With debt climbing, Japan debates tax hike

Japan has within its sights the obvious but precarious solution for its fiscal mess: a tax hike.

Tax and spend: A customer holds ,000 notes as she shops at a Bic Camera Inc. store in Tokyo on Thursday. Japanese lawmakers are currently engaged in debate over whether the consumption tax should be raised to cut the nation's deficit. BLOOMBER PHOTO

With its debt rising, its population aging and its social security costs set to soar, an increase in the consumption tax allows Japan a chance — perhaps its only chance — to keep pace, perhaps to even cut its current deficit. The International Monetary Fund recommends such a move. So do the country's finance bureaucrats. Polls even suggest that most Japanese citizens understand the need for a raise.

But among Tokyo's top politicians, the tax issue has so far led only to a sluggish form of combat, with disagreements over when rates should jump, how much they should jump and whether they should jump at all.

The emerging global slowdown has complicated the debate, with some now saying that a tax increase amid a recession would merely inflict more short-term damage on Japan's economy. Inaction, of course, brings its own risks: A recent Credit Suisse research report suggests that if Japan doesn't soon show progress toward tax reform, the credit-rating agency Moody's Investors Services , as part of its ongoing review, could downgrade Japan "in late August or soon thereafter."

Last week, two of the leading candidates to become Japan's next prime minister, replacing the soon-to-resign Naoto Kan, planted themselves on opposite sides of the tax debate with dueling statements in the Bungei Shunju monthly magazine.

Finance Minister Yoshihiko Noda said he wanted to bump the tax rate "with firm determination." Sumio Mabuchi, the former transport minister, said he preferred a long-term strategy where a fundamental economic recovery helped repay the debt. "We should not head toward a tax increase," Mabuchi said.

Like many of the European countries buckling under their debt, Japan faces an untenable strain, with more elderly to support and fewer workers to support them. And its government debt, 218 percent of GDP, is highest in the world.

But Japan, in several key ways, faces a far different calculus than those countries, and, at least for the short term, it's less prone to crisis. Some 95 percent of Japanese government bonds are domestically held. Deep household savings still far outweigh public debt. That leaves Japan, despite the scary numbers, with a stable bond market: Companies and families deposit their assets at Japanese banks. Those banks purchase government bonds. Trust and conservatism hold the system together.

The government, economists say, can prevent a potential crisis — where unraveling confidence triggers a selloff of yen-held assets — by simply keeping the deficit from flying higher.

A June report issued by the IMF called on Japan to triple its 5 percent consumption tax — still below the 20 percent average in European countries — within the next several years. Such a move, the report said, would represent half the fiscal adjustment necessary to put the public debt ratio "on a downward path."

"Without fuller exploitation of the potential of the consumption tax," the report added, "it is hard to see how fiscal sustainability can be restored."

Proponents of the consumption tax increase note that Japan, in the wake of the March 11 disaster, must now generate an additional ¥23 trillion for reconstruction in the next decade. Plus, the tax increase would correct an obvious shortcoming: Japan recoups only about 17 percent of its GDP in tax revenue, one of the lowest rates in the OECD. A step-by-step consumption tax increase, with 1 or 2 percent spikes every year, might even induce freer household spending. After all, products will be cheaper today than they are next year.

"The point is, Japan has a structural problem. The tax base is too low," said Jesper Koll, head of Japan equity research at J.P. Morgan. "Japan, with its current tax system, cannot grow itself out the problem."

Opponents of the tax hike, including many in the Liberal Democratic Party, instead favor cuts in subsidies and salary reductions for civil servants. They want no part of a European-style welfare state. And given the global economic concerns, they say, any imminent consumption tax hike comes with a risk.

"Nobody should raise taxes in the middle of a recession," said Eisuke Sakakibara, former vice finance minister for international affairs. "Eventually we have to raise the consumption tax — no question about it. But right now I'd wait."

For more than a decade, outside analysts and research institutes have called for Japan to quickly reform its tax system. Politicians who've pushed for such change, though, have generally succeeded only in hurting their own careers.

Last summer Kan, just weeks on the job, proposed a consumption tax hike, eroded his popularity and withdrew the idea. His party was summarily trounced in a parliamentary election.

With the opposition party now in control of the Upper House, future Japanese leaders could struggle to pass any tax increases, analysts say. Without a consumption tax hike, Credit Suisse anticipates that Japan's debt, as a percentage of GDP, will rise to 238 percent by the end of this fiscal year. By 2015, it will be 268 percent.

"For now, it is almost impossible to say what happens," said Naroyuki Haraoka, executive managing director of the Japan Economic Foundation. "Nobody knows the economic policy to be taken in the future. Japan needs to clarify the direction. This is the first step."

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