The consumption tax in Japan is a value-added tax. It is a tax imposed on the production, distribution and sale of goods and services at each stage in the transaction chain, though tax paid by businesses in previous stages is deducted to avoid the accumulation of taxes. It is an efficient system that has less distortionary effects on economic activities than the excise tax, which was imposed until the introduction of the consumption tax.

The Abe administration postponed the tax hike twice, in October 2015 and April 2017, due to the timing of elections and public concerns over potentially negative impacts on the economy. On 1 October 2019, the promise was finally realised.

In order to implement the consumption tax hike smoothly, efforts to offset negative impacts on the economy were taken into account such as income measures. Tax rates on goods such as food products, drinks and newspapers were reduced to decrease the tax burden on low income citizens. But implementing multiple tax rates is convoluted and Japan could adopt more efficient solutions by learning from the valued-added tax experiences of other countries.

The Abe government also adopted measures to mitigate the tax’s negative impacts on consumption. Spending fluctuated around the tax’s implementation with a last-minute surge before the hike and contraction afterwards. Relief measures included ‘gift certificates’ and ‘premium coupons’ for families with children and tax-exempted citizens, rebates for cashless settlements, free day nursery services, extended loan support for housing purchases and a reduced automobile tax. These measures should only be used for temporary relief until consumption stabilises, as the abuse of countermeasures is not preferable.

The main issues surrounding the tax rate hike concern its contribution to financing social security and its impact on consolidating Japan’s public finances.

Currently, combined central and local government debt in Japan is about 1100 trillion yen (approximately US$10 trillion) — over 200 per cent of GDP. The Japanese government is taking fiscal reconstruction measures to achieve a primary balance surplus and a stable reduction in the debt-to-GDP ratio by 2025. Both since the previous and current administrations repeatedly postponed such fiscal reconstruction goals the changes are now long overdue.

Because of its rapidly aging population, social security is the largest source of public expenditure in Japan. Services like medical care, pensions and nursing are partially financed by social insurance premiums and individual payments. But nearly 35 per cent of social insurance benefits are still supported by tax.

During the 2025 financial year, as the baby boomer generation turns 75 or older, social security benefits are expected to continue to grow from 121.3 trillion yen (approximately US$1.1 trillion or 21.5 per cent of GDP) to 140.6 trillion yen (approximately US$1.3 trillion or 21.8 per cent of GDP). The costs of social security benefits are projected to rise again to around 190 trillion yen (approximately US$1.7 trillion) by the 2040 financial year, when the second generation of baby boomers reaches 65 years or older.

The Abe administration sees no need to raise the consumption tax again and seems satisfied to leave arguments over the tax to future administrations. But considering the size of the Japanese government’s debt, consumption tax reform should continue. The IMF has already predicted the possibility of another tax rate hike for the purposes of fiscal reconstruction, especially to reduce risks associated with debt sustainability. It has proposed gradual and steady increases in the consumption tax rate beyond 10 per cent and up to 15 per cent.

In tandem with further consumption tax reform, Japan should also explore the possibilities of income tax reform. Dependence on income tax as a means to secure tax revenue is not desirable in a globalised economy. One possible reform option is to utilise tax credit schemes linked with labour incentives, in order to overcome social problems in Japan such as the labour shortage and the complex system for transferring social security benefits. Incentive schemes such as earned income tax credits and working credits may offer more efficient solutions for labour management and social security reform.

Japan’s tax reforms should not stop here. Innovation in the Japanese tax system has the potential to help resolve many more policy challenges. There remains much room for tax reform to rationalise the social security system and contribute to fiscal reconstruction.

Kiyohito Hanai is Professor of Economics at Seijo University.