Estimating the harm Japan’s next VAT rate increase will inflict on the economy

David Cashin, Takashi Unayama

Japan’s prime minister recently announced that a planned 2% VAT increase would be postponed from 2017 to 2019. This column explores how Japanese household consumption adjusted to a VAT increase that was announced in 2013 and implemented in 2014. Household consumption fell by around 4% upon announcement and 1% upon implementation, suggesting that most of the negative impact of a VAT rate increase occurs at the time of the announcement.

One of the most important political issues facing the Japanese government is when to further increase its value added tax (VAT) rate. In fact, Japan’s prime minister, Shinzo Abe, recently announced the postponement of the tax rate increase planned for April 2017 until October 2019. The law for the subsequent VAT rate increase originally passed the Diet (legislature) in 2012, and in October 2013, Abe officially confirmed that the VAT rate would increase from 5% to 8% in April 2014, and from 8% to 10% in October 2015. Although the government increased the VAT rate from 5% to 8% as planned in April 2014, it shortly thereafter postponed the second increase until April 2017. And now, the government is initiating legislation to delay the VAT rate increase once again.

While the VAT rate increase is perceived as being critical to Japan’s pursuit of fiscal consolidation (Japan’s debt to GDP ratio of more than 200% is the highest among major industrialised countries), the government is concerned that the tax increase may harm the economy by reducing household consumption. To investigate this concern, in this column we consider the response of household consumption to the October 2013 announcement and the April 2014 rate increase. We further examine what these responses might imply for the next VAT increase.

Predicting the consumption response to Japan’s recent and future VAT rate increases

We place our discussion in the context of the life cycle/permanent income hypothesis (LCPIH), which is one of the most important theoretical frameworks for analysing household decision making (for literature surveys, see Attanasio and Weber 2010, Jappelli and Pistaferri 2010). The LCPIH posits that a household’s consumption depends solely on its ‘permanent income,’ which can be interpreted as a household’s expected average real (i.e. inflation-adjusted) income over its lifetime. This simple theoretical framework has an important implication – a shock to household income induces a change in consumption once it is recognised, regardless of whether it has been realised yet. For example, the theory predicts that consumption will fall once a job loss is expected even if the individual is still employed.

Similarly, the LCPIH predicts that the October 2013 announcement, which represents a permanent negative income shock to households, would reduce consumption in proportion to the reduction in permanent income even before the implementation of the VAT rate increases. Given this prediction, it would appear that the policy discussion about postponing the future VAT rate increase is misguided because the negative impact should have already appeared in the consumption recorded in 2013.1

However, unlike a pure income shock, the future VAT increases also incentivised households to engage in substitution of consumption over time. Specifically, households have an incentive to increase consumption prior to a VAT rate increase when prices are relatively low and reduce consumption thereafter. This is known as the intertemporal substitution effect, which implies that consumption should fall upon implementation of the VAT rate increases, whereby the magnitude of the fall depends on the sensitivity of household consumption to price changes. In contrast, whether consumption fell upon the announcement depends on which effect – the negative income effect or the positive intertemporal substitution effect – dominated. For example, if the former dominated, we would observe a reduction in household consumption at the announcement and implementation of the VAT rate increase.

Of course, the LCPIH is just a theory for analysing household decision making. Indeed, while the one-to-one correspondence of consumption and permanent income changes is one of the most important implications of the LCPIH, most previous studies have found that the consumption response to an unanticipated permanent income shock is relatively small, which Campbell and Deaton (1989) refer to as “excess smoothness” (see also West 1988, Gali 1991, Hansen et al. 1991, Flavin 1993). If this phenomenon holds true for household consumption in Japan, we might expect a future VAT rate increase to have a more negative impact beyond the negative intertemporal substitution effect discussed above, as aggregate consumption responds more gradually to the tax rate increase.

Impact of Japan’s 2014 VAT rate increase on household consumption

In a recent study, we exploit the 2014 VAT rate increase episode to identify the impact of the tax increase on consumption at the time of announcement and implementation (Cashin and Unayama 2016a). We are able to test the LCPIH’s prediction that a shock to permanent income induces a proportional change in consumption once households are cognisant of the shock. Furthermore, the results allow us to make conjectures about the likely consumption response to a future VAT rate increase.

In general, it is difficult to determine the precise time at which a household recognises a shock such as a future VAT rate increase (Flavin 1993, Pistaferri 2001). In Japan’s case, however, it is reasonable to believe that most households became aware of the tax rate increases on 1 October 2013. While the legislative process to increase the VAT rate in a stepwise fashion was completed in August 2012 by the ruling Democratic Party of Japan (DPJ), its defeat to the Liberal Democratic Party in late 2012 immediately put the proposed tax rate increases in doubt. Shinzo Abe, the newly elected prime minister, repeatedly mentioned that he reserved the right to indefinitely postpone or cancel the tax rate increases. Because households knew that Abe regarded the VAT rate increases as a serious obstacle to Abenomics, his economic stimulus programme, it seems unlikely that they believed the VAT rate increases would be implemented as originally planned. Nevertheless, Abe announced on 1 October 2013 that the VAT rate increases would be implemented as originally planned.

Given our assumption on the timing of the announcement and the fact that the initial VAT rate increase went into effect in April 2014, we examined consumption changes in October 2013 and April 2014 using the Japanese Family Income and Expenditure Survey, which is available on a monthly frequency. To control for stockpiling behaviour around the time of the VAT rate increase, we examined expenditures on non-storable non-durable goods and services because unlike storable and durable goods, the timing of consumption for these items, which is unobservable, roughly coincides with the timing of expenditure, which is observable to econometricians. Furthermore, we control for seasonality in consumption and demographic changes.

Our results show that household consumption fell by around 4% upon Abe’s announcement and 1% upon implementation in April 2014. These findings suggest that most of the negative impact of the VAT rate increases occurred at the time of announcement. The result that the decline in consumption upon implementation of a VAT rate increase is small is quite consistent with the evidence we present in another paper (Cashin and Unayama 2016b).

The total consumption response, a 5% drop (4% at announcement + 1% at implementation), suggests that our results are consistent with the LCPIH’s prediction that consumption should fall in proportion to an income shock once households become aware of the shock. Recall that the law scheduled the VAT rate to increase from 5% to 8% in April 2014 and 8% to 10% in October 2015. Because the Japanese government made it known that it expected consumers to bear the full burden of the VAT rate increases in the form of higher prices, previous VAT rate increases in 1989 and 1997 were in fact passed on in full to consumers, and as households were not to receive significant offsetting compensation for the 2014 and 2015 tax rate increases, we argue that once recognised, the income shock was roughly proportional to the cumulative tax rate increases of five percentage points. As such, consumption fell one-to-one with the income shock as predicted by the LCPIH.

Implications for Japanese policymakers

The large and negative consumption response to the October 2013 VAT announcement suggests that households have already reduced their consumption in anticipation of a future VAT rate increase. In addition, the small negative implementation (i.e. intertemporal substitution) effects that we observed in 1997 and 2014 (Cashin and Unayama 2016a,b) indicate that the consumption response to an increase in the VAT rate from 8% to 10% should be less than 1%. Consequently, we do not believe that the harm to the economy from the next VAT rate increase will be as great as was the case in 2013-2014.

Author’s note: The views expressed here are strictly those of the authors. They do not necessarily represent the position of the Federal Reserve Board or the Federal Reserve System.

References

Attanasio, O P and G Weber (2010) “Consumption and saving: Models of intertemporal allocation and their implications for public policy”, Journal of Economic Literature, 48(3): 693–751.

Cashin, D and T Unayama (2016a) “The impact of a permanent income shock on consumption: Evidence from Japan's 2014 VAT increase”, RIETI Discussion Paper 16-E-052.

Cashin, D and T Unayama (2016b) “Measuring intertemporal substitution in consumption: Evidence from a VAT increase in Japan”, Review of Economics and Statistics, 98(2): 285–297.

Campbell, J and A Deaton (1989) “Why is consumption so smooth?”, The Review of Economic Studies, 56(3): 357-373.

Flavin, M (1993) “The excess smoothness of consumption: Identification and interpretation”, The Review of Economic Studies, 60(3): 651–66.

Galí, J (1991) “Budget constraints and time-series evidence on consumption”, American Economic Review, 81(5): 1238–53.

Hansen, L P, W T Roberds and T J Sargent (1991) “Time series implications of present value budget balance and of Martingale models of consumption and taxes,” In L P Hansen and T J Sargent (eds), Rational expectations econometrics, Boulder and Oxford: Westview Press, 121–61.

Jappelli, T and L Pistaferri (2010) “The consumption response to income changes”, Annual Review of Economics, 2: 479–506.

Pistaferri, L (2001) “Superior information, income shocks, and the permanent income hypothesis”, Review of Economics and Statistics, 83: 465–76.

West, K D (1988) “The insensitivity of consumption to news about income”, NBER, Working Paper 2252.

Endnotes

[1] Of course, the LCPIH predicts that postponement of a VAT rate increase will lead to higher consumption due to the increase in permanent income. However, this effect should be small so long as postponement is only for a year or so, as the increase in permanent income from a short postponement will be small.