Here's the flip side to Japan's higher consumption tax

The government will not achieve its goal of eliminating primary deficit by 2020 even with the tax hike.

According to Moody's, Japan’s upper house of Parliament enacted into law on Friday the consumption tax bill advocated by Prime Minister Yoshiko Noda. The agreement to raise the tax is credit positive for Japan (Aa3 stable) and is one of the first serious efforts in many years to rein in the budget deficit and thereby tackle Japan’s high level of government debt.

Here's more from Moody's:

The new law doubles the consumption tax to 10% from 5% by October 2015, with an intermediate step to 8% in April 2014. Increasing the consumption tax is essential for a number of reasons. First, it signals policy decisiveness after years of political and policy drift. Second, the tax increase seeks to make social welfare spending sustainable, which would relieve the government of having to cut social welfare benefits against a backdrop of an aging population. Third, the revenue increase is an essential component of Japan’s fiscal consolidation goal, achievement of which we consider necessary to maintain market confidence in Japanese government bonds (JGB).

However, the law also stipulates that implementation of the tax hike is conditional on Japan’s economy achieving an upturn. We have not yet seen the text of the new law and don’t know how it defines an economic upturn. The bill passed by the lower house had defined it as 3% growth in nominal GDP and 2% growth in real terms, adjusted for inflation. The last time such GDP growth prevailed was in 1991, when the asset bubble burst, suggesting a challenge to satisfy these conditions.

The government last raised the consumption tax in 1997 to 5% from 3%. Since then, general government revenue has remained steady at approximately 30% of GDP, even as government expenditures, driven by rising social welfare payments, have risen. According to the International Monetary Fund, general government debt as a share of GDP ballooned to 229.8% in 2011 from 105.6% in 1997, leaving Japan with by far the highest government debt level among advanced economies.

Failing to achieve necessary fiscal consolidation would undermine government credibility, threatening a sharp rise in JGB yields. Therefore, raising the consumption tax is an important step to maintain market confidence and ensure that borrowing costs do not rise rapidly. Market confidence in JGBs has remained strong thus far, despite the reversal in Japan’s fiscal consolidation efforts in the wake of the global financial crisis (see exhibit).

However, raising tax rates can also thwart growth, and policymakers fear a bring-forward and subsequent slowdown in private consumption and GDP growth similar to what accompanied the increase in the consumption tax in 1997. As such, supply-side measures that increase productivity and investment in the domestic economy are even more crucial for long-term fiscal sustainability.

Even with the agreement to raise the consumption tax, the government will not achieve its ultimate goal of eliminating the primary deficit by 2020 without implementing further reforms. Therefore, resolute political leadership is essential to advance a reform agenda and overcome the policy inertia and gridlock that has characterized Japan’s politics since the Koizumi administration (2001-06) succeeded in reining in the fiscal deficit before the onset of the global financial crisis. Without such progress, Japan risks reaching a tipping point where the market demands a risk premium on JGBs, making deficit financing and debt refinancing very costly.