Japan’s Prime Minister Shinzo Abe has decided to go ahead with an increase in
consumption taxes from 5% to 8% in April 2014, with a further increase to 10%
planned for later. Will this be the first step to reducing the very high level
of government debt in Japan (in net or gross terms, the highest in the
developed world), or will it derail the recovery? In many ways the answer
depends on whether you like your macro state of the art, or more antique.
Consider the antique first. Raising the consumption tax takes
real purchasing power out of Japanese consumers’ pockets. It is a
straightforward fiscal contraction, on a very large scale: the last thing you
need when we only have the first signs of a recovery. Now in theory this fiscal
contraction could be offset by monetary expansion, but can monetary expansion
really be strong enough to offset a fiscal contraction of that size? Some macro
antiques were always rather suspicious about the potency
of monetary relative to fiscal policy anyway, but in a liquidity trap those
suspicions become certainties. Even if the central bank does succeed in
reducing real interest rates by raising inflation, is that going to be more
powerful than the cut in real incomes that this higher inflation brings?
So why might modern macro be less pessimistic about the impact
of the consumption tax increase? For one thing it might be more optimistic
about the potency of monetary policy, particularly in an open economy. If the
central bank is really committed to bringing about a recovery come what may
then it may be prepared to see inflation go well above 2%. But I would suggest
the more important difference lies with the fiscal impact of the tax increase.
Modern macro could bring two arguments to the table.
The first is Ricardian Equivalence. The consumption tax
increase has been planned for some time, so consumers will have already
factored in its impact into their consumption decisions. Even if they had
wondered if the tax increase might be postponed, some taxes will have to rise
at some point. So if all the Prime Minister has done is confirm that tax
increases are going to come sooner rather than later, the logic behind
Ricardian Equivalence will mean that the impact on consumer spending will be
second order.
The second involves the incentive effect of higher sales taxes,
which I discussed recently. If monetary policy does not try and
offset the impact that higher sales taxes will have on inflation, then
anticipation of the tax could lead consumers to bring forward some consumption.
What this really involves is fiscal policy mimicking monetary policy. Or to put
it another way, if you were doubtful that monetary policy through Quantitative
Easing could raise inflation, here is a surer way to achieve the same thing.
The common theme here is the importance that modern macro
places on expectations of a fairly rational kind. Yet even if you are happy to
go along with this, there is an important proviso that does not get emphasised
enough. How did consumers know that the budget deficit would be reduced by
raising taxes rather than cutting spending? If they had expected the deficit to
be reduced by lower government spending, they will not have expected a fall in
their post-tax real income. For these consumers the Prime Minister’s announcement will come as a surprise, and
they will reduce their consumption as a result.
This argument is completely consistent with consumers being
rational and forward looking, as I emphasise here. All the behavioural assumptions required
for Ricardian Equivalence can still be there. What Ricardian Equivalence
implicitly does is hold the path of future government spending fixed, but that
is an artificial assumption which cannot be true in practice, if only because
of political uncertainty. (The argument applies more generally to the small
amount of modelling that has attempted to demonstrate ‘expansionary
austerity’.)
So we can summarise as follows. If consumption remains on
average unperturbed by the sales tax increase (perhaps showing a positive spike before
April 2014 which is only partially offset by falls thereafter), then modern
macro can pat itself on the back. On the other hand if consumption does take a
significant hit, modern macro has an escape clause. Let us hope it does not
need it.
Krugman won't be happy: blog September 9, 2013 'Make Japan Chaste and Continent, But Not Yet'.
ReplyDeleteThere is a danger of over interpretation here. I do not disagree with Krugman's post. I can think of things missing from modern macro that would lead you to take his more cautious line. Not every blog post needs to be about policy advocacy. This one is simply about the implications of various macro ideas.
Delete"if you were doubtful that monetary policy through Quantitative Easing could raise inflation, here [sales tax increase] is a surer way to achieve the same thing".
ReplyDeleteIs it really so?
Inflation is different in many ways... It is an ongoing effect. If you experience a 5% inflation, you might expect a 5% increase in prices every year for some. In 15 years, a 5% inflation rate halves the value of your cash (so you'd better do something with it).
A sales tax is a tax. You're just suddenly poorer (your revenue is down 5%). Maybe you can expect the tax will continue to increase, but any long term rate above 25% is highly unlikely.
Given those considerations, the sales tax is unlikely to have a monetary effect (or a small, very short-lived one on consumption), but likely to have a fiscal effect.
But there is another possible effect that is modeled neither by antique nor by modern macro. The sales tax increase is another bold measure by a government that hasn't been shy on measures so far.
Maybe it is more important that macro policies exist at all than they go in the right direction. Whatever happens, Japan macro policies are sure to give food for thought to the Eurozone.
"Even if the central bank does succeed in reducing real interest rates by raising inflation, is that going to be more powerful than the cut in real incomes that this higher inflation brings?"
ReplyDeleteBut if the CB raises inflation it will raise incomes along with the inflation wont it?
Just think about the psychological effect on consumers though.
ReplyDeleteFor decades the Japanese have become used to an environment of deflationary price pressures. Seeing prices go up could provide both a short term stimulus (Buy now while stocks last at these prices!) as well as kick start the Japanese psyche to begin buying again. These sorts of things don't need to be economically sustainable over the long run, in my view, but their effect can be huge because of the behavioural changes that last well beyond the stimulus.
Simon,
ReplyDeleteI often agree with you, but on this point I want to push back: "Now in theory this fiscal contraction could be offset by monetary expansion, but can monetary expansion really be strong enough to offset a fiscal contraction of that size? Some macro antiques were always rather suspicious about the potency of monetary relative to fiscal policy anyway, but in a liquidity trap those suspicions become certainties."
I think there is sufficient evidence to be less certain on this point. See here: http://macromarketmusings.blogspot.com/2013/09/monetary-policy-at-zlb-three-quasi_25.html
Simon, is there actually any empirical macro evidence for Ricardian Equivalence? I think RE is given far too much prominence. It's a neat theory, but I cannot see how it holds in practice. In my view, the vast majority of consumers just do not follow economic news closely enough to change their consumption patterns in advance of changes in taxation.
ReplyDeleteAcademic economists should pay more attention to REALITY. As regards Ricardian equivalence and expectations, the evidence seems to be that they are feeble effects. At least that’s the impression I get from Googling the words “ricardian evidence research” and looking at the summaries of a few papers. And Joseph Stiglitz said:
ReplyDelete“Ricardian equivalence is taught in every graduate school in the country. It is also sheer nonsense.”
Perhaps I read this too quickly, but it seems to discuss two separate issues:
ReplyDelete(a) Consumption always surges ahead of a pre-announced indirect tax rise, with some planned purchases brought forward. So consumption is higher than usual before the tax is implemented, with an offsetting payback spread over a period of time after the tax is raised. So far, so neutral.
(b) An indirect tax rise is a fiscal tightning that should come with a negative multiplier effect, which will be larger than otherwise if more consumers are credit-constrained.
(c) Monetary policy could offset this, but is unlikely too at present, though the exchange rate could depreciate.
Bottom line: GDP higher before the tax is raised, GDP lower afterwards, with the negative effect larger than the (pre-tax) positve effect.
Take a look at Bloomberg before you draw any hasty conclusions
ReplyDeletehttp://www.bloomberg.com/news/2013-10-01/japan-awaits-abe-s-third-arrow-as-companies-urged-to-invest.html
Abe is a class warrior whose goal is to subsidize big business while levying higher taxes on working people. Is that really an effective way to fight deflation?
If (Japanese) history is an indication:
ReplyDelete-Salestax rises will give a short term boost to consumption (like a temporary high inflation expectancy). We have seen that before.
-After that things will be reversed.
-Will not do much good for the deficit 1-1.5% extra tax revenue while the deficit is 10%ish.
-Especially seen a 50 Bn stimulus package.
One can doubt if moving tax burden from cies to consumers is effective especially short term. Japanes cies invest a lot abroad.
Positive they stopped (or better it stopped (by itself (?)) rates increase. See how that works out if the FED starts to taper. And how longer term investors in Japanese sov debt respond. 2% inflation and 1% or less interest is not something you keep investors aboard with.
It seems to me that inflation caused by a consumption tax is apt to be a very different beast than normal inflation. Normally, a 10% bump in inflation would also mean that sellers are receiving 10% more for their goods. It would lower real debt burdens and put upward pressure on wages, which could lower the real debt burdens of consumers.
ReplyDeleteNone of this happens with a consumption tax. Even if merchants pass on the entire tax to consumers, they're not earning anything extra. This also means that merchants won't be willing to increase nominal wages. What's more, it's highly likely that merchants won't be able to pass on the entire tax, which could put downward pressure on wages.
Another advantage of standard inflation that is lacking here is that inflation acts a continual inducement for people to spend, rather than save, as well as lowering real interest rates. This can be a big help if excess saving is leading to insufficient demand. Here the incentive to spend is a one-off that does not continue after the imposition of the tax. Furthermore, the beneficial effect of inflation on real interest rates is missing. 10% inflation allows for a real rate of -10%. A 10% price increase caused by a consumption tax does not.
In a nutshell, inflation caused by a consumption tax is completely different than that caused demand-focused stimulus. If Japan goes ahead, this sounds like a disaster.
Just for the record: there has been raise of Germany's consumption tax from 16% to 19% in 2007 (see also Hayo & Uhl 2013).
ReplyDelete