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Japans tax-induced recession: What lessons can India learn?
December, 02nd 2014

The BBC has reported that ordinary people in Japan have stopped spending money. Japanese economy has contracted, with the gross domestic product (GDP) falling for the the second quarter in succession, leading to what is generally defined as recession. And this has happened when economists were seeing distinct signs of an economic revival in Japan, the world’s third-biggest economy. The stock indices were surging, and the government had clear plans for fiscal discipline and monetary stimulus. The villain seems to be consumption tax, the increase in which has kept the customers away from shops and has drastically reduced the sales of white goods, automobiles and the like.

The Japanese consumption tax system is only a quarter century old, having been introduced in 1989, with a rate of 3%. The rate was hiked to 5% in 1997. There has been an endless debate on the contribution of the tax increase to the recession, which followed immediately. The 1997 recession also happened at the time of an expected recovery from the economic crisis of the early 1990s. Most of the countries in East Asia and Southeast Asia went through recession in varying degrees. Japan, as the biggest exporter to the region, suddenly lost a market for 40% of its exports. Japanese real estate sector and the stock market, which were apparently having a speculative bubble, burst. Big financial institutions collapsed, eroding the credibility of the financial system. The appreciation of the yen in the mid 1990s also led to a mild deflation. And then there were the increase in consumption tax, repeal of some temporary concessions in income tax, and increase in the insurance premiums for social security.

Seventeen years later, the Japanese government increased the rate of consumption tax to 8%, from April 2014, based on a decision taken in 2012. The government, as also the IMF and several economists, believed that the tax hike was inevitable for reducing the country’s debt burden. The government had taken several aggressive measures to enliven the economy and to trigger some inflation, including a $1.4 trillion stimulus and bond buyback. Abenomics was emerging as a seemingly successful macroeconomic model. However, history has repeated itself, with recession following the increase in consumption tax. The last two quarters experienced decline in GDP by 7.1% and 1.6%, respectively. The government of Japan has acted immediately—the increase of consumption tax to 10% scheduled to take effect in October 2015 has been postponed to April 2017. Prime Minister Shinzo Abe has called for mid-term elections to the Parliament.

Europe has reasons to worry as some of the major economies are stagnant; many of the symptoms and the prescriptions are similar to those for Japan. The economic environments in the US and China are each distinctive and the issues are different. India, too, is unique, but the Japanese crisis has lessons relevant for India as well.
The Indian economy is experiencing positive trends, although the fundamentals remain the same. The country expects economic and administrative reforms under Prime Minister Narendra Modi. The stock market is bullish; inflation is reasonable; the campaign to ‘make in India’ is already on. Trade and industry are awaiting the big reform in indirect taxation—the introduction of the goods and services tax (GST). The advantages of GST are several, the foremost benefit being the emergence of an Indian common market. It is expected to subsume most of the central and state taxes levied on goods and services. A good GST can make taxation simpler (thereby moving the country a few steps ahead in the ranking based on the ease of doing business). The central ministry of finance and the Empowered Committee of State Finance Ministers have converged on the broad parameters of the reform; the legislative process has to start ab initio since the 115th Constitution Amendment Bill lapsed following the dissolution of the Fifteenth Lok Sabha.

The big question which emerges following the Japanese experience is—what are the rates of GST? All official statements stress on a revenue-neutral reform, but there could be irresistible temptations both for the Centre and the states to mobilise some extra revenue. For the states, the value added tax (VAT) on goods is the single biggest source of revenue. For the Centre, too, the central excise and service tax have been significant sources of revenue, with the service tax introduced in 1994 exhibiting remarkable buoyancy, growing to R2 lakh crore and overtaking other indirect taxes in 20 years. As much as 32% of these central revenues devolves to the states as per the Finance Commission’s formula. Unlike State VAT which replaced sales tax in the middle of the last decade, the GST system is much more complex, with the integration of diverse taxes on the manufacture and sale of goods and the provision of services. Therefore, arriving at the revenue-neutral rate is an intricate economic, political, academic and bureaucratic exercise.

The revenue-neutrality challenge is not uniform as the impact of GST introduction would vary from state to state. The Centre will have to compensate monetarily those states which lose revenue; there will, of course, be no penalty on the gainers. If the central revenue falls, that would be a major calamity with all the efforts for containing the fiscal deficit getting nullified. But if there is an administrative tendency to err on the safer side by trying to mobilise higher revenues, the market could possibly strike back. Further, the perception of the market, at least in the initial stages, would be based on inadequate information. A retail customer who now pays a tax of 4-5% or 12.5-14.5% on goods purchased by him would suddenly be called upon to pay tax at a much higher rate. The price of the goods might have reduced with the integration of CenVAT, State VAT and service tax, as there could be credit for the input taxes. The fact is that the seller is responsible only for the tax on the value added by him, but this fact may not impress the purchaser who notices a heavy incidence of tax in the bill. If GST leads to the doubling of service tax, the impact would be strongly felt as the input tax credit may not offset the increase.

A 3% hike in the rate of consumption tax created havoc in Japan. Of course, this was in an economy where the GDP growth rates, inflation and interest rates were all close to zero. If the combined rate of GST is high, the market could react in several ways. There is the danger of a slowdown in trade, and therefore in manufacturing. There is the possibility of large-scale tax evasion. Theoretically, a value-added tax system with the incentive of input tax credit prevents evasion, but it may not really work in India, unless there is a well-designed robust information technology platform and a strong vigilance machinery. While one is looking for missing links in a chain, entire chains could be missing. It would be prudent not to underestimate Indian ingenuity.

Perhaps finance minister Arun Jaitley could effectively use his charge of information and broadcasting to full advantage to market GST.

 
 
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