Tax hike passage could perpetuate gridlock in Japan

By Scott Seaman and Stephen Majors

Many Japan watchers -- and the market -- are hoping for a breakthrough in Prime Minister Yoshihiko Noda's efforts to secure passage of a consumption tax increase. The general expectation is that raising the tax from 5 percent to 8 percent in April 2014, and then again to 10 percent in October 2015, wouldn't just be a solid step forward in addressing Japan's ballooning public debt, which is projected to reach 239 percent of GDP by year's end. It would also demonstrate that Japan's political parties are able to work through their differences to tackle tough problems in a country that has had seven prime ministers in the past six years.

But this view wrongly focuses on a narrow, short-term outcome rather than on the broader political malaise such a victory could prolong -- which, in Japan's case, is the most salient factor for long-term reforms. The passage of the tax hike is not necessarily a good sign for the country's ability to tackle its many pressing problems unless it leads to snap elections and a major realignment of Japan's sclerotic party system. The best outcome would be the failure of the tax hike measure, followed by Noda's call for a snap election; or the passage of the hike based on Noda's agreement with the opposition Liberal Democratic Party (LDP) that he would call an election in return for their cooperation. Outside of these two scenarios, the party realignment that is necessary for Japan to make deep economic reforms and boost competitiveness is very unlikely to happen.

Without major party system realignment, political gridlock on most reforms would persist, undermining medium- to long-term prospects for deeper economic restructuring. A core problem of Japan's political system is that the ruling Democratic Party of Japan (DPJ) and the LDP are both characterized by deep internal schisms over greater openness to economic competition and trade, as well as on fiscal and social welfare reform. Such internal cleavages have blurred distinctions between these parties and made maintaining party discipline and cohesion almost impossible. In addition, a "twisted" Diet (Japan's parliament) in which the DPJ controls the lower house, but lacks a majority in the upper house, allows opposition parties to block legislation with ease. The policy gridlock that often results has contributed to a loss of public support for parties of every stripe and a general sense that Japan's politics is essentially dysfunctional.

Noda has set a deadline to bring legislation for the tax hike to a vote in the lower house of the Diet before the end of the current session on 21 June. Strong opposition outside -- and inside -- the DPJ keeps the odds of enacting legislation for the hike during the current Diet session low. Despite the challenges, Noda may still find a way through threats and horse-trading to pass the increase. Numerous members of the DPJ, LDP, and other parties feel electorally vulnerable and would prefer to avoid a near-term snap election, strengthening their desire to pursue inter- and intra-party compromises. If Noda's government passes the hike without a snap election, markets will likely view this positively based on the argument that any success reduces the risk of a rise in Japanese bond yields and provides a signal that Japan's prospects for better fiscal management have improved.

But focusing on the short-term market spike in such a scenario would risk overlooking the larger implications of successful passage of the hike. Beneath it would lay the perpetuation of a largely dysfunctional status quo. Party system breakdown would be traumatic, and any realignment that follows would be fraught with uncertainty. But if it sets the stage for reform-minded politicians from the DPJ, LDP, and other parties to coalesce into a single party with a majority in both houses of the Diet, the outlook for future reform efforts would be brighter.

Scott Seaman is an analyst in Eurasia Group's Asia practice. Stephen Majors is an editor with Eurasia Group.