Inflation Tax

Ichiro Suzuki

The Japanese government is lately enjoying tax collection bonanza that it hasn’t known for decades, obviously not since the latter half of the 1980s when the Japanese economy boomed, in what turned out to be a massive bubble. In the mid-2020s, few are feeling that the economy is booming but at least they are reasonably certain that it is no longer faltering under deflationary pressure. In an economy that’s not booming, both the stock and real estate markets are soaring. The Ministry of Finance is raking in lots of taxes. Corporate Japan has been registering record profits every year since the pandemic was over. A heavy dose of liquidity to fight COVID-19 and revitalized global economy have brought the Japanese economy back to life. Inflation is back in Japan distinctly, after having been forgotten for over two decades. Wages and salaries are rising briskly in an attempt to beat the inflation. Higher profits and wages/ salaries are also contributing to the MOF’s coffers. Notably, higher prices on everything has a great effect on consumption tax collection.

Prime Minister Sanae Takaichi has been maniacally pro-growth for years. Having risen to the helm last October, she has been vocal of ‘responsibly aggressive fiscal policy’. She has been advocating boosting investments in the domestic economy in order to lift its potential growth rate that’s not even 1%. Dearth of investments over the last few decades has been the primary cause of anemic growth, and she desperately wants to reverse the trend. In the process of driving fiscal policy toward a more aggressive direction, her government has dropped a single year deficit goal to expand it to a multi-year basis, a method that has been employed in Europe, including the EU, the United Kingdom, Sweden or Switzerland. While she employs an aggressive spending policy, spending requirements in a variety of fields has been rising ruthlessly. Social security-related expenditure has been rising rather exponentially on the country’s aging population. In the face of crumbling of the system that kept peace for 80 years that followed WWII, greater defense spending has become imperative for Japan. Not only the first war in Europe since 1945 is being waged, Chinese planes are frequently violating Japan’s air space in East China Sea. The U.S. has grown considerably less tolerant on allies’ ‘free riding’ on its military power, either in Far East or Europe, and has been telling allies to ‘defend themselves’ essentially. 

On top of social security and defense that have been rising anyway, PM Takaichi’s responsibly aggressive fiscal policy is proposing investments in 17 fields funded by tax payers money. Industrial policy is back in vogue these days. Even the United States is actively doing it. In this context, the government’s involvement in semiconductors and clean energy, for instance, are understandable. They look highly strategic to everyone and the country doesn’t afford to fall behind others.. On the other hand, some of other areas seem questionable, such as entertainment/ soft culture. (Japan wants to emulate South Korea, which did this two decades ago and delivered great results in explosive popularity of K-pops and K-dramas.) The proposed plan on her aggressive spending has no shortage of flavor of laxity that might go out of hands. If these spending aren’t enough, she is pushing hard on a cut on consumption tax on food in order to bring the rate down to 1% from 8% for two years. A consumption tax cut was her campaign promise in the February election. This seems essentially an unfunded tax cut that could cost ¥5 trillion or 0.8% of GDP, though her circle is trying to find a way to fund it properly. She is adamant on delivering this campaign promise to maintain her political capital even if the majority of her party members think the proposed cut unwise.

Growth of all these spending requirements is a nightmare for the MOF. Not surprisingly, politicians have been displaying remarkable incompetence in controlling ever-expanding social security expenditure as the population keeps aging. Few are willing to dare to ask voters to pay more for the benefits and services that the government provides them. Consumption tax was introduced in 1989 in preparation for the coming aging society. Starting at 3%, the tax rate has been raised twice to the current 10% (8% on food items). Attempts to raise the rate have proven to be political suicides on many occasions though Shinzo Abe handled the last hike in 2019 relatively skillfully. Besides how to fund it, the proposed cut would require reversing it two years later, with a hike back up to 8%. This hike would be hard to sell politically even if it was advertised as a cut for a limited time. 

Here comes the market in the face of politicians’ inability to make hard decisions. Thankfully, the rate of revenue growth has been exceeding that of expenditure. Due to the aforementioned factors, the government’s coffer has been filled with money, even if parts of the spending has to be debt-financed. On top of revenue growth that’s beating expectations, greater nominal GDP growth due to the inflation is expanding the size of the economy. These two factors are bringing down the ratio of debt to GDP. Make no mistake, at well over 200% of GDP, the ratio for Japan is still staggering by any standard, but it has become under control, at last. Economic growth, on the other hand is far from being robust, being 1% at best, no comparison to the boom years. This is a magic that inflation works, in sharp contrast to the misery that deflation dealt for decades. The MOF in those years was afflicted with persistent revenue shortfalls caused by deflation in those nightmarish years. Ms. Takaichi can enjoy the magic of inflation, while it lasts. Every good thing has its end, however. This time around, the magic can be brought to an end by a recession, originating in the U.S. making a dent in tax collection, or government bond yields going out of hands, especially above the economy’s nominal growth rate. 

About the author: Mr. Suzuki is a retired banker based in Tokyo, Japan.