Why on earth is Prime Minister Noda pushing to double the consumption tax rate? A solid majority of voters rejects any increase, coalition partners and even much of his own party oppose the idea, and lacking a majority in the Upper House, Noda couldn't get an increase passed without the cooperation of the obstreperous LDP or Komeito anyway. When previous prime ministers proposed, introduced, or increased the consumption tax, their parties suffered at the polls and the economy tanked. Compared to Hatoyama or even Kan, Noda seems cautious and consensual-so why does he persist in promoting a highly unpopular tax increase?
Cover articles in Ekonomisuto and the Asahi this past week provide a clue: Japanese financial institutions are beginning to run simulations about when a crisis will erupt, and how they can minimize the damage from it. This implies that the alternatives to increasing the consumption tax also entail growing political and economic risks, and those risks could easily hurt the LDP as well, making it likely to cooperate at some point. As everyone knows, in recent years half of Japan's budget has relied on deficit financing, and the accumulated Japanese debt exceeds 200% of GDP-far above the level that Reinhart and Rogoff contend is historically associated with a rising risk of a sovereign debt crisis. Sooner or later, taxes will have to go up, and sooner would be safe. Indeed, "sooner" is a misnomer, since Japanese public finances have been in dire shape for years. Moreover, the ratio of taxes to GDP remains much lower than in Europe, implying that there is plenty of room to raise taxes in Japan.
Of course, Japan is very different from Greece, or even Italy. Its own banks and citizens hold the vast majority of Japanese government bonds (JGBs), and see few attractive investment alternatives: with little demand for commercial loans at home and significant foreign exchange (and sovereign) risk if they invest abroad, most of them are reluctant to dump their holdings of government bonds. Japan has large net foreign assets. And of course, unlike Greece or Italy, Japan issues its own currency, so if a crisis arrived, devaluation of the yen would spur exports and stabilize the economy. Economic weakness has pushed interest rates to record lows, so the government has had no problem paying interest on the debt. The share of debt servicing in the overall General Account budget increased rapidly in the 1980s and 1990s, but then in the 2000s it stalled at a manageable level of just under one-quarter of total spending, despite continuing massive deficits.
But all good things come to an end. Despite still-declining interest rates, payments for the interest on government bonds finally turned up in 2007 and are increasing sharply. The share of debt servicing in the overall budget is beginning a steady rise.
Together, debt repayments and the "natural increase" in social insurance spending (primarily health care, pensions, and long-term care for the elderly) caused by the aging of the population are crowding out all other types of spending: public works have fallen to one-half their once-exorbitant peak, and public universities are suffering an unrelenting squeeze.
The days of avoiding tax hikes by cutting obvious fat in expenditures have come to an end: the DPJ and indeed Koizumi and his three LDP predecessors already have done a better job of restraining spending (especially spending not related to aging) than they usually get credit for. So while the DPJ would alienate voters by increasing the consumption tax, it is already alienating them by its failure to fund promises made in its electoral manifesto, and the pressure to cut other expenditures is unrelenting. And if the threat of a sovereign debt crisis is not yet imminent, neither is it a mere chimera: as aging steadily depresses Japanese household savings-down from 15% in the early 1990s to around 3% today-reliance on foreign investors will only grow. Already, the eruption of the Eurozone crisis has caused the share of foreign holdings of JGBs to jump.
In the short run, that helps hold down interest rates and debt servicing costs, but it also increases the risk that foreigners could dump Japanese bonds in a future crisis, leading to a sharp upturn in interest rates.
As the more social democratic of the two major parties, the DPJ would gain more from increased revenue, but the LDP also has some strong incentives to go along with a tax increase. It has already agreed in principle that the consumption tax should increase. If it blocks an increase now for nakedly partisan reasons it would not only further degrade its former advantage in perceived sobriety and competence, but it would also bind its hands, so that a future LDP administration would have to oversee ever-more draconian spending cuts. Better to have the DPJ take the hit now. Nor does the consumption tax exist in a vacuum: the DPJ has plenty of room to offer concessions on other pieces of legislation, such as reduction of the corporate tax or increases in personal tax on wealthy households, or the details of how to satisfy court-mandated redistricting.
As for the impact on the economy, by the time an increase in the consumption tax could be introduced, the economy should be in better shape. But at any rate Japan (unlike the US), cannot afford to wait to begin serious financial reconstruction.
Noda may well fail. His three LDP and two DPJ predecessors certainly did, and as John Campbell notes, Noda and the DPJ have blundered badly in explaining why and how the consumption tax should increase. Yet in principle, at least, Noda's attempt to balance careful attention to the concerns of the public and the back benches of his own party with persistent promotion of an unpopular but necessary increase in the consumption tax is not crazy.