Japan's Prime Minister Shinzo Abe will do something on Tuesday that none of his predecessors have attempted in the past 15 years - attempt to make a dent in the government's runaway debt.
Abe, riding a wave of popularity with economic policies that have begun to stir the world's third-biggest economy out of years of lethargy, will announce that the government will raise the national sales tax to 8 percent in April from its current level of 5 percent, according to a final draft of the government’s economic plan seen by Reuters.
At the same time, Abe will take steps to soften the blow to the nascent economic recovery. As the tax increase is set to raise an additional 8 trillion yen ($81.42 billion) a year in revenue, Abe will also announce an economic stimulus package that, according to the draft, is worth 5 trillion yen.
A source involved in the process said the size of the package could increase somewhat, depending on how some corporate tax issues are dealt with.
The tax increase marks the first serious effort since 1997 to rein in Japan's public debt, which recently blew past 1,000 trillion yen ($10.18 trillion). At more than twice the size of the economy, this is the heaviest debt load in the industrial world.
The government has done little to rein in spending and is watering down the impact of the tax hike, leading some critics to doubt that Tuesday's move will be enough to get Japan on track to achieve its goal of halving the budget deficit - excluding debt service and income from debt sales - by the fiscal year to March 2016, and then balance it five years later.
“Even if Abe's policies go well, we still will not eliminate the primary budget deficit,” said senior Standard & Poor's official Takahira Ogawa.
“It will just slow the pace of growth in outstanding debt and slow the pace of budget-deficit growth, but things would still be deteriorating,” said Ogawa, the ratings firm's Tokyo-based director of sovereign ratings.
S&P could cut Japan's rating if it does not shrink its budget deficit, he noted.
Still, pressing ahead with the tax hike bolsters the image Abe has sought to foster of a decisive leader, withstanding opposition from his advisers and some of his own party.
“This plan was already in the works, but we have to give Abe some credit for following through with it,” said Hiroaki Muto, senior economist at Sumitomo Mitsui Asset Management Co.
Abe is seeking a difficult balance between massive fiscal and monetary stimulus programs to end 15 years of deflation and tepid growth while also setting the groundwork for getting the government's finances in order over time.
Financial markets have given Tokyo the benefit of the doubt; 10-year bonds are currently yielding less than 0.7 percent. However, government officials and private economists have long feared a crisis in confidence in Japan's creditworthiness could cause a crippling spike in interest rates.
The tax hike is part of a package agreed to last year by the previous government and the two current ruling parties as the first step in a doubling of the consumption tax – similar to a goods-and-services tax in other countries - over two years. The law stipulates that the government must confirm that the economy is strong enough to weather the tax hike before proceeding.
Japan posted the strongest growth among the Group of Seven powers in the first half of the year, expanding at an annualized pace of 3.8 percent in the second quarter after a 4.1 percent surge in the first. Abe chose Tuesday for the announcement as it should give him the final economic justification he needs with the release of the “tankan” survey from the Bank of Japan.
The closely watched quarterly survey is expected to show that positive sentiment outweighed gloom among Japan's big manufacturers for the first time since September 2011, according to a Reuters poll of economists.
Nonetheless, the tax increase remains an economic and political risk.
Japan entered a deep recession after the sales tax was increased in 1997 to 5 percent from 3 percent. Economists are divided on how much the hike was to blame, as the Asian financial crisis and then Japan's own banking crisis followed shortly afterwards.
Regardless of the economic impact, the tax increase became an enduring trauma for Japanese leaders after it helped end the political career of then-premier Ryutaro Hashimoto. Even the popular Junichiro Koizumi was unable to make significant headway on fiscal reform during his 2001-2006 term.
To ensure that the fiscal tightening does not derail the recovery, Abe ordered his government to compile the stimulus package to be announced on Tuesday.
It features public-works spending for the 2020 Tokyo Olympics, tax breaks to promote corporate capital spending and an early end to a corporate tax add-on that has funded reconstruction from the 2011 earthquake and tsunami, which will save companies 900 billion yen.
The stimulus could add 0.5-0.6 percentage points to economic growth in the fiscal year starting in April, but after that the impact is likely to fade away, said Sumitomo Mitsui's Muto.
The package offers some goodies to individuals, such as aid to home buyers, but with the tax breaks mostly targeting companies and the tax hike directly hitting consumers, Tuesday's steps bolster the view of critics that “Abenomics” favors corporate Japan at the expense of the little guy.
The stimulus offsets some two-thirds of the money being sucked out of the economy via the tax hike. This means the combined measures effectively resemble proposals from some of the premier's reflationist advisers, who suggested a raise in the tax rate of just 1 percentage point instead of 3, to protect the recovery.
Still, any improvement in government revenue from the tax increase is likely to be quickly overwhelmed by expenditures in a country where a rapidly ageing society and generous public services are blowing an ever-bigger hole in the budget.