Tracking the Third Arrow

A sales tax debate has seemingly eclipsed economic reform in the Land of the Rising Sun. Photo by David McNew/Getty Images.

Japan has had a great few days. On Sunday, Tokyo won its bid to host the 2020 Olympics. One day later, Q2 GDP growth was revised up from 2.6% annualized to 3.8%—with long-suffering business investment the primary driver. Exciting news! Policymakers, however, kept the thrill to a minimum: Economics Minister Akira Amari simply called the news “more positive signs”—signs, that is, it’s time to hike sales taxes. And, predictably, most of the headlines took the same approach. In our view, this is emblematic of a larger issue—the sales tax debate seems to have distracted investors and policymakers from Abenomics’ third arrow, which is far more crucial to Japan’s economic future and stock returns. Without deep, concrete reforms, Japan’s economic growth likely doesn’t meet investors’ lofty expectations.

To explain, let’s step into our time machine and take a trip back to 1997. Then, Japan was in a similar boat. It had emerged from recession, business investment was rising, and with the Nagano games less than a year away, policymakers thought the economy had sufficient momentum. So, in April, they raised the sales tax from 3% to 5%. Things got ugly fast. Q2 1997 GDP fell -3.7% annualized, with consumer spending down -13.2%. The economy rebounded some in Q3 but resumed sliding in Q4 and early 1998. That’s also when deflation set in—nominal GDP has never regained its Q1 1997 high. Nominal government spending, however, is well above early 1997 levels as successive administrations have tried (and largely failed) to boost output with fiscal stimulus.

None of this is to say hiking sales taxes caused Japan’s 16 years of deflation and anemic growth. But a country with Japan’s deep structural issues needs all the help it can get—especially if policymakers do nothing to address them. A sales tax doesn’t help. It is an incremental negative for consumer spending and likely detracts from GDP, even if officials try to offset it with the fiscal stimulus package Amari suggested is in the works.

Structurally, Japan is largely as it was in 1997. It has the same problems, and despite the early-2013 Abenomics Third Arrow hype, Prime Minister Shinzo Abe and his cabinet haven’t announced many credible, actionable proposals to revive corporate Japan. June’s reform package had some encouraging measures, including free trade, health care deregulation and incentives for business restructuring, but it consisted mostly of long-term growth and investment targets—hopes, not plans. In July, Abe said he planned to announce further reforms this month—boosting hopes he would include measures left off in June—but now it seems the sales tax has taken center stage. Third arrow chatter is next to nil these days.

More worryingly, we’re seeing evidence policymakers are resting on the easy gains brought by Abenomics’ first arrow, monetary stimulus. For example, instead of reforming labor markets—including abolishing lifetime employment—to foster higher business investment, they’re seemingly relying on the weak yen to boost corporate profits so businesses can have more disposable cash. They also aren’t reducing corporate tax rates, the second-highest in the world. In other words, they aren’t addressing the reasons business investment is so weak. They’re simply throwing money at the symptoms—assuming money from quantitative easing even makes it into the real economy, which is no certainty whatsoever—and hoping they’ll go away. This strategy didn’t work when Japan tried it last decade, and it’s tough to imagine it succeeding now.

But investors’ expectations are high. Many seem to think fiscal and monetary stimulus can carry Japan through. Or they see the Olympics as a huge economic boost—both through the forthcoming construction spending and the “animal spirits” that come with hosting the games. If reality disappoints—a likely outcome absent reform—the negative surprise could weigh on Japanese stocks. Unless Japanese economic policy radically shifts course, better opportunities for long-term growth investors likely exist outside of the Land of the Rising Sun.