Japan has been here before, and the outcome was far from pleasant. Yet it seems the wheels are in motion. The country will double its national sales tax, from 5% to 10%. The move, justified as a way to help the country deal with its precarious fiscal situation, has raised serious concerns, since this kind of tax hike, applied for much the same reason, was widely blamed for the country's destructive recession in the late 1990s. Though some in Japan claim that the current environment is different, this history, the already weak global economy and Japan's recent decline into a balance-of-payments deficit argue forcefully for a different route to fiscal reform.

The need to address Japan's budget situation is beyond cavil. Japan has the distinction of facing the worst fiscal situation in the developed world. This year, the country will likely see deficits rise to about 10% of its gross domestic product (GDP). Huge deficits plagued Japan for years as the government tried to prop up the economy's meager growth prospects. Now Japan also faces a huge debt overhang. According to the Ministry of Finance, outstanding bond obligations of the central government equal close to 150% of GDP. Including local governments, the outstanding debt is almost double GDP. Debt servicing costs have roughly doubled as a percent of total outlays since 1980 and this fiscal year, even with interest rates as low as they are in Japan, will amount to about 25% of all government expenditures. There is a real concern that matters have reached a point when these expenses will crowd out other necessary and legitimate government functions and bring on the untenable situation in which government goes deeper into debt largely to meet the obligations on its existing debt.

But if the need for fiscal reform is obvious, questions nonetheless remain over whether a sales tax hike is the way to go about it. History would argue otherwise. Back in April 1997, then-Prime Minister Ryutaro Hashimoto went this route despite a lot of opposition within Japan's Diet (parliament) and the public. A recession began immediately after he raised the national sales tax from 3% to 5%. Consumer spending, which had been growing at better than a 4% annual rate, fell during the second half of that year and into the middle of 1998. At the slowdown's worst, the Japanese consumer made real cutbacks at a yearly rate of over 4%. Though the Japanese consumer is a less significant part of Japan's economy than the American consumer is of the U.S. economy, the economic effect was profound. Japan's real GDP sank, and knock-on effects kept it declining. The country did not show positive growth until late 1999, more than two years after the tax went into effect. Because of the economic shortfall, the budget deficit, rather than shrinking, about doubled from its 1996 level.

Though much else occurred during that time, not least the so-called Asian Contagion financial crisis, the sales tax hike has taken the blame for this very severe economic setback. In the present debate, those opposed to the tax move, both in and out of government, have reminded the administration of this experience and the damage it did to the fiscal situation. The opposition has also pointedly reminded current Prime Minister Naoto Kan that his predecessor, Hashimoto, had to resign in 1998 as a direct result of the tax and the ensuing economic slide. The prospect of another tax has elicited so much opposition in the ruling Democratic Party that Prime Minister Kan had to rely on votes from opposition parties to push the legislation through the Diet. The situation has become so contentious that party founder Ichiro Ozawa led several members to split with the party. That act could throw Japanese politics into confusion and further delay any substantive fiscal reform.

If the sales tax hike is politically and economically dangerous—counterproductive—Japan needs an alternative way to cope with its fiscal needs. As with all other developed economies, it will almost surely have to look for the answer in entitlement reform. Budget patterns make this painfully clear. Social Security and related areas, mostly healthcare, now amount to some 29.2% of all government outlays, up from 16.6% in 1990 and 19.7% in 2000. It is the only major budget category other than debt service that has seen its proportion of the budget rise. Local grants have shrunk, as has discretionary spending, including education and defense–the former from 23% of outlays in 1990 to 18.4% presently, the latter from 29.7% to 23.1%. Even infrastructure spending, for which Japan is famous, has shrunk by almost half, to about 5% of the budget today. Without some entitlement reform, it is hard to see much deficit progress, even in the unlikely event that Japan manages to avoid adverse economic consequences from the sales tax hike.

If Japan's politicians see the country as under-taxed and want to increase taxes as part of a budget solution, perhaps a sales tax hike should be the last and not the first resort. With a strong yen and an aging population, Japan needs to shift its economy's growth engine from exports, which it has relied on for decades, to domestic sources, in particular consumer spending. The need for such a shift is well-known and widely commented on in government, academic, and policy circles. It has proceeded slowly because of Japan's legacy of anti-consumption policies, such as strictures against large box stores that could make consumption cheaper and easier. Deflation has threatened to derail the needed changes as well by convincing Japanese householders to wait for lower prices before purchasing. A major sales tax hike would not only risk recession and even larger budget deficits in the short and intermediate term, it would further delay needed fundamental change in the country's economic structure.

For an earlier article by Milton Ezrati about Japan, see Poor Japan.

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Ezrati&rsquo;s Economic Outlook: Japan&rsquo;s Sales Tax Risk

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