Japan's Dilemma: Deflation and Sales Tax

Last Thursday, we read an Economist article "The pendulum swings to the pit", which discusses the often overlooked danger of deflation. The Japanese economy since 2008 is probably the best example that illustrates this point. Having experienced the bitterness of liquidity trap, the Japanese central bank and Prime Minister Abe have strived to avoid deflation at any cost; they are currently targeting the inflation rate of 2%.

Furthermore, Japan is now grappling with the newly proposed sales tax rate. Due to deflation, their national debt has grown enormously in real value (in fact, Japan now has the largest debt among the industrialized nations). One particular way that the government has choses to ease the burden is to raise the nationwide sales tax. Last April, they increased the tax rate from 5% to 8%. The hike discouraged consumption, causing an unexpectedly deep 7.1 percent annualized contraction in the second quarter.

However, what is astounding is that the Japanese retail sale growth has accelerated despite the raise for three straight months now. Seeing this growth as an encouraging sign for recovery, the PM is now proposing another hike up to 10% early next year. His decision is causing concern among many who believe that the nation's economy is not strong enough yet to withstand another round of tax increase. Standard & Poor also worries that the country's credit rate might suffer if the tax hike results in crippling the economic recovery.

I find Japanese government in a similar situation to IMF during the Asian Meltdown. As evident to many Keynesians, tax increase will always depress consumption, leading to a recession. It is also too evident that the proposal is not only unpopular but also very risky. However, the Japanese government currently has no better alternative options. Already struggling with the government deficit, it cannot possibly push for an expansionary policy through increase in fiscal spending. Like US Fed, Japan's central bank has been pushing for monetary easing (buying government debt), yet its effectiveness has diminished as to now downgrade the country's credit.

At this point, it is very likely that Japan will end up with the 10% sales tax in 2015. It will be certainly interesting to observe how the economy copes with the change next ear.