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The Impact of an Increase in the Consumption Tax Rate
- The Implications of Past and Overseas Experiences -

Janualy 13, 2006

Overview

This article considers the probable impact of an increase in the consumption tax rate on the economy in the light of past experience and overseas trends and sets out proposals as to how the consumption tax rate should best be raised.

Estimates of the impact on the household sector suggest that a one point increase in the consumption tax rate would push consumer prices up by 0.9%. The consequent fall in real incomes would depress real consumer spending by 0.6% and real GDP by 0.4% in the first year. The increase in the burden for each household would be of the order of ¥2,000/month for households with annual incomes in the bottom 20% (average annual income ¥3.47 million) and ¥4,000/month for households with annual incomes in the top 20% (average annual income ¥12.34 million).

In practice, the impact would differ according to the method by which the tax rate was raised and the economic conditions prevailing at the time of the increase. Looking back to fiscal 1989, the abolition of the commodity tax helped to limit the fall in real incomes and the impact of the introduction of the consumption tax was slight. By contrast, in fiscal 1997, when the discontinuation of the special income tax reduction (¥2 trillion) and the reform of pension and medical care insurance (¥1.5 trillion) were exerting downward pressure on incomes, growing anxiety over pensions, among other factors, the raising of the consumption tax rate led to a fall in consumer confidence and consumption saw a sharp slump.

Looking overseas, on an effective rate basis, Japan's consumption tax rate is the lowest among the OECD countries after that of the United States. Although there are many examples of tax revenue neutrality having been achieved by combining a rise in the consumption tax rate with a reduction in income tax, the examples of France and Germany, where the outcome was a net increase in taxation, indicate that the impact of a rise in taxation varies considerably according to whether the economy is in a growth phase or a recession phase.

Again, these examples suggest that the economic impact of an increase in the consumption tax will differ according to (i) the balance of the pace of income growth and the burden in different economic phases and (ii) the degree to which the household sector assents to a tax increase. For this reason, if the tax rate is to be increased, it will be important (i) to establish a framework that is able, to some extent, to respond flexibly to current economic conditions and (ii) to implement the increase gradually and avoid major fluctuation in demand. If taxation is to be increased, it is also essential that the government (i) lay the foundations for the restoration of soundness to public finances with a thorough restructuring of expenditure and (ii) set about restoring confidence in the social security system through reforms that will ensure its sustainability.

For more information on the content of this report, please contact: Naoko Ogata the Japan Research Institute, Limited.

Tel:03-3288-5120
E-mail:Ogata.naoko@jri.co.jp

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