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Tax hike delay signals Japan giving up on fiscal reform

[TOKYO] Prime Minister Shinzo Abe is essentially giving up on fiscal reform by postponing a sales tax hike for two and a half years, putting Japan's credibility on the line and heightening the risk of a credit downgrade that could lift corporate borrowing costs.

With the central bank's massive bond buying hammering yields near zero, few in the market expect the tax delay to trigger an immediate bond sell-off and a dangerous spike in the cost of financing Japan's massive public debt.

But a second delay in less than two years - expected to be announced by Abe at a Wednesday news briefing - is a major setback for Japan's drive to get its fiscal house in order, and makes it nearly impossible to achieve a target of turning its budget deficit into a surplus by the 2020 fiscal year, analysts say.

The world's third-biggest economy barely averted recession in the first quarter, and analysts expect only feeble growth, if any, this quarter as weak emerging market demand and slow wage growth weigh on exports and consumption.

"It's become clear Mr Abe is not so serious about fiscal discipline," said Masamichi Adachi, senior economist at JPMorgan Securities Japan. "The budget balance target was considered ambitious to begin with and now looks to be given up or pushed back until a few years later."

Some analysts say Mr Abe is effectively abandoning the tax hike by delaying it to October 2019 as he's unlikely to still be in office then. His term as head of the ruling party, and thus premier, expires in September of that year.

"It's essentially a freezing of the tax hike plan," said Katsutoshi Inadome, fixed income strategist at Mitsubishi UFJ Morgan Stanley. "It might be interpreted as a message that Mr Abe won't implement fiscal reform during his tenure."

Standard & Poor's, which cut Japan's sovereign rating to A+ last year, said it made "some sense" for Mr Abe to delay the tax hike given anaemic economic growth. But it warned that Japan needs to speed up structural reforms given the limited space to deploy fiscal or monetary stimulus.

If Japan keeps dragging its feet on fiscal reform it may face a sovereign rating cut that pushes up the cost of overseas funding for some companies, according to SMBC Nikko Securities.

"A two-notch cut to A- would mean the ceiling for corporate bond ratings would be set at that level. Corporate funding conditions may worsen as a result," it said in a research note.

Japan's government debt, at nearly 250 per cent of GDP, is the biggest among major industrialised nations as tax revenues fall short of meeting ballooning social welfare costs for a rapidly ageing society.

Raising the sales tax is considered crucial to reining in debt, but has been a taboo for politicians. After an increase to 8 per cent from 5 per cent in April 2014 tipped Japan into recession, Abe postponed a further hike to 10 per cent planned for October 2015 for 18 months.

Mindful of the need to reassure markets that Japan is serious about fixing its finances, its leaders including Abe have maintained a pledge to turn the primary balance - the budget balance net of interest payments - into surplus by 2020.

But achieving the target has been a challenge even without the tax hike delay. A government estimate shows the budget balance would be 6.5 trillion yen (S$81.7 billion) in the red in fiscal 2020 even if the economy expands a nominal 3 percent.

Analysts say that's an unrealistic assumption for an economy that posted nominal growth of just 1.6 per cent in 2014 and 2.5 per cent in 2015.

Finance Minister Taro Aso said on Tuesday Japan will stick to the budget target even if the tax hike is delayed, a move that could shave roughly 5 trillion yen off annual tax revenues.

But the government is unclear on how to do this.

Lawmakers are opposed to slashing spending on childcare and subsidies to low-income pensioners, which were to be paid for by revenues from the tax hike. The government is even considering deploying fresh spending of up to 10 trillion yen to spur growth.

Mr Abe's solution seems to be to keep reflating growth in the hope that rising corporate profits would lead to higher tax revenues - enough to plug the gap left by delaying the sales tax hike.

"Without growth, it's impossible to achieve fiscal consolidation," said Etsuro Honda, an economic adviser to Mr Abe. "The budget target could still be achieved as long as GDP expands to the full and consumer sentiment stabilises, which would offset the blow from the 2019 sales tax hike."

With global headwinds intensifying and the yen's rebound clouding the outlook for corporate profits, however, even advocates of Mr Abe's reflationist policies have their doubts.

Delaying the tax hike runs counter to the basic principle of the three arrows of "Abenomics" - bold monetary easing, flexible fiscal policy and a growth strategy - said Takatoshi Ito, a Columbia University professor who is among the most prominent Japanese economists supportive of Mr Abe's policies.

"The second arrow is flexible fiscal policy, not aggressive fiscal spending. That means Japan needs to focus on restoring fiscal health," he said. "When you need short-term fiscal stimulus you deliver it. But I wonder whether that's really necessary now."