Kan May Face Ghost of Hashimoto as Japan's Economy Weakens Before Tax Rise

Japan’s slowing recovery from its worst postwar recession is signaling the world’s second-biggest economy may be too weak to sustain the higher consumption taxes under consideration by Prime Minister Naoto Kan.

Reports this week showed the jobless rate reached a five- month high in May, and wages, factory output and household spending fell, showing little sign of revival in domestic demand more than a year after the economy stopped shrinking. A gain in the Tankan business-sentiment index today reflects a post- recession rebound in manufacturers’ earnings led by exports.

The risk is that without an end to deflation and rebound in spending, the economy won’t be able to withstand the higher levy Kan plans in as soon as two years. Kan, facing midterm elections July 11, is in danger of repeating the error of his late predecessor Ryutaro Hashimoto, whose 1997 tax rise helped cause a recession, according to Morgan Stanley MUFG Securities Co.

“Hashimoto raised taxes as soon as he thought the economy had gained back just a bit of its health, and that ended up sinking the Japanese economy into a bottomless abyss,” said Akio Makabe, an economics professor at Shinshu University in Matsumoto, central Japan, who has written books on behavioral finance. “If the government doesn’t get its priorities straight, we’ll see another 1997.”

Evidence of a weakening rebound has contributed to a sell- off in Japan’s equities, with the Nikkei 225 Stock Average losing 6.8 percent in the past two weeks, to 9,382.64 at yesterday’s close in Tokyo.

Eroding Support

Kan is also feeling the impact, with eroding public support before the vote for the upper house of parliament. His approval rating fell to 50 percent last week, 18 percentage points lower than when he took office last month, a Nikkei newspaper poll showed June 26.

The poll was taken on June 24-25, days after the premier said he would consider an increase in the sales tax to 10 percent from the current 5 percent. Tax changes will be unveiled “soon,” the government said in a medium-term fiscal strategy June 22. The administration also pledged to balance the budget by fiscal 2020 and cap public spending for the next three years.

Policy makers need to implement a pro-growth overhaul of business regulations and prod the Bank of Japan to stimulate credit expansion before considering a tax increase, according to Morgan Stanley and Barclays Capital.

“More aggressive monetary and regulatory policies are needed in Japan if 1997-style economic consequences of fiscal retrenchment are to be avoided,” Morgan Stanley economists led by Robert Feldman, who previously worked at the U.S. Federal Reserve, wrote in a report yesterday.

Setting the Goal

“Strengthening the economy is the goal here -- fiscal rehabilitation is only a result of that,” said Kyohei Morita, chief economist at Barclays Capital in Tokyo. He also advocates cutting corporate taxes, a move Kan is also considering.

Koji Miyahara, president of the Japanese Shipowners’ Association and chairman of Nippon Yusen K.K., said last month that the country’s companies need a corporate tax cut to continue competing in the global economy. The government should “offset the loss” of revenue from the corporate tax cut by increasing the sales tax, he said.

Sales taxes can be an effective way of raising revenue in developed economies, according to the International Monetary Fund. More than half of gross domestic product typically comes from consumer spending in the developed world.

Fighting Deflation

Higher sales taxes, introduced gradually, could help the economy by spurring inflation expectations, according to Masamichi Adachi, an economist at JPMorgan Chase & Co. in Tokyo. An annual 1 percentage point increase from next year, eventually reaching a 20 percent level, would minimize the impact on consumer spending, he said.

“When people get used to the fact that the consumption tax rises a percentage point every year, they’ll begin to assume that prices will keep rising,” Adachi said. “That way, deflationary expectations will turn into inflationary ones.”

In 1997, Hashimoto boosted the consumption levy by 2 percentage points, an increase followed by a recession that led to his resignation. Kan, 63, has said he’s considering the opposition Liberal Democratic Party’s proposal to double it to 10 percent, and called for cross-party talks on the issue.

Japan’s dilemma is echoed around the world in developed nations with swelling public debt loads and historically high unemployment.

U.K., U.S.

The U.K. plans to boost its value-added tax to 20 percent from 17.5 percent in January. Spain is raising its main VAT rate in July to 18 percent from 16 percent. By contrast, American officials have warned that policies need to sustain a recovery in domestic demand.

Morgan Stanley analysts, who weren’t immediately available to respond to questions, said Japan’s economy is in worse shape than 1997, when the jobless rate was around 3.3 percent compared with 5.2 percent now. Deflation is more entrenched, with consumer prices slumping 1.2 percent in May, more than the 0.5 percent drop on the eve of the tax increase 13 years ago.

“Vulnerability to premature tightening is high,” the bank’s economists said.

To contact the reporter on this story: Aki Ito in Tokyo at aito16@bloomberg.net

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