Bitter tonic

Japan’s reconstruction: Japan's economy is still on track for a V-shaped recovery, but it won't happen without help. The country needs a solidarity package that combines public spending and monetary easing, financed by tax increases to avoid deepening government debt.

Contrary to what might be expected, tax hikes will prove not only politically palatable, they could - paradoxically - encourage spending and investment.

To pay for the estimated ¥25 trillion in estimated earthquake damage, the government has approved a ¥4 trillion supplementary budget. Two more supplementary budgets are under consideration. The plan is to raise the first tranche of funds without new borrowing, a wise move considering the government's debts are double the size of the economy.

Financing the rest will mean selling more bonds. Fortunately, Japan has a captive audience of pension funds and insurers that will absorb virtually any new debt without pushing up borrowing costs. That doesn’t mean Japan is right to add to its debt. It should offset new borrowing with higher revenue, which in slow-growth Japan means raising taxes.

In most countries, a progressive income tax increase would be the most equitable way. But Japan is not most countries. With a shrinking population, Japan's income is declining, too. Raising consumption taxes is more efficient. A 10 percentage point increase in income taxes would yield only ¥1.2 trillion in tax revenue, estimates Societe Generale; but a mere one-point increase in the sales tax would pull in up to ¥2.5 trillion.

Consumers typically boost spending in advance of a sales tax increase, so a rise would help offset the post-quake downturn in consumer activity. Opinion polls, meanwhile, indicate consumers and companies are willing to swallow an increase.

Raising property taxes could encourage more Japanese to sell old homes in prime areas and this could make way for new construction. But to stimulate this kind of renewal, the Bank of Japan needs to lower real interest rates. The BoJ is right not to undermine the yen by buying new government bonds. But it is wrong not to expand purchases of bonds from banks to free up credit. Such a move would put downward pressure on the yen, making life easier for exporters.

Japan's policy decisions may have some undesirable side effects, but the country's ailment demands powerful medicine.

wayne.arnold@thomsonreuters.com