Japan, having fought deflation for more than two decades, has repeatedly pursued government interventions in the hope of revitalizing its economy. Entering the fifth year of his latest turn in office, Japanese Prime Minister Shinzo Abe continues to follow a suite of policies aimed at jolting Japan’s stagnating economy out of its deflationary malaise.
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Abe’s three-pronged approach, dubbed "Abenomics," combines fiscal expansion, monetary easing, and structural reform. Its immediate goal is to boost domestic demand and gross domestic product (GDP) growth while raising inflation to 2 percent. Abe’s structural policies aim to improve the country’s prospects by increasing competition, reforming labor markets, and expanding trade partnerships.
Trans-Pacific Partnership (TPP)
However, major challeges remain. Despite massive government stimulus, growth is tepid, inflation is below target, concerns over ballooning debt remain, and difficult structural reforms have languished. The election of President Donald J. Trump, meanwhile, has disrupted Abe’s efforts to cement a regional trade deal and placed the U.S.-Japan relationship under renewed strain.
What is Abenomics?
Abenomics refers to an aggressive set of monetary and fiscal policies, combined with structural reforms, geared toward pulling Japan out of its decades-long deflationary slump. These are the policy’s "three arrows."
- Fiscal stimulus began in 2013 with economic recovery measures totaling 20.2 trillion yen ($210 billion), of which 10.3 trillion ($116 billion) was direct government spending. Abe’s hefty stimulus package, Japan’s second-largest ever, focused on building critical-infrastructure projects, such as bridges, tunnels, and earthquake-resistant roads. A separate 5.5 trillion yen boost followed in April 2014, and after the December 2014 elections, Abe pushed another spending package, worth 3.5 trillion yen. Through 2016, with Japan’s recovery still sputtering, Abe’s budget continued the near-record levels of deficit spending.
- The second arrow, unorthodox monetary policy—especially the Bank of Japan’s (BOJ) unprecedented asset purchase program—is at the heart of Abenomics. "It’s a gigantic experiment in monetary policy," says the Wall Street Journal’s Greg Ip. The BOJ has simultaneously injected liquidity into the economy (a policy known as quantitative easing, or QE) and, for the first time, pushed some interest rates into negative territory.
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Under BOJ Governor Haruhiko Kuroda, the bank undertook an initial round of QE in 2013 that doubled its balance sheet. But with inflation stagnating below 1 percent into 2017, the bank has moved into a second, open-ended phase of QE consisting of $660 billion in yearly asset purchases that Kuroda says will continue until the 2 percent inflation target is achieved. The scale of the purchases is unmatched anywhere in the world: the value of the assets held by the BOJ has exceeded 70 percent of GDP, while the U.S. Federal Reserve’s and European Central Bank’s assets, by contrast, both stand below 25 percent of their respective GDPs.
With Japan’s economy remaining weak, in January 2016 Kuroda made the unexpected decision of introducing negative interest rates in a fresh bid to spur lending and investment. The BOJ joins the ECB, Denmark, Sweden, and Switzerland as the only central banks to push some rates below the "zero bound." The BOJ’s negative rates, as well as its asset purchases, have continued into 2017, causing some economists to warn that these low rates damage the banking system and can lead to speculative bubbles.
Trans-Pacific Partnership (TPP)
- Finally, a long-delayed program of structural reform—including slashing business regulations, liberalizing the labor market and agricultural sector, cutting corporate taxes, and increasing workforce diversity—aims to revive Japan’s competitiveness.
What are the prospects for structural reform?
Many analysts argue that the success of Abe’s plans ultimately relies on structural reform. In June 2014, Abe announced a broad reform package, including corporate tax cuts, agriculture liberalization, labor market reform, and initiatives to overhaul regulation of the energy, environment, and health-care sectors.
Though Abe’s coalition has held a strong parliamentary majority for more than four years, progress has come slowly. After Abe’s emphatic win in December 2014 elections, however, he reached a breakthrough agreement to limit the power of the national agriculture cooperative, JA-Zenchu. The cooperative has long used its political heft to oppose the modernization of Japan’s moribund farming industry.
Japan’s demographics portend a troubling future. The working-age Japanese population contracted by 6 percent over the past decade, and Japan could lose more than a third of its population over the next fifty years. In September 2015, Abe announced an "Abenomics 2.0" platform that centers on raising the birth rate and expanding social security. He also created a new cabinet position, held by Katsunobu Kato, devoted to reversing Japan’s demographic decline.
Labor market reforms have focused on Abe’s so-called “womenomics” plan to raise the female employment rate from 68 percent to 73 percent by 2020. The government has required corporations to increase the appointment of women to management positions. The original goal was to have women fill a third of senior business positions by 2020; that has since been scaled back to 15 percent. The government argues that raising women’s wages and status in the labor market will also increase fertility rates, pointing to countries like Sweden and Denmark that have both higher female employment and higher fertility.
Abe has also promised broader labor reforms to break down Japan’s two-tier employment system, in which a persistent class of temporary workers are shut out of the regular workforce. So far, however, his labor policy has focused on reducing the culture of overwork that has led to a rise in depression and suicides.
What will be the impact of the U.S. withdrawal from the Trans-Pacific Partnership?
This progress on agriculture reform was central to Abe’s push to complete the Trans-Pacific Partnership (TPP), a regional free trade agreement with the United States and eleven other Pacific Rim countries. Japan’s agricultural industry in particular lobbied against the deal, objecting to the removal of high tariffs and other protective measures.
With President Trump rejecting the TPP, however, some analysts say that Abe’s economic reform efforts will be complicated. With Trump reportedly seeking a bilateral U.S.-Japan trade deal in lieu of the TPP, negotiations could put pressure on Abe to deliver even deeper tariff cuts and more extensive reforms. What the Trump administration will ultimately seek from a new deal is ultimately uncertain.
Can Abenomics reinvigorate Japan’s economy?
Since Abe took power in 2012, robust GDP growth, wage growth, and inflation have all proved elusive. The economy fell into recession in 2014, and while it returned to growth above 1 percent in 2015 and 2016, consumer prices continue to fall. Low unemployment of just over 3 percent and pressure from the government on Japanese corporate leaders have helped wages begin to rise, but that growth is slowing.
Japan’s economic woes are nothing new. The country has suffered chronic deflation since the bursting of its real estate bubble in the late 1980s. In the years since, the Japanese government has implemented years of near-zero, and now below zero, interest rates. It has also spent trillions of dollars attempting to lift the economy, in the process accumulating the largest public debt in the developed world.
Abe hoped his extraordinary monetary policy would change this dynamic, starting with bringing down exchange rates and giving exports a major boost. Indeed, the yen has fallen a dramatic 50 percent against the dollar since the end of 2012.
However, a weaker yen is a double-edged sword, given that it can drive up the price of imports, which can dampen consumer demand and lead to reduced spending. At the same time, plunging global oil prices, which fell from more than $100 a barrel in 2014 to a low of under $30 a barrel in 2016, have added to Japan’s deflation woes. With cheap oil and a stagnant world economy both likely to continue for the foreseeable future, "reflating" Japan’s economy will be even harder.
Thus, most observers agree that deeper structural changes are needed. Without greater consumer demand based on increased wages, which have fallen 9 percent in real terms since 1997, or a major demographic shift, the Japanese economy will continue to struggle.
What are the risks?
Critics argue that Abenomics brings major risks. Some think monetary easing could spur hyperinflation, while others hold that Abe’s plan may do too little to reverse deeply entrenched deflation. There is also worry about Japan’s national debt, which, at over one quadrillion yen ($11 trillion), has surpassed 245 percent of its GDP. The International Monetary Fund (IMF) has repeatedly warned [PDF] that these debt levels are unsustainable.
That’s why Abe has attempted to reduce the deficit by raising taxes, a move that some say has worked at crosspurposes with the rest of the program. A 2014 increase in the national consumption tax from 5 to 8 percent futher depressed consumer spending and likely caused recession. As a result, the next planned bump, up to 10 percent, has been continuously postponed, first to 2017 and then to 2019. While good for immediate growth, this decision arguably undermines the goal of fiscal sustainability.
At the same time, negative interest rates, a relatively untested monetary tool, give many economists pause. The BOJ was split five to four on the decision over worries that the policy could damage the banking system. Some worry that negative rates might not actually encourage spending, but rather, the hoarding of cash, thus adding to deflationary pressures.
Those who remember the unfinished public works—massive and often unnecessary road and bridge construction projects—that littered Japan’s countryside during the "lost decade" of the 1990s also worry that Abe’s stimulus may add to the debt load without boosting output.
Complicating matters, scandals have cost Abe several of his top allies. In 2015 his agriculture minister, Koya Nishikawa, was forced to step down, and in January 2016 an even bigger blow came as Economy Minister Akira Amari resigned amid bribery allegations.
What does this mean for the global economy?
Abe’s policies have been felt in the international arena. Exporters like Germany and China have sounded warnings about a global currency war, or competitive devaluation, in which countries vie to weaken their currencies to gain an advantage for their exports. Tokyo’s recent disputes with Beijing over the Diaoyu/Senkaku islands in the East China Sea have spilled over into their economic relationship, and the yen’s drop has only escalated the discord. Abe’s hawkish reputation, along with his push to amend Japan’s pacifist constitution, has led some to see his TPP trade push as a way to contain Beijing.
The election of President Trump, who brings a new vision of global trade and economic policy oriented away from the multilateral negotiations favored by President Obama, has complicated Abe’s options. Some experts have argued that Trump’s rejection of the TPP and his criticism of Japanese trade practices could unsettle the U.S.-Japan alliance, a relationship that Abe has called “the cornerstone of Japanese foreign policy.” Trump has also heavily criticized what he calls Japan’s currency manipulation, accusing Abenomics of “playing the devaluation market”—a charge which Abe strenuously denied.
Ultimately, the outcome of Japan’s experiment also holds implications for other economies, including the eurozone, that are also struggling with deflation and low growth. "It provides hope for other countries," says the Wall Street Journal’s Ip. "Almost the entire rich world is stuck in a zero-interest-rate liquidity trap situation, and I think everybody is haunted by the possibility that there’s no way out of it. If Japan shows a way out of that, it will be very encouraging."
- Takeo Hoshi, left, and Tatsuo Hatta.
The government of Prime Minister Shinzo Abe is facing daunting challenges in 2017 as it continues its struggle to revitalize the Japanese economy. In the first half of a two-part discussion, two top Tokyo Foundation economists assess the government’s fiscal and monetary policies thus far and identify areas for improvement.
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TAKEO HOSHI: Two unexpected events jolted the world in 2016: the outcome of the Brexit referendum, in which British citizens voted to leave the European Union, and the election of Donald Trump as president of the United States. Today I’d like to consider what these global developments portend for our own economy and economic policies in 2017.
Let’s begin with a review of Japan’s economic situation. Over the past four years, the government of Prime Minister Shinzo Abe has adopted a package of economic revitalization measures called Abenomics. The “three arrows” of Abenomics are an aggressive monetary policy, a flexible fiscal policy, and a long-term growth strategy through structural reform. How should we rate each of these policies?
Waiting for Wage Growth
TATSUO HATTA: From a macroeconomic standpoint, an important outcome of the prime minister’s expansionary policies has been a drop in unemployment. A lot of people seem concerned about the fact that wages haven’t risen at the same time, but I don’t see this as a problem. During the recovery phase, we experienced a surge in nonregular employment, and the increased share of these lower-paying jobs in the overall job picture has pulled average wages down. But eventually, as the number of people in line for nonregular jobs dwindles, wages for those workers will rise as well. We’ve been in the midst of an adjustment, but it’s only a matter of time before wages start to rise again. In fact, we’re already beginning to see wage growth among part-time and temporary workers. I predict wages will soon be rising across the board.
HOSHI: Wages are on the rise among both regular and nonregular employees, as you mentioned, but the situation seems to vary from one industry to another. For example, while the share of nonregular workers has been growing at about the same rate in nursing-care services and in the construction industry, wages are rising for construction workers but not for care workers.
HATTA: That’s probably due to the fact that pay in the nursing-care industry is subject to government regulation, so wages don’t rise in response to excess demand for labor. It’s the same for childcare.
HOSHI: The government has decided to accelerate corporate tax cuts in hopes of encouraging companies to give workers pay raises. Based on what you’ve said, maybe it should be focusing on wages in the regulated industries that are shielded from the ripple effects of the economic recovery—either by raising wage levels or by easing regulations.
HATTA: Yes, the government could, for example, expand the range of optional nursing-care services for which providers can set their own fees. This would have the effect of raising average wage levels in the nursing-care industry.
HOSHI: How effective has the first arrow of Abenomics, monetary policy, been? Is there really much the Bank of Japan can accomplish to boost growth?
HATTA: It takes time for monetary policy to have an impact on the real economy. But land values are beginning to rise. And that will gradually push up the value of collateral and encourage more lending and investment. I think the Bank of Japan should keep doing what it’s been doing. Before long, things will start to heat up across the board. In fact we should start studying how to manage the expansion and keep it under control.
HOSHI: Milton Friedman talked about “long and variable lags” between the implementation of monetary policy and its impact on the real economy. That suggests that getting the timing right with monetary policy can be difficult.
HATTA: I agree. So we should be prepared for possible inflation. Back in the 1970s, during the Jimmy Carter administration, inflation and nominal interest rates both hit around 20 percent. What that meant was that in real terms, annual interest was down to around zero, but since taxes apply to nominal rates, the effective tax rate on interest income was well in excess of 100 percent. That severely dampened savings and investment.
That’s why Harvard Professor Martin Feldstein stressed the importance of taxing real interest income, adjusted for inflation. That became one of the tenets of supply-side economics. But in the 1980s, the Reagan administration, in response to this call, drastically lowered taxes on asset income by eviscerating the capital gains tax and slashing corporate taxes. Unfortunately, this overreaction led to a sharp drop in tax revenues. The correct course would have been to adjust for inflation, not to cut taxes on financial income to almost nothing.
Generally speaking, the worst effects of inflation can be attributed to the tax system. We need to head off such problems by preemptively instituting an inflation deduction for income from financial assets. If we do that, then inflation won’t cause serious damage to the economy even if shoots up to around 20 percent.
HOSHI: The cost of inflation is high because taxes and financial contracts are based on nominal values and not indexed to inflation. If they were designed to respond to inflation more nimbly, the economic damage would be limited to “menu costs” [the cost to businesses of changing prices] and “shoe leather costs” [the cost of going to the bank often to withdraw cash], which are minor by comparison. Shoe leather costs should be much less of an issue now, since online banking and electronic payment have become so widespread.
HATTA: The biggest hit comes from taxes.
HOSHI: Japan isn’t experiencing inflation at this time, of course. The BOJ has been working aggressively for several years to achieve a moderate level of inflation, but without much success. It may be too early to be talking about inflation; the priority at the moment is conquering deflation.
That said, if inflation does begin to take off, the government will need to respond quickly. So, even before that happens, there’s a need to start thinking about systemic tax reforms to limit the costs of inflation. We may be in that delicate transition phase right now.
Raising Taxes without Stifling Growth
HOSHI: Let’s move on to the second arrow of Abenomics, fiscal policy. As we’ve seen, monetary policy can take a long time to affect the real economy, but fiscal policy can have a more immediate impact, at least according to textbook economics. The Abe administration initially stressed a “flexible” fiscal policy that combined short-term, targeted stimulus with long-term fiscal discipline. How do you rate the government’s performance?
HATTA: I’d say it hasn’t done enough to restore fiscal discipline. On the revenue side of the budget, there are two main problems. The first is the spousal deduction, which gives a big tax break to taxpayers whose spouses earn less than 1.2 million yen each year. If this were eliminated and replaced with a spousal tax credit, it would boost government revenues substantially without adding to the burden of low-income, married couples. Unfortunately, in the final analysis, the ruling coalition decided, rather, to keep the current system and raise the deduction threshold. There was talk of holding another snap election early in 2017, and I suppose the party was worried about a backlash from families that would end up paying higher taxes. Given the frequency of national elections these days, it’s not surprising that the government is having a hard time reining in the deficit. With its stable majority, though, it should really do better.
The second issue concerns the consumption tax. If the government is going to rely on consumption tax increases to boost revenues, then it needs to make some basic changes to the way the tax is levied.
So far, both increases in the consumption tax—in 1997 and again in 2014—were followed by economic slumps. In 2014 the Finance Ministry insisted on raising the tax rate, citing Germany’s experience with the value-added tax in arguing that a consumption tax hike wouldn’t induce a recession in Japan. The fact is that the MOF has twice miscalculated the effect of such tax increases on the economy. Now people are saying, “That’s two consumption tax increases and two recessions. Before you raise the rate again, let’s hear how you plan to head off another downturn.”
One of the biggest issues with the Japanese consumption tax is its effect on the housing market. When a consumption tax increase raises prices, consumers generally try to offset the expenditure increase by reducing consumption of those goods. With goods like food or clothing, that’s a relatively straightforward adjustment. Let’s say someone spends 1 million yen on food annually, and the government decides to slap a 10 percent sales tax on food. That person can cover the cost of the tax by reducing food consumption to around 910,00 yen, so that tax-inclusive total food expenditures remains at 1 million yen. When it comes to buying a home, though, that’s not the case; a person who is planning to purchase a 100 million yen house, partially with a loan, wouldn’t be able to purchase a 91 million house when a 10 percent consumption tax is installed.
Most people need to take out a bank loan to buy a home, and to get the loan they need to come up with a down payment equal to a certain percentage of the loan—say, 25 percent. If there were no consumption tax on the house, a person with 20 million yen at his or her disposal would be able to purchase a 100 million yen home by taking out an 80 million yen loan.
Japan’s consumption tax applies to the full sales price of the property, excluding the land, in the year of the sale. Thus if a 10 percent consumption tax is levied in this situation, the buyer has to pay the tax up front along with the down payment, out of the 20 million at their disposal, since banks won’t loan the amount to cover the tax portion. So, it’s clear that a person with 20 million yen on hand can’t purchase a house of 91 million yen. In fact, she or he in this situation can only afford a house worth about 65 million yen. Just scaling back purchases proportionately, as you might with other goods, won’t do the trick.
This explains why increases in Japan’s consumption tax have such a big impact on the housing market, compared with other sectors of the economy. In fact, both the 1997 and 2014 tax hikes caused a long-term slump in home sales, and owing to the amount of money involved in those transactions, that was enough to trigger a recession. The reason Germany has been able to avoid this is because home purchases are basically exempt from the VAT.
The government could solve this problem by eliminating the consumption tax on home sales and at the same time setting the rate of the property tax on homes at the level consistent with the consumption tax rate. This would allow the government to raise the consumption tax rate on goods and services—with the exception of housing—without triggering a recession and without losing tax revenue in the long run.
Taxing Wage and Interest Income
HATTA: There’s also a lot of room for improvement on individual income taxes. The minimum taxable income in Japan is too high from an international perspective, and the top marginal rate is quite low by historical standards. Until the mid-1980s, Japan’s top marginal income tax rate was 88 percent. That was the rate that was levied on industrialists like Konosuke Matsushita, Soichiro Honda, and Akio Morita when they were building companies like Panasonic, Honda, and Sony into top global brands. So I really don’t think that raising the top rate a bit would significantly undermine the Japanese work ethic. Some high-income earners might be prompted to move overseas to avoid paying higher taxes, but for most Japanese families, educational and healthcare considerations, as well as nursing-care needs for parents, make that a very difficult step to take. Also, high-income earners tend to cherish Japan’s safe, clean cities. I can’t believe that emigration caused by an increase in income tax rates would result in a loss of tax revenue. On the other hand, I would advise leaving taxes on asset income at 20 percent.
HOSHI: Why is that?
HATTA: I think most people would agree with the idea that people with a similar standard of living should be similarly taxed. What determines a person’s living standard is utility. And the person derives his utility from his lifetime expenditure. So expenditure is a good indicator of his living standards.
One’s lifetime expenditure is the sum of the “present value” of his lifetime personal consumption and bequests over his lifetime, discounted by the interest rate on risk-free savings accounts. Within the limits of his own lifetime budget, a person adjusts his spending at each life phase through saving and borrowing in order to maximize his overall standard of living. So, lifetime expenditure functions as an indicator of his standard of living.
Let’s suppose we have two people who receive the same wages at every stage of their lives, but one of them puts a substantial portion of that income in a risk-free savings account when he’s young while the other saves nothing. They’re operating under the same lifetime budget constraints, so their lifetime expenditure should be the same, which means that their overall standard of living, averaged out over their lifetimes, will also be the same. If the government taxes their wage income only, then they’ll naturally pay the same amount in taxes. But if it also taxes interest from bank savings, then the one who is frugal and saves will end up paying more in taxes. The lifetime tax burden is higher for the saver, even though both have the same lifetime standard of living. It’s clear from this that it’s fairer to tax only wage income, which is the “primary income.” When you also tax interest income, which is a “derived income” from the earned income, this can be considered a form of double taxation.
HOSHI: One often hears the objection that taxing income from financial assets is double taxation. Does that mean we shouldn’t tax financial income at all?
HATTA: I think it depends on the type of financial income. Let’s say someone invests in the stock market in their youth and earns big dividends, well in excess of the rate on risk-free savings. In that case you need to add those “excess gains” to the present value of their lifetime expenditure treating it as “primary income,” just like earned income. It’s your compensation for smart investment decisions. If we base taxation on living standards, then we should exempt interest on risk-free savings accounts but tax any financial income in excess of that. Ideally, tax rates on financial income should be dependent on its type.
What Japan has done instead is to tax all financial asset income separately from earned income at a flat rate of 20 percent. This, actually, can be viewed as a bold approximation of the ideal situation; it’s clearly more reasonable than the comprehensive income tax idea, which adds asset and earned income and taxing them together. What we want is to uncouple the tax rates on financial income from increases in the personal income tax.
HOSHI: A moment ago you said that it was hard to raise taxes when national elections are held so frequently. And in fact, the government announced it would postpone a scheduled consumption tax hike before holding the past two general elections. Will it ever be able to raise the consumption tax?
HATTA: I think it could if it first puts in place the necessary policy measures to prevent a hike from triggering a recession. Until then, I think the government would do better to focus on reforming the income tax. An increase in the top marginal rate wouldn’t have anywhere near the impact on economic growth that a jump in the consumption tax would.
Reining in Social Security Expenditures
HOSHI: On the expenditure side of government finances, the big issue is social security, whose outlays have risen a lot more quickly than anticipated back when the system was put in place. In November 2016, the Diet enacted pension reforms designed to curb future outlays by modifying the way benefits are calculated. Would you call this a necessary first step toward bringing social security spending under control?
HATTA: I’d say it signals the beginning of some major changes that obviously need to be made. And we shouldn’t stop with the pension system. We also need to scrutinize our health insurance system, including scope of coverage and whether to allow “mixed billing” of both treatments covered by public health insurance and those not covered by insurance.
HOSHI: Clearly, we can’t continue along our current trajectory without bankrupting the system. Even after delaying the planned consumption tax increase, the Abe cabinet still claims that it can reach its goal of a primary surplus by 2020, but I don’t think anyone really believes that.
The most urgent economic challenge facing our leaders today is to put government finances on a sustainable footing. They should be exploring every option available, both in the revenue and the expenditure column. Yet for the past four years Abenomics has focused almost exclusively on fiscal stimulus. I think we can agree that there has been virtually no progress toward fiscal discipline.
Continue to Part 2 of "The Japanese Economy in 2017: Bumps on the Road to Deregulation and Free Trade"