View original document

The full text on this page is automatically extracted from the file linked above and may contain errors and inconsistencies.

Economic Brief

October 2019, EB19-10

A Closer Look at Japan’s Rising Consumption Tax
By Thomas A. Lubik and Karl Rhodes

Japan plans to raise its national consumption tax next week from 8 percent
to 10 percent. Some commentators and economists have blamed previous
consumption tax increases for causing recessions in 1997 and 2014, but little
statistical analysis has been published to support or refute such claims. This
Economic Brief highlights new evidence that significant changes in Japan’s
household consumption behavior did in fact coincide with the 1997 tax hike.
Japan rose from the ashes of World War II and
built one of the largest economies in the world
by 1970. Its booming exports of automobiles
and consumer electronics prompted some
prognosticators to predict that the Japanese
economy eventually would surpass the American economy.1
Japan’s phenomenal GDP growth slowed somewhat in the 1970s and 1980s, but by 1990, the
nation’s real estate and stock market valuations
had soared to previously unthinkable heights. At
one point, a three-square-meter parcel of land in
downtown Tokyo reportedly sold for $600,000.2
But the lofty market prices plummeted in the
early 1990s, precipitating a financial crisis, a prolonged slowdown in Japan’s real economy, and
a steady slide into many years of deflation or
near-zero inflation.3
The government responded with numerous
rounds of fiscal stimulus, and the Bank of Japan
reduced the uncollateralized overnight call rate
(its policy interest rate) from 6 percent in 1991 to
0.5 percent in 1995. The economy seemed to be

EB19-10 – Federal Reserve Bank of Richmond

recovering nicely until the government boosted
the national consumption tax from 3 percent
to 5 percent in 1997. This abrupt and largely
unanticipated change in policy induced a small
spike in consumption ahead of the tax hike, but
after the tax increase, household consumption
decreased and remained flat for two years. (See
Figure 1 on the following page.)4 Significant
growth resumed in 1999 at a much slower pace,
but it plummeted during the global financial crisis and again in 2010. Household consumption
surged in 2013 after the government announced
two more consumption tax hikes — to 8 percent
in 2014 and to 10 percent in 2015.
The 2014 increase occurred on schedule, but the
2015 increase was postponed — until now.
A Closer Look at Consumption
To bring more rigorous statistical analysis to the
long-running debate over Japan’s consumption
tax, one of the authors of this Economic Brief
(Lubik) has studied the dynamics of consumption, the real interest rate, and measures of labor
input in Japan from 1985 through 2013.5

Page 1

Lubik and Jonathon Lecznar of Boston University
analyzed comovement patterns of macroeconomic
aggregates, conducted structural break tests, and
employed generalized method of moments (GMM)
estimations on structural Euler equations for consumption growth. They found that the behavior
of aggregate household consumption and its relationship with real interest rates did indeed change
considerably in the second quarter of 1997.6 The consumption tax increase from 3 percent to 5 percent
in April 1997 coincided with a substantial decline in
consumption growth, and the Bank of Japan’s target
interest rate reduction to 0.5 percent in 1995 (essentially to zero by 1999) coincided with a decline in the
real interest rate.
Lubik and Lecznar explain these changes in terms of
a simple model represented by the so-called Euler
equation, which explains how consumption choices
change over time and which is derived from a house-

hold’s utility-maximization problem. A household
and its members want to smooth consumption over
time. This goal can be accomplished, for instance, by
investing in interest-bearing assets that deliver returns to sustain household consumption when other
sources of income decline. Therefore, the optimal
intertemporal consumption choice depends on the
effective real rate of return on the interest-bearing
assets. In addition, consumption growth depends on
habit preferences, where consumption smoothing
also preserves past levels of purchasing.
Using various statistical methods, the authors find
little evidence of habit formation from 1986 through
the first quarter of 1997. However, starting in the second quarter of 1997, they find strong evidence of the
presence of habits. The evidence of a greater responsiveness of consumption growth to real interest rate
fluctuations also appears in the second quarter of
1997. But after the Bank of Japan’s policy rate hit zero

Figure 1: Real Household Consump�on Growth in Japan

Figure 1: Slower Growth of Real Aggregate Household Consumption in Japan




In Trillions of Chained 2011 Yen

In Trillions of Chained 2011 Yen













Source: Japan Cabinet Office and Federal Reserve Economic Data (FRED)

Ja pan
binet Office
a ndtrends.
Data (FRED)
Notes: Black
are quarterly
and seasonally
Notes : Black lines i ndicate sta�s�cal trends. Data are quarterly a nd s easonally a djusted.

Page 2

in 1999, consumption growth became less volatile
and remained at a lower level.
In addition, various structural break tests clearly identify the second quarter of 1997 as the break point
in household consumption.7 The date of this break
“aligns ominously” with the April 1997 consumption
tax hike, suggesting the possibility that the policy
change induced the break. The researchers’ GMM
estimation of the Euler equation compared with a
benchmark GMM estimation of the Euler equation
confirms their finding that the 1997 tax hike coincided with a break in household preferences.
Overall, Lubik and Lecznar conclude that Japanese
households formed stronger habit preferences and
exhibited greater sensitivity to real interest rate
movements in the wake of the consumption tax
hike. The higher degree of habit formation arose
largely from households becoming less risk averse
or equivalently from the elasticity of intertemporal
substitution. In other words, consumers became
more willing to buy sooner (ahead of the tax increase) in lieu of buying later (after the tax increase).
While all of these equations and statistical tests stop
short of blaming the 1997 tax increase for turning a
nice recovery into a nasty recession, they add statistical rigor to the correlation between the tax hike and
Japan’s long-term decline in consumption growth.
They suggest that the timing of the tax increase was
unfortunate at best.
No Easy Choices, No Single Solution
In hindsight, the decision to increase the consumption tax in 1997 may seem like an obvious misstep,
but in the 1990s, household consumption growth
was fairly robust, and Japan was looking for a way to
get its burgeoning national debt under control. The
combination of higher government spending, lower
taxes, and flat output had boosted general government gross debt from 63 percent of GDP in 1991 to
107 percent of GDP in 1997.8
Unfortunately, the tax increase did not produce
enough revenue to stem the tide, and gross debt

soared to 229 percent of GDP in 2012. At that
point, as stated above, the Japanese government
announced plans for two more consumption tax
increases — from 5 percent to 8 percent in 2014
and from 8 percent to 10 percent in 2015. The 2014
increase coincided with a spike in household consumption ahead of the increase and flatter consumption growth after the spike. The proposed 2015
increase was postponed twice, but now it seems
certain for October 1. Japan’s prime minister, Shinzō
Abe, has declared that nothing short of “the global
financial crisis triggered by the collapse of Lehman
Brothers” will delay the tax increase this time.9
Clearly, there are no easy fiscal policy choices for
Japan. To continue issuing public debt to cover substantial annual budget deficits, the people who purchase the bonds must continue to believe that the
nation will have the ability to pay them back when
the bonds mature. Economists call this concept the
“intertemporal government budget constraint.” Even
though credit-rating agencies have downgraded
Japan’s debt, yields on Japanese government bonds
have remained low and stable.10 This observation
implies that the purchasers of the bonds — primarily Japanese citizens and companies (in the primary
market) and the Bank of Japan (in the secondary
market) — are not overly concerned at the moment. But there are new challenges on the horizon.
Most notably, the Japanese workforce is shrinking,
and the average age of its population is increasing
rapidly. Productivity growth has remained low, and
the economy seems to need both expansionary fiscal
policy and expansionary monetary policy to sustain
a modest recovery.11
The problem seems too big for any single solution.12
A recent survey of Japan’s economy by the Organisation for Economic Co-operation and Development
endorsed the imminent consumption tax increase
and recommended further incremental hikes.13 The
report also recommended that the country expand
its workforce by embracing immigration and encouraging greater participation among women. Other
observers have suggested all of the above plus
public pension reforms, reductions in public health

Page 3

expenditures, programs to promote larger families,
and the sale of government-owned enterprises and
other nonfinancial assets.14 Eventually, the intertemporal budget constraint may necessitate several of
these policy actions, but additional consumption
tax increases, against the backdrop of Lubik and
Lecznar’s research, would argue for further study of
the relationship between tax policy and aggregate
consumption dynamics. Specifically, policymakers
need to know more about the extent to which consumption tax increases affect the behavior of households, especially in the United States, where private
consumption is the backbone of the economy.
Time to Watch and Learn
The Japanese economy never did surpass the American economy, but once again, Japan has arrived at an
economic crossroads well ahead of the United States.
(Japan’s financial crisis preceded the U.S. financial crisis by about eighteen years.) It would be difficult to
advise Japanese policymakers on which combination
of treatments would be most effective at this point,
but the best advice for U.S. policymakers is clear —
watch and learn. The Japanese economy is a valuable
laboratory for observing various approaches (such
as a national consumption tax) to dealing with a
looming government debt crisis exacerbated by a
baby boom generation that is leaving the workforce,
living longer, and breaking the entitlement bank.
Japan’s present could become America’s future.15


 onsumption data come from the Japan Cabinet Office via
Federal Reserve Economic Data (FRED).


J onathon Lecznar and Thomas A. Lubik, “Real Rates and Consumption Smoothing in a Low Interest Rate Environment: The
Case of Japan,” Pacific Economic Review, December 2018, vol.
23, no. 5, pp. 685–704.


T he authors also find evidence of a structural break in the behavior of employment and hours worked that occurred earlier
in the decade.


S pecifically, the sequential Bai and Perron test to determine
the number of breaks in the data indicates only one break over
the entire sample period. The global financial crisis did not
qualify, but the second quarter of 1997 did. This result supports the notion that the break in consumption was caused by
policy choices as opposed to economic forces. The Andrews
test for a single unknown break point also flags the second
quarter of 1997. To assess this finding’s robustness, the authors
perform a standard Chow test for a range of known break
dates around this period. Again, the second quarter of 1997
emerges as a break point.


 alculations of general government gross debt are from the
International Monetary Fund via Federal Reserve Economic
Data (FRED). Japan’s gross debt is substantially larger than its
net debt, defined as gross debt minus financial assets that
correspond to debt instruments. By that definition, net debt
to GDP was 19 percent in 1991 and 42 percent in 1997. See
Tanweer Akram, “The Japanese Economy: Stagnation, Recovery,
and Challenges,” presentation to the 2019 Annual Meeting of
the American Economic Association, Atlanta, January 5, 2019.


S atoshi Sugiyama, “Abe Sticks with Plan To Raise Japan’s
Consumption Tax Despite Weak Tankan Results,” Japan Times,
July 1, 2019.


S ee Tanweer Akram and Anupam Das, “The Determinants
of Long-Term Japanese Government Bonds’ Low Nominal
Yields,” Levy Economics Institute Working Paper No. 818,
October 2014.


S ee Ben S. Bernanke, “Some Reflections on Japanese Monetary
Policy,” presentation at the Bank of Japan, May 24, 2017. Near
the conclusion of the presentation, Bernanke says: “When
central bank action on its own reaches its limits, then fiscal
policy is the usual alternative. However, in Japan, even fiscal
policy may face constraints, resulting from the high debt-toGDP ratio that already exists in Japan. This leads, inevitably I
think, to discussions of coordination between monetary and
fiscal policy. There are many ways such coordination could be
implemented, but the key elements of a possible approach
are that (1) the government commits to a new program of
spending and tax cuts and (2) the central bank promises to
act as needed to offset any effects of the program on the path
of Japan’s ratio of government debt to GDP.”


S ee Selahattin İmrohoroğlu, Sagiri Kitao, and Tomoaki Yamada,
“Achieving Fiscal Balance in Japan,” International Economic
Review, February 2016, vol. 57, no. 1, pp. 117–154.


S ee Organisation for Economic Co-operation and Development, “OECD Economic Surveys: Japan 2019,” April 2019.

Thomas A. Lubik is a senior advisor and Karl Rhodes
is a senior managing editor in the Research Department at the Federal Reserve Bank of Richmond.

Eamonn Fingleton, Blindside: Why Japan Is Still on Track to Overtake the U.S. by the Year 2000, Boston: Houghton-Mifflin, 1995.


T imothy Knight, Panic, Prosperity, and Progress: Five Centuries
of History and the Markets, Hoboken, N.J.: John Wiley & Sons,
2014, p. 284.


S ome economists have blamed Japan’s economic slowdown
on low productivity growth rather than a breakdown in the
financial system. See Fumio Hayashi and Edward C. Prescott,
“The 1990s in Japan: A Lost Decade,” Review of Economic Dynamics, January 2002, vol. 5, no. 1, pp. 206–235.

Page 4

Additional support for incremental consumption tax increases
comes from Michael Keen et al., “Raising the Consumption Tax
in Japan: Why, When, How?” International Monetary Fund Staff
Discussion Note 11-13, June 16, 2011.

S ee the conclusion of Gary D. Hansen and Selahattin
İmrohoroğlu, “Fiscal Reform and Government Debt in Japan:
A Neoclassical Perspective,” Review of Economic Dynamics,
July 2016, vol. 21, p. 223.


Keen et al. (2011), p 18.

This article may be photocopied or reprinted in its
entirety. Please credit the authors, source, and the
Federal Reserve Bank of Richmond and include the
italicized statement below.
Views expressed in this article are those of the authors
and not necessarily those of the Federal Reserve Bank
of Richmond or the Federal Reserve System.

Richmond Baltimore Charlotte

Page 5