While most international attention has focused on recent developments in Japanese monetary policy, there are interesting developments on the fiscal side too. A key issue is the proposal to raise the national consumption/sales tax from 5% to 10% in two stages beginning in April next year. Japanese Prime Minister Shinzo Abe says he will wait until probably the autumn to make a final decision, and the macroeconomic outlook will be a key factor. The proposal has the support of Bank of Japan governor Haruhiko Kuroda. However the more interesting question for Kuroda is how the Bank will react to the sales tax increase.
Much of the reporting on this issue is along the familiar lines of whether it is better to focus on reducing the government’s very high level of debt (raise sales taxes) or ending deflation in Japan (don’t raise sales taxes). While this debate is a familiar one, there is an additional twist with a sales tax. An anticipated increase in sales taxes, by raising expected inflation, will - other things being equal - provide an incentive for consumers to bring forward their spending. Macroeconomists would describe this as a real interest rate effect, but in simpler terms it makes sense to buy before prices go up.
This incentive effect has been observed in Japan in the past, and in other countries. (See page 12 of this IMF report on the issue.) The UK cut VAT for just one year in response to the recession in 2009, a measure I have described as New Keynesian countercyclical fiscal policy, and this may have raised consumption by over 1%, in part because consumers anticipated that prices would rise again in 2010. (The over 1% figure comes from here, although this analysis is more conservative.)
However, this effect only occurs if monetary policy does not react to the sales tax rise, and the increase in headline inflation that this will bring. If every percentage point increase in inflation is matched by the same increase in the nominal interest rate (and we ignore taxes), the effect will disappear. (Prices will rise, but so will the value of my savings so I can afford to wait.) If the Bank of Japan attempts to reverse the increase in inflation by tightening policy still further, then we get a very undesirable outcome.
These considerations suggest two things. First, if they take place, increases in sales taxes should be deferred by long enough to allow any bringing forward of spending to happen. The worst thing you can do in current circumstances is implement an unexpected sales tax hike. Why not raise sales taxes by 1% each year for the next five years? Those who suggest that acting gradually ‘risks losing the credibility of financial markets’ should be ignored. Second, the Bank of Japan should commit to ‘see through’ the impact of sales taxes on inflation, and not tighten monetary policy in any respect (conventional or unconventional) following the increase in inflation that higher sales taxes will bring. It would be good if that commitment can be made publicly before the increase in sales taxes is confirmed.