Japan has just recently become something of an economic test tube, and in a way that might seem to delight the anti-tax crowd (which, with the recent elections, is now known as “Congress”). In April, Japan increased its consumption tax from 5 percent to 8 percent. The following quarter, gross domestic production dropped by 7.3 percent. Last quarter — and contrary to the expectations of mainstream economists — it dropped another 1.6 percent. The conclusion? Increasing taxes caused a recession.
It’s certainly conceivable that the rise in taxes only correlates and didn’t cause the fall in GDP, but few in Japan — or from the rest of the world — are buying that. The tax hike was supposed to be one of a series that would eventually bring the rate next year to 10 percent. That next hike likely will be abandoned. Moreover, there appears to be nothing else except the tax hike that could have derailed Japan’s economy. And some — such as Nobel Prize winner Paul Krugman — had been warning that the tax hike could imperil a struggling economy.
There are shades here of the Laffer Curve, the controversial Reagan-era proposition by economist Arthur Laffer. Laffer’s argument was that too-high taxes depressed economic growth, resulting in smaller tax collections. Conversely, he argued, cutting taxes could boost economic growth and thus, perhaps counterintuitively, increase tax collections.
Japan seems a clear-cut case of this. Those who wish for a smaller and less intrusive public sector can now use it as evidence that taxes hurt economies and so destroy jobs. Democrats and other advocates of greater government intervention, they would say, are actually supporting policies that hurt the very groups — for example, the unemployed — about whom they profess to care.
Well, yes and no. Japan’s sad experience does seem to prove that, all other things being equal, higher taxes can impede economic growth. But it doesn’t necessarily make the case that conservatives would hope.
For one, this may be a short blip in Japan’s economic history. The consumption tax increase was big. In retrospect, many think taking “baby steps” — a series of smaller hikes — would have been less traumatizing. And in any event, it’s likely that the nation’s businesses and people will eventually adjust and that economic life bounces back to normal. In the United States for instance, taxes rose in early 2013 with the expiration of the Bush-era tax cuts (although the tax rise was well less than had originally been feared from what was then called the “fiscal cliff”). Sure enough, the boost in taxes appeared to hurt economic growth, with the economy remaining sluggish. But almost two years later, their impact is hard to discern. The economy is growing — at a healthy 3.5 percent annualized clip in the third quarter of 2014 — and the tax hikes are largely forgotten.
Also, some other nations (such as Denmark and Sweden) have significantly higher tax burdens than Japan — or, for that matter, the United States — yet enjoy much more robust growth. Granted, comparing countries like this is a little unfair; other factors aside from taxes likely account for the differences. But the point is that taxes are not the only influence over economic growth. In fact, it’s how you spend tax money that matters most.
Here’s where the Japan example falls apart for conservatives. Japan’s tax hike was supposed to be fiscally responsible. Urged upon it by the International Monetary Fund, it was imposed not to support wildly profligate new spending, but rather to help narrow the deficit. Arguably, if the new taxes had supported increased spending — say on infrastructure — or if Japan had simply continued to deficit spend, things might have been different. Instead, Japan’s penny-pinching (yen-pinching, actually) pushed it into recession.
In the United States, those on both sides of the aisle could learn a few lessons from Japan. Yes, tax hikes — especially those that are large and sudden — can thwart economic growth. But taxes are only one factor in explaining an economy. And indeed, fiscal prudence can also be a mistake. When economies are suffering or fragile, pump-priming and deficit spending can make a lot more sense than balancing the budget.
This column originally appeared in The Boston Sunday Globe on November 23, 2014.