What Next for Abenomics?

Japan barely escaped recession – defined as two consecutive quarters of negative GDP growth – when the numbers were adjusted in early December according to updated economic data. Japan’s economy grew at an annualized 1.0 percent rate from July to September 2015, instead of contracting as originally calculated. The results were fine-tuned with the input of new numbers to more accurately reflect stronger corporate capital investment and a slightly higher pace of export growth than originally reported. Unfortunately, consumer spending and wage increases remained miniscule.

Though Japan did manage to avert a recession this time, significant economic challenges remain in the years ahead. Prime Minister Shinzo Abe and his Liberal Democratic Party (LDP) are trying to use upcoming changes in Japan’s tax policy to fight deflation and low economic growth.

A key change is lowering the corporate tax rate. This change is designed to spur greater capital investment and wage increases by Japanese companies domestically. Currently, Japan’s corporate tax rate is 32.11 percent, but on April 1, 2016, that will drop to 29.97 percent. That rate will drop further to 29.74 percent in fiscal year 2018.

The government believes lowering the corporate tax rate is important to increase the competitiveness of Japanese firms against international firms. The average corporate tax rate among OECD countries is 25 percent; the 29.97 percent rate will put Japan on par with Germany.

This isn’t exactly a new tactic – Abe’s government has already cut the effective rate since FY 2013 by 5 percent. So far this 2 trillion yen ($16.4 billion) tax cut has yet to produce the kind of capital spending and wage growth hoped for.

Abe was hoping to create a virtuous circle of the government lowering taxes for companies, leading to companies increasing wages for workers, leading to workers spending more on those companies’ products, leading to companies making more profits, leading to companies paying more in taxes to the government even with the lower rate.

The process has stalled, however. Japanese companies are investing overseas rather than increasing wages or upgrading factories at home. Accelerating the lowering of the corporate tax rate to below 30 percent as early as fiscal 2016 – overcoming the Ministry of Finance’s institutional objection – reflects the government’s nervousness. One stratagem the government could consider in the future is to tax retained earnings, in order to force companies to spend the money saved on taxes as capital investment or wages.

Meanwhile, the revenue losses from the lowering of the corporate tax rate are supposed to be made up for by expanding a standard tax that applies to businesses of a certain size – regardless of their profit margins.

In the agricultural realm, several proposals are being considered to increase the competitiveness of the aging, moribund farm sector in anticipation of greater foreign competition. One idea is a tax break for landholders who lease their lands through a government-backed land bank. Another is increasing the tax rate on unused farmland. Both proposals are meant to incentivize farm consolidation and increase productivity.

As the recently negotiated Trans-Pacific Partnership (TPP) is likely to lead to an influx of agricultural imports due to lower tariffs, Japanese farmers need to be ready if they want to have any hope of remaining relevant.

Japanese politicians are also trying to be sensitive to consumer concerns in light of the consumption tax, which is scheduled to increase from 8 percent to 10 percent in April 2017. The central government hopes to balance that increase with reduced taxes elsewhere. Examples include: the exemption for processed and fresh food negotiated between the ruling Liberal Democratic Party (LDP) and its junior coalition party, the Komeito Party; the new, fuel-economy-based vehicle tax, which will afford the most environmentally friendly cars tax-free status; a tax reduction for over-the-counter drugs; and making some expenses related to childbearing and child-rearing tax-free.

Such sensitivity to low-earners within Japan is laudable, but it does come with fiscal costs. Taking off the tax increase on food will cost either an estimated 1 trillion yen ($8.1 billion) if snacks and beverages are included or 820 billion yen ($6.7 billion) if snacks and beverages are not included. The cost will be partially offset by a postponement of social security benefits, but the government has been coy about how it will make up the rest of the difference.

Despite these changes, there has been no overhaul of the income tax writ large, even though there are also potential changes there that could be made to encourage economic growth. For example, the spousal deduction – the “1.03 million yen wall” – benefits a small number of stay-at-home wives with a little extra income, but also forces many other women to voluntarily work fewer hours than they could so that their family can keep the deduction. With the Upper House elections next summer, Japanese politicians are hesitant to unnecessarily stir up electoral trouble by making changes to the income tax. After all, businesses, which offer significant financial support to the LDP, benefit from retaining large numbers of such part-time female workers.

In the background to all this is the ever-constant concern about Japan’s increasing debt and government spending. The regular budget proposal for general-account spending is set at 97 trillion yen ($790 billion) for FY 2016 – a record high, topping the 96.34 trillion yen ($785 billion) aside in FY 2015’s initial budget. Higher social security costs and increasing defense spending are driving this increase. The Ministry of Finance will be responsible for parsing down the 102.42 trillion yen ($834 billion) requested from various government ministries and agencies to 97 trillion yen, because FY 2016 is also the year when the Japanese government has agreed to try to enforce curbs on spending growth. The government has made a commitment to limit annual growth in general account expenditures to slightly over 500 billion yen ($4 billion) on average.