Japan is yet again scheduled to raise its sales tax rate this October, from 8% to 10%. Twice before—in October 2015 and April 2017—the increase was planned to go ahead, but on both occasions the government demurred, citing economic fragility. While Japan’s economy will likely see short-term downside from the rate hike, all indications are that the government will stick to its word this time. Even a trade war between its two biggest economic partners likely won’t be enough to stop it, especially as Japan’s economic performance has been surprisingly strong of late. Now, as the country ramps up for the 2020 Olympics, its pumping in of fiscal stimulus should provide additional support.
Short-Term Pain for Long-Term…Normalcy
Having learned from its previous experience with a value-added tax (VAT) hike from 5% to 8% in 2014, the government is implementing specific measures such as subsidies to ease the burden on households and to boost consumer spending on durable goods. To begin with, the tax rate on food, beverages and other consumer staple products is set to remain at 8%. A third of additional tax revenue, JPY 1.7 trillion (~USD 15 billion) out of JPY 5.7 trillion, is also to be used for childcare and other subsidies for households. Moreover, in the aftermath of a string of natural disasters last summer, the government recently compiled an emergency program to spend JPY 7 trillion over three years to fix vulnerabilities in key infrastructure such as river embankments, roads, bridges, airports and power facilities to make them more resilient against big disasters.
However, short-term effects could still be negative, with the VAT hike possibly preventing the emergence of healthy inflation and weighing on real income. This could in turn lead to consumers becoming more protective of their money, thereby—at least temporarily—neutralizing the effects of the government’s countermeasures, with individuals initially setting aside any extra cash they pocket from fiscal stimulus. While spending by manufacturing and machinery businesses has been supporting the economy, exports may slow down after May. As with that of households, manufacturer sentiment is becoming more and more cautious. Pessimists also downplay the benefits of the aforementioned natural disaster-related infrastructure spending, pointing out that it is a one-time expenditure that provides no multiplier effect to the economy.
In the longer term, however, the increased revenue should allow the government to return to balancing its budgets. Eventually, as healthier inflation takes hold, the economy should normalise and the government will be able to start paying back its debt.
All Signs Point to Go
Japan’s economic data has been under close scrutiny, with speculation that a fragile economy could lead to the VAT hike being postponed. However, it was announced on 20 May that the country’s economy grew an annualized 2.1% in the first quarter, defying economists’ expectations for a contraction. The unexpectedly strong GDP number will likely encourage Prime Minister Shinzo Abe to go ahead as planned with the tax increase.
At the same time, there are some worrying signs connected to the U.S.-China trade dispute. Projections vary, but Morgan Stanley estimates that an escalation with 25% tariffs imposed by both sides would push China’s growth below the 6% to 6.5% target set for this year by the second half of 2019, and to 5.5% next year1. Other projections are more muted. For example, Goldman Sachs projects that under a similar scenario, where the U.S. increases tariffs on USD 300 billion of Chinese goods, the Financial Conditions Index effect on U.S. GDP growth would be a relatively modest decrease of 0.25 percentage point2.
Regardless, Japan’s government has maintained that the tax hike will go ahead as planned unless its economy faces a shock of a similar magnitude to the global financial crisis in 2008. Even the most pessimistic scenarios don’t foresee the impact of fallout from U.S.-China trade tensions being of that scale. The October tax hike is therefore more likely than not.
- Goldman Sachs Global Investment Research