TCS Daily

Tokyo Courts Disaster

By Christopher Lingle - November 22, 2004 12:00 AM

A debate rages among advisers to the ruling party concerning the nature of reforms in Japan's tax regime. Unfortunately, some loud and influential voices propose the creation of new taxes or increasing the levies on income, consumption and corporate assets.

Phasing out tax cuts could be part of the tax revisions for fiscal 2005 and reflect a frantic search to raise tax revenue to help sort out Tokyo's debt-ridden finances. Another reason is to allow the state contribution to the national pension program to be raised from the current one-third to 50 percent by fiscal 2009.

According to Finance Minister Tanigaki, the government may end or reduce the income tax cuts put in place in 1999. One current tax break allows the deduction of 20 percent of income tax, or up to 250,000 yen a year, and 15 percent of residential tax, or up to 40,000 yen a year.

In 2003, the Tax Commission released a report proposing that the consumption tax rate be raised to a "double-digit figure" over the next decade. The idea behind the government's key tax panel proposal was to provide the government with revenues in order to respond to problems arising from an aging population.

In their report, entitled "Tax System Desirable for the Declining Birthrate and Aging Population," the committee addressed inequities relating to inter-generational tax burdens. Specifics include an incremental increase in the consumption tax rate from the current 5 percent to a "double-digit figure" over the next decade. At the same time, there would be a broadening of the tax base on individuals to allow Tokyo to hike social welfare spending.

Implementing these proposals would increase the overall tax burden and dampen economic activity by reducing business investments and household savings. Consider that Japan's economy recorded slow or no growth after capital-gains tax rate rose from 0% to 20% in 1990, and a national sales tax implemented in 1989 was increased during the late-1990s.

By contrast, data from Holland and Ireland as well as the US and the UK indicate that reducing the tax burden can boost growth and cause beneficial changes in the structure of the economy. In all events, high rates induce evasion and avoidance that make it harder to meet revenue targets.

Despite claims to be concerned with equity consideration, the burden of higher consumption taxes will fall heavily on those with lower incomes. Japan's indirect taxes on consumption are already 43 percent. Similar rates in the US are 7.5 percent. And low economic growth makes it likely that increases in taxes will exceed the increases in income.

In 2003, the total burden of taxes and social welfare costs imposed on citizens was over 36 percent of GDP. Factoring in fiscal deficits raised the burden ratio to over 47 percent of total income. This compares unfavorably with the average per capita tax burden of 28 percent for all member countries of the OECD.

Japan must reduce its government's budget deficits before the economy is swamped by public-sector debt that now exceeds 150 percent of GDP. It ballooned during the 1990s due to slow economic growth and large deficit spending when over a trillion dollars was on public-works projects as part of economic stimulus packages.

Future taxpayers must pay for the enormous amount of debt issued as government bonds. Yet a rapid aging population means there will be fewer workers to support them, a fact made worse by rising social-welfare costs.

It would be better to implement policies to reduce deficits by encouraging economic growth. Japan's best bet for moving the economy towards recovery is for a radical restructuring of tax policy. At the same time, there need to be further curbs on fiscal spending and more progress on approving the privatization proposals of Prime Minister Koizumi.

Japan's policy makers might consider following the example of "supply side" economics in the 1980s in the US and the UK where sharp cuts in income and corporate taxes brought higher economic growth. One element of this is portrayed vividly by the so-called Laffer Curve that indicates that permanent tax cuts can increase tax revenues when households and businesses work and invest more when granted greater control over prospective earnings. One approach might be to implement a flat tax with a low marginal tax rate to replace the maximum income tax that was recently reduced to 50 percent from 65 percent.

Instead of raising taxes, Japan's leaders should abandon the flawed and largely fruitless policy of deficit spending while implementing a permanent and radical program of tax reform. Attempts at economic stimulus based upon deficit spending packages eventually lead to rising interest rates, inflation, or both. As it is, the massive amount of increased public debt has not brought the economy back to life.

In all events, deficit spending is normally meant to address cyclical problems. It should be obvious that Japan's economy is and has been in a long-term structural slump.

Japan still has punitive rates on inheritance taxes mean that death duties reach 70 percent on estates valued over $18 million or so. At current rates, families and individuals give up about $18 billion. These sums act as a hindrance for capital formation and new investment by diverting funds from possible business expansion. This problem may become more extensive since the average age of the population is rising. At present, almost 1/3 of owners of small businesses are over 60 years old. Lowering the overall tax burden on households would encourage an increase in consumption more than passing out freshly printed money.

Recent cuts in the corporate tax rate were a step in the right direction and brought Japan a bit more into line with international standards. But there should be a permanent lowering of taxes to end the deflationary spiral that kept Japan's economy in recession. Returning funds to households and businesses would create a sustained "wealth effect" that would boost savings to provide the basis of new capital formation.

Christopher Lingle Global Strategist for eConoLytics.


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