Japan Needs to Restructure its Tax System as the Nation Struggles to Restore Economic Growth

Japan has fallen back into a ‘technical’ recession after recording its 2^nd successive quarter of negative growth. Japanese GDP fell by 0.4% (or an annualised rate of -1.6%) in the 3rd-quarter of 2014. Reuters had forecast economic growth of 0.5% (or annualised growth of 2.1%). Quarterly figures are misleading in the context of the sales tax hike, as it’s probable that people brought forward expenses in the 2^nd quarter (contraction of -1.83%, or annualised rate of 7.3%). Based on statistical evidence, private households are not responding to the stimulus, with private consumption, representing 60% of economic activity, rising just 0.4%.

Equity markets understandably took the contraction badly, with the Nikkei-225 falling 3% (517pts) to 16,973pts in response to the news. This follows a strong recovery in the Japanese market since the BOJ revealed an expanded stimulus program. The Yen was also weaker by 0.85%, falling to 115.58 Yen against the USD, taking the Yen to a 7-year high.

Clearly there was a lack of confidence by Japanese business leaders and consumers in the sustainability of the Japanese recovery. This poor result can be attributed to:

1. A lack of substantive reform
2. The increase in the sales tax rate from 5% to 8% in April 2014.
3. The subdued growth in exports – apart from the one-off ‘yen-depreciation’ gains
4. The interim nature of the data. There is still corporate ‘capital items’ to be reported which will marginally improve the revised numbers, yet the final figure will still look bad.[i]
5. The government’s attempt to “flog a dead horse” by attempting to use stimulus to boost inflation. It is ludicrous because he is not pursuing the right monetary settings to achieve that goal.

The policy is poorly conceived for a number of reasons. The principle objective is to rebalance the public sector budget and to revitalise the economy. If they can revitalise the economy, then this will go a long way towards removing budgetary pressures. The problem is that:

1. Executive Japanese governments are renown for cowardice. They simply don’t have the ‘braze balls’ to pursue policies that will impact the Japanese people.
2. Japan's government simply does not have the courage to cut spending on public works that have sustained a substantial amount of domestic demands, even if it has been hugely inefficient and raised the public debt to ridiculous levels. The good news is that most of this debt is being carried by the Japanese people, so it is easy for the Japanese government to simply raise taxes or inflation to recapitalise the economy.
3. Japanese households are struggling to save given their lack of financial literacy, as well as the poor return on traditional ‘bonds’. The greater folly is that the Japanese government has abused pensioner savings by investing in domestic infrastructure, which has offered investors and the economy a sub-optimal benefit. Few other nations want to invest in government bonds that return a paltry yield of just 0.4%; least of all when the currency is being rapidly debased. The low-medium income Japanese investor is a sucker for it.
4. The Japanese distribution of income is very tight so a great many families are struggling on low incomes. The implication is that a lot of households are vulnerable to a rise in sales taxes. The last rise from 5% to 8% occurred in April 2014, and a further rise to 10% is scheduled for Oct 2015.
5. Given the slack economy, many commentators are expecting the Japanese government to defer the last tax increase until 2017. The problem however is that Abe is attempting to place the burden on the households, and that is just outrageous when you consider the wage restraint imposed upon the economy. The government should be taxing capital, with the ultimately intent to boosting the return on capital, as well as stimulating consumption. That would be particularly sensible strategy given that is where the asset appreciation is. The most sensible way to achieve this might be by ending 'centralised government'. Rather than central governments dispersing funds to prefectural and city governments, it would probably make more sense to bestow a greater responsibility upon local government to carry administrative burdens. 

The rationale for taxing consumers is to stimulate business activity, however this is a ludicrous idea when:

1. External markets are subdued
2. Wage growth is subdued because the reform initiative has been mute

Domestic costs need to fall and the best approach is not to raise consumption taxes, but to reduce the burden on the Japanese people. This can be done by:

1. Boosting immigration, and Abe is certainly looking at that, whilst concurrently scaling up the nationalistic rhetoric.
2. Speeding up the pace of political and industry reform that promise to cut the costs of living and to add dynamism to the economy. We have electricity privatisation in 2015, however more is required.
3. Cutting spending so that the consumer has greater discretion to optimise their own spending. It cannot rely on stronger external trade in the current context.
4. Speeding up privatisation so that capital can be more efficiently employed
5. Tax reform that shifts the burden of the state from the consumer to the holders of capital

The corporate sector, given its exposure to weaker yen were able to contribute in terms of ‘record profits’, however this is not real growth. The problem of course is that Japan cannot look to the external account to boost Japan because of the weak global economy.

There is a propensity for economic commentators to not understand inflation. The Bank of Japan's (BOJ) has a ludicrous goal of 2% inflation. You cannot blow out money supply by a massive 40% and persist in wondering why there is no inflation. They look at inflation as a simple ‘demand phenomenon’, so when they look at inflation and see no inflation, they think ‘the economy needs more pump-priming’. The reality however is that the ‘pump priming’ is boosting asset prices (i.e. asset inflation), not the ‘cost of living’ inflation that affects workers. There is a good reason why this is the case and it is the immense ‘oversupply’ of unskilled labour in the global marketplace, and Japan is no exception. Only among the higher skilled workers is there a rise in incomes.

We clearly see evidence of asset inflation with the Nikkei off its 7.5 year high of 17,500pts. In the case of Japan, the asset inflation is largely confined to the equity market and inner-city property markets, which offer the most tangible exposure to assets in a depopulating market. The property market does however offer substantive opportunity for future gains if there is evidence of economic reforms that auger well for real income growth. In the short term, the property market is destined to be constrained by:

1. Negative growth in real income
2. Slack employment growth
3. Low consumer and business confidence
4. Negative population growth

The only positive aspect is that despite ‘negative’ overall population growth, there is still migration of people to the cities. Rather than people going to the city centres, a great many of these youthful Japanese are turning to the outer areas of Tokyo, which are far cheaper.

The rationale for an election is simply because Abe’s opponents are divided and weak. It would be opportune to call an election whilst that remains the case, but why now? There is no reason why he can’t defer the sales tax, but there is an imperative that he is seen to be carrying through with his reform mandate. There is every possibility that Abe will look to other measures like immigration to boost the economy. Expect the influx of tourists to help placate Japanese fears of increased immigration.

[i] Comment by Yoshito Sakakibara, Executive Director - Investment Research, JP Morgan; “Japan's economy contracts in third quarter” by Li Anne Wong, CNBC.com, website, 17^th Nov 2014.

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Author Andrew Sheldon| Applied Critical Thinking | www.SheldonThinks.com