Decades of deflation and economic stagnation has left Japan in a struggle to restore fiscal health. However, despite outrageous public debt levels (over 200% of GDP), the country’s rapidly aging population has put pressure on the government to increase spending on public services. Forced to evaluate the country’s various sources of revenue, the government boldly raised Japan’s consumption tax from 5 percent to 8 percent as of April 1st.
Since Prime Minister Shinzo Abe’s induction into power, he has focused his efforts on stimulating economic growth through a series of structural reform measures referred to as “Abenomics”. Despite economic progress, particularly in conquering deflation, Japan’s recovery is still fragile. A consumption tax increase at this stage of economic recovery has the potential to undo much of Abe’s progress. However, new revenue generation measures is vital to restoring Japan’s fiscal health and bringing down Japan’s high level of public debt.
Social security spending, coupled with low economic growth, is the main factor behind Japan’s surge in public debt. As a direct result of Japan’s rapidly aging population, social security spending has risen by roughly 60 percent since the early 2000s.
Alternatively, capital spending has been on the decline and non-social security spending has remained stable at 16 percent of GDP, one of the lowest percentages in the OECD. With little room for adjustment in other areas of government expenditures, a rise in the consumption tax rate is the most efficient way to meet Japan’s increasing demand for social security.
Japan’s persistently weak economy and decline in working age population has resulted in a significant drop in tax revenue. Japan’s 5 percent consumption tax rate is among the lowest in the world, making it the most appealing source of revenue generation to adjust. According to Bloomberg Businessweek, by raising the consumption tax to 8 percent, the government should be able to generate an additional 4.5 trillion yen ($43.6 billion) in the new fiscal year.
Besides its comparatively low rate, the consumption tax increase is appealing for a number of other reasons. As opposed to raising income taxes, a rise in the consumption tax provides a more stable source of revenue. An aging population implies that spending exceeds income, making the consumption tax increase more robust. With a steady decrease in the working population, generating revenue through labor will become progressively less effective.
Furthermore, an increase in Japan’s Value Added Tax (VAT) is the most efficient source of revenue compared to its alternatives. In the final stage of implementing the new tax law, the tax rate is expected to again increase to 10% in 2015. However, given the incremental rise and low starting level of the increase makes this the least detrimental to economic growth. According to the IMF, unlike a tax on income, a VAT rate increase won’t distort household saving decisions, investment decisions, or trade.
Lastly, raising the consumption tax is relatively easy to administer. Japan’s VAT has a broad base and a uniform rate that is more easily implementable than would be a tier based income tax increase.
Although contradictory to some of the policies and goals of Abenomics, a rise in the consumption tax is a necessary next step for Japan’s overall fiscal stability. A progressively aging population, an increasing demand in public service spending, and public debt levels over 200% of GDP calls for the Japanese government to rethink their revenue strategies. Japan’s decision to incrementally raise the consumption tax could prove to be just what the country needs to begin stabilizing its fiscal imbalance and continue on its road to recovery.