Tax hike delayed

As Japan fell into recession for the third time in two years, PM Shinzo Abe said on Tuesday, November 18, he would hold new elections in what analysts view as an attempt by the conservative leader to win a renewed public mandate – two years ahead of schedule – to implement his economic reform agenda "Abenomics": a combination of monetary, fiscal and structural policies. The prime minister failed to give a date for the poll, but analysts expect the vote to be held in mid-December. The House of Representatives – the lower house of parliament – is set to be dissolved on November 21.

As Asia's second largest economy struggles with stagnation and deflation, Abe also announced his decision to delay the second sales tax hike to 10 percent – planned from October 2015 – until 2017. The announcement comes a day after data showed the Japanese economy fell into recession for the third time in four years. The world's third-biggest economy unexpectedly shrank for a second consecutive quarter. The latest contraction followed an initial sales tax increase in April to eight percent from five percent.

Marcel Thieliant, Japan Economist at Capital Economics, says in a DW interview that while the decision to delay next year's sales tax hike may boost economic growth it could also strengthen opposition to bolder easing within the Bank of Japan.

DW: What impact is Abe's decision to delay the tax hike likely to have on Japan's economy?

Marcel Thieliant: The direct impact of Prime Minister Abe's decision to delay next year's sales tax hike is to boost the outlook for growth and also for underlying inflation, though headline inflation will of course be lower. However, if we are right that the yen will decline to 140 against the US dollar by end-2015, import prices will rise further and both real wage growth and consumer spending are likely to stay subdued.

We, therefore, still expect inflation to fall short of the two percent target over the next couple of years, so more monetary stimulus is still likely to be needed. But the postponement of the tax hike could strengthen opposition to bolder easing within the Bank of Japan (BoJ).

What is the current situation of Japan's government finances?

The deficit is narrowing and will likely shrink further next year as a result of this year's tax hike. However, the government's target of balancing the primary budget by 2020 will not be achieved unless further measures are taken. If the BoJ eventually succeeds in lifting inflation towards two percent, there is no guarantee that government bond yields will remain as low as they are currently.

If interest rates converged to the levels observed in the US or the UK, the government's interest bill could easily reach seven percent of GDP, and the budget deficit could climb into double-digit territory.

Moreover, not raising the tax risks undermining the willingness of the BoJ to continue with large-scale asset purchases at a time when disagreements have already emerged within the central bank about the course of monetary policy. Indeed, at least one member thinks that continuing with quantitative and qualitative easing (QQE) for too long may create the perception that the BoJ is monetizing government debt – a perception that would gain credibility if attempts to establish a "sustainable fiscal structure" were abandoned.

Japan just recently slipped into recession for the first time in three years. What are the main factors behind this?

The main reason is April's consumption tax hike, which has resulted in a surge in spending ahead of the tax and a plunge thereafter. However, the third quarter GDP figures overstate the weakness somewhat, as the fall in output was mostly due to falling inventories. Demand has recovered, but remains sluggish.

We were a bit surprised by the strength of the downturn. Arguably the rise in inflation since the start of Abenomics plays an important role, as it led to a fall in real wages even before the tax was raised and left households ill-prepared for the shock from the higher tax.

What will the successful implementation of tax reform and Abe's third arrow ultimately depend on?

The LDP will almost certainly be returned to power with a large majority which, Abe will presumably argue, would give the government a strong mandate. However, the government already has majorities in both houses of the legislature and popularity ratings far ahead of the opposition.

The election may make little difference in practice. Hopefully, the recent weakness of the economy will serve as a wake-up call to policymakers that monetary easing alone is not enough to lift economic growth.

How so you see Japan's GDP developing in the next two years?

We don't think that the weaker yen will have a major impact on exports, as most exports are invoiced in foreign currency and firms prefer to reap the benefits in terms of higher revenue in yen-terms rather than higher export volumes.

More important is whether firms will pass on their surging profits to employees in the form of higher wages. Unfortunately, we think that wage growth will remain subdued, so consumer spending should remain sluggish. That said, spending should start to rise again towards the end of 2016 in anticipation of the tax hike.

Marcel Thieliant is Japan Economist at Capital Economics, a UK-based economic research consultancy.