By Leika Kihara
Japan must raise its sales tax again next year as scheduled, the International Monetary Fund said, even as it sharply cut its economic forecasts for the country and warned that the higher levy will take a toll on domestic demand.
The Bank of Japan (BOJ) should ease monetary policy further if inflation stalls or economic growth disappoints, though such action should be accompanied by structural reforms and efforts to boost Japan's long-term growth potential, the IMF said in its World Economic Outlook report on Tuesday.
Japan raised the sales tax to 8 percent from 5 percent in April to curb its massive public debt and pay for the rising cost of welfare for a rapidly aging population. Premier Shinzo Abe has said he will decide by year-end whether to proceed with a second tax hike to 10 percent in October 2015, after scrutinizing whether the economy can weather the pain.
"Given very high public debt, implementation of the second consumption tax increase is critical to establish a track record of fiscal discipline but is likely to take a toll on domestic demand, underscoring the importance of a pickup in confidence and investment," the report said.
The IMF slashed Japan's economic growth forecast for this year by 0.7 percentage point from three months ago, the biggest cut among advanced economies, to a 0.9 percent increase.
It also cut Japan's growth forecast for next year by 0.2 point to a 0.8 percent rise.
"The sharp economic contraction in the second quarter induced by the consumption tax increase is expected to be short lived, with a moderate pace of recovery returning thereafter," the IMF said.
Abe's aggressive monetary and fiscal stimulus, dubbed the first and second arrows of "Abenomics," helped boost business confidence by weakening the yen and lifting Tokyo share prices.
But the pain from the April tax hike pushed the economy into a severe contraction in the second quarter, with only a moderate rebound seen in July-September. There is also growing market concern over the slow pace of Abe's third-arrow growth strategies to boost the country's long-term potential.
"In Japan, more forceful structural reforms [the third arrow of Abenomics] are needed to boost potential growth and move decisively away from deflation," the IMF said, calling for steps to increase labour supply and deregulation of highly-protected agricultural and service sectors.
"The task of boosting growth is also critical in light of the challenges posed by high public debt and the need for sizable fiscal consolidation - for which a concrete medium-term plan beyond 2015 is urgently needed," it said.
The IMF also urged the BOJ to do more to enhance communication on its monetary policy, such as clarifying the indicators used to assess whether inflation is on track to meet its 2 percent target.
"This effort would also help guide expectations when a need arises to adjust the asset purchase program and facilitate preparations for eventual exit," the report said.
Under its stimulus program launched in April last year, the BOJ has pledged to double base money via aggressive asset purchases to achieve its 2 percent inflation target in roughly two years, though economists are skeptical it can do so within such a timeframe and believe more stimulus may be needed.
The central bank has said the wall of money it pumps out to the economy will heighten inflation expectations, but has not identified which indicators it looks at in gauging inflation expectations.