This is is a guest post from Philip Pilkington, a writer and research assistant at Kingston University.
Well, it seems that everyone is talking about Japan’s Shinzo Abe’s so-called “Fourth Arrow” in his economic recovery program. That is, a plan to raise the consumption tax to eight per cent next year followed by a hike to ten per cent in October 2015. Can we tell anything about the likely consequences of such a move from Japan’s rather colourful macroeconomic history of the past twenty years? Yes, we can.
Japan has had quite a lot of experience with both stimulus and tax hikes, which makes it far easier to forecast what might happen if the Fourth Arrow is indeed shot from Abe’s bow in the near future than it might be in a different country.
In 1997 the Japanese government engaged in some fiscal retrenchment and raised the consumption tax from three to five per cent. Soon after this policy was enacted there was a recession and a sharp increase in Japan’s government debt-to-GDP ratio – the very variable the tax increases were presumably supposed to target.
Some have sought to pin all of the blame for the recession on the East Asian financial crisis. The figures, however, tell a more complex story. In the below graph the green dotted line shows when the consumption tax was levied (April 1997), while the orange dotted line shows when the Asian financial crisis began (July 1997). As can be seen the consumption tax was followed by an immediate drop in consumption and decline in GDP growth prior to the financial crisis occurring.
It is clear that upon being levied the consumption tax had an immediate and dramatic effect on consumption. Indeed, from 1994 until the first quarter of this year the fall in consumption in the second quarter of 1997 is the largest on record.
While it is probably true that a significant part of the 1998 recession can be blamed on the Asian financial crisis, the effects of the consumption tax are nevertheless quite clear and quite dramatic when we examine the data closely. And the fall in GDP before the Asian crisis fully kicked in suggests just looking at the reasonably predictable bounce and fall in consumption around the tax increase might not be enough.
UPDATE 1810: And if we take the average quarterly growth rates in consumption on both sides of the imposition of tax — while not counting the two periods immediately prior to and after the tax, nor counting the period of the 2008 financial crisis and the effects of the stimulus that followed — we find that the average growth rate of consumption prior to the tax was 0.53 per cent and the average growth rate after the tax was only 0.08 per cent. Clearly then, the imposition of the consumption tax had substantial long term effects.
But there is also a broader picture that needs to be taken into account here. Low consumption seems to be an ever present problem for the Japanese economy – one might even say that it is the most important problem that the Japanese face. A good way to get an idea of this – and one which will help us forecast the potential effects of Abe’s Fourth Arrow – is to look at the effects of the 2009 stimulus.
In April of 2009, in response to the massive downturn in the world economy, the Japanese government announced a substantial stimulus of 3 per cent of GDP. The effects on consumption, as can be seen in the graph below, were as dramatic as they were short-lived.
The vertical black line indicates when the stimulus was announced. As we can see, private sector consumption briefly jumped from its post-2008 lows but then quickly subsided once more. This reflects a major structural problem with the Japanese economy: consumers just don’t seem that inclined to consume.
This is frequently noted in Japan and various reasons are given, from an aging population to a culture of underconsumption that formed in Japan after the excesses of the 1980s.
Whatever the causes, however, the lesson should be clear: consumer spending is the lifeblood of any advanced economy and any program geared toward economic recovery in Japan that incorporates measures that will dampen consumer spending is likely to fail. The question now is whether political pressure will lead Abe to string the bow.