Japan’s consumption tax: a test of modern macro?

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.

Japan and the consumption tax

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.

      

More on tax increases versus spending cuts in an austerity programme

Using sales taxes to mimic monetary policy in a liquidity trap

                Monetary policy works by changing the real interest rate. At the zero lower bound monetary policy loses its power, unless it can influence inflation expectations. However inflation expectations for consumers will also depend on the evolution of sales taxes (indirect taxes like VAT). A pre-announced increase in sales taxes will raise expected inflation, and so reduce the real interest rate faced by consumers at the zero lower bound. In this sense changes in sales taxes can mimic monetary policy.

                I first wrote about this some time ago (for the record Wren-Lewis, 2000, but some of that discussion is a little dated now). As a result, I thought the (surprise) temporary VAT cut introduced by the UK government at the end of 2008 was a good idea (see here). Thanks to @daniel’s comment on an earlier post, I’ve now read a nice and straightforward paper by Isabel Correia, Emmanuel Farhi, Juan Pablo Nicolini and Pedro Teles, which formalises this idea in a standard New Keynesian model at a zero lower bound.

                My original piece on this suggested that a temporary but unexpected cut in VAT, like a temporary increase in government spending, could provide an effective stimulus to aggregate demand for a given monetary stance. But what are the implications for Eurozone countries that are trying to bring down government debt? They are the mirror image: it is not a good idea to use cuts in government spending, or a surprise increase in sales taxes, as a way to bring down debt in a recession. However pre-announced increases in sales taxes work differently.

                If the increase in sales taxes is announced but delayed, then this provides a stimulus before the point at which it is increased (as in the UK 2008/9 case). Put simply, people buy before higher taxes raise prices. Furthermore, if the increase in VAT is not permanent (because the intension is to bring down debt), but it is expected to end at a point at which interest rates are no longer at a zero lower bound, then the subsequent deflationary impulse can be counteracted by monetary policy. Of course, a key proviso is that interest rates have to stay at their lower bound when sales taxes are rising – obviously higher inflation will not stimulate the economy if it is offset by rising nominal rates (see here for an example).

                This suggests that pre-announced increases in sales taxes could be used as an effective consolidation device that also stimulated demand. The government announces a sequence of increases in indirect taxes, which go on increasing for as long as the zero bound is expected to be a constraint. Once the economy has recovered such that interest rates can rise, sales taxes can then be steadily reduced towards some desired long run level, achieving whatever reduction in debt is required.

                This idea is conceptually different from but complementary to the argument I have made before for using taxes rather than government spending as part of a fiscal consolidation programme. That argument was based on consumers smoothing the income effect of tax changes. The above is an additional point about the impact of taxes on inflation, which changes the incentive to consume today rather than tomorrow.

                Raising consumer prices via sales taxes increases negative incentive effects on labour supply. The optimal strategy examined by Correia et al is in fact revenue neutral, because it involves offsetting changes in income taxes/subsidies.  As indirect taxes rise, income taxes fall (or income subsidies rise). In an environment where there is no need for fiscal austerity, this is the welfare maximising plan. When government debt is excessive, then reducing debt is bound to involve either increasing tax distortions or the suboptimal provision of public goods or transfers for some time. In this case there would be no point in a tax switch: you just raise sales taxes.

                When I have asked whether this form of deficit reduction strategy was considered in Ireland, one of the responses was that there was a concern about the distributional impact of indirect tax increases relative to direct taxes. That is a whole different issue, and should ideally be dealt with by different means. From a macroeconomic point of view temporary increases in any taxes that have relatively small income effects because of consumption smoothing, but a significant impact in raising inflation, should be the preferred fiscal consolidation instrument at the zero lower bound.