Japan's VAT hike to drag GDP growth to 0-0.5%

Higher prices of consumer goods and services will result to consumer spending falling by 3% and will trim GDP growth by 1.8ppt.

According to DBS, VAT hikes will adversely affect growth and inflation If the VAT hike of 3ppt is implemented as planned in 2014, it should lead to a one-time boost in the prices of consumer goods and services. It is, however, unlikely to result in a full-3% rise in headline CPI inflation because of the accompanying deterioration in consumption and GDP growth.

Here's more from DBS:

We estimate consumer spending to fall by 3% in real terms, which in turn, should trim real GDP growth by 1.8ppt. The impact on growth here could be limited to 1.2ppt if household savings, which averaged 2.1% of household income over the past decade, is lowered by 1ppt.

In 2011 the IMF simulated the scenario of a total of 10ppt rise in Japan’s VAT rate. The IMF’s forecast model showed that a VAT increase of 3.3ppt per year (on a three-year horizon) cut growth by 0.75ppt annuallyf.

In summary, if the first VAT hike is implemented in 2014, we expect real GDP growth to fall to 0-0.5% during the year, versus the potential growth rate of 1%. Headline CPI inflation, on the other hand, is projected to rise to 2% in 2014 – compared to 0% without VAT hikes.

If our estimates are correct, the expected economic contraction in 2014 could increase the government’s reluctance to follow through with the second tax adjustment, 18 months later after the first tax hike. Hence, we have decided that it is premature to factor in the second VAT hike into our post-2014 growth and inflation forecasts.