Japan's Escape

Japan’s economy has been in a period of stagnation ever since the ‘lost decade’ of the 1990s. For the past year or so, consumer prices have continued to fall. The continued fall has meant that consumers have put off buying in hope of cheaper prices in the future. This has created a vicious cycle of falling profits for firms and falling wages. This collapse has only been accentuated by the fact that Japanese firms have reduced investment because of low confidence in future demand.The question now is how will it get out of this mess?

Clearly, Japan must increase confidence in the economy and it must do so by stimulating demand. One way it could do this is by lowering the income tax (which can be as high as 40%) to stimulate consumer demand and raise prices. Despite the fact that this would increase the budget deficit, I feel that this fiscal reform is necessary if the crisis is to be halted.

Recently in Japan, the increase in the output gap has been closely correlated with falling consumer prices, with a slight lag. The output gap stands at around 7% of GDP today. It follows that, if Japan could shrink its output gap (the difference between actual GDP and GDP if all work-eligible people and factors of production were employed), it may be able to escape deflation. I feel that a reduction in corporate tax – which is high at 30% - is in order. This is likely to increase investment by firms – creating jobs and therefore reducing the output gap. The creation of jobs will also serve to increase aggregate demand – potentially pulling Japan out of deflation. Though, again, the reduction in corporate tax will further increase the budget deficit in the short-run, I feel that the increase in tax revenues from newly created jobs and higher profits will make up for this in the long-term. In other words, I believe that the Japanese government has implemented a tax rate that is beyond the rate at which they would achieve greatest tax revenue. This can be illustrated on the Laffer Curve below where the current rate is b% and government tax revenue could be increased by reducing the tax rate to a%

One of the most pressing problems that Japan faces is its changing demographic. With one of the lowest birth rates in the world and a shrinking working class, it is no wonder that demand is shrinking. And this is exacerbating the deflation. What Japan needs to do is relax its strict immigration laws to increase the workforce and bolster demand – an average of 381,000 foreign workers per year will need to emigrate to Japan (through until 2050) to keep the population stable. What’s more, the Japanese government will have the added benefit from the immigrants of increased tax revenue.

I believe that if the Japanese government loosened immigration controls and adopted fiscal reforms to narrow the output gap, they will be able to pull their country out of an extended period of deflation. Hopefully, with the elections coming up this summer, the government will adopt these measures to tackle the problem and regain popular support.