Japan, whose national debt topped one quadrillion yen (that’s 15 zeros) in the second quarter, is trying to fix its fiscal mess through sales tax increases. But one year after the legislation and six months before implementation, the Liberal Democratic party government of Prime Minister Shinzo Abe is having second thoughts.

After all, similar moves in 1997 played a role in pushing the country back into recession when the economy was enjoying what appeared to be a promising recovery from the bursting of a major asset-price bubble in the early 1990s.

The world’s third-largest economy has increased borrowing this year to spend more on the infrastructure as part of an ambitious plan to jump start the economy and end decades of stagnation. Today, Japan’s gross public debt is by far the highest among advanced economies, standing close to 240 percent of GDP.

The International Monetary Fund estimated that if the sales tax were not increased, Japan's net public debt would rise to around 245 percent of GDP by 2030, compared with 210 percent if the tax hike was implemented as scheduled.

By raising the sales tax from 5 percent to 8 percent next April, then again to 10 percent in October 2015, the goal is to halve Japan’s primary budget deficit (excluding interest payments) by 2015 and bring it into surplus by 2020.

So far, the Japanese economy has responded well to “Abenomics” since Shinzo Abe took office in December 2012.

Both first-quarter and second-quarter GDP growth have been revised up on Sept. 9. Real GDP grew 4.1 percent quarter-on-quarter in the first three months of this year and 3.8 percent in the second quarter. Private consumption and net export were the main contributors to growth in the first half.

Headline inflation moved back into positive territory in June and continued to rise in July -- a solid step toward overturning more than a decade of deflation in Japan. Excluding fresh food, core inflation stopped declining in May and picked up to an annual rate of 0.7 percent in July, its highest level in almost five years.

Jobs data has continued to improve since June. Unemployment rate declined to 3.8 percent in July from 4.1 percent in March, and the jobs-to-applicants ratio rose to 0.94 from 0.86 during the same period.

Industrial production has bottomed out and is showing tentative signs of recovery. The year-over-year decline in the three-month moving average narrowed to 1.4 percent in July from 8.0 percent in February. Production and orders of electrical machinery and electronic parts have shown recent signs of recovery, and the auto sector is recovering.

Raising the sales tax would be a clear first step towards fiscal consolidation, a key component of the long-term growth strategy, the so-called “third arrow” of Abenomics. However, such a move, if not handled well, could also plunge the economy into contraction, damaging an effort to end 15 years of deflation.

Then vs Now

Japan’s public debt issuance has mounted since 1992 as fiscal policy has been under increasing pressure to boost the faltering economy. The government decided to hike the sales tax to 5 percent from 3 percent in an effort to improve the debt position.

To pre-emptively offset the potential negative impact of the hike, the government cut income taxes for the three preceding years. As the economy started to recover on the back of fiscal stimulus measures (real GDP grew 0.9 percent, 1.9 percent and 2.6 percent between 1994 and 1996, after just 0.2 percent in 1993), the Ryutaro Hashimoto government -- which was strongly committed to fiscal consolidation -- decided in 1996 to implement the hike, effective in April 1997.

The 1997 increase coincided with the peak in Japan’s economy, as well as the Asian financial crisis. After the government raised the consumption tax to 5 percent April 1997, the economy sank into recession. “The downturn would last for over a year and a half, helping deflation take root in Japan,” said Betty Rui Wang, an economist in Hong Kong at Standard Chartered. Hashimoto resigned in July 1998.

Similarities between now and 1996, when the government made a final decision to hike the sales tax, are frequently cited by opponents of another hike. Strong GDP data convinced the government back in 1996 that the economy was ready for a sales tax hike. The Abe government now faces a similar question: whether the economy is strong enough to withstand such a hike in 2014.

Wang acknowledges the similarities between now and 1996, but points to more differences.

The deteriorating fiscal situation and heavy government bond issuance have led to mounting concerns about Japan’s fiscal stability and solvency in recent years. “Any indications that the government is unwilling to address this issue could threaten the current low-interest-rate environment and lead to an eventual debt crisis,” Wang said.

One of the mistakes the Hashimoto government made was to roll out the tax hike along with a withdrawal of existing stimulus measures. Pushing ahead with a fiscal consolidation plan at a time when deteriorating confidence in the economy was already apparent also didn’t help. By comparison, Abe has committed to using fiscal policy flexibly.

Another big difference between the two periods is the Bank of Japan’s current ultra-loose monetary policy stance. The policy rate remained unchanged at 0.5 percent throughout 1996 and 1997, when the government decided to pursue fiscal consolidation. In contrast, in April of this year, the Bank of Japan launched a massive asset purchase program to lift inflation and boost the economy. Central bankers said they are ready to ease again if risks to growth exceed their expectations and derail the path toward achieving 2 percent inflation in two years.

The international environment today is also vastly different. The impact of the Asian crisis on regional financial markets magnified the negative impact of the 1997 sales tax hike. But according to Wang’s analysis, Asia’s fundamentals are significantly stronger now, suggesting a better growth outlook for the region.

Abe ordered his government on Tuesday to craft measures to counter the economic drag of a tax increase -- a sign that Abe is moving toward the tax increase. Abe will make a final judgment Oct. 1 (after examining a Bank of Japan tankan business sentiment survey) on whether to go ahead with an increase in the levy, Japan's Kyodo News Agency reported Monday.