Japanese Consumption-Tax Hike Could Hurt Toyota’s Profits

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Toyota Motor Corp (NYSE:TM) retained its position as the leader in global vehicle sales for the first quarter of 2014, ahead of Volkswagen and General Motors. The automaker sold 2.58 million vehicles in the January-March period, a company record that put it ahead of GM at 2.42 million and Volkswagen at 2.4 million. Toyota finished 2013 with a record 9.98 million vehicle sales, making it the car maker with the most sales worldwide for the second year in a row. This led to the company announcing that it is pursuing sales of more than 10 million vehicles this year, something no automaker has ever achieved. [1]

The surge in volumes over the quarter was helped by a rapid increase in vehicle sales in Japan. Consumers went on a vehicle shopping spree pushing sales to more than 783,000 vehicles in March, the highest monthly figure in eight years. Retail sales in Japan grew at the fastest pace in 17 years in March as consumers rushed to purchase heavy-ticket items before a hike in the sales tax, known as consumption tax, from 5% to 8% that came into effect on April 1st. This was the first hike in the sales tax in 17 years. Another hike-from 8% to 10% is scheduled for October, 2015. [2] Thus, vehicle sales for the first quarter were artificially inflated and data from the latest industry figures shows that vehicle sales following the sales tax hike have fallen to the lowest level since December 2012. Vehicle sales for the month of April fell 5.5% to 345,226. Toyota delivered the fewest number of vehicles since 2011, according to the industry figures. The slump is expected to deepen in May as the delivery of many orders made before April 1 was delayed due to poor weather conditions. [3]

Economy Slowdown Expected

Japan is in the process of implementing a three pronged program to revive its flailing economy. The three prongs involve changes in fiscal policy, an expansionary monetary policy and structural reforms to improve investor sentiments. The economy is going to receive money supply injections through a stimulus package, which the Japanese Government wants to finance with an increase in tax-receipts, instead of issuing Government denominated bonds. It is against this background that the sales tax hike comes. The worry for Japan is that several incentives offered by the Government to corporations, such as a plan to cut corporate taxes, to increase the wages of worker, pay-increases have been minimal. [4] With households already impacted by rising costs of living, the net effect of the sales tax hike is likely to be a contraction in the economy. According to a group of economists polled by Bloomberg, the economy is expected to contract by 4.5% over the next quarter. [5]

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It is clear that the government wants corporations to start increasing investment by giving them access to cheap capital. However, this assumes that the new capital will be able to find profitable opportunities in which to invest. If the economy contracts as a result of consumers becoming more cautious in spending as a result of prohibitive taxes, corporations might shy away from investing in the economy thereby reinforcing the same cycle.

The Impact of Consumption Tax on Vehicle Sales

The most immediate effect of sales tax will be an increase in the average price of vehicles. This will occur because automakers will have to pay more for the products they buy, including vehicle parts and raw materials. The higher cost of goods will translate into higher prices for new products. This rising price from sales tax will force companies to reduce supply at existing prices, reflecting the fact that they can now produce less for the same amount of money. Besides altering the price, sales tax will also impact consumers’ buying power. When sales tax rates are high, consumers spend more money on taxes and have less to spend on additional goods. This should drives down demand or force automakers to reduce prices to keep demand steady.

The extent to which the increase sales taxes impact supply and demand depends on how automakers incorporate sales taxes into their pricing structures. They may choose to leave prices where they are and simply accept lower profits. They can also choose to pass these taxes along to customers through increased prices, which is likely to result in a decline in the number of vehicles sold.

The impact should not be limited only to reduced sales numbers in Japan. About 50% of Toyota’s manufacturing is done in Japan, so a rising cost of production will affect international sales too. Additionally, given Toyota’s reluctance to invest its cash in building factories in China and North America, reduced profitable opportunities in Japan might mean that the company has to return the cash to shareholders. [6]

We have a $128 price estimate for Toyota, which is about 15% higher than the current market price.

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Notes:
  1. Toyota Sells 2.58 Million Vehicles, Outselling GM, ABC News, April 2014 []
  2. Japanese Consumption Hangover Begins As Car Sales Decline, Bloomberg, May 2014 []
  3. Japan’s Worst Auto Sales In 16 Months Show Hangover Begins, Businessweek, May 2014 []
  4. Why An Extra $26 A Month May Decide Fate Of Abenomics, Financial Times, March 2014 []
  5. Abe Orders Japan’s First Sales-Tax Increase Since ’97, Bloomberg, October 2013 []
  6. Toyota Making Drastic Production Cuts After Japan Quake, Tsunami, CNN, April 2011 []