Japan’s lower house of parliament today passed a controversial bill to double the consumption tax to 10 percent. The move comes as the country grapples to rein in its public debt, set to hit one quadrillion — 1,000 trillion — yen ($12.6 trillion) this fiscal year.
The bill, which still has to make its way through the upper house, will increase the sales tax to 8 percent in 2014 and 10 percent in 2015. Some are concerned that the tax increase could dampen already fragile consumption in the world’s third-largest economy, and that it won’t raise enough money to make a significant dent in the growing debt mountain.
“Everybody knows a debt crisis is coming,” says Martin Schulz, senior economist at the Fujitsu Research Institute in Tokyo, “most people in Japan are simply closing their eyes to it.”
After months of political wrangling, the bill was approved by a resounding 363 to 96 votes, with the support of the two main opposition parties.
“We have taken a big first step toward reform, both for the sake of present-day Japanese and for future generations,” Prime Minister Yoshihiro Noda told reporters after the vote.
However, 57 members of the ruling Democratic Party of Japan, led by powerbroker Ichiro Ozawa, voted against the government. This raises the prospect of a mass defection that could rob Mr. Noda of his parliamentary majority.
How high of a deficit can one country sustain?
According to Ministry of Finance statistics, debt now represents 230 percent of Japan’s $5.5 trillion economy, compared with 165 percent in crisis-stricken Greece and America’s 100 percent debt. While more than 90 percent of Japanese debt is still owned domestically, meaning there is no immediate danger of the kind of external pressure that crippled Greece, Japan is now in uncharted waters for a modern industrial economy, and the potential consequences for the world economy are exponentially more severe.
Japan is also the second-largest foreign holder of American debt behind China, with approximately a trillion dollars in US Treasury bonds. The Japanese government would have to consider selling at least some of these reserves to raise funds if servicing its own debt at home became problematic. That, in turn, could increase the cost of borrowing for the US government, putting further pressure on its also creaking public finances.
However, selling US treasuries would be “very politically sensitive,” according to Dr. Schulz, and something Japan would do its best to avoid.
Over the years, Japan has managed to sustain such astronomically high levels of debt in part by borrowing at very low interest rates from its own citizens and corporations, essentially drawing on high household saving rates and huge trade surpluses. With both of these now dwindling, however, that lifeline may soon be cut.
A one-time nation of savers
Some 20 years ago, Japanese households saved nearly 15 percent of their incomes — the rate for the US was less than half that. By 2011, saving rates in the US had fallen to 3.6 percent, but in Japan they had plummeted to 3.2 percent.
With Japan recording its first trade deficit in 31 years in 2011, and a return to surpluses looking unlikely due to the declining competitiveness of its export industries, fresh funds to pay for its ballooning debts are going to be harder to come by.
Half of the government’s annual budget is now funded by issued debt, and options for bringing it under control are limited.
Takashi Shiono, an economist at Credit Suisse in Tokyo, says the government is “almost ignoring the debt except for trying to raise the consumption tax.” However, Mr. Shiono believes that as long as the government can keep borrowing from the still considerable pool of Japanese household assets, and the trade deficit doesn’t worsen severely, the debt will remain manageable.
How to escape downward spiral
The best chance of Japan escaping this downward spiral would be a period of sustained economic growth, something that looks unlikely with an aging, shrinking population and increasingly strong competition for its industries from lower-cost and more innovative Asian rivals.
And even growth would bring its own perils.
If the economy did improve meaningfully, some inflation would be inevitable, leading to a rise in interest rates. Even a small rise in the cost of borrowing for the government would make it impossible to pay the interest on its vast debt. The most likely resulting scenarios are either rampant inflation or default.