Instituting new taxes is never an easy task for politicians, but for Japan - a nation with the most critical bond over-dependency of any developed country – relying on taxes as a more central revenue stream could be a lifesaver.
On Sunday (January 27), finance minister Taro Aso released the draft 2013 fiscal year budget which includes a plan to raise more money through taxes - ¥43.1 trillion (US$474 billion) - than bond issuance - ¥42.9 trillion – for the first time in four years. Aso estimates total spending will reach ¥92.6 trillion for the fiscal year, beginning April 1.
While these figures are merely the Ministry of Finance’s (MoF) projections – and one that economists are sceptical will manifest as planned – it is a step in the right direction for a country with a 230% debt-to-gross domestic product (GDP) level.
For years, Japan’s outrageous debt level has prompted the government to contemplate new ways of financing its activities, though hiking taxes were always a career-killer. So far, the biggest success politicians have achieved is doubling the country’s consumer tax from its current 5% to 10% by October 2015, with a step up to 8% in April 2014. While this tax alone won’t be enough to free Japan of its debt burden, shifting emphasis from bonds to taxes as a primary revenue stream helps in a big way given Japan’s socioeconomic situation.
Traditionally, the country has relied on bonds to meet its funding commitments, with more being issued as problems such as a rapidly aging population, a dwindling labour force and natural disasters impacted the nation.
Yet, while it’s evident that Japan’s bond market is the glue keeping the economy together, the system’s stability relies on a constant stream of demand to absorb bond supply which only offers ultra-low rates. This hasn’t been a problem so far, but in 2013 things have changed, and demand for JGBs could waver as the government moves closer to its 2% inflation target.
To increase the competitiveness of Japan’s exporters and manufacturers, newly elected prime minister Shinzo Abe launched an aggressive campaign to reach a 2% inflation target as a means to weaken the currency. It’s good news for companies, but bad news for JGB holders.
JGBs have sustained near-zero yields for years but that’s been fine for domestic investors, who hold more than 90% of Japan’s JGBs. These JGB holders are attracted to the net gains that their bonds earn. Although five- and 10-year JGBs pay dismal yields of 0.16% and 0.75%, respectively, investors price in the yen’s additional appreciation against the dollar. This gives investors greater absolute returns.
While true that the country’s largest bond buyers such as banks, pensions and insurers will continue to participate in the market merely because they’re Japanese, their appetite for JGBs may not be nearly as robust as it is now. This may lead them to look overseas for better opportunities.
Already since November, when Abe first announced his intention to institute a 2% inflation target, the yen has depreciated more than 10% against the US dollar. By comparison, five and 10-year JGB yields have dropped by 0.03% and 0.04% in the last month.
Given that JGBs have been the lifeblood of Japanese government funding, this could present a real problem. No one realistically believes that the JGB market will collapse, but it would be practical for the government to consider their revenue-generating options away from debt sales.
But if Japan wants to truly reduce reliance on bonds, Abe will have to raise taxes further. Economists believe there’s room to do so. According to the World Bank, Japanese tax revenue has averaged at approximately 9% of its GDP between the years of 2008-2010 (more recent data isn’t immediately available). By comparison, fellow-G8 counties the UK, Germany, Canada and the US’ tax revenue-to-GDP through those years equate to 27%, 11.6%, 12.3% and 9.4%, respectively.
Raising taxes, as unpleasant as the prospect is for a politician, will go far to helping Japan reduce its debt-to-GDP and act as a buffer against fluctuating demand for JGBs, especially as the government looks to spend more on stimulus measures. And if Japanese citizens need a bit of massaging, economists should emphasise that an inflated yen – already on the cards – will bring down the value of the currency, which should cheapen the price of goods that households buy.
As bitter as taxation is, it’s a long-term solution for a country that could use a few more answers to untangle its economic woes.