t have anywhere near the impact on economic growth that a jump in the consumption tax would.

Reining in Social Security Expenditures

HOSHI: On the expenditure side of government finances, the big issue is social security, whose outlays have risen a lot more quickly than anticipated back when the system was put in place. In November 2016, the Diet enacted pension reforms designed to curb future outlays by modifying the way benefits are calculated. Would you call this a necessary first step toward bringing social security spending under control?

HATTA: I’d say it signals the beginning of some major changes that obviously need to be made. And we shouldn’t stop with the pension system. We also need to scrutinize our health insurance system, including scope of coverage and whether to allow “mixed billing” of both treatments covered by public health insurance and those not covered by insurance.

HOSHI: Clearly, we can’t continue along our current trajectory without bankrupting the system. Even after delaying the planned consumption tax increase, the Abe cabinet still claims that it can reach its goal of a primary surplus by 2020, but I don’t think anyone really believes that.

The most urgent economic challenge facing our leaders today is to put government finances on a sustainable footing. They should be exploring every option available, both in the revenue and the expenditure column. Yet for the past four years Abenomics has focused almost exclusively on fiscal stimulus. I think we can agree that there has been virtually no progress toward fiscal discipline.

Continue to Part 2 of "The Japanese Economy in 2017: Bumps on the Road to Deregulation and Free Trade"

The Bank of Japan is pulling yet another new monetary policy out of its bag of tricks in a bid to combat deflation, this time it’s “yield-curve control”. This is the latest in a history of unusual monetary policy, such as negative interest rates, that the bank maintains have been effective in improving Japan’s economy.

As part of the new policy the central bank will keep its 10-year government bond yield at zero. Usually central banks only control short-term interest rates, but the bank wants to steepen the yield curve, increasing the difference between the yields of short-term bonds (negative in Japan) and long-term bonds.

This is designed to free up more money in commercial banks in Japan for investment. In addition to this, the Bank of Japan will continue to buy about 80 trillion yen in Japanese government bonds annually.

The question is how effective the new scheme is going to be, particularly because the announced target rate of the 10-year bond is around its current market rate, so the current situation is unlikely to change.

However monetary policy hasn’t been able to control deflation and Japan’s national debt remains high. The bank is limited in what policies it can implement. Without a boost to other economic activities, such as an increase in employment, the effects of policies won’t last long.

What’s needed is some synergy between the bank’s monetary policy measures and the government’s fiscal policies. This means the government of Japan will have to step up with some consistent stimulus policies to cheer up the economy as soon as possible.

What Japan has tried so far

The Japanese economy has been stuck for a very long time. From 1995 to 2005, Japan’s GDP dropped from nearly US$5.3 trillion to US$4.5 trillion, at the same time the country also experienced deflation.

When Shinzo Abe was elected as Prime Minister of Japan, he set out a series of economic policies, dubbed “Abenomics”, to try and promote private investment, reviving the national economy.

Another aim in Abenomics is to correct excessive yen depreciation, however this hasn’t proved successful yet. After Abe nominated Haruhiko Kuroda as the new governor of the Bank of Japan in 2013, the yen depreciated drastically. In 2011, the exchange rate between US dollar and Japanese yen was almost 76 yen to 1 US dollar, after Kuroda’s nomination, it went above 100 yen to 1 US dollar.

The Bank of Japan has been implementing bold expansionary monetary policies since Kuroda’s nomination, thinking that Japan’s economy is in the process of slow recovery. The first tool the bank tried to stimulate economic activity was an extensive bond buying operation.

When a central bank buys bonds, it injects money into a country’s financial sector. The expectation is the injected money will flow into the rest of the economy and stimulate production and consumption. This in turn will start to raise price levels, helping the government achieve an inflation target.

This worked for a while in Japan. However, recently deflation shows the effect of this monetary policy has faded.

According to IMF data, the annual inflation rate in 2013 was 0.36%. In 2014 it showed some promise increasing to 2.75%. But it went back to 0.79% in 2015.

Japan’s Bureau of Statistics shows that the consumer price index for Japan, one of the measures of inflation, was 99.6 in July. It went down by 0.2% from the previous month and down by 0.4% over the year. All signs of deflation.

There could be many reasons for this sort of deflation, but one of the most serious issues in Japan is enormous national debt. Japan’s gross government debt is 226% of GDP and Japan’s fiscal situation is getting into territory we have never seen.

In April 2014 consumption tax was raised from 5% to 8% in a bid to increase government revenues and fight debt. But according to the IMF, the increment of public debt has been decreased but the public debt itself is not decreasing.

Huge national debt is a threat to sound economic systems and maintaining the social security system, or public services. Japan needs to reduce national debt as soon as possible.

Since January 2016 the Bank of Japan has been charging a negative interest rate on a portion of reserves that commercial banks keep with the bank. This means the central bank charges a fee to the commercial banks, instead of these banks receiving some interest in return for depositing money.

The aim is to encourage banks to allocate money to more productive uses for the economy, such as investing in businesses. World Bank data shows that this sort of credit to the private sector has been going up in Japan since 2011 but there hasn’t been a noticeable response in the economy.

If a central bank succumbs to government pressure and implements an overly aggressive expansionary monetary policy, it can lead to dysfunction of the whole economy. Japanese law states the importance of the central bank’s independence and neutrality from the government in deciding monetary policy. But the law also states that the Bank of Japan’s basic monetary policy should be consistent with the economic policy of the government.

Whether or not this framework will continue to work depends on whether fiscal and monetary policies can work in synergy in the Japanese economy.


This article is published in collaboration with The Conversation.

The views expressed in this article are those of the author alone and not the World Economic Forum.

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