How will today's consumption tax rise affect Japan's economy?

In a long-awaited move for Japanese economists, investors and policymakers, today Japan raised Value-Added-Tax (VAT) – otherwise known as the consumption tax – from 8% to 10%.

Investors had previously questioned whether the Japanese authorities would opt for a delay, given concerns around the ability of the economy to withstand the hike. However, this time around significant efforts to provide countermeasures and the political capital used by Prime Minister Abe has made it difficult to roll back the planned hike.

Ultimately, the willingness of the authorities to go ahead with the tax rise in a period of external weakness underlines the long-run fiscal challenge that the Japanese government faces, which is exacerbated by demographic headwinds.

Decline in demand likely

An increase in VAT (previous hikes took place  in 1997 and 2014) has typically had a large impact  on activity and we expect a sharp decline in demand, albeit less than in 2014.

This time around the hike itself is lower (2% vs. 3%) and the tax rise applies to a smaller proportion of the inflation basket (50% vs. 71%). Moreover, various offsetting measures have been prepared, including providing free early childhood education, tax credits for housing and autos as well as infrastructure spending.

Already hailed as successful policymaking by Japanese Finance Minister Aso, evidence of frontloading (a short-term increase in spending ahead of the tax rise), has been limited. This has somewhat calmed investor fears of a Japanese recession.

However, we are yet to see all September data, where most of the boost should be seen. Moreover, with consumer confidence now lower than in 2014 and broader economic weakness, we see a risk that the consumption tax hike could push the Japanese economy into recession. 

Rate cut would soften impact of tax rise

Up to this point, the Bank of Japan (BoJ) has primarily been concerned about downside risks to the external outlook and currency appreciation – both of which are driven by global factors. Recent communication at the September meeting clearly opened the door to monetary easing in the coming months. Therefore, as a domestic challenge, the BoJ will be watching the impact of the tax hike carefully.

We continue to expect a cut in the short-term policy rate in December as well as an increase in asset purchases. This should double-up as a domestic policy response to soften the blow from the consumption tax hike.