Tax 'Reforms' Could Worsen Japan's Economy: Blood From a Stone

Richard Katz (The Oriental Economist)

The original article appeared in the June issue of The Oriental Economist, posted here with permission of the author.

Later this month the Koizumi administration will propose a major overhaul of Japan's tax system. Even at this late date the contents are unclear, as several groups with conflicting priorities are battling.

The Ministry of Finance (MOF) is primarily concerned with closing the budget deficit. LDP politicians would like to pro-vide some stimulative tax cuts as well as some breaks for key constituents. Finance Minister Masajuro Shiokawa argues that tax cuts in the opening stages of reform should not be offset by tax hikes until a few years down the road. The effect would be a tem-porary tax cut. However, his proposal is opposed by his own ministry, which insists that any cuts be offset by hikes in the same year. And Heizo Takenaka, appointed by Koizumi to run the Cabinet Office's Economic and Fiscal Council, says the key goal is to improve the efficiency of the economy (see box).

There is a danger: in the name of tax reform, à la Margaret Thatcher and Ronald Reagan in the 1980s, consumer income and spending could take a big hit, further damaging Japan's economy. An increase in householders' share of national income is vital to ending Japan's long bout of ‘economic anorexia' – chroni-cally weak demand.

Flat taxes flatten demand

Discussion of tax changes in Japan is dominated by the question: Who will pay to clean up the financial mess? Japan's huge budget deficits, bad debts plaguing banks, chronic deficits at many semi-public corporations, and health care costs associated with an aging population all dictate that taxes will eventually go up. Garbed in arguments about efficiency, incentives, and revenue-enhancement is a political battle over who in Japan will get stuck with the bill.

The biggest flaw in the current tax discussion is that it seems to move the entire tax system in a regressive direction. Taxes would be lowered on companies and upper taxes on those who save a lot and raising taxes on those who spend a lot can only hurt consumer income and demand.

The plans are in line with international trends. But Japan's problems are different from those of other countries. The US for example has too little saving, while Japan has too much.

Japan is gradually moving away from income taxes to consumption and social security taxes. Income taxes have the advantage of being progressive by redistributing income from the well-off to the less well-off.They are also an automatic stabilizer for the economy since they fall when the economy turns down. Both features help overall economic demand.

With the tax proposals under discussion in Tokyo, Japan would lose much of this advantage when it needs it most.

Already, 38% of all national and local taxes in Japan are social security taxes, compared to an average of 25% among the other rich countries in the OECD (Organization for Economic Cooperation and Development). In 1986, 73% of national taxes came from income taxes. By 1999, it was down to 57% while the con-sumption tax provided 21% of taxes.

Tokyo wants to continue this trend. Back in 1998, Heizo Takenaka, now Koizumi's chief economist, proposed a phased-in hike of the consumption tax to 14%. In advance of the June package, the MOF's Tax Commission issued a call for a future consumption tax hike. However, neither Takenaka nor the MOF will suggest a consumption tax hike in the June package, as the economy is too weak.

Meanwhile, the corporate tax rate has already been cut from 42% in 1989 to 30% by 1999. The top national marginal tax rate on individual income over ¥35 million ($280,000) has been steadily lowered – from 65% to 50%, and now stands at 37%. Takenaka proposed eventually lowering it further to the 30% level now paid by corporations.

At the same time, Takenaka and the opposition Democratic Party of Japan (DPJ) propose lowering the minimum income level at which people pay taxes. A salaried worker with a spouse and two children with annual income of less than \3.8 million ($30,000) is exempted from the income tax. According to tax expert Andrew DeWit, this amounted to about 18% of tax filers in 1997 (many of whom were still subject to local income taxes where the threshold was lower). In the US, the minimum threshold is about $20,000. When higher costs in Japan are taken into account, the income levels are comparable. Takenaka has strongly argued for a further flattening of progressive taxes, saying earlier this year, "The progressive sys-tem for inheritance and other taxes is pretty severe and it is a natural direction to make the taxation system more flat....Are the people satisfied with the fact that a fourth or third of salaried workers are exempted from paying tax?"

Tax illusions

Proposals like Takenaka's partly rest on the misconception that Japan's tax system is already very progressive. It may be on paper, but not after deductions, exemptions and related factors are taken into account.

This issue has been explored in detail in a forthcoming article in Social Science Japan Journal by Andrew DeWit and Sven Steinmo. Japan's tax and spending system is redistributionist, these scholars say. However, it is not from richer to poorer; it is from city to countryside.

Hiromitsu Ishii, an academic economist who serves as head of the MOF's Tax Advisory Commission wrote: "In terms of effective, not statutory tax rates, the income tax system in Japan is only mildly progressive and therefore has little effect on the relative distribution of income." An OECD study cited by DeWit and Steinmo showed that in the mid-1990s the German budget (taxes and spending combined) reduced inequality of income by 35%, the American by 24%, but the Japanese by 22%.

Japan's Ministry of Health, Welfare and Labor has its own index measuring how much the tax system redistributes income, with a lower number meaning less redistribution. The index has steadily declined from 5.4 in 1981 to 2.9 by 1990 to 1.7 by 1996 and surely even lower given the 1997 boost of the consumption tax and cuts in rates for upper income taxpayers.

Hurting housing

With home construction down 30% from the 1990 peak, tax breaks for housing would be great for the economy. Yet the current tax code hurts housing.

For one thing, the 5% consumption tax is applied to a house at the point of purchase rather than being spread out. A 20% down payment on a $100,000 house turns into 25% when the consumption tax is thrown in. That prices many potential buyers out of the market. Stretching out the payment of the tax would be a simple yet helpful reform.

Moreover, unlike in the US, mortgage interest payments are usually not tax deductible (except for some temporary deductions put in as a stimulative measure in 1999.)

One current proposal would expand the size of gifts and inheritance that may be given tax-free as long as the transfer of money is used to buy a house. At present, only the first ¥5 million ($40,000) of either a gift from parent to a child or a bequest is tax free. When various deductions are considered, the amount can rise to about ¥18 mil-lion. One proposal that may appear in the June package is to raise this to ¥30 million ($240,000) as long as the money is used to buy a home. In the US, the tax-free level for inheritance is $600,000.

Real estate taxes

Japan's real estate taxes and zoning regulations keep land artificially scarce and thus land and housing prices too high. This hurts both efficiency and demand.

Property holding taxes on land are tiny. According to economist Richard Koo, when one looks at real market prices, rather than misleading statutory rates and ‘assessed val-uations', the property tax rate in central Tokyo is about 0.06% (versus a statutory rate of 1.4% on the assessed value). This com-pares to about 3% in New Jersey. Farmland gains special tax breaks. Put it all together and it's not surprising that within an hour's commute from central Tokyo almost half the land is either idle or nominal ‘farmland'.

On the other hand, according to Koo, the maximum tax rate on selling land – when all the capital gains taxes, land transactions taxes, and assorted other taxes are included – can reach as high as 80%.

The combination of low holding taxes and high capital gains taxes creates perverse incentives. There is no tax penalty for leav-ing property unused. Yet, what happens if some developer comes in, takes a risk and earns a profit? If he loses, he loses. If he wins, the Ministry of Finance can take most of the profits.

With nonperforming real estate projects standing at the heart of Japan's banking cri-sis, these perverse taxes hinder resolution.

Although some Koizumi advisers, including Takenaka, would like to correct this great distortion, there is not even an effort to do so in the June package. That's because reform would hurt two powerful lobbies: farmers and current holders of real estate.

Prospects

While a tax reform package will be announced this month, divisions are so strong that the content is still undecided. It is unlikely that the Diet will even address the package this year. Whatever is proposed this month will be subject to great changes.