TCS Daily

Tokyo Tax Trouble

By Christopher Lingle - February 3, 2005 12:00 AM

For most politicians and bureaucrats, so-called tax reform is a cover for them to raise taxes. And so it is not surprising that Japan's Tax Commission insists it is impossible to avoid tax increases to sort out Tokyo's fiscal problems. But it turns out that this assertion is based on logic that places the interests of politicians and bureaucrats above the interest of citizens and taxpayers.


The Tax Commission supports its recommendation for raising income taxes in fiscal 2005 by insisting that it is necessary to curb the national debt. As far as it goes, the central problem identified by the Tax Commission is correct. Japan's governments suffer from large budgetary gaps resulting from chronic shortfalls in tax revenues. For the current fiscal year, the government budgeted for general spending of 82.1 trillion yen while expected tax revenues were only 41.7 trillion yen.


By issuing tens of trillions of yen of new debt each year, the central government allowed the outstanding burden to balloon to over 600 trillion yen by the end of fiscal 2004. When the IOUs issued by central and local governments are combined, total national debt is about 160 percent of GDP, making Japan the most heavily indebted industrialized country.

It is true that the deficit will have an impact on future generations, but raising taxes is not the way to act in their interests. It would be far better to bring a halt to fiscal profligacy and politically motivated spending that inhibit Japan's long-term economic-growth potential.


Among the panel's proposals is to phase out the flat-rate cuts on the national income and the local income (residence) tax for individuals over two years, beginning in fiscal 2005, and perhaps to raise the consumption tax from 5 percent in fiscal 2007. The across-the-board income tax cuts were part of a stimulus package implemented in fiscal 1999 when economic growth was threatened by a looming bank crisis. The income tax was decreased by 20 percent and the residence tax, by 15 percent, for a combined maximum reduction of 290,000 yen per person.


The panel also favors an increase in the burden on high-bracket income earners through greater progressivity in tax rates or an increase in the estate tax. These moves are purportedly justified by the fact that Japan's progressive income tax rates are among the lowest for industrialized countries.


It would appear that members of the Tax Commission assume that government spending reflects the preferences of the community. Yet economic theory and empirical evidence suggest that spending tends to adjust to available tax revenue rather than the other way around. It turns out that government expenditures are influenced by political battles between taxpayers and interest groups that aim to benefit from higher government spending.

Unfortunately, the Tax Commission proposals move away from a borrow-and-spend approach toward a tax-and-spend approach. However, the real problem is the unwillingness of bureaucrats and politicians to curb spending. The Tax Commission lets them off the hook from making tough decisions while placing additional burdens on the private sector.


As such, the public-sector remains unreconstructed and largely immune from the adjustments forced onto the rest of the country after the asset-price bubble burst in 1990. The financial and corporate sectors were forced to improve their balance sheets, and private households have struggled to cope with the new realities.


Meanwhile, fiscal reform by central and local governments has shown scant progress. And herein lies the essential source of the problem with deficits and debt. Even though revenues disappear during economic downturns, claims on government do not. Governments tend to ratchet up tax rates during economic downturns while increasing commitments for spending during prosperity. And instead of eliminating frivolous spending on pet projects or pork-barrel items, politicians frighten citizens by insisting on cutting "essential" services.


This leads to a tendency to impose tax increases when times are bad. Unfortunately, there is no better recipe for creating the conditions for further stagnation.


And what about the impact of the proposed changes? Estimates indicate that repealing the special tax cuts will boost government revenues by only about 3.3 trillion yen. But it is likely to do more harm than good since disposable income and household spending would be substantially curtailed.


Taxes have such an important economic and social impact that politicians should not be allowed to levy them without greater democratic oversight. Left to their own devices and counsel, elected officials and their appointed bureaucrats seek new and endless ways to spend more taxpayers' money. But they are never as imaginative when it comes to finding ways to save money or cut spending.


Christopher Lingle is a global strategist for eConoLytics.


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