Japan’s Ruling Coalition Considers Eliminating Consumption Tax on Food

Prime Minister Sanae Takaichi announced that she will dissolve Japan’s lower house and has called a snap election for February 8.

A key factor in gauging the economic outlook after the election is that the ruling Liberal Democratic Party (LDP) has said it is considering eliminating the 8% consumption tax rate on food for two years, as part of its coalition agreement with the Japan Innovation Party. Opposition parties have also pledged to lower or eliminate the consumption tax rate.

On the one hand, by eliminating the consumption tax on food, tax revenue would fall by about ¥5 trillion ($31.7 billion) a year. Although the Takaichi administration has been aiming for what the prime minister calls "wise spending", which combines fiscal efficiency and fiscal discipline, a move to suspend the consumption tax would run the risk of heightening fiscal concerns.

On the other hand, the policy would boost real GDP during this period. But this would not necessarily lead to an increase in potential growth (see Figure 1). Without an acceleration in potential growth, the government would have to think hard about whether tax revenues would rise enough to offset the ¥5 trillion in lost consumption tax revenue — and whether this would constitute “wise spending”.

Will the kite become detached from its string?

If the consumption tax rate were to be temporarily eliminated, we think this might cause the yen to weaken regardless of US/Japan interest rate differentials.

Normally, USD/JPY acts like a kite and US–Japan interest rate differentials act like its string. BOJ monetary policy controls the string to move the kite. However, if fiscal instability were in some way to affect investor behavior, the kite might become detached from its string and move in an unpredictable way (yen depreciation).

We estimate that cutting the consumption tax rate on food to zero would lower CPI inflation by as much as 1.5%. However, a weakening yen could wipe out a considerable portion of the downward pressure on inflation.

Potential post-election scenarios

We think the main post-election scenarios will revolve around:

• fiscal policy
• forex reactions
• the economy and prices
• the BOJ’s policy response

The current fiscal policy conduct of Takaichi’s minority government has had to take into account the stance of the LDP’s coalition partner and opposition parties — including temporary cuts to the consumption tax rate for food — as well as forex reactions. Therefore, we cannot ignore the possibility that the scenarios inside the dotted lines in Figure 2 might become reality. In these scenarios, the terminal rate (the BOJ policy rate at the end of the rate hike cycle) could exceed the neutral policy rate for the real economy, which could make monetary policy more restrictive and lead to a slowing of the economy.

Of course, with the outcome of the general election still unknown, it is not possible to favor one scenario over another.

A new focus

The BOJ has said, with regard to how it conducts monetary policy, that if its outlook for economic activity and prices is realized, it will “continue to raise the policy interest rate and adjust the degree of monetary accommodation”.

This suggests that the focus of its policy rate control is on the economy and prices, and that improvements in the economy and prices are needed for a rate hike. It also suggests that the next rate hike will be aimed at adjusting monetary easing rather than tightening monetary policy and, because of this, it is highly likely that the neutral rate would be the same as the terminal rate.

However, given the risk of expansionary fiscal conduct with a short-term horizon — specifically, cuts to the consumption tax rate and a subsequent fall in the value of the yen — we should instead assume the following:

1. Exchange rates and fiscal conduct will have a bearing on policy rate control, in addition to the economy and prices.
2. Yen depreciation and expansionary fiscal conduct will trigger rate hikes as well as improvements in the economy and prices.
3. Depending on exchange rates and fiscal conduct, it might be necessary to tighten monetary policy rather than simply adjust the degree of easing.
4. Given this, the terminal rate might go above the neutral rate.

The fourth point is of particular importance.

Potential for more rate hikes

The focus of policy rate control had been on the economy and prices, so we had forecast that there would be no rate hikes in 2026, two rate hikes in 2027, and a terminal rate of 1.25%, which is close to the bottom of the range for the neutral rate of interest.

However, considering the risk of further yen depreciation and fiscal policy conduct with a short-term focus, we now see potential for two rate hikes in 2026 if the BOJ were to change its basic monetary policy stance to one with the characteristics of points 1 to 4 above. In addition, these rate hikes would not just bring forward hikes that would have happened anyway (in which case the terminal rate would be unchanged) but would constitute additional rate hikes (in which case the terminal rate would rise).

In this scenario, we see the possibility of three or four additional rate hikes between now and the end of 2027. As a result, the terminal rate might clearly exceed the lower limit of the neutral rate of interest.