Japan: Staff Report for the 2016 Article IV Consultation

Abenomics needs a significant policy upgrade to regain traction. Abenomics initially made good progress in revitalizing the economy, but the targets for growth, inflation, and the primary balance remain out of reach under current policies. Recognizing the risk of falling short, the authorities introduced a negative interest rate policy, delayed the planned consumption tax hike, and adopted additional structural reforms, but the outlook remains weak. Abenomics can still achieve its ambitious targets through a comprehensive and coordinated policy upgrade. In the absence of such a reload, policies and targets will need to be reset for more gradual and realistic progress to avoid adding to volatility and uncertainty.

Abstract

Abenomics needs a significant policy upgrade to regain traction. Abenomics initially made good progress in revitalizing the economy, but the targets for growth, inflation, and the primary balance remain out of reach under current policies. Recognizing the risk of falling short, the authorities introduced a negative interest rate policy, delayed the planned consumption tax hike, and adopted additional structural reforms, but the outlook remains weak. Abenomics can still achieve its ambitious targets through a comprehensive and coordinated policy upgrade. In the absence of such a reload, policies and targets will need to be reset for more gradual and realistic progress to avoid adding to volatility and uncertainty.

Abenomics is at a Crossroad

1. Abenomics met with initial success in tackling two decades of mild deflation and weak growth. Strong coordination between the Bank of Japan’s (BoJ) unprecedented quantitative and qualitative easing program and fiscal stimulus combined with an announcement of ambitious structural reforms helped narrow the large output gap, reversed the undue appreciation of the yen, eased financial conditions, boosted corporate profits, lifted actual and expected inflation into positive territory, improved corporate governance and boosted labor force participation. The economy reached full employment and modest, but historically significant, increases in base wages took hold. Progress was made with fiscal consolidation.

2. Three years after its introduction Abenomics needs a significant policy upgrade. Inflation has lost its forward momentum and the BoJ has repeatedly pushed out its timeline for hitting its inflation target. Public debt remains unsustainable while record corporate profits and rising employment have failed to generate sufficient base wage growth. Investment and consumption growth remain weak amid uncertainty surrounding the growth outlook and real income. Finally, the global trade slowdown and effects of production offshoring have prevented exports from benefitting substantially from the weak yen while the sharp fall in oil prices has put downward pressure on headline inflation. To overcome these headwinds and safeguard against associated risks, Abenomics needs a comprehensive upgrade.

Targets Out of Reach Under Current Policies

A. Recent Developments

3. Growth remains subdued. After a strong start, economic growth slowed to 0.5 percent in 2015 due to weak private consumption, hamstrung by timid wage growth despite an unemployment rate close to an all-time low (Figure 1 and Table 1). Slack has emerged in the tradeable goods sector (in line with weak global markets) but firms prefer to hold on to their work force while employment growth has been concentrated in the less productive service sectors. Private investment was muted, reflecting lack of confidence in future demand prospects, and export growth slowed. Nevertheless, the external balance improved significantly as oil prices declined and service exports rose on the back of increased tourism from China. Growth in the first quarter of 2016 showed a modest rebound, driven in part by leap-year effects. While consumption picked up, investment remained weak, which could reflect increasing economic and policy uncertainty and declining growth prospects. The highly anticipated wage negotiations in the spring fell short of expectations as base wages rose by only 0.4 percent compared to 0.6 percent the previous year. High frequency indicators show continued weakness in industrial production and consumption. The Kumamoto earthquakes have hampered near-term growth but will only have a minor impact for the year as a whole reflecting reconstruction activity, some payback after production disruptions, and the fiscal stimulus.

Figure 1.
Figure 1.
Figure 1.

Japan: Recent Economic Developments

Citation: IMF Staff Country Reports 2016, 267; 10.5089/9781475522105.002.A001

Table 1.

Japan: Selected Economic Indicators, 2011–17

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Sources: IMF, Competitiveness Indicators System; OECD, and IMF staff estimates and projections as of June 23, 2016.

Annual growth rates and contributions are calculated from seasonally adjusted data.

Contribution to GDP growth.

For 2014 export and import growth rates are inflated because of changes in the compilation of BoP statistics (BPM6) implying a break in the series relative to previous years.

Including the effects of consumption tax increases in 2014 and 2015.

Bank of Japan Measures of Underlying Inflation; excluding fresh food & energy.

Based on normalized unit labor costs; 2005=100.

2010=100.

uA01fig02

Contributions to QoQ Growth (SA)

(in percent)

Citation: IMF Staff Country Reports 2016, 267; 10.5089/9781475522105.002.A001

Source: Haver Analytics.

4. Inflation lost its forward momentum. Average headline inflation (excluding the consumption tax) declined from 1.2 percent in 2014 to 0.3 percent in 2015, due to falling oil prices. The decline has continued in 2016, with May numbers showing a 0.4 percent (y/y) decline in the price level (Figure 2). The BoJ’s Core-core inflation (excluding fresh food and energy) remained steady in 2015, reaching 1.3 percent at the end of the year, but has since fallen to 0.9 percent. Weakening inflation dynamics spilled over to medium and long-term inflation expectations due to their backward looking nature.

Figure 2.
Figure 2.
Figure 2.

Japan: Inflation Developments

Citation: IMF Staff Country Reports 2016, 267; 10.5089/9781475522105.002.A001

uA01fig03

Inflation and Headline Inflation Expectations

(YoY; in percent)

Citation: IMF Staff Country Reports 2016, 267; 10.5089/9781475522105.002.A001

Sources: Haver Analytics; and Bloomberg, L.P.

5. Financial conditions remain accommodative but tightened recently (Figure 3 and 4). While interest rates declined and the credit cycle continued to expand, falling stock prices and the strong appreciation of the yen resulted in a modest tightening of financial conditions, posing a challenge to monetary transmission.

Figure 3.
Figure 3.
Figure 3.

Japan: Monetary Policy Transmission

Citation: IMF Staff Country Reports 2016, 267; 10.5089/9781475522105.002.A001

uA01fig17
uA01fig17

Japan: Financial Condition Index and Credit Cycle

Citation: IMF Staff Country Reports 2016, 267; 10.5089/9781475522105.002.A001

Figure 4.
Figure 4.
Figure 4.

Japan: Financial Markets Developments

Citation: IMF Staff Country Reports 2016, 267; 10.5089/9781475522105.002.A001

uA01fig04

Japan: Financial Condition Index and Credit Cycle

Citation: IMF Staff Country Reports 2016, 267; 10.5089/9781475522105.002.A001

Sources: Bank of Japan; Ministry of Finance; Haver Analytics; and IMF staff estimates.1/ Estimated as the first principal component of (standardized) 3-month TIBOR, 10-year JGB yield, stock price, and NEER.2/ Estimated as the average of the HP-filtered real total credit growth (deflated by CPI) and total credit-to-GDP ratio.
  • Debt and equity markets. The nominal yield curve shifted down and flattened significantly in the first half of 2016, with the 10-year benchmark JGB falling into negative territiory. The shift in the yield curve also translated into lower lending rates and corporate bond yields, with corporate debt issuance picking up, especially in long maturities. In contrast, equity prices started to decline in the second half of 2015, led by finanical and energy sectors, and volatility increased.

  • Portfolio rebalancing: Households continued to increase the share of risky assets in their financial portfolios, but the pace slowed recently, reflecting higher market volatility. Banks have accelerated rebalancing towards domestic lending, equities and investment trusts, and foreign securities (See Selected Issues Paper “Is Home Bias Weakening?”). Japan Post Bank continued to reallocate investments towards foreign bonds, and similarly, life insurers, who used to actively purchase super-long-term JGBs, increased the share of foreign bonds in their portfolios. The Government Pension Investment Fund (GPIF) has almost reached its reduced target for JGB holdings, while other pension funds continue to rebalance towards domestic and foreign equities.

  • Credit cycle. Domestic credit growth picked up in 2015 and the credit cycle continued to expand (Table 2) (See Selected Issues Paper “QQEs Impact on Financing Conditions of Listed Firms”). Overseas loans continued to grow rapidly as did loans for, and equity investment in, real estate. Asset quality improved with the NPL ratio—including that of overseas loans—declining further. Recently, financial institutions have become more cautious in extending overseas loans due to global growth concerns, especially in emerging markets, and higher foreign currency funding costs.

  • Exchange rate. The yen depreciation started to reverse in the second half of 2015 and its appreciation accelerated in early 2016 to levels last seen prior to the 2014 expansion of QQE. Underlying drivers include safe-haven effects due to global financial market volatility, a narrowing of interest rate differentials with the U.S., market perceptions of limits to BoJ’s stimulus, and a rising current account surplus. So far the authorities have verbally expressed concern about disorderly market movements, but refrained from actual foreign exchange interventions.

Table 2.

Japan: Monetary Authority Accounts and Monetary Survey, 2011–17

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Sources: Bank of Japan; and IMF staff estimations and projections.

Projections were made using the correlation between lending and non-residential investment in the 2008–14 period.

Projections were made using the correlation between lending and residential investment in the 2004–14 period.

Defined as the ratio of credits to the private sector and net credit to other financial instituions to customer deposits.

uA01fig05

Japan Exchange Rate Movements

Citation: IMF Staff Country Reports 2016, 267; 10.5089/9781475522105.002.A001

Sources: Bloomberg, L.P.; and IMF staff calculations.

6. The weaker domestic and external economic environment triggered a sequence of monetary and fiscal policy responses in the first half of 2016.

  • Supplementary budget and earthquake relief. In January, a 0.6 percent of GDP supplementary package was approved for FY2016.1 In addition, the government later announced a frontloading of the FY2016 initial budget, and the Kumamoto earthquakes in April prompted the formulation of a supplementary budget estimated to raise GDP growth by around 0.1 percent.

  • Negative Interest Rate Policy: The adoption of the negative interest rate policy (NIRP) amid a weakening of the outlook and higher global uncertainty reinforced the BoJ’s commitment to its inflation target and added another tool to the policy framework, allowing it to be more open ended. So far the NIRP has been successful in lowering the entire yield curve and has not adversely impacted market functioning, beyond expected effects on JGB liquidity and bank profitability (Figure 5). More time is needed to see its full transmission to the real economy (Box 1) (See Selected Issues Paper “Negative Interest Rate Policy and Bank Deposit Rate”).

  • Delayed consumption tax hike and planned stimulus. The authorities’ decisions to adopt additional stimulus and to postpone the scheduled 2017 consumption tax hike by two and a half years while maintaining the FY2020 primary surplus target, demonstrate the challenge of simultaneously stimulating the economy and moving towards fiscal sustainability in a short timeframe. While these decisions will reduce deflation risks and support near-term growth, they will likely affect the achievement of the authorities’ medium-term fiscal target, unless abrupt consolidation takes place, which would again undermine reflation prospects.

Figure 5.
Figure 5.
Figure 5.

Japan: JGB Market Liquidity

Citation: IMF Staff Country Reports 2016, 267; 10.5089/9781475522105.002.A001

7. Structural reforms progressed in some core areas.

  • New “three-arrows”. In September 2015, PM Abe announced a plan to promote the “Dynamic Engagement of All Citizens,” and a new “three-arrows” strategy consisting of: (i) a strong economy, with a target of raising nominal GDP to 600 trillion yen;2 (ii) childcare support to lift the fertility rate and labor force participation; and (iii) a social security system to prevent people from leaving employment to provide nursing care. Implementing measures remain to be elaborated.

  • Minimum wage and corporate tax. The government has been rightly calling for higher wage increases through the tripartite dialogue and recently announced a floor of 3 percent on annual minimum wage increases (See Selected Issues Paper “Minimum Wages as a Policy Tool”). The government also cut the statutory corporate income tax rate below 30 percent in FY2016, one year earlier than scheduled, to entice firms to deploy their cash, although the impact on investment appears limited so far.

  • Corporate governance reform. Progress so far includes acceptance of the Stewardship Code by 210 institutional investors; the application of the Corporate Governance code, inter alia requiring listed companies to appoint at least two outside directors on a “comply or explain” basis; the amendment of the Companies Act; and the launching of the JPX-Nikkei 400 index comprising only profitable firms with good corporate governance and disclosure.

  • Trans-Pacific Partnership (TPP). The government reached an agreement on the TPP, but the ratification decision has been pushed back to the next Diet session in the fall. If fully implemented TPP would raise the level of GDP by 2–3 percentage points in the long run and associated deregulation would yield further significant benefits.

B. Headwinds and Policy Challenges

8. Structural impediments hamper demand and wage growth. Low confidence in economic prospects, related to an aging and shrinking population, is holding back investment and credit demand, constraining portfolio rebalancing (See Selected Issues Paper “Impact of Demographics on Growth and Inflation in Japan”). Labor market duality and inflexibility are limiting the pass-through from a tightening labor market and high profits of large firms to wage increases (Figure 6).3 Weak demand and a lingering deflationary mindset are reducing the ability of firms to raise output prices. Labor market duality is hampering lending owing to the inability of part-time workers to obtain bank credit, and hurting investment, corporate restructuring and mergers and acquisitions due to the high level of job protection. The financial sector does not sufficiently support risk taking, limiting access to risk-based capital, as suggested by high reliance of banks on fixed asset collateral and slow restructuring of non-viable SMEs.

Figure 6.
Figure 6.
Figure 6.

Japan: Labor Market and Wage Developments

Citation: IMF Staff Country Reports 2016, 267; 10.5089/9781475522105.002.A001

uA01fig06

Potential Growth

(percent)

Citation: IMF Staff Country Reports 2016, 267; 10.5089/9781475522105.002.A001

9. Policies could have been more effective. The stop-go nature of fiscal policy, with yearly supplementary budgets, discretionary changes in consumption tax hikes, and optimistic growth assumptions underlying medium-term budget projections have left fiscal policy without a credible medium-term anchor and are contributing to policy uncertainty (Figure 7).4 Weak monetary transmission, sluggish wage-price dynamics, and a falling natural rate of interest are preventing the needed rise in inflation expectations, creating a communication and credibility challenge for the BoJ. Structural reform efforts did not sufficiently address the above-mentioned structural impediments, notably in the labor market. Perceptions of weakness in the policy framework have contributed to the tendency of the yen to appreciate when the Japanese economy is hit by negative shocks.

Figure 7.
Figure 7.
Figure 7.

Japan: Economic and Policy Uncertainty

Citation: IMF Staff Country Reports 2016, 267; 10.5089/9781475522105.002.A001

uA01fig07

Japan: Natural Rate of Interest

(In percent)

Citation: IMF Staff Country Reports 2016, 267; 10.5089/9781475522105.002.A001

Sources: Bank of Japan; Haver Analytics; and Fund staff estimates.Note: The blue line is the actual real discount rate deflated by the inflation expectations estimated from an MA(4) model, and the red line marks the mean posterior estimates of the natural rate of interest from a Bayesian time-varying parameter vector autoregression (TVP-VAR) model following Lubik and Matthes (2015). The shadow areas highlight the recession periods (defined as when the SAAR real GDP growth falls below zero for at least two consecutive quarters)

10. Global weakness and volatility constituted headwinds. Sluggish global growth and overcapacity in the traded goods sector prevented the weaker yen from materially boosting exports in 2014–15. Since mid-2015, concerns in emerging markets and revisions to the expected path of monetary policy in advanced economies led to heightened volatility in financial markets and safe-haven appreciation pressures, which intensified in early 2016. Declining commodity prices since mid-2014 did not boost activity as expected, but instead put downward pressure on headline inflation and forced the BoJ to repeatedly push out its timeline for hitting the inflation target.

Authorities’ Views

11. The authorities emphasized that despite a deflationary mindset and structural impediments to growth, policies are gaining traction. They recognized that the public’s deflationary mindset is changing more slowly than anticipated. Together with labor market rigidities, this had led to a subdued response of wages to the very tight labor market. Low growth expectations related to an aging and shrinking population and unfavorable external conditions had dampened investment, exports, and credit demand, creating a challenging environment for monetary policy. Nevertheless, the BoJ emphasized that QQE and NIRP significantly reduced real interest rates and encouraged more risk-taking by banks as they rebalanced their portfolios away from JGBs. The authorities also pointed out that they had met their commitment to cut the primary deficit in half compared to the 2010 level while at the same time facilitating higher nominal growth through flexible fiscal policy implementation. Meanwhile, structural reforms had helped to generate a virtuous cycle between corporate profits, employment and real income, as evidenced by three consecutive years of base wage increases.

C. Outlook and Risks

12. Growth is expected to remain weak due to anemic consumption, lackluster investment and fiscal drag. The economy is projected to grow in line with potential at 0.5 percent in 2016, before slowing to 0.3 percent in 2017, excluding the possible effect of the yet-to-be-adopted supplementary budget (Table 3).

Table 3.

Japan: Medium-Term Projections, 2014–21

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Sources: Haver Analytics; Japanese authorities; and IMF staff estimates.
  • Consumption. Private consumption will grow modestly in 2016, underpinned by lower commodity prices, targeted fiscal transfers, and rising labor force participation. The rising ratio of retirees to workers, however, has increased the share of non-wage income to total net disposable income, currently at 50 percent, making consumption less dependent on wage developments.

  • Public spending and taxation. Fiscal policy will pose a drag on growth in 2017, reflecting the withdrawal of past stimulus and waning reconstruction spending.

  • Net exports. A slow global recovery and yen appreciation are expected to dampen export growth.

  • Investment. High profits, an aging capital stock, and supportive credit conditions should provide a favorable environment for investment. However, heightened uncertainty, sustained appreciation of the yen and shrinking domestic markets will curb investment demand. As a result, the expansion of the credit cycle is expected to be restrained in the medium term.

13. Inflation will remain well below the BoJ’s inflation target. Average headline inflation is projected to remain at around 0.2 percent in 2016, reflecting drag from low energy prices, the recent yen appreciation, lower inflation expectations, and weakness in demand. Over time, inflation will gradually rise, supported by energy price developments and slowly building wage-price pressures, but with adaptive expectations progress will remain slow.

14. Risks to the near-term outlook are tilted to the upside from likely additional fiscal demand support, but downside dominates in the medium term (Annex I).

  • Domestic risks. Upside risks reflect the likely adoption of a substantial supplementary budget for 2017. On the other hand, incomplete policies may lead to further appreciation of the yen, triggering renewed deflation risks.

  • External risks. A sharper-than-expected moderation of growth in China and/or weaker growth in advanced economies – including due to the outcome of the Brexit referendum – could lead to global financial turbulence causing safe-haven yen appreciation, potentially derailing the recovery (See forthcoming Supplement to this report).

  • Financial stability risks. If the decline in JGB market liquidity became structural, it could trigger higher volatility in government bond yields. Moreover, risk exposures from equity price volatility and from the rapid expansion of overseas loans could impact financial stability, particularly given global financial volatility and rising USD funding costs.

15. Macro-financial feedback loops could be shock amplifiers. At the core of the risk nexus lies the sustainability of low risk premiums in a high public debt environment, and a stable financial system in the context of unprecedented unconventional monetary policies. In this environment, shock amplification can occur through macro-financial linkages between stagnation and deflation, financial imbalances, or public debt dynamics (see figure). The main risk stems from loss of fiscal confidence, leading to higher sovereign risk premiums, and forcing abrupt further fiscal adjustment with adverse feedback loops to the financial system and the real economy. Risks from imbalances in the financial system, although limited at present, constitute a tail risk with scope for an adverse feedback loop if they triggered a sovereign backstop.

uA01fig08

Macro-financial Linkages as Shock Amplifiers

Citation: IMF Staff Country Reports 2016, 267; 10.5089/9781475522105.002.A001

16. Available buffers and policy responses to downside risks depend on the size and origin of the shock. A coordinated response, making use of fiscal and monetary policies should be the first line of defense to counter downside growth shocks. The fiscal response will need to be contingent on the behavior of the sovereign risk premium and its impact on financial stability. Substantial downward shocks with a large adverse impact on growth, inflation, and debt dynamics or the failure of policies to make progress toward fiscal sustainability over the medium term could exhaust the effectiveness of conventional buffers.

Authorities’ Views

17. The authorities were confident that growth will pick up, and the BoJ was confident that inflation could still reach its target in FY 2017. While noting recent weakness in consumption, the government expected the economy to continue its modest recovery as investment picks up and the employment and income situation improve. They noted that the decision to postpone the consumption tax and introduce an economic stimulus package should prevent demand from stalling and accelerate the recovery further. The authorities maintained their medium-term growth target of 2 percent underlying the fiscal consolidation plan and would update their medium-to long-term projections this summer. The BoJ noted that their inflation forecast hinged on inflation expectations becoming more forward-looking and rising towards the target during their timeframe, triggered by the emergence of a positive output gap, rising actual inflation, and their strong commitment and recent policy actions. The authorities broadly agreed with staff’s risk assessment, but highlighted that external factors dominated, including the slowdown in overseas economies and volatility in global financial markets.

Getting Abenomics Back on Track

Under current policies, the high nominal growth goal, the inflation target, and the primary budget surplus objective all remain out of reach within the timeframe set by the authorities. A comprehensive and coordinated policy upgrade, centered on income policies, would significantly increase chances of achieving Abenomics’ ambitious targets. In the absence of such a reload, targets and policy frameworks would need a reset to be consistent with a protracted adjustment process. More unorthodox policy packages could pay dividends, but entail unacceptable risks at the current juncture.

A. Reloading Abenomics: Comprehensive and Coordinated Policy Package

18. The staff’s reload package puts income policies at the fore in order to raise inflation, combined with further demand stimulus in the near-term based on a temporary, modest, fiscal expansion and further monetary easing. Ensuring coordinated demand support while tackling labor market reforms and removing policy uncertainty will create important synergies. To maximize long-term sustainability, these policies should be enshrined in stronger policy frameworks and high-impact structural reforms to raise growth and address demographic headwinds.

Invigorating wage-price dynamics to raise inflation

19. Sustained nominal wage increases can help trigger positive wage-price dynamics and raise inflation expectations. A deflationary mindset and a secular decline in the bargaining power of labor have led to upward wage inflexibility, while a rising share of non-regular workers with lower wages has dampened average wage growth. This highlights the need for policies to directly target the wage formation process and reforms to reduce labor market duality. Higher wages passed on to prices will boost actual and expected inflation which would stimulate economic activity through lower real interest rates and support fiscal consolidation.

20. Despite important steps to encourage higher base-wage increases, bolder measures are required to trigger positive wage-price dynamics.

  • Income policies: The government could replicate the “comply or explain” approach adopted under the corporate governance reform to ensure that profitable companies raise wages by at least three percent (the inflation target plus average productivity growth) and back this up by stronger tax incentives or penalties as a last resort, given that the latter would be contractionary if they failed to trigger higher wages.5 In addition, the government can commit to raising administratively controlled wages annually in line with the inflation target and ensure similar policies are adopted at the prefectural level. These measures can be supported by calling for supplementary wage rounds in addition to the “Shunto” and conversion of bonuses to base pay.

  • Labor market and corporate governance reforms: Promoting “intermediate” contracts that balance job security and wage increases, including by clarifying the legal framework and providing subsidies for converting non-regular workers to such contracts, would reduce labor market duality and reinforce income policies provided new hiring is done under these contracts. It would also stimulate productivity growth through greater incentives for skill formation. Moreover, accelerating the recently introduced “equal-pay for equal work” program would help close the wage gap between regular and non-regular workers faster. Eliminating disincentives to full-time or regular work due to the tax and social security system such as the spousal deduction and allowance, as well as raising the availability of child-care facilities through deregulation remain critical. Further corporate governance reform—such as more ambitious requirements for outside directors, greater transparency of beneficial ownership and explicit limits on cross-shareholdings—would encourage corporates to use their high cash reserves more efficiently, which could result in higher wages, dividends, and investment.

21. More sustained, balanced, and coordinated demand support is needed to ensure the success of income policies. To facilitate the pass-through of higher wages to prices it is imperative that monetary and fiscal policy give a balanced and sustained growth impulse in the near term, warranting a modest near-term fiscal expansion, calibrated on the need to accelerate the closing of the output gap. Supportive demand policies are also critical to ensure that structural reforms to raise potential growth such as policies to boost labor supply do not create deflationary pressures. Fiscal stimulus should be coordinated with further monetary easing, where all policy tools should remain on the table. Given the overriding importance of signaling the need for a comprehensive and balanced policy package, there are merits in using all tools: some overall increase in asset purchases, some shift to purchases of assets held outside the banking system, and a modest further cut in deposit rates. Fiscal and monetary actions should be closely coordinated in terms of timing, mix, and level of stimulus.6

22. Generating wage-push inflation is not without risks and success is not guaranteed. The main aim of income policies is to raise wages and prices in tandem, without increasing unit labor costs, distorting relative prices, or undermining competitiveness. Nevertheless, incomes policies may not successfully raise inflation, if for instance, firms increase hiring of non-regular workers, if there are timing and coordination problems, if “comply-or-explain” policies do not deliver sufficient compliance, or if there is the perception by firms or households that policies can be reversed. Possible declines in competitiveness and profitability—especially for labor intensive SMEs and export-oriented companies—could have an adverse impact on employment and growth in the near term. Finally, efforts to increase public wages are likely to encounter political resistance in light of ongoing fiscal consolidation plans.

Achieving fiscal sustainability through reliance on gradual consumption tax hikes

23. A credible fiscal consolidation course needs to be charted now, including a pre-announced path of gradual consumption tax hikes (Figure 8 and Table 4). Given low potential growth, and the need to avoid leaning excessively against the BoJ’s easing policies, committing to a gradual increase in the consumption tax towards at least 15 percent, e.g., in increments of 0.5–1 percentage points over regular intervals, would better balance the objectives of supporting growth and achieving fiscal sustainability in the long run. The precise path should be determined mindful of the need to secure political buy-in, compliance costs for firms, and the administrative burden for the tax authorities. Starting the increases as soon as possible and replacing the currently planned 2019 hike with such a pre-announced, gradual path would enhance the credibility of the long-run fiscal adjustment effort, reduce uncertainty for consumers, and avoid large intertemporal shifts in spending around the time of the tax hikes (See Selected Issues Paper “Fading Ricardian Equivalence in Ageing Japan”). The single rate structure should be maintained as much as possible and concerns for the tax impact on low income households addressed by targeted cash transfers. A steady fiscal consolidation by 0.5 percent of GDP per year through 2030 would be sufficient to put the public debt-to-GDP ratio on a downward path. In addition to the consumption tax increase, broadening the tax base, containing nominal social security spending growth to 0.5 percent and implementing some other expenditure reforms would balance the adjustment between revenue and expenditure side.7

Figure 8.
Figure 8.
Figure 8.

Japan: Fiscal Developments and Sustainability

Citation: IMF Staff Country Reports 2016, 267; 10.5089/9781475522105.002.A001

Table 4.

Japan: General Government Operations, 2011–17

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Sources: Japan Cabinet Office; IMF staff estimates and projections.

Including fines.

Fiscal year basis.

In percent of potential GDP.

Market value basis.

Nonconsolidated basis.