Abenomics

Japan and the consumption tax by Simon Wren-Lewis

...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.

How does an anticipated increase in sales tax raise expected inflation? It brings spending forward in anticipation of higher prices?

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.)

Didn't the UK "cut" VAT not raise taxes?

More on tax increases versus spending cuts in an austerity programme by Simon Wren-Lewis