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Japan's tax, spending plan double-edged sword for central bank

Japan's Prime Minister Shinzo Abe attends a news conference to announce a raise in the sales tax rate at his official residence in Tokyo Oct
Japan's Prime Minister Shinzo Abe attends a news conference to announce a raise in the sales tax rate at his official residence in Tokyo Oct

By Leika Kihara

TOKYO (Reuters) - The Japanese prime minister's policy mix announced on Tuesday of giving to the economy on the one hand and taking away with the other is set to complicate life for the central bank next year.

It had already factored in an increase in the national sales tax to 8 percent from 5 percent from April 2014. Prime Minister Shinzo Abe confirmed the rise on Tuesday.

But Abe also said most of the extra revenue initially raised from the higher sales tax would end up back in the economy through a stimulus package amounting to about $50 billion, a move designed to offset the economic blow of increasing the tax.

That is likely to result in the Bank of Japan (BOJ) increasing its already rosy long-term growth and inflation forecasts, sources familiar with the bank's thinking said.

Still, the impact of the sales tax is an unknown. Economists expect it to deal an initial blow to the economy, which could easily place the BOJ under political pressure to ramp-up its stimulus yet further to ensure the economic feel-good factor - central to Abenomics - continues.

The last time that Japan raised its sales tax - to 5 percent from 3 percent in 1997 - the economy spiraled into recession. Although other factors were at play at that time, lawmakers may be jumpy next year if data shows the economy is starting to slide.

"Even with the stimulus package, Japan's economy won't be able to escape a contraction in the second quarter of 2014 after the tax hike," said Masaaki Kanno, chief Japan economist at JPMorgan Securities.

"The BOJ is highly likely to ease monetary policy in April next year to support the economy and accelerate inflation, which won't be picking up much by then."

The central bank's nine-member board will discuss the impact of the stimulus package and tax increase this week when it reviews policy on Thursday and Friday.

However, Governor Haruhiko Kuroda is likely to welcome the sales tax hike - a move he had publicly supported as a crucial first step in curbing Japan's huge public debt.

The review is widely expected to leave policy unchanged. The BOJ pledged in April to inject some $70 billion a month into the economy to try to drive inflation to 2 percent in two years.

But the board will also consider how Abe's latest policies might affect their long-term economic projections, which are due to be published on October 31.

BIG TEST

The BOJ's current forecasts point to the world's third-largest economy expanding by 1.3 percent in the business year beginning in April 2014, when the tax increase takes effect.

That in itself may be a downside risk for the BOJ because the prediction is much more optimistic than private economists in a Reuters poll, which produced a median forecast of 0.7 percent growth.

The BOJ also hopes overseas economies will pick up and boost Japan's exports, thus taking up the slack from the sales tax hike and avoiding the need for additional monetary action.

Still, for now the BOJ is likely to see Abe's stimulus plan as a net benefit compared with their previous expectations. So the central bank may raise its 2014/15 growth forecast to around 1.5 percent, the sources familiar with its thinking said.

That could slightly push up the BOJ's core consumer inflation forecast for fiscal 2015/16 from the current projection of 1.9 percent.

Japan's growth topped the Group of Seven powers in the first half of the year as Abe's reflationary policies bolstered household spending and drove down the yen to the benefit of exports.

Big manufacturers' sentiment improved sharply in the three months to September to a near six-year high, the BOJ's closely watched "tankan" survey showed on Tuesday, underscoring the bank's view the economy is on track for a moderate recovery.

While it all seems to be one-way traffic for now, the big test will come next spring and not just because of the sales tax hike.

The BOJ and Abe will know the outcome of annual pay negotiations between companies and workers. Boosting basic salaries, which have been falling for years owing to Japan's deflation, is a key element for the success of Abe's prescription of reviving consumption.

Critically next year, the outcome will also point to how much pain households will be able to tolerate from the tax hike, BOJ officials say.

(Editing by Neil Fullick)

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