Asia Economy

Risks to 'Abenomics' growing, whether Japan PM raises tax or not

Shinzo Abe, Japan's prime minister.
Tomohiro Ohsumi | Bloomberg | Getty Images

If history is a guide, a string of disappointing economic reports in Japan would seem to argue against raising the country's sales tax again. But the risks for "Abenomics" are increasing whatever Prime Minister Shinzo Abe decides to do.

A recovery in the world's third-biggest economy is faltering, despite Abe's massive monetary easing and government spending over the past 21 months, and Japan may already be sliding into recession just as Abe must decide whether to raise the tax once again.

The damage from an April tax hike has been worse than expected and worse than an increase in 1997, which began a tailspin that ended the career of the then prime minister.

At the same time, delaying the tax hike is looking riskier. Some economists, investors and business people say it could spook financial markets already worried about Japan's commitment to curbing its runaway government debt.

Read MoreJapan economy still struggling with tax hike, data show

"If they don't go ahead with it, that will shake confidence in Japan's finances to some degree," said Takao Yasuda, chief executive of discount retailing giant Don Quijote Holdings.

"People would interpret it as evidence of just how weak the economy is," Yasuda told Reuters on Tuesday. "If you ask me, it would be better to raise it to 10 percent soon and get all the negative factors out there."

Economists generally expect Abe to decide by year-end to proceed with a longstanding plan to raise the tax to 10 percent next October. That would complete a two-stage doubling over 18 months in a bid to rein in a debt that is over twice the size of the economy, the heaviest in the industrial world.

Abe raised the tax in April to 8 percent from 5 percent and says he will decide on the next step based on his judgment of whether the economy is strong enough to withstand another blow.

Read MoreJapan business sentiment improves: September Tankan survey

In fact, the economy may already be shrinking. The Bank of Japan's tankan survey on Wednesday showed that while sentiment has ticked up for big manufacturers thanks to a weaker , service companies were markedly less confident, highlighting prolonged weakness in domestic demand..

This followed data on Tuesday showing an unexpected drop in factory output for August and a deeper drop than expected in household spending, the fifth decline in a row.

The economy shrank by an annualized 7.1 percent in April-June, more than twice as steep as in 1997, when then-premier Ryutaro Hashimoto raised the sales tax.

It is expected to claw back 3.6 percent in the July-September quarter, a Reuters poll forecast before the latest bleak data, a bigger bounce than 17 years ago but only because the drop was deeper this time.

Japan still adjusting to tax hike impact: Pro

Hashimoto's recession was compounded by the start of the Asian financial crisis, but that will be scant comfort to Abe as he decides whether to hike again.

Delaying the tax hike carries its own risks, given the need to control the debt as the rapidly ageing population makes budget-balancing ever more difficult. The government promises to balance the budget - net of new bond sales and debt servicing - by 2021, which already looks ambitious.

The impression that Abe is losing his nerve on fixing Japan's debt problem could undermine the very confidence that has underpinned the early success of Abenomics.

"It's an extremely tough decision. Delaying the tax hike by, say half a year, may be one option. But then, there's no guarantee the economy will improve by then," said Koichi Haji, chief economist at NLI Research Institute.

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"Proceeding with the tax hike despite a weak economy is also politically risky with nationwide local elections looming early next year," he said. "It's a huge dilemma for Abe."

The main scenario among economists is for Abe to press ahead with the tax hike while ordering more government spending to bolster growth to soften the blow, perhaps joined by the Bank of Japan expanding its already massive monetary stimulus.

Confidence shaky already

More important is the potential impact on confidence.

"If the second tax hike is shelved and Japan's fiscal sustainability is questioned, that could cause unpredictable events such as a market turbulence," said economist Naoki Iizuka at Citigroup Global Markets Japan.

Read MoreJapan's core consumer prices rose 3.1% in August

"Maintaining fiscal sustainability is crucial when Japan's ability to finance its own debt is waning due to the smaller current-account surplus and persisting trade deficit."

BOJ head Haruhiko Kuroda has called on Abe to raise the tax as scheduled, warning that while the risk of a market backlash is slim for now, it would be hard to control if it erupted.

A delay could also complicate Japan's economic diplomacy within the Group of 20 big nations. The International Monetary Fund in July said Tokyo should press on with the tax hike and take further measures to lower the public debt burden, as well as accelerate structural reforms.

But if growth continues to stagnate, Abe may struggle to sell the tax hike to some members of his Liberal Democratic Party, who fret about the damage to regional areas of Japan ahead of nationwide local elections early next year.