Lessons from Japan's 'Lost Decades': The pitfalls of consumption tax

Editor's note: The ongoing discussions about Japan's "Lost Decades," a period of prolonged economic stagnation spanning 30 years, have sparked debates on whether Japan indeed lost momentum for three decades, the reasons behind it, and the potential takeaways for China. In June 2023, Professor Zhou Muzhi from Tokyo Keizai University delivered a lecture in Shanghai, offering a novel and comprehensive perspective on how Japan missed out on the prosperity driven by Moore's Law. The initial segment of his lecture focused on analyzing the adverse impact of the consumption tax.

1. Japan as No. 3

The title "Lessons from Japan's 'Lost Decades' for China" encompasses three key points. Firstly, there's the debate over whether Japan truly experienced the "lost decades" spanning 30 years. Some argue that this notion is misleading, asserting that Japan didn't actually lose three decades, whereas more people believe that Japan not only lost three decades but might also continue to face challenges in the future. Secondly, the discussion revolves around the factors that contributed to Japan's "lost decades," leading to a wide range of viewpoints. Lastly, there has been a heated discussion on whether China could potentially find itself in a situation of prolonged economic stagnation similar to Japan's.

From 2007 to 2009, I was in Boston, where I had frequent talks with professor Ezra F. Vogel of Harvard University. He was then working on the book, "Deng Xiaoping and the Transformation of China," which made him famous among the Chinese readers. Actually, he was also well-known in Japan, largely due to his book "Japan as Number One: Lessons for America," which heightened Japanese confidence following a period of rapid economic growth.

In 2009, Xinhua News Agency organized a dialogue between Professor Vogel and me, and subsequently published an article on the event. Notably, the Japanese edition of Newsweek magazine later featured a cover story titled "Japan as No. 3." This emphasis on our dialogue stemmed in part from the significant news of China surpassing Japan to become the world's second-largest economy.

A decade later, coinciding with the abdication of Emperor Akihito and the conclusion of the Heisei era in 2019, Newsweek produced a special issue titled "Looking at Heisei Through Newsweek." The Heisei era spanned from 1989 to 2019, encompassing 30 years. Over this extensive period, Newsweek published a total of 1,500 issues. This special edition meticulously selected representative articles from this vast archive, offering insights into and defining Japan's Heisei era.

2. Lessons from Heisei Era: The Japanese concept of impermanence

This special edition is structured into three segments, representing the three decades of the Heisei Era. In the final decade, only three articles were selected. Among them was our dialogue with Professor Vogel titled "Japan as No. 3," another delved into the aftermath of the "3.11" earthquake and nuclear disaster, while the third explored the enduring cultural legacy left by Hayao Miyazaki on the global stage. As a concluding note, the chief editor penned a thought-provoking commentary titled "Unveiling the Notion of 'Impermanence' in the Heisei Era."

The chief editor believed that a series of unforeseen events marked the beginning of the Heisei Era - ranging from the bursting of the economic bubble to shifts in political power, the "3.11" earthquake and its nuclear aftermath, and the gradual loss of Japan's economic prominence to China. These unprecedented events, accompanied by their resulting catastrophes, upheavals, and a prevailing sense of loss, underscore the profound "impermanence" that defined the Heisei Era.

The changes in the global corporate market values rankings further underscores Japan's decline over the Heisei Era. At the dawn of Heisei Era, seven Japanese companies were among the top 10 in market capitalization, with the top five being all Japanese enterprises - a period of remarkable Japanese economic supremacy.

Yet, by the year 2019, as Japan transitioned out of the Heisei Era, none of Japan's companies remained in the top 10 global corporate market value rankings, and instead, two Chinese firms, Alibaba and Tencent, took their place among the top contenders.

The top 50 global corporate market values ranking reveals a startling statistic: in 1989, a total of 32 Japanese companies were featured. However, by 2019, only Toyota maintained a presence in the top 50, while eight Chinese companies had surged into the ranks. As of today in 2023, five Chinese companies have secured spots in the global corporate market values ranking. Meanwhile, Toyota, which is the sole representative from Japan, has fallen in the rankings and is at risk of dropping out of the top 50.

Considering these changes, it's clear that Japan has indeed felt a significant sense of decline.

3. Japan has truly experienced three decades of decline

If we divide the past 60-plus years since 1960 into two 30-year periods, with 1990 as the dividing point, we can see distinct shifts in Japan's trajectory. The first 30 years, from 1960 to 1990, were characterized by consistent growth. Japan's economic expansion consistently outpaced the average of the OECD, a group of developed countries. During this period, Japan's share of the global GDP doubled from 5.4% to 10%, reaching its peak.

However, the subsequent 30 years was a complete different story. In 1992, Japan transitioned from being an exemplary performer within the OECD to a lagging player. Its economic growth rate consistently fell below the OECD average. In other words, Japan's stagnation stood out starkly among developed nations, representing a prolonged and structural challenge that persisted for three decades without a turnaround. Over the past 30-plus years since 1990, Japan's global GDP share dwindled from 10% to today's 5.1%, even dipping below levels from 60 years ago. This downward trend still continues.

Without a doubt, Japan's later three decades can be labeled as "lost decades," debunking any notion that it's a false premise. So, what are the reasons behind this prolonged stagnation? Many have offered explanations, some more convincing than others. From the vantage point of someone who has lived in Japan for over 30 years, continuously observing its socio-economic landscape from both broad and intricate perspectives, if I were to highlight three key reasons, they would be the consumption tax, the small constituency system, and a prevalent aversion to taking risks.

4. Consumption tax has drained vitality from Japan's economy

This tax has been a subject of contention among Japanese leaders spanning several generations since 1970, and its implementation came at the cost of multiple administrations, gradually increasing the tax rate to 10%.

In 1979, Prime Minister Masayoshi Ohira first introduced the concept of "consumption tax," which resulted in the Liberal Democratic Party's defeat in the elections and compelled the abandonment of the proposal. In 1987, Prime Minister Yasuhiro Nakasone attempted to introduce the concept of "sales tax" but faced strong opposition and setbacks. In 1989, the forceful Prime Minister Noboru Takeshita imposed a 3% consumption tax, only to resign a month later due to mounting pressure. Five years later, in 1994, Prime Minister Morihiro Hosokawa, buoyed by immense popularity, proposed the concept of "National Welfare Tax" to raise the consumption tax rate. However, the proposal encountered much greater opposition than expected, leading to its withdrawal and his resignation. In 1997, Prime Minister Ryutaro Hashimoto raised the consumption tax rate to 5%, eventually costing him his position. In 2009, the Democratic Party came to power with the pledge of "no increase in consumption tax for four years," marking a change in administration. The consumption tax rate was increased to 8% in 2014 and further raised to 10% in 2019 under Prime Minister Shinzo Abe's administration. The reasons behind Abe's ability to raise the consumption tax twice without losing power will be discussed in subsequent sections.

What force compelled successive generations of Japanese politicians to champion the implementation of the consumption tax? This tax was strongly advocated by the Ministry of Finance. Without the backing of this powerful government agency, no political leader could maintain the continuity of their administration.

The name "consumption tax" itself was a "Trojan horse conspiracy." Having spent time as a visiting researcher at the Institute for Fiscal and Economic Policy in the Japanese Ministry of Finance, I gained insights into the ministry's dynamics. In my perspective, the Ministry of Finance's greatest post-war blunder was the introduction of consumption tax. The term "consumption tax" should rightly be referred to as a "transaction tax." Unfortunately, the misleading name led people to believe it is only related to purchasing. While generating public resentment, it seems to have little negative effect on production. Actually, the consumption tax applies not only to consumption but also to transactions within the production process. So, I'd rather call it a transaction tax.

The misleading "consumption tax" have led the Japanese society to underestimate its harmful impact.

The first chapter of the economics classic "The Wealth of Nations" discusses division of labor. Adam Smith considered division of labor the foundation of modern society and a key factor in boosting productivity. Today, it's universally acknowledged that advancing a society hinges on expanding, refining, making fairer, and globalizing its division of labor. Yet, Japan's consumption tax has cast a shadow on the development of division of labor within its society. Achieving a 10% profit in business is no simple feat, and the substantial consumption tax levied on each transaction severely impedes the growth of Japan's division of labor and social vitality.

Indeed, the consumption tax could be likened to a "tumor" that systematically hinders Japan's economic growth. Since its introduction in 1989, the Japanese economy has been on a downward trajectory.

5. Excessive emphasis on risk aversion constitutes the biggest risk

Another factor that has contributed to the prolonged stagnation of the Japanese economy is an excessive emphasis on risk aversion. I have had extensive interactions with the Japanese business community and have served as an independent director and advisor for companies listed on the main board in Japan. If I were to define the operating style of Japanese companies in one phrase, it would be "risk avoidance."

Japanese corporate leaders often seek to thoroughly understand, eliminate, or mitigate all potential risks before making decisions. Compared to entrepreneurs in China and the U.S., Japanese business leaders have a particularly strong risk-averse mindset.

This mindset is not limited to business leaders but is also prevalent in the Japanese government. However, things often turn out to be counterproductive.

Reflecting on the first year of Heisei Era, or the year 1989, we can see that among the top 10 global companies by market value, there were five Japanese banks: the Industrial Bank of Japan, Sumitomo Bank, Fuji Bank, Dai-Ichi Kangyo Bank, Mitsubishi Bank. These banks were among the highest-valued financial institutions globally at that time. Despite this, the Japanese government was concerned that their size was insufficient to cope with future global financial competition. They insisted on expanding the scale of these banks to make them capable of standing firm in the face of global financial storms.

As a result, an unprecedentedly massive wave of bank mergers was initiated by the government. Every bank on the top 10 list underwent these forced mergers. However, the outcome after 30 years was that Japanese banks not only vanished from the top 10 global market value list but were also absent from the top 50 list.

These forced mergers, often involving mismatched corporate cultures and personnel factions, resulted in internal conflicts outweighing the benefits of synergies. For instance, the Mizuho Bank, which was formed after the merging of the Industrial Bank of Japan, Fuji Bank, and Dai-Ichi Kangyo Bank in 1999. Since the merging, it has encountered frequent system failures even today due to the inability to effectively integrate their systems.

Therefore, excessive emphasis on risk aversion can ironically become the greatest risk itself.

(The author is a professor at Tokyo Keizai University.)